Acct Ethics & related regulation issue
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final_project_page_4.docxThis presentation addresses material covered in all weeks and all TCOs. Instead of a written final exam, you will work to read, analyze, and evaluate Major Case 4, Cendant Corporation, pages 468-474. Your grade will be based on a PowerPoint presentation,
Here are the pages 468-474:
Major Case 4 (for use with Chapters 1 – 7 ) Cendant Corporation 1
The Merger of HFS and CUC
1
The information for this case comes from a variety of litigation releases on the SEC Web site including: www.sec.gov/litigation/admin/34-42935.htm (June 14, 2000); www.sec.gov/litigation/admin/34-42934.htm (June 14, 2000); www.sec.gov/litigation/admin/34-42933.htm (January 24, 2001); www.sec.gov/litigation/litreleases/lr16587.htm (April 30, 2003); and www.sec.gov/litigation/complaints/comp18102.htm (April 30, 2003).
Overview of the Scheme
The Cendant fraud was the largest of its kind until the late 1990s and early 2000s. Beginning in at least 1985, certain members of CUC's senior management implemented a scheme designed to ensure that CUC always met the financial results anticipated by Wall Street analysts. The CUC senior managers utilized a variety of means to achieve their goals including:
· • Manipulating recognition of the company's membership sales revenue to accelerate the recording of revenue
· • Improperly utilizing two liability accounts related to membership sales that resulted from commission payments
· • Consistently maintaining inadequate balances in the liability accounts and on occasion reversing the accounts directly into operating income
With respect to the last item, to hide the inadequate balances, senior management periodically kept certain membership sales transactions off-books. In what was the most significant category quantitatively, the CUC senior managers intentionally overstated merger and purchase reserves and subsequently reversed those reserves directly into operating expenses and revenues. CUC senior management improperly wrote off assets—including assets that were unimpaired—and improperly charged the write-offs against the company's merger reserves. By manipulating the timing of the write-offs and by improperly determining the nature of the charges incurred, the CUC senior managers used the write-offs to inflate operating income at CUC. As the scheme progressed over the course of several years, larger and larger year-end adjustments were required to show smooth net income over time. The scheme added more than $500 million to pretax operating income during the fiscal years ended January 31, 1996; January 31, 1997; and December 31, 1997.
SEC Filings against CUC and Its Officers
SEC complaints filed on June 14, 2000, alleged violations of the federal securities laws by four former accounting officials including Cosmo Corigliano, CFO of CUC; Anne M. Pember, CUC controller; Casper Sabatino, vice president of accounting and financial reporting; and Kevin Kearney, director of financial reporting. The allegations against Corigliano included his role as one of the CUC senior officers who helped engineer the fraud, and he maintained a schedule that management used to track the progress of their fraud. Corigliano regularly directed CUC financial reporting managers to make unsupported alterations to the company's quarterly and annual financial results. The commission alleged that Corigliano profited from his own wrongdoing by selling CUC securities and a large number of Cendant securities at inflated prices while the fraud he helped engineer was under way and undisclosed.
The commission alleged that Pember, the former CUC controller, was the CUC officer most responsible for implementing directives received from Corigliano in furtherance of the fraud including implementing directives that inflated Cendant's annual income by more than $100 million, primarily through improper use of the company's reserves. According to the SEC, Pember profited from her own wrongdoing by selling CUC and Cendant stock at inflated prices while the fraud she helped implement was under way and undisclosed.
Sabatino and Kearney, without admitting or denying the commission's allegations, consented to the entry of final judgments settling the commission's action against them. The commission's complaint alleged that Sabatino was the CUC officer most responsible for directing lower-level CUC financial reporting managers to make alterations to the company's quarterly financial results.
In the first of the three separate administrative orders, the commission found that Steven Speaks, the former controller of CUC's largest division, made or instructed others to make journal entries that effectuated much of the January 1998 income inflation directed by Pember. In a second separate
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administrative order, the commission found that Mary Sattler Polverari, a former CUC supervisor of financial reporting, at the direction of Sabatino and Kearney, regularly and knowingly made unsupported alterations to CUC's quarterly financial results.
In a third administrative order, the commission found that Paul Hiznay, a former accounting manager at CUC's largest division, aided and abetted violations of the periodic reporting provisions of the federal securities laws by making unsupported journal entries that Pember had directed. Hiznay consented to the issuance of the commission's order to cease and desist from future violations of the provisions.
In a fourth and separate administrative order the commission found that Cendant violated the periodic reporting, corporate recordkeeping, and internal controls provisions of the federal securities laws, in connection with the CUC fraud. Among other things, the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the commission, as a result of the long-running fraud at CUC. Simultaneous with the institution of the administrative proceeding, and without admitting or denying the findings contained therein, Cendant consented to the issuance of the commission order, which ordered Cendant to cease and desist from future violations of the provisions.
