The Limestone Cops — Tips on Madoff Red Flags Never Escalated at SEC

It’s hard to believe that with all the resources poured into government following the adoption of Sarbanes Oxley Act in 2002, the escalation process in the SEC failed in the Madoff case. New reports show that junior SEC staff neglected to involve more seasoned enforcement officers and failed to stop what ended up to be a $65 billion Ponzi scheme. See SEC chiefs in dark as Madoff evaded junior staff.

The cost to all the investors has been devastating and the internal escalation process in the agency needs signicant remediation.


Brocade to Pay $7 Million Penalty to Settle Charges for Fraudulent Stock Option Backdating

As reported in an earlier post, the SEC has, indeed, settled backdating claims against issuer Brocade Communications Systems, Inc.

The SEC press release indicates that it filed “a civil action against Brocade Communications Systems, Inc., a San Jose, California computer networking company, for falsifying its reported income from 1999 through 2004. Brocade has agreed to pay a penalty of $7 million to settle the charges that it committed fraud through its former CEO and other former executives who repeatedly granted backdated stock options, misstated compensation expenses, and concealed the conduct by falsifying documents.”

For more see SEC Press Release.

Email Trail Comes Back to Haunt Former Executives: SEC Settles With Mercury Interactive and Sues Former Mercury Officers for Stock Option Backdating and Other Fraudulent Conduct

In an earlier post, it was reported that an allegedly inculpatory email trail between in-house counsel and executives at Mercury Interactive regarding stock options could lead to regulatory or criminal action. That possibility became a reality, as the SEC has announced a settlement stemming from that evidence discovered in the form of email.

In a press release, the Securities and Exchange Commission announced that it “filed civil fraud charges in federal district court for the Northern District of California against California-based software maker Mercury Interactive, LLC (formerly known as Mercury Interactive Corporation) and four former senior officers of Mercury — former Chairman and Chief Executive Officer Amnon Landan, former Chief Financial Officers Sharlene Abrams and Douglas Smith, and former General Counsel Susan Skaer. The SEC alleges that the former senior officers perpetrated a fraudulent and deceptive scheme from 1997 to 2005 to award themselves and other employees undisclosed, secret compensation by backdating stock option grants and failing to record hundreds of millions of dollars of compensation expense. The SEC also alleges that during this period Mercury, through Landan and at times Abrams, Smith or Skaer, backdated stock option exercises, made fraudulent disclosures concerning Mercury’s “backlog” of sales revenues to manage its reported earnings, and structured fraudulent loans for option exercises by overseas employees to avoid recording expenses. Mercury, which was acquired by Hewlett-Packard Company on November 8, 2006, after the alleged misconduct, settled the matter by agreeing to pay a $28 million civil penalty and to be permanently enjoined.”

For more see SEC Press Release and Complaint.

SEC Settles With IBM for Misleading Statements Regarding Stock Option Expenses


Washington, D.C., June 5, 2007 – The Securities and Exchange Commission announced today a settled enforcement action against International Business Machines Corporation for making materially misleading statements in a chart concerning the impact that the company’s decision to expense employee stock options would have on its first quarter 2005 (1Q05) and fiscal year 2005 (FY05) financial results. The misleading chart caused analysts to lower their earnings per share (EPS) estimates for the company.

For more see the SEC’s Press Release.

In KPMG Case, the Thorny Issue of Legal Fees — Dynegy’s Mr. Olis, Now in Prison, Shows Stakes in Trial Of Accounting Firm’s Executives

Wall Street Journal
June 12, 2007

The federal judge overseeing criminal proceedings against 16 former KPMG LLP executives has been wrestling with a thorny issue: how to ensure they get a fair trial given his finding that the government improperly forced the accounting giant to cut off payment of their legal fees.

For a vivid illustration of what’s at stake, consider the case of Jamie Olis, a former executive at Dynegy Inc., who is serving a six-year term at the Bastrop Federal Correctional Institute in Texas.

Pressed by the government, Dynegy cut off Mr. Olis’s legal fees after he was indicted in 2003 on charges that he helped engineer a sham financial transaction at the Houston energy company. Mr. Olis, who sold his house as a result of his legal troubles, says he was outgunned by the federal government’s legal team, which he believes led to his conviction.

Late last month, a jury in a civil court in Texas ruled that Dynegy improperly cut off his defense costs in a bid to avoid a criminal indictment of the energy company. The jury ordered Dynegy to pay Mr. Olis’s attorney, who brought the case, $2.5 million in damages. The company plans to appeal.

For Mr. Olis, 41 years old, the decision was a hollow victory. A former midlevel accountant at Dynegy, Mr. Olis was convicted in November 2003 on fraud and conspiracy charges for helping arrange a $300 million loan disguised to look like normal corporate cash flows. Mr. Olis’s original sentence of 24 years was overturned on appeal, with help from a high-powered legal team. His lawyers won’t say who paid for the appeal, but one expert witness said he testified at no charge. Mr. Olis remains in prison.

Dynegy, like many other companies, had traditionally paid legal fees for employees caught up in company-related investigations. But as part of a broad crackdown on white-collar crime brought on by the collapse of Enron, the government increased pressure on companies to cut off legal support for employees.

The Justice Department has since repudiated that approach, codified in a document that became known as the Thompson memorandum.

Mr. Olis’s criminal defense attorney said the lack of financial resources limited his ability to mount a strong defense. “It would’ve made a difference,” said attorney Terry Yates.

The government, for example, used computer programs to sort through 12 million pages of documents produced as evidence. Mr. Olis couldn’t afford the $100,000 to print the documents. The government had prosecutors, Federal Bureau of Investigation agents, postal inspectors and accounting experts work the case. Mr. Olis found his attorney — part of a three-lawyer practice — after his wife saw a picture of him in the Houston Chronicle getting kissed by a client he had successfully defended.

