The current bailout isn’t the first time something like this has happened. As I understand the situation (and please correct me if I am wrong), the value of real estate has declined, and there are too many problem or uncollectible mortgages. Didn’t that happen in the 1980s with the savings and loan debacle? On the one hand, on a large or grand scale, it can be difficult to estimate or value when real estate will decline in value, and, for the most part, in general real estate as a whole does not decline in value. However, as I understand the situation, in the late 1990s or the early 2000s Congress eased the Fannie Mae and Freddie Mac loan qualifying requirements allowing for more risky loans to be made (such as with no money down, or without proof of income). That action, if true, was ill-advised. Does anyone view Congress as being prudent when it comes to issues of money or finances? I don’t. It has also been discussed for some number of years that the real estate market is over heated, and that values may drop. Of course, whether values would drop, and the amount of anticipated drop would be difficult to estimate. How should the lenders take those factors, and the amount of reserves, into consideration? How should the regulatory agencies take those factors into consideration? How should the outside auditors take those factors into consideration? I understand that the outside auditor may well be entitled to take the loan/property appraisals at face value. The point of this discussion is not to find fault. The point is to identify the weaknesses in the system, and to correct those weaknesses so as to better prevent a problem of this magnitude from happening again in the future. And, the problem is a very big problem, which will be paid for by the taxpayers. As I see it, not too long ago a similar fiasco occurred. It is way too early for a similar problem to have occurred. This time the weaknesses in the system need to be fixed. What do you think? How do we fix the problems?
Dave Tate, CPA, Esq.
http://auditcommittee.blogspot.com
http://davidtate.us
Sunday, September 21, 2008
Sunday, September 14, 2008
Corporate climate change disclosures: Xcel Energy settlement with Cuomo
The following is a link discussing corporate climate change disclosures relating to the Xcel Energy settlement with Cuomo.
http://lawprofessors.typepad.com/business_law/2008/09/xcel-energy-set.html
http://lawprofessors.typepad.com/business_law/2008/09/xcel-energy-set.html
Saturday, September 13, 2008
Auditing firm liable for allowing company to go deeper into insolvency
The following link is to the U.S. Court of Appeals, Third Circuit opinion upholding a verdict against PwC for an alleged negligent audit which allowed the insurance company which it was auditing to go deeper into insolvency.
http://www.ca3.uscourts.gov/opinarch/062209p.pdf
http://www.ca3.uscourts.gov/opinarch/062209p.pdf
Deloitte paper, When CFOs Debate
The following is a somewhat interesting paper published by Deloitte, When CFOs Debate. The paper discusses a few of the issues that CFOs face, and then goes one additional step by providing point and counterpoint discussion. The paper is limited in the "advice" category.
http://www.deloitte.com/dtt/cda/doc/content/us_fintrans_WhenCFOsDebate20088_13.pdf
http://www.deloitte.com/dtt/cda/doc/content/us_fintrans_WhenCFOsDebate20088_13.pdf
Friday, September 12, 2008
IFRS coming to an audit committee near you?
On August 27 the SEC voted to publish for public comment a proposed Roadmap that could lead to the use of International Financial Reporting Standards (IFRS) by U.S. issues beginning in 2014, or earlier. The SEC proposes to make a final decision in 2011 whether adoption of the IFRS is in the public interest and would benefit investors. The possible adoption of IFRS by U.S. issuers has been seriously discussed for at least the past couple of years. Based on this latest action by the SEC, and the volume of IFRS guidance published by the large accounting/auditing firms, adoption of the use of IFRS appears likely. What might adoption mean for audit committees? Audit committee member financial literacy would suggest a future need for some additional committee member continuing education about the differences between IFRS and GAAP. Additionally, generally IFRS tends to be less rules and more principles based, requiring the company and the audit committee to exercise (and justify) greater accounting method discretion and judgment. Some current audit committee members might not be interested in making the effort to learn the important aspects of IFRS, or in having to deal with the conversion process, or in the additional effort that may be required to exercise judgment on a greater number of accounting issues.
For your information, the following is a link to an EY paper that summarizes differences between IFRS and GAAP. http://www.ey.com/Global/assets.nsf/US/Assurance_US_GAAP_v_IFRS/$file/us_gaap_v_ifrs.pdf
For your information, the following is a link to an EY paper that summarizes differences between IFRS and GAAP. http://www.ey.com/Global/assets.nsf/US/Assurance_US_GAAP_v_IFRS/$file/us_gaap_v_ifrs.pdf
Sunday, August 31, 2008
Governance lessons learned from SEC v. Con-way
Governance lessons learned from SEC v. Con-way, Inc.
Dave Tate, Esq.
http://davidtate.us/ ; tateatty@yahoo.com
Summary
On August 27, 2008 the SEC entered a Cease and Desist Order ("Order") against Con-way, Inc. ("Con-way") (Securities Exchange Act of 1934 Release No. 58433). Con-way consented to the entry of the Order without admitting or denying the findings, except as to the SEC’s jurisdiction over it and the subject matter of the proceedings. The findings, although not admitted and rather sparse on detail, nevertheless provide insight, lessons and missed opportunities. This discussion is organized in the following order: Summary; Comments, Lessons Learned and Missed Opportunities; and Details of the Cease and Desist Order.
In pertinent part, the Order alleges that Con-way is a public company, listed on the New York Stock Exchange. Menlo Worldwide Forwarding, Inc. was a wholly-owned U.S-based subsidiary of Con-way that Con-way purchased in 1989. During the relevant period, Menlo Forwarding had a 55% voting interest in Emery Transnational ("Emery"). As alleged by the SEC, “this matter involves Con-way’s violations of the books and records, and internal controls provisions of the Foreign Corrupt Practices Act (“FCPA”) through a Philippine-based firm, Emery Transnational. From 2000 to 2003, Emery Transnational made hundreds of small payments totaling at least $417,000 to Philippine customs officials and to officials of numerous majority foreign state-owned airlines. These payments were made with the purpose and effect of improperly influencing these foreign officials to assist Emery Transnational to obtain or retain business. In connection with these improper payments, Con-way failed to accurately record these payments on the company’s books and records, and knowingly failed to implement or maintain a system of effective internal accounting controls.”
Comments, Lessons Learned and Missed Opportunities
1. As alleged, the payments in question, although numerous, appear individually not to be material in amount. From the information provided it is not possible to determine whether the amounts would be material in total. Of course, materiality can be quantitative and qualitative in nature. An unlawful act can be material qualitatively, even if it is not material quantitatively. Quantitative materiality also may depend on whether it is viewed from the perspective of Con-way or from the perspective of Emery. In light of the disparity in size between Con-way and Emery, the transactional occurrences at Emery may have simply fallen under the radar screen.
2. Nevertheless, illegal payments are unlawful, and internal controls are required, even at subsidiaries. Thus, the SEC alleges that Con-way knowingly failed to implement or maintain a system of effective internal accounting controls. Without additional background information, such a conclusion appears harsh. “Knowing” failure to implement effective controls may imply intentional wrongdoing. The factual allegations do not support an inference of intentional wrongdoing. However, companies, officers, internal auditors, boards and audit committees should take note that lack of attention to internal controls may prompt an allegation of “knowing” failure to implement.
3. The outside auditor was required to evaluate internal controls for the purpose of performing its annual audit of Con-way‘s consolidated financial statements. Additionally, Statement on Auditing Standards (SAS) 99 required the auditor to consider the risks of fraud and related programs and controls, and Statement on Auditing Standards 54 required the communication of information pertaining to unlawful acts. Although new Auditing Standards 109, 112, and 114 had not yet been enacted during the relevant period in question, SAS 60 (communicating internal control related matters) and SAS 61 (auditor’s communications) were applicable. Additionally, Sarbanes-Oxley §404 (management’s assessment of internal controls) and §302 (chief executive and chief financial officer financial statement certification) were applicable during part of the period in question. The SEC missed an opportunity to evaluate and comment on how this situation did not come to the attention of the outside auditor. Alternatively, if the situation did come to the attention of the outside auditor, the SEC missed an opportunity to comment about how it could or should have been handled differently. The Order does not provide information from the outside auditor perspective. Even if the Order is limited to a cease and desist against Con-way, more detailed discussion about the other participants, as dicta, would help other companies, officers, outside auditors, inside auditors, boards and audit committees learn from the situation.
