Major Case 5 Vivendi Universal "Some of my management decisions turned wrong, but fraud? Never, never, never. This statement was made by the former CEO of Vivendi Universal, Jean-Marie Messier, as he took the stand in November 20, 2009, for a civil class action lawsuit brought against him, Vivendi Universal, and the former CFO, Guillaume Hannezo. The class action suit accused the company of hiding Vivendi's true financial condition before a $46 billion three-way merger with Seagram Company and Canal Plus. The case was brought against Vivendi, Messier, and Hannezo after it was discovered that the firm was in a liquidity crisis and would have problems repaying its outstanding debt and operating expenses (contrary to the press releases by Messier, Hannezo, and other senior executives that the firm had excellent and strong liquidity); that it participated in earnings management to achieve earnings goals, and that it had failed to disclose debt obligations regarding two of the company's subsidiaries. The jury decided not to hold either Messier or Hannezo legally liable because scienter (i.e., knowledge of the falsehood) could not be proven. In other words, the court decided it could not be shown that the two officers acted with the intent to deceive other parties. The stock price of the firm dropped 89%, from $111 on October 31, 2000, to $13 on August 16, 2002, over the period of fraudulent reporting and press releases to the media. As you read the case, consider whether Messier was accurate in his belief that fraud was not committed and whether this was an ethics failure. Background Vivendi is a French international media giant, rivaling Time Warner Inc., that spent $77 billion on acquisitions, including the world's largest music company, Universal Music Group (UMG). Messier took the firm to new heights through mergers and acquisitions that came with a large amount of debt. In December 2000, Vivendi acquired Canal Plus and Seagram, which included Universal Studios and its related companies, and became known as Vivendi Universal. At the time, it was one of Europe's largest companies in terms of assets and revenues, with holdings in the United States that included Universal Studios Group, UMG, and USA Networks Inc. These acquisitions cost Vivendi cash, stock, and assumed debt of over $60 billion and increased the debt associated with Vivendi's Media & Communications division from approximately $4.32 billion at the beginning of 2000 to over $30.25 billion in 2002. In July 2002, Messier and Hannezo resigned from their positions as CEO and CFO, respectively, and new management disclosed that the company was experiencing a liquidity crisis that was a very different pic- ture than the previous management had painted of the financial condition of Vivendi Universal. This was due to senior executives using four different methods to conceal Vivendi Universal's financial problems: Issuing false press releases stating that the liquidity of the company was "strong" and "excellent" after the release of the 2001 financial statements to the public. Using aggressive accounting principles and adjustments to increase EBITDA and meet ambitious earnings targets. Failing to disclose the existence of various commitments and contingencies. Failing to disclose part of its investment in a transaction to acquire shares of Telco, a Polish telecommunications holding company. Earnings Releases/EBITDA On March 5, 2002, Vivendi issued earnings releases for 2001, which were approved by Messier, Hannezo, and other senior executives, that their Media & Communications business had produced $7.25 billion in EBITDA and just over $2.88 billion in operating free cash flow. These earnings were materially misleading and falsely represented Vivendi's financial situation because, due to legal restrictions, Vivendi was unable unilaterally to access the earnings and cash flow of two of its most profitable subsidiaries, Cegetel and Maroc Telecom, which accounted for 30% of Vivendi's EBITDA and almost half of its cash flow. This contributed to Vivendi's cash flow actually being "zero or negative," making it difficult for Vivendi to meet its debt and cash obligations. Furthermore, Vivendi declared $1.44 per share dividend because of its excellent operations for the past year, but Vivendi borrowed against credit facilities to pay the dividend, which cost more than $1.87 billion after French corporate taxes on dividends. Throughout the following months before Messier's and Hannezo's resignations, senior executives continued to lie to the public about the strength of Vivendi as a company. In December 2000, Vivendi and Messier predicted a 35% EBITDA growth for 2001 and 2002, and, in order to reach that target, Vivendi used earnings management and aggressive accounting practices to overstate its EBITDA. In June 2001, Vivendi made improper adjustments to increase EBITDA by almost $85 million, or 5% of the total EBITDA of $1.61 billion that Vivendi reported. Senior executives did this mainly by restructuring Cegetel's allowance for bad debts. Cegetel, a Vivendi subsidiary whose financial statements were consolidated with Vivendi's, took a lower provision for bad debts in the period and caused the bad debts expense to be $64.83 million less than it would have been under historical meth- odology, which in turn increased earnings by the same amount. Furthermore, after the third quarter of 2001, Vivendi adjusted earnings of UMG by at least $14.77 million or approximately 4% of UMG's total EBITDA of $360.15 million for that quarter. At that level, UMG would have been able to show EBITDA growth of approximately 6% versus the same period in 2000 and to outperform its rivals in the music business. It did this by prematurely recognizing revenue of $4.32 million and temporarily reducing the corporate overhead charges by $10.08 million. Financial Commitments Vivendi failed to disclose in its financial statements commitments regarding Cegetel and Maroc Telecom that would have shown Vivendi's potential inability to meet its cash needs and obligations. It was also worried that, if it disclosed this information, companies that publish independent credit opinions would have declined to maintain their credit rating of Vivendi. In August 2001, Vivendi entered into an undisclosed current account borrowing with Cegetel for $749.11 