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UNITED STATES OF AMERICA
before the
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In the Matter of Ira A. Gerard and Karen S. Harris, Respondent. |
: |
ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING CEASE- AND-DESIST ORDER |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Respondents Ira A. Gerard ("Gerard") and Karen S. Harris ("Harris").
II.
In anticipation of the institution of these cease-and-desist proceedings, Gerard and Harris have submitted Offers of Settlement ("Offers") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings contained herein, except as to the Commission's jurisdiction over them and the subject matter of these proceedings, Gerard and Harris consent to the entry of this Order InstitutingCease-and-Desist Proceedings, Making Findings and Imposing Cease-and-Desist Order ("Order") as set forth below.
III.
On the basis of this Order and the Offers, the Commission finds that:
A. RESPONDENTS
Gerard, 53, of Ridgefield, Connecticut, was CFO and Vice President of Finance for Mercator Software, Inc. ("Mercator") from October 1995 until August 1, 2000. In the first quarter of 2000, Mercator's CEO began an active search for a replacement CFO.1 As of August 1, 2000, Gerard stepped down as CFO and Mercator named him Vice President of Finance. On August 20, 2000, Gerard was terminated by the company in connection with the company's announcement on August 21 of the restatement of financial results for the first and second quarters of 2000. Gerard has never been licensed as a Certified Public Accountant and is currently self-employed.
Harris, 41, of Riverside, Connecticut, was controller at Mercator from December 1997 until August 20, 2000, when she was relieved of her duties in connection with the company's announcement of the restatement of financial results for the first and second quarters of 2000. Harris resigned from Mercator in February 2001 and is not currently licensed as a Certified Public Accountant.
B. OTHER RELEVANT ENTITY
Mercator is a Delaware corporation with its principal place of business in Wilton, Connecticut. Mercator was incorporated in Connecticut in 1985 as TSI International Software, Inc. and reincorporated in Delaware in September 1993. The company changed its name to Mercator, effective April 3, 2000. At all relevant times, Mercator's securities were traded on the NASDAQ National Market and registered with the Commission pursuant to Section 12(g) of the Exchange Act, and the company was required to file reports with the Commission pursuant to Section 13(a) of the Exchange Act.
C. SUMMARY
This matter involves material understatements of expenses in Mercator's publicly released financial statements for the first and second quarters of 2000.2 During those quarters, Mercator failed to record certain expenses in the quarter during which they were incurred, resulting in understated losses for both quarters. This practice understated the extent of Mercator's losses and resulted in Mercator's misstating its net losses in financial statements filed in its Form 10-Q for the first quarter and in its earnings release at the conclusion of the second quarter.3 Gerard and Harris each knew, or were reckless in not knowing, that certain expenses were not reported. Those certain expenses were excluded in an attempt to meet Wall Street analysts' earnings expectations for the two quarters. On August 21, 2000, Mercator announced that it had understated expenses for the first quarter by $1.3 million and for the second quarter by $1.1 million. As a result of the understated expenses, first quarter net loss, operating loss and loss per share were each understated by 14% and second quarter net loss, operating loss and loss per share were each understated by 10%.
As described below, Gerard violated Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5, 13b2-1 and 13b2-2 thereunder, and he caused Mercator's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) and Rules 12b-20 and 13a-13 thereunder. Harris violated Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder and she caused Mercator's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.
D. FACTS
Mercator specializes in software which allows businesses to integrate different types of systems and applications. In 1999, Mercator's annual revenues were $99 million. Starting in late 1998 through the end of 1999, Mercator made three substantial acquisitions which placed a strain on its operational resources and its internal controls. Although Mercator's business grew substantially as a result of the acquisitions, its accounting staff was not correspondingly expanded at the time of the acquisitions.
From the time Mercator began publicly trading in 1997 until the end of 1999, the company met analysts' earnings expectations for every fiscal quarter. During the first and second quarters of 2000, Gerard placed substantial pressure on Harris to continue to meet analysts'earnings expectations in reported financial results. As a result of that pressure, Harris intentionally failed to record certain operating expenses which were material to both quarters. Gerard was informed of, or was reckless in not knowing of, the underreporting in both quarters.
In addition to Gerard and Harris being aware of the underreporting of certain expenses, Mercator also failed to report expenses material to both quarters because its internal controls relating to expense reporting were inadequate. Both Gerard and Harris had responsibility for implementing adequate internal controls. In particular, Mercator had inadequate procedures in place to ensure accurate and timely communication between the accounting department and other areas of the company, with the result that certain expenses were not internally reported to the accounting department until after the financial statements for the period had already been publicly released.