4. The Order does not discuss or provide information from the Con-way audit committee perspective. Such a discussion might have been helpful for other audit committees, especially with respect to governance. The audit committee is required to oversee internal controls. See, e.g., NYSE Listed Company Manual §303A.07 (audit committee composition, and additional audit committee requirements), Sarbanes-Oxley §301 (public company audit committee requirements), and Sarbanes-Oxley §407 (disclosure of audit committee financial expert). Management and the audit committee, and the outside auditor and the audit committee are also required to communicate regarding internal controls.
5. The Order also does not discuss or provide information from the internal audit perspective. New York Stock Exchange Listed Company Manual §303A.07 requires each listed company to have an internal audit function. Curiously, NASDAQ does not have such a requirement. Working with the audit committee, and with management, it may have been possible to use internal audit to evaluate and report on subsidiary internal controls and payments. A discussion in the Order about how internal audit was or was not used might have been helpful from a governance learning perspective.
These are my initial thoughts that readily come to mind. I am sure that other people will have other thoughts. What are your opinions about the events and circumstances leading to the Cease and Desist Order, and the Order itself? Please feel free to drop me an email. See below for additional detail about the Cease and Desist Order.
Regards,
Dave Tate
Details of the Cease and Desist Order
The Cease and Desist Order in part alleges:
“During the relevant period, Con-way and Menlo Forwarding engaged in little supervision or oversight over Emery Transnational. Neither Con-way nor Menlo Forwarding took steps to devise or maintain internal accounting controls concerning Emery Transnational, to ensure that it acted in accordance with Con-way’s FCPA [Foreign Corrupt Practices Act] policies, or to make certain that its books and records were detailed or accurate.
During the relevant period, Con-way and Menlo Forwarding required only that Emery Transnational periodically report back to Menlo Forwarding its net profits, from which Emery Transnational then paid Menlo Forwarding a yearly 55% dividend. Menlo Forwarding incorporated the yearly 55% dividend into its financial results, which were then consolidated in Con-way’s financial statements. Neither Con-way nor Menlo Forwarding asked for or received any other financial information from Emery Transnational. Accordingly, neither Con-way nor Menlo Forwarding maintained or reviewed any of the books and records of Emery Transnational – including the records of operating expenses, which should have reflected the illicit payments made to foreign officials.
Emery Transnational made hundreds of small payments to foreign officials at the Philippines Bureau of Customs and the Philippine Economic Zone Area between 2000 and 2003 in order to obtain or retain business. These payments were made to influence the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. By these payments, foreign officials were induced to: (i) violate customs regulations by allowing Emery Transnational to store shipments longer than otherwise permitted, thus saving the company transportation costs related to its inbound shipments; and (ii) improperly settle Emery Transnational’s disputes with the Philippines Bureau of Customs, or to reduce or not enforce otherwise legitimate fines for administrative violations.
To generate funding for these payments, Emery Transnational employees submitted a Shipment Processing and Clearance Expense Report (“SPACER”) to Emery Transnational’s finance department. These SPACER reports requested cash advances to complete customs processing. The cash advances were then issued via checks made payable to Emery Transnational employees, who cashed the checks and paid the money to designated foreign officials. Unlike legitimate customs payments, the payments at issue were not supported by receipts from the Philippines Bureau of Customs and the Philippine Economic Zone Area. Emery Transnational did not identify the true nature of these payments in its books and records. During the period 2000 to 2003, these payments total at least $244,000.
Emery Transnational, in order to obtain or retain business, also made numerous payments to foreign officials at fourteen state-owned airlines that did business in the Philippines between 2000 and 2003. (Footnote omitted). These payments were made with the intent of improperly influencing the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. Emery Transnational made two types of payments. The first type were known as “weight shipped” payments, which were made to induce airline officials to improperly reserve space for Emery Transnational on the airplanes. These payments were valued based on the volume of the shipments the airlines carried for Emery Transnational. The second type were known as “gain shares” payments, which were paid to induce airline officials to falsely under-weigh shipments and to consolidate multiple shipments into a single shipment, resulting in lower shipping charges. Emery Transnational paid the foreign officials 90% of the reduced shipping costs.
Both types of payments to foreign airline officials were paid in cash by members of Emery Transnational’s management team. Checks reflecting the amount of the “weight shipped” and “gain shares” payments were issued to these managers, who cashed the checks and personally distributed the cash payments to the foreign airline officials. Emery Transnational did not characterize these payments in its books and records as bribes. During the period 2000 to 2003, these payments totaled at least $173,000. Neither Con-way nor Menlo Forwarding requested or received any records of these payments, or any of Emery Transnational’s expenses, during this period.”
The Cease and Desist Order further in part alleges:
1. Con-way’s books, records, and accounts did not properly reflect the illicit payments made by Emery Transnational to Philippine customs officials and to officials of majority state-owned airlines, and that as a result, Con-way violated Exchange Act Section 13(b)(2)(A). The FCPA, enacted in 1977, added Exchange Act Section 13(b)(2)(A) to require public companies to make and keep books, records and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer, and added Exchange Act Section 13(b)(2)(B) to require such companies to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: (i) transactions are executed in accordance with management’s general or specific authorization; and (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and to maintain accountability for assets. 15 U.S.C. §§ 78m(b)(2)(A) and 78m(b)(2)(B).
2. Con-way also failed to devise or maintain sufficient internal controls to ensure that Emery Transnational complied with the FCPA and to ensure that the payments it made to foreign officials were accurately reflected on its books and records. As a result, Con-way violated Exchange Act Section 13(b)(2)(B).
3. Exchange Act Section 13(b)(5), 15 U.S.C. § 78m(b)(5), prohibits any person or company from knowingly circumventing or knowingly failing to implement a system of internal accounting controls as described in Section 13(b)(2)(B), or knowingly falsifying any book, record, or account as described in Section 13(b)(2)(A). By knowingly failing to implement a system of internal accounting controls concerning Emery Transnational, Con-way also violated Exchange Act Section 13(b)(5).
* * * * *
Dave Tate, Esq.
http://davidtate.us/ ; tateatty@yahoo.com
Summary
On August 27, 2008 the SEC entered a Cease and Desist Order ("Order") against Con-way, Inc. ("Con-way") (Securities Exchange Act of 1934 Release No. 58433). Con-way consented to the entry of the Order without admitting or denying the findings, except as to the SEC’s jurisdiction over it and the subject matter of the proceedings. The findings, although not admitted and rather sparse on detail, nevertheless provide insight, lessons and missed opportunities. This discussion is organized in the following order: Summary; Comments, Lessons Learned and Missed Opportunities; and Details of the Cease and Desist Order.
In pertinent part, the Order alleges that Con-way is a public company, listed on the New York Stock Exchange. Menlo Worldwide Forwarding, Inc. was a wholly-owned U.S-based subsidiary of Con-way that Con-way purchased in 1989. During the relevant period, Menlo Forwarding had a 55% voting interest in Emery Transnational ("Emery"). As alleged by the SEC, “this matter involves Con-way’s violations of the books and records, and internal controls provisions of the Foreign Corrupt Practices Act (“FCPA”) through a Philippine-based firm, Emery Transnational. From 2000 to 2003, Emery Transnational made hundreds of small payments totaling at least $417,000 to Philippine customs officials and to officials of numerous majority foreign state-owned airlines. These payments were made with the purpose and effect of improperly influencing these foreign officials to assist Emery Transnational to obtain or retain business. In connection with these improper payments, Con-way failed to accurately record these payments on the company’s books and records, and knowingly failed to implement or maintain a system of effective internal accounting controls.”
