Monday, April 21, 2008 and Patrick Byrne: Anatomy of a Stock Market Manipulation Scheme – First Quarter Earnings Release

On Friday, in a surprise announcement, (NASDAQ: OSTK) released its first quarter fiscal year 2008 earnings report and highlighted in the very first line of’s “Key Q1 2008 Metrics” was’s much hyped increase in first quarter revenues:

Total revenue: $200.7 million vs. $157.9 million (a 27% increase)

In the hours that followed’s surprise earning release, the company’s common stock climbed from an opening price of $14 per share to $18.47 per share, a $4.47 climb in the price of the company’s shares or a whopping 31.93% single day increase.

If this revenue increase were actually sustainable, the market reaction would have been justified. But as I will describe below, the Overstock news release was materially and significantly misleading in violation of SEC Rule 10b-5. Of all the many accounting and disclosure issues I have described in this blog over the past year, Overstock's Friday release was by far the most significant, the most blatant, and most damaging to investors and the integrity of the market.

An analysis of their public filings indicates that the actual revenue increase was significantly lower. As will be described below, I believe that this blatantly misleading news release was intentionally timed with expiration of options to manipulate the market (i.e., as a "short squeeze") and to bury and downplay grave news of a criminal investigation in California.

As the criminal CFO of Crazy Eddie Inc., I learned to always accentuate positive news in company press releases and to do my very best to bury any mention of negative news that may cause the stock price to drop. As a good friend Barry Minkow once said, “Financial reports are like icebergs. 90% of its mass is under the surface.” Today, both Barry Minkow and I teach fraud detection seminars to law enforcement, the accounting profession, and Wall Street. One of our most important lessons is to always read financial information from the bottom to the top and to cross check company disclosures.

Working your way up from the bottom

Two questions need to be addressed:
  1. Are these numbers genuine?
  2. Why did, without prior notice, suddenly release what seemed to be on its face very good news for the company, earlier than expected?
Let’s address these questions one by one.

First, are these numbers genuine?

In its earnings release, left out certain key disclosures in an apparent effort to hype its first quarter fiscal year 2008 financial performance.

As detailed above, reported that revenues for Q1 2008 were $200.7 million compared to $157.9 million in Q1 2007 or a 27% increase in revenues. However, in its earnings release, failed to disclose that it compared Q1 2008 revenues reported on a GAAP basis to Q1 2007 revenues that were reported on a non-GAAP basis.

In December 2007, as part of its continuing investigation of, the Securities and Exchange Commission required the company to report its revenues in compliance with GAAP. In previous blog items, (here and here), I detailed how had intentionally departed from GAAP and its own disclosures in reporting revenues dating back at least to fiscal year 2000, in violation of Securities and Exchange Commission Staff Accounting Bulletin No. 99.

At the end of the forth quarter of fiscal year 2007, made a one-time catch up adjustment to revenues and other related items to bring its financial statements in compliance with GAAP. In a previous 8-K report, claimed that $13.7 million of revenue and $2.1 million of net income shifted from Q4 2007 to Q1 2008 as a result of the SEC imposed revenue recognition change to comply with GAAP, and that likewise offsetting amounts would be shifted out of Q1 2008 to Q2 2008. However, by failing to restate its Q1 2007 financial reports, we cannot determine the comparability of Q1 2008 versus Q1 2007. We simply don’t know what Q1 2007 would have looked like if it had been reported in accordance with GAAP.

Not only is this a problem for investors, but it is also another violation of GAAP.’s failure to restate prior year’s financial reports for accounting errors is in violation of paragraph 25 and 26 of Statement of Financial Accounting Standards No. 154. According to Statement 154,’s prior year first quarter revenues and related items must be restated if the company elects to compare it to current period results.

According to an article in the CPA Journal by Robert Bloom and Jayne Fuglister, under SFAS 154:

The nature of an error must be disclosed, as well as the effect on the current and prior periods presented. In addition, if an error affects the current or prior periods presented or is expected to affect subsequent periods, the entity must disclose that comparative information has been restated, the effect of the correction by line-item and per-share amounts for all periods presented, and the amount of the adjustment to opening retained earnings. makes no such disclosures in its earning release, making comparisons impossible, and violating GAAP in the process. So why didn’t report restated data? We can’t say for sure. But in my experience companies rarely omit disclosures by accident.

