Green Mountain Coffee Roasters’ Growing Inventory Levels: Is It a Fumble or a Fraud?

Has Green Mountain Coffee Roasters (NASDAQ: GMCR) fumbled in managing its inventory or has it engaged in an inventory fraud to inflate earnings?

Background

As the criminal CFO of Crazy Eddie, I learned that the overstatement of inventory levels was the easiest way to inflate earnings. Auditors don't always supervise the counting of each and every physical inventory item to confirm their existence. Even if the auditors confirm the physical existence of all inventory items, they don't always trace how every single item arrived in a company's storage facilities. Therefore, the same inventory items can be moved from location to location and counted several times to inflate earnings.

In September 2010, the Securities and Exchange Commission started a probe of Green Mountain Coffee's revenue accounting practices. Shortly afterwards, a class action lawsuit was filed against the company alleging that it engaged in securities fraud by inflating its inventory numbers to overstate its reported earnings. According to the amended class action lawsuit, several confidential witnesses who worked for Green Mountain Coffee allege that it moved around its inventory from location to location without a document trail to overstate inventory counts and inflate earnings. For example, paragraph 79 of the amended complaint alleges that:

CW7 [confidential witness 7], a lower-level employee in the Company's shipping department in Knoxville Tennessee, who worked at the Company from August 2009 through August 2011, also witnessed GMCR improperly transferring product from one plant to the next for no apparent reason. [Bracketed information added for clarity.]

In October 2011, money manager David Einhorn slammed Green Mountain Coffee's and noted "odd material movements" of inventory to possibly confound its auditors.

If there is inventory growth that is higher than revenue growth over extended periods of time combined with declining inventory turnover trends, it is considered to be a red flag for the possible inflation of inventory numbers and overstatement of earnings. For example, before the Crazy Eddie fraud was uncovered, independent analyst Thornton L. O’glove noted that its inventory levels were growing much faster than revenues. He was suspicious that Crazy Eddie was fraudulently inflating its inventories to overstate its profits. Unfortunately, most investors and analysts ignored the red flags that he spotted. (Source: Wall Street Journal – By the Numbers: How One Analyst Scores Big by Finding the Dark Side, by Jeffrey A. Tannenbaum and Lee Berton, August 4, 1987).

Is Green Mountain Coffee another Crazy Eddie?

Green Mountain Coffee's inventory levels have grown much faster than its growth in revenues in the last seven quarters since the S.E.C started its probe. Therefore, Green Mountain Coffee's inventory turnover rate declined in each quarter reflecting longer periods of time to sell its products. A comparison of Green Mountain Coffee's financial reports reveal that ever larger amounts inventory on hand are required to sell relatively less products quarter-after-quarter and year-after-year. See the chart below comparing Green Mountain Coffee's reported revenue increases compared to its reported increases in inventories. (Click on the table image below to enlarge it.)

Likewise, Crazy Eddie's had a similar pattern of inventory increases that exceeded revenue increases over an extended period of time resulting in declining inventory turnover. It seemed like Crazy Eddie needed ever larger amounts of inventory to sell relatively less product. For example, in fiscal year 1987 Crazy Eddie's reported revenues increased 34% while its inventories increased 82% when compared to the previous fiscal year. Its reported inventories grew at more than twice the rate of reported revenues. In November 1987, new management ousted the Antar's from Crazy Eddie and discovered that most of the inventory on its books did not exist!

Similarly, Green Mountain Coffee's reported inventories grew at more than twice the rate of revenues in the last two quarters. In the most recent quarter ended June 23, 2012, its reported revenues grew 21% while its inventories grew 60% when compared to the previous fiscal year's comparable quarter. In the quarter ended March 24, 2012, Green Mountain Coffee's reported revenues grew 37% while its reported inventories grew 100% when compared to the previous fiscal year's comparable quarter.

Consistent decline in inventory turnover

In each the last seven quarters, Green Mountain Coffee's inventory turnover has decreased when each quarter’s numbers are compared to the same quarter of the previous fiscal year. For example, in the latest quarter ended June 23, 2012, it took Green Mountain Coffee an average of 102.04 days to sell its inventory compared to 72.12 days in the same quarter of the previous fiscal year. In the quarter ended June 26, 2010 it took Green Mountain Coffee an average of only 64.89 days to sell its inventory. (Click on table images below to enlarge them.)

Green Mountain Coffee has claimed that it stocked up on inventories in each quarter in order to meet anticipated customer demand. However, in each of the last seven quarters, Green Mountain Coffee's rate of inventory buildup exceeded its own estimates of anticipated revenues. When it beat its own revenue projections, its inventory turns should have increased because it ended the period with fewer inventories on hand than it had anticipated. However, Green Mountain Coffee's inventory turnover still decreased in those periods.

When Green Mountain Coffee failed to meet its revenue projections, inventory turnover understandably decreased because it had more inventory on hand than it had anticipated. However, even if it had made up for the shortfall in sales by selling more products and depleting more inventory to match its revenue projections, its inventory turnover rate still would have decreased. Therefore, Green Mountain Coffee's consistent decline in inventory turnover rates cannot be explained by its failure to meet revenue projections. In any case, its inventory buildup appears to defy rational explanation.

Inventory turnover declined even when Green Mountain Coffee beat minimum and maximum revenue expectations

In four of the last seven quarters, Green Mountain Coffee's reported revenues exceeded both the minimum and maximum guidance it gave to investors several weeks before the close of the quarter (see green highlighted areas in the table above). Inventory turnover should have been higher because the company pushed its product out the door faster to meet unexpected excessive demand from its customers. However, Green Mountain Coffee’s inventory turnover decreased, reflecting a longer time to sell its inventory despite reporting revenues that exceeded its minimum and maximum projections.

When Green Mountain Coffees sales fell below expectations, inventory turns would have still declined if it had met expectations

In two of the last seven quarters, Green Mountain Coffee failed to meet both its minimum and maximum revenue projections it gave investors just a few weeks before the end of each quarter. Therefore, a decline in inventory turns would be expected because it sold fewer products than it anticipated to its customers and had more inventory on hand than it anticipated at the end of the period. However, even if the company had matched its revenue projections by selling more merchandise, its inventory turnover would have still declined in those same quarters. The decline in inventory turnover cannot be explained by a failure to meet revenue expectations, (See red highlighted areas in the tables above and below).

For example, in the quarter ended March 24, 2012 Green Mountain Coffee’s reported revenues of $885.052 million were $54.052 million short of its minimum revenue expectation and $86.435 million short of its maximum revenue expectations. Green Mountain Coffee reported a gross profit on revenues of 35.37% in that quarter. Therefore, the cost of product that it sold to customers was 64.63% of revenues.

To meet its minimum revenue projection, Green Mountain Coffee needed to sell an additional $54.052 million of products costing it approximately $34.934 million ($54.052 million multiplied by 64.63%). To meet its maximum revenue projection, Green Mountain Coffee needed to sell an additional $86.435 million of products costing it approximately $55.863 million ($86.435 million multiplied by 64.63%).

Even if Green Mountain Coffee had achieved its minimum revenue estimate for the quarter ended March 24, 2012, it would have still taken the company 88.0 days to sell its inventory compared to only 64.06 days in the previous fiscal year. If Green Mountain Coffee had met its maximum revenue estimate for that quarter, it would have still taken the company 83.55 days to sell its inventory compared to only 64.06 days in the previous fiscal year. (Click on the table image below to enlarge it.)

