SEC Accounting Enforcement Continues Apace
In its annual summary of SEC enforcement activity, Cornerstone Research found a sharp increase during the past year in SEC actions alleging accounting violations. Cornerstone also found that the number of cases involving individual defendants/respondents was well above the historical average, reflecting SEC Chair Gensler's commitment to holding individuals accountable. See Accounting Class Actions are Increasing Slowly While SEC Accounting Cases are Skyrocketing, May-June 2023 Update. Three recent SEC enforcement matters indicate that the focus on accounting and on individual culpability for accounting violations has not abated.
On July 3, 2023, the Commission filed a settled administrative proceeding against View, Inc., a manufacturer of “smart” windows. The order alleges that View failed to disclose $28 million in warranty-related liabilities for replacement of defective windows. From December 2020 to May 2021, View disclosed warranty liabilities of $22 million to $25 million, consisting of projected costs to manufacture replacements for the defective windows. However, View failed to include in its liability computation the additional cost to ship and install the new windows. Including those costs, View should have disclosed total warranty liabilities of $48-$53 million. View agreed to cease and desist from future violations.
The SEC simultaneously filed a civil action in federal court against View’s former CFO, Vidul Prakash, for his alleged negligent failure to ensure that View disclosed the full amount of warranty-related liabilities. Prakash is charged with antifraud, proxy disclosure, and books and records violations. The Commission is seeking a permanent injunction against future violations, civil penalties, and an order barring Prakash from serving as an officer or director of public company.
On June 27, 2023, the Commission filed civil actions against four former officers of MusclePharm Corp., a nutritional supplement company that is now in bankruptcy.
Brian Casutto was MusclePharm Corp.'s former Executive Vice President of Sales and Operations, Matthew Zucco was the company’s former Vice President of Sales, and Kevin Harris was the former Chief Financial Officer. The complaint against these three individuals alleges that Casutto, with the assistance of Zucco, engaged in a fraudulent scheme to prematurely recognize revenue and that Harris should have known that the revenue in question had been prematurely recognized. The scheme involved recording orders for MusclePharm products as sold and shipped to customers (and therefore recognizing revenue) when in fact the products were held in MusclePharm storage trailers or warehouses at the end of the quarter in which the “sale” was recorded. The SEC also alleges that Harris overstated revenue by misclassifying customer credits as advertising expenses, rather than as reductions to revenue. These maneuvers allegedly inflated the company' s quarterly revenues by as much as 25 percent and gross profits by as much as 49 percent. Messrs. Casutto, Zucco, and Harris consented to injunctions against future violations, disgorgement, and civil penalties. Casutto was also barred from serving as an officer or director of a public company for five years.
Ryan Drexler was MusclePharm’s former CEO. A separate complaint against Drexler alleges that he failed to ensure that MusclePharm had appropriate internal control over financial reporting and disclosure controls and procedures to ensure that its accounting for revenue, profit, and other financial metrics was correct and that he made false statements concerning MusclePharm’s controls and procedures. In addition, the SEC alleges that Drexler concealed from investors that a $10 million MusclePharm debt had been accelerated and was due. The complaint seeks injunctive relief, civil penalties, reimbursement of compensation paid based on inaccurate financial statements, and an officer and director bar.
On June 5, 2023, the Commission filed a settled administrative proceeding against Cantaloupe, Inc., formerly known as USA Technologies (USAT), a manufacturer and distributor of cashless payment devices. According to the SEC’s order, USAT attempted to maximize end-of-quarter revenue and meet its internal sales by entering into bill-and-hold sales transactions that did not conform to the company's sales and revenue recognition policies. In addition, USAT inflated quarterly sales revenue by deliberately shipping devices to its customers that the customers had not ordered or had explicitly told USAT they did not want. After these practices came to light, an audit committee investigation resulted in a restatement that reduced 2017 and 2018 revenue by $4.61 million or 3.5 percent. USAT consented to a cease-and-desist order against future violations and to payment of a $1.5 million civil penalty.
The SEC simultaneously brought administrative proceedings against Maeve Duska, USAT’s former Vice President for Sales and Marketing, and Michael Lawlor, USAT’s former Chief of Services Officer. The SEC alleges that each participated in USAT’s efforts to maximize revenue and meet internal sales targets in contravention of its sales and revenue recognition policies and GAAP, including by participation in the shipment of devices to USAT customers who had not ordered the devices. Both individuals consented to cease and desist from future violations, pay civil penalties, and to disgorge bonuses they received based on the improperly recognized revenue.
Comment: While the View case is somewhat unusual in that it is based on a liability misstatement, the other two cases are classic examples of revenue recognition fraud, which has traditionally been a main focus of SEC accounting enforcement. As the three cases illustrate, the current SEC enforcement philosophy almost guarantees that the Commissions will charge individuals in actions based on financial reporting violations – and in many cases, will seek, not only an injunction against future violations and/or a fine, but also a bar from serving as a public company officer or director in the future. Audit committees should be vigilant as to the adequacy of controls around revenue, especially when revenue-based goals are a key part of measuring management performance and setting compensation.