April 12, 2008

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Weekend Investor
Why Do Investors Ignore Inquiries?

From the looks of its stock price, you would never know that Take-Two Interactive Software is at the center of multiple open investigations, including an undisclosed number of grand-jury subpoenas from the New York County district attorney examining almost every aspect of the videogame company.

Even with the unresolved risks, the creator of the crooks-beat-the-cops franchise, Grand Theft Auto, recently received an unwanted takeover bid from Electronic Arts. The hostile offer propelled Take-Two's stock to roughly where it was when the subpoenas first started to fly two years ago.

Then there is Bally Technologies. Its stock is trading at a considerable premium to where it was in 2005, when the maker of slot machines disclosed that the Securities and Exchange Commission was investigating its revenue-recognition practices.

When it comes to government investigations, "investors are dangerously complacent," says John Gavin, president of Disclosure Insight, a research firm that analyzes SEC filings with a focus on uncovering investigations before they are publicly disclosed. Too often, he says, they are simply "too generous" in their assessment of regulatory risk.

He says that is because management often gives little in the way of facts while analysts don't probe "because they're afraid" of getting frozen out by the company.

But buyer beware: While it may seem that investigations no longer matter, there is plenty of research -- and more than a few examples -- to show that many if not most still tend not to bode well for investors, assuming investors know about them in the first place.

As Mr. Gavin has found, many companies avoid disclosing investigations until long after they are under way. To break the code, he files Freedom of Information Act requests with various government entities. His findings are available without charge on his company's Web site.

The reality: There isn't a rule that says a company must disclose investigations until they are deemed, by the company, as material. "They are the judge," says Mr. Gavin, who acknowledges that "inasmuch as investigations matter, in fairness sometimes they truly don't. They might be a tiny matter -- something where the SEC just goes away."

On the other hand, Mr. Gavin adds, "Dell sat on its revenue-recognition investigation for a year and then disclosed it."

Dell, for its part, says it waited to disclose the investigation until the inquiry became "more focused." And even then, a spokesman says, it was announced before it officially turned "formal," the time at which the SEC can begin issuing subpoenas.

Even after last year's announcement of a restatement, which at less than $100 million amounted to a fraction of sales, Dell's stock has been an underperformer as the company has tried to reinvent itself.

But restatements, which would appear to put overly aggressive accounting in the past, don't necessarily establish a clean slate in the eyes of investors.

According to a Treasury Department restatements report this past week by University of Kansas associate professor of accounting Susan Scholz, while there are some indications of apathy by investors, "returns are statistically negative for restatements involving fraud" in every year but 2004.

Restatements, alone, aren't as ominous for investors as outside investigations. From "the first revelation of misconduct" until an investigation is resolved, stocks of target companies tend to fall by an average of 40%, says Jonathan Karpoff, a finance professor at the University of Washington, who co-authored a study on the topic.

The reason, he says, is a loss of reputation, which on one level is an intangible, but on the other can be seen as a direct hit to the business.

Lenders, for example, might be reluctant to lend to companies that have been tagged as having inadequate internal controls. "And in some cases," he says, investigations can "be the cause of losing customers."

Mr. Karpoff's study also shows that about 90% of companies under regulatory fire tend to lose their top executives by the time the investigation has been settled.

So, with so much uncertainty, why would Electronic Arts want to acquire Take-Two? Electronic Arts declined to comment.

Even more puzzling is Bally Technologies, which in February held its first earnings conference call in more than two years -- the first since disclosing the SEC inquiry. Not one analyst asked for an update of the investigation, and the company didn't volunteer anything.

So let me do the dirty work, paraphrasing what I asked in an email to the company: "If I were an investor, why shouldn't I be concerned about the existence of such a long-running investigation?" I'll take the lack of a response as a no comment.

Herb Greenberg, MarketWatch senior columnist, doesn't own stocks except his employer's -- nor sell individual stocks short or invest in hedge funds. MarketWatch is a unit of Wall Street Journal publisher Dow Jones. Email hgreenberg@marketwatch.com¹.