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

April 23, 2004

Public Allegation of Copyright Infringement
Leads to $300K Defamation Verdict

If you think a competitor is doing something illegal, like infringing your copyright, it's usually best not to complain to customers about it. If it turns out you're wrong about the alleged illegality, you could be liable for defamation. A Web site operator named Boats.com recently learned a $300,000 lesson on that subject in a Florida federal district court.

The "student," now $300K poorer -- plus legal expenses, of course -- is a company called Boats.com. It has a Web site, Yachtworld.com, where subscribing yacht brokers can post listings of yachts for sale. The "teacher" is another company, Nautical Solutions Marketing (NSM), which started a competing Web site, Yachtbroker.com.

NSM's competing Web site apparently was an "aggregator"; it used a "spider" program called Boat Rover to harvest factual data from other yacht-brokerage Web sites, including the Yachtworld Web site of Boats.com. NSM employees also copied and pasted other data from the Yachtworld Web site.

Boats.com didn't especially like having data copied from its Web site to a competing site. According to a report published by the Bureau of National Affairs in one of its printed weeklies (not available on-line), Boats.com sent out letters to yacht brokers and others, claiming that NSM's data-harvesting was illegal.

In response, NSM filed a lawsuit accusing Boats.com of defamation and asking the court to declare that its data-harvesting activities were legal. In November 2003, the jury awarded NSM $250,000 in damages for defamation, plus $50,000 in punitive damages. And then earlier this month, the judge issued findings of fact and conclusions of law that pretty much gave NSM the declaration it had asked for.

References: The Associated Press story was carried in USAToday. The district court's findings of fact and conclusions of law on the copyright issue are here.

April 23, 2004 in Intellectual Property, Litigation, Marketing, Sales | Permalink | Comments (1) | TrackBack

January 07, 2004

SEC Hammers Company's Customers
for Securities-Fraud Participation

The SEC has again gone after customers of a company for allegedly helping to perpetrate the company's securities fraud by "round-tripping," i.e., creating fictitious transactions that were reported as revenue. As part of the settlement, the customers' principals, as well as the company insiders who were involved, were barred from serving as an officer or director of a publicly-held company.

The SEC announced today that it had reached a settlement with the former controller, former operations manager, and several former customers and vendors of Suprema Specialties, Inc., a now-defunct cheese manufacturer based in Paterson, N.J. customers in question. According to the SEC press release:

The SEC's complaint alleges that defendants Quattrone [Ed: Robert Quattrone -- if it had been Frank Quattrone, surely we would have heard more about it before now] and Vieira, using the private companies they controlled, knowingly entered into numerous circular round-tripping transactions with Suprema from at least 1998 through early 2002, and that defendant Fransen similarly entered into such transactions with Suprema from at least 2000 through early 2002.

The complaint further alleges that, during the respective time periods, Quattrone, Vieira, and Fransen each signed false audit confirms that were provided to Suprema's independent auditors, and each received kick-backs for their participation in the scheme.

According to the complaint, the round-tripping transactions involving Quattrone, Vieira, Fransen, and their companies collectively resulted in overstatements of Suprema's reported revenues by approximately 5.75%, 7.41%, 14.25%, 19.51%, and 19.48% in fiscal years 1998, 1999, 2000, 2001, and the first quarter of 2002, respectively.

(Paragraphing added for readability)

(Link via Securities Litigation Watch.)

January 7, 2004 in Accounting, Litigation, Sales, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack

November 05, 2003

Review Your Unused Sales Tax Permits

In late 2001, a Texas lighting-fixtures vendor sued one of its customers, a California company, for breach of contract. The vendor brought the suit in, surprise, Texas. The California customer tried to get the lawsuit thrown out because of lack of "personal jurisdiction." That means the customer claimed it didn't have enough presence in, or contact with, the state of Texas to be subject to suit there.

Earlier this year, a federal magistrate judge in San Antonio denied the California customer's motion to dismiss the suit. Her principal stated reason suggests that companies might do well to periodically review their state sales- and use-tax permits. See Ergonomic Lighting System, Inc. v. Commercial Petroleum Equipment/USALCO, No. SA-02-CA-0031 (W.D.Tex. 03/05/2003).

What the Federal Judge Regarded as "Doing Business"

The federal magistrate judge listed several reasons for denying the California customer's motion to dismiss the lawsuit.

  • The first reason she listed was also the one she discussed in the most detail. The customer had obtained a Texas sales-tax permit in 1994. From 1999 to 2002 the customer had filed sales- and use-tax returns with the Texas tax authorities and had paid an aggregate of less than $1,000 in state tax. The magistrate judge appears to have taken this as tantamount to an admission of regularly doing business in Texas.
  • The California customer had "engaged in business with either Texas-based corporations or with out-of-state corporations that have locations in the state."
  • The customer had an interactive Web site that could be accessed by Texas-based companies.
  • The customer had "maintained exclusive distributorship arrangements with businesses that have distribution facilities in Texas."

