Cover Story

Stone Cold

by Jeremy Alford

A scathing audit and drastically revised financial statements from the Wall Street darling of Lafayette have shareholders and federal authorities questioning the integrity of Stone Energy.

Norman V. Meyer used to split his days laboring over drive shafts on a Chrysler assembly line and cultivating his vast farmland, a place where stalks of soybean and wheat once flourished. Today, at the age of 70, he's retired and living a quiet life with his family in St. Louis, Mo. The factory and the farm are distant memories.

On the surface, Meyer's apple pie persona and blue-collar work ethic might not sound like part of the Wall Street Journal's demographic, but Meyer has been trading stocks since 1956, dodging bulls and bears during the boons and busts of recent decades. When Meyer sees a good deal, he doesn't hesitate.

That's what happened last summer when he came across SGY, the New York Stock Exchange symbol for Stone Energy Corp., the Lafayette-based independent oil and gas company. At the time, Stone's properties in the Gulf Coast Basin and Rocky Mountains were practically minting their own money, thanks to rising natural gas prices and high discovery rates for oil.

Similar stocks had been outperforming the market for months, and Forbes magazine had recently named Stone among the "Top 200 Best Small Companies." At $59 a pop, Meyer pounced and purchased 1,500 shares with high hopes.

"I really got caught up when I saw that turkey," Meyer recalls. "I just knew it was going to go up."

Meyer was right. On Sept. 29, his stock was valued at $62.50 per share ' a $5,250 profit on paper. It was a good day, a time for celebration. But it was short-lived. Only seven days later, on Oct. 6, Stone announced that erroneous information was included in some of its public reports and the company had a smaller supply of natural gas reserves than it had told investors.

In short, Stone had reported bad data and scores of investors had been acting on it. Upon hearing the news, the market reacted violently, and Stone's stock fell to $48.14 per share. Meyer's holdings suffered a $16,290 dip during those dark fall days. The stock has rebounded slightly in recent months, but even if Meyer sold his Stone Energy stock at today's market value, he would still suffer a loss of more than $13,000.

"I feel like I was lied to," Meyer says. "I don't know if it was intentional or not, but I have to go by the figures that I get. I would have never bought the stock if I would have known what was going on."

LAWSUITS AND RESIGNATIONS

Meyer isn't the only one wondering what's going on at Stone. Federal authorities and a major equities market have launched inquiries into the inaccuracies, questioning whether the overstatements were done intentionally to make the stock more appealing, or to help company officials make more money.

A wave of class-action lawsuits are also being filed around the country by shareholders who want to know if company officials were intentionally dumping their stock before the devastating news was released last year. Such activity is nothing new ' domestic goddess Martha Stewart spent time in prison after the courts in 2004 found her guilty of obstruction of justice and lying to investigators about a well-timed stock sale that took place in December 2001.

Already, a director has been forced to retire in light of the scandal, along with two senior management officials ' based on information that the inaccuracies were encouraged by "tone from the top," according to a scathing audit investigation. New fiscal statements from the 33-year-old company are due out in early March, and Wall Street is watching the investigations and lawsuits with great interest, as both could possibly lead to criminal charges.

A SCATHING AUDIT

Stone Energy's corporate headquarters off Kaliste Saloom Road are a picture of serenity. Lush, green trees and rolling hills around the four-story mortar-and-rock building offer a comfortable place to watch the Vermilion River flow by. On a bright, cloudless day, the sun reflects off the river and the building's huge windows, offering a peaceful, corporate retreat just outside the back door.

It's also the view from the accounting offices on Stone's first floor, where the atmosphere is far from bucolic these days. The damning news announced last year that Stone would have to downgrade its gas reserves, meaning a negative revision of the amount of fuel it could eventually produce in coming years, shook the foundation of the company.

If the overstatement had been modest, then maybe onlookers would have been more understanding. But the data was way off ' to the equivalent of 171 billion cubic feet of natural gas. According to a calculation by the staff of the Louisiana State University Center for Energy Studies, the error has a cash value of $1.4 billion in today's market.