Latest quarter

In the latest quarter ended June 23, 2012, Green Mountain Coffee’s reported revenues exceeded its minimum revenue guidance, but fell short of its maximum revenue guidance. It took an average of 102.04 days to sell its inventory compared to only 72.12 days in the same third quarter of the previous fiscal year. Its revenues increased 21% while its inventory levels increased by 60%. The company had projected a revenue increase of 20% to 25% for the quarter. Even if it had met its maximum 25% increase in revenue projection, it still would have taken an average of 97.55 days to sell its inventory compared to 72.12 days in the previous fiscal year. See the yellow highlighted areas in the tables above and below:

During a conference call with investors, Green Mountain Coffee CFO Fran Rathke attempted to deflect criticism over inventory levels by explaining that it was stocking up on brewers far in advance of the holiday season:

Because of the time it takes to ship brewers to the US from our contract manufacturers in Asia, we must have on hand all of the brewers we expect to sell during holidays by early October to ensure availability on retailer shelves. It is this timing dynamic that necessitates that we begin building brewer inventory starting in Q3 toward anticipated demand.

Green Mountain Coffee reported that total inventory at the end of the quarter had jumped 60% to $667.0 million compared to only $417.5 million in the previous year's comparable quarter. The brewer and accessory portion of the total inventory increased 73% to $301.5 million compared to $174.2 million in the previous year's comparable quarter. However, the balance of the total inventory excluding brewers and accessories grew still grew at 50% over the previous year. As I detailed above, revenues for the quarter only increased by 21% over the previous year's comparable quarter. Brewer and accessory sales increased only 32%, single serve pack sales increased only 31%, and other sales categories declined when compared to the previous fiscal year. Therefore, inventory turnover decreased in every revenue category.

Portfolio manager Ben Strubel took issue with Rathke and noted that the purported buildup in brewer inventories ahead of the holiday season was much higher than the buildup in the previous year taking into account anticipated revenue projections by the company.

On June 6, 2012, Green Mountain CEO Larry Blanford told investors at a Piper Jaffray Consumer Conference:

…But should something like that happen we have a number of tactical responses, one of which could in fact be deciding to raise the price of the K-Cup brewing system.

It appears that both Rathke and Blanford were fibbing to investors. On Tuesday September 26, 2012, Green Mountain Coffee announced that it was offering $50 rebates for its brewers. Investor Daniel Yu noted in his blog that:

GMCR is offering up to a $50 rebate in Keurig brewers, after saying they might raise prices just a few months ago. Should Larry Blanford, CEO of GMCR/Keurig, change his middle name to ‘liar’? Larry Liar Blanford?

Apparently, Green Mountain Coffee had too many brewers on hand ahead of the holiday season and must now cut prices to move them, contrary to previous comments by Rathke and Blanford. Fibbing by management aside, still the question remains as to whether Green Mountain Coffee also inflated its inventory numbers to create fictitious profits. Green Mountain Coffee's inventory buildup does not appear to be solely the result of mismanagement. Its unusual growth in reported inventory levels could be the result of intentional inflation to overstate earnings as alleged in the class action lawsuit.

Was it a fumble or fraud?

No matter how you slice and dice it, Green Mountain Coffee’s troubling growth in inventory levels is not a single quarter fluke. As evidenced by the consistent decline in inventory turnover over the last seven quarters, the company continues to build excessive layers of inventory on top of previous excessive layers of inventory.

The S.E.C. is investigating whether Green Mountain Coffee’s excessive growth in inventory levels resulted from mismanagement or a fraud. However, I caution them that claiming incompetence is the last refuge of the white-collar criminal. Fraudsters know that stupidity is not a crime.

Was it a fumble or fraud? Maybe it is both.

Written by,

Sam E. Antar

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 as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. More recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

I do not own any Green Mountain Coffee Roasters securities long or short.

Is Green Mountain Coffee’s Management Team Milking Shareholders For Every Last Penny?

In an interview last Monday with veteran investigative reporter and best-selling author Gary Weiss, I described how executives at Green Mountain Coffee Roasters (NASDAQ:GMCR) apparently received higher bonuses in 2011 because computations for annual cash incentive rewards did not take into legal and accounting expenses relating to an ongoing Securities and Exchange Commission probe into its financial reporting and class action litigation alleging securities fraud. Those executives are already indemnified for legal fees to defend themselves in any S.E.C. investigation and class action lawsuit.

It’s equivalent to management double dipping into corporate coffers at the expense of shareholders. While the company has the burden of paying for the ongoing S.E.C. probe and management’s legal defense in class action lawsuits, their bonuses don’t take into account such costs. It’s like tossing a coin and if it lands on heads, management wins, or if it lands on tails, investors still loose.

In addition, the cash incentive plan does not factor in acquisition-related expenses and the cost of amortizing identifiable intangible assets related to those acquisitions. Therefore, management is encouraged to overpay for acquisitions since such costs are not included in calculating annual cash incentive rewards, while they are still borne by the company. The executives running Green Mountain Coffee seem to be milking the company for every last penny they can get in compensation.

Background

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its revenue accounting practices and relationship with a certain fulfillment vendor eight days earlier. On that same day, the company reported that it discovered an accounting error involving its K-Cup margin percentages during the preparation of its financial report for the period ended September 25, 2010. Within days, class action lawsuits were filed against the company and certain officers alleging securities fraud.

On November 19, 2010, Green Mountain disclosed that it found four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to the period ended June 26, 2010 to correct its errors and conceded that there were material weaknesses in internal controls.

Since then, this blog has detailed ongoing accounting rule violations by the company. Its so-called restated numbers still don’t appear to add up. More recently, money manager David Einhorn has uncovered serious improprieties at the company.

2011 cash incentive rewards plan

On January 17, 2012, Green Mountain Coffee’s preliminary proxy statement revealed details of its “annual incentive awards” paid for key executives (page 18):

We use these two metrics to determine the amount of annual incentive awards earned. For fiscal 2011, these results translated into an achievement of 122% of the bonus targets set for the year, with net sales for fiscal 2011 of $2.7 billion exceeding the prior year’s target by 9% and non-GAAP operating income of $428 million exceeding the prior year’s target by nearly 14%. The Compensation Committee set these targets at challenging levels that it believed would incentivize the executives to perform at the highest levels. [Emphasis added.]

Furthermore, the company disclosed (see page 26):

Consistent with prior years, the Compensation Committee again chose challenging net sales and non-GAAP operating income (as defined in the GAAP to non-GAAP Reconciliation of Consolidated Statements of Operations table as set fourth [spelled incorrectly] in Exhibit 99.1 on the Company’s current report on Form 8-K filed November 9, 2011.) targets as the financial targets against which to measure any annual incentive compensation payable to the named executive officers. Under the Company’s annual incentive plan for fiscal 2011, for any payout to have occurred, the Company’s net sales and non-GAAP operating income had to have been at least equal to the “threshold” amounts as set forth below. At the “threshold,” 20% of an individual’s target bonus opportunity would have been paid. If the Company’s net sales and non-GAAP operating income met the “target” level as set forth below for fiscal 2011, then 100% of the individual’s target opportunity would have been paid. Finally, if the Company’s net sales and non-GAAP operating income for fiscal 2011 had reached the “maximum” levels, as set forth below, then, all else being equal, 150% of the individual’s target bonus opportunity would have been paid. The amounts below are in thousands.

For fiscal 2011, the Compensation Committee set the target percent of base salary for each of our named executive officers to be consistent with the Company’s compensation philosophy and the competitive marketplace data, which are shown below. In addition, the table also shows the target and maximum annual incentive opportunity and the actual annual cash incentive paid to the named executive officers as a result of the Company’s achievement of 122% of the financial goals set by the Compensation Committee at the beginning of the fiscal year. [Emphasis added.]

The company was able to pay higher bonuses to its executives in part because its non-GAAP operating income of $428,693 for the fiscal year ended September 24, 2011 exceeded the $376,100 target set for that year. According to Exhibit 99.1 of the 8-K report referenced in the proxy statement detailed above, non-GAAP operating income excluded legal and accounting expenses related to the S.E.C. inquiry and pending litigation which increased non-GAAP operating income by $7.9 million to $428 million. Therefore, executive bonuses were higher because such costs do not count in computing their annual incentive rewards. See below. (Click on image to enlarge.):

The company’s incentive compensation calculation ignores the cost it incurred due to management incompetence, negligence, and possibly fraud. The company had to restate its financial reports from the beginning to 2007 to June 26, 2010 due to inadequate internal controls and material accounting errors and it now faces on ongoing S.E.C. probe and class action lawsuits.

