June 09, 2004

Adelphia Vendors Motorola, Scientific-Atlanta Implicated in Executives' Securites-Fraud Trial

Today's WSJ ($) reports that, in the trial of two former Adelphia executives, an email and witness testimony have implicated Adelphia vendors Motorola and Scientific-Atlanta as "allegedly help[ing] Adelphia cook its books."

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According to [prosecution witness Jarmes R.] Brown's testimony in U.S. District Court in Manhattan, Adelphia in mid-2000 realized it was going to miss its earnings targets, in part because of higher-than-expected expenses related to the rollout of new set-top converter boxes -- the equipment that generally sits on top of cable subscribers' televisions -- that it had purchased from Motorola and Scientific-Atlanta.

Mr. Brown testified that Timothy Rigas, one of the former Adelphia executives on trial, suggested capitalizing the marketing and advertising expenses associated with the rollout of the equipment. That would stretch out the expenses and boost Adelphia's earnings.

The article notes that "the Securities and Exchange Commission has taken a harder line on suppliers, customers, bankers and others who knowingly helped companies commit accounting fraud."

See also SEC Hammers Company's Customers for Securities-Fraud Participation.

June 9, 2004 in Criminal Penalties, Finances, Litigation, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack

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 | Comments (0) | TrackBack

June 03, 2004

Good News -- I Guess

The Associated Press reports that today the U.S. Attorney's office announced criminal indictments against seven former employees of Symbol Technologies for securities fraud. Symbol's home page announced, "No Criminal Complaint Filed Against Symbol." Imagine being a customer and seeing that on a vendor's home page. (The Symbol home-page item is linked to this press release.)

It all reminds me of an old Navy joke: A ship was visiting a foreign port after a long stretch at sea. On liberty, the captain imbibed a bit too freely. Returning to the ship, he stumbled across the gangway, gave a slurred acknowledgement to the young seaman who had the gangway watch, and staggered off to his cabin. The seaman dutifully recorded in the ship's log, "The Captain returned to the ship drunk." The seaman's supervisor, a grizzled chief petty officer, chastised him for his lack of discretion. Two nights later, the captain went on liberty again but, having learned his lesson, he drank only tea and made an early night of it. As luck would have it, the same seaman had the gangway watch again. He, too, had learned his own lesson -- this time he recorded in the log, "The Captain returned to the ship sober."

June 3, 2004 in Criminal Penalties, Finances, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack

October 31, 2003

Alone, Unarmed (maybe), and Uninsured

Here's a story about a software vendor that found out -- in probably the worst possible way -- that its general-liability insurance policy did not have the specific coverage that was probably the most crucial for the vendor's software business. Not a good day for the vendor's risk-management people.

Background

The software vendor was a company called Professional Data Services (PDS). Its software was used to help manage medical clinics.

The customer apparently was an opthamology practice or maybe an optometry shop, Heart of America Eye Care, P.A. I'll just call it "the eye clinic."

The software license agreement dated back to 1995. It was a pretty vanilla agreement, judging from the court's sketchy description of it. The agreement gave the eye clinic a license to use several of the vendor's software programs, and required the vendor to investigate and correct problems with the software.

The Vendor-Customer Dispute

At some point the eye clinic had problems with the software. In April 2002 -- some seven years after it first acquired the software -- the eye clinic sued the vendor, PDS. The eye clinic claimed:

  • that PDS failed to provide the required training, customer service, investigation, and correction of software problems;
  • that PDS improperly maintained the software;
  • that the software was not fit for the purposes for which it was intended [Editorial comment: Most software license agreements expressly disclaim any warranty of fitness for a particular purpose; perhaps this agreement didn't do so];
  • that the software did not satisfy the medical accounting needs of the eye clinic [Editorial comment: Many software license agreements expressly disavow any commitment to satisfy the customer's particular needs]; and
  • that PDS misrepresented the quality of service and support it would provide to the eye clinic. [Editorial comment: Many software license agreements contain an "integration" clause that says, among other things, that neither party is relying on any representation of the other except as expressly set forth in the agreement. It sounds like this agreement didn't say that.]

The Missing Insurance Coverage

The vendor, PDS, apparently figured that its insurance carrier would pay the attorneys' fees for defending against the eye clinic lawsuit. It no doubt was also counting on the insurance to cover any damage award that the eye clinic might receive (up to the policy limits, of course).

The insurance carrier thought otherwise. It filed its own, separate lawsuit against the vendor (and the customer too), seeking a judicial declaration that there was no coverage and no duty to defend.

Right you are, the court said. The applicable coverage in the insurance policy was for "property damage." That phrase was defined in the policy as (i) physical injury to tangible property or (ii) loss of use of tangible property that is not physically injured. Loss of use of a software package and corruption of intangible data doesn't count, at least not when the computer itself isn't damaged or rendered useless. The court cited other recent judicial holdings to the same effect.

So, the software vendor is now facing, uninsured:

  • the expense of defending against the customer's lawsuit; and
  • if it loses, the expense of paying any resulting damage award.

The customer didn't necessarily come out ahead here either, because without insurance coverage, the vendor may not have the assets to pay a damage award.

(Cincinnati Insurance Co. v. Professional Data Services, Inc., No. 01-2610-CM, U.S. District Court, District of Kansas, July 18, 2003)

Possible Lessons

If you're a software vendor:

  • Check your insurance policies to make sure you have coverage for information and network technology errors and omissions -- a general-liability policy may not cut it.
  • Take a look at the warranty disclaimers in your standard license agreements.
  • Remember that disputes can arise even with long-time customers.

October 31, 2003 in Embarrassments / Bad Career Moves, Finances, Litigation, Sales | Permalink | Comments (0) | TrackBack

October 09, 2003

Backdated Sales Contracts Resurface Years Later

The CFO of software giant Computer Associates was forced to resign, along with two other senior financial executives of the company -- and who knows what else now lies in store for those folks -- because several years ago the company "held the books open" to recognize revenue for sales contracts signed after the quarter had ended.

According to CA's press release of yesterday, in the fiscal year ended March 31, 2000, the company took sales into revenue in Quarter X even though the contracts weren't signed until after the end of the quarter. See also these stories from Reuters, the AP, and Dow Jones.

(Continued below)

CA stressed that the sales in question were legitimate and that the cash had been collected; the issue was one of the timing of revenue recognition. The Audit Committee was still looking into whether the company's financial results would need to be restated. In the above-cited news stories, outside observers speculated that the company was attempting to position itself to minimize the SEC penalties that were likely to be imposed.

These revenue-recognition problems came to light during an Audit Committee inquiry triggered by a joint investigation by the U.S. Attorney's office and the SEC. It just goes to show that past sins can come to light years after the fact, possibly as a domino effect of unrelated events.

A May 2001 column, The Fraud Beat, by Joseph T. Wells, in the Journal of Accountancy, has a readable explanation of this so-called "cut-off fraud" and how it can be detected. The column recounts a couple of interesting war stories, including one about a Boca Raton company that programmed its time clocks to stop advancing at 11:45 a.m. on the last day of the quarter. The company would continue making shipments -- with the paperwork time-stamped by a stopped clock -- until sales targets had been met, at which point the time clocks would be restarted.

As I observed in a previous post, backdating a contract can be perfectly legal in some circumstances, but -- as illustrated here -- not when it comes to recognizing sales revenue.

It remains to be seen what else will happen to the three former CA financial executives. It can't be a good thing for their peace of mind that the Justice Department and SEC are already involved.

October 9, 2003 in Accounting, Contracts, Embarrassments / Bad Career Moves, Finances, Sales, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack