This is the third in a series of articles examining the creation of the new Financial Reporting and Audit Task Force along with a Center for Risk and Quantitative Analysis. Today’s article examines select cases concerning improper revenue enhancement techniques used by issuers in actions brought by the Commission in the wake Chairman Levitt’s speech.
Following the Numbers Game speech, and continuing through the market crisis to the time of the reorganization of the enforcement division, the Commission brought a series of financial statement fraud cases. Driven by pressure to meet street expectations, a variety of fraudulent techniques to manipulate the numbers were used. Those ranged from the simple falsification of revenue, to sham transactions to managing income using a variety of improper accounting devices. One group of actions used various devices to improperly enhance revenue.
Falsification of revenue: In some instances the pressure to make the numbers resulted in the fabrication of income. Examples of these cases include:
- SEC v. HealthSouth Corporation, Civil Action CV -03-J-0615 (N.D. Ala. Filed March 19, 2003). The Commission’s complaint alleged that the company systematically overstated its earnings by at least $1.4 billion to meet street expectations beginning as early as 1999. Each quarter the company accounting staff created entries to ensure that the firm met expectations for the period. In many instances these entries took the form of reducing a contra revenue account and/or decreasing expenses and correspondingly increasing assets or decreasing liabilities. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and13(b)(20(B); See Lit. Rel. No. 1804 (March 20, 2003).
- SEC v. Koninkijke Ahold N.V.¸ Civil Action No. 04-1742 (D.D.C. Filed Oct. 13, 2004) is an action against the company and three of its former senior executives centered on an accounting fraud that took place between 2000 and 2002. While the complaint alleged a variety of fraudulent practices, one of the key elements of the scheme was the inflation of revenue. An important source of operating income was vendor payments known as promotional allowances. The company materially inflated those allowances, according to the Commission’s complaint. See also Lit. Rel. No. 18929 (Oct. 13, 2004).
- Other significant cases include: SEC v. The Penn Traffic Company, Civil Action No. 08-CIV. 01035 (N.D.N.Y. Filed Sept. 30, 2008) (alleging a financial fraud which in part involved creating fraudulent entries and/or adjustments to the books of a wholly owned subsidiary to inflate income in 2003); SEC v. VeriFone Holdings, Inc., CV 09-4046 (N.D. Cal. Filed Sept. 1, 2009) (complaint alleging that the company improperly boosted its gross margins and income by 129% in the first three quarters of 2007 by doing manual adjustments at quarter end to ensure that earnings expectations were met); SEC v. Farkas, Civil Action No. 1:10 CV 667 (E.D. Va. Filed June 16, 2010); U.S. v. Farkas, 10-cr-00206 (E.D. Va. Filed June 16, 2010) (civil and criminal actions against the former chairman of collapsed mortgage lender Taylor, Bean and Whitaker who engaged in a massive kiting scheme based on fictitious mortgaged backed loans in an effort to sustain the mortgage loans being originated); SEC v. NurtraCea, Civil Action No. 11-0092 (D. Az. Filed Jan. 13, 2011)(Lit. Rel. No. 21819 Jan. 20, 2011) (in a settled action the SEC complaint alleged that the Arizona company and three former executives engaged in an accounting fraud scheme in which the company recorded false sales, thereby over-stating product sales and revenue by as much as 35% in the second quarter of 2007).
Sham transactions. In some instances issuers structured deals to create the false appearance of a legitimate business transaction that generated revenue. Those transactions frequently recycled company cash or goods through a third party and back to create the appearance of an arm-length transaction. These “round trip” transactions lacked economic substance.
- SEC v. Dynergy, Inc., Case No. H-0203623 (S.D. Tex. Filed September 25, 2002); In the Matter of Dynergy, Inc., Adm. Proc. File No. 3-10897 (September 25, 2002) is an action against the company which alleged in part that its statement of cash flows was falsified by recording cash flow from a structured financing transaction that was nothing more than a loan. In addition, the company recorded the impact of two huge round trip energy trades that were nothing more than pre-arranged sham transactions. The company settled the action which alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).
- SEC v. Time Warner Inc., Civil Action No. 1:05 cv 00578 (D.D.C. Filed March 21, 2005) is an action alleging in part that over a two year period beginning in 2000 the company fraudulently inflated its revenue from online advertising by utilizing fraudulent round-trip transactions. Central to the scheme was the fact that the company essentially funded the advertising by giving counterparties the means to pay for what they otherwise would not have purchased. To conceal the true nature of the transactions, the company documented the round trip arrangements as if they were two separate, arms-length transactions. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The company settled the case at filing.