million and continued to grow to over $1.44 billion at certain periods of time. Vivendi maintained cash pooling agreements with most of its subsidiaries, but the current account with Cegetel operated much like a loan, with a due date of the balance at December 31, 2001 (which was later pushed back to July 31, 2002), and there was a clause in the agreement that provided Cegetel with the ability to demand immediate reimbursement at any time during the loan period. If this information would have been disclosed, it would have shown that Vivendi would have trouble repaying its obligations. Regarding Maroc Telecom, in December 2000, Vivendi purchased 35% of the Moroccan government-owned telecommunications operator of fixed line and mobile telephone and Internet services for $3.39 billion. In February 2001, Vivendi and the Moroccan government entered into a side agreement that required Vivendi to purchase an additional 16% of Maroc Telecom's shares in February 2002 for approximately $1.58 billion. Vivendi did this in order to gain control of Maroc Telecom and consolidate its financial statements with Vivendi's own because Maroc carried little debt and generated substantial EBITDA. By not disclosing this information on the financial statements, Vivendi's financial information for 2001 was materially false and misleading. Stakeholder Interests The major stakeholders in the Vivendi case include (1) the investors, creditors, and shareholders of the company and its subsidiaries-by not providing reliable financial information, Vivendi misled these groups into lending credit and cash and investing in a company that was not as strong as it seemed; (2) the subsidiaries of Vivendi and their customers-by struggling with debt and liquidity, Vivendi borrowed cash from the numerous subsidiaries all over the globe, jeopardizing their operations; (3) the governments of these countries-because some of Vivendi's companies were government owned (such as the Moroccan company Maroc Telecom), and these governments have to regulate the fraud and crimes that Vivendi committed; and (4) Vivendi, Messier, Hannezo, and other senior management and employees-Messier was putting his future, the employees of Vivendi, and the company itself in jeopardy by making loose and risky decisions involving the sanctity of the firm. SEC Actions Under Section 1103 of SOX Section 1103 of SOX provides that: Whenever, during the course of a lawful investigation involving possible violations of the Federal securities laws by an issuer of publicly traded securities or any of its directors, officers, partners, controlling persons, agents, or employees, it shall appear to the Commission that it is likely that the issuer will make extraordinary payments (whether compensation or otherwise) to any of the foregoing persons, the Commission may petition a Federal district court for a temporary order requiring the issuer to escrow, subject to court supervision, those payments in an interest-bearing account for 45 days. In the Fair Funds provisions of SOX, Congress gave the SEC increased authority to distribute ill-gotten gains and civil money penalties to harmed investors. These distri- butions reflect the continued efforts and increased capacity of the commission to repay injured investors, regardless of their physical location and their currency of choice. Based on these provisions, Messier was required to relinquish his claim to a severance package of about $29.4 million, which includes back pay and bonuses for the first half of 2002, and to pay a civil money penalty of $1 million and disgorgement of $1. Hannezo was required to disgorge $ 148,149 and to pay a penalty of $120,000. On August 11, 2008, the SEC announced the distribution of more than $48 million to more than 12,000 investors who were victims of fraudulent financial reporting by Vivendi Universal. Investors receiving checks resided in the United States and 15 other countries. More than half bought their Vivendi stock on foreign exchanges and received their Fair Fund distribution in euros. Failure of Ethical Leadership In his analysis of the fraud at Vivendi, Soltani points to failures in ethical practice, corporate governance, and leadership as the root cause of the failure at Vivendi. He characterizes the actions of Messier as motivated by egoism, using one's authoritative position to influence others to ignore ethical practices, failure to set an ethical tone at the top, and failed corporate governance. What follows is an analysis of the points he makes in dissecting the fraud.? Use of company funds for personal benefit, including to enhance lifestyle choices. Failure to conceptualize core values and ethical standards in the company. Lack of internal control mechanisms to prevent and detect fraud. Ineffective control environment to prevent and detect fraud. Excessive risk taking. Opportunistic behavior. False earnings announcements. Aggressive earnings management. Use of loopholes in financial reporting standards to alter numbers as far as possible to achieve a desired goal. Lapses in accountability. Inability of external auditors to exercise their functions in an independent manner and detect material misstatements and fraudulent financial reporting. It is clear that the culture at Vivendi enabled the fraud to occur and prevented the company from dealing with the crisis as it unfolded. Questions 1. What is the role of internal controls in facilitating ethical behavior in an organization? Briefly describe the problems with internal controls at Vivendi with respect to its relationships with Cegetel and Maroc Telecom. 2. Why are disclosures in financial statements important? Why were they important in the relation- ship between Vivendi and Cegetel and Maroc Telecom? Is there such a thing as disclosure fraud? Explain. 3. Why do financial analysts look at measures such as EBITDA and operating free cash flow to evaluate financial results? How do these measures differ from GAAP earnings? Do you believe auditors should be held responsible for auditing such information? 4. Is using earnings management and aggressive accounting in EBITDA calculations just as serious as doing the same with the financial statements prepared under GAAP? Explain. 5. Analyze the appropriateness of the provisions in Section 1103 of SOX from an ethical reasoning perspective.