RECENT SEC ENFORCEMENT FINANCIAL
FRAUD AND REPORTING CASES*
Thomas C. Newkirk
Susan A. Mathews
Division of Enforcement
Securities and Exchange Commission
September 25, 2002
* Parts of this outline, written by present and former employees, have been used in other
** The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any
private publication or statement by any of its employees. The views expressed herein are
those of the author(s) and do not necessarily reflect the views of the Commission or of the authors’
colleagues upon the staff of the Commission.
FINANCIAL FRAUD AND OTHER DISCLOSURE AND REPORTING
The Division’s number one priority continues to be aggressive prosecution of financial fraud
and reporting cases. Actions involving false financial statements or false and misleading disclosures
about matters affecting an issuer’s financial condition tend to be complex and generally demand a
greater commitment of resources than other types of cases. Effective prosecution in this area is
essential to preserving the integrity of the full disclosure system.
This Outline will review some of the Division’s significant recent activity in this area. Copies of
orders, administrative releases, and litigation releases concerning the cases discussed below can be
accessed on the Commission’s web site at <www.sec.gov>.
1. SEC v. Homestore, Inc., Litigation Release Number _________ (Sept. 25, 2002),
The SEC filed charges against three former senior executives of Homestore Inc. (formerly
Homestore.com Inc.), based in Westlake Village, Calif., for perpetrating an extensive scheme to
fraudulently inflate Homestore's online advertising revenues in 2001. The complaint, filed today in
U.S. District Court in Los Angeles, charges that John Giesecke Jr., Homestore's former chief operating
officer; Joseph J. Shew, its former chief financial officer; and John DeSimone, its former vice
president of transactions, caused Homestore to overstate its advertising revenues by $46 million (64%)
for the first three quarters of 2001. This action was brought in coordination with the U.S. Attorney's
Office for the Central District of California, which simultaneously announced related criminal charges
against the three defendants. Giesecke, Shew, and DeSimone have each agreed to settle the
Commission's lawsuit, to plead guilty to the criminal charges, and to cooperate with the government in
its continuing investigation. At the time of the violations, Homestore was one of the top Internet
portals for real estate and related services.
The Commission's complaint charges Giesecke, Shew, and DeSimone with arranging
fraudulent "round-trip" transactions for the sole purpose of artificially inflating Homestore's revenues
in order to exceed Wall Street analysts' expectations. The defendants circumvented applicable
accounting principles and lied to Homestore's independent auditors about these transactions. While the
fraud was ongoing, the defendants exercised stock options at prices ranging between approximately
$21 and $32 per share, reaping profits ranging from approximately $169,000 to approximately $3.2
The returned ill-gotten gains of approximately $4.6 million will be paid to the benefit of
Homestore shareholders. In addition, the Commission is seeking the permission of the Court to have
Giesecke's civil monetary penalty of $360,000 paid to the benefit of shareholders under the Fair Funds
provision of the recently enacted Sarbanes-Oxley Act of 2002.
In related proceedings filed by the U.S. Attorney's Office in Los Angeles, Giesecke has agreed
to plead guilty to one count of conspiracy and one count of wire fraud, Shew has agreed to plead guilty
to one count of conspiracy, and DeSimone has agreed to plead guilty to one count of securities fraud.
Giesecke and DeSimone each face a maximum possible penalty of 10 years in prison, while Shew
faces up to 5 years in prison. Their pleas are based on fraudulent conduct similar to that described in
the Commission's complaint. As part of their plea agreements, all three defendants have agreed to
cooperate with the Commission and the criminal authorities.
The Commission did not bring any enforcement action against Homestore because of its swift,
extensive and extraordinary cooperation in the Commission's investigation. This cooperation included
reporting its discovery of possible misconduct to the Commission immediately upon the audit
committee's learning of it, conducting a thorough and independent internal investigation, sharing the
results of that investigation with the government (including not asserting any applicable privileges and
protections with respect to written materials furnished to the Commission staff), terminating
responsible wrongdoers, and implementing remedial actions designed to prevent the recurrence of
fraudulent conduct. These actions, among others, significantly facilitated the Commission's
expeditious investigation of this matter.
2. SEC v. Dynegy Inc., Litigation Release No. 17744 (Sept. 25, 2002), In the Matter of Dynegy Inc.,
Securities Exchange Act of 1934 Release Number 34-46537,
The Securities and Exchange Commission filed a settled enforcement action against Dynegy
Inc., in connection with alleged accounting improprieties and misleading statements by the Houston-
based energy production, distribution and trading company. The Commission's case arises from (i)
Dynegy's improper accounting for and misleading disclosures relating to a $300 million financing
transaction, known as Project Alpha, involving special-purpose entities (SPEs), and (ii) Dynegy's
overstatement of its energy-trading activity resulting from "round-trip" or "wash" trades —
simultaneous, pre-arranged buy-sell trades of energy with the same counter-party, at the same price
and volume, and over the same term, resulting in neither profit nor loss to either transacting party.
