The SEC’s New Financial Fraud Task Force: Part V, Significant Cases Following the Speech – Using Multiple Improper Techniques

This is the fifth 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 a variety of improper techniques to distort financial statement trends.

While some issuers utilized primarily one improper approach to ensure that the firm met its numbers, others utilized a variety of techniques. In those instances issuers frequently enhanced revenue, manipulated expenses and managed trends. Select examples of these cases include:

· SEC v. Buntrock, Civil Action No. 02C 2180 (N.D. Ill. Filed March 26, 2002) is an action against the founder and other former senior officers of Waste Management, Inc. The complaint alleges a massive accounting fraud beginning in 1992 and continuing through 1997 which involved, in part, improperly eliminating and deferring current period expenses to inflate earnings. A variety of other techniques were used including: avoiding depreciation expense on certain assets; assigning arbitrary salvage values to others; failing to record expenses for decreases in the value of landfills as they were filled in with waste; and improperly capitalizing a variety of expenses. When the financial statements were restated for the periods 1992 through 1997 the company acknowledged misstating its pre-tax earnings by about $1.7 billion. At the time the restatement was the largest in corporate history. The complaint alleged 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. No. 17435 (March 26, 2002).

· SEC v. Xerox Corporation Civil Action No. 02-CV-2780 (S.D.N.Y. Filed April 11, 2002) is an action against the office equipment manufacturer alleging an accounting fraud to manage earnings from 1997 through 2000. During that period Xerox employed seven different accounting actions to help it meet street expectations as to earnings. Those included in its leasing operations shifting revenue from servicing and financing which is recognized over the term of the lease to the equipment so that it could be immediately recognized; shifting revenue to equipment that the company had historically allocated to financing; and shifting revenue to equipment that historically had been allocated to servicing. These techniques, which departed from GAAP and the historical practices of the company, were combined with a series of other artful accounting conventions, the adoption of which added about $1 billion of revenue. All of these actions, in conjunction with the use of “cookie jar reserves,” helped the company meet street expectation. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and13(b)(2)(B). See Lit. Rel. No. 17465 (April 11, 2002).

· SEC v. Safety-Kleen Corp., Civil Action No. 02 Civ. 9791 (S.D.N.Y. Filed December 12, 2002) is an action in which the Commission alleged a massive accounting fraud beginning in late 1998 and continued through the end of the first quarter of 2000. During that period two officers of the company implemented a scheme to inflate revenue primarily by improperly recognizing revenue, inappropriately capitalizing expenses, incorrectly recording derivative transactions, improperly deferring expenses and other fraudulent techniques. The company’s revenue was further distorted by fraudulently recording about $38 million of cash generated by speculative derivative transactions. The SEC’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(b)(5). The two individual defendants were also criminally charged. See Lit. Rel. Nos. 17891 (Dec. 12, 2002) and 185555 (Jan. 28, 2004).

· SEC v. Symbol Technologies, Inc., Case No. CV 04 2276 (E.D.N.Y. Filed June 3, 2004) is an action against the company and eleven former officers alleging a massive accounting fraud scheme that took place from 1998 through early 2003. During that period the defendants utilized numerous fraudulent accounting practices which had a cumulative net impact of over $230 million on reported revenue and over $530 million on pretax earnings. To ensure that the company met its financial projections the defendants: a) made baseless accounting entries to conform quarterly results to management projections; b) fabricated and misused restructuring and other non-recurring charges to artificially reduce operating expenses, and create “cookie jar” reserves; c) engaged in channel stuffing and other revenue recognition schemes; and d) manipulated inventory levels and accounts receivable data to conceal the adverse side effects of the revenue recognition scheme. The company settled at the time of filing. See Lit Rel. No. 18734 (June 3, 2004).

· SEC v. Gemstar-TV Guide International, Inc., Case No. CV 04-04-4506 (C.D. Cal. Filed June 23, 2004) is an action in which the Commission alleged that the company fraudulently inflated its revenues from 1999 through 2002 using five improper practices: a) It recorded revenue under expired, disputed or non-existent agreements; b) revenue was reported under long-term agreements on an accelerated basis in contravention of GAAP and company policy; c) revenue was improperly recorded from multi-element transactions, some of which utilized round trip transactions; d) revenue was improperly recorded from non-monetary and barter transactions; and e) revenue was improperly classified. During the period the company overstated revenue by almost $250 million. The complaint alleged violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The company settled on filing. The settlement was based in part on the cooperation and remedial efforts of the company. See also Lit. Rel. No. 2045 (June 23, 2004).

· The collapse of Enron Corporation was the result of perhaps the largest financial fraud to date. It spawned a number of cases. At the center of the improper practices was the manipulation of the financial statements of the company utilizing a variety of techniques. A key case regarding Enron is SEC v. Causey, Civil Action No. H-04-0284 (S.D. TX. Filed July 8, 2004; amended Feb. 19, 2004), an action against former Enron Corporation President and CEO Jeffrey Skilling and Richard Causey, the former Chief Accounting Officer of the company. The amended complaint details a massive accounting fraud scheme which centered on claims that the defendants: a) manufactured and manipulated reported earnings through the improper use of reserves; b) concealed huge losses in the retail energy business by manipulating Enron’s business segment reporting; c) fraudulently promoted another, Enron Broadband Service, using false statements and fraudulently inflated its value and manufactured earnings by recognizing millions of dollars as earnings from the increase in the stock price; and d) used special purpose entities to manipulate financial results. See Lit. Rel. No. 18582 (Feb. 19, 2004) (amended complaint) and No. 18776 (July 8, 2004) (adding former Chairman and CEO Kenneth Lay).

