Cendant Fraud: The $14 Billion One-Day Wipeout

Key Takeaways

• CUC inflated pre-tax income by over $500 million from 1995 to 1997 alone.
• Disclosure on April 16, 1998 cut the stock about 46%, erasing roughly $14 billion.
• Chairman Walter Forbes got 12 years 7 months; vice chairman Kirk Shelton got 10 years.
• The class action settled for about $3.19 billion, then a record, including Ernst & Young.

Background

In the 1980s and 1990s, CUC International ran membership and discount-shopping clubs, selling consumers access to programs like Shoppers Advantage and Travelers Advantage. The economics were appealing on paper: members paid recurring fees, and CUC reported steady, rising earnings that made the stock a Wall Street favorite. Walter A. Forbes, CUC's chairman and chief executive, had run the company since its early days, with E. Kirk Shelton as president and chief operating officer.

The reality behind the reported numbers was different. The Securities and Exchange Commission later concluded that a financial fraud "began at CUC in the 1980s and continued until its discovery and disclosure by Cendant in April 1998." Year after year, senior managers adjusted CUC's published results so the company would appear to deliver the ever-increasing earnings investors expected.

A subscription business is unusually easy to manipulate. Membership fees can be recognized over time or pulled forward, cancellations and refunds can be understated, and the cost of acquiring members can be deferred. Those judgment calls gave CUC's finance team room to bend the numbers, and the SEC found they used it across many of the company's operating units.

In December 1997, CUC merged with HFS Incorporated, a franchising company that owned brands such as Ramada, Howard Johnson, Avis, Coldwell Banker, and Century 21. The combined company was named Cendant Corporation. The merger, meant to create a consumer-services giant, instead joined a clean franchising business to a company whose core had been rotten for more than a decade.

What Happened

The fraud surfaced only months after the merger closed, when HFS-side executives examining the combined books found numbers that did not add up.

• December 17, 1997: CUC merges with HFS to form Cendant Corporation. Forbes becomes chairman; Shelton becomes a director and vice chairman.
• April 15, 1998: Cendant announces, after the market closes, that it has discovered potential accounting irregularities in certain former CUC business units within its Alliance Marketing division.
• April 16, 1998: The stock collapses. Shares that closed at 35 5/8 on April 15 trade as low as about $17, a drop of more than 50% intraday, closing down roughly 46% and erasing about $14 billion in market value.
• Mid-1998: Forbes resigns as Cendant chairman in July 1998; Shelton had already resigned in April 1998. Cendant launches an internal investigation overseen by its audit committee and outside counsel.
• September 29, 1998: Cendant files restated financial statements with the SEC, disclosing that reported income from continuing operations before taxes had been overstated by approximately 24% and earnings per share by 130% during the affected period.
• June 14, 2000: The SEC charges seven former CUC officers and managers and brings a settled financial-reporting action against Cendant itself. The same day, the US Attorney for New Jersey announces guilty pleas from three former executives.
• February 28, 2001: The SEC charges Forbes and Shelton, the two top former CUC officers, with directing the fraud.
• 2005 to 2007: The criminal cases against Shelton and Forbes conclude with convictions and multi-year prison sentences.

The disclosure on April 15, 1998 began as a seemingly contained problem in one division. The Alliance Marketing units were the most heavily affected, but the investigation soon showed the manipulation reached far wider. By the time Cendant restated, the issue was not a localized error; it was a systematic, multi-year practice of inflating income.

The market reaction was immediate and brutal. Cendant had been a large, widely held stock, so a near-halving in one day translated into one of the largest single-day market-value losses recorded to that point. The US Attorney's office later told a jury the fraud "caused the company to lose $14 billion in market value in a single day when the fraud was revealed to shareholders in April 1998."

Why It Happened

The mechanics of the Cendant fraud sit at the center of forensic accounting because they combine two classic techniques: inventing revenue and abusing reserves. Both served the same goal, which was to make reported earnings hit a predetermined target regardless of how the business actually performed.

The first technique was direct falsification of results. The SEC found that CUC's chief financial officer, Cosmo Corigliano, maintained a schedule that management used to track the progress of the fraud, and that he "regularly directed CUC financial reporting managers to make unsupported alterations to the company's quarterly and annual financial results." Lower-level managers entered journal entries that had no legitimate basis. They existed only to lift income to the number senior management wanted.

The second technique is the one investors should study hardest: the deliberate use of mergers to manufacture reserves. The SEC's complaint against Forbes and Shelton alleged they "undertook a program of mergers and acquisitions on behalf of CUC in order to generate inflated merger and purchase reserves at CUC to be used in connection with the fraud." When a company acquires another, it can set up reserves for restructuring and expected costs. Those reserves are a balance-sheet cushion. By overstating them at the time of a deal and then quietly releasing them into income in later quarters, an acquirer can feed phantom profit into future periods. This is the "cookie jar" reserve, and CUC was a serial acquirer precisely because each deal refilled the jar.

