California District Attorneys Sue Overstock.com for Defrauding Consumers While the SEC Finds New Disclosure Problems

Last week, district attorneys from seven California counties sued Overstock.com (NASDAQ: OSTK) alleging that the company has engaged in fraudulent pricing practices after a two year investigation. The lawsuit alleges that:

9. Beginning on a date no later than January 1, 2006, Overstock routinely and systematically made untrue and misleading comparative advertising claims about the prices of its products.

[Snip]

11. …Overstock used various misleading measures to inflate the comparative prices, and thus artificially increase the discounts it claimed to be offering consumers.

[Snip]

22. Often Overstock has not been determining or verifying the price other merchants charge for those identical products. Rather, Overstock has been using various misleading methods to make up its own “straw-man” prices which it claims other merchants are charging for those products, and then claiming that its own prices are significantly lower.

23. Overstock has advertised comparative prices which do not exist (i.e., simply making up the prices charged by other merchants).

The district attorneys are seeking at least $15 million of restitution, fines, penalties, and cost reimbursements from Overstock.com for defrauding consumers. (Download a copy of the lawsuit).

Overstock.com rejected proposed settlement and may take significant hits against earnings in future periods

In March 2010, those California county district attorneys offered to resolve the case for $7.5 million, but Overstock.com refused to settle.  According to Overstock.com's Q3 2010 10-Q report filed on October 29, 2010, just 21 days before the lawsuit was filed, the company had accrued a loss contingency reserve totaling only $1.2 million to cover its potential litigation risks:

We establish liabilities when a particular contingency is probable and estimable. We believe the $1.2 million accrued at September 30, 2010 in our consolidated financial statements is adequate in light of the probable and estimable liabilities. It is reasonably possible that the potential losses may exceed our accrued liabilities.

We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated.

Under FASB ACE 450, "probable and estimable" losses must be recognized and accrued in financial reports.  If Overstock.com had offered in excess of $1.2 million to settle those claims, such a larger amount should have been reflected in its loss contingency reserves. Therefore, Overstock.com probably offered no more than $1.2 million to resolve consumer fraud allegations being investigated by the California attorneys.

Loss contingencies which are "reasonably possible" are not accrued in financial reports. However, the range of possible losses must be disclosed. Even though Overstock.com accrued $1.2 million in loss contingency reserves, the company conceded that "It is reasonably possible that the potential losses may exceed our accrued liabilities." Furthermore, Overstock.com did not "accrue legal fees expected to be incurred in connection with loss contingencies." Such legal fees are only expensed as incurred.

With the filing of the lawsuit, Overstock.com faces the prospect of significantly higher future legal costs to defend itself against allegations of consumer fraud at time when the company is losing money and bleeding cash. In its last two quarters, Overstock.com reported losses far in excess of Wall Street analysts’ consensus forecasts. With only $1.2 million of loss contingencies reserves accrued as of Q3 2010, the company faces the prospect of taking significant charges in excess of the sum currently reserved to settle or to pay in the event of an adverse trial verdict in the future.

Veteran securities litigator Howard Sirota analyzed the lawsuit in his blog:

Overstock.com, having made the now-obvious blunder of not settling with the seven District Attorneys, now faces a Hobson’s Choice of epic proportions which may be a life-or-death corporate decision: settle now, confirming to everyone that Overstock.com’s claimed discounts are suspect and hope the company survives past this fourth-quarter long enough to rebuild its tarnished brand name, or not settle, look forward to its day in court “as always” and have a sword of Damocles over the principal claimed reason to shop at Overstock.com…its supposedly low prices.

In addition, Overstock.com faces the possibility of a Federal Trade Commission probe and investigations by other states to determine if the company's alleged misleading of consumers spread beyond the California state line.

Overstock.com under investigation by SEC Enforcement Division for GAAP violations

Patrick Byrne while intoxicated

In 2009, I correctly reported in my blog that Overstock.com violated Generally Accepted Accounting Principles (GAAP) in accounting for its recoveries of certain offsetting costs and reimbursements amounts due to the company from its fulfillment partners (suppliers) who were under-billed in previous reporting periods, from Q1 2007 to Q 2 2008. Overstock.com should have restated its financial reports to recognize income when those offsetting costs and reimbursement amounts were actually earned by the company in those previous reporting periods. Instead, the company improperly recognized income as those amounts were collected in future accounting periods (Q4 2008 to Q3 2009) on a non-GAAP cash basis. In one instance, Overstock.com improperly reported Q4 2008 profits, even though the company should have reported a loss under accounting rules.