Chief Executive Officer Lawrence Blanford and Chief Financial Officer Frances Rathke received 18.8% and 15.4% respective raises in base compensation despite signing inaccurate Sarbanes-Oxley certifications claiming that adequate internal controls existed from 2007 to 2010. Their raises were bigger than raises received by other executive officers who did not sign such certifications. So far, no key executive has been held accountable for the company’s financial reporting and legal troubles. See below. (Click on image to enlarge.):

Furthermore, the 2011 cash incentive plan did not take into account acquisition-related expenses and the amortization of identifiable intangibles from those acquisitions. The cash incentive plan encourages management to overpay for acquired companies, since such costs resulting from acquisitions are not included in the calculation of their annual rewards.

Under the 2010 cash incentive plan, the amortization of identifiable intangibles was included in the calculation of cash incentive rewards, unlike the current 2011 plan. Therefore, the 2011 plan was apparently richer for executives than in 2010 because it did not factor in certain costs that were used to calculate annual incentive rewards in the prior year. That contradicts its disclosure that the plan was "Consistent with prior years...." (See Proxy page 26.)

On a lighter note, Green Mountain Coffee’s high-paid executives and high-priced lawyers are advised to use a spell-checker before preparing reports such as the latest proxy statement detailed above. On page 26, they misspelled “forth” as “fourth” in language describing the incentive compensation plan. My Microsoft Word spell-checker was able to flag that error right away.

Written by:

Sam E. Antar

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 as an independent whistleblower. Furthermore, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not own any Green Mountain Coffee Roasters securities long or short.

Is Green Mountain Coffee Going to Get Roasted by its Exes?

Last week, lawyers representing investors filed an amended class-action lawsuit against Green Mountain Coffee Roasters (NASDAQ: GMCR) and members of its management containing new allegations of wrongdoing based on information:

…obtained from confidential witnesses, including former Green Mountain Coffee Roasters, Inc. ("GMCR" or the "Company") and M.Block & Sons, Inc. ("MBlock") employees…. [Emphasis added.]

Note: Download the amended class-action complaint here.

The three exes

In law enforcement circles, there is a term known as the “three exes” for ex-lovers, ex-employees, and ex-business associates. In many cases, such informants provide crucial information to law enforcement agencies that investigate and prosecute white-collar crime. In this case, the amended complaint is based on detailed first-hand accounts of alleged wrongdoing by the company obtained from several ex-employees and ex-business associates who are identified as "confidential" witnesses such as CW 1, CW2, and CW 3. One such ex-employee identified as "CW 6" is a former Vice President of Operations for Green Mountain Coffee.

The amended complaint identifies various alleged schemes employed by Green Mountain Coffee to deliberately violate Generally Accepted Accounting Principles (GAAP) and prematurely recognize income on the shipment of products to M. Block, its primary fulfillment vendor.

CNBC Senior Stock Commentator Herb Greenberg wrote in his blog that:

My take: I generally ignore class action lawsuits, but they're hard to dismiss out of hand when they include allegations from multiple former employees.

Is M. Block a "black box" entity used to inflate earnings?

The complaint effectively describes M. Block, in what is known in fraud investigation circles, as a "black box entity" used by fraudsters to play shell games with inventory and inflate income. Back in the day at Crazy Eddie, we took advantage of our cozy relationship with certain third party entities and effectively used them as "black box entities" to help us inflate our earnings.

For example, the amended complaint alleges that:

64. Information provided by former GMCR and MBlock employees described the companies' relationship as one where GMCR dictated their business dealings and being something other than on an arms-length basis.

[Snip]

66. A former regional sales manager for GMCR from late 2008 until late 2010 ("CW2") stated that anyone at the Company would acknowledge that MBlock was, in essence, a captive company and would do as GMCR instructed. CW2 indicated that his/her current employer is careful in its dealings with MBlock because it is aware of the close relationship between GMCR and MBlock.

One of the alleged schemes detailed in the amended complaint involves the shipment 150 truck loads of merchandise to M. Block to inflate revenues in the quarter ended December 26, 2009:

70. CW1 indicated that GMCR improperly recognized revenue on 150 truck loads of product that was shipped to MBlock during the quarter ended December 26, 2009. This former GMCR manager stated that he/she and other Company employees, including the Company's global transportation manager, were unable to locate the requisite paperwork, including purchase orders, material requisition orders, or product shipment authorizations, traditionally used by GMCR to validate the sale.

71. Specifically, CW1 indicated that because there was no order for those products, no payment was ever made on the 150-truckload shipment. In addition, the order was not listed on the Company's production forecast schedule and employees who worked under CW1 not only saw the trucks go out, but visited MBlock and saw its warehouses filled to the rafters with K-Cups. CW1, who estimated that the value the revenue recognized on the foregoing improperly recorded transaction to be between $7.5 and $15 million dollars, indicated the following GMCR executives were aware of the shipment: Vice President of Operations Jonathan Wettstein (who regularly provided updates to CEO Blanford), SBCU President McCreary and Vice President of Finance Tina Bissonette.

72. As a result of the foregoing, GMCR violated GAAP's criteria of revenue recognition, which provides that the conditions for revenue recognition ordinarily are met when the seller's price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer's obligation to the seller is not changed in the event of theft or physical destruction of the product; the buyer has economic substance apart from the seller; the seller does not have significant future performance obligations to the buyer; and the amount of future returns, if any, can be reasonably estimated. See, e.g., Accounting Standards Codification 605.

73. Consequently, GMCR violated its revenue recognition policy, as disclosed in the 2010 Form 10-K, when it prematurely recorded revenue on shipments of product to MBlock:

The Company recognizes revenue when the fulfillment entities ship the product based on the contractual shipping terms, which generally are upon product shipment, and when all other revenue recognition criteria are met. 

74. CW1 also indicated that GMCR had earlier changed the wording of its revenue recognition policy because the auditors had found discrepancies and senior management was thus aware that GMCR was accounting for revenue incorrectly.

75. In addition, a former regional sales director for Keurig between 2004 and the fall of 2010 ("CW 5"), indicated that distributors were unhappy with certain sales made to them by MBlock and that during a March 2010 sales conference call with regional directors, Keurig Vice Presidents Chris Stevens, Dan Cignarella and Dave Manly denied sales to distributors had been made by MBlock.

76. A former Vice President of Operations for GMCR during 2010 ("CW6"), stated that while the accounting department in Vermont told CW6 to book shipments to MBlock as a sale, the SEC [Securities and Exchange Commission] questioned the existence of an arms-length relationship between GMCR and MBlock. In fact, CW6 did not know if MBlock ever owned the products shipped to it. [Emphasis added.]

When did the Securities and Exchange Commission start investigating Green Mountain Coffee?

The amended complaint alleges that the company knew it was being investigated by the SEC months before it was disclosed to investors. On September 28, 2010, Green Mountain Coffee issued an 8-K report claiming that:

On September 20, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information. Based on the request, the Company believes the focus of the inquiry concerns certain revenue recognition practices and the Company’s relationship with one of its fulfillment vendors. The Company, at the direction of the audit committee of the Company’s board of directors, is cooperating fully with the SEC staff’s inquiry. [Emphasis added.]

However, the amended complaint takes issue with Green Mountain Coffee's disclosure:

68. Moreover, although the September 28, 2010 Form 8-K indicates that, "[o]n September 20, 2010, the staff of the SEC's Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information," the above-noted former employee has stated that by no later than the first week of May 2010, he/she was contacted by Company employees who asked if he/she had been had been the whistleblower in an SEC investigation of GMCR.

69. Accordingly, Company employees contacted the confidential witness concerning an SEC investigation five months prior to the issuance of the September 28, 2010 Form 8-K, which disclosed that the SEC informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information on September 20, 2010. [Emphasis added.]