The Commission issued a settled cease-and-desist Order against Dynegy and filed a settled
civil suit in the Southern District of Texas, Houston Division, seeking a $3 million penalty. The
Commission made findings in the cease-and-desist order (and alleged in the civil complaint) that
Dynegy engaged in securities fraud in connection with its disclosures and accounting for Project
Alpha, and negligently included materially misleading information about the round-trip energy trades
in two press releases it issued in early 2002. In settlement of the Commission's enforcement action,
Dynegy, without admitting or denying the Commission's findings, has agreed to the entry of the cease-
and-desist order and to pay a $3 million penalty in a related civil suit filed in U.S. district court in
The $3 million penalty imposed directly against Dynegy in this case reflects the Commission's
dissatisfaction with Dynegy's lack of full cooperation in the early stages of the Commission's
investigation, as discussed in the Commission's Order. In assessing a penalty directly against Dynegy,
the Commission was mindful of the impact that a penalty on a corporate entity can have on the entity's
innocent shareholders. The amount of the penalty here reflects the commitment of the company's
present board of directors to cooperate with the Commission and certain remedial actions undertaken
by the company, as well as a careful balancing by the Commission between the need to encourage full
cooperation and the desire to avoid imposing the economic consequences of a penalty on shareholders.
As the Commission's investigation continues, it will consider the responsibility of and take appropriate
actions against others with respect to the penalty that the company has agreed to pay.
3. SEC v. L. Dennis Kozlowski, Mark H. Swartz and Mark A. Belnick: Lit. Rel. No. 17722 (Sept. 12,
The SEC filed a civil enforcement action in the United States District Court for the Southern
District of New York against three former top executives of Tyco International Ltd. charging that they
violated the federal securities laws by failing to disclose to shareholders the multi-million dollar low
interest and interest-free loans they took from the company. L. Dennis Kozlowski, the former chief
executive officer and chairman of Tyco's board of directors, and Mark H. Swartz, the former chief
financial officer and a director, granted themselves hundreds of millions of dollars in secret low
interest and interest-free loans from the company that they used for personal expenses. They then
covertly caused the company to forgive tens of millions of dollars of those outstanding loans, again
without disclosure to investors as required by the federal securities laws. In addition, they engaged in
other undisclosed related party transactions that cost shareholders hundreds of thousands, if not
millions of dollars. Mark A. Belnick, the former chief legal officer, failed to disclose the receipt of
more than $14 million of interest-free loans from the company to acquire two residences, an apartment
in New York City and a $10 million home in Park City, Utah, where he already owned another home.
Kozlowski, Swartz and Belnick also sold their shares of Tyco stock valued at millions of dollars while
their self-dealing remained undisclosed.
The Commission seeks a final judgment ordering the defendants to disgorge all ill-gotten gains,
imposing civil money penalties, and enjoining the defendants from future violations of the federal
securities laws. In the cases of Kozlowski and Swartz, this includes (i) disgorgement of all
compensation they received subsequent to their fraudulent acts and omissions, including salary,
bonuses, stock options and grants and any advances that have not been repaid; (ii) all loans not
properly repaid by them to Tyco; (iii) interest imputed at market rates on all low interest or interest-
free loans that they should have disclosed to investors; (iv) all losses avoided from their sales of Tyco
securities subsequent to their fraudulent acts and omissions; (v) prejudgment interest on the amounts
disgorged; (vi) civil money penalties; (vii) orders barring them from ever again serving as officers or
directors of a publicly-held company; and (viii) an order enjoining them from violating the antifraud,
proxy, reporting, books and records and lying to auditor provisions of the federal securities laws.
In the case of Belnick, the Commission seeks (i) disgorgement of all loans not properly repaid
by him to Tyco; (ii) interest imputed on all low interest or interest-free loans that he should have
disclosed to investors; (iii) all losses avoided from his sales of Tyco securities subsequent to his
fraudulent acts and omissions at market rates; (iv) all rent payments that he received from Tyco for the
home office he maintained in the Utah residence; (v) prejudgment interest on the amounts disgorged;
(vi) civil money penalties; (vii) an order barring him from ever again serving as an officer or director
of a publicly-held company; and (viii) an order enjoining him from violating the antifraud, proxy and
reporting provisions of the federal securities laws.
The Commission's Complaint alleges that defendants violated or aided and abetted violations of
the anti-fraud, periodic reporting, proxy, books and records, internal controls and lying to auditors
provisions of the federal securities laws. At the same time, the Manhattan District Attorney unsealed
indictments against the three defendants.
4. SEC v. Adelphia Communications Corp., John J. Rigas et al., Lit. Rel. No. 17627; Accounting and
Auditing Enforcement Release (“AAE”) Rel. No. 1599 (July 24, 2002).
The SEC filed suit in the United States District Court for the Southern District of New York
charging major cable television provider Adelphia Communications Corporation; its founder John J.
Rigas; his three sons, Timothy J. Rigas, Michael J. Rigas, and James P. Rigas; and two senior
executives at Adelphia, James R. Brown and Michael C. Mulcahey, in one of the most extensive
financial frauds ever to take place at a public company. Commission charges that Adelphia, at the
direction of the individual defendants: (1) fraudulently excluded billions of dollars in liabilities from
its consolidated financial statements by hiding them in off-balance sheet affiliates; (2) falsified
operations statistics and inflated Adelphia's earnings to meet Wall Street's expectations; and (3)
concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds
for Rigas Family stock purchases and the acquisition of luxury condominiums in New York and
The Commission seeks a final judgment ordering the defendants to account for and disgorge all
ill-gotten gains including — as to the individuals — all compensation received during the fraud, all
property unlawfully taken from Adelphia through undisclosed related-party transactions, and any
severance payments related to their resignations from the company. The Commission also seeks civil
penalties from each defendant, and permanent injunctions from violating the securities laws. The
Commission further seeks an order barring each of the individual defendants from acting as an officer
or director of a public company.
The Commission's complaint alleges that between mid-1999 and the end of 2001, John J.
