(FORTUNE Magazine) – Remember when "hot coffee" meant, literally, hot coffee? Those seemingly innocent little words took on an entirely different meaning on July 20 when the videogame industry's Entertainment Software Rating Board concluded that sexually explicit scenes hidden deep within the bestselling game Grand Theft Auto: San Andreas could be easily accessed via software available on the Internet. The sex scenes--which begin with the invitation "How 'bout some coffee?"--prompted the ESRB to change the game's rating from "mature" (analogous to an R rating for a movie) to "adults only."

The reaction was fast and furious--even overblown, some might say, given that Grand Theft Auto has long been wildly popular and wildly controversial precisely for its less-than-wholesome enticements. "It appears that a game already known for sex and violence had a little more sex than was already advertised," noted an analyst from Prudential. Retailers from Wal-Mart to Best Buy that refuse to sell adult-only games began yanking Grand Theft from their shelves. Politicians, already riled by violence in the video world, quickly stepped into the fray (as did lawyers--an 85-year-old New York City grandmother filed a suit alleging that the game had caused damage to her teenaged grandson). With a consensus rarely seen in Washington, the House of Representatives passed a resolution 355 to 21 asking the Federal Trade Commission to investigate Grand Theft Auto and its maker, a division of publicly traded company Take Two Interactive Software.

But the dirty little secret about the games business isn't just those unsavory embedded sex scenes but unsavory business practices--and Take Two is Exhibit A. The videogame industry has mushroomed into a $10-billion-a-year behemoth in the U.S., according to the NPD Group, which tracks retail sales--hauling in more cash than the movie box office. With that success has come questions about industry accounting practices, and in 2003 the SEC began investigating a number of gamemakers. But Take Two is the industry's wild child. A not-so-small publicly traded company--its market capitalization today is almost $2 billion--it has a history of financial improprieties, hefty stock sales in the midst of scandal, and revolving-door management. In June, just before the hot-coffee controversy erupted, Take Two settled SEC charges that it had engaged in fraudulent accounting practices designed to inflate revenue, meet earnings targets, and trigger bonuses to executives.

For the videogame industry, struggling to gain credibility and respect in the mainstream entertainment world, Take Two should be a cautionary tale. (The company declined to comment for this story.) Remarkably, it's not. Because despite all the outrage--and the outrageous corporate behavior--Take Two's stock remains a widely owned, much-prized commodity. "Acting like a thug in one of their own games," as one industry insider describes the company's transgressions, has apparently had few repercussions. How, in an era when investors are supposedly obsessed with corporate governance, are this firm's troubles so easily overlooked? The lesson of Take Two, it turns out, is not what you would expect.

FOR THE UNINITIATED, PLAYING GRAND Theft Auto can be a bit of a shock. San Andreas is a dark fantasy world where anything goes--players are rewarded for committing crimes like carjacking, for instance, or beating up prostitutes after sex to reclaim their money. While the embedded hot- coffee scenes are quite explicit, even the game's regular sequences feature cars rocking from sexual activity. No wonder Tim Winter, executive director of the Parents Television Council, which wants to rein in videogame violence, accuses the game of "lacking any redeeming social values."

In fairness, it isn't just the sex and violence that makes Grand Theft addictive. Dennis McCauley, editor of GamePolitics.com, argues that the game has succeeded in part because it was the first to drop a player into a large, free-ranging three-dimensional world that isn't bound by a script, letting him go anywhere and do anything. "Playing GTA is like living an episode of The Sopranos," he says. "It's an amazing piece of game design."

Take Two's rise to prominence was also a bit amazing. The company was founded in 1993 by a 21-year-old recent Wharton graduate named Ryan Brant. Among his financial backers: his father, Peter Brant--the owner of high-brow magazines like Interview and Art in America, a co-founder of the Greenwich Polo Club, future husband of world-famous Victoria's Secret model Stephanie Seymour, and a former jailbird. (He served time for tax evasion in 1990.) Take Two started out modestly enough (Seymour and Dennis Hopper, who is a friend of Peter Brant's, played supporting roles in early games), producing titles with names like Hell: A Cyberpunk Thriller and Millennia: Altered Destinies. The company wasn't exactly a force, but it did manage to go public in 1997. At that time Peter Brant--related entities owned roughly half the stock.

