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Securities and Exchange Commission v. Espuelas

March 30, 2010


The opinion of the court was delivered by: Richard J. Holwell, District Judge


This is an enforcement action by the Securities Exchange Commission ("SEC") against former executives of StarMedia Network, Inc. ("StarMedia" or the "Company") for accounting fraud. The SEC alleges violations of Section 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77q(a); Sections 10(b), 13(a), 13(b)(2)(A), and 20(e) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. §§ 78j(b), 78m(a), 78m(b)(2)(A), and 78t(e); and Rules 10b-5, 12b-20, 13a-1, 13a-13, 13b2-1, and 13b2-2 thereunder, 17 C.F.R. §§ 240.10b-5, 240.12b-20, 240.13a-1, 240.13a-13, 240.13b2-1, and 240.13b2-2. This Court previously dismissed all of the SEC's claims against Espuelas and Chen, and some of the claims against Scolnik and Kampfner, but it granted the SEC leave to replead. The SEC did so, and defendants Fernando J. Espuelas ("Espuelas"), Jack C. Chen ("Chen"), Betsy D. Scolnik ("Scolnik"), and Adriana J. Kampfner ("Kampfner")*fn1 again move to dismiss the claims against them. For the reasons set forth below, the Court denies the motion in part and grants it in part.


The SEC's original allegations are set forth in the Court's prior Memorandum Opinion and Order dated September 30, 2008, SEC v. Espuelas, 579 F. Supp. 2d 461 (S.D.N.Y. 2008) ("Espuelas I"), familiarity with which is assumed. Allegations relevant to the disposition of this motion are stated below and are taken as true. Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 151 (2d Cir. 2007).

I. The Basic Allegations

StarMedia, which at one time employed each of the defendants, was an Internet portal that targeted Spanish- and Portuguese-speaking markets. (Am. Compl. ¶ 24.) Espuelas and Chen co-founded the company in 1996. (Id. ¶ 16.) Espuelas was its CEO from 1996 until August 2001 and Chairman of its Board of Directors until November 2001. (Id.) Chen was its President and a member of its Board from 1996 until August 2001; from June to August 2001, he also served as Vice Chairman of the Board. (Id. ¶ 17.) Scolnik worked for StarMedia from February 1999 through November 2001, first as Senior Vice President for Strategic Development and later as an Executive Vice President. (Id. ¶ 19.) Kampfner worked for the company from August 1997 through December 2001; in 2000 and 2001, she was Senior Vice President, Global Sales and President of StarMedia de Mexico. (Id. ¶ 20.)*fn2

In both its original and amended complaints, the SEC's allegations center on StarMedia's recognition of revenue from three types of transactions, which the SEC refers to as the base book, incremental revenue, and contingent transactions. (Compl. ¶ 1; Am. Compl. ¶ 1.) In late 2001, StarMedia restated its financial statements to correct the accounting for these transactions. (Am. Compl. ¶ 3.)

A. The Base Book Transactions

StarMedia acquired AdNet S.A. de C.V. ("AdNet") in 1999. (Id. ¶ 30.) Pre-acquisition, as much as 60 percent of AdNet's revenue had come from "base book" transactions. (Id. ¶ 31.) Post-acquisition, these transactions continued through 2000 and the first two quarters of 2001. (Id. ¶¶ 31, 33, 39, 52, 72, 86, 103.) The essence of the base book transactions was AdNet's sale of services in exchange for its reciprocal purchase of services. Grupo MVS, S.A. de C.V. ("MVS") and Harry Möller Publicidad, S.A. de C.V. ("HMP")*fn3 (collectively, "MVS/HMP"), which owned AdNet before StarMedia acquired it, would buy Internet advertising from AdNet for their clients; in return, AdNet would buy advertising services from MVS/HMP in the same amount. (Id. ¶ 31.) Because AdNet was obligated to pay MVS/HMP exactly what MVS/HMP paid AdNet, neither party generated any cash revenue on the transactions. (Id. ¶ 33.)