Rigas, Timothy J. Rigas, Michael J. Rigas, James P. Rigas, and James R. Brown, with the assistance of
Michael C. Mulcahey, caused Adelphia to fraudulently exclude from the Company's annual and
quarterly consolidated financial statements over $2.3 billion in bank debt by deliberately shifting those
liabilities onto the books of Adelphia's off-balance sheet, unconsolidated affiliates. Failure to record
this debt violated GAAP requirements and precipitated a series of misrepresentations about those
liabilities by Adelphia and the defendants, including the creation of: (1) sham transactions backed by
fictitious documents to give the false appearance that Adelphia had actually repaid debts when, in
truth, it had simply shifted them to unconsolidated Rigas-controlled entities, and (2) misleading
financial statements by giving the false impression through the use of footnotes that liabilities listed in
the Company's financials included all outstanding bank debt.
Timothy J. Rigas, Michael J. Rigas, and James R. Brown made repeated misstatements in press
releases, earnings reports, and Commission filings about Adelphia's performance in the cable industry,
by inflating: (1) Adelphia's basic cable subscriber numbers; (2) the extent of Adelphia's cable plant
"rebuild" or upgrade; and (3) Adelphia's earnings, including its net income and quarterly earnings
before interest, taxes, depreciation, and amortization ("EBITDA"). Each of these represents crucial
aspects by which Wall Street evaluates cable companies.
Since at least 1998, Adelphia, through the Rigas Family and Brown, made fraudulent
misrepresentations and omissions of material fact to conceal extensive self-dealing by the Rigas
Family. Such self-dealing included the use of Adelphia funds to finance undisclosed open market stock
purchases by the Rigas Family, purchase timber rights to land in Pennsylvania, construct a golf course
for $12.8 million, pay off personal margin loans and other Rigas Family debts, and purchase luxury
condominiums in Colorado, Mexico, and New York City for the Rigas Family. The Commission's
complaint alleges that based on the conduct set forth above, the defendants violated the antifraud,
periodic reporting, record keeping, and internal controls provisions of the federal securities laws. The
Commission's investigation is continuing.
Simultaneously, the United States Attorney for the Southern District of New York arrested
three members of the Rigas Family.
5. In re PNC Financial Services Group, Inc., Securities Act Release No. 33-8112; Exchange Act
Release No. 34-46225; AAE Rel. No. 1597 (July 18, 2002).
The Commission issued a settled cease and desist order against The PNC Financial Services
Group, Inc., a Pittsburgh, Pennsylvania, bank holding company. This case is the Commission's first
enforcement action resulting from a company's misuse of special purpose entities. The Commission's
Order found that, in violation of GAAP, PNC transferred from its financial statements approximately
$762 million of volatile, troubled or under-performing loans and venture capital assets sold to three
special purpose entities created by a third party financial institution in the second, third, and fourth
quarters of 2001, which resulted in material overstatements of earnings, among other things. The Order
stated that PNC should have consolidated these special purpose entities into its financial statements.
The Order also found that PNC made materially false or misleading disclosures and statements about
these transactions and the consequences of those transactions.
Among other things, the Order found that in 2001, PNC endeavored to remove approximately
$762 million of volatile, troubled or under-performing loans and venture capital investments from its
financial statements by transferring them to three special purpose entities that were specially created to
receive these assets and in which PNC held a substantial interest. PNC failed to consolidate the special
purpose entities on its second and third quarter financial statements filed with the Commission even
though the entities failed to meet the requirements under GAAP for non-consolidation. In connection
with its improper accounting for its interest in the three special purpose entities, PNC also made
materially false and misleading disclosures in certain press releases and in quarterly reports filed with
the Commission for the second and third quarters of 2001 about its financial condition, earnings and
exposure to the risks of its commercial lending activities.1
PNC consented to the entry of the Order, without admitting or denying the Commission's
findings, requiring that it cease and desist from committing or causing any future violations of the anti-
fraud and periodic reporting provisions. Simultaneously, the Federal Reserve and the Office of the
Comptroller of the Currency entered into agreements with the PNC and its subsidiary bank,
respectively, to improve their practices and management.
The Commission's investigation is continuing as to others.
6. SEC v. WorldCom, Inc., Litigation Release No. 17588, AAE Rel. No. 1585 June 27,
The SEC filed a civil action in federal district court in New York charging major global
communications provider WorldCom, Inc. with a massive accounting fraud totaling more than $3.8
billion. The Commission's complaint alleges that WorldCom fraudulently overstated its income before
income taxes and minority interests by approximately $3.055 billion in 2001 and $797 million during
the first quarter of 2002.
The complaint further alleges that WorldCom falsely portrayed itself as a profitable business
during 2001 and the first quarter of 2002 by reporting earnings that it did not have. WorldCom did so
by capitalizing (and deferring) rather than expensing (and immediately recognizing) approximately
$3.8 billion of its costs: the company transferred these costs to capital accounts in violation of
established generally accepted accounting principles ("GAAP"). These actions were intended to
mislead investors and manipulate WorldCom's earnings to keep them in line with estimates by Wall
The complaint charges WorldCom with violating various antifraud and reporting provisions of
the federal securities laws. The Commission is seeking court orders permanently enjoining WorldCom;
imposing civil monetary penalties; prohibiting WorldCom and its affiliates, officers, directors,
employees, and agents from destroying, altering, or hiding relevant documents; prohibiting WorldCom
and its affiliates from making any extraordinary payments to any present or former officer, director, or
employee of WorldCom or its affiliates, including but not limited to any severance payments, bonus
payments, or indemnification payments; and appointing a corporate monitor to ensure that documents
are not destroyed and that no such extraordinary payments are made.