The defining moment in the company's evolution came in 1998, when it bought BMG Entertainment's game business, including a successful but still small property called Grand Theft Auto. Take Two put the game into a new division called Rockstar, which cultivated a bad-boy image (helped by comments like those from Senator Joseph Lieberman, who denounced games like Grand Theft as "graphic, gruesome, and grotesque"). When the third installment of the game--Grand Theft Auto III--hit the streets in 2001, the response was overwhelming. Grand Theft III has since sold roughly ten million copies, in an industry in which sales of 500,000 once defined a hit. The next iteration of the game, Vice City, released in 2002, was even bigger. In 2003, Take Two's revenues surpassed $1 billion. The stock, which had gone public at a split-adjusted $3.33, shot above $25.

BUT THE GOOD TIMES WERE NOT quite as good as they looked. In the videogame industry it's easy to fudge numbers--in fact, even if a company tries, it can be hard to get the numbers right because of the difficulty of estimating returns. Take Two's growth was spectacular, thanks to Grand Theft Auto. To some, it was a little too spectacular.

An investment firm called Rocker Partners, which specializes in short-selling, noticed in early 2001 that, among other things, the sales figures Take Two was reporting didn't track with NPD's figures. Soon Rocker began to send information about Take Two to the SEC. That marked the beginning of Take Two's battle with short-sellers, one that continues to this day.

It would soon become all too clear that there was nothing accidental about the sales inconsistencies Rocker had discovered. In February 2002, Take Two restated its results for the previous seven quarters, citing, among other things, what the SEC would later call "parking transactions," in which the company shipped games to a distributor, recognized the revenue, and then took the games back in the subsequent quarter. Two years later the company restated results again, this time for fiscal years 1999 through 2003. Some of this was a matter of accounting methodology, but the company also admitted to additional parking transactions in 2000 and 2001. As the SEC would later state, "revenue and/or earnings were materially overstated in nine of 15 quarters."

Indeed, the SEC had launched an investigation, issuing so-called Wells notices to Ryan Brant and other Take Two executives in 2003, indicating that the government intended to bring enforcement actions. The SEC complaint that grew out of the investigation notes that the Take Two distributors "had no obligation to pay for the product," and "in many cases Take Two created fraudulent invoices to disguise the returns as 'purchases of assorted product.' " When the case was finally settled earlier this summer, Take Two neither admitted nor denied guilt but paid a fine of $7.5 million; four executives, including Ryan Brant, also paid fines totaling $6.4 million, and Brant was barred from serving as an officer or director of a public company for five years.

Those are not inconsequential penalties and indicate the regulators' high level of concern. But the fines are a pittance compared to the cash that was piled up by Brant, his father, and other company insiders who sold shares in a period when Take Two's faulty financials were widely accepted. Peter Brant--related entities reaped some $50 million in proceeds from Take Two stock sales between 1998 and 2003, while Ryan Brant sold some $20 million in stock between early 1999 and late 2003. A large shareholder and audit committee member named Oliver Grace also sold millions' worth in the second half of 2003. As Bank of America analyst Gary Cooper noted about Grace in a January 2004 report, "It does not seem appropriate to us that one of the largest shareholders, who represents the audit committee, would be able to sell a significant amount of shares at a time when the accounting for the business was not accurate."

And like a massacre from Grand Theft Auto itself, Take Two's management team was being knocked off one after another: Even before the first restatement in 2002, Ryan Brant stepped down as CEO; soon after the CFO also resigned. Since then, the company has had four more CEOs and two more CFOs. The current CEO, Paul Eibeler, who took the reins in early 2005, was Take Two's president from December 2000 until June 2003, before departing for rival Acclaim Entertainment (which ultimately declared bankruptcy).

