Diamond Foods Shell-acked As SEC Cracks Its Nuts

January 10, 2014

Another day, another dollar, and another publicly traded company ponies up a whole mess of cash to settle charges that its books were the stuff of dreams. In this latest installment of Pay-Now-But-Don't-Go-Directly-To-Jail, on Jan. 9, 2014, the Securities and Exchange Commission ("SEC") charged:

  • Diamond Foods;
  • Former Chief Financial Officer Steven Neil; and
  • Former Chief Executive Officer Michael Mendes

with engaging in an accounting scheme to falsify Diamond's costs in purchasing from walnut growers. 

How You Like Them Nuts?

Yup, that Diamond Foods -- the one with those bags of walnuts and assorted snack foods. As a result of the alleged bookkeeping shenanigans, Diamond purportedly reported higher net income and inflated earnings for 2010 and 2011 -- notably, such number beat analysts' estimates.  Upon restating its financials in November 2012 to reflect the accurate costs of its purchased walnuts, Diamond's stock price fell  to about $17 (from a 2011 high of $90).

Diamond agreed to settle the SEC's charges for $5 million without admitting or denying the allegations. Mendes has agreed to pay a $125,000 penalty to settle the charges without admitting or denying the allegations; and he has  returned or forfeited more than $4 million in bonuses and other benefits he received during the alleged fraud. Neil, proving to be a harder nut to crack, has not settled and is presumed innocent of the charges until and unless proven guilty.

Shell Game

As set forth in Paragraph 17 of the SEC's Complaint against Diamond:

In its SEC Forms 10-K for fiscal years ended July 31, 2010 and July 31, 2011, Diamond disclosed the following accounting policy regarding the accounting for walnut crop payments:

We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the minimum price for this inventory by March 31, or later, of the following calendar year. This purchase price will be a price determined by us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant.

Ah yes . . . a price to be determined by Diamond "in good faith." One can only imagine where such an ethical obligation could lead when it involves the financial comings and goings of yet another publicly-traded company. Of course why guess when we can read the SEC's allegations in its Complaint, among which is this morsel:

1. Manipulation of the 2009 Walnut Cost to Meet EPS Targets

23. Diamond began understating its walnut cost, and thereby overstated earnings and EPS, in financial statements prepared for the second quarter of 2010 (ending January 31, 2010).

24. As of the quarter ending October 31, 2009, Diamond had received the 2009 walnut crop from growers and had recorded an average walnut cost of 82 cents per pound in Diamond's financial statements based on the estimated walnut price of 82 cents.

25. In February 2010, Diamond CFO Neil instructed members of the Finance Team to adjust the walnut cost to hit an EPS target for the second quarter. Members of the Finance Team provided Neil with a walnut cost estimate that would result in reported EPS that would be higher than the consensus analyst estimates of $0.47 per share for the quarter. Based on these calculations, Neil reduced the existing walnut cost estimate of 82 cents per pound by 10 cents per pound, to 72 cents per pound. Diamond's quarterly financial statements for the second quarter of 2010, as well as its books and records, accounted for the walnut cost at the adjusted estimate of 72 cents per pound.

. . .

29. Neil was aware that growers were dissatisfied with Diamond's estimated "final minimum price" of 71 cents per pound, and that other walnut handlers who purchased walnuts from growers for resale were paying approximately 87 cents per pound. Neil was informed by his Grower Relations Team that walnut growers expected Diamond to pay walnut prices that were within five to seven cents per pound of what other handlers were paying for the 2009 crop. Neil instructed the Grower Relations Team to tell growers that Diamond would "close the gap" with other handlers' prices through its final payment.

30. From March 2010 through July 2010, Neil and others at Diamond discussed an extraordinary payment to walnut growers that they termed a "continuity" payment. During these discussions, Neil proposed excluding the "continuity" payment from costs recorded in Diamond's financial statements for fiscal year 2010. However, Neil knew, or was reckless in not knowing, that the payment should be treated as a cost of acquiring the 2009 crop and thus recognized in fiscal year 2010. Ultimately, Neil caused Diamond to record the final walnut cost for the 2009 crop using an average cost of 71 cents per pound, and excluded the "continuity" payment (equal to $20 million, or approximately 10 cents per pound) from the recorded walnut cost at the end of fiscal year 2010 (July 31, 2010) in its financial statements for fiscal year 2010, and its books and records.

. . .

34. Growers generally understood the "continuity" payment to be a 2009 payment. The payment, if considered in conjunction with the previous installments and final payments, would have totaled 82 cents per pound as the final walnut cost for the 2009 crop. The 82 cents per pound would have brought Diamond closer to the walnut prices paid by other handlers for the 2009 crop (approximately 87 cents per pound) and in some cases, what Diamond had promised growers for the 2009 crop.

Going Nuts

Y'all got all of that?  You pay 72¢ a pound for nuts that you actually purchase for 82¢  a pound when others are paying 87¢ a pound so that you can show more profit than analysts were projecting; except, you know, you are actually paying 10¢ more a pound than you have disclosed but not really because it's a continuity payment that doesn't actually get recognized in the year when the walnuts were grown. And, who knows, maybe you could continuously continue the continuity payment -- ad infinitum, as it were -- and never actually need to recognize on the books that you're paying more for nuts in a given year than you are, which, gee, would sort of give you more profit on what you're paying less for, but for the fact that, well, okay, you're actually paying more than what you're paying even though you're earning more money and beating the analysts' estimates.

Nutcracker 22

Alas, life does imitate art! For those of you perplexed by Diamond Foods' cracking of its nut books, consider Joseph Heller's iconic 1961 novel "Catch 22." In that classic work of fiction, Capt. John Joseph Yossarian is befuddled by how Lieutenant Milo Minderbinder, the mess officer, bought eggs for seven cents each, sold them for five cents, but still made a profit.  Here's the excerpt of that scene:

"I don't understand why you buy eggs at seven cents a piece in Malta and sell them for five cents."

"I do it to make a profit."

"But how can you make a profit? You lose two cents an egg."

"But I make a profit of three and a quarter cents an egg by selling them at four and a quarter cents an egg to the people in Malta I buy them from for seven cents an egg. Of course, I don't make the profit. The syndicate makes the profit. And everybody has a share."

Yossarian felt he was beginning to understand. "And the people you sell the eggs to at four and a quarter cents a piece make a profit of two and three quarter cents a piece when they sell them back to you at seven cents a piece. Is that right? Why don't you sell the eggs directly to you and eliminate the people you buy them from?"

"Because I am the people I buy them from," Milo explained. "I make a profit of three and a quarter cents a piece when I sell them to me and a profit of two and three quarter cents apiece when I buy them back from me. That's a total profit of six cents an egg. I lose only two cents an egg when I sell them to the mess halls at five cents apiece, and that's how I can make a profit buying eggs for seven cents apiece and selling them for five cents apiece. I pay only one cent a piece at the hen when I buy them in Sicily."

"In Malta," Yossarian corrected. "You buy your eggs in Malta, not Sicily."

Milo chortled proudly. "I don't buy eggs from Malta," he confessedů "I buy them in Sicily at one cent apiece and transfer them to Malta secretly at four and a half cents apiece in order to get the price of eggs up to seven cents when people come to Malta looking for them."

READ the full-text source documents: