Lessons From A Loss In A Financial Fraud Case

A ruling in a financial fraud case last week should serve as a reminder of the care which must be taken in bringing SEC enforcement actions. Last week, the District Court in SEC v. Goldsworthy, Civil Action No. 06-cv-10012 (D. Mass. Filed Jan. 4, 2006) rejected most of the Commission’s claims brought against former Applix, Inc. CEO Alan Goldsworthy and former CFO Walter T. Higler. The court rejected the SEC’s accusations of intentional fraudulent conduct amounting to “cooking the books,” finding only negligent conduct.

In its complaint, the Commission claimed that Messrs. Goldsworthy and Hilger, along with then-current director of world-wide operations Mark Sullivan, engaged in two separate schemes to inflate the revenue of Applix. The first scheme, according to the Commission, involved the premature recognition of about $890,000 in revenue for the fiscal year ended December 31, 2001. The second concerned improperly reported revenue of about $341,000 for a transaction with a German customer.

The Commission claimed that the defendants violated Section 17(a) of the Securities Act, Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act along with Exchange Act Rules 10b-5, 12b-20, 13a-1, 13a-11, 12a-13 and 13b-2-1. In addition, the complaint claimed that Messrs. Goldsworthy and Higler violated Exchange Act Section 13(b)(5), which prohibits knowing falsification of books and records and Rule 13b2-2, which prohibits officers of a company from lying to auditors.

Based on the findings of a jury made after a four-week trial, the court concluded that the Commission established its claims only as to alleged violations of Section 17(a)(3) and Rule 13b2-1 as to Mr. Hilger. The court concluded that the SEC failed to establish all of the other claimed violations by Messrs. Higler and Goldsworthy. Accordingly, the court imposed a $5,000 penalty on Mr. Higler. No injunction was entered.

The results in this case should serve as a reminder to the care which must be exercised when bringing an enforcement action. The SEC has vast investigative powers. Before it elects to bring an enforcement action, the division typically conducts an extensive inquiry to ascertain the facts. When the division conducts a full investigation there is little excuse for not having the facts to support its claims. Here, it clearly did not.

To be sure, the SEC, like every other litigant, will lose cases. Here, however the SEC suffered what can only be viewed as an almost complete loss. The Commission’s efforts to dress it up in its press release by claiming that it won a fraud finding, while technically true, misses the point. The accusation was intentional fraudulent conduct, not a negligent act meriting only a small fine and no injunction.

It is of little consequence that the company settled in a related administrative proceeding. There, the company consented to the entry of a cease and desist order and agreed to implement certain undertakings it included in its offer of settlement. Those undertakings included retaining an independent financial consultant and implementing the recommendations of that consultant. In the Matter of Applix, Inc., Adm. Proc. File No. 3-12138. But companies often settle with the SEC as a simple matter of pragmatic business judgment.

In the end, the results in this case suggest that the Commission must renew its efforts to carefully consider the facts and applicable legal principles before making an accusation in a complaint or administrative order. The SEC knows well that its power to accuse is all too often the power to convict. That the injury caused to the good name and reputation of persons by its accusations of intentional fraudulent conduct are irreparable and only compounded by the years of litigation it takes to demonstrate that the claim is wrong. In the future, it is essential that the Commission renew its efforts to carefully assess the factual and legal basis for its enforcement actions before bringing an action.