Has a turnaround really occurred?

In a letter to investors, contained in’s earnings release, CEO Patrick Byrne claimed:

We returned to above industry-level revenue growth this quarter, capping off our turnaround plan that started with growth in contribution and gross profits over a year ago. The combination of an expanding top line, gross profits and contribution dollars, along with declining fixed costs, is generating operating leverage in our business. [Emphasis added.]

Did really return to “above industry-level growth” in the company’s first quarter of fiscal year 2008 as touted by Patrick Byrne? The short answer is no. As described in more detail below,’s first quarter revenue growth was helped by several material factors undisclosed in the company’s press release (no surprise) and in the process it violated SEC Rule 10b-5. Before we continue, let's examine Rule 10b-5:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security. [Emphasis added.]

By omitting material and significant information, described in more detail below,'s earning release violates SEC Rule 10b-5 by misleading investors in a deliberate effort to drive up the market value of the company's stock and squeeze short sellers. violates Rule 10b-5 by omitting material facts from its earnings release

During Q1 2008, disproportionately benefited from the arrival of an early Easter season and an extra shopping day due to the leap year not present its recent two fiscal year first quarters.’s previous two fiscal year first quarters did not include high volume Easter holiday sales. The leap year benefit was also absent in prior years. In addition, the arrival of Easter at the tail end of Q1 2008 (March 23), provided a disproportionate bump to cash flows.

In addition, most of’s touted growth in revenues for Q1 2008 compared to Q1 2007 resulted from the fact that Q1 2007 revenues had declined substantially in comparison to Q1 2006, creating an inordinately low revenue base to “improve” upon.

Since did not restate prior year’s revenues as required by SFAS 154, we need to examine other financial disclosures by to determine if the company has really returned to “industry level growth.” I’ll examine’s non-GAAP sales volume disclosures. Consider the next table below (Click on image to enlarge):

Two things stand out in the above table. While total sales volume increased 25.06% in Q1 2008 compared to Q1 2007, unlike Q1 2007, Q1 2008 benefited from high volume Easter holiday sales and an extra shopping day due to a leap year. In addition,’s Q1 2007 sales volume had dropped 16.2% in comparison with Q1 2006, creating an inordinately low sales volume base for the company's hyped up resumption of “industry level growth” in revenues.

Since the drop in Q1 2007 sales volume compared Q1 2006 created a low base of comparison with Q1 2008, we should instead compare’s Q1 2008 sales with Q1 2006. By this comparison,’s Q1 2008 sales only grew 4.76% compared to Q1 2006, hardly the return to “above industry-level growth” as hyped by Byrne. On an annualized basis, this is barely above 2% growth.

Now consider the fact that this 2% annualized growth rate was made possible only because of high volume Easter sales. Q1 2006 did not receive this benefit, nor did it receive the benefit of an extra shopping day due to a leap year.

By failing to disclose the material information above,'s earnings release violates Rule 10b-5 by omitting "a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading."

Auction volume falls substantially

On January 10, 2008, Patrick Byrne congratulated’s Auction Community posting a letter on the company’s discussion board:

Dear Auction Community,
You made it. This experiment, this alternative to eBay, has pulled through. That only happened because of a lot of faith and trust from you, the community, as well as a lot of hard work from people inside the company whom most of you will never meet. As hard as you worked, and as much patience as you exhibited, you should know that a group here really coughed up lungs to make this work on your behalf. And now, it has. In 2007 it paid for itself, and even left a few sheckles over. And things look better and better from here. [Emphasis added.]

Contrary to Byrne’s statement, Q1 2008 results paint a very different picture. Auction gross merchandise volume declined steeply from $8.1 million in Q1 2006, to $4.7 million in Q1 2007, and only $2.6 million in Q1 2008. With this kind of dismal performance, it’s hard to see what the double talking CEO of was talking about when he claimed that “In 2007 it paid for itself, and even left a few sheckles over. And things look better and better from here.”