Had StarMedia categorized these transactions as barter-two parties trading services without earning cash-it would have reported them in its SEC filings as "barter revenue."*fn4 (See id. ¶¶ 39, 43, 45.) Instead, the SEC alleges, StarMedia treated them as entirely independent transactions: AdNet sold services to MVS/HMP, and MVS/HMP sold other services to AdNet. StarMedia thus recognized all of AdNet's sales to MVS/HMP as advertising revenue, just as if no reciprocal arrangement existed. (Id. ¶ 39.) Later, StarMedia re-categorized these transactions as barter transactions; treated revenue from them as barter revenue; and, pursuant to the relevant accounting rules, wrote off more than 90 percent of the barter revenue. (Id. ¶¶ 3, 43.) The original complaint asserted that "Espuelas and Chen each caused StarMedia to book the full amount of AdNet's base book transactions" even though they "knew or were reckless in not knowing that these amounts were improperly recorded as revenue." (Compl. ¶ 39.)

The amended complaint adds several allegations. First, it alleges that StarMedia's acquisition of AdNet was a deal done partly on the books and partly off them. As part of the acquisition, StarMedia had agreed to buy a dollar of services from MVS/HMP for every dollar of advertising MVS/HMP directed their clients to buy from AdNet. (Am. Compl. ¶ 33.) This part of the agreement was not recorded. (Id.) Thus none of the documents executed in connection with the acquisition disclosed the reciprocal nature of the barter deal; nor did any of the AdNet acquisition documents, StarMedia's SEC filings, or the company's public statements in 2000 and 2001. (Id. ¶¶ 33, 36.)

The amended complaint also adds facts about the extent of Espuelas's and Chen's knowledge of the nature and significance of reciprocal barter transactions as opposed to unlinked cash transactions. Espuelas and Chen were allegedly familiar with barter transactions because of "their executive positions, their knowledge of the company's business, and StarMedia's disclosures" in SEC filings and public statements that differentiated between cash revenues and barter (non-cash) revenues. (Id. ¶ 44.) Moreover, Espuelas and Chen, as "members of the executive team," had received StarMedia's written policies on how to account for barter transactions. (Id. ¶ 46.) And in April and October 2000, when analysts questioned whether barter was boosting company revenue, Espuelas indicated his comprehension of the concept when he assured them that StarMedia had "surging revenue" and that barter would likely fall "below 10 percent by the end of the year." (Id. ¶ 46.) Relying on these allegations, the SEC asserts that Espuelas and Chen knew or should have known that the base book transactions were barter transactions; that, without documentation of the reciprocal arrangement, the "linked nature of the base book transactions would not be apparent to [StarMedia's] finance department"; and thus that StarMedia's representations as to the amount of its barter revenue would be understated. (Id. ¶ 39.)

B. Incremental Revenue Transactions

The incremental revenue transactions involved both AdNet and StarMedia de Mexico, another StarMedia subsidiary. They occurred in the fourth quarter of 2000 and the first two quarters of 2001, and all defendants allegedly took part in them. (Id. ¶¶ 4, 57--71, 88--93, 104.) The genesis of these transactions was the defendants' realization in late 2000 that revenues were projected to fall well short of analyst expectations. (Id. ¶ 57.) As Espuelas, Chen, Heller, Kampfner, and Scolnik began searching for ways to close the revenue gap, they decided that Möller's connections with MVS/HMP- Möller's family owned HMP-could prove a useful way to boost revenue. (Id. ¶¶ 57, 59.) Scolnik and Kampfner had "initial discussions with Möller" about possible transactions; later, Chen got Heller involved in the discussions, and Heller became a "conduit" between Chen and Möller. (Id.) In late November of 2000, Möller sent Heller an e-mail diagramming what became called the "incremental revenue" transactions; Heller discussed the structure with Chen, who approved it. (Id. ¶ 60.) The next day, Heller spoke with Espuelas and Kampfner about "possible terms for the incremental revenue transactions," and later Espuelas and Kampfner confirmed to Möller that StarMedia had decided to go through with them. (Id. ¶ 61.) As the transactions were structured, StarMedia made capital contributions to AdNet, which AdNet then used along with its own funds to buy services from MVS and HMP. (Id. ¶ 62.) In return, clients of MVS and HMP agreed to buy the same amount in advertising from StarMedia. (Id.) The SEC claims that some of these clients were unaware of the purchases, and that others knew but did not care because it was MVS and HMP, not their clients, who were actually paying for the advertising. (Id. ¶ 65.).

The amended complaint adds that the defendants did not document the underlying oral agreement that made clear the transactions were reciprocal, and knew that no such documentation existed. (Id. ¶¶ 67, 80, 97, 110.) Although StarMedia's internal controls "requir[ed] all terms of a sales contract to be in writing," no document was recorded "showing all the terms of the agreement." (Id.) Without documentation, the finance department and StarMedia's auditors were unable to assess the transactions holistically. (Id.) Consequently, the transactions were recorded as non-barter revenue when they should have been recorded either as barter revenue or not as revenue at all.

C. Contingent Transactions

The contingent transactions, which implicate Kampfner, Scolnik, and Blacker, took place in the last three quarters of 2000 and the first quarter of 2001. (Id. ¶¶ 47--51, 73--74, 82, 94, 100.) These transactions were subject to contingencies, but StarMedia recorded revenue from them without taking those contingencies into account. (Id. ¶ 5.) In the second quarter of 2000, for example, Scolnik, Kampfner, and Blacker orally agreed to provide advertising to AMG International, Inc. ("AMG") on a contingent basis: if AMG approved of the advertising services, it would owe StarMedia $500,000; if it did not, it would owe only $10,000. (Id. ¶ 47.) "At Blacker's direction," an order for $500,000 was submitted to StarMedia's finance department, and the contingency was not noted. (Id.) StarMedia then recognized revenue of $500,000. (Id. ¶ 48.) Although the oral contingency was later documented, Blacker, Scolnik, and Kampfner did not give that documentation to the finance department. (Id. ¶ 49.) Such transactions occurred in the second and fourth quarters of 2000 and in the first quarter of 2001. (Id. ¶¶ 47, 74, 94.) The defendants also engaged in transactions with a company called Groupe Danone ("Danone"); although the SEC calls these contingent transactions, they actually seem to have been nothing more than free giveaways. In the third quarter of 2000, for example, Blacker and Kampfner are said to have offered Danone $500,000 of Internet services at no charge, to provide an incentive for Danone to hire StarMedia for a large project in Latin America. (Id. ¶ 50.) At Blacker's direction, a $500,000 order was submitted to StarMedia's finance department, and none of the three defendants informed the department that the services were actually to be provided free of charge. (Id. ¶ 51.) Such transactions occurred in the third and fourth quarters of 2000. (Id. ¶¶ 50, 73.)

The amended complaint adds allegations that Scolnik and Kampfner knew that StarMedia reported too much revenue from the contingent sales it made to Danone and AMG's portfolio company. Scolnik and Kampfner each received revenue reports generated from StarMedia's books and records that recorded the contingent transactions as revenue. (Id. ¶ 56.) Thus, says the SEC, these defendants were or should have been aware that StarMedia improperly recognized the full amount of the contingent deals as revenue. (Id.)

D. Misleading Statements

The SEC contends that the defendants made misleading statements in SEC filings,*fn5 to external auditors, and to potential investors. (Id. ¶¶ 112--21.) First, Chen and Espuelas are alleged to have made a misleading statement by signing StarMedia's annual Report on Form 10-K for its fiscal year 2000. (Id. ¶ 113.) As in its first complaint, the SEC alleges that this 10-K overstated the company's total revenue for 2000 because it had improperly accounted for several transactions in that year. But now the SEC also alleges that the 10-K misrepresented the quality of StarMedia's 2000 revenue. (Am. Compl. ¶¶ 7, 28, 44, 45, 113.) The 10-K contained this disclosure:

[a] portion of the Company's revenues are from barter advertisements (agreement whereby the Company trades advertisements on its Network in exchange for advertisement from third parties). Barter advertising revenues and expenses are recognized in accordance with Emerging Issues Task Force Issue No. 99-17, "Accounting for Barter Advertising." Revenues from barter transactions are recognized during the period in which the advertisements are displayed on the Company's Network. Barter expense is recognized when the Company's advertisements are run by the third-party, which is typically in the same period when barter revenues [are] recognized. For the years ended December 31, 1998, 1999 and 2000, revenues derived from barter transactions, were approximately $2,400,000, $5,500,000, and $7,200,000 respectively. . . . For the years ended December 31, 1998, 1999 and 2000, advertising expense amounted to approximately $21,246,000, $29,076,000, and $33,131,000 respectively. For the years ended December 31, 1998, 1999 and 2000, advertising expense includes approximately $2,400,000, $5,500,000 and $7,200,000 of charges related to barter advertising transactions.