On February 28, 2001, the SEC filed a civil enforcement action in the U.S. District Court for the District of New Jersey against Walter A. Forbes, the former chair of the board of directors at CUC, and E. Kirk Shelton, the former vice chair, alleging that they directed a massive financial fraud while selling millions of dollars' worth of the company's common stock. For the period 1995–1997 alone, pretax operating income reported to the public by CUC was inflated by an aggregate amount of over $500 million. Specific allegations included:
In February 1997, Hiznay received a schedule from the CUC controller setting forth the amounts, effective back-dates, and accounts for a series of postclosing entries reducing the commissions payable account by $9.12 million and offsetting that reduction by increases to CUC revenue accounts. Hiznay approved the unsupported entries and had his staff enter them. They all carried effective dates spread retroactively over prior months. The entries reversed the liability account directly into revenues, a treatment that, under the circumstances, was not in accordance with GAAP.
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2
Postclosing journal entries means entries that are made after a reporting period has ended, but before the financial statements for the period have been filed, and that have effective dates spread retroactively over prior weeks or months.
Keeping Rejects and Cancellations Off-Books: Establishing Reserves
During his time at CUC, Hiznay inherited, but then supervised, a long-standing practice of keeping membership sales cancellations and rejects off CUC's books during part of each fiscal year. Certain CUC membership products were processed through various financial institutions that billed their members' credit cards for new sales and charges related to the various membership products. When CUC recorded membership sales revenue from such a sale, it would allocate a percentage of the recorded revenue to cover estimated cancellations of the specific membership product being sold, as well as allocating a percentage to cover estimated rejects and charge-backs. 3 CUC used these percentage allocations to establish a membership cancellation reserve.
Over the years, CUC senior management had developed a policy of keeping rejects and cancellations off the general ledger during the last three months of each fiscal year. Instead, during that quarter, the rejects and cancellations appeared only on cash account bank reconciliations compiled by the company's accounting personnel. The senior managers then directed the booking of those rejects and cancellations against the membership cancellation reserve in the first three months of the next fiscal year. Because rejects and cancellations were not recorded against the membership cancellation reserve during the final three months of the fiscal year, the policy allowed CUC to hide the fact that the reserve was dramatically understated at each fiscal year-end. At its January 31, 1997, fiscal year-end, the balance in the CUC membership cancellation reserve was $29 million; CUC accounting personnel were holding $100 million in rejects and $22 million in cancellations off-books. Failing to book cancellations and rejects at each fiscal year-end also had the effect of overstating the company's cash position on its year-end balance sheet.
3
Rejects resulted when the credit card to be charged was over its limit, closed, or reported as lost or stolen. Charge-backs resulted when a credit card holder disputed specific charges related to a particular membership program.
SEC Settlements
Between Hiznay's arrival at CUC in July 1995 and the discovery of the fraudulent scheme by Cendant management in April 1998, CUC and Cendant filed false and misleading annual reports with the commission that misrepresented their financial results, overstating operating income and earnings and failing to disclose that the financial results were falsely represented.
The commission's complaint alleged that Sabatino, by his actions in furtherance of the fraud, violated, or aided and abetted violations of, the antifraud, periodic reporting, corporate record-keeping, internal controls, and lying to auditors provisions of the federal securities laws. Sabatino consented to entry of a final judgment that enjoined him from future violations of those provisions and permanently bar him from acting as an officer or director of a public company.
Kearney consented to entry of a final judgment that enjoined him from future violations of those provisions, ordered him to pay disgorgement of $32,443 in ill-gotten gains (plus prejudgment interest of $8,234), and ordered him to pay a civil money penalty of $35,000. Kearney has also agreed to the issuance of a commission administrative order that barred him from practicing before the commission as an accountant, with the right to reapply after five years.
Corigliano, Pember, and Sabatino each pleaded guilty to charges pursuant to plea agreements between those three individuals and the SEC. Pursuant to his agreement, Corigliano pleaded guilty to a charge of wire fraud, conspiracy to commit mail fraud, and causing false statements to be made in documents filed with the commission including signing CUC's periodic reports filed with the commission and making materially false statements to CUC's auditors. Pember pleaded guilty to a charge of conspiracy to commit mail fraud and wire fraud. Sabatino, pursuant to his agreement, pleaded guilty to a charge of aiding and abetting wire fraud.
In another administrative order, the commission found that Paul Hiznay aided and abetted violations of the periodic reporting provisions of the federal securities laws, in connection with actions that he took at the direction of his superiors at CUC. Among other things, the commission alleged that Hiznay made unsupported journal entries that Pember had directed. Additional orders were entered against lower-level employees.
