Another settled financial fraud case raises more questions than it answers. The SEC filed a settled action involving VeriFone Holdings, Inc., a San Jose, California based company which designs, markets and services transaction automation systems, and Paul Periolat, formerly the supply chain controller for the company. SEC v. VeriFone Holdings, Inc., Case No. CV 09-4046 (N.D. Cal. Filed Sept. 1, 2009).

The Commission claims that the company improperly boosted its gross margins and income by 129% to meet guidance for the first three quarters in 2007. This resulted in a restatement, announced on December 3, 2007. That announcement cased the share price to drop 46% from a prior close of just over $48 to about $26 per share.

VeriFone relied on gross margin as an indicator of its financial results, according to the complaint. The company regularly provided forecasts for its quarterly gross margins to investment analysts. In the first quarter of 2007, internal preliminary results showed a gross margin of 42.8% which was about four points below guidance. Mr. Periolat then determined that the internal actual result for gross margin was wrong because inventory had been incorrectly accounted for at a foreign subsidiary. Without checking with the subsidiary, Mr. Periolat made adjustments and manually entered his calculations. As a result of Mr. Periolat’s calculations, VeriFone reported gross margin just over guidance. In fact, the inventory at the subsidiary was correct, according to the SEC.

This same pattern reoccurred in the next two quarters. In the second quarter, internal preliminary results showed a gross margin lower than guidance. Mr. Periolat then determined that the internal actual results were incorrect because of a failure to properly account for in-transit inventory. Mr. Periolat again made adjusting entries and then signed the vouchers as the “reviewer.” The vouchers were used to manually make the adjustments.

In the third quarter, Mr. Periolat again determined that internal actual results for gross margin needed correction because of an error involving in-transit inventory. Again, he prepared the entries which were manually entered. In both quarters the company met guidance after the adjusting entries were made.

In each instance, Mr. Periolat failed to take the necessary steps to verify his calculations the Commission claims. His first failure occurred in the first quarter after he and others could not determine the reason for the variance in the forecast. At that point, VeriFone’s CEO and then CFO expressed increasing frustration over the variance. E-mails characterized the low gross margin as an “unmitigated disaster.” The CEO then instructed management to “figure it out.” Mr. Periolat and others were provided with an analysis that showed the impact of making certain adjustments on gross margin.

In the second and third quarters senior management was aware of the adjustments being made by Mr. Periolat, but did not question them. They also assumed that the preliminary actual results were wrong when they differed from the forecasts.

Mr. Periolat was able to make his manual adjustments, according to the complaint, because of inadequate internal controls. As the complaint states “VeriFone’s internal controls were inadequate and did not detect the adjustments made by a mid-level controller who was able to make multi-million [dollar] entries which grossly distorted the company’s true financial results.”

To settle the case, the company consented to a permanent injunction prohibiting future violations of the reporting and internal controls provisions of the federal securities laws. Mr. Periolat consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) as well as reporting and internal control provisions. He also agreed to pay a $25,000 civil penalty. See also Litig. Rel. 21194 (Sept. 1, 2009).

The settlement here raises more questions than it answers. According to the complaint, Mr. Periolat crafted the scheme and falsified the books, repeatedly making entries that he could have determined were wrong if he checked. How precisely he was able to falsify these records as a mid-level accounting employee without being questioned is not clear. Stated differently, where were his supervisors? The only things are known about them are: 1) everyone assumed that the internal projects were correct; 2) the CEO made it clear he wanted it “fixed” after the cause for the variance between projected and actual could not be determined; 3) subsequently Mr. Periolat and others were given a road map to the adjustments he made; and 4) for at least the second and third quarters, senior management was aware of his entries.

According to the complaint, Mr. Periolat’s mistake was assuming the internal actual calculations were wrong and then making adjustments without checking with anyone. Yet, the CEO and senior management assumed the projections on which guidance was based were correct, further assumed that Mr. Periolat’s adjustments were correct and further assumed that revenues almost 130% over actual were correct, all without verification. Presumably the CEO and CFO also relied on these unverified assumptions when executing their SOX certifications for each quarter.

Perhaps more importantly, the reason all these assumptions turned into wrong financial statements, according to the SEC, is that the internal controls of the company “were inadequate and did not detect the [multimillion dollar] adjustments.” Despite repeated failures however, there is no indication that the company has taken any steps to improve what appears to be an almost total lack of internal controls.

It is axiomatic that a key priority of law enforcement is to prevent a reoccurrence of improper conduct in the future. This has always been a key focus of SEC enforcement. If the SEC is going to fulfill its statutory obligation to protect investors and the markets from wrongful conduct, taking steps to make sure that the wrongful conduct will not be repeated is critical. Here, that means making sure, at a minimum, that the internal accounting controls are corrected and strengthened. Aside from the usual consent injunction however, the is no indication in this case that the SEC took any action to make sure this critical step was taken. The reason for this failure is unclear but needs to be resolved quickly if the enforcement program is going to become effective.