The opinion of the court was delivered by: Denise Cote, District Judge
In this action, the Securities and Exchange Commission ("SEC") alleges that KPMG LLP ("KPMG") and several KPMG audit partners participated in a massive accounting fraud at Xerox Corporation ("Xerox") from 1997 through 2000. This Opinion concerns the summary judgment motions filed by Michael A. Conway ("Conway"), Anthony P. Dolanski ("Dolanski"), Ronald A. Safran ("Safran"), and Thomas J. Yoho ("Yoho"), the remaining defendants in the action. For the reasons stated below, the motions are granted in part.
A. History of the Litigation On January 29, 2003, the SEC filed a complaint against KPMG, Xerox's auditor during the years in question, and four KPMG partners, Joseph T. Boyle ("Boyle"), Conway, Dolanski, and Safran. The complaint alleges that these defendants permitted Xerox to manipulate its accounting practices in order to fill a $3 billion gap between its actual operating results and the results it reported to the investing public. In 2001, Xerox released a $312 million restatement of 1998 and 1999 pretax earnings (the "First Restatement"). In 2002, after the scope of the alleged fraud was exposed, and with the assistance of a new auditor, Xerox issued a $6.1 billion restatement of its equipment revenues and a $1.9 billion restatement of its pre-tax earnings for the years 1997 through 2000 (the "Second Restatement"). The Second Restatement was the largest financial restatement in American history up to that time. The nature of the alleged fraud and the involvement of the various defendants are discussed in detail below, as drawn principally from the evidence presented by the SEC in opposition to these motions.
On April 9, 2003, the defendants' motion to transfer venue to the District of Connecticut, where privately filed civil actions were pending, was denied. SEC v. KPMG LLP, et al., No. 03 Civ. 671 (DLC), 2003 WL 1842871, at *5 (S.D.N.Y. Apr. 9, 2003). In an August 20, 2003 Opinion, the SEC's motion to strike four defendants' affirmative defenses of laches, undue delay, estoppel, waiver, unclean hands, and statutes of limitations was granted. SEC v. KPMG LLP et al., No. 03 Civ. 671 (DLC), 2003 WL 21976733, at *4 (S.D.N.Y. Aug. 20, 2003). An August 22, 2003 Opinion denied Boyle's motion to dismiss. SEC v. KPMG LLP et al., No. 03 Civ. 671 (DLC), 2003 WL 21998052, at *6 (S.D.N.Y. Aug. 22, 2003). On November 5, 2003, the SEC filed an amended complaint that included Yoho, a fifth KPMG partner, as a defendant. A Second Amended Complaint (the "Complaint") was filed on May 5, 2004.
In November 2004, KPMG reached a settlement with the SEC. KPMG consented to a finding that it violated Section 10A of the Securities Exchange Act of 1934 (the "Exchange Act"); to pay disgorgement of $9,800,000, plus prejudgment interest; to pay a civil penalty of $10 million; and to implement a number of internal reforms. A final judgment against KPMG was issued on April 20, 2005. In June 2005, defendant Boyle settled with the SEC. The settlement was renewed in October 2005 after an initial rejection by the Commissioners. Pursuant to the settlement, Boyle paid a civil penalty of $100,000 and was permanently enjoined from violating Exchange Act Section 10A. The final judgment against Boyle was issued on October 11, 2005.
Five claims remain against Conway, Dolanski, Safran, and Yoho (the "KPMG Partners"): (1) violations of Section 17(a) of the Securities Act of 1933 (the "Securities Act") and Section 10(b) of the Exchange Act; (2) aiding and abetting violations of Exchange Act Section 10(b); (3) violation of Exchange Act Section 10A; (4) aiding and abetting violations of Section 13(a) of the Exchange Act; and (5) aiding and abetting violations of Section 13(b) of the Exchange Act. The SEC seeks permanent injunctions and civil penalties against the KPMG Partners.
In June 2005, the KPMG Partners filed the summary judgment motions that are the subject of this Opinion. All four defendants contend that they did not make false or misleading statements on which primary liability under Exchange Act Section 10(b) and Rule 10b-5 could be predicated, and that they face, at most, aiding and abetting liability under Exchange Act Section 20(e). Dolanski and Safran also move on the basis that they made no actionable misstatements that would support Securities Act Section 17(a) liability. All defendants also argue that actual knowledge is necessary to support liability under Section 20(e). Dolanski, Conway, and Yoho argue that the evidence is insufficient to establish that they possessed actual knowledge of the alleged violations.
