Book Cooking Consequences: SEC Sanctions Corporate Executives and Outside Auditors for Accounting Fraud
The U.S. Securities and Exchange Commission (“SEC”), on Tuesday, June 7, 2022, initiated administrative proceedings against a Delaware software company (headquartered in New Jersey) and six of its executives, reached a settlement with the company’s former CEO, and filed suit in the U.S. District Court for the Southern District of New York against the company’s former CFO and the former Controller. All these actions involved, in the words of the Commission’s June 7 Press Release, “accounting-related misconduct.” Not content to relax, the SEC on Wednesday, June 8, 2022, filed suit in the U.S. District Court for the District of New Jersey against a Nevada medical supply company, its former CEO and Chairman, and its former COO for materially inflating the company’s 2017 and 2018 financial statements. In a related administrative proceeding, the Commission sanctioned the engagement partner and the audit manager of the company’s outside audit firm for failing to adhere to audit standards established by the Public Company Accounting Oversight Board (“PCAOB”).
The software company provides products, software, and services to telecommunication companies. In July 2018, the software company announced a restatement of its audited financial statements for the fiscal years ended Dec. 31, 2015, and Dec. 31, 2016. In addition, it restated selected financial data for fiscal years 2013 and 2014, collectively involving previously reported cumulative revenues totaling approximately $190 million. The restatements resulted from the company improperly recognizing revenue, inconsistent with general accepted accounting principles. The restatement primarily involved the following: i) transactions that lacked “persuasive evidence of an arrangement”; ii) acquisitions and/or divestitures in which the company recognized revenue on license agreements instead of including those amounts in the purchase or sale prices; and iii) transactions in which the company converted multi-year software-as-a-service (so-called “SaaS”) agreements into perpetual license agreements, and then took the entire revenue upfront instead of recognizing it ratably over the perpetual term.
The SEC’s June 7, 2022, administrative Orders instituting Cease-and-Desist Proceedings against the software company and six of its executives detail the nefarious steps taken to enhance revenue reporting in particular fiscal periods, almost certainly to suggest that the company was having more success, and having it faster, than the actual performance. So, in some cases a customer would be pressed to buy a product before the end of a reporting period (fiscal quarter or fiscal year) with the company issuing “side letters” protecting the customer from any economic loss, and in at least one case, advancing the purchase price to the customer to “close the sale.” Similar inappropriate steps were taken in certain acquisition and divestiture transactions.
Among the software company’s executives involved was the (now former) general counsel, who reviewed transactions and, in some instances, drafted purported “supporting documents” and made misleading statements to the company’s outside auditors. All the six executives subject to SEC Orders consented to the entry of cease-and-desist judgments. The former general counsel was ordered to pay a civil penalty of $25,000 and suspended from practicing before the Commission for 18 months. The other five executives consented to the applicable SEC Order and were required to pay civil penalties ranging from $15,000 to $90,000. The company’s founder and CEO, although not charged with the accounting misconduct, agreed to reimburse the company over $1.3 million, reflecting stock sale profits and bonuses. This reimbursement was made in accordance with executive clawback provisions of the Sarbanes-Oxley Act. Similarly, the founder and CEO agreed to forfeit previously granted shares of stock that he still held. The company was ordered, in addition to agreeing to cease-and-desist, to pay $12.5 million in installments of $1,562,500 each, together with post-Order interest, over 21.5 months. The SEC’s federal lawsuit against the former CFO and the former Controller of the company asserts financial fraud and intentional misleading of the company’s outside auditor. The lawsuit also invokes the Sarbanes-Oxley Act. It seeks permanent injunctions against the two defendants, a permanent officer and director bar against the former CFO, clawback of all performance-based or equity-based compensation received by the former CFO, and civil penalties against each of them as determined by the Court.
The Nevada medical supply company is a manufacturer of hemostatic gauze for healthcare and wound care use. The SEC’s June 8 Complaint in the New Jersey Federal Court asserts that the company “recorded two fraudulent sales that materially overstated its reported revenue and accounts receivable balances in its publicly-filed financial statements.” In May 2017, the company and its two executives created “a sham, back-dated purchase order” involving “a purported March 31, 2017, sale of product.” The Complaint states that the customer “formally cancelled the order the following day, … [the company] never shipped the product to the customer, and no payment was sought or received from the customer.” Despite these facts, the company reported the transaction as a sale and recorded both the revenue number and accounts receivable balance in its Quarterly Report on Form 10-Q for the first three quarters of 2017 filed with the SEC.
The second fraudulent transaction was the “purported December 20, 2017 sale of product to the company’s largest customer for delivery in February 2018. However, the customer never agreed to purchase the product,” according to the Complaint. Once again, the two executives did their best to mask the falsehoods and to persuade the company’s outside auditors to certify the fraudulent financial statements. Indeed, legal counsel for the purported purchaser wrote to the company on May 8, 2018, citing suspicious behavior by the company and terminating its relationship with the company. All this information was concealed from the company’s outside auditors, who were first engaged in March 2018. In fact, the outside auditor was repeatedly misled by the company and its two executives. As the Complaint details, the outside auditors repeatedly asked the correct questions, but allowed themselves to be persuaded by inventive explanations from the executives. Perhaps the prospect of having the audit fees from a public company was a not-insignificant inducement to listen sympathetically to the client’s stories.
By March 31, 2020, the outside auditor had withdrawn its opinions for the 2017 and 2018 financial statements and advised the company to “withdraw, restate or correct” them as well as the company’s “interim financial statements for 2017, 2018, and 2019.” The company also announced that these statements should no longer be relied upon. The company’s 2019 Annual Report on Form 10-K, filed on July 9, 2020, included restatements of the relevant prior financial statements. The SEC Complaint notes that during the statutory period for clawbacks under Sarbanes-Oxley, the former CEO and Chairman received $1,010,976.15 from the sale of 2,466,953 shares of the company’s stock, which he acquired in 2015 as a “signing bonus.” Interestingly, in addition to all the other fraud, the former CEO and Chairman failed to file with the Commission in a timely manner, if at all, Form 4 and Form 5 to document the sales and other dispositions of the stock.
The company and the two executives consented to the entry of a final judgment subject to Court approval, which would permanently enjoin each of the defendants from violating the securities laws; order civil penalties of $450,000 against the company, $240,000 against the former CEO and Chairman, and $225,000 against the former COO; permanent officer and director bars against the two executives; and reimbursement of the $1,010,976.15 by the former CEO and Chairman pursuant to the Sarbanes-Oxley clawback.
In a separate cease-and-desist administrative proceeding, also brought on June 8, 2022, the SEC issued an Order finding that each of the engagement partner and the audit manager of the outside audit firm had failed to exercise required professional care and had failed to evaluate adequately the audit results in connection with certifying the financial statements of the company. The Commission further found that the auditors had failed to address material misstatements in the reviews of interim financial statements. In addition, the SEC cited the auditors for failing to obtain sufficient audit evidence concerning the December “transaction” consistent with PCAOB standards. The auditors were also found not to have identified and assessed the risk of material misstatements and the possibility of fraud.
The 50-year-old engagement partner was suspended from appearing before the Commission, with the right to apply for readmission after three years. The 36-year-old audit manager received a one-year suspension with a similar right to apply for readmission. Their professional careers are surely negatively affected by this experience.
Can the desire for success, profit, and reputation can ever justify engaging in deception, dishonesty, and/or neglect? It certainly did not in these proceedings. As Jesus is quoted in the Gospel of St. Mark, Chapter 8, verse 36 (King James version) speaking to Peter:
For what shall it profit a man, if he shall gain the whole world, and lose his own soul?