The magistrate judge concluded: "This evidence, in my opinion, clearly establishes that [the customer] conducted regular business in the Texas, sufficient enough for this court to conclude that [the customer] 'purposefully availed itself of the Texas marketplace' such that it could reasonably anticipate being called into court in Texas."

Possible Lessons

1. Your company may have applied for sales- and use-tax permits in numerous states. It might be a good idea to review them periodically. Consider canceling any permits that you don't need. Of course, check with counsel -- and your sales execs -- before doing so.

2. Consider including a forum-selection clause in your contracts, especially in important deals. A forum-selection clause will typically provide that any lawsuit will be brought in a specified jurisdiction. Such clauses are usually enforced (although there are some notable exceptions to that rule).

There are downsides to proposing a forum-selection clause. Such clauses often cause pushback from the other side in contract negotiations. If the other side has the bargaining power, it might respond, fine, but the chosen forum will be our home turf, not yours. Then you might have to choose between agreeing to sue or be sued in the other side's jurisdiction, or not doing the deal.

Overall, you might decide you're better off not proposing a forum-selection clause, or, if the other side proposes one, insisting that it be deleted. Then each side would accept the risk that someday it might be sued in a foreign jurisdiction. That's a judgment call.

3. Watch out for contract clauses that say something along the lines of, "this contract is entered into in Paris, Texas, as of the date signed by the parties." (Emphasis added.) That might be used to argue that the parties were doing business in Paris, Texas, and therefore were subject to suit there.

4. To state the obvious: The more business relationships you have in other jurisdictions, the more likely you are to being subject to suit in one of those other jurisdictions.

November 5, 2003 in Litigation, Record-keeping, Sales | 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 11, 2003

Bye-Bye, Carolina; Hello, California

Late last month, a North Carolina customer of Oracle Corporation found itself involuntarily headed for California to pursue its lawsuit against Oracle. This came to pass because the customer -- probably without even knowing it -- agreed to a forum-selection clause when it bought its Oracle software license.

The Forum Selection Clause

The customer apparently signed an order form which stated that its terms were governed by the Oracle License and Services Agreement. That agreement contained a fairly typical choice-of-law and forum-selection clause:

This agreement is governed by the substantive and procedural laws of California and [ACC] and Oracle agree to submit to the exclusive jurisdiction of, and venue in, the courts in California in any dispute relating to this agreement.

The customer, unhappy about something (the court's opinion doesn't say what exactly), sued Oracle in North Carolina despite the forum-selection clause.

The Court's Analysis

The forum-selection clause didn't automatically mean that the case would be transferred to California. The judge still had to go through a detailed, 11-factor analysis to determine whether the interests of justice and the convenience of the parties would be best served by transferring the case or by keeping it in North Carolina.

In the end, the judge concluded that the case should be transferred. He quoted a prior case that said that "once a mandatory choice of forum clause is deemed valid, the burden shifts to the plaintiff to demonstrate exceptional facts explaining why he should be relieved from his contractual duty."

The customer now faces the increased expense and inconvenience of having to litigate its case across the continent from where it originally hoped. That likely will give Oracle some bargaining leverage.

(AC Controls Co. Inc. v. Pomeroy Computer Resources, Inc., No. 3:03CV302 (W.D.N.C. 09/29/2003))

Possible Lessons

1. Read all contracts before you sign them.

2. Know that, if your contract contains a forum-selection clause, you may well have to live with litigating your case in a courtroom far, far away.

October 11, 2003 in Contracts, Litigation, Purchasing, 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

September 16, 2003

Side Letter in Sales Deal Leads to SEC Fraud Suit

Last week the SEC announced that it had filed a civil lawsuit against a former Logicon executive who allegedly placed a $7 million order with Legato Systems that included a secret side letter giving Logicon the right to cancel its purchase. According to the SEC, the Logicon executive not only knew that Legato planned to fraudulently misstate its financial results, he even advised Legato's sales people how to conceal the cancellation right from the Legato finance department.

LESSON: The SEC's news release quoted Helane L. Morrison, District Administrator for the Commission's San Francisco District Office, as saying, "Sales executives who book phony deals often rely on assistance from people who work for their customers. Today's action highlights the Commission's resolve to hold such persons responsible when they knowingly assist in fraudulent revenue recognition practices."

September 16, 2003 in Accounting, Contracts, Embarrassments / Bad Career Moves, Purchasing, Sales, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack

September 12, 2003

Big Fine for Helping Customer Cover Up Business Losses

Insurance giant American International Group was hit with a $10 million fine for doing a deal with one of its customers that was supposed to look like insurance for the customer but in fact was designed to reduce the financial loss reported by the customer. Compounding AIG's problem was that the SEC was reportedly infuriated by AIG's withholding of documents. See the New York Times article (free subscription required).

September 12, 2003 in Embarrassments / Bad Career Moves, Sales, Securities law, SEC regs / actions | Permalink | Comments (0) | TrackBack

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 | Comments (0)