In a related action, the Commission ordered WorldCom to file with the Commission, under
oath, a detailed report of the circumstances and specifics of these matters by July 1st. The
Commission's investigation is continuing.
On August 1, 2002, Scott D. Sullivan, former WorldCom CFO, and David Meyers, former
WorldCom Controller, were criminally charged by the United States Attorney for the Southern District
of New York with securities fraud and conspiracy..
7. SEC v. Frank M. Bergonzi et al. (Rite Aid), Litigation Release No. 17577, AAE Rel. No. 1581
Jun.21, 2002), www.sec.gov/litigation/litreleases/lr17577.htm.
The SEC filed accounting fraud charges against several former senior executives of Rite Aid
Corp. for conducting a wide-ranging accounting fraud scheme. The SEC’s complaint alleges that Rite
Aid overstated its income in every quarter from May 1997 to May 1999, by massive amounts. When
the wrongdoing was ultimately discovered, Rite Aid was forced to restate its pre-tax income by $2.3
billion and net income by $1.6 billion, the largest restatement ever recorded. The complaint also
charges that former CEO Martin Grass caused Rite Aid to fail to disclose several related-party
transactions, in which Grass sought to enrich himself at the expense of Rite Aid's shareholders. Finally,
the Commission alleges that Grass fabricated Finance Committee minutes for a meeting that never
occurred, in connection with a corporate loan transaction.
The Commission is seeking disgorgement of annual bonuses and imposition of civil penalties
against Grass, former CFO Frank Bergonzi and former Vice Chairman Franklin Brown. The
Commission also seeks an order permanently enjoining each defendant from violating the securities
laws and barring each of them from serving as an officer or director of a public company. The
Commission also announced settled administrative cease-and-desist proceedings against Rite Aid and
against Timothy Noonan, the company's former Chief Operating Officer. In determining the
appropriate resolution of these proceedings, the Commission considered the substantial cooperation
provided by Rite Aid and Noonan in the investigation of this matter.
The U. S. Attorney for the Middle District of Pennsylvania simultaneously announced related
8. In re Microsoft Corporation, Securities Exchange Act (SEA) Rel. No. 46017, AAE Rel. No. 1563
(Jun. 3, 2002), www.sec.gov/news/press/2002-80.htm.
The Commission brought a settled administrative enforcement action against Microsoft Corp.
ordering the company to cease and desist from committing accounting violations and other violations
of federal securities laws. The Commission found that Microsoft had maintained seven reserve
accounts in a manner that did not comply with Generally Accepted Accounting Principles (GAAP).
More particularly, the Commission found that these reserves did not comply with GAAP because, to a
material extent, they did not have adequately substantiated bases. As a result, Microsoft misstated its
income by material amounts in certain periodic filings with the Commission made between July 1,
1994, and June 30, 1998. The Commission also found that Microsoft did not properly document the
bases for these accounts and failed to maintain proper internal controls, as required by the federal
The Commission's Order makes the following findings:
• Microsoft recorded reserves, accruals, allowances, and liability accounts relating to marketing
expenses, sales to original equipment manufacturers, accelerated depreciation, inventory
obsolescence, valuation of financial assets, interest income, and impairment of manufacturing
facilities (collectively "reserve accounts") that did not have properly substantiated bases, as
required by GAAP. During 1995 through 1998, the total balance of these accounts ranged from
approximately $200 million to $900 million.
• Microsoft's quarterly and annual filings with the Commission included or incorporated by
reference financial statements containing undisclosed and unsupported adjustments to reserve
accounts that, to a material extent, did not comply with GAAP. By including these adjustments
in its financial statements, Microsoft failed to accurately report its financial results, causing
overstatements of income in some quarters and understatements of income during other
• Microsoft failed to maintain sufficient documentation of the bases for these reserve accounts
and to apply its own accounting policy relating to the reconciliation of entries in its accounting
system. Microsoft exempted the reserve accounts from its company-wide requirement that
every account be reconciled at least once each quarter and that the reconciliation include
ascertaining if there existed adequate supporting documentation relating to activity in the
account. As a result, Microsoft lacked important safeguards to ensure that adjustments to the
reserve accounts and the balances of these accounts were appropriate or accurately reported in
conformity with GAAP.
Microsoft consented to the issuance of the Commission's Order without admitting or denying the
findings. The Commission found that Microsoft violated the periodic reporting and books and records
and internal accounting controls provisions of the federal securities laws and ordered Microsoft to
cease and desist from committing future violations of these provisions.
9. Software Company Financial Fraud Sweep (Quintus, Unify and Legato), See Lit. Rel. Nos. 17521,
17522 and 17524 (May 20, 2002).
In separate cases, the Commission charged former executives at three northern California
software companies for perpetrating financial accounting frauds including a practice called
“roundtripping.” Roundtripping occurs when a company provides funds to customers so they can
purchase product from the company, with no reasonable expectation that the customers would ever
repay the funds. Among those named were the former chief executive officer of Quintus Corp., the
former chief executive and chief financial officers of Unify Corp., and former senior sales executives
of Legato Systems, Inc. The U.S. Attorney's Office for the Northern District of California also
announced criminal charges against former officers at Quintus and Unify for their roles in the frauds.
