The SEC’s New Financial Fraud Task Force: Part IV, Significant Cases Following the Speech – Distorting Trends and Balance Sheet Items

This is the fourth in a series of articles examining the creation of the Financial Reporting and Audit Task Force along with a Center for Risk and Quantitative Analysis. Today’s article examines select cases brought in the wake of Chairman Levitt’s Numbers Game speech in which issuers and others utilized improper techniques to distort financial statement trends or distort balance sheet items.

In some instances issuers have distorted revenue trends by improperly combining income from one source with that from another. This was typically done to mask the fact that the primary business of the company was not meeting expectations in terms of revenue.

  • SEC v. Quest Communications International Inc., Civil Action No. 04-Z-2179 (D. Co. Filed October 21, 2004) is an action against the telecommunication company. The complaint alleged that Quest fraudulently recognized over $3.8 billion in revenue while excluding about $231 million in expenses to meet street expectations. When the revenue for the company from telecommunications services began to decline, it started selling indefeasible rights of use which are an irrevocable right to use a specific fiber strand or specific amount of fiber capacity for a period. Later the company sold capital equipment. While the investment community discounts such one-time transactions, Quest continually used these types of non-recurring transactions to bolster revenue. The company also engaged in a number of other fraudulent practices. The complaint alleged violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a). The company settled the case at the time of filing. See Lit. Rel. No. 2127 (Oct. 21, 2004); see also SEC v. Nacchio, Civil Action No. 05-MSK-480 (D. Co. Filed March 15, 2005) (action against former Chairman and others of company).
  • SEC v. Tenent Healthcare Corporation, Civil Action No. CV 07-2144 (C.D. Cal. Filed April 2, 2007) is a financial statement fraud action in which the company concealed the fact that a key source of income came not from the primary business of the company but by exploiting a loophole in a statute. Specifically, from 1999 through 2002 the revenue of the company was largely the result of exploiting a loophole in the Medicare reimbursement system, a fact not disclosed to the shareholders. See Lit. Rel. No. 2591 (April 2, 2007).
  • SEC v. Dell, Inc., Civil Action No. 10-cv-01245 (D.D.C. Filed July 22, 2010) is an action against the company, it found and other officers, alleging that they concealed a key source of the company’s revenues. Specifically, the complaint alleged that from 2003 through 2007 the company repeatedly touted its superior products and management as the source of its consistently increasing revenues. In fact, a significant and increasing portion of those revenues were from payments made by chip maker Intel Inc. so that Dell would not buy chips from a rival manufacturer. When the payments began to decrease in 2007, so did Dell’s revenues. The complaint alleges violations of Securities Act Sections 17(a)(2) and 17(a)(3). The action settled at the time of filing. See also SEC v. Davis, Case No. 1:10-cv-01464 (D.D.C. Filed Aug. 2, 2010); SEC v. Inhofe, Case No. 1:10-cv-01465 (D.D.C. Filed Aug. 27, 2010) (actions against Dell officers).
  • See also SEC v. Biovail Corporation, Civil Action No. 08 CV 02979 (S.D.N.Y. Filed March 24, 2009) (issuer falsely blamed failure to meet revenue goals on a truck accident while improperly moving certain expenses off-balance sheet, creating a fictitious bill and hold transaction to increase revenue and misstating foreign exchange losses).

Reserves: In a number of cases, issuers distorted trends by managing their earnings through the improper use of reserves. In some instances the company failed to release cash from the reserve as required by GAAP, holding it until needed to smooth an earnings trend. In other instances the company failed to add to the reserves as required by GAAP.

· Cendant Corporation. This company was at the center of what was at the time one of the largest financial frauds. The company was the product of a merger between CUC International Inc. and HFS Incorporated in 1997. The financial fraud began prior to the merger and traces to the 1980s. It continued until Cendant discovered and disclosed it in April 1998. At the core of the allegations was the manipulation of reserves. For example, in the complaint against Walter Forbes and E. Kirk Shelton, two former senior officers of CUC, the Commission alleged that the two men implemented a program of mergers and acquisition in an effort to generate inflated merger and purchase reserves. The transaction with HFS which created Cendant was sought out for this reason. SEC v. Forbes, Civil Action No. 01-987 (D.N.J. Filed Feb. 28, 2001); see also Lit. Rel. Nos. 16910 (Feb. 28, 2001) and 21356 (Dec. 30, 2009). Similarly, the complaint against Cosmo Corigliano, Anne Pember, Casper Sabatino and Kevin Kearney, also officers of CUC, alleged in part that the reserves of the company were manipulated to fraudulently inflate revenue. SEC v. Corigliano, Civil Action No. 00-2873 (D.N.J. Filed June 14, 2000); see also Lit. Rel. No. 16587 (June 14, 2000).

