In United States of America v. Prabhat Goyal (United States v. Goyal, 9th Cir., No. 08-10436, 12/10/10) a panel of the Ninth Circuit Court of Appeals not only reversed the criminal conviction of a former CFO of Network Associates on fifteen counts of securities fraud and making materially false statements to auditors, but also took the extraordinary step of remanding the case for entry of judgment of acquittal on all counts. Many have remarked on the passionate concurring opinion of Chief Judge Kozinski, in which he expressed concern for Mr. Goyal and his family and expressed the hope that "the government will be more cautious in the future." The decision goes beyond the criminal sphere, however, and when one reviews the extensive discussion of the evidence found wanting by the Ninth Circuit, there are important lessons for securities litigators.
The charges revolved around the accounting method employed by the software company in recognizing revenue from sales to its largest domestic distributor. Following a practice the panel described as common in the software industry, the company negotiated significant quarter-end deals with the distributor to meet its quarterly revenue projections, and granted substantial discounts, rebates and other favorable terms to close the sales. One "enticement" the company offered was a guarantee that it's wholly owned subsidiary would repurchase unsold product from the distributor in specified amounts, and the subsidiary would then sell the repurchased product to customers. The government objected to the company's use of "sell-in" accounting, which allowed for the recognition of revenue when the company shipped the product to the distributor, instead of "sell-through" accounting, which would defer recognition of revenue until the distributors sell the product to a reseller (i.e., sell through the distribution channel).
The appellate court first addressed whether the government had met its burden of showing that the company materially misstated the revenue it earned in certain quarters and years through its choice of the sell-in accounting method; the government relied on a stipulation that use of sell-through accounting would have resulted in a revenue figure that was materially less than the reported figure for the periods charged. But the panel found that the stipulation did not address whether use of a different accounting method would have made a material difference in any given period. After the verdict the government presented calculations that the challenged orders represented approximately 24% of the revenue for three years, but the panel noted that the jury was never presented with those figures, it was not the absolute magnitude of the buy-ins that mattered, and the jury was not presented with evidence to allow it to assess whether the use of one method of accounting materially increased the company's overall revenue when compared to using a different method of accounting. In short, the government's reliance on a general broad stipulation was misplaced.
The discussion of the counts that the CFO lied to the outside auditors is telling on what is necessary to prove fraudulent intent when a CFO certifies to the auditors that the financial statements complied with generally accepted accounting principles ("GAAP") and that the company had disclosed all sales terms. GAAP guidelines allow sell-in accounting under certain conditions, but the government was required to show that the company had set aside reserves adequate to cover future contingencies. The government relied on what the Ninth Circuit called "equivocal and conclusory statements" from two of the auditors to the effect that some of the terms would "raise questions about the accounting the company was using." The court noted in a footnote that the auditors were not disclosed as experts, and thus the witnesses were not permitted to give opinion testimony, including their views as to whether the accounting conformed to GAAP. We are also aware that the government did not call any retained experts to opine that the accounting was non-GAAP. On the record before it, the Ninth Circuit held that the witnesses had no basis to opine on whether the reserves were indeed inadequate and did not apply the factors set out by one of the accounting principles. The appellate court held that without evidence of what the reserves were or how they fell short, "no reasonable juror could have found a GAAP violation that depended on insufficient reserves."
Of particular interest is the court's discussion of whether the arrangement with the subsidiary violated GAAP, and whether the CFO could be criminally liable when he told the auditors that the company's financials complied with GAAP:
- the jury could not have inferred fraudulent intent from the CFO's desire to meet revenue targets and his knowledge of and participation in deals to help make that happen, because that was "simply evidence of Goyal's doing his job diligently."
- nor could the jury infer fraudulent intent from the CFO's presumed knowledge of GAAP: "If simply understanding accounting rules or optimizing a company's performance were enough to establish scienter, then any action by a company's chief financial officer that a juror could conclude in hindsight was false or misleading could subject him to fraud liability without regard to intent to deceive. That cannot be."
- the jury could not have inferred fraudulent intent from the fact that one half of the CFO's bonus was based on achieving corporate goals: such a general financial incentive "merely reinforces Goyal's preexisting duty to maximize [the company's] performance, and his seeking to meet expectations cannot be inherently probative of fraud."
The court also rejected the claim that the representation letters to the auditors contained an affirmative duty on the part of the CFO to disclose certain information, holding that such a theory of liability "makes a strict-liability crime out of one that requires willful and knowing deception."
The SEC declined to comment on what effect the Ninth Circuit's decision reversing the conviction and instructing the district court to enter a judgment of acquittal would have on pending civil charges. While the burden of proof is lower in a civil action than it is for a criminal matter, the Ninth Circuit's holding that no "rational trier of fact" could have found the essential elements beyond a reasonable doubt sets a high bar on further civil litigation seeking to impose civil liability for fraud.
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