- SEC v. Delphi Corporation, Civil Action No. 2:06-cv-14891 (E.D. Mich. Filed Oct 30, 2006) is an action against the company and 13 former officers based on a scheme which took place from 2000 to 2004. The complaint alleged that the company entered into two improper inventory schemes to sell and then repurchase $270 million of metals, automotive batteries and similar items at year end, concealed a $237 million warranty claim, booked what it claimed as a $20 million rebate that was really part of a round trip transaction and concealed about $325 million in factoring, or sales of accounts receivable to boost non-GAAP pro forma measures of company performance. See Lit. Rel. No. 19891 Oct. 30, 2006.
- SEC v. Goldberg, Civil Action No. 09 Civ. 6939 (S.D.N.Y. Filed Aug. 6, 2009) is an action against the former Chairman and CEO and the former vice chairman of the company for managing the financial results of American International Group from 2002 through 2005. During that period the complaint alleges that the defendants: a) used sham reinsurance transactions to make it appear AIG had legitimately increased its general loss reserves; b) entered into purported deals with an offshore entity to conceal multi-million dollar underwriting losses; c) engaged in round trip transactions to improperly report income; and d) improperly realized capital gains on the sale of tax exemption bonds owned by a subsidiary to a trust AIG controlled. The complaint alleged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). See Lit Rel. No. 21270 (Aug. 6, 2009); see also SEC v. General Re Corporation, Civil Action No. 10 Civ. 458 (S.D.N.Y. Filed Jan 20, 2010) (charged for its involvement in two sham transactions with AIG). See Lit. Rel. No. 3108 (Jan. 20, 2010).
- Other significant cases: SEC v. Foster, Civil Action No. H-03-2044 (Filed June 12, 2003) (action against three former employees of Dynegy Inc. charging them with fraud). See also SEC v. Prudential Financial, Inc., Civil Action No. 08 Civ. 3916 (D. N.J. Aug 6, 2008) (firm entered into round trip sham reinsurance agreements with General Re to build up and draw down off-balance sheet sums; firm settled books and records charges); In the Matter of CMS energy Corp., Adm. Proc. File No. 3-11436 (March 19, 2009) (round trip trades used to artificially increase revenue).
Channel stuffing: Another technique used by a number of issuers in an effort to increase reported revenue is channel stuffing. In the typical scheme the company ships product that may not have been ordered or is not needed by customers prematurely in an effort to record additional revenue. Examples of this type of activity include:
- SEC v. Bristol-Myers Squibb Company, Civil Action No. 04-3680 (D.N.J. Filed Aug. 4, 2004) is an action in which the Commission alleged that beginning in 2000, and continuing through the end of 2001, the company systematically overstated revenue by engaging in channel stuffing and improperly recognizing about $1.5 billion in revenue from consignment-like sales associated with the channel-stuffing. The company also used cookie jar reserves to further inflate income when it fell short of street expectations. The complaint alleged violations of the antifraud, books and records and internal control provisions of the federal securities laws. The company settled with the Commission at the time of filing. See Lit. Rel. No. 18820 (August 4, 2004).
- SEC v. Take-Two Interactive Software, Inc., Civil Action No. 1:05-CIV 5443 (S.D.N.Y. Filed June 9, 2005). The Commission’s complaint alleged that the software maker and its senior executives engaged in a fraudulent accounting scheme which inflated revenue for the fiscal years 2000 to 2001. At or near the end of a quarter the company shipped hundreds of thousands of video games to distributors who had no obligation to pay for the product. The shipments, which were what the complaint calls “parking transactions,” were then recorded as sales. This practice, along with others, permitted the company to improperly recognize about $60 million in revenue during 2000 and 2001. When the company announced a restatement of earnings its stock price declined by 31%. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and13(b)(2)(B). The company, and the officers named in the complaint, settled with the Commission on filing. See Lit. Rel. No. 2259 (June 9, 2005).
- SEC v. Vitesse Semiconductor Corporation, Case No. 10 Civ. 9239 (S.D.N.Y. Filed Dec. 10, 2010) is an action against the company and four of its executives centered on an accounting fraud and options backdating claims. The complaint, in part, alleges that from September 2001 through April 2006 the defendants engaged in a channel stuffing scheme to inflate revenue. Specifically, the defendants caused the company to immediately recognize revenue for product shipped to a large distributor that had the unconditional right to return it. As a result, the revenue for the company was materially inflated over fourteen quarters from September 2001 through early 2006. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a). The defendants settled the action simultaneous with filing. See Lit. Rel. No. 21769 (Dec. 10, 2010).