Customer acquisition costs keep going up

Another key financial measure that Patrick Byrne would like to ignore is’s continual growth in customer acquisition costs, which hampers its ability to make profits. The average customer acquisition cost for shopping customers continues to rise, growing at 2.56% in Q1 2008 vs. Q1 2007 and 29.99% in Q1 2008 vs. Q1 2006.

Now put it all together

Now let’s put it all together. Compare the 29.99% rise in shopping customer acquisition costs from Q1 2008 to Q1 2006 with the tepid rise in customer sales volume of 7.68% during the same period. Then factor in the inclusion of Easter and an extra shopping day due to a leap year on Q1 2008 and the absence of such factors in Q1 2006. Last, consider the fact that the company still lost money, despite all of the one-time benefits enjoyed during the quarter. Now ask yourself, have things really improved? Or is Overstock still losing ground?

The next question is, why not be forthright with shareholders? Was it just another effort by Patrick Byrne to “knee the shorts in the groin” with his pattern of lies, deceit, and false and misleading statements and disclosures.

Why did, without prior notice, suddenly release what seemed to be on its face very good news for the company, earlier than expected?

On Friday April 19, all put and call options were due to expire at the close of the market. Patrick Byrne’s disdain for short sellers, and just about any person or entity that has a skeptical position or opinion of his company is well known. For example, when asked about a short squeeze in December 2003 Patrick Byrne replied, “when opportunities come along where we can knee the shorts in the groin, that's always good for fun and amusement."

Was Friday’s press release by a deliberate attempt to “knee the shorts in the groin” and manipulate the price of common stock? To determine this, let’s examine’s first quarter earnings release from the bottom up.

Buried at the very bottom of’s press release was the following new disclosure:

On April 15, 2008, we received a letter from the Office of the District Attorney of Marin County, California, stating that the District Attorneys of Marin and four other counties in California have begun an investigation into the way we advertise products for sale, together with an administrative subpoena seeking related information and documents. We follow industry advertising practices and we intend to respond fully to the subpoena and cooperate with the investigation. [Emphasis added.]

By placing news of a multi-county California District Attorney investigation of’s advertising practices at the bottom of the press release while heralding a supposed 27% increase in revenues, apparently Patrick Byrne wanted to bury news of such investigation while accentuating’s supposedly good financial performance. Apparently, wanted to bury the news of a criminal investigation of the company’s advertising practices by the early issuance of an earnings release that overstated its financial performance. In the process, the stock would rise and cause losses to short sellers as their put options expired.

Sell high, buy low, and afterwards drive the stock price higher again

To make matters worse, on December 15, 2006, sold about 2.7 million common shares to a group of institutional investors at $14.63 per share several weeks before releasing unexpectedly horrendous results for the final quarter of that fiscal year. Several months later, in April 2007, Patrick Byrne revealed a previously undisclosed "game plan" and admitted that "We knew things were going to get really ugly and that the company was going to have take medicine.... in the form of dumping a bunch of inventory....We knew it was going to get ugly."

During Q1 2008, the company repurchased 1.1 million shares at an average price of $10.90 or $3.73 per share lower than it sold shares to institutional investors in December 2006. After’s materially and significantly misleading Q1 2008 earnings release, as described above, the company’s shares climbed from $14.00 per share to close at $18.47 per share.

Apparently, Patrick Byrne's "game plan" for is to hype the company's financial performance and screw investors by selling shares to investors at higher prices to finance his perennially money losing company before releasing unexpected horrendous news. Afterwards, buys back such shares at lower prices before releasing a materially misleading earnings release, again hyping the company's financial performance. uses that same materially misleading earnings release to drive the stock price back up and "knee the shorts in the groin."


The news release was intentionally misleading in violation of Rule 10b-5, and was timed to manipulate the market. In the process, the company walked away with some nice trading profits, too.

To be continued….

Written by:

Sam E. Antar (former Crazy Eddie CFO and a convicted felon)

Disclosure: Not short or long

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