Conway, Dolanski, and Yoho also argue that they should not be held liable under Exchange Act Section 10A, claiming that the provision does not apply to individual accountants. Conway contends that he should not incur Section 10A liability because he performed an extensive investigation of potential illegal acts by Xerox, reported those acts to the Xerox Audit Committee, and insisted upon appropriate remedial action. Yoho argues that he should not be held liable under Section 10A because there is no reason to believe that he failed to notify the Audit Committee as required under the statute.*fn1
Conway and Dolanski argue that, even if they made misstatements sufficient to support Section 10(b) liability, the evidence is not sufficient to support an inference that they had scienter. Dolanski argues additionally that the claims against him under Sections 10A and 20(e) are barred by the statute of limitations, and that he should receive judgment as a matter of law on claims premised on "price increases and extensions to existing leases" because such claims are not asserted against him in the complaint.
Conway has filed a motion to strike certain portions of plaintiff's Response to Mr. Conway's Statement of Material Facts Pursuant to Local Rule 56.1 and the Statement of Facts in plaintiff's opposition brief. That motion is considered at the end of this Opinion.
The following facts are taken from the parties' evidentiary submissions and are either undisputed or stated in the light most favorable to the SEC, unless otherwise noted. The various accounting treatments at issue, including lease accounting methodologies and accounting for reserves, and Dolanski's, Safran's, and Yoho's involvement in them, are described in subsection B. Conway's involvement, and the events that led up to the Second Restatement in 2001, are described in subsection C.
B. The Defendants' Involvement in the Accounting Treatments at Issue
Financial statements must be reported in accordance with Generally Accepted Accounting Principles, or "GAAP." The meaning of GAAP was explored in detail in this Court's January 18, 2005 Opinion deciding the summary judgment motion of Arthur Andersen LLP in In re WorldCom, Inc. Securities Litigation, 352 F. Supp. 2d 472, 478-79 (S.D.N.Y. 2005), and this Opinion draws heavily from that discussion.
The goal of financial reporting is to "provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions." Financial Accounting Standards Board ("FASB"), Statement of Financial Accounting Concepts No. 1 (1978). The purpose of GAAP is "to increase investor confidence by ensuring transparency and accuracy in financial reporting." In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 339 (S.D.N.Y. 2004).
There are "19 different GAAP sources." Shalala v. Guernsey Mem'l Hosp., 514 U.S. 87, 101 (1995). When a conflict among these sources arises, "the accountant is directed to consult an elaborate hierarchy of GAAP sources to determine which treatment to follow." Id. Standards issued by FASB sit at the top of this hierarchy and are used as reference points by all parties to the summary judgment motions considered in this Opinion. FASB, an independent private sector organization, is the "designated organization in the private sector for establishing standards of financial accounting and reporting." FASB, Facts About FASB, available at http://www.fasb.org/facts/index.html. FASB's standards have been recognized by the SEC as authoritative. See Statement of Policy on the Establishment and Improvement of Accounting Principles and Standards, SEC Release No. AS-150, 1973 WL 149263, at *1 (Dec. 20, 1973).
The SEC offers evidence that Xerox used several improper accounting treatments to distort its reported financial results in the years 1997 through 2000. One of its accounting experts contends that the accounting treatments violated GAAP, and it has presented evidence to show that the purpose and effect of these treatments was artificially to inflate Xerox's reported quarterly earnings to meet the earnings targets that the company had announced to Wall Street. Without these alleged accounting manipulations, Xerox would have missed the consensus earnings predictions made by Wall Street analysts in every quarter from the third quarter of 1997 through the second quarter of 1999. In both the fourth quarter of 1997 and the fourth quarter of 1998, the accounting treatments at issue added over $0.20 to the reported earnings per share. KPMG was aware of the earnings pressures Xerox faced. For example, a 1997 memorandum from KPMG's Rochester audit team noted that "[t]oday's bull market has been fueled by companies' ability to replicate [their] earnings over relatively long periods of time. Xerox Corporation-Rochester is no exception to these pressures . . . ."