· SEC v. Integrated Electrical Services, Inc., Case No. 4:07-CV-2779 (S.D. Tex. Filed August 29, 2007) is an action against the company and its senior officers alleging that in 2003 and 2004 the company failed to disclose that about $3 million in unsigned change orders from two construction contacts were in dispute at one of its subsidiaries. To the contrary, the subsidiary president represented that the change orders were fully collectible. The parent failed to reserve for the change orders. Subsequently, about 70% of the change orders were written off. In addition, the company lowered its allowance for doubtful accounts by about $1.8 million without informing investors. The Commission’s complaint alleged violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). See Lit. Rel. No. 2673 (August 30, 2007); see also In the Matter of David A. Miller, CPA, Adm. Proc. File No. 3-12714 (August 29, 2013) (proceeding against the former Chief Accounting Officer of the company).

· SEC v. Dunn, Civil Action No. 07-CV 2058 (S.D.N.Y. Filed March 12, 2007) is an action initially brought against three senior officers of Nortel Networks Corporation. The amended complaint, filed on September 12, 2007, added four additional officers as defendants. That complaint alleged that in the second half of 2002 and early 2003 various business units of the company had millions of dollars in excess reserves. Those reserves were held and not immediately released as required by GAAP. Subsequently, in early January 2003, and during the year end closing, $44 million in additional excess reserves were established to lower Nortel’s consolidated earnings and bring it in line with internal management expectations. Then, in the first and second quarters of 2003, about $500 million of excess reserves were released to inflate earnings, changing a loss into a profit for the first quarter and largely eliminating a loss in the second. The release also permitted the payment of bonuses. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). See Lit. Rel. Nos. 20036 (March 12, 2007) and 2676 (Sept. 12, 2007).

· See also, SEC v. Rand, Civil Action No. 1:09-CV-1780 (N.D. Ga. Filed July 1, 2009) (action against the former COO of Beazer Homes, USA, Inc. alleging that during some periods net income was decreased by improperly recording reserves between 2000 and 2005 to meet expectations and later reversing those entries to pay bonuses and mask declining financial performance. See Lit. Rel. No. 2114 (July 1, 2009).

Expenses: In some of the largest financial statement fraud cases the issuer’s earnings were distorted by minimizing the expenses which offset revenue.

  • SEC v. WorldCom, Inc., Civil Action 02 CV 4963 (S.D.N.Y. Filed June 27, 2002) is one of a series of actions arising out of the $3.8 billion financial fraud at the global communications provider. In 2001 and the first quarter of 2002, the company falsely portrayed itself as being profitable by capitalizing and thus deferring about $3.8 billion in costs. Those costs were transferred to capital accounts in violation of GAAP. The complaint alleged violations of Exchange Act Sections 10(b) and 13(a). See Lit. Rel. No. 1585 (June 27, 2002).
  • SEC v. Adelphia Communications Corporation, Case No. 02 Civ. 5776 (S.D.N.Y. Filed July 24, 2002) is an action against the cable company and six of its senior executives which the Commission called “one of the most extensive financial frauds ever to take place at a public company.” One key aspect of the fraud was the exclusion from mid-1999 through the end of 2001 of over $2.3 billion in bank debt by shifting the liability onto the books of Adelphia’s off-balance sheet, unconsolidated affiliates. This resulted in a series of misrepresentations about those liabilities including the creation of sham transactions backed by fictitious documents and misleading notes in the financial statements claiming that all the bank debt was included in the financial statements. The principals of the company also used a series of loans and other devices to essentially loot the company. See Lit. Rel. No. 1599 (July 24, 2002).
  • See also In the Matter of America Online Inc., Adm. Proc. File No. 3-10203 (May 15, 2000) (alleging violations of the books and records provisions by capitalizing most of the costs of acquiring new subscribers in violation of GAAP).