· SEC v. Collins & Akiman, Corp., Case No. 1:07-CV-2419 (S.D.N.Y. Filed March 26, 2007) is an action against the company, former OMB director David Stockman, and other officers at the company. The complaint, echoed in part by a parallel criminal case which was later dropped, alleged a multi-year earnings fraud beginning in 2001 and continuing through 2005. During that period the defendants engaged in a multifaceted financial fraud which included: a) Fictitious round trip transactions which supposedly gave the company increased revenue through the payments of rebates; b) improper accounting for certain rebates by, in some instances, recognizing the income prematurely while, in other instances, taking the sums into income when in fact they should not have been booked; and c) concealing a liquidity crisis at the firm. The complaint alleged 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. No. 20005 (March 26, 2007).

• SEC v. Cardinal Health, Inc., Civil Action No. 07 CV 6709 (S.D.N.Y. Filed July 26, 2007) is a settled action against the pharmaceutical distribution company. The complaint alleged that from September 2000 through March 2004 the company managed its earnings to match guidance and analysts’ expectations using a variety of techniques. Those included: a) misclassifying over $5 billion of “bulk sales” – those that related to certain full case sales of product under firm policies – as operating revenue; b) selectively accelerating without disclosing the payment of vendor invoices to prematurely record about $133 million in cash discounts; c) improperly adjusting reserve accounts which misstated earnings by more than $65 million; and d) improperly classifying $22 million of expected litigation settlement proceeds to increase operating earnings. The SEC’s complaint alleged 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. No. 20212 (July 26, 2007).
• SEC v. Fisher, Civil Action No. 07C 4483 (N.D. Ill. Filed Aug. 9, 2007) is an action against three former senior executives of Nicor, Inc., a major Chicago-area natural gas distributor. From 1999 through 2002 the defendants devised a method by which the company could profit from accessing its low cost last-in, first-out layers of gas inventory through a series of misrepresentations and improper transactions. They also failed to disclose the impact of LIFO inventory liquidations on the reported income of the company, manipulated earnings and improperly caused losses on a supply agreement with an insurance provider to be charged to its utility customers. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b). See Lit. Rel. No. 20233 (Aug. 9, 2007).
• SEC v. General Electric Co., Civil Action No. 3:09 CV 1235 (D. Conn. Filed Aug. 4, 2009) is a financial fraud action which alleged that the company used four key fraudulent practices to artificially impact its financial results: a) Beginning in 2003 it applied an improper application of the accounting standards to GE’s commercial paper funding program to avoid unfavorable disclosures and about a $200 million pre-tax charge to earnings; b) in the same year the company failed to correct a misapplication of financial accounting standards to certain interest rate swaps; c) in 2002 it improperly accelerated $370 million in revenue by reporting as a year-end transaction the sale of locomotives that had not occurred; and d) in 2002 the company made an improper change in accounting for sales and commercial aircraft engines’ spare parts that increased earnings by $585 million. The complaint alleged violations of Securities Act Sections 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The company settled the action on filing. See Lit. Rel. No. 21166 (Aug. 4, 2009).
• Other significant cases include: SEC v. Dunlap, Civil Action No. 01-8437 (S.D. Fla. Filed May 15, 2001) (action against the former CEO and Chairman of Sunbeam Corporation and others based on an accounting fraud that began in 1996 and continued through 1998 which used channel stuffing and cookie jar reserves); In the Matter of Sunbeam Corporation, Adm. Proc. File No. 3-10481 (Filed May 15, 2001)(proceeding against the company); In the Matter of David C. Fanning, Adm. Proc. File No. 3- 10482 (Filed May 15, 2001) (action against former E.V.P. and general counsel of Sunbeam for participating in drafting of false press releases); SEC v. Conaway, Case No. 05 Civ. 40263 (E.D. Mich. Filed Aug. 23, 2005) (action against two former officers of Kmart alleging that they failed to disclose in the MD&A the reasons for a massive inventory build-up which had a material impact on the liquidity of the company); SEC v. Federal National Mortgage Association, Case No. 06-00959 (D.D.C. Filed May 23, 2006) (action alleging that from 1998 through 2004 the company used a variety of devices to smooth earnings to establish a trend and obtain bonuses by, among other things, not properly applying FAS 91 which requires that loan fees, premiums and discounts be taken as adjustments over the life of the applicable loan; failing to comply with FAS 133 regarding accounting for derivative instruments and hedging activities; and improperly estimating and maintaining the loan loss reserve); SEC v. Fraser, Case No. 2:09-cv-00442 (D. Ariz. Filed March 6, 2006) (action against four executives of CSK Auto Corporation who manipulated earnings from 2002 to 2004 through the use of allowances with vendors); SEC v. BISYS Group, Inc., Case No. 07-Civ-4010 (S.D.N.Y. Filed May 23, 2007) (alleging earnings management through a series of accounting practice which included improperly recording as revenue commissions earned by entities acquired by BISYS before they were acquired and failing to properly adjust reserves. See Lit. Rel. No. 20125 May 23, 2007); SEC v. Italian Pasta Co., Civil Action No. 4:08-CV-00675 (W.D. Mo. Filed Sept. 15, 2008) (action against the company and its senior executives who engaged in a variety of fraudulent actions from 2002 to 2004 including inflating earnings, fraudulently capitalizing period costs, failing to write off obsolete or missing spare parts, engaging in round trip cash transactions and recording false receivables).

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