The HFS merger was the audacious extension of that logic. According to the SEC, Forbes and Shelton "sought out HFS as a merger partner because they believed the reserves that would be created would be big enough to bury the fraud," and they inflated CUC's earnings and projections to entice HFS into the deal. The SEC alleged that soon after the merger the two men "explicitly congratulated each other on being masterful 'financial engineers'" who had nurtured the fraud through the years and had "assured their continued success by duping HFS into agreeing to a merger with CUC." A merger was not just where the fraud was discovered; it was a tool the fraud was built to use.

The gatekeepers failed too. Ernst & Young had been CUC's outside auditor, and the shareholder litigation alleged the firm committed numerous violations of generally accepted accounting principles involving hundreds of millions of dollars of revenue and income that it did not catch. The fraud touched 17 of the former CUC's 22 operating units, yet it ran for years before the merger forced a fresh set of eyes onto the books.

By the Numbers

• Income inflation, 1995 to 1997: CUC's pre-tax operating income reported to the public was inflated by an aggregate of over $500 million. (SEC LR-16910)
• Restatement scale: Cendant's restated statements, filed September 29, 1998, showed income from continuing operations before taxes overstated by approximately 24% and earnings per share by 130%. (BLBG; SEC filings)
• Single-day market loss: about $14 billion in market value, with the stock down roughly 46%, falling from 35 5/8 to about $17 on April 16, 1998. (DOJ Forbes release; Associated Press via NBC News; Washington Post archive)
• Victims: prosecutors told the court there were roughly 119,000 victims of the fraud. (Associated Press via NBC News)
• Forbes sentence: 12 years and 7 months in prison and $3.275 billion in restitution, imposed January 17, 2007. (Associated Press via NBC News)
• Shelton sentence: 10 years in prison and approximately $3.25 to $3.275 billion in restitution, imposed in 2005. (DOJ Shelton release; Associated Press via NBC News)
• Class-action settlement: about $3.19 billion total, comprising roughly $2.8515 billion from Cendant and $335 million from Ernst & Young, the largest such settlement to that point. (BLBG; Wiley)

Aftermath

The criminal cases were long and hard-fought. Shelton went to trial first and, on January 4, 2005, was convicted on all counts, including conspiracy, mail fraud, wire fraud, securities fraud, and making false statements to the SEC. On August 3, 2005, US District Judge Alvin W. Thompson sentenced him to 10 years in prison and ordered restitution to Cendant, reported at approximately $3.25 billion in the government's later filing and as $3.275 billion in press accounts. Shelton appealed his conviction and sentence.

Forbes proved harder to convict. His first trial, alongside Shelton, ended with the jury deadlocked on all counts against him. A retrial in early 2006 again ended without a verdict. In his third trial, on October 31, 2006, a jury in Bridgeport, Connecticut found Forbes guilty on three of four counts, namely conspiracy and two counts of making false statements to the SEC, and acquitted him of one count of securities fraud. On January 17, 2007, Senior US District Judge Alan H. Nevas sentenced him to 12 years and 7 months in prison and ordered him to pay $3.275 billion in restitution. Forbes indicated he would appeal.

At the executive level below the chairmen, the SEC brought charges against seven former CUC officers and managers in June 2000. CFO Cosmo Corigliano, controller Anne M. Pember, and vice president Casper Sabatino pleaded guilty to criminal informations and settled or contested the SEC's civil claims; several lower-level managers settled administrative charges and agreed to penalties and bars from practicing before the Commission as accountants. Cendant the company, without admitting or denying the findings, consented to a cease-and-desist order, and the SEC noted its remedial actions and cooperation.

The shareholder class action produced the headline civil number. The settlement fund totaled roughly $3.19 billion in cash plus interest, with about $2.8515 billion from Cendant and $335 million from Ernst & Young, then the largest payment by an accounting firm in a securities case. The Third Circuit affirmed the settlement, cementing it as the largest securities class-action recovery to that date. Cendant itself survived, later splitting into separate businesses; the surviving entity was eventually renamed Avis Budget Group.

Lessons for Investors

1. Treat serial acquirers with extra scrutiny. CUC bought companies in part to keep refilling its reserves, and the SEC found the entire HFS merger was chosen because its reserves would be "big enough to bury the fraud." When a company grows mostly through deals and books large merger or restructuring reserves each time, ask whether those reserves are later quietly feeding reported profit. The same reserve-abuse pattern recurs in cases like Waste Management and Sunbeam.

