Home > Uncategorized > SEC v. Todd, an important accounting and disclosure case for executive officers, auditors, board members and audit committee members to consider . . .

SEC v. Todd, an important accounting and disclosure case for executive officers, auditors, board members and audit committee members to consider . . .

SEC v. Todd, an important accounting and disclosure case for executive officers, auditors, board members and audit committee members to consider . . .

The full opinion can be found at: http://www.ca9.uscourts.gov/datastore/opinions/2011/06/23/07-56098.pdf

SEC v. Todd (US Court of Appeals, Ninth Circuit, Case No. 07-56098, June 23, 2011)

David Tate, Esq. (San Francisco, CA), http://davidtate.us; https://davidtate.wordpress.com; tateatty@yahoo.com.

Overview.  SEC v. Todd, et al. was filed by the SEC in the District Court, Southern District of California.  In pertinent part the SEC brought securities claims for alleged revenue recognition accounting improprieties against senior officers of Gateway including the CEO, CFO and Controller, and alleged misrepresentation by the CEO and CFO.  From my viewpoint the opinion is of interest not because of who did right or wrong but because the Ninth Circuit continues to use a standard of “reckless” misconduct to determine scienter, i.e., the required level of wrongful intent by the Defendant, the Court substantially deferred to the jury’s determination of wrongdoing, and the Court held that following GAAP and the support of expert opinion on correct accounting treatment will not necessarily save the Defendant from liability for alleged accounting improprieties.

Addressing the alleged misrepresentation issue first, the alleged misrepresentation was that “Gateway was experiencing ‘accelerating revenue growth,” without also discussing alleged one-time transactions and/or an alleged different or change in accounting treatment.  The lesson, again, great care needs to be taken when preparing and communicating financial results as it certainly can be argued that the disclosure was correct or mere non-actionable puffery. 

In its Opinion, the Court described scienter, or the requisite level of wrongful intent:

“Scienter is the “mental state embracing intent to deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Reckless conduct may also constitute scienter. Dain Rauscher, Inc., 254 F.3d at 856. Reckless conduct is a highly unreasonable act or omission that is an “extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” Id. (citation and internal quotation marks omitted).”

On the issue of GAAP, experts, credibility, and the type of evidence that the jury and Court will consider, the Court states:

“We recognize that GAAP “tolerate[s] a range of ‘reasonable’ [accounting] treatments, leaving the choice among alternatives to management.” Thor Power Tool Co. v. Comm’r of Internal Revenue, 439 U.S. 522, 544 (1979). Fraudulent accounting decisions are “not merely the difference between two permissible judgments,” as flexible accounting concepts “do not always (or perhaps ever) yield a single correct figure.” In re GlenFed, Inc. Sec. Litig., 42 F.3d 1541, 1549 (9th Cir. 1994) (en banc), superseded by statute on other grounds as recognized in Ronconi v. Larkin, 253 F.3d 423, 429 n.6 (9th Cir. 2001); see also Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1020-21 (5th Cir. 1996) (explaining that GAAP encompasses “a wide range of acceptable procedures, such that ‘an ethical, reasonably diligent accountant may choose to apply any of a variety of acceptable accounting procedures when that accountant prepares a financial statement’ “) (citation omitted).

Here, the parties presented competing expert testimony concerning the propriety of Gateway’s accounting treatment of the Lockheed transaction. Todd and Manza justified their treatment of the Lockheed transaction by relying on GAAP’s Statement of Financial Accounting Concept #6, which defines revenue as “inflows or other enhancements of assets or an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.” According to the defense, because Gateway ordinarily sold computer equipment as part of its central operations, Gateway could properly recognize the revenue even though it was generated by the sale of a “fixed asset” rather than the sale of inventory.

On the other hand, substantial evidence was presented to the jury that enabled it to properly find that GAAP did not permit Gateway to book the Lockheed transaction as it did. The SEC’s expert testified at trial that, based on his reading of Concept #6, it was inappropriate to consider the sale as revenue generating because “no company sells its fixed assets on a regular basis” unless “it’s liquidating.” Additionally, the defense expert conceded that in his entire career as an auditor he had never seen a fixed-asset sale recorded as revenue.

Assessing expert witness credibility is within the province of the jury. See, e.g., Dorn v. Burlington N. Santa Fe R.R. Co., 397 F.3d 1183, 1196 (9th Cir. 2005) (“If two contradictory expert witnesses can offer testimony that is reliable and helpful, both are admissible and it is the function of the finder of fact, not the trial court, to determine which is the more trustworthy and credible.” (citation and alterations omitted)). Here, the jurors were presented with competing expert testimony about the propriety of the accounting treatment, and they were at liberty to choose which testimony they found more credible.