Quintus was a developer of customer relationship management software. According to the
complaint, from December 1999 through October 2000 CEO Alan K. Anderson personally forged
contracts, e-mails, purchase orders, letters, and an audit confirmation in order to boost Quintus'
financial results. Anderson created three fake transactions that ranged in value from $2 million to $7
million, for a total of $13.7 million in nonexistent sales. In addition, Anderson caused Quintus to
recognize improperly $3 million in revenue on a barter transaction, which was contingent on Quintus'
agreement to purchase $4 million of product from its customer. In each case, Anderson caused
Quintus to recognize revenue in violation of GAAP.
The Commission brought fraud charges against former Unify CEO Gholamreza (Reza) Mikailli
and former CFO Gary L. Pado. Sacramento based Unify develops and sells database management
software. The complaint alleges that from May 1999 through May 2000, Mikailli and Pado caused
Unify to recognize revenue fraudulently on transactions that they knew were subject to contingencies
(including rights of return or cancellation), or involved barter transactions. In several instances
Mikailli and Pado engaged in "roundtripping," by causing Unify to provide funds its customers needed
to buy Unify products, with no reasonable expectation that the customers would ever repay the funds.
In some instances, Unify made an investment in another company, which then used most or all of the
invested funds to purchase Unify product. In others, Unify contracted for services from other
companies through so-called Funded Development Agreements. However, the companies provided no
such services, and simply used funds from Unify to buy Unify product.
The Commission also brought fraud charges against former Legato executive vice president of
worldwide sales David Malmstedt and former vice president of North American sales Mark
Huetteman. Legato develops and sells software for managing the data storage functions of computer
networks. The complaint alleges that from May 1999 through December 2000, Malmstedt and
Huetteman caused Legato fraudulently to record millions of dollars in revenue on orders that were
contingent on resellers' ability to sell the product to an end customer, or on customers' rights of
exchange, return or cancellation. As a result of the fraud, Legato overstated its revenue over three
fiscal quarters in amounts ranging from 6% to 20% per quarter.
In a related matter, the Commission settled cease-and-desist proceedings against Legato and its
former CFO, Steven Wise. Legato and Wise consented to the issuance of the Commission’s order
without admitting or denying any of its findings. The order found that Legato violated the corporate
reporting, bookkeeping and internal controls provisions of the federal securities laws. In addition, the
order found that Wise caused Legato's violations of these provisions, and that Wise knowingly failed
to implement adequate internal accounting controls at the company. The order requires Legato and
Wise to cease and desist from future violations of these provisions.
10. In re Edison Schools, Inc., Securities Exchange Act (SEA) Rel. No. 45925, AAE Rel. No. 1555
(May 14, 2002).
The Commission announced a settlement in which it found that Edison Schools Inc.
inaccurately described aspects of its business in SEC filings. The Commission found that Edison failed
to disclose that a substantial portion of its reported revenues consist of payments that never reach
Edison. These funds are instead expended by school districts (Edison's clients) to pay teacher salaries
and other costs of operating schools that are managed by Edison. Among other relief, the Commission
ordered that Edison add a Director of Internal Audit to its management team.
The Commission did not find that Edison's revenue recognition practices contravene GAAP or
that earnings were misstated. The Commission nonetheless found that Edison committed violations by
failing to provide accurate disclosure.
The Commission's Order makes the following findings, among others:
• Edison manages approximately 130 schools under agreements with 62 school boards and
charter holders. Under a typical management agreement, a school board agrees to pay Edison a
fee based on the number of students enrolled in the district's Edison-managed schools ("Per-
Pupil Funding"). The agreements with many districts also provide, however, that the district
may withhold from its payments to Edison funds sufficient to pay the salaries of teachers (who
are employees of the school district) and in many cases to pay other costs of operating the
schools (together, these costs are "District-Paid Expenses").
• Throughout its existence, Edison has included the total amounts of District-Paid Expenses in
both Edison's reported revenues and its reported expenses. In certain circumstances, GAAP
requires that expenses paid by another party on behalf of a reporting company be included in
the reporting company's revenue. This is referred to as "gross" reporting of revenue.
• Edison's SEC filings inaccurately stated that Edison "receives" all Per-Pupil Funding. In its
most recent Form 10-Q, Edison disclosed for the first time that districts typically deduct from
their remittances the amounts they pay in District-Paid Expenses. Edison has never disclosed
the magnitude of the District-Paid Expenses. Consequently, Edison's SEC filings have not
provided accurate disclosure regarding significant aspects of Edison's business.
• Edison cooperated in the Commission's inquiry. Edison and its independent auditor conducted
a comprehensive review of Edison's accounting practices. Based on this review and in light of
recent clarifications of GAAP, Edison has concluded that revenues from seven districts should
exclude amounts paid for teacher salaries going forward. Similarly, Edison has determined that
revenues should be reported net of (i.e., excluding) certain other District-Paid Expenses for
Edison consented to the issuance of the Commission's Order without admitting or denying the findings.
The Commission found that Edison violated the periodic reporting provisions of the federal securities
laws and ordered Edison to cease and desist from committing such violations in the future.
11. SEC v. Xerox Corporation, Lit. Rel. No. 17465 (April 11, 2002)
On April 11, 2002, Xerox settled the Commission’s civil fraud injunctive action against it by
agreeing to pay a $10 million penalty - - the largest ever levied in a Commission action against a
public company for financial fraud. The complaint alleged that from 1997 through 2000, Xerox
Corporation employed a variety of undisclosed accounting actions to meet or exceed Wall Street
expectations and disguise its true operating performance from investors. These actions, most of which
violated GAAP, accelerated Xerox's recognition of equipment revenue by over $3 billion and
increased its pre-tax earnings by approximately $1.5 billion over the four-year period from 1997
The complaint alleges that these accounting actions, which often were approved, implemented
and tracked by senior Xerox management, had a substantial impact on Xerox's reported performance.