From my experience at Crazy Eddie and later consulting work, I learned that the SEC usually communicates its concerns to targeted companies before sending an official notification of inquiry or investigation to them.

Alleged Illegal Insider Trading

Further, the amended complaint alleges that Michelle Stacy (President of Keurig operating segment) and Scott McCreary, (President Specialty Coffee Business Unit) engaged in illegal insider trading stemming from recent stock sales starting in August 2010:

7. Approximately one month earlier, both Stacy and Scott McCreary ("McCreary"), the President of GMCR's other business division, the Specialty Coffee Business Unit ("SCBU"), unloaded a total of 230,000 Company shares for proceeds of more than $7.5 million. These sales, which also occurred shortly before the Company's official announcement of an SEC inquiry, were made after the SEC's initial contact with GMCR. Prior to these sales, there had not been significant insider trading activity since June 2009.

In the weeks before Green Mountain Coffee claims it was notified about the SEC inquiry, Michelle Stacy and Scott McCreary simultaneously exercised options and sold large amounts of shares. On August 13, 2010, Michelle Stacy exercised 30,000 options at $6.20 per share and simultaneously sold those shares at $30.95 per share for gross proceeds of $928,500. On August 18, 2010, Scott McCreary exercised 200,000 options and $1.47 per share and simultaneously sold his shares at $33.08 per share for gross proceeds of $6.616 million. On September 13, 2010 Michelle Stacy exercised another 5,000 options at $6.20 per share and sold those shares at $35.40 for gross proceeds of $177,000.

On September 20, 2010, Green Mountain Coffee claimed that it was notified by the SEC of an informal inquiry concerning its “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” On September 21, 2010, Michelle Stacy exercised 5,000 options and immediately sold her shares at $37 per share.

On September 28, 2010, Green Mountain Coffee disclosed the SEC inquiry to investors. In addition, the company disclosed that it discovered an "immaterial accounting error" involving its K-Cup margin percentages which resulted in a $7.6 million cumulative overstatement of pre-tax income in financial reports issued from 2007 to June 26, 2010. The company’s disclosure was vague about when it discovered K-Cup margin error:

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit.

In my blog, interviews by fellow Seeking Alpha contributor Ilene (here and here), and in a televised interview on WCAX TV Vermont, I expressed my concern about the possibility of illegal insider trading by Michelle Stacy and Scott McCreary based on the timing of their stock sales.

Michelle Stacy sold her shares a day after Green Mountain Coffee claimed it was notified by the SEC of its inquiry but seven days before that inquiry was disclosed to investors. Green Mountain Coffee did not disclose exactly when it initially discovered its K-Cup margin error. Usually weaknesses in internal controls that cause accounting errors are discovered months or weeks in advance of the disclosure of such errors to investors.

On October 28, 2010, Stacy belatedly filed amended Form 4 reports and claimed that her September 13 and September 21 sales of stock were "affected pursuant to a Rule 10b5-1 trading plan" established on August 13, 2010.  A Rule 10b5-1 trading plan provides certain safe harbors which help executives defend against potential allegations of illegal insider-trading by removing their discretion to decide when their stock is bought or sold.

The amended complaint took issue with the timing of Michelle Stacy and Scott McCreary's stock sales:

103. Prior to these sales, there had not been significant insider trading activity since June 2009. Not only did both division presidents sell the majority of their shares, but Stacy did so the day after the SEC's information request and one week before GMCR made the SEC inquiry public.

104. Even worse, in October 2010, Stacy amended her Form 4s for the August and September sales, claiming that she forgot to include in the original Form 4s that the sales were made pursuant to a Rule 10b5-1 trading plan adopted on August 13, 2010. Not only did the Company fail to inform the SEC of the plan on the day it was adopted, but it failed to disclose the plan when Stacy's Form 4 for the $928,500 sale was filed a mere four days after its adoption.

In a follow up blog post, I noted that:

If a corporate executive already has nonpublic knowledge of certain adverse events such as undisclosed weaknesses in internal controls, accounting errors, or an SEC inquiry, a 10b5-1 plan cannot provide a safe harbor against illegal insider trading allegations.

As detailed above, the amended class-action complaint alleges that Green Mountain Coffee executives knew that it was being investigated by the SEC months as early as May 2010, which was about 90 days before Michelle Stacy and Scott McCreary sold their stock and before Stacy claims she set up a 10b5-1 trading plan.

According to the SEC:

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

If the class-action lawyers or the SEC can prove that Michelle Stacy or Scott McCreary knew about any material weaknesses in internal controls involving financial reporting, any material accounting errors, or an impending or actual SEC investigation and then sold their stock before it was disclosed to investors, they could be successfully prosecuted for illegal insider trading. The class-action lawyers and the SEC do not have to prove that Michelle Stacy or Scott McCreary knew of and participated in any alleged schemes to improperly inflate revenues and income to successfully prosecute them for illegal insider trading.

Closing comments

The amended complaint cites reporting by me and fellow Seeking Alpha contributor Jason Merriam:

GMCR's accounting practices have also garnered attention from the financial press. For example, in a February 13, 2011 Seeking Alpha article entitled "Green Mountain Coffee: Only Thing Brewing Is Trouble," author Jason Merriam, noted "[t]he accounting practices at Green Mountain Coffee Roasters (GMCR) are not baffling ... they are downright ludicrous." Similarly, on February 15,2011, Sam Antar began his Seeking Alpha article, entitled "More Mucky Disclosures For Green Mountain Coffee Roasters," with the following sentence: "Just about every time I examine financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I find new troubling accounting practices and financial disclosures. [Emphasis added.]

In my Seeking Alpha article, I detailed how starting in the quarter ended December 25, 2009 Green Mountain Coffee restated its segment numbers without disclosing it to investors months before it announced the SEC inquiry and certain accounting errors. The company's restatement of segment numbers may indicate that it was aware of material weaknesses in internal controls over in its financial reporting as far back as 2009.

In another blog post, I questioned whether Green Mountain Coffee correctly determined that its K-Cup margin error was an "immaterial accounting error" when it was initially disclosed on September 28, 2010. My analysis showed that the K-Cup margin error caused Green Mountain Coffee to overstate profits and beat analysts' consensus earnings expectations in the quarter ended March 27, 2010. According the SEC Staff Accounting Bulletin No. 99, Green Mountain should have considered its K-Cup margin error as a material accounting error on September 28, 2010 and it should have immediately disclosed to investors that it was going to restate its financial reports from 2007 to 2010 to correct that error.

Instead, Green Mountain Coffee waited until November 19, 2010 to inform investors that it was going to restate its financial reports when it disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income. These errors plus the K-Cup margin error resulted in a total overstatement of $10.1 million in pre-tax income. This time, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

In addition, the company claimed that its own internal investigation cleared it of misconduct. I told Ilene, fellow Seeking Alpha contributor and editor at Phil's Stock World:

In any case, I am naturally suspicious of self-proclaimed absences of wrongdoing without thorough outside independent examination. Back in the old days at Crazy Eddie, we conducted a similar internal inquiry with help from our auditors into certain allegations of wrongdoing involving a supplier and proclaimed ourselves clean… Management and auditors have little incentive to report their own foul-ups.

To date, Green Mountain Coffee has not specifically disclosed details of who conducted the internal investigation, how it was conducted, or why the company missed certain red flags. For all we know, it could be the janitor who conducted the company's internal investigation.

In my last blog post, I wrote an open letter to Green Mountain Coffee's Chief Financial Officer Frances G. Rathke questioning unusual numbers reported for its Timothy's Coffee subsidiary. I questioned how the company missed a 75% overstatement of revenues for Timothy's Coffee in the quarter ended December 26, 2009 and how the subsidiary was able to report income before taxes in excess of revenues in the quarter ended June 26, 2010. So far, Rathke has not responded to me.