Moreover, technical compliance with GAAP does not preclude a finding that an accounting treatment was a material misrepresentation. See, e.g., United States v. Sarno, 73 F.3d 1470, 1482 n.6 (9th Cir. 1995) (“Adherence to GAAP would obviously qualify as weighty exculpatory evidence; it does not, however, necessarily shield one from [ ] liability.”) (citing United States v. Weiner, 578 F.2d 757, 785-86 (9th Cir. 1978)); Monroe v. Hughes, 31 F.3d 772, 774 (9th Cir. 1994) (same). Regardless of whether Gateway’s accounting treatment of the Lockheed transaction technically complied with GAAP, there was evidence to support a finding that booking the transaction as revenue was nonetheless materially misleading to investors. The SEC proffered the testimony of other witnesses at trial who claimed that it was unreasonable to record the transaction as revenue. For example, McLaughlin, a partner from PwC, testified that “there was no basis to record a sale of fixed assets as revenue in GAAP.” Foote, a PwC manager, testified that she was “surprised, shocked” that the transaction was recorded as revenue. Manza himself, while stating that he eventually grew comfortable with the idea, also testified that if he were CFO, he would not have recognized the transaction as revenue generating. Other Gateway employees—Bird, head of Gateway’s consumer division; Richard, a Gateway manager; and Paustian, a Gateway CPA —all testified that they would not have recognized the proceeds of the Lockheed transaction as revenue. Collectively, this testimony constitutes substantial evidence that the jury was entitled to credit in reaching its verdict. See United States v. Reyes, 577 F.3d 1069, 1076 (9th Cir. 2009) (holding that the witnesses’ cumulative testimony, viewed in the light most favorable to the prosecution, was sufficient to support the jury’s finding of material omissions and misstatements) (citing United States v. Gonzalez-Torres, 309 F.3d 594, 598 (9th Cir. 2002)).

Furthermore, evidence was also introduced showing that Gateway’s internal policies, which had been disclosed to investors, were violated. For example, there was evidence that booking the Lockheed transaction as revenue was contrary to Gateway’s accounting policy of recording fixed-asset sales as gains or losses, rather than as revenue. Gateway’s accounting policy for fixed assets was stated in its 1999 Form 10-K report, and neither Todd nor Manza disclosed a change to that policy in Gateway’s third-quarter 10-Q report. For these reasons, we conclude that the jury relied on substantial evidence in finding a material misrepresentation concerning improper and misleading accounting for the Lockheed transaction.

Generally, a GAAP violation is insufficient, without more, to support a finding of scienter. In re Software Toolworks Inc., 50 F.3d 615, 627 (9th Cir. 1994); see also In re Daou Sys., Inc., 411 F.3d 1006, 1022 (9th Cir. 2005) (“[W]hile scienter cannot be established by publishing inaccurate accounting figures, even when in violation of GAAP, significant violations of GAAP standards can provide evidence of scienter.” (citation omitted)).

Here, there is additional evidence in the record that Todd understood that the VenServ transaction was not a complete sale, and therefore acted recklessly by improperly recording revenue that they knew was not yet realized. Todd knew the terms of the VenServ agreement and that it was not yet a complete sale. The referral agreement outlined the terms of the transaction, and specified that the sale would be considered incomplete until a sufficient number of customers were referred to VenServ by Gateway.

Even though Todd did not directly admit at trial that he signed the referral agreement, he acknowledged that the signature on the referral agreement could have been his, and the jury was able to compare the signature on the referral agreement with other examples of his signature in order to determine that he signed the agreement. See, e.g., United States v. Jenkins, 785 F.2d 1387, 1395 (9th Cir. 1986). The jury could also reasonably conclude that Todd knew and agreed with the terms of the referral agreement. Indeed, evidence was introduced showing that Todd knew that Gateway was obligated to refer customers to VenServ.

Other evidence suggested that Todd knew that the VenServ sale was not complete. He was informed that, to fill a Gateway order, Gateway had removed computers allegedly sold to VenServ from a separated area of Gateway’s warehouse used to store VenServ purchases. He also approved the immediate booking of the revenue from the VenServ sale even though VenServ was given a four-month extension to pay for the computers. Because there was sufficient evidence to support a finding that Todd knew that the VenServ sale was incomplete, but was nevertheless included in Gateway’s quarterly revenue, the jury could properly infer at least recklessness on Todd’s part. Accordingly, we conclude that the jury reasonably could have found that Todd acted with scienter as to the improper treatment of the VenServ transaction.”

If you are an executive officer, auditor, board member or audit committee member it is worthwhile reading the entire opinion of the Court.  The opinion should also be considered an indication that care needs to be taken to justify significant actions taken and decisions made including for accounting treatment.  Some of the information not provided: were the accounting treatment issues taken to the audit committee, board or internal audit or evaluation before the company adopted the treatment in question?   

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