Comments, Lessons Learned and Missed Opportunities
1. As alleged, the payments in question, although numerous, appear individually not to be material in amount. From the information provided it is not possible to determine whether the amounts would be material in total. Of course, materiality can be quantitative and qualitative in nature. An unlawful act can be material qualitatively, even if it is not material quantitatively. Quantitative materiality also may depend on whether it is viewed from the perspective of Con-way or from the perspective of Emery. In light of the disparity in size between Con-way and Emery, the transactional occurrences at Emery may have simply fallen under the radar screen.
2. Nevertheless, illegal payments are unlawful, and internal controls are required, even at subsidiaries. Thus, the SEC alleges that Con-way knowingly failed to implement or maintain a system of effective internal accounting controls. Without additional background information, such a conclusion appears harsh. “Knowing” failure to implement effective controls may imply intentional wrongdoing. The factual allegations do not support an inference of intentional wrongdoing. However, companies, officers, internal auditors, boards and audit committees should take note that lack of attention to internal controls may prompt an allegation of “knowing” failure to implement.
3. The outside auditor was required to evaluate internal controls for the purpose of performing its annual audit of Con-way‘s consolidated financial statements. Additionally, Statement on Auditing Standards (SAS) 99 required the auditor to consider the risks of fraud and related programs and controls, and Statement on Auditing Standards 54 required the communication of information pertaining to unlawful acts. Although new Auditing Standards 109, 112, and 114 had not yet been enacted during the relevant period in question, SAS 60 (communicating internal control related matters) and SAS 61 (auditor’s communications) were applicable. Additionally, Sarbanes-Oxley §404 (management’s assessment of internal controls) and §302 (chief executive and chief financial officer financial statement certification) were applicable during part of the period in question. The SEC missed an opportunity to evaluate and comment on how this situation did not come to the attention of the outside auditor. Alternatively, if the situation did come to the attention of the outside auditor, the SEC missed an opportunity to comment about how it could or should have been handled differently. The Order does not provide information from the outside auditor perspective. Even if the Order is limited to a cease and desist against Con-way, more detailed discussion about the other participants, as dicta, would help other companies, officers, outside auditors, inside auditors, boards and audit committees learn from the situation.
4. The Order does not discuss or provide information from the Con-way audit committee perspective. Such a discussion might have been helpful for other audit committees, especially with respect to governance. The audit committee is required to oversee internal controls. See, e.g., NYSE Listed Company Manual §303A.07 (audit committee composition, and additional audit committee requirements), Sarbanes-Oxley §301 (public company audit committee requirements), and Sarbanes-Oxley §407 (disclosure of audit committee financial expert). Management and the audit committee, and the outside auditor and the audit committee are also required to communicate regarding internal controls.
5. The Order also does not discuss or provide information from the internal audit perspective. New York Stock Exchange Listed Company Manual §303A.07 requires each listed company to have an internal audit function. Curiously, NASDAQ does not have such a requirement. Working with the audit committee, and with management, it may have been possible to use internal audit to evaluate and report on subsidiary internal controls and payments. A discussion in the Order about how internal audit was or was not used might have been helpful from a governance learning perspective.
These are my initial thoughts that readily come to mind. I am sure that other people will have other thoughts. What are your opinions about the events and circumstances leading to the Cease and Desist Order, and the Order itself? Please feel free to drop me an email. See below for additional detail about the Cease and Desist Order.
Regards,
Dave Tate
Details of the Cease and Desist Order
The Cease and Desist Order in part alleges:
“During the relevant period, Con-way and Menlo Forwarding engaged in little supervision or oversight over Emery Transnational. Neither Con-way nor Menlo Forwarding took steps to devise or maintain internal accounting controls concerning Emery Transnational, to ensure that it acted in accordance with Con-way’s FCPA [Foreign Corrupt Practices Act] policies, or to make certain that its books and records were detailed or accurate.
During the relevant period, Con-way and Menlo Forwarding required only that Emery Transnational periodically report back to Menlo Forwarding its net profits, from which Emery Transnational then paid Menlo Forwarding a yearly 55% dividend. Menlo Forwarding incorporated the yearly 55% dividend into its financial results, which were then consolidated in Con-way’s financial statements. Neither Con-way nor Menlo Forwarding asked for or received any other financial information from Emery Transnational. Accordingly, neither Con-way nor Menlo Forwarding maintained or reviewed any of the books and records of Emery Transnational – including the records of operating expenses, which should have reflected the illicit payments made to foreign officials.
Emery Transnational made hundreds of small payments to foreign officials at the Philippines Bureau of Customs and the Philippine Economic Zone Area between 2000 and 2003 in order to obtain or retain business. These payments were made to influence the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. By these payments, foreign officials were induced to: (i) violate customs regulations by allowing Emery Transnational to store shipments longer than otherwise permitted, thus saving the company transportation costs related to its inbound shipments; and (ii) improperly settle Emery Transnational’s disputes with the Philippines Bureau of Customs, or to reduce or not enforce otherwise legitimate fines for administrative violations.
To generate funding for these payments, Emery Transnational employees submitted a Shipment Processing and Clearance Expense Report (“SPACER”) to Emery Transnational’s finance department. These SPACER reports requested cash advances to complete customs processing. The cash advances were then issued via checks made payable to Emery Transnational employees, who cashed the checks and paid the money to designated foreign officials. Unlike legitimate customs payments, the payments at issue were not supported by receipts from the Philippines Bureau of Customs and the Philippine Economic Zone Area. Emery Transnational did not identify the true nature of these payments in its books and records. During the period 2000 to 2003, these payments total at least $244,000.
Emery Transnational, in order to obtain or retain business, also made numerous payments to foreign officials at fourteen state-owned airlines that did business in the Philippines between 2000 and 2003. (Footnote omitted). These payments were made with the intent of improperly influencing the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. Emery Transnational made two types of payments. The first type were known as “weight shipped” payments, which were made to induce airline officials to improperly reserve space for Emery Transnational on the airplanes. These payments were valued based on the volume of the shipments the airlines carried for Emery Transnational. The second type were known as “gain shares” payments, which were paid to induce airline officials to falsely under-weigh shipments and to consolidate multiple shipments into a single shipment, resulting in lower shipping charges. Emery Transnational paid the foreign officials 90% of the reduced shipping costs.
Both types of payments to foreign airline officials were paid in cash by members of Emery Transnational’s management team. Checks reflecting the amount of the “weight shipped” and “gain shares” payments were issued to these managers, who cashed the checks and personally distributed the cash payments to the foreign airline officials. Emery Transnational did not characterize these payments in its books and records as bribes. During the period 2000 to 2003, these payments totaled at least $173,000. Neither Con-way nor Menlo Forwarding requested or received any records of these payments, or any of Emery Transnational’s expenses, during this period.”
The Cease and Desist Order further in part alleges:
1. Con-way’s books, records, and accounts did not properly reflect the illicit payments made by Emery Transnational to Philippine customs officials and to officials of majority state-owned airlines, and that as a result, Con-way violated Exchange Act Section 13(b)(2)(A). The FCPA, enacted in 1977, added Exchange Act Section 13(b)(2)(A) to require public companies to make and keep books, records and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer, and added Exchange Act Section 13(b)(2)(B) to require such companies to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: (i) transactions are executed in accordance with management’s general or specific authorization; and (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and to maintain accountability for assets. 15 U.S.C. §§ 78m(b)(2)(A) and 78m(b)(2)(B).
2. Con-way also failed to devise or maintain sufficient internal controls to ensure that Emery Transnational complied with the FCPA and to ensure that the payments it made to foreign officials were accurately reflected on its books and records. As a result, Con-way violated Exchange Act Section 13(b)(2)(B).
