Ratings Agencies Review ARCP Accounting Errors; SEC Expected to Investigate

Shares in American Realty Capital Properties continued dropping Thursday, one day after the REIT admitted there were accounting errors that were intentionally covered up in its recent financial statements leading to the resignation of two top executives, reviews by two ratings agencies and a possible investigation by the U.S. Securities and Exchange Commission.

David Kay, ARCP

By Gail Kalinoski, Contributing Editor

Shares in American Realty Capital Properties continued dropping Thursday one day after the REIT admitted there were accounting errors that were intentionally covered up in its recent financial statements leading to the resignation of two top executives, reviews by two ratings agencies and a possible investigation by the U.S. Securities and Exchange Commission.

The Wall Street Journal and Bloomberg reported Thursday that the SEC was expected to investigate accounting practices at New York-based ARCP. The REIT announced Wednesday that CFO Brian Block and Chief Accounting Officer Lisa McAllister had resigned after the errors came to light. ARCP appointed Michael Sodo as CFO and Gavin Brandon as Chief Accounting Officer. Sodo will report directly to ARCP CEO David Kay and the Auditing Committee.

Also on Thursday, Moody’s Investors Service placed the Baa3 senior unsecured rating of ARCP under review for downgrade stating that the action “reflects the uncertainty surrounding the effect on the rating from the accounting review.”

Moody’s said its review will “focus on the ultimate impact on ARCP of the accounting and legal review of its accounting irregularities, its timely filing of 3Q14 financials, and implementation of better financial controls.”

A day earlier, Standard & Poor’s Ratings Services placed ARCP, which it had given a BBB- corporate credit rating, on its CreditWatch as it looks closer at the accounting failures at the largest single-tenant net-lease firm.

“The CreditWatch placement reflects some uncertainty, in our view, that the company has the adequate infrastructure to manage its robust growth and we will  monitor the extent to which the company’s access to equity and debt capital markets is impacted by these events,” credit analyst Jaime Gitler said in a S&P Ratings Services release. “An investigation underway by the audit committee of the company’s board of directors has not uncovered any errors that would affect previously reported audited results, but the investigation is ongoing and we will monitor developments as they occur.”

S&P stated it would seek to resolve the CreditWatch within 90 days and would meet within the next several weeks to review the company’s plans to improve financial controls.

Kay noted during a Wednesday afternoon conference call that they had already had “an initial dialogue with the rating agencies” as well as a “tremendous amount of dialogue with our banks.”

The conference call came several hours after ARCP issued a press release admitting the errors in the first and second quarter filings and said they “should no longer be relied upon.”

While ARCP does not believe there were errors in the financial statements for the fiscal year ending Dec. 31, 2013, it was still investigating the time period.

Kay said an error was made in the first quarter on calculations of adjusted funds from operations. In the second quarter, changes were made in the accounting method to intentionally conceal the initial mistake, he said. The errors led ARCP to overstate AFFO by $12 million in the first quarter and about $10.9 million in the second quarter ending June 30.

“We don’t have bad people, we had some bad judgment there,” Kay said during the conference call. “We had two employees which have resigned as the result of the effects of that calculation and the non-disclosure of the error in the first quarter.”

Kay said an unidentified employee approached the board of directors’ Audit Committee on Sept. 7 with concerns. He said the Audit Committee engaged counsel in Weil, Gotshal as well as Ernst & Young’s forensic accounting group. A six-week investigation, described as “very, very thorough” followed. The information was brought to non-implicated executives late on Friday, Oct. 24, Kay said.

“I’m not happy about these announcements. Friday was a pretty crushing blow,” said Kay, who took over as CEO from Chairman Nicholas Schorsch on Sept. 30 in a planned management change. “This isn’t the ideal situation, but I think that it is not the parade of horribles that the market may view this as today. We have an exceptional team that runs this company. It’s an ethical team.”

Schorsch, who has grown ARCP from a $100 million business to a $20 billion over three years of aggressive acquisitions, was not on the conference call with Kay. Several other entities run by Schorsch, including RCS Capital Corp., American Realty Capital Healthcare Trust Inc., and New York REIT Inc., also saw their shares slide a bit Wednesday following the news of the ARCP accounting irregularities. By Thursday, shares of American Realty Capital Healthcare Trust Inc., which trade as HCT, were inching back up while the others remained slightly down.

But investors and analysts say they are watching the investigation closely. Several law firms announced Thursday they were filing class action lawsuits on behalf of investors who owned shares during the first half of 2014. Other law firms noted they were also considering class action suits.

Brad Thomas, an ACRP investor who is editor of the “Intelligent REIT Investor,” told Commercial Property Executive, he must “decide whether or not I can tolerate the continued volatility. More importantly, I am concerned about the sustainability of the dividend and whether ARCP can cover its all important payout.”

Daniel Donlan, an analyst with Ladenburg Thalmann, noted in an investors’ report that the resignation of Block was a good sign.

“Given that we have never been able to effectively reconcile ARCP’s forward earnings projections with our own earnings model, we believe that the departure of CFO Brian Block should be a strong positive for the REIT’s future financial transparency,” Donlan added.