I've been able to identify financial reporting irregularities from just reading and analyzing Green Mountain Coffee's financial reports. However, the class-action lawyers and the SEC have the power to subpoena witnesses and compel the production of internal documents from Green Mountain Coffee and M. Block to get at the bottom of what happened.

Last quarter, Green Mountain Coffee disclosed that it spent about $6 million on "legal and accounting expenses related to the SEC inquiry, the Company’s internal investigation and pending litigation." I don't see any quick resolution of legal issues facing Green Mountain Coffee and the company should expect to spend significantly more money dealing with these issues in future periods. Back on October 21, 2010, I warned Green Mountain Coffee that "Your lawyers will defend you to your very last dollar."

Written by:

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

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. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, 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 Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.

A Question for the CFO of Green Mountain Coffee Roasters

To Green Mountain Chief Financial Officer Frances G. Rathke:

On September 20, 2010, the Securities and Exchange Commission (SEC) started an informal investigation of the Green Mountain Coffee Roasters (NASDAQ: GMCR). Since that time, I’ve written several blog posts critically examining Green Mountain’s compliance with certain accounting and disclosure rules.

This time, I have a question. How was Green Mountain Coffee Roasters able to report income before taxes in its Timothy’s Coffee of the World Inc. subsidiary that exceeded revenues in the thirteen-weeks ended June 26, 2010? While I wait for an answer from you, please let me explain to my readers why I am asking the question. You may listen in, too.

My question is based on the following computations

On November 13, 2009, Green Mountain acquired Timothy’s Coffee of the World and its operations were integrated into the company’s SCBU segment. In the quarter ended December 26, 2009 10-Q report, Green Mountain reported the following financial results for Timothy’s:

For the thirteen-weeks ended December 26, 2009, Timothy’s contributed approximately $7,141,000 in revenue and $902,000 of income before taxes.

In the quarter ended March 27, 2010 10-Q report, Green Mountain reported the following year-to-date financial results for Timothy’s:

For the twenty-six weeks ended March 27, 2010, Timothy’s contributed approximately $26,288,000 in revenue and $5,422,000 of income before taxes.

Therefore, Timothy’s revenues were $19,147,000 and income before taxes was $4,520,000 for the thirteen-weeks ended March 27, 2010 (Timothy’s revenue and income before taxes for the twenty-six weeks ended March 27, 2010 minus its revenue and income before taxes for the thirteen-weeks ended December 26, 2009).

How Timothy’s income before taxes exceeded revenues during the thirteen-weeks ended June 26, 2010

In the quarter ended June 26, 2010 10-Q report, Green Mountain reported the following year-to-date financial results for Timothy’s:

For the thirty-nine weeks ended June 26, 2010, Timothy’s contributed approximately $28,586,000 in revenue and $10,112,000 of income before taxes.

Therefore, Timothy’s revenues were $2,298,000 and income before taxes was $4,690,000 for the thirteen-weeks ended June 26, 2010. (Timothy’s revenue and income before taxes for the thirty-nine weeks ended June 26, 2010 minus its revenue and income before taxes for the twenty-six weeks ended March 27, 2010.)

In other words, income before taxes exceeded revenues by $2,392,000 for the thirteen-weeks ended June 26, 2010. How can that happen?

I will present three scenarios below. First, let’s discuss some basic accounting.

How is income before taxes computed?

Income before taxes is computed by starting with revenues and deducting operating expenses to compute operating income. Non-operating income is added to operating income to compute income before taxes. Non-operating losses and interest expense are deducted from operating income to compute income before taxes.

Scenario 1: Good for Green Mountain

Under this scenario, the reason that Timothy’s income before taxes exceeded revenues during the thirteen-weeks ended June 26, 2010 is due to it having non-operating income. Green Mountain did not specifically disclose any non-operating items for Timothy’s. However, on a consolidated basis, non-operating income was only $27,000 for the thirteen-weeks ended June 26, 2010, nowhere near $2,392,000. It is still possible that Timothy’s had over $2 million of non-operating income, but only if such income was offset by non-operating losses in other subsidiaries.

However, any non-operating income from Green Mountain’s Timothy’s subsidiary cannot come from investment income. According to the company’s 10-Q report for the quarter ended June 26, 2010, Timothy’s financial results are included as part of its SCBU segment. The company disclosed that:

Expenses not specifically related to either operating segment are shown separately as “Corporate”. Corporate expenses are comprised mainly of the compensation and other related expenses of certain of the Company’s senior executive officers and other selected employees who perform duties related to our entire enterprise. Corporate expenses also include interest expense, certain corporate legal and acquisition-related expenses and compensation of the board of directors. In addition, fiscal 2009 corporate expenses are offset by $17,000,000 of proceeds received from a litigation settlement with Kraft. Corporate assets include cash and short-term investments. [Emphasis added.]

If “Corporate expenses also include interest expense” and Corporate assets include cash and short-term investments”, then likewise investment income should be a corporate expense, too. Therefore, Timothy’s non-operating income would have had to result from non-operating income which is not investment income, such as gains on the disposal of assets. It's possible, though I personally don't think that it's likely.

Scenario 2: Not good for Green Mountain

If Timothy’s did not have any non-operating income, the $2,392,000 excess of income before taxes over revenues for the thirteen-weeks ended June 26, 2010, could have resulted from understating revenues in that quarter.

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its accounting practices eight days earlier. On that same day, the company reported an accounting error involving its K-Cup margin percentages. On November 19, 2010, Green Mountain disclosed four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

Even if we assume that those accounting errors which were corrected by Green Mountain also corrected an overstatement of Timothy's revenues in the thirteen-weeks ended June 26, 2010, why didn't the company find that revenue overstatement earlier? When operating income that exceeds revenues, it is certainly a major red flag for close scrutiny by management and its auditors.

Scenario 3: Very bad for Green Mountain

If Timothy's did not have any non-operating income and its revenues were correctly reported, the $2,392,000 excess of income before taxes over revenues for the thirteen-weeks ended June 26, 2010 could only come from its operating expenses. However, in this case, operating expenses would have increased operating income, rather than reducing it, because operating expenses would have exceeded revenues by $2,392,000 for the thirteen-weeks ended June 26, 2010.

In other words, Timothy’s would have had negative operating expenses for that quarter. Negative operating expenses are normally caused by an adjustment to the current period’s operating expenses, because of an error in a previous reporting period. Therefore, Green Mountain may have been aware of material weaknesses in internal controls as early as June 2010 and not on November 19, 2010 when it first admitted to such problems.

In addition, none of the errors reported by Green Mountain involved any adjustment to operating expenses for the thirteen-weeks ended June 26, 2010. Therefore, there may be another undisclosed accounting error for Green Mountain to report to investors.

Missing a major overstatement of Timothy’s revenues and income back in 2009

In any case, Green Mountain missed a major overstatement of revenues and income before taxes in its Timothy’s subsidiary for the thirteen-weeks ended December 26, 2009 (the first quarter it was integrated into the company's operations).

In the quarter ended December 26, 2009 10-Q report, Green Mountain reported the following financial results for Timothy’s:

For the thirteen-weeks ended December 26, 2009, Timothy’s contributed approximately $7,141,000 in revenue and $902,000 of income before taxes.

In the quarter ended December 25, 2010 10-Q report, Green Mountain reported the following revised financial results for Timothy’s in 2009:

For the thirteen weeks ended December 26, 2009, the Timothy’s acquisition resulted in an additional $4.1 million of revenue and $0.0 million of income before income taxes.

Therefore, Green Mountain overstated revenues for Timothy’s by about $3 million and income before taxes by $900,000 in its 2009 10-Q report. How could Green Mountain miss a 75% overstatement in revenues in a single subsidiary? It's a very big error in a small subsidiary. The revenue overstatement should not have been hard to find.