1. Failure To Properly Record Expenses in the First Quarter
In its Form 10-Q filed on May 15, 2000, Mercator understated actual first quarter expenses by approximately $1.3 million. Gerard signed the Form 10-Q on behalf of Mercator. At the time the Form 10-Q was filed, Gerard and Harris both knew, or were reckless in not knowing, that at least $750,000 in first quarter expenses had not been included in the financial statements for the first quarter. The balance of the unreported expenses (approximately $550,000) was excluded largely as a result of either inadvertence or failure of internal controls relating to expense reporting.4
The unreported $750,000 in first quarter expenses was comprised of three categories: (1) legal expenses; (2) bonus expenses; and (3) expenses related to a shareholder value study completed in the first quarter. The understatement of legal and bonus expenses began because Mercator had inadequate procedures in place for ensuring that its accounting department was informed of such expenses in a timely manner. By the time the Form 10-Q was filed, however, both Gerard and Harris knew, or were reckless in not knowing, that legal expenses and bonus expenses were not being adequately tracked by Mercator's internal expense reporting systems. Both also knew, or were reckless in not knowing, that Mercator had incurred substantial legal and bonus expenses during the first quarter that were not included in the first quarter financial statements. In addition to being aware of the unrecorded legal and bonus expenses, both Gerard and Harris knew that a substantial non-recurring expense relating to a shareholder value study had been incurred in the first quarter and that the expense had not been recorded in the first quarter financial statements. Gerard and Harris did not include the $750,000 in expenses in financial statements filed with the Form 10-Q. Neither notified Mercator's outside auditors that substantial expenses had been excluded from the financial statements. The numbers reported in the Form 10-Q allowed the company to meet analysts' expectations. If all first quarter expenseshad been reported, Mercator would not have met analysts' earnings expectations. As a result of the total $1.3 million in excluded expenses, Mercator's first quarter net loss, operating loss and loss per share were each understated by 14%.
2. Failure to Properly Record Expenses in the Second Quarter
On July 20, 2000, Mercator announced financial results for the second quarter which understated expenses by approximately $1.1 million. Gerard and Harris intentionally excluded approximately $850,000 of those expenses. An additional $850,000 of second quarter expenses was excluded largely as a result of Mercator's inadequate internal expense reporting controls and through inadvertence.5
Harris realized by June 2000 that revenue figures for the second quarter would not be high enough for the company to meet published analysts' earnings expectations. During the second quarter, Harris expressed concerns to Gerard that expenses were likely to be higher than anticipated and second quarter revenue figures were turning out to be lower than anticipated. When Harris closed the accounts payable system after the end of the second quarter, she kept track of invoices for second quarter expenses that had not been entered into the accounts payable system. As second quarter expenses came in to the accounting department, Harris added them to her list but did not include them in the financial statements she was preparing for the second quarter because she was concerned that, if she did, the company would not meet earnings expectations. In early July 2000, Harris informed Gerard about her decision not to record certain expenses in the second quarter. Gerard approved Harris' decision, telling her not to worry about it and that there was an expense cushion in the budget in the fourth quarter that would cover those expenses. In addition to excluding the expenses described above, Gerard and Harris excluded certain second quarter bonus expenses from the financial statements. The total second quarter expenses which Gerard and Harris decided to exclude was $850,000. Neither notified Mercator's outside auditors that substantial expenses had been excluded from the financial statements.
Notwithstanding the exclusion of second quarter expenses from the financial statements, Mercator did not meet analysts' earnings expectations for the second quarter. Mercator issued an earnings warning after the close of the market on July 14, 2000 indicating that it expected pro-forma earnings per share to be $.04, which was $.04 lower than expectations.6 The preliminary figures that Mercator released on July 14, 2000 were misleading because they did not include the $850,000 in expenses that Gerard and Harris had excluded, nor did they include the additional$850,000 in expenses that were excluded due to inadvertence and poor internal controls. On July 20, 2000, Mercator issued a press release and financial statements that still did not include those second quarter expenses. As a result of the excluded expenses, second quarter net loss, operating loss and loss per share were each understated by 10%.7
3. Mercator's Response to the Reports of Accounting Impropriety
In late 1999, Mercator's Chief Executive Officer (the "CEO") removed certain non-financial responsibilities from Gerard. In the first quarter of 2000, the CEO began an active search for a replacement CFO. On August 1, 2000, Gerard was replaced by a new Chief Financial Officer (the "new CFO").