- Other significant cases: SEC v. Lucent Technologies Inc., Civil Action No. 04-2315 (D. N.J. Filed May 17, 2004) ($1.1 billion accounting fraud action against the company and ten officers based in part on the recognition of revenue from conditional sales; the company and three officers settled on filing; See Lit. Rel. No. 18715 (May 17, 2004)). SEC v. Silva, Case No. 09-5395 (N.D. Cal. Filed Nov. 17, 2009) (action against the former Vice President at Tvia, Inc., which alleged in part that the company prematurely recognized revenue because the sales were subject to side agreements in which the customers were promised extended payment terms); SEC v. Bjorkstrom, Case No. 09-5394 (N.D. Cal. Filed Nov. 17, 2009) (action against the former CFO of Tvia, Inc.).
Premature recognition: In a number of cases the issuer prematurely recognized revenue in violation of GAAP in a misguided effort to increase earnings and make street expectations.
- SEC v. System Software Associates, Inc., Civ. No. 00C 4240 (N.D. Ill. Filed July 13, 2000) is an action against the software maker and its former CEO and Chairman and former CFO. The complaint alleged that for the fiscal years 1994 through 1996 the company prematurely recognized revenue on its developmental stage UNIX-language software product in violation of GAAP. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). See Lit. Rel. No. 1667 (July 14, 2000);
In the Matter of i2 Technologies, Inc., Adm. Proc. File No. 3-11518 (June 9, 2004) is a proceeding in which the Order alleged that the company misstated about $1 billion of software license revenue, including about $125 million which should never have been recognized. The events took place over five years which ended in 2002. During that period the company, in part, immediately recognized revenue for its software licenses despite the fact that some required lengthy implementation and customization efforts to meet customer needs. This practice was not in accord with GAAP. The action, settled at the time of filings, alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).
- SEC v. Computer Associates International, Inc., Case No. 04 Civ. 4088 (E.D.N.Y. Filed September 22, 2004) is an action in which the company recognized over $3.3 billion in revenue from 363 software contracts that had yet to be executed. The scheme took place from January 1, 1998 through September 30, 2000 and was implemented in part by “holding open” the end of the quarter so that revenue from later executed agreements could be counted in the held open quarter. This practice improperly inflated quarterly revenue in fiscal year 2000 for each quarter by 25%, 53%, 46% and 22% beginning with the first. When the practice was halted in the first quarter of fiscal 2001 the company missed its earnings estimate. The share price fell 43%. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B). The company settled simultaneously with the SEC and the U.S. Attorney’s Office. See Lit. Rel. No. 18891 (Sept. 22, 2004). Later the former CEO of the company, Sanjay Kumar, was sentenced to serve 12 years in prison. See, Lit. Rel. No. 19898 (Nov. 3, 2006); see also SEC v. Kumar, 04-Civ. 4104 (E.D.N.Y. Filed Sept. 22, 2004); SEC v. Woghin, Case No. 04 Civ 4087 (E.D.N.Y. Filed Sept. 22, 2004) (actions against Computer Associates executives).
- In the Matter of Raytheon Company, Adm. Proc. File No. 3-12345 (June 28, 2006) is a proceeding against the company and certain officers which centered on improper accounting practices. Specifically, the Order alleged that from 1997 through 2001 Raytheon improperly recognized revenue on the sale of unfinished aircraft through a “bill and hold” arrangement that failed to comply with GAAP. This resulted in a material overstatement of sales. The company also engaged in improper disclosures during the same period. The Order alleged violations of Securities Act Sections 17(a)(2) and (2) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The case was settled at the time of filing.
- Other significant cases include: SEC v. Saylor, Civil Action No. 1:00 CV 02995 (D.D.C. Filed Dec. 14, 2000) (settled action against the three senior officers of MicroStrategy, Inc., alleging violations of Securities Act Section 17(a) and Exchange Act Section 10(b) in connection with the premature recognition of revenue from the sale of software, contrary to GAAP, from the time of the IPO for the company in June 1998 through early 2000); SEC v. Peregrine Systems, Inc., Civil Action No 03 CV 1276 (S.D. Cal. Filed July 23, 2003) (alleging an accounting fraud from mid-1999 through the end of 2001 centered on premature revenue recognition which improperly inflated revenue resulting in a restatement that reduced previously reported revenue of $1.34 billion by $509 million, at least $259 million of which was reversed because the underlying transactions lacked substance). SEC v. Redeopp, Case No. 3:10-cv-05557 (W.D. Wash. Filed Aug. 9, 2010) (action based on a scheme in 2007 involving the recognition of revenue prematurely from what were called “drop shipments” where the product was not actually purchased); see also, In the Matter of Dolan + Company, CPAs, Adm. Proc. File No. 3-13997 (Aug. 9, 2010) (proceeding against outside auditors of Redeopp); SEC v. TheStreet, Inc., Civil Action No. 12-CV-9187 (S.D.N.Y. Filed Dec. 18, 2012) (action against media company centered on premature recognition of revenue where work not completed); 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. 19, 2012) (actions against the officers of TheStreet).