by T. GormanPosted on Posted in SECActions

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.

by T. GormanPosted on Posted in SECActions

A recurring topic of discussion these days is the rejuvenation of SEC enforcement. In the wake of gaffes, blunders and outright failures, it is all but conceded that the program requires a major overhaul for the agency to carry out its role as the top cop of Wall Street and primary protector of all investors. If the enforcement program is only suffering from a couple of blunders requiring a bit of tinkering, then one might ask what is all this talk of “rejuvenation” and “reinvigorating” (with apologies perhaps to George Carlin who had a way with words). A brief look at the not so distant past surely will convince even the casual observer that “rejuvenation” is the correct word for the right idea.

No one should think that the current Chairman and her fellow Commissioners have anything but a big job ahead in rebuilding enforcement – and it is a long term job. Yet, in the time of the 24/7 news cycle, it is hard to get that much time and easy to lose focus. Success today is the barometer and at a premium. Statistics – the number of skins on the wall and dollars in the coffers – becomes a driving force. Whether they should be or not is a different matter, but in headlines and congressional testimony, both count for plenty.

In this context, consider the recently published first half of 2009 statistics for SEC enforcement. Not exactly a picture of a rapid rise to restoration. NERA reports that in the first half of 2009, the SEC settled 335 cases compared to 330 in the same period last year. If the immediate past is viewed as less than successful, these numbers arguably are an improvement (this year is up by 5 cases), but they hardly bespeak of a program rapidly being rejuvenated.

There are more statistics to ponder. For example, according to NERA, in the second quarter of 2009 the SEC settled 160 cases, which is down from the 174 in same quarter in 2008. It is also down from the 175 cases settled in the first quarter of 2009 which again looks a lot like the year before when things were not supposed to be very good – the reason that enforcement needs to be “revitalized” and “rejuvenated.”

But wait, like those TV offers where there is always more if you wait and then rush to order, NERA has more. Penalties always make a good headline and are great fodder for congressional testimony. In the first quarter of 2009 the median penalty was $1.7 million. In the second quarter it dropped to $1.6 million. Both of these numbers are over the median for 2008 of $1.3 million. Likewise, the average for the first half of 2009 is $10.1 million which is up from the 2008 amount of $8.4 million. Overall however, the trend for 2009 is a decline from the beginning of the year.

What all of this says is that in the 24/7 headline news cycle scoreboard of rejuvenating enforcement, the SEC has some numbers to talk about. The trends however, suggest that much more needs to be done. The trend for this year is down. The trend compared to last year while up is hardly robust.

Statistics are only a small part of the story. In fact they say little about the overall health and vitality of the enforcement program. During some periods, the Commission might in fact bring fewer cases and levy smaller penalties and have a better, more effective enforcement program. After all, in the glory days of the program the SEC could not even impose penalties. Rather, its enforcement efforts focused on identifying who was involved and on remedial measures such as the imposition of procedures or the installation of a monitor to ensure that whatever went wrong was fully corrected and, more importantly, that it did not happen again in the future. Those measures protected investors in a way that taking their money through a corporate fine does not and can not. Those efforts protected the markets. This is what statistics do not measure. Effective enforcement is the key to rejuvenating enforcement, not big number, big headline enforcement.

The current skirmish over the SEC’s proposed settlement with Bank of America, discussed here, is emblematic of this point. It is also what is missing in the settlement with General Electric. Both cases were resolved (assuming the court eventually accepts the settlement in Bank of America) with injunctions and big fines. Both got the SEC headlines at the time, some suggesting the enforcement program was back and restored. Both suggest that revitalization efforts need to be refocused from the 24/7 new cycle to long term effectiveness.

As Bank of America’s briefs trying to justify the deal makes clear, the settlement (and the headlines) miss the point. Bank of America candidly admits it made a business decision to settle the case by paying out the shareholder’s money, despite the fact it claims that it did no wrong. Given the bank’s view, what assurance did the SEC obtain for investors and the markets that everything that went wrong according to the SEC, has been cleared up? Given the bank’s view, what assurance did the SEC obtain for investors and the markets that in the future those who participated in the wrongful conduct and the bank will not repeat it?

When the SEC can answer these questions adequately about any of its settlements – and surely the fine did not do it here, it just increased the shareholder’s loss – then the agency can say that enforcement has been rejuvenated. At the moment, there are numbers to talk about and perhaps some headlines, but surely it is a long road.