To put that into context, the figure slightly trumps what Stone's total market capitalization was earlier this month ' $1.3 billion. (A market cap represents a company's total stock value during a certain period.)

Annette Finch, Stone Energy's financial reports manager, says in a phone interview that the company found the problem itself and voluntarily contacted the U.S. Securities and Exchange Commission, which has regulatory authority over publicly traded companies. Finch also says Stone's audit committee immediately hired the New York City firm Davis Polk & Wardwell to look into the matter and compile a report.

Finch and other Stone officials refused any additional comment for this story.

Davis Polk & Wardell's report was issued in early December and included some troubling findings.

The report found that "some former members of Stone management failed to fully grasp the conservatism" of SEC reserve accounting rules, which require "reasonable certainty." The report likewise urged Stone to further train staff and "cultivate a culture of compliance."

It's still unknown exactly how long bad data was being reported to the public, but Stone announced late last year in a press release that financial statements dating back to 2001 would be reissued, and stated its "prior filings with the Securities and Exchange Commission should no longer be relied upon."

AN HONEST MISTAKE?

Could this whole Stone Energy fiasco be the result of an honest ' albeit colossal ' mistake? Those in the industry loathe the process of calculating natural gas reserves because it's an imperfect science, akin to nothing more than a guessing game.

It's easy to understand what might have went wrong, says Paul Hilliard, president and Chief Executive Officer of Badger Oil in Lafayette. For starters, Stone is a large company that could potentially produce a significant amount of gas, like the amount it overstated, off just a few sites, he says.

But, more importantly, calculating gas reserves is a process that's easy to slip up on, he adds. A dizzying array of factors must be taken into account ' including the quality of a reservoir, depth, pressure, rocks and historical production.

"I know how difficult it is to estimate what's down there," says Hilliard, who has been a part of the local oil industry since 1951. "Petroleum is so elusive. Everyday we try to evaluate if we should or shouldn't drill. You're only making an estimate if it's there. You're only making a guess. It's more an art than a science, and it's easy in hindsight to say you misled investors."

The Davis Polk report doesn't give Stone Energy the benefit of the doubt. In fact, the report notes an "optimistic and aggressive â?¦ tone from the top" in the way reserves were calculated at Stone and found "several factors that may have prevented or discouraged technical staff from pushing back" against the upper management's desires to make the numbers shine.

This is one of the many reasons the SEC has launched an "informal inquiry," and it seems to be the main thrust behind another inquiry from the Philadelphia Stock Exchange regarding insider trading.

THE INSIDERS

One of the first heads to roll after the news was announced last year belongs to former Stone CEO D. Peter Canty, who stepped down as a board director last year following the audit findings. Canty was with Stone when it went public in 1993. He refused to be interviewed for this story.

In a Dec. 2 resignation letter obtained by Platts Oilgram News, Canty wrote that he disagreed with "many conclusions" of the Davis Polk report, but the "investigations and lawsuits relating to these issues will consume much of my time and energy." Canty further wrote that he "acted as a professional and in good faith."

Stone also stated in a December press release that the board had "directed management to request the resignations of an officer and a senior manager associated with the reserve estimation problem." Company officials refused to release the names of these employees, but Platts Oilgram News reported that one of them was Gerald Yunker, a geologist who formerly served the company as senior vice president for exploitation and, prior to that, manager of planning, acquisition and analysis. Yunker did not return a call for comment.

David H. Welch, the president and CEO since 1994, signed a new three-year employment contract with Stone just a few weeks ago. Welch's annual base salary will remain at $400,000 in 2006 and will be reviewed by the board on an ongoing basis. If he should be fired for any reason, according to a public filing regarding the contract, Welch will be entitled to a "lump sum cash payment" that was not disclosed, in addition to other benefits.

Other Stone officials are on the hot seat as well. Many of the class actions that have been filed thus far focus on stock trades made inside the company by officials who allegedly had knowledge of the bad information. The lawsuits argue that company officials started dumping their stock in order to make a profit before the shares bottomed out.