On the morning of July 20, 2000, prior to Mercator's second quarter earnings release, Harris met informally with the new CFO. At that meeting Harris informed the new CFO that she had concerns about the recording of expenses in both the first and the second quarter financial statements. When the new CFO started work on August 1, 2000, he began investigating Harris' claim that the company's first and second quarter expenses were understated. By August 9, 2000, the new CFO's investigation revealed that substantial expenses had not been recorded in the first and second quarters. On August 10, 2000, the new CFO contacted Mercator's in-house counsel about the accounting issues and instructed him to contact outside counsel and the audit committee. The new CFO also tendered his own immediate resignation.
On August 10, 2000, the company began an internal investigation. On August 14, 2000, Mercator placed Gerard (who had previously been replaced on August 1, 2000) on administrative leave and terminated his employment on August 20, 2000. Also on August 20, 2000, Mercator relieved Harris of her duties and of all responsibility for accounting decisions. On August 21, 2000, Mercator announced that the previously released financial statements for the first and second quarters were inaccurate and that it had hired its outside auditors to conduct a special review of its systems and controls and to make recommendations for improvements. The company filed an amended Form 10-Q for the first quarter and a Form 10-Q for the second quarter reflecting restated results. The restatement revealed that the first quarter net loss, operating loss and loss per share were each understated by 14%. For the second quarter, net loss, operating loss and loss per share were each understated by 10%.
E. VIOLATIONS
1. Gerard and Harris violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder.
Section 17(a) of the Securities Act prohibits fraud in the offer or sale of securities, and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit fraud "in connection with the purchase or sale" of securities. In particular, Rule 10b-5 prohibits any person from engaging in "any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." Misstatements and omissions of material fact in a registration statement may violate Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5. SEC v. Benson, 657 F. Supp. 1122, 1130-1131 (S.D.N.Y. 1987). Violations of Section 10(b) and Rule 10b-5 occur when an issuer makes material misstatements in periodic reports filed with the Commission and trading thereafter occurs in the issuer's securities.8 Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988). Liability is appropriately imposed against individuals involved in the fraud even where the issuer itself is not held directly liable for the fraud. See Charles W. Wallin, Exchange Act Rel. No. 37127 (April 19, 1996), 1996 SEC LEXIS 1137 (settled proceeding) (treasurer and CFO of accounting operations violated Section 10(b) by engaging in various fraudulent accounting practices at company, even though company itself was not charged with violations of Section 10(b)).
Gerard and Harris violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by intentionally failing to record expenses on Mercator's publicly released financial statements for the first and second quarters of 2000 in an attempt to meet Wall Street analysts' earnings expectations for those quarters. Gerard also violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by signing the false and misleading Form 10-Q for the first quarter which was filed with the Commission.
2. Gerard and Harris Caused Mercator's Violations of Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 Thereunder
Section 13(a) of the Exchange Act and Rule 13a-13 thereunder require issuers of registered securities to file quarterly reports with the Commission. It is implicit in this requirement that the information provided be accurate. See United States v. Bilzerian, 926 F.2d 1285, 1298 (2d Cir.), cert. denied, 502 U.S. 813 (1991); SEC v. Kalvex, Inc., 425 F. Supp. 310, 316 (S.D.N.Y. 1975). Regulation S-X requires that financial statements filed with the Commission pursuant to Section 13(a) of the Exchange Act be prepared in accordance with generally accepted accounting principles ("GAAP") or such statements will be presumed to be misleading or inaccurate. In addition, Exchange Act Rule 12b-20 requires that these periodicreports contain all information necessary to ensure that statements made in them are not materially misleading. The issuer reporting provisions are violated when false and misleading reports are filed. SEC v. Falstaff Brewing Corp., 629 F.2d 62, 67 (D.C. Cir. 1980). No showing of scienter is necessary to establish a violation of Section 13(a) or Rules 12b-20 or 13a-13. See SEC v. McNulty, 137 F.3d 732, 740-41 (2d Cir. 1998); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1167 (D.C. Cir. 1978); SEC v. Wills, 472 F. Supp. 1250, 1268 (D.D.C. 1978); In re Curtis L. Dally, Exchange Act Rel. No. 39144 (September 29, 1997), 1997 SEC LEXIS 2026.
Mercator filed a Form 10-Q for the quarter ended March 31, 2000 that materially misstated the company's operating results. Mercator's net loss, operating loss and loss per share were each understated by 14%. Accordingly, Mercator violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder. Gerard and Harris caused Mercator's violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder by preparing the misleading financial statements that were included in the Form 10-Q that was filed with the Commission.
