Company Officers Litigating Financial Fraud Action With SEC

While retail customers and cyber may be key areas for a refocused SEC enforcement program, financial fraud remains a critical and important area of concentration. This focus is will illustrated by the recent action filed against an issuer and four of its senior officers. Unlike most financial fraud actions, this case was not settled at filing and is proceeding to litigation. SEC v. Osiris Therapeutics, Inc., Civil Action No. 1:17-cv-03230 (D. Md. Filed Nov. 2, 2017).

Osiris operated a bio-surgery business. It included the sale of various biologic products. Named as defendants along with the firm are: Phillip Jacoby, Jr., initially the CFO and later the Principal Accounting Officer; Gregory Law, initially the Vice President of Finance and later the CFO; Lode Debrabandere, the CEO of the firm; and Bobby Montgomery, the general manager of orthopedics and sports medicine and later the chief business officer.

Osiris sold its products through an in-house sales force and a network of third-party distributors. The company also consigned products to distributors and end-users. Revenue was not recognized on the consigned items until the company was notified that the product had been used in a surgical procedure, according to disclosures in Osiris filings. Otherwise, revenue was recognized under GAAP principles when: 1) title and the risk of loss passes to the customer; 2) persuasive evidence of an arrangement was present; 3) sales amounts were fixed and determined; and 4) collectability was reasonably assured.

Throughout 2014, and during the first three quarters of 2015, the company failed to maintain an effective system of internal controls. During the period the existing controls of Osiris were circumvented as the defendants sought to meet certain revenue targets. Ultimately this resulted in the firm restating its financial statements for that period. According to that restatement the company overstated revenue by about 17% during 2014 and about 9% during the first three quarters of 2015.

Revenue was overstated during the nearly two year period as a result of arrangements made with four different distributors as a result of the efforts of the defendants to hit certain revenue targets. While the result was the same in each instance – the improper recognition of revenue – the method employed differed with each distributor. With Distributor A, for example, the company prematurely recognized over $1 million in revenue in the fourth quarter of 2014 despite the fact that the transaction was not finalized until January 2015. At the time Mr. Debrabandere had set a revenue target for the quarter of $20 million to sustain the then existing trend. The firm was short. Accordingly, the company recognized the revenue from the transaction with Distributor A despite the fact that the deal was incomplete in the fourth quarter and not finalized until after year end. This was contrary to GAAP.

A different approach was utilized with Distributor B, but with the same result. In the first quarter of 2015 the company recognized about $650,000 from the sale of product. Yet at the time the Turkish distributor had not paid for the the products. Perhaps more importantly, the distributor needed regulatory approval from the Turkish government to import the products. By the third quarter of 2015 that approval had still not been obtained. After the end of the third quarter, and despite the fact that the revenue booked in the first quarter still had not been received, the firm recorded an additional $1.7. Recognizing the revenue under these circumstances was not in accord with GAAP.

Yet a different approach was employed with Distributor C. With this distributor the company recognized revenue that had been consigned in contravention of its disclosed revenue recognition standard for such transactions. Nevertheless, the firm recognized the millions of dollars in revenue over the first three quarters of 2015. In addition, the revenue was recognized by using the list price for the products despite the fact that the Distributor actually sold them at a lower price.

Finally, the firm recognized millions of dollars in revenue from Distributor D, despite large accounts receivable. Specifically, despite doubts about the collectability of the accounts, according to the complaint (based on “information and belief”), the company recognized the revenue. Under these circumstances recognition of the revenue was contrary to GAAP. This approach, like the others used with Distributors A, B and C, had the impact of boosting revenue to hit targets, but was improper. This improper conduct resulted in the filing of false and misleading financial statements over the nearly two year period and reflected an inadequate control environment and the circumvention of those controls which did exist. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2), 13(b)(5) and 20(a) and SOX Section 304. The case is in litigation.

The company settled with the Commission agreeing to pay a penalty of $1.5 million. Mr. Jacoby was also charged by the U.S. Attorney’s Office for the Southern District of New York. See Lit. Rel. No. 23978 (Nov. 3, 2017).