A key law enforcement focus should be the prevention of violations in the future. SEC enforcement has traditionally focused on this point. The resolution of a recent financial fraud case however, again raises questions about whether the Commission is in fact focused on the critical goal.

SEC v. Isilon Systems, Inc., Case No. C-09-1292 (W.D. Wash. Filed Sept. 14, 2009) and SEC v. Fuhlendorf, Case No. C-09-1292 (W.D. Wash. Filed Sept. 14, 2009) are two related financial fraud cases. The former is against the company, while the latter is against its former CFO, Stuart W. Fuhlendorf. The company settled. Mr. Fuhlendorf did not.

The cases center on the fraudulent efforts of Mr. Fuhlendorf to ensure that the company would meet the high expectations set for it by analysts. According the Commission, the company had a very successful IPO in 2006. After the offering, the share price increased by 77%. The success of the offering placed significant pressure on management. Analysts projected rapid growth for the end of 2006 and through 2007. At the same time, there was a significant concern inside the company regarding its ability to meet the projections.

Mr. Fuhlendorf implemented a fraudulent scheme to ensure that the company met expectations by inflating revenue. His scheme included the following:

1) In the Fourth Quarter of 2006, the company improperly recognized revenue on a $1.1 million transaction with a reseller. Isilon received a $1 million order from a significant reseller. Later, when the reseller could not pay for the shipment, Mr. Fuhlendorf arranged for the reseller to take delivery and store the goods despite the fact it could not pay. Isilon improperly booked $900,000 from the transaction despite the fact that there was no commitment from the reseller to pay for the goods absent a sale. Mr. Fuhlendorf subsequently made false statements to the outside auditors about the transaction.

2) In the First Quarter of 2007, Mr. Fuhlendorf approved the recognition of over $3 million in revenue which was improper. Two of the transactions involved sales to resellers where there was no reasonable assurance of collection. A third involved a fraudulent round-trip transaction with an end user where collection was not assured without Isilon’s cash payment to the end user.

3) In the Second Quarter of 2007, Mr. Fuhlendorf again improperly approved the recognition of income. By late June, the company had come close to finalizing a deal for the sale of $1 million of product. The transaction hinged on approval by the board of the purchaser. On the last day of the quarter, Mr. Fuhlendorf shipped the product and authorized recognition of the revenue, despite the fact that the contingency had not been removed.

The company subsequently discovered the improper transactions, conducted an investigation and on February 29, 2008 announced a restatement. In that restatement, the Isilon corrected $7 million of the $67.4 million of revenue reported from the fourth quarter of 2006 through the second quarter of 2007.

Isilon agreed to settle with the Commission, which considered its cooperation, by consenting to the entry of a permanent injunction prohibiting future violations of the reporting provisions of the Exchange Act. See also Litig. Rel. 21210 (Sept. 14, 2009). Although the complaint alleges that Isilon had inadequate internal controls which apparently were repeatedly overridden or circumvented by its former CFO, there is no reference in the settlement indicating that the company has adopted new or improved procedures. Nor is there any condition in the settlement that the company review, analyze or even consider improving its controls. While the injunction provides an assurance of future compliance, when the CFO routinely overrides systems, the need to strengthen controls seems apparent. The lack of adequate assurances of future compliance in this settlement, a key law enforcement goal, questions about the focus of SEC enforcement – particularly when viewed in the context of other settlements such as SEC v. General Electric, discussed here.