Financial Fraud: An SEC Staple?

Since the SEC announced the formation of its Financial Fraud Task Force two years ago the agency has struggled to establish this once enforcement mainstay as a current staple. Some commentators have suggested that a trend is emerging in this area. To be sure the SEC is bringing financial fraud cases. Last week, for example, the Commission filed a financial fraud action. As the week ended a second was brought, detailed below. SEC v. Garthright, Civil Action No. 23361 (S.D. Fla. Filed September 25, 2015). Whether actions such as these suggest a return to the days when the SEC routinely brought significant financial fraud cases as part of its efforts to police the markets is, at best, debatable.

Garthright is tailor made for today’s environment in which the clamor demands naming as defendants the senior executives of the firm. The case centers on a financial fraud at SMF Energy Corporation. The defendants are the firm’s senior executives: CEO and Chairman, Richard Gathright; Senior Vice President and CFO, Michael Shore; CAO and Vice President of Finance and Accounting, Laura Messengaugh; and Senior Vice President of Marketing and Sales, Robert Beard. The company is not a defendant – it is in bankruptcy. Each defendant took the Fifth Amendment. The case stems from a self-report following the filing of the bankruptcy petition. That petition was filed after Mr. Garthright was replaced by the chair of the audit committee and the fraudulent practices were halted.

SMF’s primary business was commercial mobile-fueling and lubricant distribution. The company used the Oil Price Information Service or OPIS to set fuel prices for its customers. Customers were typically billed using the OPIS – based price per gallon, plus a service charges and applicable taxes. Some customers had written contracts for specified periods with prices based on the OPIS price plus the agreed upon fixed service charges. Other customers received fuel based on written quotes.

IN 2004 SNF created a billing practice called Incremental Volumetric Allowance or Incremental Allowance — the IA. The IA, applied initially to select customers, resulted in charging the customer for fuel that was delivered and, in addition, a surcharge for fuel that was not actually delivered. Stated differently, those customers who paid the IA paid for nothing, but added to the profit of the firm which was the point. Initially, the charge was 4%. Over time it reached 33%.

As the IA charge increased over time it transformed from a minor contributor to revenue to a significant component of cash flow and profit for the company. SMF did not break out the IA charge as a separate line item on customer invoices. Thus, for customers like USPS which had contracts, the charge was applied but did not appear as a separate item on their bill.

At the same time firm customers who received documentation of the actual amount of fuel delivered were not charged the IA since the overcharge would be apparent. When, however, a customer raised questions about the IA the company stopped applying it to them. Likewise, when customers quested the number of gallons of fuel being delivered, SNF stopped applying the charge.

In 2006 the state of North Carolina tax authorities audited the fuel taxes being imposed by the company. During the audit state authorities discovered the IA. The state ordered SMF to halt the practice. In 2010 the state of California also began investigating the practice. Each defendant was aware of these inquiries and knew, or was reckless in not knowing, about them as well as similar, related fraudulent billing practices used to inflate revenue.

In late 2011 Mr. Gathright left SMF. He was replaced by Steven Goldberg, a long-time director and chair of the audit committee. Mr. Goldberg was provided with materials regarding the IA and tables showing its impact by Defendant Shore. Mr. Goldberg was advised by counsel that the practice was improper. He advised the board of directors. Counsel for the board agreed that the charge was improper. The IA practice ended in March 2012. A press release was issued stating that the firm was changing its pricing structure and reducing sales and revenue projections. SMF filed for bankruptcy in April 2012.

The complaint 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). The case is pending. See Lit. Rel. No. 23361(Sept. 25, 2015).