3. Exchange Act Section 13(b)(5), 15 U.S.C. § 78m(b)(5), prohibits any person or company from knowingly circumventing or knowingly failing to implement a system of internal accounting controls as described in Section 13(b)(2)(B), or knowingly falsifying any book, record, or account as described in Section 13(b)(2)(A). By knowingly failing to implement a system of internal accounting controls concerning Emery Transnational, Con-way also violated Exchange Act Section 13(b)(5).
* * * * *
Saturday, August 30, 2008
Climate Change Disclosures
An interesting recent discussion about climate change disclosures from the dandodiary, What's Next: Climate Change Financial Risk Disclosure . Review my earlier blogs for additional discussions.
Thursday, August 7, 2008
IRS allows reformation of CRT in accord with trustor's intent
The IRS has issued a private ruling that allows a charitable remainder unitrust to be reformed in accordance with the trustor's intent following a court order. The ruling conforms with California law which also holds that a trust should be administered in accord with the trustor's intent.
Full Text:
Third Party Communication: NoneDate of Communication: Not ApplicablePerson To Contact: * * *, ID No. * * *Telephone Number: * * *Index Number: 664.03-02Release Date: 8/1/2008
Date: May 1, 2008
Refer Reply To: CC:PSI:B01 - PLR-100818-08LEGEND:Trust = * * *Trustee = * * *A = * * *D1 = * * *D2 = * * *State = * * *n = * * *Court = * * *Dear * * *:
This letter responds to a letter dated December 21, 2007, and subsequent correspondence, submitted on behalf of Trustee, requesting a ruling that the reformation of Trust, as described below, will not cause Trust to fail to meet the requirements of § 664(d)(2) of the Internal Revenue Code.
FACTS. The information submitted states that A created Trust on D1 under the laws of State. A created Trust with the intention that Trust qualify as a charitable remainder unitrust (CRUT) under § 664(d)(2). Trustee is the trustee and charitable remainder beneficiary of Trust. Trustee and A represent that A's intention upon establishing Trust was that the term of Trust would extend until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A, with payments during that term being made to A, then to A's spouse if surviving, then to A's issue by right of representation. The original Trust agreement provides that the unitrust amount is payable to A until A's death, and thereafter, to A's spouse until the death of A's spouse.
A and Trustee arranged the terms of Trust in a series of telephone conversations. A was assisted by certain family members, but no professional tax advisor assisted A with the creation of Trust. Trustee and A represent that several months after signing the Trust agreement, but within the same taxable year of the donation, they discovered that Trust did not accurately express A's intent as to the term of the payments and the ability of A's children to receive payments after the death of A and A's spouse.
Because of the error, and because Trust is irrevocable, Trustee sought an order from Court authorizing a reformation ab initio of Trust. No parties objected to the proposed reformation. On D2, Court issued a judgment approving the reformation of Trust, ab initio, to reflect A's intention as described above. The reformed Trust agreement provides that the term of Trust extends until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A. The reformed Trust agreement further provides that payments during Trust's term will be made to A, then to A's spouse if surviving, then to A's issue by right of representation. The judgment states that Court finds by clear and convincing evidence that, due to mistakes in the expression of A's intent, Trust failed to accurately implement A's intent. The judgment is contingent on receipt of a favorable private letter ruling from the Internal Revenue Service. State law permits the reformation of a trust to conform to the settlor's intent.
Trustee and A represent that they have not filed any income tax returns or other documents, taken any other action or received any payments inconsistent with Trust, including the proposed changes. A, A's spouse, Trustee, and the attorney general of State all consent to the reformation of Trust.
LAW AND ANALYSIS. Section 664(d)(2) provides that for purposes of § 664, a charitable remainder unitrust is a trust (A) for which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid not less often than annually, to one or more persons (at least one of which is not an organization described in § 170(c) and, in the case if individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals, (B) from which no amount other than the payments described in § 664(d)(2)(A) may be paid to or for the use of any person other than an organization described in § 170(c), (C) following termination of the payments described in § 664(d)(2)(A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in § 170(c) or is to be retained by the trust for such a use, and (D) with respect to each contribution of property to the trust, the value (determined under § 7520) of such remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date such property is contributed to the trust.
Section 1.664-3(a)(3)(ii) of the Income Tax Regulations provides that a trust is not a charitable remainder unitrust if any person has the power to alter the amount to be paid to any named person other than an organization described in § 170(c) if such power would cause any person to be treated as the owner of the trust, or any portion thereof, if Subpart E, Part 1, Subchapter J, Chapter 1, Subtitle A of the Code were applicable to such trust.
Section 1.664-3(a)(4) provides that a charitable remainder unitrust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in § 170(c).
CONCLUSION. Based solely on the information submitted and the representations made, we conclude that the judicial reformation of Trust, ab initio, does not violate § 664. Accordingly, we conclude that the judicial reformation, ab initio, of Trust does not adversely affect Trust's qualification as a charitable remainder unitrust under § 664(d)(2).
Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether Trust is or was a charitable remainder unitrust within the meaning of § 664(d)(2).
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that it may not be used or cited as precedent.
In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to Trust's authorized representative.
Sincerely,Audrey EllisSenior Counsel, Branch 1(Passthroughs & SpecialIndustries)Enclosure (1)Copy of letter for § 6110 purposescc: * * *
Full Text:
Third Party Communication: NoneDate of Communication: Not ApplicablePerson To Contact: * * *, ID No. * * *Telephone Number: * * *Index Number: 664.03-02Release Date: 8/1/2008
Date: May 1, 2008
Refer Reply To: CC:PSI:B01 - PLR-100818-08LEGEND:Trust = * * *Trustee = * * *A = * * *D1 = * * *D2 = * * *State = * * *n = * * *Court = * * *Dear * * *:
This letter responds to a letter dated December 21, 2007, and subsequent correspondence, submitted on behalf of Trustee, requesting a ruling that the reformation of Trust, as described below, will not cause Trust to fail to meet the requirements of § 664(d)(2) of the Internal Revenue Code.
FACTS. The information submitted states that A created Trust on D1 under the laws of State. A created Trust with the intention that Trust qualify as a charitable remainder unitrust (CRUT) under § 664(d)(2). Trustee is the trustee and charitable remainder beneficiary of Trust. Trustee and A represent that A's intention upon establishing Trust was that the term of Trust would extend until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A, with payments during that term being made to A, then to A's spouse if surviving, then to A's issue by right of representation. The original Trust agreement provides that the unitrust amount is payable to A until A's death, and thereafter, to A's spouse until the death of A's spouse.
A and Trustee arranged the terms of Trust in a series of telephone conversations. A was assisted by certain family members, but no professional tax advisor assisted A with the creation of Trust. Trustee and A represent that several months after signing the Trust agreement, but within the same taxable year of the donation, they discovered that Trust did not accurately express A's intent as to the term of the payments and the ability of A's children to receive payments after the death of A and A's spouse.
Because of the error, and because Trust is irrevocable, Trustee sought an order from Court authorizing a reformation ab initio of Trust. No parties objected to the proposed reformation. On D2, Court issued a judgment approving the reformation of Trust, ab initio, to reflect A's intention as described above. The reformed Trust agreement provides that the term of Trust extends until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A. The reformed Trust agreement further provides that payments during Trust's term will be made to A, then to A's spouse if surviving, then to A's issue by right of representation. The judgment states that Court finds by clear and convincing evidence that, due to mistakes in the expression of A's intent, Trust failed to accurately implement A's intent. The judgment is contingent on receipt of a favorable private letter ruling from the Internal Revenue Service. State law permits the reformation of a trust to conform to the settlor's intent.
