SEC Files Financial Fraud Actions, Mired In Controversy
In the wake of the market crisis and the formation of a task force, the SEC has sought to focus in part on financial fraud actions. The action filed at the close of last week against Computer Sciences Corporation and seven of its executives may be one of the more significant financial fraud actions brought since the formation of the task force. At the same time, the action was mired in controversy regarding the imposition of corporate penalties and the charging of individuals according to the New York Times (Saturday, June 6, 2015). In the Matter of Computer Sciences Corporation, Adm. Proc. File No. 3-16575 (June 5, 2015); SEC v. Edwards, Civil Action No. 15 CV 04339 (S.D.N.Y. Filed June 5, 2015); SEC v. Parker, Civil Action No. 15 CV 04341 (S.D.N.Y. Filed June 5, 2015); SEC v. Sutcliffe, Civil Action No. 15 CV 04340 (S.D.N.Y. Filed June 5, 2015).
The action centers on fraudulent conduct that occurred over a two year period beginning in 2009 in connection with the falsification of earnings from a multi-billion dollar contact the firm secured with the U.K.’s National Health Service or NHS. It also involved separate fraudulent conduct that occurred in the firm’s Australian subsidiary and its Nordic region.
The settled administrative proceeding named as Respondents the firm, CEO Michael Laphen, CFO Michael Mancuso, CFO of the Australian subsidiary Wayne Banks, Nordic Region Finance Manager Claus Zilmer and Nordic Region Finance Director Paul Wakefield. The separate actions, each of which is being litigated, named as defendants Nordic Finance Manager Chris Edwards, Australia Controller Edward Parker and Finance Director for the NHS Robert Sutcliffe.
The NHS contract, one of the most significant for Computer Sciences, evolved from a 2003 plan to electronically integrate patient medical records across the United Kingdom. Initially IT contracts were awarded to Computer Sciences and three other firms for the develop the system. Difficulties with the project began at the outset. Eventually the other firms dropped out, leaving Computer Sciences as the sole developer on the project.
Computer Sciences had the potential to earn $5.4 billion in revenue if it could meet the terms of the contract. That revenue could only be earned if the firm delivered product and services within the specified time frame. Failure to comply with deadlines could result in penalties of up to $160,000 per day.
The firm experienced substantial difficulties developing the software for the patient medical records system. As a result the contract was amended, resetting the deadlines. The amended contract was approved by various levels of the U.K. government. It was authorized in April 2009 and known as SARPA. At the time the agreement was executed executives at the firm knew Computer Sciences could not meet its commitments. Those executives also believed that the NHS could not fulfill its obligations.
Initial models for the NHS projected a 16% profit margin. Within months of executing the agreement, however, those projections changed – the contract would no longer be profitable. Messrs. Laphen and Mancuso were warned that a “major contract reset” was required and that the models had to be re-cast. Late in 2009 the two men initiated what became a series of steps that would falsely enhance the projected financial results of the contract. Those included:
Contract amendments: The firm began negotiating amendments to the contract with the NHS. Messrs. Laphen and Mancuso hoped the U.K. government would agree. The accounting models were altered to included the then under negotiation amendments. The assumptions in the model thus did not reflect the reality of the contract terms.
Progressively higher prices: As the delays continued the profits under the actual contract declined. Agreement could not be reached on the proposed amendments. The models were adjusted to assume that the NHS would agree to pay progressively higher prices.
Misleading statements: In two instances during 2009 Mr. Laphen told investors that the firm had met, and expected to continue meeting, its deadlines. The executive did not tell investors that Computer Sciences was not achieving the milestones specified in the agreement and that he was referring to informally revised deadlines.
Misleading disclosures: Messrs. Laphen and Mancuso repeatedly failed to inform investors that the firm was calculating its profit margin under the contract based on proposed amendments.
Free cash flow: Investors were not told that Mr. Mancuso directed that the firm continue to obtain cash advances which had to be repaid under the agreement at an uneconomic rate that caused an economic loss because the advances bolstered cash flow, an important metric for analysts. When asked about any large prepayments by analysts, Mr. Mancuso denied the fact.
Ultimately Computer Sciences failed to disclose the impairment of the agreement as required or report the revenue under the actual contract.
Accounting violations also occurred in the internal business segments of Computer Sciences. In Australia regional CFO Wayne Banks and Controller Edward Parker manipulated the earnings through excess accruals maintained in “cookie jar” reserves. They also failed to record expenses as required. This permitted them to meet analysts’ earnings targets while causing the firm’s consolidated pretax income to be overstated by 5% in Q1FY2009.
Similarly, in FY 2010 the firm’s Nordic region manipulated its operating results. Nordic Region Finance Director Paul Wakefield, and others, improperly accounted for client disputes, overstated assets and capitalized expenses. The accounting fraud in Denmark resulted in the overstatement of the firm’s consolidated pre-tax income by 5% in Q1FY 2010, 3% in Q2FY2010, 4% in Q3FY2010 and 7% in Q4F2010.
As a result of these actions the financial statements of Computer Science for FY 2010, 2011 and 2012 contained material errors. A restatement was required. During the 12 month period that followed the filing of those periodic reports Messrs. Laphen and Mancuso received bonuses and incentive-based compensation. Neither official reimbursed the firm.
The Order alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5).
In resolving the case the Commission considered the remedial acts and cooperation of the firm. Computer Sciences also agreed to implement a series of undertakings. Those included the retention of a qualified independent ethics and compliance consultant who will analyze these programs at the firm and determine “whether the culture is supportive of ethical and compliant conduct, including strong, explicit, and visible support and commitment by the Board and senior management.” The consultant will prepare a report with recommendations, if necessary, regarding the modification and supplementation of the firm’s polices, practices and procedures related to the matters assessed.
To resolve the proceeding the firm consented to the entry of a cease and desist order based on Securities Act Sections 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The firm will also pay a civil penalty of $190 million.
Mr. Laphen consented to the entry of a cease and desist order. It is based on Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) as well as SOX Section 304. He is denied the privilege of appearing and practicing before the Commission as an accountant with the right to apply for reinstatement after three years. Mr. Laphen will also pay a civil money penalty of $750,000 and, under SOX Section 304, $3,771,000 to the firm.
Mr. Mancuso consented to the entry of a cease and desist order based on Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a) and SOX Section 304. Mr. Mancuso will pay a penalty of $175,000 and, under SOX Section 304, $369,100 to the firm.
Mr. Zilmer consented to the entry of a cease and desist order based on Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). Mr. Wakefield also agreed to the entry of a cease and desist order based on the same Sections and, in addition, Exchange Act Section 13(b)(5). Both men are denied the privilege of appearing or practicing before the Commission as an accountant with a right to apply for reinstatement after, respectively, four years and three years. In addition, Mr. Wakefield is barred from serving as an officer or director of a public company for three years.
Mr. Banks consented to the entry of a cease and desist order based on Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). In addition, he is barred from serving as an officer or a director of a public company for four years and denied the right to appear or practice before the Commission as an accountant with a right to apply for reinstatement after four years. Mr. Banks will also pay disgorgement of $10,990 along with prejudgment interest. A fair fund was created for the civil penalties.
Messrs. Edwards, Parker and Sutcliffe did not settled with the Commission, In the separate civil injunctive actions brought against each man the SEC alleged violations of: As to Mr. Edwards, Sections 17(a)(1) & (3) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5); and as to Messrs. Parker and Sutcliffe, Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). These actions are being litigated.