Closing comment for Frances G. Rathke

If you respond to my question, I will post your answer in my blog. If you find additonal time, please respond to my blog post questioning your compliance with SEC Staff Accounting Bulletin No. 99 on materiality and my last blog post questioning your segment reporting and compliance with SEC Regulation G.

I hope you had a happy Valentine's day and I truly love reading Green Mountain's financial disclosures.

Very truly yours,

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

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. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, 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 Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.

Green Mountain Coffee Roasters, Time to Spill the Beans?

To truly exonerate itself after the discovery of certain material violations of Generally Accepted Accounting Principles (GAAP), Green Mountain Coffee Roasters (NASDAQ: GMCR) needs to come clean with investors and disclose exactly when it found certain accounting errors. In addition, Green Mountain needs to provide clearer and more transparent disclosures to investors about the Securities and Exchange Commission (SEC) inquiry and the discovery of those errors.

Timing of certain disclosures

On Monday, September 20, 2010, the SEC notified Green Mountain Coffee Roasters that it was conducting an informal inquiry and requested it voluntarily submit information concerning “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.”

Eight days later, on September 28, 2010, Green Mountain surprised investors by disclosing news of the SEC inquiry in an 8-K filing with the SEC. In that same 8-K report, Green Mountain disclosed that it discovered an "immaterial accounting error" affecting financial reports issued from 2007 to 2010:

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit. Management discovered that the gross margin percentage used to eliminate the inter-company markup resulted in a lower margin applied to the Keurig ending inventory balance effectively overstating consolidated inventory and understating cost of sales. Management determined that the accounting error arose during fiscal 2007 and analyzed the quantitative impact from that point forward to June 26, 2010.

As of June 26, 2010, there is a cumulative $7.6 million overstatement of pre-tax income. Net of tax, the cumulative error resulted in a $4.4 million overstatement of net income or a $0.03 cumulative impact on earnings per share.

After evaluating the quantitative and qualitative aspects of the error in accordance with applicable accounting literature, including Staff Accounting Bulletins published by the SEC, the Company, with the participation of the audit committee of the Board of Directors, has determined that the correction in the margin calculation represents a correction of an error in accordance with Accounting Standards Codification 250 Accounting Changes and Error Corrections, that the correction was not material to the fiscal years and the respective quarters ended 2007, 2008 and 2009 and that the Company anticipates that the correction will not be material to fiscal year 2010 and the respective quarters of fiscal 2010. As a result, the Company anticipates the cumulative amount of the accounting correction will be made in the quarter ended September 25, 2010. [Bold and italicized emphasis added.]

Green Mountain did not disclose exactly when it discovered the margin error but only that the margin error was discovered “In connection with the preparation of its financial results for its fourth fiscal quarter…..” Green Mountain’s fiscal year ended on September 25, 2010. Usually companies prepare for their year-end audits up to two months in advance.

Two scenarios

If Green Mountain had discovered the margin error before it was notified about the SEC inquiry, on September 20, 2010, why didn’t the company disclose the margin error to investors earlier, instead of waiting until it filed its 8-K report September 28, 2010?

If Green Mountain discovered the margin error after it was notified about the SEC inquiry, on September 20, 2010, why was the company able to find an accounting error within eight days or by September 28, 2010, when it didn't find the error during the previous fiscal years (2007 to 2010)? This scenario is possible, but it would be very coincidental.

The unknown timing of Green Mountain’s discovery of its margin error raises the question: did the company disclose the error to investors when it was discovered or did the company wait?

Green Mountain’s Common Stock Purchase Agreement with Luigi Lavazza S.p.A.

In that same September 28, 2010 8-K report, Green Mountain disclosed that it closed its Common Stock Purchase Agreement with Luigi Lavazza S.p.A. See below:

On September 28, 2010, Green Mountain Coffee Roasters, Inc., a Delaware corporation (the “Company”), completed a sale of 8,566,649 shares (the “Shares”) of its common stock, par value $0.10 per share (“Common Stock”), to Luigi Lavazza S.p.A., an Italian corporation (“Lavazza”), for an aggregate purchase price of $250,000,000. The sale of the Shares was effected pursuant to the Common Stock Purchase Agreement, dated as of August 10, 2010 (the “SPA”), by and between the Company and Lavazza. The execution of the SPA was previously reported by the Company in its Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission (the “SEC”) on August 11, 2010, and the full text of the SPA was filed as Exhibit 10.1 thereto. 

In connection with the stock purchase agreement, Green Mountain provided certain warranties that the Company and its auditors have not identified and are not aware of:

(A) any significant deficiency or material weakness in the design or operation of internal control over financial reporting utilized by the Company; (B) any illegal act or fraud, that involves the Company’s management or other employees; or (C) any claim or allegation regarding any of the foregoing that would have a Material Adverse Effect. [Bold and italicized emphasis added.]

According to Statement of Auditing Standards No. 115:

.07 A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.

A material weakness in internal controls generally arises when accounting errors have a “reasonable possibility” of causing a company to restate its financial reports to correct those errors. A "significant deficiency" in internal controls arises when accounting errors are not material enough to cause a restatement of financial reports, but are instead corrected by making a cumulative adjustment to the latest period’s financial reports.

Initially, Green Mountain claimed that its margin error was “immaterial” and disclosed that it would correct that error by making a cumulative adjustment to its Q4 2010 financial reports, rather than restate its financial reports issued from 2007 to 2010. At the very least, that margin error appeared to result from a “significant deficiency” under auditing rules. It could be a breach of warranty under Green Mountain’s Common Stock Purchase Agreement with Luigi Lavazza, though Green Mountain never told investors that may have breached a key warranty under its agreement with Luigi Lavazza.

Green Mountain initially entered into its agreement to sell shares to Luigi Lavazza on August 10, 2010. On the following day, Green Mountain disclosed to investors that:

On August 10, 2010, Green Mountain Coffee Roasters, Inc., a Delaware corporation (“Green Mountain” or the “Company”), and Luigi Lavazza S.p.A., an Italian corporation (“Lavazza”), entered into a Common Stock Purchase Agreement (the “SPA”). Pursuant to the terms of the SPA, Lavazza has agreed to make a $250,000,000 investment (the “Investment”) in Green Mountain’s common stock, par value $0.10 per share (“Common Stock”), at a purchase price per share equal to the volume-weighted average price of the Common Stock for the 60 trading days before the closing of the Investment, less 7.5% (the “Shares”). [Bold and italicized emphasis added.]

Thus, Lavazza's "purchase price per share would be equal to the volume-weighted average price of the Common Stock for the 60 trading days before September 28, 2010, less 7.5% (the “Shares”).” If the share price were to have dropped prior to Sept. 28, it would be reflected in Lavazza's final purchase price.

Based on the agreed upon terms, Luigi Lavazza paid $250 million to purchase 8,566,649 shares, or an average price per share of $29.18 which was computed as follows:

$31.55 gross volume-weighted average price of the Common Stock less 7.5% discount or $2.37 equals $29.18.

On September 28, 2010, Green Mountain closed its Common Stock Purchase Agreement with Luigi Lavazza. Later that same day, after the stock market closed, the company finally disclosed the SEC inquiry and the discovery of the margin error to investors.

On September 29, 2010, Green Mountain stock dropped $5.95 per share to close at $31.06 per share, a 16.1% drop in market value that day in reaction to news of the SEC inquiry and accounting error. The stock continued to drop to $26.87 per share on October 11, 2010.

Green Mountain’s gross "volume-weighted average price" per share of stock in the sixty trading days prior to closing its Common Stock Purchase Agreement with Luigi Lavazza was about $31.55 per share. Apparently, if Green Mountain had waited to close the deal until after it disclosed news of the SEC inquiry and margin error, Luigi Lavazza would have paid less money per share to the company. This leads to the question: did Green Mountain purposely delay disclosure to investors of the SEC inquiry, the margin error, significant weaknesses in internal controls, and possible breaches of representations and warranties under its agreement with Luigi Lavazza?

