The transition from a privately held company to being part of a public entity can be difficult. As a private company there is no requirement that its financial reporting systems comply with the dictates of the Exchange Act which were designed to protect investors who entrusted their money to those running the company. Once the private entity becomes part of the public corporation however, the parent must have internal controls sufficient to effectively monitor the newly acquired entity and the subsidiary is required comply with the Exchange Act.
This lesson was recently learned by on-line media company The Street.com, Inc. when it acquired a privately held entity. The acquisition eventually resulted in a restatement and enforcement actions against the parent company, its former CFO and two officers of the subsidiary. SEC v. TheStreet, Inc., Civil Action No. 12-CV-9187 (S.D.N.Y. Filed Dec. 18, 2012); SEC v. Ashman, Civil Action No. 12-CV-9189 (S.D.N.Y. Filed Dec. 18, 2012); SEC v. Alwine, Civil Action No. 12-CV-9191 (S.D.N.Y Filed Dec. 18, 2012).
TheStreet.com, Inc., now TheStreet, Inc. acquired a privately held company in August 2007. The acquisition was designed to propel the company forward as a one stop shopping destination. Instead, it soon became apparent that the company was having difficulty reaching its financial targets.
First, the subsidiary recorded revenue prematurely in violation of GAAP. At the time, defendant Eric Ashman was the CFO of TheStreet. He permitted the company to book revenue when the work had not been completed by the subsidiary or there was an insufficient basis to believe that it had been completed. In four large transactions Mr. Ashman is alleged to have permitted the revenue to be recognized at a time when he knew, or recklessly disregarded the fact that the work was not completed in connection with the transaction.
Second, the subsidiary engaged in three round trip transactions with friendly counter-parties to create or inflate revenue. The transactions were structured by defendants Gregg Alwine and David Barnett, the co-presidents of the subsidiary. In support of the transactions the two men backdated at least one contract and obtained a false audit confirmation for another.
The books and records of the subsidiary were consolidated into those of TheStreet for financial reporting purposes. That entity did not maintain adequate internal controls and, according, the fraud at the subsidiary went undetected, according to the complaint. The financial statements of the parent for the first, second, third and fourth quarters overstated revenue by, respectively, 31%, 118%, 21% and 105% and by 152% for the entire year.
The Commission’s actions alleged violations of Exchange Act Sections 13(a), 3(b)(2)(A) and 13(b)(2)(B) by the company; Section 13(b)(5) and aiding and abetting violations of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) and failing to comply with SOX 304(a) by Mr. Ashman; and Sections 13(b)(5) and aiding and abetting violations of Section 10(b), 13(a) and 13(b)(2)(A) by Messrs. Alwine and Barnett.
Each defendant settled with the Commission, consenting to the entry of a permanent injunction based on the Sections cited in the pertinent complaint. In addition, Mr. Ashman agreed to pay a civil penalty of $125,000, to reimburse the parent company $34,240 under SOX 304 and to be barred from serving as a director or officer of a public company for three years. Messrs. Alwine and Barnett will pay penalties of $120,000 and $130,000 respectively and be barred from serving as officers or directors of a public company for ten years. See also Lit. Rel. No. 3232 (Dec. 18, 2012).