A Financial Fraud Case Based On A Sham Barter Transaction

The Commission filed a settled accounting fraud case on Friday which had shades of Enron, Homestore, and Stoneridge. SEC v. Retail Pro, Inc., Case No. CV 08-1620 (S.D. Cal. Sept. 5, 2008). Each of those massive financial fraud cases involved at least in part barter deals later clamed to be sham transactions. At the time, of course, the deals helped inflate the revenue and profits of the company to make Wall Street expectations.

Retail Pro, while clearly not on the same scale as these massive cases, is based on the same kind of accounting scheme: a sham barter transaction. The Commission’s complaint names as defendants the company; Barry Schechter, at times an officer of the company, but during the relevant period a consultant the SEC claims is a control person, de facto officer and a South African Chartered Accountant; Ran Furman, the former CFO; and Harvey Braun, another former CFO. It alleges that the defendants engaged in a scheme to improperly inflate the revenue of the company for the second and third quarters and at fiscal year end.

Specifically, in the second quarter of 2004, the three individual defendants caused Island Pacific to improperly record $3.9 million in revenue from a sham transaction with an Australian software company that was a start up, QQQ Systems Pty Limited. Under the terms of the agreement, Island Pacific licensed certain software to QQQ in return for either $3.25 million to be paid in two installments or 20% of QQQ’s net sub-licensing fees up to $4 million. A side agreement executed at the same time called for Island Pacific to purchase certain software from QQQ.

According to the Commission, the transaction did not have any economic substance and was a sham. Including this transaction in the financial statements of Island Pacific caused its revenues to be overstated by 140% in the second quarter of 2004, 29% for the nine months ended third quarter 2004 and 22% for the 2004 fiscal year.

To conceal the scheme from the outside auditors, the complaint alleges that the three individual defendants forged and backdated documents in an effort to demonstrate that the revenue had been properly recognized. Mr. Schechter also sold 637,750 shares during the period for more than $1.5 million.

To resolve the case with the company and two of the individual defendants:

• Island Pacific consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions;

• Mr. Schechter consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions, the entry of an order requiring him to pay disgorgement of over $488,000 plus prejudgment interest and a civil penalty of $120,000, barring him from serving as an officer or director of a public company for ten years and agreed to the entry of an administrative order suspending him form practicing before the Commission as an account; and

• Mr. Braun consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions and an order requiring him to pay a civil penalty of $75,000 and barring him from serving as an officer or director of a public company for a period of five years.

This Week In Securities Litigation (September 5, 2008)

This week, the Department of Justice and the SEC continued their renewed emphasis on FCPA enforcement. In addition, two brokers were charged with fraud in connection with the sale of auction rate securities by the SEC and DOJ. Finally, in the Oracle securities litigation, the court ruled that the company had intentionally failed to produce materials after being notified that they should be preserved.

FCPA

DOJ and the SEC brought FCPA actions against Albert Jackson Stanley, the former CEO of Kellogg, Brown & Root, Inc., now a subsidiary of Halliburton Company, for bribery and books and records violations discussed here. The SEC’s complaint claims that between 1995 and 2004 Mr. Stanley engaged in a scheme to bribe Nigerian government officials in payments funneled through two intermediaries to obtain multiple contracts with to build liquefied natural gas production facilities in Bonny Island, Nigeria.

Mr. Stanley settled the SEC action by consenting to the entry of a permanent injunction prohibiting future violations of FCPA anti-bribery and books and records provisions. SEC v. Stanley, 08-cv-02680 (S.D. Tex. Filed Sept. 3, 2008). In a related criminal case, Mr. Stanley pled guilty to one count of conspiring to violate the FCPA and one count of conspiring to commit mail and wire fraud unrelated to the FCPA charge. Mr. Stanley is awaiting sentencing. U.S. v. Stanley, 4:08-cr-00597 (S.D. Tex. Filed Aug. 29, 2008).

The Department of Justice concluded two FCPA cases this week with the sentencing of two former ITXC officials: Roger Young, former managing director of the company; and Steven Ott, a former vice president. As discussed here, Mr. Young pled guilty in 2007 to conspiring to violate the anti-bribery provisions of the FCPA as well as the Travel Act. Mr. Young was sentenced to five years probation including three months of home confinement and three months in a community confinement center. He was also ordered to pay a fine of $7,000. Mr. Young’s sentence was reduced for cooperation. U.S. v. Young, No. 07-609 (D. N.J. Sept. 25, 2007).

Mr. Ott pled guilt to the same charges. He was sentenced to serve five years probation, including six months in a community confinement center and six months home confinement. He was ordered to pay a $10,000 fine. Mr. Ott also received a reduced sentence based on his cooperation with the investigation. U.S. v. Ott, No 07-608 (D.N.Y. July 27, 2007).

A third defendant, Ya Osei Amoak, was sentenced on August 1, 2007 to 18 months in prison, a $7,500 fine and to serve two years of supervised release following release from prison. U.S. v. Amoak, No. 05-1122 (D.N.J. June 28, 2006).

Auction Rate Securities

Two former Credit Suisse brokers were charged with fraud by DOJ and the SEC, discussed here. The two brokers, Julian Tzolov and Eric Butler, are charged with defrauding customers by selling them auction rate securities backed by subprime mortgages, collateralized debt obligations and similar collateral rather than the federally guaranteed student loans the customers were led to believe backed the securities. In total, customers of the two brokers held over $800 million in illiquid securities. The cases are in litigation. SEC v. Tzolov, Case No. 08 Civ. 7699 (S.D.N.Y. Filed Sept. 3, 2008); U.S. v. Tzolov, No. 1:08-cr-00370 (E.D.N.Y. Aug. 26, 2008).

Oracle litigation

Nursing Home Pension Fund v. Oracle Corp., No. 3:01-cv-00988 (N.D. Ca. Filed March 9, 2001) is a securities suit against Oracle and its Chief Executive Larry Ellison. The case is based on claims that Mr. Ellison misled investors and engaged in insider trading. In rejecting a motion by plaintiffs for summary judgment, the court noted that it was clear that the company had failed to turn over key evidence and that, in some instances, the company had permitted materials to be destroyed after it was notified that it should preserve them for the litigation. The case is set for trial in March 2009.

New articles

Donald C. Langevoort, “The SEC, Retail Investors, and the Institutionalization of the Securities Markets” (Sept. 2, 2008). Georgetown Law Faculty Working Papers, Paper 80 (Abstract available here). This paper discusses the question of whether the SEC is fit to be the market regulator today, in view of the fact that it originated and is tied to a time when the markets were largely for retail customer compared to today when those markets are dominated by institutional investors.