3. Gerard and Harris Caused Mercator's Violation of Section 13(b)(2) of the Exchange Act
Section 13(b)(2) of the Exchange Act states, in pertinent part, that every reporting company must: (A) make and keep books, records and accounts which, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer; and (B) devise and maintain a system of internal controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP. These provisions require an issuer to employ and supervise reliable personnel, to maintain reasonable assurances that transactions are executed as authorized, to properly record transactions on an issuer's books and, at reasonable intervals, to compare accounting records with physical assets. SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724, 750 (N.D. Ga. 1983). Sections 13(b)(2)(A) and 13(b)(2)(B) do not require a showing of scienter. Id. at 751.
Mercator violated Section 13(b)(2)(A) of the Exchange Act by failing to maintain accurate records concerning its expenses. It failed to record quarterly expenses in the quarters in which they were incurred, as required by GAAP. Gerard and Harris caused Mercator's violation of Section 13(b)(2)(A) by intentionally failing to record expenses in the time period in which they were incurred. In addition, Mercator violated Section 13(b)(2)(B) of the Exchange Act by failing to devise and maintain a system of internal controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP. Gerard and Harris caused the company's violation of Section 13(b)(2)(B) by failing to ensure that proper reviews and checks were in place to ensure that expenses were recorded in the financial reporting period during which they were incurred. In particular, during the first and second quarters of 2000 both knew that Mercator had inadequate procedures in place to ensure accurate and timely communication between the accountingdepartment and other areas of the company, with the result that certain expenses were not internally reported to the accounting department until after the financial statements for the period had already been publicly released; neither implemented a system of controls, however, that would correct the problem.
4. Gerard and Harris Violated Section 13(b)(5) of the Exchange Act and Rule 13b2-1 and Gerard Also Violated Rule 13b2-2
Section 13(b)(5) prohibits any person from knowingly circumventing or knowingly failing to implement a system of internal accounting controls, or knowingly falsifying any book, record or account described in Section 13(b)(2). By its terms, Section 13(b)(5) requires that a person act with scienter. This section enables the Commission to address conduct that undermines the integrity of the books and records and internal controls of an issuer. Rule 13b2-1 prohibits any person from directly or indirectly falsifying or causing the falsification of any books, records, or accounts subject to Section 13(b)(2)(A). Rule 13b2-2 prohibits an officer or director of a public company from making or causing to be made a materially false or misleading statement or to omit or cause a person to omit certain material facts to an accountant in connection with an audit, examination of financial statements, or the preparation or filing of documents with the Commission.
Gerard and Harris committed or caused violations of Section 13(b)(5) and Rule 13b2-1 by failing to implement a system of internal accounting controls to accurately track Mercator's expenses and by falsifying Mercator's financial statements by understating expenses in the first and second quarters. Gerard, who was an officer of Mercator, violated Rule 13b2-2 because he failed to disclose to Mercator's outside auditors that expenses were materially understated in those quarters.
IV.
In view of the foregoing, the Commission deems it appropriate to accept the Offers submitted by Gerard and Harris and to impose the cease-and-desist order agreed to in the Offers.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that: (i) Gerard cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5, 13b2-1 and 13b2-2 thereunder, and that Gerard cease and desist from causing any violation and any future violation of Section 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder; and (ii) Harris cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder, and that Harris cease and desist from causing any violation and any future violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.
By the Commission.
Jonathan G. Katz
Secretary
1 During the first and second quarters of 2000, Gerard was undergoing treatment for a serious illness.
2 Mercator's first quarter ended on March 31, 2000. Its second quarter ended on June 30, 2000.
3 Simultaneously with the institution of these proceedings, the Commission is instituting settled cease and desist proceedings against Mercator for violations of the federal securities laws.
4 Mercator also filed a Form S-3 registration statement on May 15 which became effective on June 1. The registration statement incorporated by reference Mercator's filings with the Commission, including the misleading Form 10-Q for the first quarter.
5 The total $1.7 million understatement was offset by approximately $550,000 in credits to the second quarter (for first quarter expenses that had been improperly recorded in the second quarter), resulting in the net restatement amount of approximately $1.1 million.
6 In its releases, Mercator disclosed that the pro forma figures were calculated excluding amortization of intangibles.
7 Mercator's reported pro-forma numbers were also substantially inaccurate; on a pro forma basis, the understatement resulted in earnings per share being overstated by 100%, operating income being overstated by 168%, and net income being overstated by 139%.
8 Financial statements incorporated in Commission filings must comply with Regulation S-X, which in turn requires conformity with GAAP.
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