Yet somehow, through all the corner- office mayhem, the company's stock has remained buoyant. Upon news of the first restatement, the stock plummeted more than 30%, to less than $7 a share, but it immediately recovered. Since then it has climbed steadily to around $25. Big owners include major mutual fund houses like Fidelity, Oppenheimer, J. & W. Seligman, and Wellington. In other words, even though the short-sellers were right about the problems at Take Two, in investment terms they were dead wrong. Admits David Rocker of Rocker Partners: "We've lost our butts on this thing."

"YOU'D BE HARD-PRESSED TO FIND A worse set of guys," insists Rocker partner Mark Cohodes, referring to the Take Two crew. He's not the only short whose guns are still blazing when it comes to the gamemaker. Some 13% of Take Two's freely traded shares are still sold short. Research firm Gradient Analytics has raised questions about Take Two's balance sheet, even after the SEC settlement, and Bank of America analyst Cooper points out that while Take Two has reported $95 million in net income over the past four quarters, it has generated just $6 million in cash flow from operations (excluding the effect of stock options exercises).

In the past few months the insider selling has picked up again too. Audit committee member Grace has filed to sell almost $20 million worth. CFO Karl Winters sold more than $5 million of shares between mid-March and mid-June. In mid-July, a week before the ESRB's ruling, COO Gary Lewis exercised 20,000 options at $21.28 per share and sold them at $27.75 per share. As for Ryan Brant, any sales activity isn't disclosed, since he's no longer an officer or a director. But he is still at the company, with the title of publishing director, and is still by far the highest-paid person. Last year he made just over $4 million in salary, bonus, and stock--a reduction from the more than $7 million he made in 2003.

None of those developments have made a dent in the stock. "Take it or leave it," says one money manager. "The accounting issues are not material to the bigger picture." Videogames are a growth business, and Take Two is owner of one of the biggest hits. As long as Grand Theft Auto continues to sell, investors will probably ignore the drawbacks. In fact, in an irony that perhaps sums up the whole story, the furor over "hot coffee" has brought Grand Theft Auto new notoriety--propelling it toward the top of Amazon.com's bestseller list. (The company did set up a reserve of $45 million after the ESRB ruling, due to anticipated returns from retailers like Wal-Mart, though some critics argue that the figure is excessive.)

Take Two hasn't won the game yet. The FTC is investigating the company for deceptive advertising. The question: If Take Two's management knew the hidden sex scenes were there, then did they purposefully deceive the ESRB? Take Two, for its part, adamantly denies this and says its programmers simply failed to remove the code from early drafts of the game, instead burying it out of sight, like an artist painting over a canvas. CEO Eibeler has even managed to muster a self-righteous tone: "We are deeply concerned that the publicity surrounding these unauthorized modifications has caused the game to be misrepresented to the public," he preached in a press release, "and has detracted from the creative merits of this award-winning product."

Inspiring stuff. Yet Take Two hasn't exactly been consistent when it comes to the sex-scene allegations. When news of the scenes first surfaced in June, the company quickly blamed "modders"--nonemployee fans who seek to modify existing games--for "disassembling, then combining, recompiling, and altering the game's code." But as the ESRB eventually discovered, that explanation wasn't quite true. In fact, the sexually explicit scenes were in the original code of the game. All the modders did was uncover them--which is what anyone who knows anything about gaming would expect a modder to do.

No wonder that when the controversy broke, Congresswoman Mary Lou Dickerson of Washington got a bit riled. "It looks like Take Two Interactive purposefully conned the videogame industry ratings board and parents across the country," she observed. "There should be legal consequences ... so [the company doesn't] laugh all the way to the bank." Of course, it might be a bit late for that.

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RESEARCH ASSOCIATE Doris Burke