by T. GormanPosted on Posted in SECActions

Internal controls has been at the center of a number of Commission enforcement actions in recent months. Its most recent action in this area focuses on a firm that recognized revenue in a manner that was inconsistent with its own policies. Ultimately the firm discovered the issue, corrected its filings and self-reported. In the Matter of L3 Technologies, Inc., Adm. Proc. File No. 3-17769 (January 11, 2017).

L3 is a prime contractor for various foreign and U.S. government agencies, including the Department of Defense. Its shares are traded on the NYSE. The firm contacted to maintain a fleet of about 100 fixed-wing C-12 airplanes for the U.S. Army at bases in the United States and around the world. The contract was initially handled through a subsidiary and later through its Army Sustainment Division. The contract had a five year term beginning in June 2010.

In mid-2013 the firm realized it might lose money on the contract that year. At the same time the firm concluded that it has not billed the Army for all of the work. L3 then developed a “Revenue Recovery Initiative” – a plan to determine the amount of unbilled work which would then be billed to the Army. By November of 2013 the company determined that there was $50 million in unbilled work. While the Army was billed for that amount, by year end there was no agreement on payment because of the complexity of the work.

The VP of Finance for the Army Sustainment Division, under pressure from superiors, had employees generate about 69 invoices for work performed but unbilled. The invoices were not delivered to the Army. By recognizing the revenue of $17.9 million represented by the invoices the Division was just able to meet its target for management bonuses.

Recognizing the revenue from the 69 invoices was not consistent with L2’s revenue recognition policy. That policy required that: there be persuasive evidence of an arrangement; the services have been provided; the price be fixed or determinable; and collectability be reasonably assured. Here collectability was not reasonably assured since the invoices had not been delivered. Nevertheless, the revenue was recognized. Steps were taken to evade the internal controls and deceive the auditors.

When the invoices were created a report was forwarded to the internal ethics department. An investigation failed to uncover the scheme largely because of a lack of understanding of firm procedures.

By June 2014, however, the invoices were discovered. An internal investigation using outside advisers was launched. On July 31, 2014 a press release reporting the preliminary unaudited financial results for the second quarter of 2014 stated that the firm was conducting a review of an accounting matter. The release also stated that the firm expected to incur a pre-tax charge against operating income for periods prior to 2014.

In October 2014 L3 filed a Form 10-K/A for the fiscal year ended December 31, 2013 and a Form 10-Q/A for the first quarter of 2014. Those filings amended the disclosures following the internal review, admitting the company had not maintained an effective control environment in one segment with respect to revenue, that there had been an intentional override related to certain transactions and that personnel did not perform reviews of certain employee concerns regarding violations of accounting policies. The amended filings also disclosed that the review concluded that the accounting treatment for certain sales-type lease transactions in another segment of the company required correction. The correction was made.

In its Form 10-K for 2015 the firm stated that it had undertaken certain steps to remediate the material weakness of internal controls. Those steps had been tested and found effective. The firm self-reported. The Order alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B).

To resolve the proceeding the company consented to the entry of a cease and desist order based on the Sections cited in the Order. Respondent will also pay a penalty of $1.6 million.

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by T. GormanPosted on Posted in SECActions

The Port Authority of New York and New Jersey is a significant participant in the capital markets with about $20 billion in debt outstanding. Tracing its history to 1921 when the two states entered into an interstate compact approved by Congress, it is the steward of virtually all major transportation facilities in the Port District which includes significant portions of each state. Those facilities include two tunnels, four bridges, five airports, a bus terminal and the World Trade Center complex. Nevertheless, its authority is limited. In issuing a series of bonds in 2012, 2013 and 2014 the Port Authority failed, however, to tell investors that it may not have had the necessary legal authority. In the Matter of The Port Authority of New York and New Jersey, Adm. Proc. File No. 3-17763 (January 10, 2017).

The Port Authority has responsibility for creating and maintaining significant portion of the New York and New Jersey transportation infrastructure. To fund those projects the Port Authority relies in part on the capital markets for the issuance of bonds and other financing obligations.

In January 2011 the Governor of the State of New Jersey announced a five year transportation capital plan. It included $1.8 billion in projects the Governor asked the Port Authority to undertake in connection with the New Jersey Department of Transportation. The projects included critically important transportation projects in the Port District that linked the Holland Tunnel and the Port. It included certain road and bridge projects.

Port Authority attorneys reviewed the projects and concluded on multiple occasions that there was a risk of a successful challenge by the bondholders and investors to its legal authority in connection with the roadway projects. Indeed, on multiple occasions the Port Authority lawyers cautioned that project which are outside the scope of its authority cannot be undertaken. In one draft memorandum prepared about the project the attorneys noted that there “is no clear path to legislative authority to undertake such projects.” While another memorandum prepared by the legal department suggested a way to link the projects to certain legislative authority, ultimately the department concluded that “this statutory construction is not without doubt” – the analysis “veers away from the traditional model used by the Port Authority . . . in determining if it has authority to proceed.

On March 29, 2011 the Port Authority’s Board of Commissioners met and approved the projects. No disclosure to the Board of Commissioners occurred regarding the potential legal issues. The Official Statements for an aggregate of $2.3 billion in bonds issued in June 2012, December 2012, November 2013 and June 2014 all stated that the bonds were only for purposes for which the Port Authority is authorized by law to issue bonds.” The Order alleges violations of Securities Act Sections 17(a)(2) and (3).

In resolving the proceeding the Port Authority undertook a number of remedial acts and undertakings, including the retention of an independent consultant. The Port Authority also consented to the entry of a cease and desist order based on the Sections cited in the Order. In doing so, the Port Authority admitted violating the federal securities laws – a first in a municipal bond case. The Port Authority will also pay a penalty of $400,000.

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