2. Reserves released into income are a warning, not a one-off. Cookie-jar reserves let management smooth or fabricate earnings by recognizing costs in a good period and releasing the cushion in a weak one. If a company's profit holds up while operations clearly struggle, and the footnotes show reserves shrinking into income, the earnings may be borrowed from a balance-sheet cushion rather than earned.

3. Recurring-revenue models can hide the most. CUC's membership business gave management discretion over when to recognize fees and how to treat cancellations. Businesses with long deferred-revenue tails or heavy subscription accounting deserve a careful read of revenue-recognition policies, because the same flexibility that helps a real business can mask a fake one.

4. A merger is a stress test of the target's books. The Cendant fraud was discovered not by regulators or the long-time auditor, but by HFS-side executives looking at CUC's numbers for the first time. Fresh, motivated eyes find what familiar ones miss, which is exactly why merger due diligence and the integration period are when long-running frauds tend to surface.

5. The auditor is a check, not a guarantee. Ernst & Young audited CUC throughout the fraud and still paid $335 million to settle claims it missed violations involving hundreds of millions of dollars. A clean audit opinion confirms the books were examined, not that they are true. Read the financial statements and the trend in cash flow yourself rather than outsourcing all trust to the auditor.

Frequently Asked Questions

What was the Cendant fraud in simple terms? The Cendant fraud was a long-running accounting scheme at CUC International, the predecessor that merged into Cendant in 1997, where executives faked profits for years using fictitious revenue and abused reserves. When it was revealed in April 1998, the stock lost about 46% and roughly $14 billion of value in one day.

Why did the Cendant fraud happen? CUC's leaders wanted the company to keep posting the steadily rising earnings investors expected, so managers altered the published results to hit targets. They also used acquisitions to create oversized merger reserves that could be released into income later, and chose the HFS merger partly because its reserves would be large enough to keep the scheme hidden.

How much money was lost in the Cendant fraud? The single-day market-value loss was about $14 billion when the stock fell roughly 46% on April 16, 1998. CUC had inflated pre-tax income by over $500 million from 1995 to 1997, and the shareholder class action later settled for about $3.19 billion, including $335 million from auditor Ernst & Young.

Could the Cendant fraud happen again today? Some defenses are stronger now, including Sarbanes-Oxley personal certification by CEOs and CFOs, the PCAOB overseeing auditors, and tighter rules on merger reserves. Reserve abuse and revenue manipulation still occur, but the specific cookie-jar and merger-reserve tricks CUC used are far easier for auditors and analysts to flag today.

What is the main lesson from the Cendant fraud? Be most skeptical of companies that grow through endless acquisitions and lean on reserves to deliver smooth, rising earnings. Mergers can be used to manufacture and bury accounting fraud, so the quality of reported profit, not the headline growth, is what deserves your attention.

Sources

1. SEC Litigation Release No. 16910 / AAER No. 1372. SEC v. Walter A. Forbes and E. Kirk Shelton. February 28, 2001. https://www.sec.gov/litigation/litreleases/lr16910.htm
2. SEC Litigation Release No. 16587 / AAER No. 1276. SEC v. Cosmo Corigliano et al.; In re Cendant Corporation. June 14, 2000. https://www.sec.gov/litigation/litreleases/lr16587.htm
3. SEC Press Release 2000-80. SEC Brings Enforcement Actions Against Former Top Financial Officers and Managers at CUC International. June 14, 2000. https://www.sec.gov/news/press/2000-80.txt
4. U.S. Attorney, District of New Jersey. Former Cendant Chairman Walter Forbes Convicted of Conspiracy and False Statements to SEC. October 31, 2006. https://www.justice.gov/archive/usao/nj/Press/files/pdffiles/Older/forb1031rel.pdf
5. U.S. Attorney, District of New Jersey. Government Files Suit Against Former Cendant Vice Chairman Seeking $30 Million in Fraudulently Transferred Assets. November 14, 2006. https://www.justice.gov/archive/usao/nj/Press/files/pdffiles/Older/shel1114rel.pdf
6. Associated Press via NBC News. Ex-Cendant chairman gets 12 years, 7 months. January 17, 2007. https://www.nbcnews.com/id/wbna16672186
7. Bernstein Litowitz Berger & Grossmann LLP. In re Cendant Corporation Securities Litigation (case summary). https://www.blbglaw.com/cases-investigations/cendant-corporation
8. Wiley. Third Circuit Affirms Record $3.2 Billion Settlement of Securities Class Action Lawsuit Against Cendant Corporation and Auditor Ernst & Young. https://www.wiley.law/newsletter-1919

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.