As a result of the downward revision, Stone's market capitalization suffered about an $898 million hit. But in the years and months preceding the bad news for investors, Stone executives sold roughly $29 million of their personally held stock, according to lawsuits.

Canty, for instance, made about $7.9 million in 2003 and 2004 from 164,500 shares of Stone stock he sold ' his total holdings were 253,561 shares as of last year.

Prominent Lafayette resident James H. Prince, former chairman of the Greater Lafayette Chamber of Commerce and former UL Foundation Board President, made $940,700 last June by selling off 20,000 of his 250,000 shares. He retired as Stone's chief financial officer in August, leaving a position that is partly responsible for signing off on all financial statements and public filings, along with the CEO.

When contacted for comment, Prince declined any discussion, despite the fact that he was CFO during the years in question. "All of this happened after I left," he says. "You'll have to call the company."

The lawsuits name nearly every member of the board, who sold Stone shares in varying amounts from 2001 to 2005. Those individuals, and their resulting proceeds, are: Robert A. Bernhard, $1.1 million; James H. Stone, $8.3 million; John P. Laborde, $155,917; Richard A. Pattarozzi, $47,960; David R. Voelker, $10.1 million; Raymond B. Gary, $111,090; and B.J. Duplantis, $421,220.

The amount of trading during this period by these people is not out of the ordinary, says Peter F. Ricchiuti, assistant dean of the A.B. Freeman School of Business at Tulane University and a director at Amedisys, a publicly traded home health care company based in Baton Rouge.

"One of the reasons intent might be difficult to prove is because of all the industry groups that are selling off from the inside, oil is at the top," he says. "There are plenty of reasons for them to be selling off, other than negative news coming out. Oil and gas stocks have been out-producing the market, and that's triggering people to take profits. Plus, any prudent person would want to lessen their holdings if it's all in one area, which happens with directors. They hold a lot of stock in the company they're involved with."

That explanation might not be enough to save some Stone officials from criminal proceedings; current laws place them in the hot seat just for holding the titles that they do.

UNDER THE GUN

When Congress passed the Sarbanes-Oxley Act in 2002, in the wake of large corporate financial scandals involving Enron, WorldCom, Global Crossing and Arthur Andersen, it represented one of the most substantial changes to federal securities laws in recent history.

The law requires all publicly traded companies to submit an annual report of the effectiveness of their internal accounting controls to the SEC. The act also details criminal and civil penalties for noncompliance, certification of internal auditing and increased financial disclosure.

Coincidentally, Prince was the individual at Stone instrumental in implementing the accounting procedures required by Sarbanes-Oxley at the Lafayette headquarters. Even if they had no knowledge of the inaccuracies, Prince and others could be held monetarily liable or slapped with other penalties under the law because they are responsible for the accuracy of public reports.

"I think to some degree all of this is a product of the Sarbanes-Oxley Act," Hilliard says. "It's just so easy to make an inaccurate estimate sometimes. With this law, I think we're going to see more and more of these stories coming down the road."

Shell overestimated its oil reserves twice during a four-month period in 2004, and it took more than a year to wrap up all the related investigations and lawsuits. In the end, Shell had reduced its reserves by 1.4 billion barrels, which was radically more than the 900 million barrels originally thought, and it proved to be a costly move.

While nothing ever came from a slew of criminal investigations, the scandal cost Shell more than $151 million in fines, $10 billion in corporate reform measures, a $5 billion settlement with shareholders to buy back shares and a $90 million settlement with its employees.

It's still too early to tell what might come of the lawsuits related to Stone, but the company stated in a press release it is currently "evaluating the complaints and intends to vigorously defend any lawsuits that are filed."

Even with the controversy, Ricchiuti says Stone remains a "Wall Street darling" and the Lafayette company could rebound from the troubles, depending on the pending inquiries.

For now, it's a troubling chapter in what has otherwise traditionally been a major success story in the bayou.

"It's kind of sad in a way because Stone was always one of those companies people point to as a shining example when they talk about publicly traded companies in Louisiana," Ricchiuti says. "And they still may be when all of this is over. If enough time passes, and things work out for them, there's no reason Stone can't return to their former glory in a quick way."