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August 23, 2003

Backdating Contracts Leads to Prison Term --
But It Can Be Entirely Proper

From the notes I took while getting ready to start this blog:

A former public-company CFO was recently sentenced to three and a half years in federal prison. His company, Media Vision Technology, had inflated its reported revenues, in part by backdating sales contracts. Because of the inflated revenue reports, the company’s stock price went up – until the truth came out, which eventually drove the company into bankruptcy. (We've all seen that particular movie in the past couple of years, eh?)

The judge noted that the CFO had an otherwise-exemplary record. If the new, stiffer penalties of the post-Enron sentencing guidelines had applied, however, the CFO likely would have faced more than 10 years in prison. (The Recorder, Apr. 8, 2003; see archived story.)

But backdating a contract is not necessarily illegal, depending on the circumstances.

Let's look at a hypothetical example. Suppose that:

  • Jones is an end-customer from Customer Corporation. Smith is a sales rep from Vendor Corporation.

  • While playing golf together one Saturday, Jones and Smith start talking about a potential sales deal. (That’s why I keep telling myself I should learn to play golf.)

  • During their conversation, sales-rep Smith tells Jones about some features that will be in Vendor Corporation's next product release; he asks Jones to keep the information to himself, because it's still confidential. Jones says "no problem."

  • Monday morning, sales-rep Smith starts getting nervous about having disclosed his company's confidential information to Jones. He calls his company's lawyer. The lawyer drafts a nondisclosure agreement (NDA), which states that it is “executed to be effective as of” the previous Saturday.

  • Smith takes Jones out to lunch. While they're waiting for their food, he and Jones sign the NDA.

    (Whether Smith and Jones had authority to sign contracts under their companies' respective policies is another question -- many companies have internal policies that restrict who is allowed to sign what kind of contracts. But chances are that Smith and Jones each had apparent authority, vis à vis the outside world, and that may well have been enough to create a binding contract.)

So far, so good – the backdated NDA very likely will be deemed to be effective during Jones’s and Smith’s conversation on the golf course. There's no deception involved; the written NDA simply memorializes and fleshes out the oral confidentiality agreement that Smith and Jones entered into. (There's another lesson here, which is that oral agreements can sometimes be entered into very casually.)

Now change the facts a little, and the possibility of jail time looms into view:


  • Customer Jones and sales-rep Smith continue with their discussions. It ends up being a big-dollar deal. Smith, the sales rep, starts shopping for the new car that he intends to buy with his commission check. Jones and Smith work hard to get the sales contract executed by March 31, the last day of the first (calendar) quarter.

  • Unfortunately, however, Customer Corporation’s legal department is too busy to review the contract before March 31. Customer’s purchasing department refuses to sign the contract without the legal department’s blessing. (Damned lawyers, always screwing up deals . . . .)

  • On April 10, Customer’s legal department blesses the sales contract (finally!), without asking for any changes, so the purchasing department signs the contract – without dating it – and FAXes it back to Smith the sales rep.

  • A happy Smith and his sales director fill in “March 31” on the date line. The sales director signs the contract and sends a copy to Accounting. The company's controller calls up the sales director and says, "it's about time!"

If Vendor’s accounting department books the revenue in the first quarter, that might well constitute securities fraud. The Media Vision Technology CFO undoubtedly knew this. Unfortunately for him, he had the lesson reinforced the hard way, with a prison sentence.

August 23, 2003 in Accounting, Contracts, Criminal Penalties, Embarrassments / Bad Career Moves, Sales, Securities law, SEC regs / actions | Permalink

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