In SEC v. Todd, the SEC appealed the district court’s granting of Gateway Inc. officials John Todd and Robert Manza’s motions for judgment as a matter of law, which set aside the jury verdict against them on Section 10(b), Rule10b(5), and Rule 13b2-2 claims; they also appealed the district court’s granting of motions for summary judgment regarding alleged securities violations by Jeffrey Weitzen, Gateway’s CEO and president. Sec. Exch. Comm’n v. Todd, 2011 U.S. App. LEXIS 12692 (9th Cir. June 23, 2011).
The SEC claimed that Gateway’s CFO, Todd, and lead CPA, Manza, unlawfully misrepresented Gateway’s financial condition to meet earnings and revenue expectations in the third quarter of 2000. Their claims revolved around transactions between Gateway and Lockheed Martin, VenServ Inc., and AOL.
In 2000, according to the SEC, Gateway entered into an agreement with Lockheed Martin to sell $47.2 million of fixed assets in the form of IBM and Sun Microsystems servers. Gateway planned to then lease back the servers, booking the initial transaction as revenue. This technique was not in accordance with revenue recognition under Generally Accepted Accounting Principles (“GAAP”). Gateway booked this one time gain as revenue in its third quarter report. During that same quarter, Gateway included $21 million from a transaction with Venserv. However, when it was recorded, the Venserv sale was incomplete because Gateway did not fulfill the services stipulated in the contract. Gateway also modified the AOL agreement to be able to book revenue sooner, creating a one-time revenue boost during the third quarter of $72 million.
The Lockheed transaction involved the defendants recording the sale of fixed assets as revenue; Manza and Todd argued that the Lockheed transaction did not violate a specific provision of GAAP while the SEC presented experts that disputed that claim. However, Manza testified that while he did not believe their actions violated a specific GAAP provision, if he were the CFO he would not have recorded the transaction as revenue.
The SEC alleged that the actions constituted securities fraud under Rule 10b-5. Violations of § 10(b) of the Act require “a material representation, in connection with the purchase or sale of a security, with scienter, by means of interstate commerce.” SEC v. Dain Rauscher, Inc., 254 F.3d 852, 855-56 (9th Cir. 2001). The SEC also claimed that Todd and Manza’s signing of the management representation letter sent to Price Waterhouse Coopers amounted to a violation of rule 13b2-2 for improper reporting to accountants. Although the SEC prevailed at trial, the district court set aside the jury verdict, holding that the evidence was insufficient to establish scienter or the materiality of the alleged misstatements.
On appeal, the Ninth Circuit reversed. The appellate court found ample evidence in the Lockheed and VenServ transactions for the jury to have found a material misrepresentation. In the Lockheed transaction, the jury heard expert opinions of how the transaction should have been recorded as well as testimony that Gateway had violated its own internal accounting policy by booking the transaction as revenue. Both parties agreed that the Venserv transaction was not complete and improperly recognized.
With respect to scienter, the court held that the mental state embraced both an “intent to deceive, manipulate or defraud” and recklessness. In the Lockheed transaction, Todd and Manza allegedly kept information from their internal auditors because Manza said “they wouldn’t go for it.” In the Venserv transaction, evidence was presented which showed that the defendants knew the sale was incomplete at the time it was recognized.
A violation of rule 13b2-2 requires an officer to knowingly making a false or misleading statement to an accountant. The Ninth circuit found that the same evidence sufficient for scienter with regard to Section 10(b) violations was sufficient to show Todd and Manza knew the financial documents were not accurate when they signed the management representation letters.
The Ninth Circuit reversed the trial court’s grants of summary judgment for Weitzen with regard to his liability under § 10(b), Rule 10b-5, and control person liability under §20(a) of the Securities Act of 1933. Despite the nature of the transactions that were recorded in Gateway’s third quarter earnings report, Weitzen repeatedly referred to revenue growth as accelerated during conference calls with analysts. The court drew from this a genuine issue of material fact regarding whether Weitzen materially misrepresented Gateway’s revenue and acted with scienter in doing so. The court again found a genuine issue of fact as to whether Weitzen could be considered a “control person” with regard to Gateway. The control person must have power or control over the primary violator of the Act.
The Ninth Circuit upheld summary judgment for Weitzen with regard to the rule 13b2-2 claim of improperly reporting to accountants. The court also affirmed the district court’s order denying defendants Todd’s and Manza’s motions for a new trial and motions for judgment as a matter of law on aiding and abetting claims.
Further posts on SEC v. Todd can be found here.
The primary materials for this case may be found on the DU Corporate Governance website.