Regaining credibility after a crisis.

Facing horrific problems of fraud and deceit, here are the steps Cendant management took to preserve the corporation.

IN DECEMBER 1999, some 20 months after massive accounting irregularities were first uncovered, Cendant Corp. achieved a milestone in its recovery effort. It reached a preliminary agreement to settle the principal securities class action litigation pending against the company. The settlement of $2.83 billion, if approved by the court, would end one of the largest shareholder suits in history. Also that same month, Ernst & Young, auditor of the business units in which the financial problems were uncovered, agreed to pay $335 million to Cendant shareholders, one of the largest accounting-negligence shareholder settlements.

Further claims between Ernst & Young and Cendant are pending, as are continuing investigations by the U.S. Attorney's Office and the Securities and Exchange Commission. Nonetheless, Cendant management feels that its problems are substantially behind it. "By eliminating what was by far our largest remaining uncertainty, the [shareholder] settlement effectively brings closure to this most unfortunate event," said Cendant Chairman, President and CEO Henry Silverman in announcing the agreement.

Six months earlier, in June 1999, Mr. Silverman appeared before the annual conference of the National Investor Relations Institute and spoke candidly about what it was like to be embroiled in one of the largest frauds ever in Corporate America. The following article is an adaptation of his remarks, including his responses to several followup questions from the audience, in which he recounted how management was dealing with the crisis, what steps it was taking to rebuild credibility with Wall Street, and what important insights were gained from this "near-death" experience.

James Kristie

IMAGINE THAT YOU ARE THE CEO of what was the then-56th largest company in America with a $38 billion market capitalization. You just finished a very positive conference call with several hundred investors during which you told them that the company is going to meet or exceed the Street's expectations for the quarter. An hour later, your CFO calls and says, "Are you sitting down? We've got a problem" That was the beginning of this nightmare.

Those of us who use M & A as a strategic resource spend every day of our professional lives challenging management -- probing whether they are giving us the straight word on their businesses and their prospects. But some things we all take for granted.

We expect the numbers in financial statements certified by a Big Five accounting firm to be true. We expect managements to be aggressive in projecting growth but we don't expect them to lie about the base from which they are growing. We expect optimism regarding the return on capital but we don't expect the capital to be fictitious.

The first and most important point that one comes away with from an experience like ours is a staggering realization of the importance of truthfulness in our financial and corporate governance system, and how vulnerable that system is to fraud.

Our system is built on a presumption of honesty, of respect for the rule of law, and of a common shared assumption that institutions of stature and credibility will tell the truth. Every one of your shareholders owns your stock because he or she has faith in what you have told them.

Bald, flat-out fiction is an alien concept in this system. I learned first hand how alien this concept was in the aftermath of our initial accounting revelations in April 1998.

Since then, over and over again, I've been asked, "Well, what really happened?" "How aggressive was CUC's accounting?" "Was it somewhat aggressive? Really aggressive? Difficult-to-defend accounting? Much-too-clever accounting?" And, "How could this happen to you?"

People assume that CUC had started with the truth and then stretched it -- perhaps using amortization lives that were 10% too long or that maybe 10% of the expenses charged as merger reserves were really operating expenses. However, what we were dealing with were revenues and expenses that were pure fiction.

In my 33 years of doing transactions, I've gained a number of deeply practical insights. What I've learned is that, in the end, you must rely upon the truthfulness of the people that you are dealing with. We have all come to know that every good partnership, whether in business or in marriage, is based on trust.

Due diligence, like the rest of our financial system, is based on trust. You have a duty to ask a lot of questions. In acquiring CUC, I talked to some of America's most respected managers and investors and with CUC's business partners -- their bankers, lawyers, auditors, major shareholders, customers, suppliers -- as well as many sell-side analysts. But even that may not protect you. Fraud, outright lies, and deliberate attempts to conceal are very difficult to detect, especially when they are not subject to external verification.

So how do you deal with such a subversion of our financial system? What do you rely upon? The answer is quite simple: your own integrity. All of us here believe in our system and believe deeply in the obligations of managers under that system: obligations to the shareholders, to the employees, and to our customers who have trusted us and our companies, and to the free enterprise system and the institutions of capitalism that we've all been a part of and have benefitted from throughout our careers. All these groups have suffered from the fraud at Cendant. Among my obligations is restoring at least the truth, and hopefully the wealth, to many of these constituencies.

A strong economic model

How have we have attempted to handle the crisis at Cendant? Happily I am blessed by some wise decisions that my colleagues and I made as we built HFS. HFS's economic model was the sum total of all that I have learned over many years of building companies. Specifically there are six integral aspects of this model:

* First, create recurring revenues. Ninety percent of Cendant's revenues are recurring based on ongoing multiple-year contractual relationships with the same customers. They get to know you, you get to know them, you have a relationship, and you develop mutual trust and loyalty. You don't have to recreate your company every year, or even every quarter. The strength of these relationships and the stability of this revenue model gave us the resilience that few other companies could benefit from in similar circumstances. Our customers have stood by us as a result of those relationships and, in fact, we've gained market share in all of our businesses.

* Second, minimize economic risk. We built HFS to participate in three areas: the overall level of aggregate economic activity, not corporate profitability within that cycle; to benefit the services that enhance revenue or lower costs for clients; and the demographic trend of baby boomers driving a huge shift in demand patterns over time. None of these forces are exposed to business cycles that may cause the profits of much of Corporate America to vary...