For example, in the fourth quarters of both 1998 and 1999, accounting actions generated 37% of
Xerox's reported pre-tax profit. The Commission's complaint further alleges that by 1998, nearly $3 of
every $10 of Xerox's annual reported pre-tax earnings resulted from undisclosed accounting actions.
Without these accounting actions, the complaint alleges, Xerox would have fallen short of market
earnings expectations in virtually every reporting period from 1997 through 1999.
The allegations in the complaint center around seven different accounting actions that Xerox
used to help meet or exceed market expectations from 1997 to 2000. Many of these actions accelerated
Xerox's recognition of revenue into current periods at the expense of future periods. According to the
complaint, Xerox fraudulently disguised these actions so that investors remained unaware that the
company was meeting earnings expectations only by using accounting maneuvers that could
compromise future results.
The complaint alleges that several of the accounting actions related to Xerox's leasing
arrangements. Under these arrangements, the revenue stream from Xerox's customer leases typically
had three components: the value of the "box," a term Xerox used to refer to the equipment; revenue
that Xerox received for servicing the equipment over the life of the lease; and financing revenue that
Xerox received on loans to its lessees. Under GAAP, Xerox was required to book revenue from the
"box" at the beginning of the lease, but was required to book revenue from servicing and financing
over the course of the entire lease. According to the complaint, Xerox relied on accounting actions to
justify shifting more lease revenue to the "box," so that a greater portion of that revenue could be
The complaint alleges that the two accounting actions with the largest impact on Xerox's
financial statements were methodologies that Xerox called "return on equity" and "margin
normalization." Xerox used the return on equity method to shift revenue to equipment that the
company historically had allocated to financing. Margin normalization shifted revenue to equipment
that historically had been allocated to servicing. These two methodologies, which did not comply with
GAAP, increased Xerox's equipment revenues by $2.8 billion and its pre-tax earnings by $660 million
from 1997 to 2000. The complaint alleges that Xerox fraudulently failed to disclose to investors its
use of and changes to these methodologies — which were changes in accounting methods and changes
in accounting estimates.
The complaint also alleges that Xerox used approximately $1 billion of additional accounting
actions to artificially improve its operating results. By using these accounting actions and failing to
disclose their use, Xerox violated GAAP as well as disclosure requirements. These additional actions
included the improper use of "cushion" or "cookie jar" reserves, the improper recognition of the gain
from a one-time event, and miscellaneous lease accounting related actions.
Without admitting or denying the allegations of the complaint, Xerox consented to the entry of
a Final Judgment that permanently enjoins the company from violating the antifraud, reporting and
recordkeeping provisions of the federal securities laws. In addition, Xerox agreed to pay a $10 million
civil penalty and to restate its financial results for the years 1997 through 2000. In imposing the fine,
the Commission noted that the fine was based in part on the company’s failure to fully cooperate with
the Commission’s investigation. Xerox also agreed to have its board of directors appoint a committee
composed entirely of outside directors to review the company's material internal accounting controls
and policies. Finally, the Commission entered an Order exempting Xerox from certain filing
requirements of the Exchange Act to extend, until June 30, 2002, the date by which Xerox and its
finance subsidiary, Xerox Credit Corporation, may file annual and quarterly reports.
The SEC is continuing its investigation of this matter as it relates to other parties.
12. SEC v. Dean L. Buntrock et al. (Waste Management), Lit. Rel. 17435 (Mar. 26, 2002)
The Commission filed a Complaint charging the founder and five other former top officers of
Waste Management, Inc. with perpetrating a massive financial fraud lasting more than five years. The
Commission alleged that, beginning in 1992 and continuing into 1997, defendants engaged in a
systematic scheme to falsify and misrepresent Waste Management's financial results and thereby
enrich themselves and keep their jobs. The scheme was orchestrated and implemented by Waste
Management's most senior officers, including Dean L. Buntrock - founder, chairman of the Board of
Directors, and chief executive officer and Phillip B. Rooney - president and chief operating officer,
director, and CEO for a portion of the relevant period.
The Commission alleges that Defendants fraudulently manipulated the Company's financial
results to meet predetermined earnings targets. The Company's revenues and profits were not growing
fast enough to meet these targets, so defendants instead resorted to improperly eliminating and
deferring current period expenses to inflate earnings. They employed a multitude of improper
accounting practices to achieve this objective. Among other things, defendants avoided depreciation
expenses, assigned arbitrary salvage values to other assets, failed to record various expenses and failed
to establish sufficient reserves (liabilities) to pay for income taxes and other expenses.
Defendants concealed their scheme in a variety of ways. They made false and misleading
statements about the Company's accounting practices, financial condition, and future prospects in
filings with the Commission, reports to shareholders, and press releases. They also used accounting
manipulations known as "netting" and "geography" to make reported results appear better than they
actually were and avoid scrutiny. Defendants used netting to eliminate approximately $490 million in
current period operating expenses and accumulated prior period accounting misstatements by
offsetting them against unrelated one-time gains on the sale or exchange of assets. They used
geography entries to move tens of millions of dollars between various line items on the Company's
income statement to, in Koenig's words, "make the financials look the way we want to show them."