CEO Patrick Byrne retaliated against me by seeking to publicly humiliate me during various conference calls with investors. For example, during the Q2 2009 earnings conference call, Patrick Byrne referred to me as, “Sam Antar the crook, as I like to call him.” The company continued to violate GAAP and materially overstate earnings in Q1, Q2, and Q3.
 
Ultimately, the Securities and Exchange Commission Enforcement Division started investigating Overstock.com for securities law violations and forced the company to restate its financial reports for the third time in three years to correct those GAAP violations. Overstock.com was wrong about its accounting.

Patrick Byrne delighted in calling me a “crook.”  Now, his company is being sued by seven California district attorneys for scamming its own consumers.  Chris Moran in the Consumerist blog observed:

Apparently, the "O" in Overstock.com stands for "Overstating discounts and misleading customers," at least according to the district attorneys in seven California counties.

On pages 8 to 10 and paragraphs 41 to 48, the lawsuit claims that as far back as 2004, Patrick Byrne knew that Overstock.com was making up comparative list prices to consumers.

In any case, Chris Moran was half-right. The "O" in Overstock.com also stands for overstating earnings and misleading investors.

SEC Division of Corporation Finance uncovers more financial reporting violations by Overstock.com
 
While the Enforcement Division has been investigating Overstock.com's potential securities law violations, the SEC Division of Corporation Finance has been carefully examining company’s financial disclosures. On June 11, 2010, the SEC Division of Corporation Finance reviewed Overstock.com's 2009 10-K report and Q1 2010 10-Q report and found that its disclosures did not fully comply with applicable accounting standards concerning its litigation risks (See question 30):

FASB ASC 450 indicates that if an unfavorable outcome is determined to be reasonably possible but not probable, or if the amount of loss cannot be reasonably estimated, accrual would be inappropriate, but disclosure must be made regarding the nature of the contingency and an estimate of the possible loss or range of possible loss or state that such an estimate cannot be made. We note that in instances where an accrual may have been recorded because all of the criteria in FASB ASC 450-20-25-2 appear to have been met, you have not disclosed the amount of the accrual, nor have you provided disclosure indicating that there is an exposure to loss in excess of the amount accrued and what the additional loss may be for each particular litigation matter. Please revise to include all of disclosures required by paragraphs 3-5 of FASB ASC 450-20-50. In this regard, we do not believe that your general disclosure indicating that you have certain contingencies which are reasonably possible, with exposures to loss which are in excess of the amount accrued satisfies the criteria in FASB ASC 450. For example, we note you received a collective proposal to resolve a dispute by your payment of $7.5 million. Your disclosure does not indicate if you believe a loss is probable and have accrued any amounts or if a loss is reasonably possible. Please tell us the amounts accrued for those “certain contingencies” with exposures to loss in excess of the amount accrued. Further, please explain why you believe disclosure of the amount of accrual is not required for each particular matter where an estimate of the loss or range of loss can be made. Also, please tell us the date you received the proposal to resolve the dispute for payment in the amount of $7.5 million. [Emphasis added.]

Prior to the SEC's June 2010 intervention, Overstock.com inappropriately failed to disclose the amount of any loss contingencies it accrued in its 2009 10-K and Q1 2010 10-Q reports. After the SEC's intervention, Overstock.com started disclosing its loss contingency accrual in its Q2 2010 10-Q report.

Overstock.com revealed to the SEC Division of Corporation Finance reviewers that its loss contingency accruals only covered two matters:

There are two matters for which we have established accrued liabilities, namely, the California district attorneys’ investigation and the administrative proceeding before the Ohio Tax Commissioner.

In the Ohio administrative proceeding, Overstock.com faces potential claims of $612,784 in taxes, interest, and penalties. In the California lawsuit, Overstock.com faces potential claims in excess of $15 million after rejecting $7.5 million settlement offer.  Based on Overstock.com’s responses to the SEC, its $1.2 million contingency loss reserve covers only those two matters.