Trustee and A represent that they have not filed any income tax returns or other documents, taken any other action or received any payments inconsistent with Trust, including the proposed changes. A, A's spouse, Trustee, and the attorney general of State all consent to the reformation of Trust.
LAW AND ANALYSIS. Section 664(d)(2) provides that for purposes of § 664, a charitable remainder unitrust is a trust (A) for which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid not less often than annually, to one or more persons (at least one of which is not an organization described in § 170(c) and, in the case if individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals, (B) from which no amount other than the payments described in § 664(d)(2)(A) may be paid to or for the use of any person other than an organization described in § 170(c), (C) following termination of the payments described in § 664(d)(2)(A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in § 170(c) or is to be retained by the trust for such a use, and (D) with respect to each contribution of property to the trust, the value (determined under § 7520) of such remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date such property is contributed to the trust.
Section 1.664-3(a)(3)(ii) of the Income Tax Regulations provides that a trust is not a charitable remainder unitrust if any person has the power to alter the amount to be paid to any named person other than an organization described in § 170(c) if such power would cause any person to be treated as the owner of the trust, or any portion thereof, if Subpart E, Part 1, Subchapter J, Chapter 1, Subtitle A of the Code were applicable to such trust.
Section 1.664-3(a)(4) provides that a charitable remainder unitrust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in § 170(c).
CONCLUSION. Based solely on the information submitted and the representations made, we conclude that the judicial reformation of Trust, ab initio, does not violate § 664. Accordingly, we conclude that the judicial reformation, ab initio, of Trust does not adversely affect Trust's qualification as a charitable remainder unitrust under § 664(d)(2).
Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether Trust is or was a charitable remainder unitrust within the meaning of § 664(d)(2).
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that it may not be used or cited as precedent.
In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to Trust's authorized representative.
Sincerely,Audrey EllisSenior Counsel, Branch 1(Passthroughs & SpecialIndustries)Enclosure (1)Copy of letter for § 6110 purposescc: * * *
Sunday, June 8, 2008
Audit Committee, CEO, CFO, Internal Audit, Outside Auditor Hypothetical
Audit Committee, CEO, CFO, Internal Audit, Outside Auditor Hypothetical:
The following is a hypothetical based at least in part on a real occurrence. How do you believe the various parties should handle the situation?
1. The internal auditor and the CEO disagree about whether an item should be booked currently, or left as an unadjusted error and booked over time.
2. If the item is not currently booked, the current unadjusted amount would be a material.
3. One option is to book the unadjusted error amount now.
4. Is it relevant that it is believed that competing companies will not be booking their amounts
for similar items?
5. Another option is to not currently book the amount, but to leave the current amount as an unadjusted error--although the unadjusted item is currently material, the unadjusted error will be booked over time such that by the time that a financial report is to be issued to the shareholders the remaining unadjusted error will have been reduced to an amount that is not material. This this additional information influence your belief as to how the situation should be handled?
6. What if the CEO believes that the unadjusted error should be currently booked, and internal audit believes otherwise? What if the CEO believes that the unadjusted error should not be currently booked, and the internal auditor believes otherwise?
7. What if in the hypothetical it is not internal audit, but the CFO (i.e., you exchange the CFO for internal audit)?
8. What if the outside auditor believes that the amount should be currently booked? What if the outside auditor does not believe that the amount should be currently booked? Does that change the discussion?
9. What if whether or not the amount is booked, no financial report is currently due to the shareholders but a financial report still must be currently filed with the regulators?
10. The issue is brought to the attention of the audit committee. What does the audit committee do?
11. What if internal audit or the CFO had contacted the outside auditor to discuss the issue of the adjustment, and now management is also working on adding structure including protocols for when internal audit or the CFO can access outside resources such as the outside auditor? How should protocols be determined? What if protocols are suggested for contact with the audit committee?
12. How do you handle friction that may have developed between the CEO, internal audit, the CFO, the audit committee, and the outside auditor?
* * * * *
The following is a hypothetical based at least in part on a real occurrence. How do you believe the various parties should handle the situation?
1. The internal auditor and the CEO disagree about whether an item should be booked currently, or left as an unadjusted error and booked over time.
2. If the item is not currently booked, the current unadjusted amount would be a material.
3. One option is to book the unadjusted error amount now.
4. Is it relevant that it is believed that competing companies will not be booking their amounts
for similar items?
5. Another option is to not currently book the amount, but to leave the current amount as an unadjusted error--although the unadjusted item is currently material, the unadjusted error will be booked over time such that by the time that a financial report is to be issued to the shareholders the remaining unadjusted error will have been reduced to an amount that is not material. This this additional information influence your belief as to how the situation should be handled?
6. What if the CEO believes that the unadjusted error should be currently booked, and internal audit believes otherwise? What if the CEO believes that the unadjusted error should not be currently booked, and the internal auditor believes otherwise?
7. What if in the hypothetical it is not internal audit, but the CFO (i.e., you exchange the CFO for internal audit)?
8. What if the outside auditor believes that the amount should be currently booked? What if the outside auditor does not believe that the amount should be currently booked? Does that change the discussion?
9. What if whether or not the amount is booked, no financial report is currently due to the shareholders but a financial report still must be currently filed with the regulators?
10. The issue is brought to the attention of the audit committee. What does the audit committee do?
11. What if internal audit or the CFO had contacted the outside auditor to discuss the issue of the adjustment, and now management is also working on adding structure including protocols for when internal audit or the CFO can access outside resources such as the outside auditor? How should protocols be determined? What if protocols are suggested for contact with the audit committee?
12. How do you handle friction that may have developed between the CEO, internal audit, the CFO, the audit committee, and the outside auditor?
* * * * *
Sunday, May 11, 2008
UTStarcom, Inc., SEC action
The following are links to the complaint, offer of settlement, consent and litigation release in the recent SEC proceeding involving UTStarcom, Inc. A copy of the Cease and Desist Order is posted below, with select noted comments to various authorities which may be relevant to the subject (preceded by the notation "DWT Comment:”). Although determinations in these proceedings often do not constitute adjudications or admissions of fact or wrongdoing, the allegations and resolutions can provide insight and interesting reading for outside and internal auditors, governance and compliance professionals, officers, directors (audit committee members), and legal counsel.
Complaint http://www.sec.gov/litigation/complaints/2008/comp20548.pdf
Offer of Settlement and Consent http://www.sec.gov/litigation/admin/2008/34-57754.pdf
Litigation Release http://www.sec.gov/litigation/litreleases/2008/lr20548.htm
ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934
I.
The Securities and Exchange Commission (“Commission”) deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”), against UTStarcom, Inc. (“UTSI”), Hong Liang Lu (“Lu”) and Michael J. Sophie (“Sophie”) (collectively “Respondents”).
II.
In anticipation of the institution of these proceedings, Respondents have submitted an Offer of Settlement (the “Offer”) which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over them and the subject matter of these proceedings, which are admitted, Respondents consent to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 (“Order”), as set forth below.
III.
On the basis of this Order and Respondents’ Offer, the Commission finds that:
Summary
1. This matter involves recurring internal control deficiencies and inaccurate financial filings by UTSI, a publicly-traded telecommunications company that has restated its financial statements three times since 2005 to correct multiple accounting irregularities. Since 2000, UTSI has improperly recognized revenue on transactions subject to undisclosed side agreements, failed to properly disclose and account for related party transactions, and failed to properly record compensation expenses related to employee stock options. Despite being put on notice of potential accounting issues by, among other things, material weakness letters sent by the company’s outside auditors, CEO Hong Liang Lu and former CFO Michael J. Sophie failed to implement and maintain adequate internal controls and falsely certified that UTSI’s financial statements and books and records were accurate.
Respondents
UTSI, a Delaware corporation with headquarters in Alameda, California, is a telecommunications company that sells software and hardware products in emerging and established telecommunications markets around the world. The majority of UTSI’s operations are in Hangzhou, China and overseas. UTSI went public in 2000, and its common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and trades on the NASDAQ Global Select Market under the symbol UTSI.