Xerox had long been a Fortune 500 Company that maintained a presence in many areas of the world. It was headquartered in Stamford, Connecticut, and had major offices in Rochester, New York; Canada; Great Britain; and Brazil. The KPMG Partners all worked out of KPMG's Stamford office, but there were also KPMG audit teams in Rochester, Canada, Great Britain, and Brazil.
KPMG served as Xerox's independent auditor for forty years, until September 2001. Xerox was an important client for KPMG. During the years 1997 through 2000, KPMG received $23 million in audit fees and $56 million in consulting fees from the company. The responsibilities of an auditor were outlined in detail in WorldCom, 352 F. Supp. 2d at 479-82. In conducting an audit, an auditor must follow the standards that constitute Generally Accepted Auditing Standards, or GAAS. The American Institute of Certified Public Accountants created the ten GAAS standards. See
Codification of Accounting Standards and Procedures, Statement on Auditing Standards No. 1, § 150 (American Inst. of Certified Pub. Accountants 2001). Compliance with GAAS is mandatory. WorldCom, 352 F. Supp. 2d at 479 (citing AU § 161.01).*fn2
KPMG's audit certifications for the years in question represented that Xerox's annual financial statements presented fairly, in all material respects and in accordance with GAAP, the company's financial position, and that KPMG's audits had been conducted in accordance with GAAS. The SEC disputes both the propriety of the accounting treatments and the adequacy of KPMG's investigation and approval of those treatments, and contends that the audit certifications thus constituted misstatements of fact.
Dolanski was the KPMG engagement partner who supervised the 1997 audit of Xerox's financials; he had served as engagement partner for Xerox since 1995. Yoho was the concurring review partner on KPMG's audits of Xerox for 1997, 1998, 1999, and 2000; he, too, had served Xerox in his position since 1995. Dolanski retired after the 1997 audit and was replaced by Safran, who oversaw the 1998 and 1999 audits. Conway replaced Safran as engagement partner after the 1999 audit, at Xerox's insistence, and was responsible for supervising the 2000 audit.
In opposing summary judgment, the SEC has emphasized those accounting treatments that apply to "bundled leases" and loss contingency reserves. The accounting treatments at issue, and the evidence presented by the SEC regarding the KPMG Partners' knowledge and approval of those accounting treatments in the years 1997 through 1999, are summarized directly below. Events beginning in 2000, the year in which the SEC began its investigation of Xerox's accounting practices, are discussed infra.
During the period from 1997 through 2000, bundled leases accounted for the majority of Xerox's sales revenue. Under a bundled lease, a customer pays a single negotiated monthly fee for photocopier equipment, servicing, and financing. Xerox's bundled lease contracts did not specify how a customer's monthly fee was allocated among the various components of the lease package. That is, customers and competitors could not determine what percentage of a lease price was allocable to the cost of equipment, as opposed to service or financing. Internally, however, Xerox operating units assigned a value to each of these lease components in the company's sales data entry system close to the time a lease was negotiated. Xerox's sales data entry system in the United States is known as "ValueQuix."*fn3
Xerox claimed that ValueQuix overstated finance revenue and understated equipment revenue. Beginning in 1997, the company also claimed that ValueQuix overstated service revenue in Europe and, later, in Latin America, also with the effect of understating equipment revenue. During the years in question, rather than simply carrying the lease price components as entered on ValueQuix through to the company's top-level financial reporting, Xerox made topside adjustments to its reported lease revenues. It justified these adjustments with reference to the distortions that allegedly inhered in the ValueQuix system, but the accounting techniques had the overall effect of advancing the recognition of revenues for the company in a manner that nudged the company's current earnings toward its projected earnings goals. The SEC presents evidence that the KPMG Partners understood that these accounting techniques were used by Xerox to meet the company's short-term earnings targets rather than to offset the effects of distorted allocations in ValueQuix.
According to one of the SEC's accounting experts, D. Paul Regan ("Regan"), a topside adjustment "modif[ies] the reported results of underlying systems, accounting processes, or accounting records maintained in the normal course of day-to-day business activity." Topside adjustments may be legitimate, but they are prone to abuse ---a concern that Safran voiced in a March 15, 1999 memorandum to Xerox's chief financial officer. Safran warned:
Accounting and internal control risks are heightened when top-level adjustments are used in lieu of transaction-based accounting which can be controlled locally. We recommend that the additional use of top-level adjustments be curtailed until systems and record-keeping capabilities are developed to record such adjustments at the transaction level on local books where the accounting records can be effectively monitored and prudently controlled. (Emphasis supplied.)
