At its annual meeting of shareholders last week, the board of CommonWealth REIT (NYSE: CWH) sank to a new low, explicitly demonstrating that the company has little interest in the rights of their shareholders. For the past few months, the company has been involved in a tumultuous takeover fight with certain activist shareholders, namely Keith Meister’s Corvex Management LLC (Corvex) and Jeff Blau’s, Related Fund Management LLC (Related).

In April, CommonWealth blocked a proxy contest attempt by shareholders to remove the entire board of directors. While the initial action by shareholders looked promising, CommonWealth’s board unilaterally amended the company charter and bylaws to align with Maryland State statutes, resulting in stricter requirements for the removal of directors. In addition to the supermajority vote threshold that was already in place, shareholders must now show cause when attempting to remove any director. So, unless CommonWealth’s board can be shown to be criminally negligent, it looks like shareholders are stuck with the leadership they have.

To make matters worse, the CommonWealth’s poison pill contains a “dead hand” provision which states that the original directors who put the pill into place must approve the pill’s removal. As the document was initiated in 2004, early expiration of its terms is no longer possible as several of the directors have long since retired from the company. Shareholders must now wait until October of 2014 before attempting to acquire more than 10% of the company’s shares, making any further takeover through increased ownership impossible.

Meanwhile, Corvex and Related have been engaged in litigation with CommonWealth in the Maryland Courts, claiming that the company misled investors with regard to its future financial prospects. This legal battle, coupled with Corvex and Related’s failed proxy contest, indicate that certain shareholders at CommonWealth are extremely unhappy with the company’s leadership. While this season’s proxy battle may be over, the war for company control is likely to continue for many more months.

And most recently, at the company’s annual meeting on May 14, shareholders voted out CommonWealth director Joseph L. Morea. Despite Mr. Morea receiving only 21% of the vote—no other director received less support in 2012 or 2013—and his subsequent resignation, CommonWealth issued the following statement: “the Board of Trustees requested that Mr. Morea accept appointment to the vacancy created by his resignation.” In an act of corporate black art, CommonWealth immediately reanimated the defeated Morea and reappointed their fallen colleague back to the board of directors. Such flagrant indifference for clear shareholder intent has to make one wonder why the company bothered holding an election at all.

GMI Ratings currently ranks CommonWealth REIT a “D” in Ownership & Control. The combination and use of poison pills, director removal restrictions, business combinations, and controlling share thresholds has left the company’s shareholders with little means to enact change in the company. CommonWealth investors have seen steady decline in share value since 2010 and these recent events do not provide much hope for a leadership change or an increase in shareholder control anytime soon. In addition to adopting new takeover defenses, further entrenching its board, and utilizing the rarely used “dead hand” poison pill tactic, CommonWealth has now shown a complete disregard for shareholder rights.

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Fundamental investment analysis typically assumes the reliability of corporate financial reports. But a growing body of empirical research characterizes this assumption as dangerously naïve, especially for investment portfolios pegged to broad market indices.

In How Pervasive is Corporate Fraud? (February 22, 2013), researchers at the University of Toronto and University of Chicago found that “The probability of a company engaging in a fraud in any given year is 14.5%,” and “on average, corporate fraud costs investors 22 percent of enterprise value in fraud-committing firms and 3 percent of enterprise value across all firms.”

Importantly, surveys of corporate finance chiefs and other employees generally corroborate this finding. Ernst & Young’s latest Fraud Survey (May 7, 2013) confirmed again that businesses often resort to aggressive and illegal measures to meet increasingly ambitious growth targets. About 20% of almost 3,500 respondents said that “have seen financial manipulation of some kind occurring in their own companies.” In addition, 42 percent of board directors and top managers who responded to the survey said they were aware of “some type of irregular financial reporting.” Respondents from high-growth, emerging and frontier markets were far more likely to report that “financial performance is often exaggerated.” Fifty-four percent of Indian respondents and 61% of respondents from Russia agreed with this assessment.

Similarly troubling findings emerge from another recent survey of 169 public company CFOs. Conducted by a team of researchers from Duke and Emory, the survey — Earnings Quality: Evidence from the Field (February 21, 2013) — finds that “About 20% of firms manage earnings to misrepresent economic performance, and for such firms, 10% of EPS is typically managed.” This is an important finding, not only because it points to the scope and severity of the problem, but also because it comes from respondents (i.e., CFOs) who understand the problem well.

Many recent news stories have chronicled material shortfalls of auditors in detecting and mitigating earnings manipulation. According to a news report based on a study by University of Tennessee accounting professor Joseph Carcello, auditors sanctioned in fraud cases from 1998 through 2010 “sometimes did not question documents that appeared to be fabricated,” and they “overlooked discrepancies between real inventory and amounts on the books.”

In sum, accounting practices that distort the value of underlying assets remain widespread. Pressures to sustain growth continue to mount. Accounting standards still provide significant leeway for earnings manipulation, even within legal boundaries. Regulatory enforcements remain handicapped by limited resources. Investors remain exposed to mispriced and inadequately disclosed risks.

Given the incidence of earnings manipulation, investors will increasingly recognize that stock rejection may affect portfolio performance at least as heavily as stock selection, and forensic accounting will need to become an essential part of every investor’s analytical arsenal. The discipline continues to evolve. It no longer relies primarily on the work of a small team of sleuths investigating a single suspect, ferretting out inconvenient truths veiled in accounting conventions. Today, investors can apply sophisticated forensic algorithms to broad indices, industry groups, focusing on tested and validated markers of fraudulent accounting.

Early next week, we will share summaries of the presentations at our seminar on May 14, where we introduced our new Quantitative Equity Model (QEM), which uses forensic measures of risk to predict equity performance. This model builds on the research we’ve conducted since the founding of Audit Integrity, one of the GMI Ratings predecessor firms. The QEM has shown a strong out-of-sample ability to predict equity returns globally, across industries, large-cap and small-cap portfolios.

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Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

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Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

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Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

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