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June 04, 2004

After-the-Fact Contract Changes, Side Letter,
Lead to Federal Fraud Indictments

The Department of Justice recently announced that several former Enterasys executives had been indicted for securities fraud and wire fraud. According to the Justice Department, the accused executives altered an already-signed contract to change its terms -- after the close of the quarter -- so that revenue could be recognized in the quarter. One of the executives also allegedly drafted and signed a secret side letter giving a customer an exchange right, and insisted that the exchange right not be referenced in the customer's purchase order, so that revenue could improperly be recognized.

According to the Justice Department press release:

The Indictment further alleges that, several weeks after the close of the quarter and after learning that Enterasys’ outside auditors had selected the Ariel transaction for review, the conspirators allegedly caused the Letter of Agreement to be altered to delete or change the problematic terms. The altered Letter of Agreement was then backdated to create the false impression that it had been executed before the close of the quarter, and a new secret side letter reinstating the deleted terms was issued to Ariel. According to the Indictment, some of the conspirators caused the altered and backdated Letter of Agreement to be sent to the company’s outside auditors in connection with their review of Enterasys’ quarterly financial statements. Neither the original Letter of Agreement nor the side letter were provided to Enterasys’ outside auditors. Some of the conspirators also allegedly caused Enterasys to issue a press release and to make an SEC filing which included the fraudulent revenue and contained related false statements. After the fraud was uncovered, the company restated its earnings and reversed all of the revenue associated with the Ariel transaction.

The Indictment also charges Spence in connection with an additional transaction between Enterasys and SAP AG, a German commercial computer solutions company. According to the Indictment, SAP sought an eighteen month right to exchange $1 million in computer products it was purchasing from Enterasys in the final days of the quarter ending December 29, 2001. Enterasys allegedly agreed to the right of exchange even though it was not consistent with revenue recognition under relevant accounting principles. The Indictment alleges that Spence and a “very senior” Enterasys official insisted that SAP not refer to the right of exchange in its purchase order, promising instead to put that term in a secret side letter. The Indictment further alleges that Spence then drafted and signed such a side letter and sent it to SAP.

The maximum sentences associated with conspiracy, mail fraud and wire fraud at the time of the offenses was five years per count. The maximum sentence for securities fraud is ten years per count. The offenses also carry with them the possibility of substantial criminal monetary penalties.

June 4, 2004 in Criminal Penalties, Finances, Sales, Securities law, SEC regs / actions | Permalink

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