Two forms of topside adjustments Xerox made to its lease revenues were "return on equity," or "ROE," adjustments, which reallocated a portion of financing income to equipment revenue, and "margin normalization" adjustments, which reallocated a portion of service income to equipment revenue. Xerox also made topside adjustments that advanced the recognition of revenues and earnings attributable to price increases and extensions of existing leases, and retroactively increased the residual values of leased equipment.
a. Return on Equity (ROE)
The authoritative statement on GAAP-compliant financial accounting and reporting for leases is FASB, Statement of Financial Accounting Standards No. 13: Accounting for Leases (Fin. Accounting Standards Bd. 1976) ("FAS 13"). FAS 13 requires a company to recognize revenue from the fair value of the leased equipment in the reporting period in which a lease commences. Service and financing revenues, on the other hand, are recognized ratably over the lease period. FAS 13 defines the "fair value" of leased equipment as "the price for which the property could be sold in an arm's-length transaction between unrelated parties." FAS 13, ¶ 5(c). FAS 13 further specifies that fair value at the inception of a lease "will ordinarily be its normal selling price, reflecting any volume or trade discounts that may be applicable." Id. ¶ 5(c)(I). The "interest rate implicit in the lease" is determined, in broad terms, by calculating the interest rate that would account for the difference between the fair value of the lease equipment, less the unguaranteed residual value of the equipment that will be recouped by the lessor at the end of the lease term, and the actual lease payment amount.*fn4
The SEC's evidence indicates that, near the end of financial reporting periods, Xerox management made topside adjustments allocating a larger percentage of the aggregate bundled lease revenues to the equity value of the equipment than could actually be supported by objective sales data. Rather than using the fair value of the copier equipment as a starting point, Xerox determined that it would back into its equipment value from an interest rate figure and derive the interest rate figure from another arbitrary figure. After conducting a survey of the reported ROE of the financing units of other companies,*fn5 Xerox calculated an interest rate that would create a total annual ROE of 15% for Xerox's finance subsidiary, Xerox Credit Corporation. Xerox's operating units then derived their reported equipment revenues from the contrived ROE figure rather than by reference to the equipment allocations entered in ValueQuix or some other objective data point such as cash sales of Xerox's copier equipment --- essentially allowing the tail to wag the dog. The ROE formula applied across Xerox's worldwide operations, even in countries such as Brazil, where skyrocketing inflation meant that market rates of financing were much higher than those calculated pursuant to the ROE figure. Xerox also reallocated revenues from lease transactions that had already been reported, which is itself a GAAP violation. Altogether, the SEC maintains that Xerox manipulated its ROE formula to pull forward a total of $303.5 million in additional reported earnings in 1997 through 2000.
The SEC provides evidence from which it could be inferred that Dolanski knew as early as 1995 that the Xerox's topside ROE adjustment was not in accordance with GAAP, the year in which Xerox lowered its ROE target from 18% to 15%. It also points to a number of later KPMG-generated documents that express significant reservations about the ROE method. For example, in its 1996 management letter to Xerox, KPMG told the company that its topside ROE adjustments were not an "appropriate and prudent accounting practice." A KPMG memorandum of November 6, 1996, on which Dolanski was copied, states that "[t]he formula used to determine the rate charged by the finance company to the marketing company has been changed (usually resulting in a lower rate and higher sales revenue)" and that "[t]he marketing companies are allowed to 'recast' the rates after the leases have been booked." The memorandum recommends that "the formula for the finance rate should be specifically defined and marketing companies should not be allowed to adjust the rates once the leases have been booked." A February 7, 1997 memorandum to Xerox management from KPMG's Rochester office, and copied to Dolanski, recommended that the ROE adjustment be discontinued. Yoho testified in his deposition that the ROE adjustment was a "significant issue" in the 1997 audit. The 1997 Xerox Completion Memorandum, signed by both Dolanski and Yoho, contains no discussion of the ROE methodology.
In 1998, Xerox applied an even lower interest rate to its sales leases to maintain the 15% ROE. It also expanded its use of the ROE adjustment to leases recorded by Xerox Business Services, a unit to which the ROE method had not formerly been applied. Safran stated at his deposition that he understood that the reason the latter change was made as a topside adjustment was that "the transactions at the initial point of entry did not reflect fair value" due to declining interest rates.
