Opening

In March of 2002, Adelphia was the 6th largest cable TV provider in the U.S. But then the company made one tiny financial disclosure…AND WITHIN 3 MONTHS IT WAS BANKRUPT.  Shareholders filed lawsuits, the SEC alleged there was fraud, and executives went on trial.  What the heck happened?

I’m Michael McLaughlin, and this is Scheme.

The founding of Adelphia

Adelphia’s founder, John Rigas, came from humble beginnings.  He was born in 1924 to Greek immigrants in Wellsville, New York, and his dad ran a hot-dog stand.  After serving in World War II, Rigas got into business by purchasing a movie theater.  But then a friend gave him a hot tip: cable TV, not movie theaters, was the future.  Rigas listened, and in 1952 he paid $300 for a license to become a cable TV provider. He started out with just 2 channels.  Rigas called the company “Adelphia” which means “brothers” in Greek.

Adelphia grows larger as the family joins the business

Adelphia became successful; so successful that Rigas was able to send his kids to the finest schools in the country: Harvard, Wharton, Stanford.  And when they finished school, Rigas’s sons came back to work for the company.  One son would become CFO, and another Chief Accounting Officer.

Rigas’s sons wanted to expand, and Adelphia went public in 1986.  But even with the inflow of capital from outside investors, Adelphia remained a family-dominated business: 5 of the 9 people on the company’s board were part of the Rigas family.  And the company remained headquartered in the small town of Coudersport, Pennsylvania.

But there were many changes on the horizon.

The rise of the internet and digital cable in the 1990’s led to consolidation in the cable TV industry, with lots of acquisitions.  Adelphia expanded, acquiring 3 companies in a single month in 1999.  The company doubled in size over just a few years.  By 2002, Adelphia was doing business in 32 states with more than 5 million subscribers.

So what seems to be the problem? 

Everything seems great so far; we’ve got the son of immigrants building a business from scratch and turning it into a thriving family business.  But there were several issues.

First, the Rigas family operated a number of cable entities outside of Adelphia, which had 300,000 subscribers of their own. No one thought much of this complex series of partnerships at the time, but their interactions with Adelphia would lead to serious problems.

Second, Adelphia’s growth was funded by debt. Adelphia first borrowed to create the infrastructure to provide cable TV, and then it borrowed again to acquire other cable TV providers.  As a result of these acquisitions, Adelphia’s debt ballooned from $3 billion to nearly $13 billion.

The fraud develops…

And this growing debt put the company at risk of violating its debt covenants.

You see when banks lend money, they make borrowers agree to certain stipulations—for example, that their debt load won’t exceed a certain threshold—and they do this to make sure companies can continue making their interest payments. But Adelphia’s strategy required more and more debt; so to get around the debt covenants Rigas began hiding some of the debt.

This is called off-balance sheet financing, and Rigas did it in several ways.

First, he transferred debt from Adelphia to his own partnerships. Adelphia would remove a liability and then add that liability to one of Rigas’s entities. They called this a quarterly “re-classification.”  Basically, the debt of one company was transferred to another company.

Second, the Rigas family started buying massive amounts of Adelphia stock. Rigas said was putting more money into the firm to “de-leverage” the company. Investors see this as a great sign; management has faith in the company’s stock, because the executives are putting their own money at risk. Except they weren’t…

Rigas wasn’t actually paying for the stock; he has borrowing the money. Worse yet, Adelphia guaranteed the borrowings.  Rigas was effectively borrowing money from Adelphia to buy stock in Adelphia. The Rigas family didn’t disclose these co-borrowings, and some people wondered how the family kept coming up with money to put into Adelphia. The secret was, they weren’t putting money into the company. These were not trivial amounts. They bought 29 million shares for $1.8 billion between 1998 and 2002, and Rigas had employees forge receipts to make it look like the family actually paid for the stock.  In reality, they were just overstating the company’s equity.