Defendants were aided in their fraud by the Company's long-time auditor Arthur Andersen
LLP, which repeatedly issued unqualified audit reports on the Company's materially false and
misleading annual financial statements. Andersen identified the Company's improper accounting
practices and quantified much of the impact of those practices on the Company's financial statements.
Although Andersen annually presented Company management with proposals to correct errors that
understated expenses and overstated earnings in the Company's financial statements, management
consistently refused to make the adjustments. Instead, defendants secretly entered into an agreement
with Andersen fraudulently to write off the accumulated errors over periods of up to ten years and to
change the underlying accounting practices, but to do so only in future periods.
Defendants' scheme eventually unraveled. In mid-July 1997, a new CEO ordered a review of
the Company's accounting practices. That review ultimately led to the restatement of the Company's
financial statements for 1992 through the third quarter of 1997. When the Company filed its restated
financial statements in February 1998, the Company acknowledged that it had misstated its pre-tax
earnings by approximately $1.7 billion. At the time, the restatement was the largest in corporate
The Complaint alleges that the defendants violated, and aided and abetted violations of,
antifraud, reporting, and record-keeping provisions of the federal securities laws. As relief, the
Commission seeks final judgments permanently enjoining defendants from further violations of these
provisions, ordering disgorgement of defendants' ill-gotten gains plus prejudgment thereon, imposing
civil money penalties, and prohibiting defendants from serving as officers or directors of public
13. SEC v. Trump Hotels & Casino Resorts, Inc., SEA Rel. No. 45287, AAE Rel. No. 1499 (Jan. 16,
On January 16, 2002, the Commission accepted an offer by Trump Hotels & Casino Resorts
(Trump) to settle cease and desist proceedings based upon a misleading earnings release. Trump,
through various subsidiaries, owns and operates the Trump Taj Mahal Casino Resort. Trump and its
subsidiaries file reports, including their financial statements, on a consolidated basis.
The order found that Trump issued a press release announcing its results for the third quarter of
1999 that used a net income figure that differed from net income calculated in conformity with GAAP.
The Release touted Trump’s purportedly positive operating results for the quarter and stated that the
Company had beaten analysts’ earnings expectations. The Release was materially misleading because
it created the false and misleading impression that the Company had exceeded earnings expectations
primarily through operational improvements, when in fact it had not.
The Commission accepted Trump’s offer imposing a cease-and-desist order to stop committing
or causing any violation, and any future violation, of the antifraud provisions of the federal securities
A. Cases Involving Accountants and Auditors
1. In re PricewaterhouseCoopers LLP and PricewaterhouseCoopers Securities LLC,
Exchange Act Rel. No. 46216; AAE Rel. No.1596 (July 17, 2002).
The SEC announced a settled enforcement action against PricewaterhouseCoopers LLP (PwC)
and its broker-dealer affiliate, PricewaterhouseCoopers Securities LLC (PwCS), for violations of the
auditor independence rules. The auditor independence violations span a five-year period from 1996 to
2001 and arise from (1) PwC's use of prohibited contingent fee arrangements with 14 different audit
clients for which PwCS provided investment banking services, and (2) PwC's participation with two
other audit clients, Pinnacle Holdings Inc. and Avon Products Inc., in the improper accounting of costs
that included PwC's own consulting fees.
The SEC's order finds that, by virtue of PwC's independence violations, the firm caused 16
PwC public audit clients to file financial statements with the SEC that did not comply with the
reporting provisions of the federal securities laws. The order also finds that, in connection with the
improper accounting of its consulting fees, PwC caused two of those clients to violate the reporting,
recordkeeping, and/or internal controls provisions of the federal securities laws. PwC and PwCS
agreed to pay a total of $5 million and PwC agreed to comply with significant remedial undertakings
as a result of its settlement with the SEC. PwC also agreed to cease and desist from violating the
auditor independence rules and to be censured for engaging in improper professional conduct.
From 1996 to 2001, PwC and one of its predecessors, Coopers & Lybrand, entered into
impermissible contingent fee arrangements with 14 public audit clients. In each instance, the client
hired the audit firm's investment bankers, either PwCs or Coopers & Lybrand Securities, to perform
financial advisory services for a fee that depended on the success of the transaction the client was
pursuing. These fee arrangements violated the accounting professions' own prohibition against
contingent fee arrangements with audit clients and violated the SEC's independence rules. As a result,
the SEC found that PwC lacked the requisite independence when it performed audits for these 14
In 1999 and 2000, PwC participated in and approved of the improper accounting of its own
non-audit fees by two public audit clients, Pinnacle and Avon:
In 1999 and 2000, while accounting for a 1999 acquisition of certain assets of Motorola, Inc.,
PwC assisted Pinnacle in establishing more than $24 million in improper reserves and in improperly
capitalizing approximately $8.5 million in costs, including $6.8 million in fees paid to PwC for
consulting and other non-audit services that should have been expensed. In April and May 2001,
Pinnacle restated its accounting for the 1999 acquisition, and in December 2001, the SEC issued a
settled cease and desist order against Pinnacle. See In the Matter of Pinnacle Holdings, Inc., Exchange
Act Release No. 45135 (Dec. 6, 2001).
In the first quarter of 1999 and in its 1999 audit of Avon's financial statements, PwC assisted in
and approved of Avon's improper accounting of an impaired asset that included PwC's non-audit
consulting fees. In April 1999, after nearly three years and an investment of approximately $42
million, Avon stopped an uncompleted order-management software project that PwC consultants had
attempted to develop for Avon's internal use. Instead of writing off all of the project's costs in the first
quarter of 1999, however, Avon improperly retained $26 million, which was comprised mostly of
PwC's own consulting fees. PwC participated in and approved of Avon's improper accounting, and also
contributed to Avon's misleading disclosures concerning the accounting.