It also became evident in 1998 that Xerox was applying the ROE methodology to the accounting for Xerox's operations in other areas of the world.*fn6 Safran admitted at his deposition that he was concerned that, at Xerox Brazil, the discount rate being used as a result of the ROE model was too low. He had been told by KPMG Rio de Janeiro ("KPMG Rio") that there were concerns over this issue. KPMG's 1998 Final Issues Memorandum for Xerox Europe stated that the ROE adjustment, which had been implemented there in 1998, had "'pull[ed] forward' $85.1 million . . . of unearned finance income as sales revenue."
In 1999, Xerox's ROE methodology in Brazil was producing untenable results. An April 1999 memorandum from KPMG Rio to Safran noted that, in March 1998, the interest rate implicit in the lease contracts had been adjusted from 7% to 6% to produce the 15% ROE, and that in April 1999, a 0% interest rate would be necessary to produce such an ROE. The memo states that "KPMG's position is that a 0% interest rate does not cause the aggregate present value of the leases entered into in 1999 to be equal to the fair value of the leased property to the lessor at the inception of the lease and, consequently, we have included the adjustment as an audit difference."*fn7 At the end of the year, the interest rate for all quarters was adjusted back to 6%, an amount still far below the prevailing interest rates in Brazil at the time. The KPMG Europe audit team noted in its 1999 Year End Sign-Off Memorandum that Xerox Europe had been instructed to make a topside adjustment to reflect a 15% ROE for all 1998 leases, but that Xerox Europe "ha[d] not carried out its own benchmarking to determine whether a 15% ROE is appropriate to its operations on a stand alone basis." The memorandum acknowledges that the ROE method pulled forward $38 million in revenue for the year. Despite these concerns, no scrutiny of the ROE method is reflected in either KPMG's 1999 Audit Plan for Xerox or its Completion Memorandum for the year.
Xerox's margin normalization adjustments affected the company's reported revenue in the same manner as the ROE adjustments, but involved the accounting treatment of the service portions of bundled leases rather than the financing portions. The first margin normalization adjustments were made by Xerox Limited, Xerox's European subsidiary ("Xerox Europe") in 1997. Through this adjustment, Xerox applied the lower margins on service that existed in the United States to the European market, despite any difference in the competitive environment. By increasing the portion of the lease amount allocated to the value of the equipment, rather than to anticipated service revenues, Xerox was able to advance the recognition of revenue in its financial statements. The adjustments resulted in equipment margins that were significantly higher than service margins, even though Xerox knew that, at least in the United States, equipment margins were declining. A series of twenty-three margin normalization adjustments, of which fourteen increased equipment revenue, bolstered Xerox's revenues by $550.7 million, and pretax earnings by $321.3 million, in 1997 through 2000.
Yoho testified that the margin normalization adjustment for Xerox Europe was identified as a "significant" issue for the 1997 audit. Several documents issued by KPMG UK during this period express skepticism as to whether the adjustment was appropriate or anything other than arbitrary. For example, the 1997 Final Issues Memorandum regarding Xerox Europe describes the margin normalization adjustment in connection with its description of unadjusted audit differences and begins by stating that "evidence does support the view that there is an inherent structural bias in the accounting which favours service margin," the claimed justification for the adjustment. It explains that "[t]he margins currently achieved are largely determined by the allocation of revenue which, given contracts are negotiated on a total cost basis, is potentially arbitrary." The memorandum adds that "the concept behind the normalization adjustment is sound," and that "the base data used for the calculations is robust." Nevertheless, the memorandum concludes "that any such adjustment undertaken centrally without [operating company] management input is inherently less reliable than data produced on a contract by contract basis using actual operations data." (Emphasis supplied.) The SEC also submits evidence that Dolanski decided that the margin normalization adjustment would be treated as a "quality of earnings" issue rather than an audit difference.*fn8
KPMG's 1997 Xerox Completion Memorandum describes the adjustment but states that it "appears appropriate and . . . is supported by a detailed calculation."
KPMG's 1998 Xerox Completion Memorandum ("1998 Completion Memorandum"), signed by Safran and Yoho, recognized that top-side adjustments for KPMG Europe, most of which were attributable to the margin normalization adjustment, totaled $198 million. The 1998 Completion Memorandum further cautions that "[t]he risk of a material financial statement error remains low, but will increase over time unless processes are established to push down these top level adjustments to the contract level." It concluded, "[t]his could create a reportable condition in the future." Safran told KPMG's European audit team that he was worried that "there is too much judgment applied in the process [of making margin normalization adjustments], and the habit of periodic adjustment of the formula when needed is driven by the wrong motives."