Lu, 53, is a co-founder of UTSI and has served as a board member and Chief Executive Officer since 1995. Lu resides in San Ramon, California and Hangzhou, China.
Sophie, 50, was UTSI’s Chief Financial Officer from 2000 through August 2005 and UTSI’s Chief Operating Officer from June 2005 through May 2006. Sophie resides in Pleasanton, California.
DWT Comment: NASDAQ listed companies are not required to have internal audit functions. NYSE listed companies are required to have internal audit functions (Listed Company Manual §303A.07).
Facts
Background
Historically, China has been UTSI’s largest market. Between 1995 and 2002, nearly all of UTSI’s revenue derived from sales by UTSI’s subsidiary in China (“UT-China”). By late 2002, UTSI’s business plan was expanded to include growth on an international scale. UTSI defines “international” sales as all sales outside of China, including sales in the U.S., Japan, India, and other overseas markets. In 2003 and 2004, sales in China accounted for 86% and 79% of UTSI’s revenue, respectively. By 2006, sales in China accounted for 32% of UTSI’s revenue. The finance department at UT-China handled the accounting for all transactions in China, and UTSI’s finance department in the U.S. handled the accounting for all international transactions.
6. In March 2003, UTSI received a Management Recommendation letter from its auditors detailing internal control weaknesses identified during the December 31, 2002 year-end audit. The letter was addressed to the audit committee and copied to Lu and Sophie. Among other things, the letter specifically noted that UTSI should “strengthen procedures to ensure side letters and contract amendments are communicated and accounted for in a timely manner.” In its written response to the auditor’s letter, UTSI said it had implemented the necessary controls to track and monitor side letters and non-routine transactions. UTSI sometimes used letter agreements, or side letters, to supplement or amend contractual terms. Such letters were allowed so long as the accounting for them was done properly.
7. UTSI received another Management Recommendation letter from its auditors in April 2004 detailing multiple internal control weaknesses (many classified as material) identified during the December 31, 2003 year-end audit. The letter was copied to Lu and Sophie, and again noted concerns about the use of side letters that were not forwarded to the finance department. The auditors also expressed concerns with many complex related-party transactions entered into by UTSI. The auditors informed UTSI that the company did not adequately disclose significant transactions involving joint venture arrangements between UTSI and its customers. In its written response, UTSI said it had strengthened controls to identify side letters and implemented monitoring procedures to identify significant joint venture transactions.
8. UTSI also received management recommendation letters from its auditors noting multiple material weaknesses in connection with the 2004 and 2005 year-end audits.
DWT Comment: alleged management recommendation letters for 2002, 2003, 2004 and 2005, some of which noted ongoing internal control weaknesses relating to side agreements, contract amendments and related party transactions not being communicated or recorded. Although NASDAQ listed company rules do require the audit committee to have a written charter, there are no specific duties that are enumerated with respect to internal controls. NASDAQ Marketplace Rule 4350(d)(3) in part does require the audit committee to have responsibility for complaints relating to internal accounting controls. Auditing pronouncements applicable to the outside auditor also would be relevant, including the outside auditor's evaluation of internal controls for the purpose of performing the following year audit, and evaluation to determine whether the company had in fact corrected prior year issues.
UTSI Prematurely Recognized Revenue From International Sales Subject To Undisclosed Side Agreements
9. Between 2003 and 2005, UTSI prematurely recognized nearly $50 million in net revenue from international sales, all of which occurred outside the U.S., which were subject to side agreements that had been concealed from the company’s finance personnel. Because these agreements promised future performance by UTSI, revenue should not have been recognized under Generally Accepted Accounting Principles (“GAAP”).
10. Among other contingent transactions, UTSI improperly recognized revenue from the sale of a $22 million network system to a purchaser in India. At the time of the sale, securities analysts had expressed concerns about UTSI’s ability to enter markets outside China, and Lu specifically highlighted this deal as indicative of UTSI’s success in gaining traction in India.
11. UTSI delivered the system and recognized revenue from the $22 million sale in phases over several quarters, including the second quarter of 2004 and the second quarter of 2005. Before recognizing the revenue, UTSI’s finance department required the purchaser to sign a final acceptance certificate certifying that all elements of the phase had been delivered and successfully installed.
12. During the second quarter of 2004, the purchaser sent UTSI the final acceptance certificate, but included a proposed side agreement requiring UTSI to upgrade the system after the end of the quarter. Lu and Sophie were aware of the proposed side agreement. UTSI’s revenue recognition manager, with the knowledge of Lu and Sophie, specifically admonished that approving the side agreement would prevent revenue recognition. Lu personally communicated with the customer to request that they accept the products without a side agreement.
13. Notwithstanding these directions, a UTSI sales executive signed a side agreement with the purchaser, but failed to adequately disclose the agreement to finance personnel, resulting in the improper recognition of revenue by the company. Lu and Sophie failed to take adequate steps to determine how the customer’s request for a side agreement had been resolved and whether revenue recognition was appropriate.
14. During the second quarter of 2005, UTSI recognized additional revenue from the India sale. Once again, a UTSI sales executive had signed a side letter making the customer’s acceptance contingent on future upgrades (and thus rendering revenue recognition improper under GAAP). Lu and Sophie were aware the customer had made such a request, but received a communication from finance personnel that the final acceptance certificates received from the customer were acceptable. Neither Lu nor Sophie took steps to determine how the issue was resolved and whether revenue was properly recognized.
15. In addition to the India transaction, UTSI entered into five other international sales transactions totaling $27.5 million in net revenue where side agreements had been entered into promising future products or services. These side agreements should have precluded revenue recognition. On June 26, 2006, UTSI restated its financial statements for the period between Q1 2003 through Q3 2005, reversing $49.5 million in net revenue that had been improperly recognized by the company.
UTSI Prematurely Recognized Revenue On Sales In China With Undisclosed Contract Modifications
16. Between 2000 and 2005, UTSI prematurely recognized over $350 million in revenue from 78 sales transactions in China. On some occasions, UTSI sales personnel entered into contracts that contained non-standard product upgrade provisions precluding revenue recognition. In some instances, sales personnel documented the sales on two separate contracts, and only the company’s standard contract (without the upgrade provisions) was made available to UTSI’s finance personnel. As a result, UTSI repeatedly recognized revenue for contingent sales in violation of GAAP.
17. Lu and Sophie had been on notice since at least 2003 of significant internal control weaknesses in China, including the fact that in some instances side letters and contract amendments introducing revenue contingencies were not forwarded by sales offices to the contract and finance departments. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper dual contract practices and failed to prevent certain improprieties.
18. On October 10, 2007, UTSI restated its financial statements from 2000 through the second quarter of 2006 to reverse $271 million in net revenue improperly recognized by the company.
UTSI Failed to Disclose and Properly Account for Related Party Transactions
19. In 2001, a China-based company called MDC was formed in order to provide value-added services to UTSI products. The father of UT-China’s Executive Vice President founded MDC; the UT-China executive served as the “alternate” chairman of MDC’s board of directors. Numerous officers and other employees of UT-China invested in MDC, and certain UT-China employees worked for MDC while their salaries were paid by UT-China.
20. In 2003, UT-China entered into a complex transaction involving MDC and another customer in China, whereby MDC took ownership of UTSI inventory that had decreased in value. Because UTSI failed properly to treat MDC as a consolidated entity, no impairment of the inventory value was recorded by UTSI at the time.
21. Lu and Sophie had been on notice of concerns raised by the company’s auditors about UTSI’s failure to adequately disclose related party transactions entered into by UTSI. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper transaction with MDC and failed to prevent inaccurate reporting of certain related party transactions.
22. On April 13, 2005, UTSI restated its 2003 financial statements in part to consolidate MDC, as MDC was deemed a related party controlled by UTSI. The restatement resulted in the write down of $7.5 million in UTSI inventory held by MDC.