Or did Green Mountain give early warning to Luigi Lavazza under the terms of their confidential agreement? (See Common Stock Purchase Agreement Section 7). In such case, did Luigi Lavazza not care about the probable negative impact on the stock price after the SEC inquiry and margin errors were disclosed to investors? And if so, why not?

More accounting errors discovered

On November 19, 2010, Green Mountain filed an 8-K report updating investors about the margin error it disclosed on September 28, 2010 and also disclosed additional accounting errors:

["Margin error"] A $7.6 million overstatement of pre-tax income, cumulative over the restated periods, due to the K-Cup inventory adjustment error previously reported in the Company’s Form 8-K filed on September 28, 2010. This error is the result of applying an incorrect standard cost to intercompany K-Cup inventory balances in consolidation. This error resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales. Rather than correcting the cumulative amount of the error in the quarter ended September 25, 2010, as disclosed in the September 28, 2010 Form 8-K, the effect of this error will be recorded in the applicable restated periods.

A $1.4 million overstatement of pre-tax income, cumulative over the restated periods, due to the under-accrual of certain marketing and customer incentive program expenses. The Company also has corrected the classification of certain of these amounts as reductions to net sales instead of selling and operating expenses. These programs include, but are not limited to, brewer mark-down support and funds for promotional and marketing activities. Management has determined that miscommunication between the sales and accounting departments resulted in expenses for certain of these programs being recorded in the wrong fiscal periods.

A $1.0 million overstatement of pre-tax income, cumulative over the restated periods, due to changes in the timing and classification of the Company’s historical revenue recognition of royalties from third party licensed roasters. Because royalties were recognized upon shipment of K-Cups by roasters pursuant to the terms and conditions of the licensing agreements with these roasters, Keurig historically recognized these royalties at the time Keurig purchased the K-Cups from the licensed roasters and classified this royalty in net sales. Management has determined to recognize this royalty as a reduction to the carrying cost of the related inventory. The gross margin benefit of the royalty will then be realized upon the ultimate sale of the product to a third party customer. Due to the Company’s completed and, when consummated, pending acquisitions of third party licensed roasters, these purchases and the associated royalties have become less of a factor, since the post-acquisition royalties from these wholly-owned roasters are not included in the Company’s consolidated financial statements.

An $800,000 overstatement of pre-tax income, cumulative over the restated periods, due to applying an incorrect standard cost to intercompany brewer inventory balances in consolidation. This error was identified during the preparation of the fiscal year 2010 financial statements and resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales.

A $700,000 understatement of pre-tax income for the Specialty Coffee business unit, due primarily to a failure to reverse an accrual related to certain customer incentive programs in the second fiscal quarter of 2010. The over-accrual was not identified and corrected until the fourth fiscal quarter of 2010.

In addition to the errors described above, the Company also will include in the restated financial statements certain other immaterial errors, including previously unrecorded immaterial adjustments identified in audits of prior years’ financial statements. [Bold and italicized emphasis added.]

Green Mountain also claimed that:

… these errors were discovered by management during the course of its preparation of the year-end financial statements and audit, as well as during the course of an internal investigation initiated by the audit committee of the Company’s board of directors in light of the previously disclosed inquiry by the staff of the Securities and Exchange Commission’s (“SEC”) Division of Enforcement. [Bold and italicized emphasis added.]

In its September 28, 2010 8-K report, Green Mountain claimed that the margin error was discovered “In connection with the preparation of its financial results for its fourth fiscal quarter.” Presumably, the additional errors listed in the November 19, 2010 8-K report were discovered during the internal investigation after the SEC notified the company of it informal inquiry.

We still don’t know exactly when Green Mountain discovered the margin error, whether it was before or after the company learned about the SEC inquiry on September 20, 2010. However, we now know that Green Mountain found several new accounting errors about sixty days after it was notified of the SEC inquiry. It also appears that Green Mountain is taking the position that its errors were "immaterial."

Materiality of accounting errors

Originally on September 28, 2010, Green Mountain disclosed that it overstated pre-tax income from 2007 to 2010 because of the margin error. The company claimed that the margin error was “immaterial” and said it would correct that error by making a cumulative adjustment to earnings “in the quarter ended September 25, 2010.”

On November 19, 2010, Green Mountain disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income, making a total overstatement of $10.1 million in pre-tax income. This time, the company announced that it would restate its financial reports issued from 2007 to 2010 to correct all of its errors:

On November 15, 2010, the board of directors of Green Mountain Coffee Roasters, Inc. (the “Company”), based on the recommendation of the audit committee and in consultation with management, concluded that, because of errors identified in the Company’s previously issued financial statements for the fiscal years ended September 29, 2007, September 27, 2008 and September 26, 2009 and the first three fiscal quarters of 2010, the Company will restate its previously issued financial statements, including the quarterly data for fiscal years 2009 and 2010 and its selected financial data for the relevant periods. Accordingly, investors should no longer rely upon the Company’s previously released financial statements for these periods and any earnings releases or other communications relating to these periods. [Bold and italicized emphasis added.]

Green Mountain did not identify any specific accounting error as "material." However, under SEC Staff Accounting Bulletin No. 99, accounting errors are material when they cause the "financial statements taken as a whole" to be "materially misstated" or "materially misleading." Such errors must be corrected by restating financial reports, instead of using a cumulative adjustment to the latest quarter's report to correct those errors.

How Green Mountain tried to spin the materiality issue

In its November 19, 2010 8-K report, Green Mountain tried to minimize to seriousness of its accounting errors by using carefully crafted language claiming that:

The effects on certain reported periods are quantitatively significant, and the impact of the individual errors will be disclosed in more detail in the Company’s restated financial statements.

The adjustments necessary to correct the errors will have no effect on reported cash flow from operations, and are not expected to have a material impact on the balance sheet.

Such errors can still be cause "financial statements taken as a whole" to be "materially misstated" or "materially misleading." SAB No. 99 directly addresses that issue:

If the misstatement of an individual amount causes the financial statements as a whole to be materially misstated, that effect cannot be eliminated by other misstatements whose effect may be to diminish the impact of the misstatement on other financial statement items. To take an obvious example, if a registrant's revenues are a material financial statement item and if they are materially overstated, the financial statements taken as a whole will be materially misleading even if the effect on earnings is completely offset by an equivalent overstatement of expenses.

Even though a misstatement of an individual amount may not cause the financial statements taken as a whole to be materially misstated, it may nonetheless, when aggregated with other misstatements, render the financial statements taken as a whole to be materially misleading. [Bold and italicized emphasis added.] 

For example, Company A and Company B are both competitors and each company has $100 of revenue, $100 of expenses, and zero profits. Both companies make only cash sales to customers and pay all of their expenses in cash. Each company started and ended the year with $100 in cash because they had zero profits.

Company A wants to make it appear that it has more market share (revenues) than company B and it inflates revenues and expenses by $100 each to report $200 of revenues, $200 of expenses, and but still zero profits. At the end of the year both companies report zero profits, zero cash flows from operations, and $100 cash on their balance sheets.

Company A's inflation of revenues and expenses did not change its reported profits, cash flow from operations, or balance sheet. However, Company A materially overstated both its revenues and expenses. Therefore, Company A's financial statements "taken as a whole" were "materially misleading."

Green Mountain said that "The effects on certain reported periods are quantitatively significant, and the impact of the individual errors will be disclosed in more detail in the Company’s restated financial statements." However, Green Mountain made no specific mention that its "financial statements taken as a whole" were "materially misstated" or "materially misleading."

Green Mountain should explain its decision to consider the margin error as an "immaterial accounting error"

When Green Mountain issues its restated financial reports, it should provide a thorough analysis and explain to investors why, originally on September 28, 2010, it considered the margin error “immaterial” and initially decided to use a cumulative adjustment to Q4 2010’s financial report to correct that error instead of restating its financial reports.