KPMG's 1998 Completion Memorandum recognizes that the margin normalization adjustments made for Xerox Europe and, beginning in that year, Xerox Brazil had the effect of advancing over $72 million in revenue, and that certain adjustments made in the fourth quarter of 1998 applied retrospectively to the beginning of the year. That memorandum acknowledges that some of the adjustments were inappropriate in interim quarters but concludes that the annual financial statements are properly stated. "From a KPMG reporting standpoint, we evaluated the materiality of this misuse of facts during interim periods in relation to income for the full year and determined that it is not material to income or the trend of income." Notes from a January 1, 1999 conference call between Safran and a member of the audit team for KPMG Brazil indicate that Safran stated "that when [adjustments] are made retroactively to other quarters this has to be treated as an audit difference." Safran also stated "that [KPMG] must obtain reference data for the adjustment. When this can not be obtained it must be included as an audit difference."
Xerox made more dramatic margin normalization adjustments in 1999. Safran confirmed at his deposition that Xerox intended to change the allocation such that equipment margins would exceed service margins by 17% in Brazil and Mexico, where the methodology was implemented at the end of 1999. In Europe, Xerox applied margin normalization even to contracts that explicitly specified the allocations devoted to equipment and service. KPMG auditors in Europe, Brazil, and Mexico all expressed reservations about the application of the margin normalization methodology in their countries.
The third quarter Completion Memorandum for 1999, signed by Safran and Yoho, states that "[d]uring the third quarter . . . Xerox Europe made adjustments to the allocation methodologies for certain contracts that were recorded during the quarter and earlier in the year." It acknowledges that we considered whether management had properly applied accounting principles related to changes in estimates during interim quarters of 1999 and determined that they had not. . . . Our conclusion, however, is that the annual financial statements will be properly stated, and there is no audit difference. From a KPMG reporting standpoint, we evaluated the materiality of this misuse of facts during interim periods in relation to income for the full year and determined that it is not material to income or the trend of income. (Emphasis added.)
KPMG's 1999 Completion Memorandum contains a detailed discussion of margin normalization. It states:
In 1997, Xerox initiated a central margin normalization adjustment within Xerox Europe to bring sales and service margins in line with management's view of the commercial realities of the business and to better conform worldwide practices. During 1998 and 1999, Xerox Europe and Xerox of Brazil made adjustments, at Corporate direction, to the allocation methodologies for certain contracts that were recorded earlier in the year. The methodology was also initiated in Mexico in Q4 1999. These adjustments were made to obtain greater consistency in the worldwide process of revenue bifurcation results, and because local and Corporate management collectively concluded that changes occurring in pricing and competitive factors in the marketplace had caused a distortion of revenue allocations from fair value. The 1999 adjustments in Brazil and Mexico were made on a prospective basis at the time they were recorded. Europe's adjustments were recorded on a retroactive basis to the beginning of 1999.
The 1999 Completion Memorandum goes on to offer a series of general recommendations for testing the propriety of the margin normalization adjustment.*fn9 It recognizes that "[i]deally, adjustments should be allocated to the contract level to ensure accurate monitoring. We understand that at the current time systems limitations preclude this."
By this time, Safran was becoming more assertive in voicing his misgivings about some of the dubious topside adjustments made by Xerox, especially the margin normalization adjustment. A January 23, 2000 e-mail to Yoho, Conway, and Boyle indicates that Safran believed Xerox was manipulating its financial reporting specifically to meet earnings projections, and that the company was pressuring its auditors in the process. Safran advocated that these issues be raised with the Audit Committee of Xerox's board of directors:
I believe that it is a must (a professional obligation under SAS 61)*fn10 that we discuss the "[u]ndue time pressure" issue with the audit committee. . . .
The undue time pressures are the result of both the 1) pressures in their current environment (the need for quarter end transactions to "bridge the gap"), and 2) stresses of the accounting model (Brazil) and they are also too often intentional on the part of management (example: Q4 margin normalization), and this needs be said.
