Last week, the SEC brought a settled action against VMware, a provider of cloud-storage software and services, alleging that it misled shareholders by failing to disclose material information about its “managed pipeline” of orders in quarterly and annual Exchange Act reports, on earnings calls and in earnings releases during its 2019 and 2020 fiscal years. According to the press release, the company used its “backlog management practices” to “push revenue into future quarters by delaying product deliveries to customers, concealing the company’s slowing performance relative to its projections.” Interestingly, the charges in the SEC’s Order were not about funny accounting or even that favorite Enforcement standby, failure to maintain and comply with adequate disclosure controls and procedures. As VMware noted in a statement, the “SEC’s findings do not include any findings that the Company failed to comply with generally accepted accounting principles.” Rather, the charges were about the disclosures about the accounting. “Although VMware publicly disclosed that its backlog was ‘managed based upon multiple considerations,’” the SEC said, “it did not reveal to investors that it used the backlog to manage the timing of the company’s revenue recognition.” VMware was ordered to cease and desist and pay a civil penalty of $8 million. According to an Associate Director in the Division of Enforcement, “by making misleading statements about order management practices, VMware deprived investors of important information about its financial performance….Such conduct is incompatible with an issuer’s disclosure obligations under the federal securities laws.”
Under GAAP, in general, revenue is recognized when the service is performed or the product is considered delivered to the customer upon transfer of control. As described in the Order, VMware recognized revenue when it delivered “license keys” to customers “to access on-premises or cloud-based software, or through delivery of services—such as technology support and consulting work—as such services are performed.” In FY2019, the SEC alleged, VMware began to delay the delivery of some license keys to customers on a discretionary basis—even though they were otherwise “ready to be booked and recorded as revenue in the current quarter”— to “control the timing of revenue recognition, which was important to the company.” VMware referred to these discretionary holds internally as its “managed pipeline” or “MPL.” Held in backlog, these orders enabled VMware, the SEC charged, to shift “tens of millions of dollars in revenue into future quarters,” smoothing revenue and effectively disguising a slowdown in business. VMware’s pipeline management, the SEC alleged, enabled the company “to meet guidance and analyst estimates, or reducing the amount by which it missed guidance and/or estimates, during multiple quarters, for both total and license revenue.”
As described in the Order, during FY19 and FY20, VMware used these discretionary holds when it had met its objectives for the quarter “in order not to exceed the company’s revenue guidance by too much and as a way, in the words of VMware personnel, to start the next quarter with a buffer or more momentum than it might have had otherwise.” Beginning with Q1 FY19, VMware included in its MD&A a statement, formulated by VMware senior finance and accounting personnel and reviewed (or at least available for review) by senior management, the audit committee and VMware’s independent auditor, that “[t]he amount and composition of [VMware’s] backlog will fluctuate period to period, and backlog is managed based upon multiple considerations, including product and geography.” In Q3 FY19, VMware adopted a formal policy for bookings and backlog providing that discretionary holds could be “value-based, product-based, geo[graphy]-based or any combination.” During the period, VMware also disclosed a backlog metric that included orders withheld from booking for both discretionary and (mostly) nondiscretionary reasons, but did not disclose that information, the SEC said.
During FY19, VMware’s quarter-end backlog MPL increased by approximately 50%. But during FY20, the SEC alleged, as a result of both macro factors and an accelerated shift by VMware to subscription-based software sales, VMware’s business slowed against its own guidance and analysts’ revenue estimates, and VMware began to “use,” or reduce, its MPL. According to the Order, “VMware’s quarter-over-quarter net reductions in the large end-of-quarter backlog numbers that it had initially carried into FY20 from FY19 obscured this shift. The existence and net (i.e., quarter over quarter) reduction of that backlog throughout FY20 resulted in more revenue being recognized in each quarter than would otherwise have been recognized, allowing VMware to meet analyst estimates it would otherwise have missed. Internal FY20 emails at VMware noted the company’s ongoing ‘use’ or ‘burn[ing]’ of MPL.” Analysts who made inquiry were not advised about “the largely discretionary nature of VMware’s backlog and VMware’s use of backlog to manage its quarterly total and license revenue.”
The Order alleged that VMware’s continual reductions in MPL over FY20 were “material, enabling the company to meet guidance and analyst estimates, or reducing the amount by which it missed guidance and/or estimates, during multiple quarters, for both total and license revenue.” Over the course of FY20, VMware’s MPL in total backlog fell by nearly 99%, “from roughly $409 million at the end of Q4 FY19 to only, approximately, $4 million at the end of Q4 FY20, as the company essentially ‘used’ or ‘burned’ the entirety of its MPL. Moreover, VMware’s license MPL fell in three of four quarters during FY20, by a total of nearly 100% over the course of the fiscal year, from nearly $124 million to approximately $0.1 million. By FY20 year-end, VMware’s business had slowed to such an extent versus expectations that it was essentially no longer generating any perceived excess sales to ‘hold’ as MPL.” On the day following VMware’s announcement of Q4 FY20 and full-year FY20 results, VMware’s stock price fell by approximately 37%.
According to the Order, VMware’s earnings calls sought to deliver a message of consistency and a “narrative of strong growth.” When some analysts apparently “understood the revenue impact of VMware’s backlog declines,” the SEC alleged, their questions were effectively “dismissed” with responses such as “[w]e are pleased with the performance of the quarter,” and “[b]acklog is only one part of our overall sales pipeline. ” On its Q4 FY20 earnings call, VMware acknowledged only that “revenue came in a bit short of expectations.”
The SEC charged that VMware’s public statements regarding its backlog were misleading because they “omitted material information regarding the extent to which the company controlled its quarter-end total and license backlog numbers through its use of discretionary holds, and the extent to which it used backlog to control the timing of revenue recognition generally.” Its “practice of managing the timing of revenue recognition through its use of backlog enabled it to more closely match guidance and analyst estimates for its total and license revenue. Without disclosure regarding all material aspects of the backlog, investors lacked necessary information to meaningfully evaluate VMware’s reported financial results and the extent to which those results might be indicative of future results. VMware thus made materially misleading disclosures regarding its backlog practices in its FY19 and FY20 periodic reports.” In addition, during earnings calls and in press releases issued in FY20, “VMware misleadingly reassured investors…that its revenue growth was meeting expectations,” and presented year-over-year percentage increases for revenue that “misleadingly portrayed the company’s revenue growth. This was the case not only because the FY20 results were almost always higher than they would have been without VMware’s quarter-end backlog reductions but also because the prior fiscal year’s results had been generally held back by VMware’s quarter-end backlog increases during FY19—meaning FY19 orders that otherwise could have been booked had instead been discretionarily held in order to more closely track revenue to VMware’s FY19 quarterly guidance and analysts’ estimates.”
As the company knew, “VMware’s ability to meet guidance and analysts’ estimates was material to its stock price.” In the SEC’s view, the disclosure omissions were material because they “concealed a substantial FY20 slowing in the company’s recognized revenue growth versus expectations.” In the absence of FY20 backlog reductions in several quarters, the SEC alleged, the company “would have missed rather than met” guidance and/or analyst consensus estimates for total revenue and/or for license revenue. In addition, the SEC contended, reasonable investors would have considered the information important in making an investment decision.
The SEC charged VMware with violation of Securities Act Sections 17(a)(2) and (3), which may be based on negligence, in connection with offers and sales of securities, as well as Section 13(a) of the Exchange Act and related Rules 13a-1, 13a-11, 13a-13 and 12b-20, in connection with their Exchange Act filings. In the settled action, VMware was ordered to cease and desist and to pay a civil penalty of $8 million