Why Do High-Yield Stocks Like American Realty Capital Bring Out Bad Executive Behavior?

By Markets Fool.com

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The ongoing accounting debacle at American Realty Capital is a sordid affair. But far from being an exception to the rule among high-yielding companies such as real estate investment trusts and business development companies, this scandal is only the latest instance in which the managers of these companies have behaved in questionable ways.

American Realty's sordid affair
At the heart of American Realty's fall from grace is a somewhat esoteric measure of performance known as the "adjusted funds from operations," or AFFO, which real estate investment trusts encourage shareholders to focus on instead of net income as a gauge of performance.

There's little value in getting mixed up in the details of how AFFO is calculated other than to say that it excludes certain non-cash receipts and expenditures from the official measure of GAAP income. According to boilerplate language included in American Realty's quarterly filings with the SEC:

By providing AFFO, we believe we are presenting useful information that assists investors and analysts to better assess the sustainability of our ongoing operating performance without the impacts of transactions that are not related to the ongoing profitability of our portfolio of properties.

The problem, in turn, is this: Beginning in the fourth quarter of last year, American Realty changed how it calculated AFFO -- which, significantly, is one of four financial metrics that determine its executives' pay. And, at least according to the findings of American Realty's own audit committee, the illicit change was made intentionally and resulted in a fraudulent overstatement of AFFO through the second quarter of this year.

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While American Realty initially heaped blame on its chief financial officer and chief accounting officer, both of whom left the firm at the end of October, it now looks as though the malfeasance originated at the top -- that is, with chairman Nicholas Schorsch and chief executive officer David Kay.

In a lawsuit filed on Thursday,American Realty's former chief accounting officer, Lisa McAlister, says she brought the fraudulent calculation to Schorsch and Kay's attention in February. However, McAlister alleges that, at Schorsch and Kay's "specific direction," the company continued to use it. If this weren't bad enough, McAlister alleges that Schorsch later instructed former CFO Brian Block to "take steps that would cover up the improper change in accounting with ... further fraudulent accounting."

Suffice it to say that these allegations weren't well-received. The day after McAlister's attorney informed Schorsch and Kay of her pending lawsuit, they resigned -- and, at least in Schorsch's case, not only from American Realty. According to The Wall Street Journal, he also stepped down from the boards of more than 10 other companies and resigned as CEO of at least six additional non-publicly traded firms.

A pattern of unsavory conduct
There's no getting around the fact that allegations like these are discouraging to the individual investor. But what makes this situation worse is the pattern of questionable behavior that has become commonplace among similarly situated high-yielding companies -- namely, real estate investment trusts like Annaly Capital Management and Chimera Investment Corporation , as well as business development corporations such as Prospect Capital Corporation .

As I've noted in the past, Annaly's founder was previously suspended by industry regulators for filing "inaccurate [regulatory] reports." Further, the company's board routinely defies shareholder votes, its executives obfuscate their compensation structure to the detriment of shareholders, and, worst of all, executives recently restructured the company in a way that both eliminates transparency and, in my opinion, effectively saps any intrinsic value from the corporate entity beyond its portfolio holdings.

Meanwhile, in 2012, shareholders of Chimera learned that the company had overstated its income by a factor of three over the preceding four years: Chimera originally claimed that it earned $1.06 billion when, by its own subsequent admission, it had actually earned only $367 million. In addition, after acknowledging the alleged error, Chimera proceeded to miss nearly every filing deadline for its quarterly and annual reports over the next two years, was nearly de-listed from the New York Stock Exchange, and fired Deloitte & Touche after the firm informed Chimera that all of its financial statements since inception needed to be restated.

Finally, as my colleague Jordan Wathen pointed out last month, the high-yielding business development company Prospect recently structured the sale of one of its portfolio companies in a way that maximized advisory fees to its external manager -- which, it's important to point out, is operated by the same people that ostensibly run Prospect. The net result is that Prospect's managers helped themselves to a $600,000 payday at the expense of shareholders.

What's going on here?
Of course, mistakes and outright malfeasance that enrich executives at the expense of shareholders aren't unique to real estate investment trusts and business development companies. Roughly a decade ago, for instance, a wave of scandals washed over corporate America, leading to the downfall of Enron, WorldCom, Adelphia, and others.

Yet investors would be excused for wondering about the current concentration of questionable conduct among high-yielding companies in particular, such as American Realty, Annaly, Chimera, and Prospect. What is it about these business types that encourage executives to, at the very least, reap a disproportionate share of earnings?

The answer, at least in my opinion, is threefold. First, given their enormous dividend yields, it seems fair to assume that companies like these are principally held by income-seeking retirees who don't have the means to challenge the injustice in court. Second, because these companies are externally managed, they are exempt from many disclosure obligations under the securities laws. They accordingly attract executives who prefer to operate without the oversight of shareholders. And third, the executive compensation structure at these firms often incentivizes dubious behavior, such as simply issuing more shares of common stock.

What can investors learn from this?
The first lesson from the ongoing debacle at American Realty, as well as the other examples mentioned above, is that the integrity of executives matters. The fact that these qualities aren't easy to measure shouldn't detract from their value when it comes to selecting common stocks. And a second, related lesson is that analysts and investors can't take the statements of executives at face value; corporate chiefs' words must be supported by a record of correspondent behavior.

At the end of the day, it's important to remember that corporate executives are human. They may often earn millions of dollars a year, but that doesn't make them invulnerable to our species' tendencies toward greed and self-dealing.

The article Why Do High-Yield Stocks Like American Realty Capital Bring Out Bad Executive Behavior? originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.