For both Pinnacle and Avon, the SEC found that PwC failed to exercise the objective and
impartial judgment required by the independence rules.
In consenting to the SEC's order, PwC agreed to perform significant remedial undertakings
designed to prevent the type of independence violations found in the order. Simultaneous with the
issuance of the order in this case, the SEC brought a settled enforcement action against Avon for
failing to properly value costs that it had capitalized in connection with the software development
project. Avon agreed to cease and desist from violating the reporting and recordkeeping provisions of
the federal securities laws and to restate its financial statements to appropriately reflect the complete
impairment of the project in the first quarter of 1999. See In the Matter of Avon Products, Inc.,
Exchange Act Release No. 46215 (July 17, 2002).
2. In re Moret Ernst & Young Accountants, SEA Rel. No. 46130, AAE Rel. No. 1584,
(Jun. 27, 2002) http://www.sec.gov/litigation/admin/34-46130.htm.
In the first-ever auditor independence case against a foreign audit firm, the SEC brought a
settled enforcement action against Moret Ernst & Young Accountants, a Dutch accounting firm now
known as Ernst & Young Accountants. The case arises from Moret's joint business relationships with
an audit client. The SEC censured Moret for engaging in improper professional conduct and ordered
Moret to comply with certain remedial undertakings, including the payment of a $400,000 civil
penalty. This is the first time that the SEC has ordered any audit firm to pay a civil penalty for an
auditor independence violation. Moret consented to the order without admitting or denying the SEC's
Moret audited the 1995, 1996, and 1997 financial statements of Baan Company, N.V., a
business software company headquartered in the Netherlands. During this period, consultants
affiliated with Moret had joint business relationships with Baan that impaired Moret's independence as
auditor. Most of these joint business relationships were established to allow Moret consultants to
assist Baan in implementing its software products for third parties. The joint business relationships
included a Dutch government-subsidized project for Moret and Baan to jointly develop faster software
implementation tools; an agreement to coordinate global efforts in implementing Baan software
products for third parties; joint marketing activities emphasizing the "partnership" and overall
coordination between Baan and Moret in the implementation of Baan software products; and Baan's
use of Moret consultants as subcontractors and temporary employees in servicing Baan's clients.
Altogether, the SEC found that Moret consultants billed Baan approximately $1.9 million from
these improper joint business relationships during the years in question. Baan disputed, and ultimately
did not pay, approximately $328,000 of these billings, which further impaired Moret's independence as
The SEC concluded that Moret's conduct constituted an extreme departure from the standards
of ordinary care that resulted in violations of the auditor independence requirements imposed by the
SEC's rules and by generally accepted auditing standards. In addition to censuring Moret, the SEC
ordered Moret to comply with a number of remedial undertakings, including the payment of a
$400,000 civil penalty.
3. In the Matter of KPMG LLP, SEA Rel. No. 45272, ICA Rel. No. 25360, AAE Rel.
No. 1491 (Jan. 14, 2002) www.sec.gov/litigation/admin/34-45272.htm.
The SEC censured KPMG LLP for engaging in improper professional conduct because it
purported to serve as an independent accounting firm for an audit client at the same time that it had
made substantial financial investments in the client. The SEC found that KPMG violated the auditor
independence rules by engaging in such conduct. KPMG consented to the SEC’s order without
admitting or denying the SEC’s findings. In addition to censuring the firm, the SEC ordered KPMG
to undertake certain remedies designed to prevent and detect future independence violations caused by
financial relationships with, and investments in, the firm’s audit clients.
The SEC found that, from May through December 2000, KPMG held a substantial investment
in the Short-Term Investments Trust (“STIT”), a money market fund within the AIM family of funds.
According to the SEC’s order, KPMG opened the money market account with an initial deposit of
$25 million on May 5, 2000, and at one point the account balance constituted approximately 15% of
the fund’s net assets. In the order, the SEC found that KPMG audited the financial statements of STIT
at a time when the firm’s independence was impaired, and that STIT included KPMG’s audit report in
16 separate filings it made with the SEC on November 9, 2000. The SEC further found that KPMG
repeatedly confirmed its putative independence from the AIM funds it audited, including STIT, during
the period in which KPMG was invested in STIT.
According to the SEC, KPMG’s independence violation occurred primarily because the firm
lacked adequate policies or procedures to prevent or detect such violations, and because the steps
which KPMG personnel usually took before initiating investments of the firm’s surplus cash were not
taken in this instance. The SEC also found that KPMG: had no procedures directing its treasury
department personnel to check the firm’s “restricted entity list” to confirm that a proposed investment
was not restricted; had no specific policies or procedures requiring any participation by a KPMG
partner in the investigation and selection of money market investments; and had no policies or
procedures designed to put KPMG audit professionals on notice of where the firm’s cash was invested,
or requiring them to check a listing of the firm’s investments, prior to accepting new audit
engagements or confirming the firm’s independence from audit clients.
As a result, the SEC found that there was no system KPMG audit engagement partners could
have used to confirm the firm’s independence from its audit clients. The SEC concluded that KPMG’s
lack of adequate policies and procedures constituted an extreme departure from the standards of
ordinary care, and resulted in violation of the auditor independence requirements imposed by the
SEC’s rules and by Generally Accepted Auditing Standards.