Safran expressed worry that the Xerox-KPMG relationship has been "strained" due to KPMG's "waffling on issues," and emphasizes that the "waffling" should be attributed to the time pressures intentionally placed on KPMG by Xerox management. Neither the management pressures nor the disputed accounting treatments were apparently raised with the Audit Committee during this time period, however. At his deposition, Safran admits that he had concerns about maintaining the Xerox relationship. A January 19, 2000 e-mail from Safran to Yoho states that "it would be management's preference that we simply say that there are no audit differences."
Ultimately, in its 1999 year-end reporting, Xerox made "adjustments" to the 17% margin differential that was originally its target in Mexico and Brazil, decreasing the magnitude of the company's margin normalization adjustment for the year. At deposition, Safran described the size of these scale-backs as "substantial relative to the amounts that had been proposed" but admitted that they did not reverse the entirety of the margin normalization adjustment in those countries in the fourth quarter.
c. Price Increases and Lease Extensions
FASB, Statement of Financial Accounting Standards No. 27: Classification of Renewals or Extensions of Existing Sales-Type or Direct Financing Leases (1979) ("FAS 27") is a brief amendment of FAS 13. It provides, in relevant part: "A renewal or extension of an existing sales-type . . . lease . . . shall be classified as a direct financing lease unless the renewal or extension occurs at or near the end of the original term specified in the existing lease . . . ." Id. ¶ 6. The significance of this classification is that revenue from a renewal or extension must be recognized over the term of the lease as financing revenue, unless the extension is negotiated at or near the end of the lease. Revenue from any price increases to existing leases must be recognized over the lease term as well:
If the provisions of a lease are changed in a way that changes the amount of the remaining minimum lease payments . . . the balance of the minimum lease payments receivable and the estimated residual value, if affected, shall be adjusted to reflect the change . . . and the net adjustment shall be charged or credited to unearned income.
FAS 13 ¶ 17(f)(i).*fn11 The SEC presents evidence that Xerox improperly advanced the recognition of revenues and earnings attributable to price increases and extensions of existing leases, recognizing such revenues in the periods in which the increases and extensions were first negotiated rather than ratably over the lease term. This accounting tactic was used primarily in Xerox's Brazil operations.
A memorandum expressing doubt as to the propriety of the adjustments for price increases and lease extensions was copied to Dolanski in November 1996. Later, KPMG Rochester's reservations about the adjustments were reflected in an exhibit entitled "Summary of GAAP Departures" attached to the Xerox 1999 Rochester Operations Final Signoff Memorandum, which was addressed to Safran. The exhibit recognizes that "[a]ccording to FAS 13, incremental sale revenue cannot be recognized on contracts that renew before the end of the original lease term nor on equipment if it is in the last 25% of its economic life." The document notes that the impact of these adjustments had been $37.3 million in 1998 and $46.5 million in 1999. It concludes, however, that the company's use of the accounting treatment was "[i]mmaterial to the worldwide consolidated financial statements taken as a whole."
As noted in KPMG's 1999 Completion Memorandum, in the first two quarters of 1999, Xerox Brazil recognized a great deal of revenue, although those amounts were reversed in Xerox's audited financial statements at the end of the year. The memorandum notes that the accounting treatment of contract extensions in Xerox Brazil did not comply with GAAP. It states:
During the first and second quarters of 1999 Xerox Brazil took operational measures to recover the economic consequences of the devaluation of the Brazilian Real by repricing certain contracts and amending certain contracts through extensions. The increase in net-present-value associated with a portion of these rent adjustments was recognized immediately as revenue in accordance with Xerox's historical practices. Under GAAP rent adjustments on sales-type leases that result from inflation adjustments, renegotiations of prices, and extensions must be recognized in income over the remaining life of the leases as additional finance income. Historically, the effect of the differences between Xerox policy and GAAP have been considered immaterial. (Emphasis supplied.) It states that the current Xerox policy was created because Xerox considered it to be "a fairer presentation of the results of the business" because the GAAP treatment "result[ed] in unrealistic finance returns on the finance business." The memorandum notes that Xerox made first-quarter adjustments in 1999 "to reduce the impact of the departure from GAAP to an amount that management, with KPMG's concurrence, determined was immaterial," but that "[p]retax income would have been reduced further by approximately $50 million in Q1 and Q2 of 1999 if [Xerox Brazil's] accounting fully conformed to GAAP." It states, however, that on December 31, 1999, Xerox "recorded an adjustment of $34 million to reverse the 1999 income statement impact of the above-mentioned revenue recognition issues for Brazil. This amount represents the estimated balance sheet impact of revenue overstatements that had not [been] reversed as of December 31, 1999." The memorandum nevertheless cautions that "[d]uring the 1999 audit, we noted an unacceptably high level of contracts [by Xerox Brazil] that did not meet minimum requirements under GAAP for revenue recognition" and that it was unclear whether additional controls adopted during the second half of 1999 would reduce risks to an "acceptable level" in the future. KPMG warned of the pressures facing Xerox Brazil in its 1999 management letter as well. This management letter was copied to the Audit Committee of Xerox's board of directors.