UTSI Failed Properly to Account for Stock Compensation Expenses
23. UTSI failed properly to account for certain stock option grants because the company used incorrect grant dates for determining compensation expenses. Under GAAP, UTSI was required to record an expense on its financial statements for any stock options granted “in-the-money” – i.e. where the exercise price of the option was less than the market price for the security on the date the option was granted.
24. Certain grants to UTSI officers were backdated or accounted for with incorrect grant dates prior to the proper authorization of the grant by the company’s Compensation Committee. This resulted in an exercise price below market price on the date of the grant, yet no expense was recorded by the company.
25. UTSI failed to establish and implement adequate internal controls for the granting of employee stock options. Among other things, UTSI failed to maintain necessary documentation showing when the grants were actually authorized by the Compensation Committee.
26. On October 10, 2007, UTSI restated its financial statements from 1998 through the second quarter of 2006 to recognize an additional $27 million in compensation expenses related to employee stock options.
Respondents Lu And Sophie Signed False Certifications Under Section 302 Of The Sarbanes-Oxley Act
27. Lu and Sophie, as UTSI’s CEO and CFO, were required to sign certifications each fiscal quarter and fiscal year stating that, based on their knowledge, the company’s quarterly and annual reports did not contain any misstatements or omit material information, that the reports disclosed all significant deficiencies in the design or operation of UTSI’s internal controls, and that the reports fairly presented in all material respects UTSI’s financial condition and results of operations. Lu executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2006, and Sophie executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2005. For the reasons set forth above, these certifications were false.
Violations
28. As a result of the conduct described above, UTSI violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder by filing inaccurate periodic reports with the Commission, by failing to make and keep accurate books and records, and by failing to devise and maintain an adequate system of internal accounting controls. The company filed inaccurate periodic reports and failed to keep accurate books and records because the company improperly recorded revenue for transactions that involved side agreements with revenue contingencies and failed properly to account for related-party transactions and stock compensation expenses. In addition, UTSI failed to devise and maintain an effective system of internal controls relating to side agreements, related parties and stock option practices.
29. As a result of the conduct described above, Lu and Sophie caused UTSI’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder insofar as they did not take steps adequate to ensure that UTSI filed accurate financial statements, made and kept accurate books and records, and implemented and maintained adequate internal controls. Also as a result of the conduct described above, Lu and Sophie violated Exchange Act Rule 13a-14 by falsely certifying that UTSI’s periodic filings did not contain any material misstatements or omissions, disclosed all significant deficiencies in UTSI’s internal controls, and fairly presented UTSI’s financial condition and results of operations.
UTSI’s Remedial Efforts
In determining to accept the Offer, the Commission considered remedial acts undertaken by UTSI.
IV.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondents’ Offer.
Accordingly, it is hereby ORDERED that:
A. Respondent UTSI cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder;
B. Respondent Lu cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder; and
C. Respondent Sophie cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder.
By the Commission.
DWT Comment: the SEC requires the company to agree to stop doing the alleged activities.
Complaint http://www.sec.gov/litigation/complaints/2008/comp20548.pdf
Offer of Settlement and Consent http://www.sec.gov/litigation/admin/2008/34-57754.pdf
Litigation Release http://www.sec.gov/litigation/litreleases/2008/lr20548.htm
ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934
I.
The Securities and Exchange Commission (“Commission”) deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”), against UTStarcom, Inc. (“UTSI”), Hong Liang Lu (“Lu”) and Michael J. Sophie (“Sophie”) (collectively “Respondents”).
II.
In anticipation of the institution of these proceedings, Respondents have submitted an Offer of Settlement (the “Offer”) which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over them and the subject matter of these proceedings, which are admitted, Respondents consent to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 (“Order”), as set forth below.
III.
On the basis of this Order and Respondents’ Offer, the Commission finds that:
Summary
1. This matter involves recurring internal control deficiencies and inaccurate financial filings by UTSI, a publicly-traded telecommunications company that has restated its financial statements three times since 2005 to correct multiple accounting irregularities. Since 2000, UTSI has improperly recognized revenue on transactions subject to undisclosed side agreements, failed to properly disclose and account for related party transactions, and failed to properly record compensation expenses related to employee stock options. Despite being put on notice of potential accounting issues by, among other things, material weakness letters sent by the company’s outside auditors, CEO Hong Liang Lu and former CFO Michael J. Sophie failed to implement and maintain adequate internal controls and falsely certified that UTSI’s financial statements and books and records were accurate.
Respondents
UTSI, a Delaware corporation with headquarters in Alameda, California, is a telecommunications company that sells software and hardware products in emerging and established telecommunications markets around the world. The majority of UTSI’s operations are in Hangzhou, China and overseas. UTSI went public in 2000, and its common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and trades on the NASDAQ Global Select Market under the symbol UTSI.
Lu, 53, is a co-founder of UTSI and has served as a board member and Chief Executive Officer since 1995. Lu resides in San Ramon, California and Hangzhou, China.
Sophie, 50, was UTSI’s Chief Financial Officer from 2000 through August 2005 and UTSI’s Chief Operating Officer from June 2005 through May 2006. Sophie resides in Pleasanton, California.
DWT Comment: NASDAQ listed companies are not required to have internal audit functions. NYSE listed companies are required to have internal audit functions (Listed Company Manual §303A.07).
Facts
Background
Historically, China has been UTSI’s largest market. Between 1995 and 2002, nearly all of UTSI’s revenue derived from sales by UTSI’s subsidiary in China (“UT-China”). By late 2002, UTSI’s business plan was expanded to include growth on an international scale. UTSI defines “international” sales as all sales outside of China, including sales in the U.S., Japan, India, and other overseas markets. In 2003 and 2004, sales in China accounted for 86% and 79% of UTSI’s revenue, respectively. By 2006, sales in China accounted for 32% of UTSI’s revenue. The finance department at UT-China handled the accounting for all transactions in China, and UTSI’s finance department in the U.S. handled the accounting for all international transactions.
6. In March 2003, UTSI received a Management Recommendation letter from its auditors detailing internal control weaknesses identified during the December 31, 2002 year-end audit. The letter was addressed to the audit committee and copied to Lu and Sophie. Among other things, the letter specifically noted that UTSI should “strengthen procedures to ensure side letters and contract amendments are communicated and accounted for in a timely manner.” In its written response to the auditor’s letter, UTSI said it had implemented the necessary controls to track and monitor side letters and non-routine transactions. UTSI sometimes used letter agreements, or side letters, to supplement or amend contractual terms. Such letters were allowed so long as the accounting for them was done properly.
7. UTSI received another Management Recommendation letter from its auditors in April 2004 detailing multiple internal control weaknesses (many classified as material) identified during the December 31, 2003 year-end audit. The letter was copied to Lu and Sophie, and again noted concerns about the use of side letters that were not forwarded to the finance department. The auditors also expressed concerns with many complex related-party transactions entered into by UTSI. The auditors informed UTSI that the company did not adequately disclose significant transactions involving joint venture arrangements between UTSI and its customers. In its written response, UTSI said it had strengthened controls to identify side letters and implemented monitoring procedures to identify significant joint venture transactions.
8. UTSI also received management recommendation letters from its auditors noting multiple material weaknesses in connection with the 2004 and 2005 year-end audits.
DWT Comment: alleged management recommendation letters for 2002, 2003, 2004 and 2005, some of which noted ongoing internal control weaknesses relating to side agreements, contract amendments and related party transactions not being communicated or recorded. Although NASDAQ listed company rules do require the audit committee to have a written charter, there are no specific duties that are enumerated with respect to internal controls. NASDAQ Marketplace Rule 4350(d)(3) in part does require the audit committee to have responsibility for complaints relating to internal accounting controls. Auditing pronouncements applicable to the outside auditor also would be relevant, including the outside auditor's evaluation of internal controls for the purpose of performing the following year audit, and evaluation to determine whether the company had in fact corrected prior year issues.