When the SEC Division of Corporation Finance conducts periodic reviews of public company financial reports and finds accounting errors, it requires the companies to provide a detailed materiality analysis using criteria under SAB No. 99. The analysis is later made publicly available in company filings after the review is completed. At the very least, Green Mountain should provide this analysis to investors when it files its 2010 annual 10-K report.

According to SAB No. 99:

Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are –  

• whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate 
• whether the misstatement masks a change in earnings or other trends   
• whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise   
• whether the misstatement changes a loss into income or vice versa  
• whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability  
• whether the misstatement affects the registrant's compliance with regulatory requirements
• whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements   
• whether the misstatement has the effect of increasing management's compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation 
• whether the misstatement involves concealment of an unlawful transaction. 

This is not an exhaustive list of the circumstances that may affect the materiality of a quantitatively small misstatement. Among other factors, the demonstrated volatility of the price of a registrant's securities in response to certain types of disclosures may provide guidance as to whether investors regard quantitatively small misstatements as material. Consideration of potential market reaction to disclosure of a misstatement is by itself "too blunt an instrument to be depended on" in considering whether a fact is material. When, however, management or the independent auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material.

If Green Mountain's margin error fell under any of the criteria listed above, it should have been considered a material accounting error under SAB No. 99, rather than an "immaterial accounting error" as originally claimed by the company.

Insider sales of stock

In a previous blog post, I detailed how on September 21, 2010, a day after Green Mountain was notified of the SEC inquiry, but seven days before the SEC inquiry was disclosed to investors, executive officer Michelle Stacy exercised 5,000 options and immediately sold her shares at $37 per share. At that time, Michelle Stacy's Form 4 disclosure did not reflect that she sold her shares pursuant to a Rule 10b5-1 trading plan. A Rule 10b5-1 trading plan provides certain safe harbors which help executives defend against potential allegations of illegal insider-trading by removing their discretion to decide when their stock is bought or sold.

About five weeks after that blog post, on October 28, 2010, Stacy belatedly filed an amended Form 4 report and disclosed that:

This Form 4 has been amended to note that these sales were affected pursuant to a Rule 10b5-1 trading plan adopted by Ms. Stacy on 08/13/2010. 

In addition, Michelle Stacy filed another amended Form 4 report to reflect that her September 13, 2010 option exercise and sale of stock was also "affected pursuant to a Rule 10b5-1 trading plan." That option exercise and sale took place just seven days before Green Mountain was notified by the SEC on an inquiry.

At the very least, Michelle Stacy’s filing of amended Form 4 reports displays a continuous pattern of problematic financial reporting by Green Mountain and its officers and which increases investor uncertainty about the integrity of the company’s SEC filings.

Many responsible companies voluntarily disclose their insider's 10b5-1 trading plans as they are adopted, even though such disclosure is not required under existing SEC rules. The existence of 10b5-1 trading plans are only required to be disclosed on Form 4 as insiders purchase or sell their stock pursuant to such plans. However, voluntary disclosure at the inception of a 10b5-1 trading plan by insiders increases corporate transparency.

On August 13, 2010, Michelle Stacy exercised 30,000 options and immediately sold her shares at $30.95 per share. Not till October 28 did Stacy file amended Form 4 reports to reflect that her September 13th and 21st option exercises and sales of stock were carried out pursuant to a Rule 10b5-1 trading plan. Stacy claimed that she adopted a 10b5-1 trading plan on August 13. On August 13th, Stacy exercised options and sold stock, but she still does not claim that those transactions were made pursuant to a 10b5-1 trading plan.

If a corporate executive already has nonpublic knowledge of certain adverse events such as undisclosed weaknesses in internal controls, accounting errors, or an SEC inquiry, a 10b5-1 plan cannot provide a safe harbor against illegal insider trading allegations. If it turns out that Michelle Stacy had non-public knowledge of any of those issues affecting Green Mountain before adopting her 10b5-1 trading plan, she could be charged by the SEC with alleged insider trading violations. Several lawsuits seeking class action status have already alleged securities law violations by Green Mountain and its officers.

Usually 10b5-1 trading plans call for the purchase or sale of stock by insiders at regular intervals.  Michelle Stacy’s plan doesn't appear particularly regular. On Monday, September 13, 2010, she exercised options and sold 5,000 shares of Green Mountain stock. Eight days later on Tuesday, September 21, 2010 (and a day after Green Mountain received notification of the SEC inquiry) she exercised options and sold another 5,000 shares of Green Mountain stock. Forty-five days later, on November 5, 2010, Michelle Stacy exercised options and sold 10,000 shares of Green Mountain stock. In the interest of transparency, Michelle Stacy should explain how the timing of option exercises and sales were determined under her 10b5-1 plan.

PricewaterhouseCoopers

PricewaterhouseCoopers is Green Mountain’s current auditor and it is now evident that it missed a growing list of accounting errors covering fiscal years 2007 to 2010. Likewise, until 2009 PricewaterhouseCoopers was Overstock.com’s (NASDAQ: OSTK) auditors, too. Every single initial financial report issued by Overstock.com from 1999 to 2009 had to be restated at least once and as many as three times due to accounting errors. Therefore, PricewaterhouseCoopers missed accounting errors by Overstock.com in each and every audit it performed of the company.

In 2009, I identified certain violations of Generally Accepted Accounting Principles (GAAP) which ultimately caused Overstock.com to restate its financial reports for the third time in three years, after the SEC intervened and forced to company to correct its accounting errors. During the ongoing SEC investigation, PricewaterhouseCoopers defended Overstock.com’s improper accounting treatment of cost recoveries from vendors and as it turns out, they were wrong.

Prematurely proclaiming the absence of wrongdoing 

In its November 19, 2010 8-K report, Green Mountain claimed that none of the financial statement errors implicate misconduct with respect to the Company or its management or employees:

The internal investigation is nearly complete, and the Company continues to cooperate fully with the SEC. None of the financial statement errors implicate misconduct with respect to the Company or its management or employees. In addition, none of the financial statement errors are related to the Company’s relationship with M.Block & Sons, the fulfillment vendor through which the Company makes a majority of the at-home orders for the Keurig business unit’s single-cup business sold to retailers. [Bold and italicized emphasis added.]

It is premature for Green Mountain to proclaim the absence of any wrongdoing while the SEC inquiry is still ongoing and it admits that its own internal investigation is not fully completed. The SEC inquiry began on September 20 and has not been concluded. That statement will come back to haunt Green Mountain if the SEC decides to conduct a formal investigation.

In any case, I am naturally suspicious of self-proclaimed absences of wrongdoing without thorough outside independent examination. Back in the old days at Crazy Eddie, we conducted a similar internal inquiry with help from our auditors into certain allegations of wrongdoing involving a supplier and proclaimed ourselves clean. The auditors falsely claimed to both our audit committee and the SEC that they thoroughly checked out those allegations and found no wrongdoing. Management and auditors have little incentive to report their own foul-ups.

Final comment

Every financial report issued by Green Mountain and certified by PricewaterhouseCoopers from 2007 to 2010 had to be restated because of accounting errors. In addition, Green Mountain CEO Lawrence J. Blanford and CFO Frances G. Rathke signed Sarbanes-Oxley certifications covering those reports. So far no one has been held accountable by Green Mountain for its financial misstatements – not its auditors, CFO, or CEO.

While I personally like the smell of Green Mountain's coffee, I don't like the smell of its financial disclosures. A little more enthusiasm in cleaning up its financial reporting (like it devotes to cleaning up the environment) and a little more transparency would go a long way.

Written by,

Sam E. Antar (with research assistance from Ilene)

Recommended reading about issues with 10b5-1 trading plans

February 1, 2009: Stanford University Graduate School of Business - Sec Rule 10b5-1 and Insiders' Strategic Trade by Alan D. Jagolinzer

July 2009: Stanford University Graduate School of Business - Research Underpins SEC Scrutiny of Scheduled Insider Trades by Bill Snyder

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. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, 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 Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of those companies is a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.