StarMedia Network, Inc. April 2, 2001 Form 10-K, 2000 Annual Report, at F-6, F-8 (available at 0000912057-01-506571.txt).*fn6 Investors viewed barter revenues as qualitatively different from cash revenues. (See Am. Compl. ¶ 46 ("analysts questioned whether the company was increasing revenue by using barter").) Thus the 10-K's disclosure on barter-that, in 2000, only $7.2 million of StarMedia's revenue came from barter transactions-made a representation about the quality of the company's total revenue. The SEC says that because StarMedia was not treating the base book and incremental transactions as barter transactions during this period, as it should have, that representation was false.

The SEC also alleges that the defendants misled potential investors in StarMedia. The original complaint alleged simply that "Espuelas, Chen, Heller, and Scolnik each played a role in the presentation of financial information, discussions, and negotiations with entities, led by BellSouth, that were considering whether to provide financing to the company during 2000 and 2001." (Compl. ¶ 87.) As the Court said in Espuelas I, "this allegation fails utterly to provide these defendants with 'fair notice of the specific conduct with which [each] is charged.'" Espuelas, 579 F. Supp. 2d at 473 (citation omitted). The amended complaint provides somewhat more detail. It alleges that, in mid-2000, Chen told Scolnik to try to "secure financing for StarMedia from a consortium of investors led by BellSouth." (Am. Compl. ¶ 117.) BellSouth ultimately did provide financing, by buying $35 million in convertible preferred shares of StarMedia stock. (Id. ¶ 118.) The deal closed in mid-2001. (Id.) Prior to the closing, Scolnik acted as a "conduit" between BellSouth, which wanted additional financial information, and StarMedia, which provided that information. (Id.) In connection with the parties' agreement, StarMedia represented to BellSouth that none of its SEC filings, as of their filing dates, contained any materially false or misleading statements and that its financial statements complied with Generally Accepted Accounting Principles ("GAAP"). (Id. ¶ 120.) Espuelas executed the agreement, and he and Chen approved it. (Id.) The SEC alleges that the following defendants made materially misleading statements about the amount and quality of StarMedia's revenue: (1) Chen and Heller, by providing "financial information . . . relating to StarMedia's revenue in 2000 and the first quarter of 2001" to BellSouth during negotiations; (2) Scolnik, by relaying unidentified "financial information" from StarMedia to BellSouth; and (3) Chen and Espuelas, by approving the agreement with the BellSouth group, which represented that StarMedia's SEC filings contained no materially false or misleading statements and that its financial statements complied with GAAP. (Id. ¶¶ 118--121.) The SEC says these representations were misleading in that they endorsed the veracity of StarMedia's public disclosures about its total revenues, its total barter revenues, and its barter revenues as a percentage of total revenues. (Id. ¶ 121.)

Finally, the SEC alleges that Chen, Heller, and Morales made misleading statements to StarMedia's outside auditor, Ernst & Young ("E&Y"). These defendants signed letters representing to E&Y that "[w]e have made available . . . all significant contracts and agreements"; "[r]eceivables represent valid claims . . . and do not include amounts for . . . other types of arrangements not constituting sales"; "[w]e have disclosed to you all sales terms, including all rights of return or price adjustments"; "[w]e have provided you with all sales agreements . . . [and] [t]hese represent the entire arrangements and are not supplemented by other agreements either written or oral"; "[t]here has been no fraud involving management or employees who have significant roles in internal control"; and "[t]here has been no fraud involving other employees that could have a material effect on the financial statements." (Id. ΒΆ 116.) ...

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