The SEC points to a draft memorandum regarding "First Quarter Lease Modifications in Brazil" showing that KPMG auditors, including Yoho, knew that the recognition of revenue from price uplifts and lease extensions did not conform to GAAP. It indicates that KPMG suggested that Xerox reduce the overstatement of current revenue to an amount representing less than 5% of consolidated income. Next to the 5% figure is a handwritten notation by Yoho: "Do we want this in writing?"
d. Retroactive Increases to Residual Values of Leased Equipment
The "estimated fair value of the leased property at the end of a lease term" is known as the "residual value." FAS 13 ¶ 5(h). FAS 13 flatly provides that "[a]n upward adjustment of the estimated residual value shall not be made." Id. ¶ 17(d). Xerox increased residual values retroactively, albeit within the year in which the leases originated.
The SEC presents clear evidence that Dolanski knew of the upward adjustments to residual values, including an internal e-mail message from a Xerox officer stating that Dolanski "had finally albeit with some reluctance accepted the practice of backdating residual value recognition within the same year." The e-mail message describes the argument over the issue as "heated." Safran indicated at deposition that retroactive increases to residual values were among his concerns as well. He stated that he did not, however, view these adjustments as inconsistent with GAAP.
2. Loss Contingency Reserves
A second set of accounting manipulations relates to the
improper creation and release of reserves. Under GAAP, a company must set up a loss contingency reserve if a future loss is both probable and reasonably estimable. See Statement of Financial Accounting Standards No. 5: Accounting for Contingencies ¶ 8 (Fin. Accounting Standards Bd. 1975) ("FAS 5").*fn12 When such a reserve is created, it is charged to current earnings; when the anticipated loss occurs, it is charged to the reserve. When a reserve is created without a sufficient likelihood that the relevant expense will be incurred, it permits a company to draw on the reserve to cover expenses for which the reserve was not created and thereby artificially boost its earnings in subsequent reporting periods.
The SEC submits evidence regarding a number of excess, or "cushion," reserves that it contends were improperly maintained or released by Xerox. One particular reserve, of $100 million, was created pursuant to Xerox's 1997 acquisition of the 10% outstanding ownership interest in Rank Xerox, Xerox's European subsidiary, which was renamed Xerox Limited (the "Rank Reserve"). KPMG's due diligence report for the acquisition concluded that the risk of future tax liability stemming from the acquisition, the contingency for which the Rank Reserve was ostensibly created, was remote at the time of the transaction and thus did not justify the creation of the Rank Reserve in the first instance. Xerox drew down on that reserve in 1998 and 1999 for purposes unrelated to the stated purpose of the reserve.
The SEC provides evidence that both Dolanski and Yoho knew of the existence of the unspecified excess reserves. Yoho, for example, admitted at his deposition that he knew in 1997 that Xerox maintained such reserves, but stated that they would not have caused him concern "so long as [they were] considered as an audit difference and evaluated for materiality." The 1997 Summary Audit Plan prepared by KPMG Rochester headed a chart showing amounts of reserve releases and other "accounting actions" in 1995, 1996, and 1997 with the statement "the pressure to maintain favorable earnings trends and increase the stock price is a top priority of public companies."
Testimony by Xerox officers suggests that creation of the $100 million Rank Reserve in 1997 was Dolanski's idea. At deposition, Yoho testified that he had knowledge of the Rank Reserve beginning at the end of 1998 or early 1999. He also testified that he believed the improper releases from the Rank Reserve had been corrected in 1999. Safran testified that he became aware of the take-downs of the Rank Reserve in 1999. KPMG's 1999 Audit Completion Memorandum acknowledges the impropriety ...