But the hidden debt was just one part of the fraud…

Overstating profits

Adelphia was also overstating its profits with fictitious transactions. It did this in several ways. First, it booked phony management fees from Rigas’s partnerships for services it never provided to those entities. Second, it pretended to pay an extra $26 per cable box to its suppliers. On the side, the suppliers agreed to return the money as “marketing support payments.” Adelphia amortized the extra $26 in costs, effectively spreading it over a period of years. But the $26 of marketing support payments was fully booked as revenue in the current period. Third, Adelphia shifted expenses to the Rigas partnerships. So they took expenses of Adelphia and booked them to unconsolidated entities.

But Adelphia didn’t just overstate profits; it also overstated number of basic cable subscribers by including subscribers of unconsolidated affiliates. So this is a pretty complicated fraud; Adelphia didn’t do just one thing wrong. Adelphia concealed all of this fraud by creating a second set of books; it had a special accounting system that pooled cash from Adelphia and Rigas’s separate entities.

Was this all just a misunderstanding?

John Rigas was in his seventies when all this happened, so some people in the town of Coudersport thought this might just be a misunderstanding. After all, Rigas had a reputation for being a really nice guy, and he was very kind and giving toward the Coudersport community where Adelphia was headquartered.

However, the story gets darker when you consider that the Rigas family profited significantly from this fraud. They didn’t actually sell any stock, which makes this different from Global Crossing, Enron, and other accounting scandals. However…Rigas lent $150 million of company money to a hockey team he owned, the Buffalo Sabres. The Rigas family also:

  • Spent $3 million of company money on a movie produced by Rigas’s daughter.
  • Spent $12.8 million of company money on a golf course.
  • Rigas let his kids enjoy rent-free apartments on the company’s dime.
  • And they used Adelphia’s 3 corporate jets quite liberally, at one point flying one of Rigas’s sons and his friends to Africa for a safari.

Now Rigas was deep in personal debt, and he was withdrawing so much money from Adelphia that his son had to ask him to withdraw no more than $1 million/month. All of this without investors’ knowledge.

Discovering the fraud

Now the fraud was eventually discovered when a bond analyst and a new outside director on Adelphia’s board began asking questions. After significant pressure, Adelphia disclosed the hidden liabilities on March 27, 2002. In a small footnote, it acknowledged that it had $2.3 billion in off-balance sheet debt.

This disclosure caused a firestorm. Investors panicked, the stock price plummeted, the SEC launched an investigation. Shockingly, the Rigas family continued to commit fraud even after this happened. They had bought some of the Adelphia stock on margin so the large decline in the stock price led to a lot of margin calls. Rigas responded by transferring $252 million from the company to pay the margin calls.

Aftermath

But the Rigas family and several other executives soon stepped down. The company disclosed the details of the fraud, and Adelphia filed for bankruptcy on June 25, 2002. In 2006, its assets were sold to Comcast and TimeWarner, and Adelphia was no more. The government indicted the 77-year old Rigas, two of his sons, and two other executives. They were charged with securities fraud, wire fraud, and bank fraud. In 2004, Rigas and one of his sons were found guilty – Rigas was sentenced to 15 years, while his son was sentenced to 20.

Takeaways

So how did something like this happen? What went wrong here?

In my opinion, this fraud was able to take place for two reasons:

  1. The combination of a public company and all these private family entities made it easy for the Rigas family to shift debt and expenses around, and to create bogus revenue.
  2. There was no outside oversight. The top executives were members of the Rigas family. A majority of the board was part of the Rigas family. Thus, no one was looking out for the interests of shareholders. Had it not been for all of Rigas’s private entities, and had there been more oversight from the board, maybe this never would have happened.

References

https://www.nytimes.com/2002/04/04/business/market-place-a-family-affair-at-adelphia-communications.html
https://www.nytimes.com/2004/02/01/magazine/the-company-they-kept.html
https://www.wsj.com/articles/SB1027516262583067680
https://www.sec.gov/litigation/complaints/complr17627.htm
https://www.sec.gov/news/press/2002-110.htm
https://www.sec.gov/news/press/2005-63.htm
https://www.wsj.com/articles/SB1025046390984507800
https://www.sec.gov/litigation/litreleases/lr17627.htm
https://buffalonews.com/2019/07/09/tim-rigas-wins-early-release-from-prison/
https://www.sec.gov/news/press/2005-65.htm
https://www.sec.gov/litigation/complaints/comp19202.pdf
https://www.wsj.com/articles/SB108145096075478152