The conviction of a chief financial officer for lying to the company’s outside independent auditor has been overturned by a Ninth Circuit panel which found that the government did not sufficiently prove that the CFO willfully and knowingly made false statements to PwC, the outside auditor. No jury could have found the CFO guilty beyond a reasonable doubt based on the evidence the prosecution presented at trial. Writing for the panel, Judge Clifton said that the government was unable to prove that the CFO voluntarily made statements to PwC that he knew were false, and thus unable to satisfy the regulatory standard under SEC Rule 13b2-2, the basis of the lying-to-auditors charges, and the statutory standard of Exchange Act Section 13(b) from which the rule is derived. (U.S. v. Goyal, CA-9, No. 08-10436, December 10, 2010).
In a concurring opinion, Chief Judge Kozinski called the instant case one of a string of recent cases in which courts have found that federal prosecutors overreached by trying to stretch criminal law beyond its proper bounds, citing Arthur Andersen LLP v. United States, 544 U.S. 696, 705-08 (2005).
Since only those who knowingly circumvent or knowingly fail to implement a system of internal accounting controls or knowingly falsify any book, record, or account are subject to criminal prosecution under the statute, reasoned the court, criminal liability under Rule 13b2-2 also requires that a false statement to an auditor be made knowingly. Rule 13b2-2 could not impose a lesser mens rea requirement, said the panel, because the SEC cannot promulgate a rule whose scope exceeds that of the statute it implements, and a lesser mens rea requirement would criminalize a broader swath of conduct. For this proposition, the panel cited Ernst & Ernst v. Hochfelder, 425 U.S. 185, 213-14 (1976), whcre the Supreme Court held that Rule 10b-5 cannot impose liability for negligent conduct because the statute under which it was promulgated requires scienter.
The company, a vendor of antivirus software, sold products through distributors who in turn sold the company’s software to retail stores that resold to end users. The prosecution’s case against the CFO challenged the accounting method the company used to recognize revenue from sales to its largest domestic distributor. The government maintained that the company violated GAAP by using sell-in accounting to recognize revenue from these deals earlier than it should have and thereby overstated its revenue. Under sell-in accounting, a company recognizes revenue when it ships products to its distributors, thereby selling into the distribution channel. The company must estimate the amount of future rebates, discounts or returns, explained the panel, and then reduce its stated revenue by this amount.
In this action, the lying-to-auditors counts depended on independent statements that the CFO made in management representation letters to the auditor that the company’s financial statements complied with GAAP and that the company had disclosed all sales terms. Regarding the GAAP-compliant representation to the outside auditor, the court found that the government was unable to show that the CFO’s assertion of GAAP compliance to PwC was willfully and knowingly false.
The CFO’s presumed knowledge of GAAP as a qualified CFO did not make him criminally responsible for his every conceivable mistake, said the panel. If simply understanding accounting rules or optimizing a company’s performance were enough to establish scienter, reasoned the court, then any action by a company’s chief financial officer that a juror could conclude in hindsight was false or misleading could subject him or her to fraud liability without regard to intent to deceive Similarly, the fact that the CFO’s compensation, especially a bonus, was linked to corporate success did not change matters, said the court, since such a general financial incentive merely reinforced the CFO’s preexisting duty to maximize the company’s performance, and his seeking to meet expectations cannot be inherently probative of fraud
When the events in this case occurred, the company’s accounting for sales to distributors was governed by FASB Statement No. 48, which allowed the use of sell-in accounting only when the seller’s price to the buyer was substantially fixed or determinable at the date of sale; the seller did not have significant obligations for future performance to directly bring about resale of the product by the buyer; and the amount of future returns could not be reasonably estimated.
The government argued that GAAP was violated because terms in the distribution deals allowing for future adjustments to prices, such as sell-through rebates, meant that prices were not substantially fixed or determinable within the meaning of FAS 48 when the company made the sales. Rejecting this contention, the court noted that future contingencies do not render sell-in revenue recognition improper if the seller can reasonably estimate the effect of the contingencies and set aside reserves adequate to cover them.
The prosecution, therefore, could only prove this species of GAAP violation beyond a reasonable doubt by showing that the company’s reserves did not reasonably account for the terms of the quarter-end sales, said the panel, and this it failed to do. The government offered no evidence that the company’s reserves were, in fact, inadequate With no evidence of what the reserves were, or how they fell short of amounts that the distribution sales required, no reasonable juror could have found a GAAP violation that depended on insufficient reserves.
A similar problem arose with respect to sales terms that allowed the distributor to return software to the company. GAAP only allows sell-in accounting to be used when the amount of future returns can be reasonably estimated. The government argued that certain terms in the buy-in transactions gave the distributor an unlimited right to return software it purchased, and that an unlimited right of return automatically defeated sell-in accounting.
FAS 48 lays out four factors that may impair the ability to make a reasonable estimate of future returns, noted the panel, and no witness applied these factors to the company’s buy-in deals or concluded that the company could not accurately estimate returns. The government needed to prove what the company did, said the court, not what the buy-in terms made hypothetically possible. Without evidence that the distributor’s returns were not amenable to reasonable estimation, no reasonable juror could have found that using sell-in accounting for these sales violated GAAP.
The lying-to-auditors counts, therefore, could not be sustained on the ground that the CFO’s assertion of GAAP compliance to PwC was willfully and knowingly false.
The CFO also affirmed in seven signed management representation letters to PwC that the company had fully disclosed to PwC all sales terms, including all rights of return or price adjustments, and all warranty provisions. The government argued that this statement was willfully and knowingly false, independent of any GAAP violation, because the company did not turn over the buy-in letters memorializing the quarter-end distributor transactions.
But even if sales terms were not disclosed to PwC, said the panel, the government’s case suffered from a total failure of proof that the CFO willfully and knowingly misled PwC. Several of the government’s arguments for inferring mens rea in connection with GAAP violations apply equally to the CFO’s knowledge of withholding of buy-in letters.
Even if the CFO had a duty as set forth in the management representation letters to disclose the buy-in letters, continued the appeals panel , his failure to do so does not indicate scienter. This duty theory, which was relied on by the trial court, is untenable because it makes a strict-liability crime out of one that requires willful and knowing deception. Absent any proof that the CFO willfully concealed buy-in letters from PwC, concluded the panel, his convictions on this basis must be reversed.