Sunrise Scam Throws Light on Incentive Pay Programs
There are few worse nightmares on Wall Street: You own highflying shares in a company that has been a fantastic earnings-growth story for many years. Then, out of the blue, you find out that the earnings growth has been phony--a deliberate falsification.
Shareholders of Carlsbad-based Sunrise Medical Inc. have been living that nightmare since Oct. 26, when the medical products company announced that it had discovered accounting irregularities in a key division.
On Jan. 4 Sunrise’s directors released their report on the matter, and the news was worse than expected. Not only had Sunrise’s Bio Clinic division falsified its results, but the bogus numbers were so huge that earnings for the company as a whole will have to be restated downward by 16% for fiscal 1994 and 37% for 1995.
Sunrise’s stock price, $36.75 at its peak last year, has fallen to half that, wiping out $340 million in shareholder value. The firm’s president and marketing chief have resigned, although they weren’t officially connected to the scandal. The Securities and Exchange Commission is investigating.
What makes the debacle so shocking is that it could occur at a company like Sunrise, which has long presented itself as a values-conscious health-care firm whose employees carry lofty corporate precepts about customers, shareholders and social responsibility on wallet cards.
“It is the ultimate irony,” concedes Chief Executive Richard H. Chandler, 52, who founded Sunrise in 1983 and is now battling to restore its credibility with investors.
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But Wall Street is less concerned with irony than with a deeper question: Did Sunrise’s culture, which stresses decentralization and a bonus-driven pay structure based on reaching earnings targets, encourage employee behavior that led to the fabrication of Bio Clinic’s results?
It’s an issue that may become a much bigger topic of discussion nationwide in the near future, because so many U.S. firms have in recent years shifted their compensation plans to favor “pay for performance,” which holds out the promise of large annual bonuses if profit targets are met.
Hewitt Associates, a Lincolnshire, Ill.-based consulting group, says that “results-sharing” bonuses for salaried employees accounted for 7.6% of 1995 payroll at 1,811 firms surveyed, up from 3.8% in 1991. “Companies appear to be growing more confident that results-sharing programs do go a long way in improving overall company performance,” Hewitt says.
Much less talked about, however, is the inherent pressure the new bonus programs may place on employees--especially in times when the economic backdrop makes sales and earnings targets much harder to reach.
Whereas 1995 was a year of record profits for many U.S. companies, 1996 is looking to be a tougher year because of the economy’s sluggish pace and because many of the 1994 and 1995 earnings gains from restructuring programs aren’t repeatable.
Daniel Ben-Ora, a senior manager in human resources at accounting firm Deloitte & Touche in San Francisco, says one of the questions that compensation consultants must increasingly ask is, “What are people willing to risk for incentives?”
Illegal behavior, Ben-Ora notes, isn’t the big worry, because it’s reasonable to assume that most people are honest. But ill-conceived incentive-pay plans may encourage employee behavior that, although legal, heavily favors short-term corporate performance over the long-term good of the company and the best interests of customers and/or shareholders, Ben-Ora says.
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In Sunrise’s case, the directors’ report said four employees were involved in falsifying financial reports at the Ontario-based Bio Clinic division, which makes specialty beds and mattresses for hospitals and home use, and which accounted for a fifth of Sunrise’s $604 million in 1995 sales.
The highest-ranking employee involved was Robert Barton, Bio Clinic’s vice president of finance. The other three weren’t named. All four have resigned or were fired.
Sunrise did not specifically say what motivated Barton and the others. Barton could not be reached for comment.
In an interview, CEO Chandler refused to speculate about motive. “What I can say is that [the scheme] was designed to make the division’s performance look better than it was and to conceal a deteriorating financial situation,” he said. “It was a snowball that got progressively [bigger].”
Yet Sunrise said it found no evidence of misuse of cash. The scam was uncovered, Chandler said, when “some people in the accounting department came forward and confessed.”
If they weren’t stealing money outright, why would employees make up numbers showing stellar earnings growth, and how could they hide the lies for more than two years? Searching for answers, some Wall Street analysts are focusing on Sunrise’s decentralized management structure and on its compensation program, a pay-for-performance plan that awards managers annual cash bonuses worth 10% to 50% of salary.
Chandler has long touted Sunrise as a company where workers are individually empowered and held to high standards of integrity, but also constantly driven to do better--with pay based on results.
He now insists that “we have never viewed ourselves as a numbers-driven company.” But Jerome Dodson, whose San Francisco-based Parnassus Fund owns 770,000 Sunrise shares, says simply, “That’s not true.”
Sunrise’s 1995 proxy statement notes that “associates at all levels participate in one or more of the company’s various incentive plans,” and that the compensation system “not only pays for performance, it penalizes for nonperformance using arithmetic formulas that do not allow for excuses.”
Key to the Sunrise pay program is its focus on divisional performance, “reinforcing the company’s unique corporate culture,” the proxy says. “Each division’s performance is measured and rewarded with year-end bonuses computed independently of the others.” For certain top executives, a stock-option plan rewards for the company’s performance overall.
Could Sunrise’s pay plan be too skewed toward divisional performance--and divisional bonuses--at the expense of the whole?
Chandler defends the divisional focus as an effort to “replicate the entrepreneurial model” within a multifaceted corporation. “People want to be rewarded based on their own efforts,” he says. Without divisional accountability, he adds, “You end up with a system like the U.S. Post Office. There’s no incentive” for workers to excel.
There are certainly many other U.S. firms that pay bonuses based on divisional performance. But unlike some companies, Sunrise pays no bonuses at all in a division that fails to record an earnings increase for the year. So even if employees meet personal goals or excel individually, they don’t qualify for bonuses if the bottom line hasn’t risen.
That requirement is controversial among compensation analysts.
“Companies are becoming more concerned about how [profit] outcomes are generated rather than just what the outcome is,” says Jay Schuster, principal at consulting firm Schuster-Zingheim & Associates in Los Angeles.
“Companies can communicate a vision of ‘profit at any cost,’ or they can communicate how they want to make a profit by basing a portion of pay on measures of customer satisfaction, customer retention, product and service quality . . . and other issues that define how they want to get where they want to go,” Schuster says.
Chandler, while defending his compensation program, concedes that revising it “is an item of active discussion.” As for Bio Clinic’s 1995 bonuses, he says they actually ended up minuscule despite the phony earnings gain, because the bonus plan also adjusts for a division’s cash flow. Bio Clinic had negative cash flow, though it isn’t clear that employees involved in the fraud would have known in advance that would be the case.
Babette Heimbuch, president of FirstFed Financial and one of Sunrise’s independent directors, said the bonus plan was “certainly one of the issues” that directors studied in the wake of the scam, and that it remains under discussion.
In general, she said, any board faced with judging a pay plan must ask “what loopholes have we left that are going to [encourage] behavior we don’t want?”
That’s a question many more companies may soon be asking.
Since 1990 Wall Street has “wanted shareholder-based [pay] plans, and they got it,” says Keith Tobias, principal at Compensation Resource Group in Pasadena. “We have gone to a very performance-based pay situation, and [managements] have performed.”
But if the economy weakens further and sales growth slows, employees will be challenged as never before to keep corporate earnings--and their own pay--at high levels.
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Sunrise--and Fall
Sunrise Medical’s stock, closing prices every six months since March 1990, and the latest:
Friday: $18.625
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The Growing Importance of Bonuses
Bonuses paid to salaried employees based on corporate performance have soared at U.S. firms in recent years, according to a survey of 1,811 employers by Hewitt Associates. Average corporate spending on bonuses:
1995: 7.6%
Source: Hewitt Associates
