Cooperation: SEC Misses An Opportunity to Define What Is Expected, What is Gained

The SEC regularly touts the benefits of cooperation, encouraging companies and individuals to self-report and cooperate with its investigations. Since cooperation is typically tied to the facts and circumstances of the case, the description of what is expected and its benefits is often general and somewhat vague. While this may be understandable, it leaves those who might be considering whether to step forward wondering just what benefit they might receive.

When, however, a case is settled where cooperation is involved the SEC has an opportunity to give definition to the nature of the cooperation and the benefits of it. The Commission had this opportunity in two proceedings filed which arose out of the financial fraud at Diebold, Inc. In the Matter of Michael McKenna, CPA, Adm. Proc. File No. 3-17002 (December 14, 2015); In the Matter of Charles Loveless, CPA, Adm. Proc. File No. 3-17001 (December 14, 2015). Mr. McKenna was the vice president of Global Finance at Diebold from 2002 through 2005. Mr. Loveless was a finance manager at the firm from 2001 to 2006.

The financial fraud at Diebold, Inc. began in 2002 and culminated in a $127 million 2008 restatement. Prior to the restatement the financial fraud resulted in over forty misstated annual, quarterly, and other reports being filed with the Commission, along with dozens of inaccurate press releases. SEC v. Diebold, Inc., Civil Action No. 1:10-CV00908 (D.D.C. Filed June 2, 2010).

During the five-year fraud Diebold, a manufacturer and seller of automated teller machines:

Inflated revenue: Improperly inflated revenue on what were called “F-term” orders, or factory orders, when shipping products. The company used improper “bill and hold” transactions which failed to comply with GAAP to materially overstated earnings. For example, in 2003 those practices resulted in the premature recognition of $29.5 million.

Improper buy-backs: Improperly recognized revenue on a lease transaction which was subject to a side buy-back agreement. As a result of this transaction the company improperly recognized $5 million in revenue in the first quarter of 2005.

Accruals: Manipulated its reserves and accruals. For example, in 2004 the company improperly released from a reserve $1 million in the first quarter, another $1.25 million in the second quarter and an additional $5.25 million in the third quarter. Diebold also under-accrued liabilities.

Capitalization: Improperly delayed and capitalized expenses.

Inventory: Improperly increased the value of inventory.

In 2008, Diebold restated its financial statements for the years 2003 through 2006 and the first quarter of 2007.

To resolve the Commission’s action, Diebold consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) and the related rules. The company also agreed to pay a $25 million civil penalty.

Mr. McKenna participated in the fraud by directing employees to ship certain F-term orders from factory to warehouse before the shipment dates agreed to with customers. This practice was known as pulling in F-term orders. It had varying effects from quarter to quarter but in many instances was done purposely to inflate earnings to meet forecasts. As a result Mr. McKenna caused Diebold’s violations of Exchange Act Section 13(b)(2)(A).

In 2002 and 2003 Mr. Loveless knew that an account which consolidated several sub-accounts in the North American business units was frequently under accrued. This resulted from the fact that the business units were not properly recording liabilities. Mr. Loveless was also responsible for an account which at times was used as a cookie jar reserve. As a result he caused Diebold’s violations of Exchange Act Section 13(b)(2)(A).

In resolving the proceedings, each Respondent consented to the entry of a cease and desist order based on the Section cited in the Order. Each paid disgorgement with Mr. McKenna paying $42,700 while Mr. Loveless will pay $7,724.

The Orders state that Messrs. McKenna and Loveless cooperated with the Commission’s investigation. The section of each Order describing the cooperation is identical. Each lists a series of actions brought by the SEC related tied to the Diebold financial fraud. Neither, however, specified what either man did. There is no indication if either reported the fraud to the SEC before it was discovered. There is no indication if either testified in one or both of the actions identified by the agency as contested. There is no suggestion that either furnished the SEC with critical evidence that might not otherwise been discovered or that the investigation was accelerated because of the cooperation.

In contrast the fact that neither was charged with fraud nor was a penalty imposed clearly indicates that the two men benefitted in the charging process. At the same time there is no indicated of the basis for requiring that disgorgement be paid. Thus, while the two actions give some indication of the benefits of cooperation, the Commission appears to have missed an opportunity to illustrate what is expected and the full benefits of cooperation.

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