Actions against Cendant and Walter A. Forbes, Former Board Chair
The commission found that Cendant violated the periodic reporting, corporate recordkeeping, and internal controls provisions of the federal securities laws, in connection with the CUC fraud in that the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the SEC.
On December 29, 2009, the SEC announced a final judgment against Walter A. Forbes, the former chair of Cendant, arising out of his conduct in the Cendant fraud. 4 The commission alleged that Forbes orchestrated an earnings management scheme at CUC to improperly inflate the company's quarterly and annual financial results during the period 1995 to 1997. CUC's operating income was improperly inflated by an aggregate amount exceeding $500 million.
The final judgment against Forbes, to which he consented without admitting or denying the commission's allegations, enjoined him from violating relevant sections of the securities laws and bars him from serving as an officer or director of a public company.
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4
Securities and Exchange Commission v. Walter A. Forbes et al., District Court N.J. filed February 28, 2001.
Improper Establishment and Use of Merger Reserves
The company completed a series of significant mergers and acquisitions and accounted for the majority of them using the pooling-of-interests method of accounting. 6 In connection with this merger and acquisition activity, Company management purportedly planned to restructure its operations. GAAP permits that certain anticipated costs may be recorded as liabilities (or reserves) prior to their incurrence under certain conditions. However, here CUC and Cendant routinely overstated the restructuring charges and the resultant reserves and would then use the reserves to offset normal operating costs—an improper earnings management scheme. The company's improper reversal of merger and acquisition related restructuring reserves resulted in an overstatement of operating income by $217 million.
The EY auditors provided accounting advice as well as audit services to CUC and Cendant in connection with the establishment and use of restructuring reserves. The auditors excessively relied on management representations concerning the appropriateness of the reserves and performed little substantive testing despite evidence that the reserves were improperly established and utilized.
One example of auditor failures with reserve accounting is the Cendant reserve. Cendant recorded over $500 million in merger, integration, asset impairment, and restructuring charges for the CUC-side costs purportedly associated with the merger of HFS and CUC. The company recorded a significant portion of this amount for the purpose of manipulating its earnings for December 31, 1997, and subsequent periods and, in fact, Cendant had plans, which it did not disclose to defendants and EY, to use a material amount of the reserve to artificially inflate income in subsequent periods.
In the course of providing accounting and auditing services, the auditors failed to recognize evidence that the company's establishment and use of the Cendant reserve did not conform to GAAP. For example, CUC and Cendant provided EY with contradictory drafts of schedules when EY requested support for the establishment of the Cendant reserve. The company prepared and revised these various schedules, at least in part, as a result of questions raised and information provided by the defendants. The schedules were inconsistent with regard to the nature and amount of the individual components of the reserve (i.e., component categories were added, deleted, and changed as the process progressed). While the component categories changed over
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time, the total amount of the reserve never changed materially. Despite this evidence, the auditors did not obtain adequate analyses, documentation, or support for changes they observed in the various revisions of the schedules submitted to support the establishment of the reserves. Instead, they relied excessively on frequently changing management representations.
The company planned to use much of the excess Cendant reserve to improperly increase operating results in future periods. During the year ended December 31, 1997, the company wrote off $104 million of assets that it characterized as impaired as a result of the merger. Despite the size and timing of the write-off, the defendants never obtained adequate evidence that the assets were impaired as a result of the merger and, therefore, properly included in the Cendant reserve. In fact, most of the assets were not impaired as a result of the merger.
6
Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, which eliminated the pooling methods for business combinations. The purchase method must now be used for all acquisitions.
The EY defendants did not adequately test the collectibility of these rejects and the adequacy of the cancellation reserve and instead relied primarily on management representations concerning the company's successful collection history and inconsistent statements concerning the purported impossibility of substantively testing these representations.
Membership Cancellation Rates
The company also overstated its operating results by manipulating its cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period. A large determinant of the liability associated with cancellations was CUC and Cendant's estimates of
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the cancellation rates. During the audits, CUC and Cendant intentionally provided EY with false estimates that were lower than the actual estimated cancellation rates. This resulted in a significant understatement of the cancellation reserve liability and an overstatement of income. To justify its understated cancellation reserve, CUC and Cendant provided to EY small, nonrepresentative samples of cancellations, which understated the actual cancellation rates. The defendants allowed the company to choose the samples. EY did not test whether the samples provided were representative of the actual cancellations for the entire membership population.
