SEC Suffers Another Trial Loss

The SEC lost another trial. In a financial fraud action where the company had restated certain financial statements, the Court found against the Commission on all claims asserted against the founder and former CEO of Basin Water, Inc., Peter Jensen, and former CFO Thomas Tekulve, Jr. SEC v. Jensen, Civil Action No. CV 11-05316 (C.D. Cal.).

Basin designed, manufactured and serviced groundwater treatment systems. The company conducted an IPO in May 2006. Following that transaction Mr. Jensen brought in Michael Stark as his replacement in an effort to improve the management of Basin. Mr. Jensen confined his activities to select projects.

On February 10, 2009 Basin restated its financial results for 2006 and 2007. The restatement focused on transactions involving two special purpose entities and the application of FIN 46(R) which changed the conceptual framework regarding consolidation. In a letter to the SEC in response to a request for information about the restatement the firm acknowledge that FIN 46(R) had been misapplied, noting that at the time the statement was new, complex and difficult to apply. Basin also stated that it did not have “sufficiently robust accounting background” to identify all the relevant accounting issues with the transactions.

Prior to the restatement Basin’s audit committee retained outside counsel to conduct an internal investigation of certain accounting transactions involving the two special purpose entities as well as each of the points later raised by the SEC in its complaint. Following the inquiry the audit committee concluded that there was no fraud.

In June 2011, the SEC filed an accounting fraud action against the two former company officers. The complaint centered on claims that Basin had prematurely recognized revenue in six transactions thereby improperly inflating its financial results in 2006 and 2007. Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(5) and Sarbanes Oxley Section 304 were violated, according to the Commission.

Following a bench trial the Court prepared detailed findings of fact and conclusions of law, analyzing the evidence and reviewing each of the six accounting issues raised by the Commission. At trial, the Court noted, a number of fact witnesses testified as well as an expert accountant for each side. That testimony established that Mr. Jensen never participated in decisions on how or when to recognize revenue from transactions. No witness testified that either defendant ever instructed any Basin employee to do an improper act. To the contrary, all who were asked attested to the absolute integrity of each man. In addition, while the experts for each side were well qualified, the SEC’s expert was not credible because his analysis was based on hindsight.

In reviewing each of the six accounting issues raised by the Commission, the Court concluded that while there were accounting errors, there was no fraud or statutory violation:

Opus Trust transaction: On December 29, 2005 Opus executed a letter agreement to purchase two Basin ion exchange units. The agreement, in accord with company practice, contained the terms of the transaction including the fact that Opus would receive 5% of the shares of a firm subsidiary that owned certain technology. It also stated that a more formal contract would be executed later. Drafts of that agreement were exchanged in June 2006. It was executed after March 30, 2006 but provided that the agreement was “effective as of” that date. Basin recognized revenue in the first quarter of 2006 based on the letter agreement in accord with professional advice from the outside audit firm.

The Court rejected SEC claims that the revenue was improperly recognized. Under SAB 104 the criteria for recognition are: 1) whether there is persuasive evidence of an arrangement: 2) if delivery has occurred or the services rendered; 3) whether the price is fixed or determinable; and 4) if collectability is reasonably assured. Here the evidence establishes each point. Indeed, after rejecting SEC claims that the contract was “backdated,” it found that “[o]nly in hindsight has the Opus Trust transaction come under attack” because in 2008 one of the units purchased was damaged and a dispute arose between the parties over the last contract payment.

Thermax transaction: On September 28, 2006, Thermax, a large international company, delivered a Purchase Order to the company for certain units. Previously, Thermax had sent Basin a letter in an email to purchase the units which contained a number of caveats, that is, essentially a contingent offer. It was rejected by Basin. The company began recognizing revenue under the contract in the third quarter of 2006 using the percentage of completion method of accounting. That method is widely accepted for orders of custom equipment that require time to construct, the Court found.

Here all the requirements for recognizing the revenue were met. The Court rejected SEC allegations that recognition was improper. The claims by one witness that in fact Basin had agreed to the caveats orally were not credible since they were inconsistent with the subsequent Purchase Order and other testimony. In addition, the outside auditors agreed with the accounting treatment. While later Thermax repudiated the contract, there was no way for Basin at the time of entering into the agreement could have foreseen this event.

Capital transaction: In a June 2007 transaction Basin sold ten leased units to a special purpose entity called VL Capital or VLC. The deal went forward after a financing arrangement with a European lender was set up. The transaction represented a new line of business being developed by the then new CEO. Mr. Jensen had no involvement with this transaction.

Contrary to the SEC’s claim, the transaction had economic substance, the Court concluded: “Basin entered into the transaction for legitimate business reasons including, among other things, to establish an ongoing relationship with a lender and to establish a model for future third-party financial sales.” The transaction was also reviewed in detail by the outside auditors. Later it was discovered, however, that FIN 46(R) had been misapplied. Subsequent SPE transactions were essentially the same and had the same accounting error, the Court found.

Finally, the Court concluded that the SEC failed to establish that the outside auditors were furnished with false information. Indeed, the Commission did not even call a witness from the audit firm.