Don DeGabrielle, the U.S. attorney in Houston, says Mr. Olis had “excellent” legal representation throughout his criminal trial and appeal. “A jury convicted him and an appeals court upheld the conviction,” he says.

A Dynegy spokesman says the company “fully cooperated” with the government and “we believe we satisfied all our obligations to our employees.”

In January 2003, Houston’s then-U.S. Attorney Michael Shelby sent Dynegy’s Chief Executive Bruce Williamson a letter expressing concern the firm’s cooperation in the government probe was “more apparent than real.” Mr. Williamson testified at the civil trial last month that he met with Mr. Shelby the next day and “walked out of there a few pounds lighter,” in a reference to the pressure he felt the government brought to bear on him.

Mr. Shelby then sent a copy of the Thompson memorandum, which at the time detailed factors prosecutors could consider when deciding whether to indict a company rather than individual employees, Mr. Williamson said. Among them: whether a company is paying an employee’s legal fees.

Mr. DeGabrielle, who succeeded Mr. Shelby, said his office “followed appropriate Justice Department policies and procedures at the time.”

Initially, Dynegy said it would pay Mr. Olis’s fees — as called for in its bylaws — even after he was fired in February 2003. But after Mr. Olis was indicted that June, along with two others, the following month Dynegy’s board passed a resolution placing his defense funds into an escrow account.

Before and after his indictment, and even after his conviction, Mr. Olis said federal prosecutors pressured him to accept a plea deal in return for testifying against others at the company. He refused.

“What they wanted was for me to tell the story that I and everyone else engaged in a conspiracy,” Mr. Olis said in testimony from prison during his attorney’s civil trial against the firm seeking his fees. “I couldn’t ruin those people’s lives. I’m Catholic. And I can’t do that.”

Mr. DeGabrielle said Mr. Olis was offered a plea deal before trial and chose to exercise his constitutional right to go to trial.

Two of Mr. Olis’s co-workers accepted the plea deals. His boss received a 15-month sentence; a colleague was sentenced to 30 days. Mr. Olis was convicted in November 2003. His lengthy sentence became a flashpoint for harsh federal sentencing guidelines. “I got a 24-year prison sentence based on a transaction that my bosses told me to work on that I didn’t make a dime off of,” Mr. Olis said at the civil trial brought by his lawyer.

No senior Dynegy executives were ever charged in connection with the financing, which prosecutors said was designed to help bolster the company’s financial results and in turn its share price.

At KPMG, the government held “the proverbial gun” to the firm’s head in forcing it to cut off legal payments for executives caught up in the investigation into the sale of allegedly improper tax shelters, Judge Lewis A. Kaplan ruled last year.

Attorneys for the former KPMG executives have argued that the fees are needed to ensure an adequate defense. Failing that, they argued in filings Friday that the judge should dismiss the charges because it would be impossible to undo the harm wrought by the government’s actions. The U.S. attorney’s office in Manhattan, which is overseeing the KPMG case, declined to comment.

Judge Kaplan allowed the defendants to sue KPMG for the fees, but a federal appeals court overturned his decision. Now, the judge is left weighing extreme choices — he could dismiss the charges, force the KPMG defendants to foot their own legal bills or hope the government comes up with a compromise. Judge Kaplan has scheduled oral arguments on the issue for July 2.


• The Issue: After finding that prosecutors pressured KPMG to cut off legal fees for ex-partners indicted for tax fraud, a judge will determine how to proceed.

• Similar Stakes: A Texas jury just awarded $2.5 million to the attorney who defended former Dynegy Inc. executive Jamie Olis after finding prosecutors pressured the energy company to cut off his defense fees.

• The Impact: White-collar employees and defense laywers are watching the legal-fee issue for the impact on companies that come under investigation.

Write to Paul Davies at paul.davies@wsj.com1 and David Reilly at david.reilly@wsj.com2

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Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved

SEC Files Action in Fraud for “Round Tripping” Transactions against Collins & Aikman, along with its for CEO and Other Former Officers and Directors

In a civil action filed on March 26, 2007, in the U.S. District Court for the Southern District of New York, the SEC charged auto parts manufacturer Collins & Aikman Corporation (C&A), David A. Stockman, its former Chief Executive Officer and Chairman of the Board of Directors, and eight other former C&A directors and officers, with fraudulent schemes to inflate C&A’s reported income by accounting improperly for illusory supplier payments. The complaint alleges that Stockman and other defendants obtained false documents from suppliers designed to mislead external auditors and falsely inflate revenues.

For more see the Complaint filed in SEC v. Collins & Aikman et al.

In Landmark Ruling, Overton et al. v. Todman & Co. et al., Second Circuit Says Accountants have Duty to Speak and Correct Certified Opinions to Protect Investing Public

The U.S. Court of Appeals for the Second Circuit issued an important ruling on February 26, 2007. In Overton et al. v. Todman & Co. et al., the court held that outside auditors have a duty to speak up and correct a previously-issued certified opinion letters or be held primarily liable under the federal securities law.

The Second Circuit has recognized for a long time that “[a]ccountants do have a duty to take reasonable steps to correct misstatements they have discovered in previous [certified] financial statements on which they know the public is relying,” but never extended that principle under the facts of the Overtoncase.

See also Accounting for the Future — Down to four big firms and fearing the effects of even one major suit, the audit industry presses for legal relief.

In this important ruling, the Overton court held “that an accountant violates the “duty to correct” and becomes primarily liable under § 10(b) and Rule 10b-5 when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied.

Here is a copy the landmark opinion of Overton and recent coverage in Compliance Week titled Court Ruling May Broaden Accountant Liability.