Meeting Street Expectations With A Cookie Jar

With all the discussion of the market crisis, ponzi schemes, toxic assets and regulatory reform, it is easy to lose sight of the fact that ensuring companies make money the old fashioned way — by earning it — and using proper accounting is a critical mission of SEC enforcement. Thus, managed earnings has long been a key target.

In SEC v. Rand, Civil Action No. 1:09-CV-1780 (N.D. Ga. Filed July 1, 2009) the Commission filed a financial fraud action centered on a years long scheme to manage the earnings of home builder Beazer Homes USA, Inc. The defendant is Michael Rand, the former chief accounting officer of the company. Mr. Rand is litigating the case. See also Lit. Rel. 21114 (July 1, 2009).

Beginning as controller and later as chief accounting officer, Mr. Rand, according to the SEC, engaged in a scheme over a period of about eight years to meet analysts’ expectations essentially through the use of cookie jar reserves. The fraudulent scheme had three key facets. First, the land inventory accounts were manipulated. Under company accounting policies, as subdivisions were built, costs accumulated in the land inventory accounts were allocated to individual home lots which were then offered for sale. When the home was sold the allocated costs in the account were expensed as a cost of sale.

Beginning in 2000 and continuing through 2004, Mr. Rand over allocated land inventory costs in material amounts. For example, in the first quarter of 2004, the amounts were overstated by about $3.9 million. In the second quarter, they were over allocated by about $4.2 million. This caused the company to understate income by a total of $56 million between 2000 and 2005 or by about 5% of reported net income. Beginning in 2006, the over allocations were reversed, thereby overstating income.

In a second facet of the scheme, the “house cost to complete” reserves were utilized in a similar fashion. This reserve was established under company policy for completed homes to cover unexpected minor expenses such as small repairs or final cosmetic touchups. Typically, the reserve was a few thousand dollars per home. Company policy called for the reserve to be zeroed out a few months after the sale with any remaining amounts taken to income.

Beginning in 2000 and continuing through 2005, this reserve was over accrued thereby understating income. Beginning in 2006, Mr. Rand, according to the Commission, reversed these entries and took the amounts reserved into income, thereby overstating revenue. For example, in the first quarter of 2007 the reversal of excess cost to complete reserves added over $1.5 million to earnings for that period.

Fraudulent sale-lease back transactions were the final part of the scheme. Prior to 2006, the company typically retained ownership of most of its model homes. For a few models however Beazer entered into sale-lease back arrangements with third parties. Revenue for these transactions was recognized at the beginning of the lease term.

Near the end of 2005, the company began entering into sale-lease back transactions where it retained the right to a percentage of the appreciation on the ultimate sale of the model home. Retention of the appreciation right, the auditors advised, meant the transaction had to be recorded as a financing, not a sale-leaseback. This would preclude the company from recording the model home sales revenue and profit at the beginning of the lease term. To ensure immediate recognition of the revenue, the company put the appreciation rights provisions in oral side agreement. This avoided scrutiny by the auditors and permitted the revenue to be improperly booked. As a result, 2006 revenues were overstated by $117 million and net income by $14 million.

The fraudulent scheme caused filings of the company to be materially false for years. This included Beazer’s annual and quarterly reports and a 2002 registration statement. The complaint contains counts alleging fraud in violation of Sections 17(a) and 10(b) and aiding and abetting violations of various reporting and internal control provisions as well as lying to the accountants in violation of Rule 13b-2-2.

Last year, Beazer settled similar charges with the Commission. In its settlement the Company consented to the entry of a cease and desist order for future violations of Sections 17(a) and 10(b) and the reporting provisions. The SEC stated that it took into consideration the cooperation and remedial efforts of the company in entering into the settlement. In the Matter of Beazer Homes USA, Inc., Adm. Proc. File No. 3-13234 (Sept. 24, 2008).

SEC Concludes Its Action Against Former Putnam Employees

The Commission settled with former Putnam employee Donald F. McCracken, concluding its case against six former Putnam Fiduciary Trust Company alleged to have engaged in a scheme to defraud Putnam client Cardinal Health, Inc. SEC v. Durgarian, Case No. 05-12618 (D. Mass. Filed Dec. 30, 2005). Mr. McCracken is the former senior managing director and head of fund accounting at Putnam.

To resolve the case, portions of which were unsuccessfully appealed to the First Circuit by the SEC, Mr. McCracken consented to the entry of a permanent injunction prohibiting future violations of Section 17(a)(3) of the Securities Act. He also agreed to the entry of an order requiring the payment of a civil penalty of $35,000 and, in a separate administrative proceeding to be filed, an order barring him from association with any broker or dealer or transfer agent with a right to reapply after one year. See also Lit. Rel. No. 21110 (June 29, 2009).

The Commission’s initial complaint in this action named six former employees of Putnam, including Mr. McCracken. It centered on a claimed cover-up of a one-day delay in investing certain Cardinal assets in a defined benefit plan in 2001. As a result of the delay, Cardinal lost about $4 million in market gains. Rather than disclose the error to Cardinal, the defendants took steps to conceal it, according to the complaint. Those steps included improperly shifting about $3 million of the costs to the shareholders of other Putnam funds by backdating accounting entries and other mechanism. Cardinal ended up with about $1 million in losses. The complaint charged Mr. McCracken and the other defendants with fraud in violation of Exchange Act Section 10(b) and Rule 10b-5 thereunder and Securities Act Section 17(a) as well as aiding and abetting violations of Section 10(b).

Previously, the district court granted a motion to dismiss as to three of the six defendants. The court refused to dismiss the claims against Mr. McCracken and two other defendants however. See Lit. Rel. No. 20373 (Nov. 27, 2007). The Commission appealed the partial dismissal of its complaint to the First Circuit Court of Appeals. That court rejected the SEC’s claims, as discussed here, concluding that the three defendants had not aided and abetted the fraud since their claimed participation in the scheme occurred after the fraud was complete. See also Lit. Rel. No. 20900 (Feb. 13, 2009). The other two defendants, Karnig Durgarian, Jr. and Ronald Hogan, previously settled with the Commission, consenting to the entry of permanent injunctions prohibiting violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and Rule 10b-5 thereunder. Mr. Durgarian also agreed to pay a civil penalty of $100,000 while Mr. Hogan paid $35,000. See Lit. Rel. No. 20797 (Nov. 3, 2008).