September 2014

A settlement agreement has been reached In the Matter of Lynn R. Blodgett, Adm. Proc. File No. 3-16045 (August 28, 2014), but without consensus on the part of the Securities Exchange Committee (“SEC”) as to the appropriate penalty. The underlying circumstances involve a financial fraud action against two executives at Affiliated Computer Services, Inc. (“ACS”), Lynn Blodget, the president and CEO, and Kevin Kyser, the CFO. The SEC alleged that Mr. Blodget and Mr. Kyser improperly recorded revenues in an effort to meet analyst expectations.

According to the SEC complaint, ACS took fraudulent measures to increase revenues when early results suggested that expectations for 2009 growth contained in company guidance and analyst expectations would not be realized. ACS violated generally accepted accounting principles (“GAAP”) by recording revenues associated with having inserted itself after the fact into pre-existing sales transactions between a manufacturer and a reseller.  Company transaction documents gave the false appearance that ACS was involved in the transaction, but the equipment was shipped directly from the manufacturer to the reseller’s customers at their normal prices without ACS ever taking possession. The reseller’s customers were not even aware of ACS’ claimed involvement in the transactions.

There was no economic substance to those revenues, which totaled approximately $125 million over four quarters and importantly, misled the market that ACS had met its revenue growth guidance in three of those four quarters.  According to the SEC’s order, Mr. Kyser:

  • Understood that ACS had inserted itself into these pre-existing transactions and that they would impact ACS’s reported revenue growth;
  • Was responsible for the content of ACS’s false and misleading public filings with the Commission, earnings releases, and analyst conference calls;
  • Highlighted ACS’s false and misleading internal revenue growth in earnings releases and analyst conference calls;
  • Failed to ensure that ACS adequately disclosed and described the significance of these transactions in ACS’s public filings and analyst conference calls;
  • Signed false certifications in connection with the Company’s periodic filings; and
  • Received an inflated bonus based on ACS’s financial performance that was overstated by 43%.

The Order alleges violations of Exchange Act Section 13(a), 13(b)(2)(A) and 13(b)((2)(B) and the related Rules. In settlement, Mr. Blodgett and Mr. Kyser agreed to (i) a cease and desist order regarding future violations, and (ii) pay disgorgement of $351,050 and $133,192 respectively. Both men are also required to pay prejudgment interest and a $52,000 civil penalty.

Commissioner Luis A. Aguilar vehemently disagreed with this resolution, writing in his dissent:

“The importance of a strong and robust Enforcement program cannot be overstated.  It is a vital component of an effective capital market on which investors can rely….Given the egregious conduct that Mr. Kyser engaged in at ACS, the Commission’s settlement, which lacks fraud charges or a timeout in the form of a Rule 102(e) suspension, is a wrist slap at best….

Accountants—especially CPAs—serve as gatekeepers in our securities markets.  They play an important role in maintaining investor confidence and fostering fair and efficient markets.  When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust.  To this end, when these accountants engage in fraudulent misconduct, the Commission must be willing to charge fraud and must not hesitate to suspend the accountant from appearing or practicing before the Commission…. 

In addition, where CPAs engage in this type of egregious securities fraud—especially misconduct that relates to the CPAs’ core expertise of financial reporting—the Commission has rightly required such persons to forfeit their privilege to appear and practice before the Commission by imposing a suspension under Rule 102(e) of the Commission’s Rules of Practice. 

Beyond this particular matter, I am concerned that the Commission is entering into a practice of accepting settlements without appropriately charging fraud and imposing Rule 102(e) suspensions against accountants in financial reporting and disclosure cases.  I am also concerned that this reflects a lack of conviction to charge what the facts warrant and to bring appropriate remedies.” 

Commissioner Aguilar highlights that the statistics on financial reporting and disclosure cases and related Rule 102(e) suspensions from practicing before the SEC suggest increasing leniency. In 2010, the Commission brought 117 financial reporting and disclosure cases against issuers and individuals, and imposed Rule 102(e) suspensions in 54% of those cases. Those numbers dropped each year, such that by 2013, the Commission brought only 68 similar cases, and imposed Rule 102(e) suspensions in only 41% of those cases.  He complains:

“These declining numbers reveal a departure from the Commission’s efforts to keep bad apples out of the securities industry, and this puts investors and the integrity of the Commission’s processes at grave risk.

[It is to be expected that] defendants strenuously object to scienter-based and non-scienter-based fraud charges (as opposed to lesser charges, such as books and records or internal control violations)….What is not to be expected is when defendants engage in fraud and the Commission affirmatively accepts a weak settlement with lesser charges.  This leaves the investing public significantly at risk, as bad actors are not appropriately charged or sanctioned and are permitted to continue to operate in the securities industry.  This is completely unacceptable…..When this happens, the public is denied a full accounting and appreciation of the egregious nature of a defendant’s misconduct….In the end, these behind-the-curtain decisions can make fraudulent behavior appear to be an honest mistake…The Commission must send a strong and consistent message to the industry that the Commission takes seriously its responsibility of requiring integrity in the financial markets.  For these reasons, I dissent.”

The SEC’s growing focus on data analytics should allow for increased identification of earnings management and unexpected data relationships. However, when perpetrators only face relatively small penalties such as the ones describe above, the incentives to engage in fraudulent behavior may be found to greatly outweigh the risks associated with “getting caught”. The resulting damages to the public are normally revisited upon the companies themselves in the form of a shareholder lawsuit. Such shareholder losses are generally not measured in the hundreds of thousands assessed against the actual perpetrators of the fraud, but in the many millions of dollars. It is in the interest of both the public and the companies themselves that the SEC heed Commissioner Aguilar’s warnings and not let CPAs with a demonstrated lack of professional integrity continue to practice.

Fulcrum Inquiry performs forensic accounting and other financial investigations and related damages calculations.