Overstock.com had expressed its concern to the SEC reviewers that disclosing the amount it accrued for loss contingencies on a case-by-case-basis in its financial reports might be prejudicial to its defenses:

Further, we believe that disclosure of these amounts on a case-by-case basis could impact attorney-client privilege and cause us to disclose information that would be prejudicial to our defense. Any disclosure of such matters becomes a roadmap to a litigant’s thinking and strategies and often unfolds to an opponent the most highly attorney-client privileged information that may compromise and put us at a severe disadvantage in our negotiations with plaintiffs. As such, we believe it would harm both the Company and our investors to provide amounts accrued on a case-by-case basis.

Overstock.com was able to convince the SEC that it should not disclose the amount of loss contingencies it accrued for each specific case in its future 10-Q and 10-K financial reports, because such disclosure "may compromise and put us at a severe disadvantage in our negotiations with plaintiffs." Overstock.com was required by the SEC to disclose the amount of loss contingencies it accrued on an aggregate basis.

However, the company’s responses to the SEC, which are not included in its recent Q2 and Q3 10-Q reports, clearly show that Overstock.com accrued a $1.2 million contingency loss to specifically settle claims with the California district attorneys’ offices and the State of Ohio. In both cases, Overstock.com acknowledged to the SEC reviewers that it was “reasonably possible that the potential losses may exceed our accrued liabilities.”

If it weren’t for the SEC Division of Corporation Finance review of Overstock.com’s litigation disclosures in the months before the California district attorneys filed its lawsuit, investors would have been in the dark as to the extent of the company’s loss contingency accruals. Apparently, the SEC is doing the job that Overstock.com's management stubbornly refuses to do - obey the securities laws and provide full and transparent disclosures to investors.

Possible illegal insider trading by Patrick Byrne

More recently, I raised questions of possible illegal insider trading by Patrick Byrne. Last May, Byrne's 100% controlled High Plains Investments LLC dumped 140,000 company shares at an average price of $22.11 per share and collected over $3 million in proceeds, according to SEC filings. Before and after Byrne sold his stock, he hyped Overstock.com's prospects by leading investors to believe that the company would break even and beat Wall Street analysts' consensus expectations in Q2 and Q3 2010. However, in both quarters Overstock.com stunned investors by losing money and failing to meet analysts' expectations.

Byrne even skipped Overstock.com's Q3 2010 earning conference call, rather than face analysts and explain his actions. Writer William K. Wolfrum said:

...it’s probably more likely that his lawyers, his Daddy, and others have him under orders to keep his mouth shut.

If a court finds that Patrick Byrne had actual knowledge of Overstock.com’s alleged scheme to defraud consumers, it could provide additional evidence of illegal insider trading by Byrne.  Overstock.com does not disclose in its SEC filings that its business model is based on scamming consumers.

The beat goes on

In his personal blog, financial columnist Gary Weiss showed that Overstock.com is still making up its competitor's prices:

Just for the heck of it I checked out Overstock's price for the paperback edition of Andrew Sorkin's Too Big to Fail. The price at Overstock is $11.06 and the search page for the book fraudulently says "compare at $20.55" and "you save 46%."

Baloney. The biggest online retailer, Amazon, lists the book at $9.90 and gives the list price as $18.00, not "$20.55." Barnes & Noble also prices the book at $9.90, and gives the correct list price.

So where did Overstock conjure up that "compare at" price? The Future Felons of America outlet shop in Salt Lake City? Misstating an easily determined (you look at the book cover or website) publisher's list price takes a degree of unmitigated gall, and contempt for the law, found only at Overstock.com.

Seems that Overstock has as much contempt for its customers as it does for its long-suffering shareholders.

Conclusion

Way back, on December 11, 2001, Overstock.com CEO Patrick Byrne appeared on the Fox News show "Your World with Neil Cavuto." He looked straight into the camera and proclaimed that "We're profitable." It was a bald-faced lie. In the following year, Overstock.com filed its registration statement for its initial public offering which revealed that the company actually lost $14.2 million in 2001!

Almost nine years later, Patrick Byrne's continuous disregard for honesty, transparency, and the law seems to be catching up to him with an ongoing SEC investigation into possible securities fraud and a California lawsuit alleging consumer fraud.

Written by:

Sam E. Antar

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Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them

For example, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Overstock.com securities long or short. My investigation of that company is a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.