Balance sheet. While most financial fraud actions focus on improperly boosting earnings, in some instances issuers have sought to enhance select balance sheet entries through improper techniques. Examples of these cases include:

· Overstate assets: SEC v. Parmalat Finanziaria S.p.A., Case No. 03 CV 10266 (S.D.N.Y. Filed Dec. 30, 2003) is an action against an Italian seller of dairy products. The complaint alleged that from August through November of 2003 the company sold debt securities in the United States while engaging in what the complaint called “one of the largest and most brazen corporate financial frauds in history.” The assets of the company in its audited financial statements were overstated by at least €3.95 billion. In addition, during 2003 the company also told U.S. investors that it had used its “excess cash balances” which actually did not exist to repurchase corporate debt securities worth about €2.9 billion. In fact there had been no repurchase and the securities remained outstanding. Earlier the company had sold about $1.5 billion in bonds and notes to U.S. investors. The complaint alleged violations of Securities Act Section 17(a). See Lit. Rel. No. 18527 (Dec. 30, 2003).

· Overstated mineral reserves: In the Matter of Royal Dutch Petroleum Company, Adm. Proc. File No. 3-11595 (Aug. 24, 2004) is a settled proceeding against the company and its affiliates alleging that the issuer’s proved oil reserves were overstated. Specifically, in 2004 the company recategorized 4.47 billion barrels of oil equivalent, or about 23% of the proved reserves reported at the end of 2002, because they did not conform to the applicable rule. This action reduced the standardized measure of future cash flows reported by the company by about $6.6 billion. It also significantly reduced the reserves replacement ratio of the company from a previously reported 100% to 80%. That ratio is a standardized measure of future cash flows. The company had delayed the recategorization to avoid this impact, according to the Order. Previously, Shell had disregarded warnings about these errors. In early 2004 the boards of directors requested and received the resignations of the chairman of two companies in the group. The CFO of the group also stepped aside. Following the recategorization, Shell under implemented substantial remedial efforts and addressed its internal control deficiencies. The Order alleged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The action was resolved at the time of filing. The company also resolved market abuse charges in the U.K.

· Reduce liabilities: In the Matter of PNC Financial Services Group, Inc., Adm. Proc. File No. 3-10838 (July 18, 2002) is a settled action against the financial services company. The Order alleged that the company improperly removed about $762 million in loan and venture capital assets from its books through the use of a special purpose entity in a transaction with American International Group. The purpose was to eliminate the risk of the loans while having the opportunity to benefit from their possible appreciation. The Order alleged violations of Securities Act section 17(a)(2). See also SEC v. American International Group, Inc., No. 1:04CV02070 (D.D.C. Dec. 7, 2004) (companion action against AIG).

Self-dealing/looting: Perhaps the ultimate financial statement fraud case is one centered on what is essentially the looting of the corporation by certain executives for their personal benefit. While these cases can be viewed as financial fraud actions because the financial statements of the company are distorted, they differ significantly from those where the focus is to meet street expectations. Examples of these cases include:

· SEC v. Black, Civil Action No. 04C7377 (N.D. Ill. Filed March 16, 2007) is an action against Conrad Black, the former Chairman of Hollinger International, David Radler, the former Deputy Chairman of the company and Hollinger Inc., a Canadian holding company. The complaint alleged that over a period of four years beginning in 1999 the defendants engaged in a scheme to fraudulently divert cash and assets from Hollinger International and conceal their self-dealing schemes from the public. Specifically, the complaint alleged that through a series of related party transactions the individual defendants diverted to themselves and others about $85 million from the sale by the company newspaper publications. In addition, the two men are alleged to have orchestrated the sale of newspaper properties at below market prices to an entity controlled by them. The Commission’s complaint alleged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5) and 14(a). A parallel criminal case was also filed. See Lit. Rel. No. 2136 (Nov. 15, 2007).

· Other significant cases include: SEC v. Kozlowski, Civil Action No. 02 CV 7312 (S.D.N.Y. Filed Sept. 12, 2002) (action against three senior executives of Tyco International Ltd. alleging that from 1997 through 2002 they looted the company through a variety of techniques for their personal benefit. See Lit. Rel. No. 17722 Sept. 12, 2002); SEC v. Brooks, Civil Action No. 07-61526 (S.D. Fla. Filed Oct. 25, 2007); SEC v. Schlegel, Civil Action No. 06-61251 (S.D. Fla. Filed Aug. 17, 2006); SEC v. DBH industries, Inc., Civil Action No. 0:11-cv-60431 (S.D. Fla. Filed Feb. 28, 2011) (series of actions against senior officers of body armor manufacturer for looting the company; parallel criminal charges were also brought); SEC v. Rica Foods, Inc., Case No. 08-23546 (S.D. Fla. Filed Dec. 29, 2008) (action against the company and its former CEO based on related party transactions in which the former CEO utilized company assets to secure personal loans).

Next: Cases following the speech – multiple improper techniques

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