The SEC prevailed in then Ninth Circuit in its long running action against three former executives of Gateway, a computer manufacturer. SEC v. Todd, No. 07-56098 (9th Cir. June 23, 2011). The Circuit Court reversed the ruling of the district court setting aside a jury verdict which found that defendants John Todd and Robert Manza violated the antifraud provisions with respect to certain financial transactions and made misrepresentations to the auditors. The court rejected a claim by Messrs. Todd and Manza that the district court should have set aside a jury verdict finding that they had aided and abetted certain filing violations by their former employer, Gateway. The Court also overturned a grant of summary judgment in favor of defendant Jeffrey Weitzen on Section 10(b) and 20(a) claims.
The complaint centers on a claimed financial fraud and misstatements which trace to 2000. According to the SEC, former CEO Jeffrey Weitzen, former CFO John Todd and former controller Robert Manza participated in a scheme in which they misrepresented the financial condition of the company in the third quarter of 2000 to meet analyst expectations. At the time the computer market was weakening. At one point in the quarter the company had a gap of over $100 million between revenue and street projections. Nevertheless, Gateway reported earnings which met analyst expectations and Defendant Witzen reported in an earnings call and the related release that Gateway had “accelerated year-over-year revenue growth.”
The company met expectations by booking over $100 million as revenue from three transactions. The first was a sale-lease back of fixed assets to Lockheed Martin. The transaction recorded $47.2 million. While the parties agreed that the transaction was unusual, they disputed whether under GAAP it was properly recorded as revenue.
The second involved $21 million from an incomplete sale of computers to VenServ. It was recorded as revenue. The parties agree that the transaction was improperly booked because it was incomplete. The third involved a change in contact terms with AOL regarding the payment of certain fees to Gateway. The modified agreement permitted Gateway to recognize those fees earlier giving it a revenue boost of $72 million.
Initially, the Court considered the SEC’s challenge to the district court’s ruling setting aside the jury verdict against Messrs. Todd and Manza. On the Lockheed transaction each side presented expert testimony that the transaction had been recorded in accord with GAAP. A dispute of fact is normally within the province of the jury the Court noted. Here however there is more. Regardless of its treatment under GAAP, Gateway’s internal polices which had been disclosed specified that a sale of fixed assets is not booked as revenue. Furthermore, while the defendants’ claim that the transaction was disclosed to the auditors is correct, in fact PWC did not learn about it until after the close of the period and the publication of the financial statements. Ultimately Gateway restated the transaction. Based on the delayed disclosure to PWC there is evidence to support the jury’s verdict that the two defendants acted with scienter the Court found.
Similarly, the Court concluded that there is sufficient evidence to support the jury’s findings as to the VenServ transaction. A violation of GAAP as all agree occurred with respect to this transaction is not sufficient to establish scienter and a Section 10(b) claim. Here however the evidence demonstrated that the two defendants acted recklessly by improperly recording the revenue while knowing the transaction terms and that the deal was not complete.
The Court also found that there was sufficient evidence to support the findings of the jury that Messrs. Todd and Manza made false statements to the auditors although it rejected the SEC’s claims about the applicable standard. Rule 13b2-2 prohibits an officer or director from making a materially false or misleading statement to an accountant. To be liable one must “knowingly” make the false statement, meaning the person must be aware of the falsification and that it was not the result of accident, mistake or ignorance. While acknowledging that the Rule does not impose strict liability the SEC argued that the standard is “closer to negligence or reasonableness.” The Court rejected this argument in favor of the knowing standard. Here since there is sufficient evidence to establish scienter for the Section 10(b) violations, the Court concluded that the evidence supported the jury’s verdict of liability.
Finally, the Court overturned the district court’s grant of summary judgment in favor of former CEO Weitzen on the Section 10(b) claim, concluding that there were genuine issues of material fact in dispute. Here the question focused on whether the statement of Mr. Weitzen about the earnings was false. Generally, such an issue is a mixed question of law and fact. In this instance the Court concluded that a rational fact finder could determine that Mr. Weitzen misled investors by publically describing Gateway’s growth as “accelerated” without disclosing the unusual nature of the Lockheed and AOL transactions. Indeed, there is evidence in the record which demonstrates that Mr. Weitzen participated in a “gap filling” program when the company realized it might miss analyst expectations. The evidence also demonstrates that the former CEO understood the significance of the transactions and that the revenue gap would not be closed without them.
The Court also concluded that there were genuine issues of material fact with respect to the Commission’s Section 20(a) claim against Mr. Weitzen which precluded summary judgment. Under this Section the defendant can be liable if there is a violation of the Act and if he directly or indirectly controls any person liable for it. There is no liability however if the controlling person acted in good faith and did not directly or indirectly induce the violation. The critical question here is control. The fact that Mr. Weitzen is the CEO does not create a presumption that he is a controlling person. In the context of this case actual authority over the preparation and presentation of the financial statements is sufficient. In this case there is a dispute of fact regarding the control of Mr. Weitzen which precluded granting summary judgment in his favor. Accordingly, the Section 10(b) and 20(a) claims against Mr. Weitzen were sent back to the trial court. The jury verdicts against Messrs. Todd and Manza were reinstated.