Audit Opinion
EY issued audit reports containing unqualified audit opinions on, and conducted quarterly reviews of, the company's financial statements that, as already stated, did not conform to GAAP. The Securities Exchange Act requires every issuer of a registered security to file reports with the commission that accurately reflect the issuer's financial performance and provide other information to the public. By reason of the foregoing, the firm aided and abetted violations of the securities laws.
Class Action Lawsuits
A class action suit by stockholders against Cendant and its auditors, with the largest pension funds in the lead, alleged that stockholders paid more for Cendant stock than they would have if they had known the truth about CUC's income. The lawsuit ended in a record $3.2 billion settlement. Details of the settlement follow.
The law firm of Barrack, Rodos and Bacine (BR&B) was one of two lead counsels for the class in In re Cendant Corporation Litigation. That firm was retained by the two largest state pension funds and the largest municipal pension funds in the country—the New York State Common Retirement Fund, California Public Employees' Retirement System, and New York City Pension Funds—to represent it in the lawsuits. Each of the funds had suffered losses in the range of $30 million. Through its prosecution of the case, BR&B succeeded in certifying a class of purchasers of Cendant and CUC publicly traded securities during the period from May 31, 1995, through August 28, 1998, and recovering for the class nearly four times more than had ever been recovered in the history of federal securities law class actions. By the time the dust had settled, BR&B had achieved recoveries of more than $3.3 billion for the class, as well as highly significant corporate governance changes negotiated as part of the settlement with Cendant. Notably, the $3.3 billion recovery represented nearly 40 percent of the damages suffered by class members, and provided very significant payments—in a number of cases, in excess of $100 million—for the largest claimants, many of which were public pension funds. 7
By December 1999, BR&B announced on behalf of the lead plaintiffs the landmark $2.85 billion settlement with Cendant that far surpassed the recoveries in any other securities law class action case in history. Until the settlements reached in the WorldCom case in 2005, this stood as the largest recovery in a securities class action case, by far, and clearly set the standard in the field. In addition to the cash payment by Cendant, which was backed by a letter of credit that the company secured to protect the class, the Cendant settlement included two other very important features. First, the settlement provided that in the event Cendant or the former HFS officers and directors were successful in obtaining a net recovery in their continuing litigation against EY, the class would receive one-half of any such net recovery. As it turned out, that litigation lasted another seven years—until the end of 2007—when Cendant and EY settled their claims against each other in exchange for a payment by EY to Cendant of nearly $300 million. Based on the provision in the Cendant settlement agreement and certain further litigation and a court order, in December 2008 the class received another $132 million. This brought the total recovered from the Cendant settlement to $2.982 billion.
Second, Cendant was required to institute significant corporate governance changes that were far-reaching and unprecedented in securities class action litigation. Indeed, these changes included many of the corporate governance structural changes that would later be included within the Sarbanes-Oxley Act of 2002. They included the following:
· • The board's audit, nominating, and compensation committees would be comprised entirely of independent directors (according to stringent definitions, endorsed by the institutional investment community, of what constituted an independent director).
· • The majority of the board would be independent within two years following final approval of the settlement.
· • Cendant would take the steps necessary to provide that, subject to amendment of the certificate of incorporation declassifying the board of directors by vote of the required super-majority of shareholders, all directors would be elected annually.
· • No employee stock option could be “re-priced” following its grant without an affirmative vote of shareholders, except when such re-pricings were necessary to take into account corporate transactions such as stock dividends, stock splits, recapitalization, a merger, or distributions.
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In Re: Cendant Corporation Litigation, 264 F3d 201 264 F.3d 201 (3rd Cir. 2001), http://openjurist.org/264/f3d/201/in-re-cendant-corporation-litigation .
The Settlement with Ernst & Young
Ten days after reaching agreement on the Cendant settlement, BR&B finalized negotiations of an equally impressive settlement with EY. On December 17, 1999, it was announced that EY had also agreed to settle the claims of the class for $335 million. This recovery was and remains today as the largest amount ever paid by an accounting firm in a securities class action case. The recovery from EY was significant because it held an outside auditing firm responsible in cases of corporate accounting fraud. The claims against EY were based on EY's “clean” audit and review opinions for three sets of annual financial statements, and seven quarterly financial statements, between 1995 and 1997, but that it had failed to review quarterly reporting packages by CUC subsidiaries; it did not require adequate documentation for the company's merger reserves and “top-side” adjustments; and it failed to review the company's general ledgers.
The district court approved the settlements and plan of allocation in August 2000, paving the way for Cendant and EY to fund the settlements. Approximately one year later, in August 2001 the settlements and plan of allocation were affirmed on appeal by the U.S. Third Circuit Court of Appeals. And, in March 2002 the U.S. Supreme Court determined that it would not hear any further appeals in the case.