UTSI Prematurely Recognized Revenue From International Sales Subject To Undisclosed Side Agreements
9. Between 2003 and 2005, UTSI prematurely recognized nearly $50 million in net revenue from international sales, all of which occurred outside the U.S., which were subject to side agreements that had been concealed from the company’s finance personnel. Because these agreements promised future performance by UTSI, revenue should not have been recognized under Generally Accepted Accounting Principles (“GAAP”).
10. Among other contingent transactions, UTSI improperly recognized revenue from the sale of a $22 million network system to a purchaser in India. At the time of the sale, securities analysts had expressed concerns about UTSI’s ability to enter markets outside China, and Lu specifically highlighted this deal as indicative of UTSI’s success in gaining traction in India.
11. UTSI delivered the system and recognized revenue from the $22 million sale in phases over several quarters, including the second quarter of 2004 and the second quarter of 2005. Before recognizing the revenue, UTSI’s finance department required the purchaser to sign a final acceptance certificate certifying that all elements of the phase had been delivered and successfully installed.
12. During the second quarter of 2004, the purchaser sent UTSI the final acceptance certificate, but included a proposed side agreement requiring UTSI to upgrade the system after the end of the quarter. Lu and Sophie were aware of the proposed side agreement. UTSI’s revenue recognition manager, with the knowledge of Lu and Sophie, specifically admonished that approving the side agreement would prevent revenue recognition. Lu personally communicated with the customer to request that they accept the products without a side agreement.
13. Notwithstanding these directions, a UTSI sales executive signed a side agreement with the purchaser, but failed to adequately disclose the agreement to finance personnel, resulting in the improper recognition of revenue by the company. Lu and Sophie failed to take adequate steps to determine how the customer’s request for a side agreement had been resolved and whether revenue recognition was appropriate.
14. During the second quarter of 2005, UTSI recognized additional revenue from the India sale. Once again, a UTSI sales executive had signed a side letter making the customer’s acceptance contingent on future upgrades (and thus rendering revenue recognition improper under GAAP). Lu and Sophie were aware the customer had made such a request, but received a communication from finance personnel that the final acceptance certificates received from the customer were acceptable. Neither Lu nor Sophie took steps to determine how the issue was resolved and whether revenue was properly recognized.
15. In addition to the India transaction, UTSI entered into five other international sales transactions totaling $27.5 million in net revenue where side agreements had been entered into promising future products or services. These side agreements should have precluded revenue recognition. On June 26, 2006, UTSI restated its financial statements for the period between Q1 2003 through Q3 2005, reversing $49.5 million in net revenue that had been improperly recognized by the company.
UTSI Prematurely Recognized Revenue On Sales In China With Undisclosed Contract Modifications
16. Between 2000 and 2005, UTSI prematurely recognized over $350 million in revenue from 78 sales transactions in China. On some occasions, UTSI sales personnel entered into contracts that contained non-standard product upgrade provisions precluding revenue recognition. In some instances, sales personnel documented the sales on two separate contracts, and only the company’s standard contract (without the upgrade provisions) was made available to UTSI’s finance personnel. As a result, UTSI repeatedly recognized revenue for contingent sales in violation of GAAP.
17. Lu and Sophie had been on notice since at least 2003 of significant internal control weaknesses in China, including the fact that in some instances side letters and contract amendments introducing revenue contingencies were not forwarded by sales offices to the contract and finance departments. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper dual contract practices and failed to prevent certain improprieties.
18. On October 10, 2007, UTSI restated its financial statements from 2000 through the second quarter of 2006 to reverse $271 million in net revenue improperly recognized by the company.
UTSI Failed to Disclose and Properly Account for Related Party Transactions
19. In 2001, a China-based company called MDC was formed in order to provide value-added services to UTSI products. The father of UT-China’s Executive Vice President founded MDC; the UT-China executive served as the “alternate” chairman of MDC’s board of directors. Numerous officers and other employees of UT-China invested in MDC, and certain UT-China employees worked for MDC while their salaries were paid by UT-China.
20. In 2003, UT-China entered into a complex transaction involving MDC and another customer in China, whereby MDC took ownership of UTSI inventory that had decreased in value. Because UTSI failed properly to treat MDC as a consolidated entity, no impairment of the inventory value was recorded by UTSI at the time.
21. Lu and Sophie had been on notice of concerns raised by the company’s auditors about UTSI’s failure to adequately disclose related party transactions entered into by UTSI. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper transaction with MDC and failed to prevent inaccurate reporting of certain related party transactions.
22. On April 13, 2005, UTSI restated its 2003 financial statements in part to consolidate MDC, as MDC was deemed a related party controlled by UTSI. The restatement resulted in the write down of $7.5 million in UTSI inventory held by MDC.
UTSI Failed Properly to Account for Stock Compensation Expenses
23. UTSI failed properly to account for certain stock option grants because the company used incorrect grant dates for determining compensation expenses. Under GAAP, UTSI was required to record an expense on its financial statements for any stock options granted “in-the-money” – i.e. where the exercise price of the option was less than the market price for the security on the date the option was granted.
24. Certain grants to UTSI officers were backdated or accounted for with incorrect grant dates prior to the proper authorization of the grant by the company’s Compensation Committee. This resulted in an exercise price below market price on the date of the grant, yet no expense was recorded by the company.
25. UTSI failed to establish and implement adequate internal controls for the granting of employee stock options. Among other things, UTSI failed to maintain necessary documentation showing when the grants were actually authorized by the Compensation Committee.
26. On October 10, 2007, UTSI restated its financial statements from 1998 through the second quarter of 2006 to recognize an additional $27 million in compensation expenses related to employee stock options.
Respondents Lu And Sophie Signed False Certifications Under Section 302 Of The Sarbanes-Oxley Act
27. Lu and Sophie, as UTSI’s CEO and CFO, were required to sign certifications each fiscal quarter and fiscal year stating that, based on their knowledge, the company’s quarterly and annual reports did not contain any misstatements or omit material information, that the reports disclosed all significant deficiencies in the design or operation of UTSI’s internal controls, and that the reports fairly presented in all material respects UTSI’s financial condition and results of operations. Lu executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2006, and Sophie executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2005. For the reasons set forth above, these certifications were false.
Violations
28. As a result of the conduct described above, UTSI violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder by filing inaccurate periodic reports with the Commission, by failing to make and keep accurate books and records, and by failing to devise and maintain an adequate system of internal accounting controls. The company filed inaccurate periodic reports and failed to keep accurate books and records because the company improperly recorded revenue for transactions that involved side agreements with revenue contingencies and failed properly to account for related-party transactions and stock compensation expenses. In addition, UTSI failed to devise and maintain an effective system of internal controls relating to side agreements, related parties and stock option practices.
29. As a result of the conduct described above, Lu and Sophie caused UTSI’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder insofar as they did not take steps adequate to ensure that UTSI filed accurate financial statements, made and kept accurate books and records, and implemented and maintained adequate internal controls. Also as a result of the conduct described above, Lu and Sophie violated Exchange Act Rule 13a-14 by falsely certifying that UTSI’s periodic filings did not contain any material misstatements or omissions, disclosed all significant deficiencies in UTSI’s internal controls, and fairly presented UTSI’s financial condition and results of operations.
UTSI’s Remedial Efforts
In determining to accept the Offer, the Commission considered remedial acts undertaken by UTSI.
IV.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondents’ Offer.
Accordingly, it is hereby ORDERED that:
A. Respondent UTSI cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder;
B. Respondent Lu cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder; and
C. Respondent Sophie cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder.
By the Commission.
DWT Comment: the SEC requires the company to agree to stop doing the alleged activities.
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