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UNITED STATES OF AMERICA
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In the Matter of: LEGATO SYSTEMS, INC. and
Respondents. |
: |
ORDER INSTITUTING PUBLIC CEASE-AND-DESIST PROCEEDING, MAKING FINDINGS AND ISSUING A CEASE-AND-DESIST ORDER |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate that a public cease-and-desist proceeding be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Legato Systems, Inc. ("Legato" or the "Company" and Stephen Wise ("Wise") (collectively, "Respondents").
Accordingly, IT IS HEREBY ORDERED that a cease-and-desist proceeding against Legato and Wise be, and hereby is, instituted.
II.
In anticipation of the institution of this proceeding, Legato and Wise have submitted Offers of Settlement ("Offers"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein except that Respondents admit the jurisdiction of the Commission over them and over the subject matter of this proceeding, Respondents consent to the issuance of this Order Instituting Public Cease-and-Desist Proceeding, Making Findings and Issuing a Cease-and-Desist Order ("Order").
III.
On the basis of this Order and the Offers, the Commission makes the following findings:
A. Respondents
Legato Systems, Inc. is a Delaware corporation headquartered in Mountain View, California that develops and markets software for managing the data-storage functions of computer networks. Legato's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and is quoted on the NASDAQ Stock Market.
Stephen Wise, 47, is a resident of Pleasanton, California. Wise was Chief Financial Officer of Legato Systems, Inc. ("Legato") from September 1996 to September 2000.
B. Summary
This matter involves false financial reporting by Legato Systems, Inc. ("Legato" or the "Company"), a Mountain View, California, software developer. In May 2000, Legato restated its financial results for the first, second, and third quarters of the fiscal year ended December 31, 1999, and revised its preliminary results for the fourth quarter and fiscal year 1999 contained in a press release issued on January 19, 2000. The restatement revealed that Legato's actual revenue and net income had been overstated by $22.5 million (approximately 10%) and $12.3 million (approximately 80%), respectively.
Legato overstated its financial results due in large part to side agreements with customers by its former sales staff. The side agreements granted rights of return or other terms that made the sales contingent and, thus, made it improper for Legato to recognize revenue on those transactions. The former sales staff's use of side agreements was contrary to Legato policy.
C. Legato's Business and Its Efforts to Increase Sales During 1999
In 1999, Legato's former management team decided to increase the sale of enterprise license agreements ("ELAs") to large business customers. Prior to 1999, Legato sold mostly "shrink wrap" software products to corporate customers. By contrast, an ELA allowed a business to install an unlimited volume of Legato software on its computer systems on a company-wide basis for a defined period of time. ELAs generated more revenue for Legato by bundling together software products for an entire company as opposed to sales of one product to a single division. In the last three quarters of the fiscal year ended December 31, 1999, the sales force responded by producing a record number of ELA transactions which were recorded as revenue, much of which was ultimately reversed.
In order to meet their increasing sales targets for ELAs and other large dollar volume transactions, in many instances, former Legato sales executives resorted to inducing resellers to "prebuy" ELAs-purchasing a license to use software before the reseller had arranged to sell the license to an end-user. This was generally accomplished by transmitting a written side letter to the reseller providing the reseller with a right of return or rotation for the products sold to the reseller, and/or extended payment terms. Legato's sales force did not forward these side letters to the Company's finance department. Instead, the finance department generally received "clean" purchase orders or other contracts from the resellers, which did not contain any contingencies or non-standard payment terms. The finance department then recorded revenue for each of the ELA transactions. In fact, it was improper for Legato to record revenue for ELA transactions with stock-rotation rights without making reasonable estimates of potential returns.
D. Legato's False Periodic Reports During 1999
1. Second Quarter Ended June 30, 1999
On August 12, 1999, Legato filed with the Commission its Form 10-Q for the quarter ended June 30, 1999 which was signed by Wise. In the financial statements included in Legato's Form 10-Q, the Company reported total revenue of $62,008,000 and net income of $4,438,000 for the period. As a result of adjustments in the restatement by Legato, revenue was later reduced to $51,564,000 and the Company reported a net loss of $1,093,000. Actual revenue was overstated by approximately 20%.
In one transaction in late June 1999, two former Legato sales executives arranged for a reseller to "pre-buy" five ELAs that were not closed with the prospective end customers before the end of the second quarter. In "pre-buying" the deals, the reseller agreed to submit purchase orders for the product on the understanding that the reseller would receive extended payment terms and the right to return the product in the event the prospective ELA sales could not be closed with end-users. Legato's former head of sales approved these terms, and the reseller sent "clean" purchase orders to Legato for the five transactions. Legato then recorded $3,313,500 in second quarter revenue from these deals, which overstated actual revenue by approximately 6%.
Also during the second quarter, other former Legato sales personnel sent side letter emails to three other resellers involving $1,756,174 of recorded second quarter revenue, which overstated actual revenue by approximately 3%. The emails granted the resellers stock rotation rights and other terms that made it improper for Legato to recognize revenue from these transactions. The emails were not forwarded to Legato's finance department but were approved by Legato's former head of sales.
2. Third Quarter Ended September 30, 1999
On November 10, 1999, Legato filed with the Commission its Form 10-Q for the period ended September 30, 1999 which was signed by Wise. In the financial statements included in Legato's Form 10-Q, the Company reported total revenue of $71,688,000 and net income of $3,438,000 for the period. As a result of adjustments in the restatement by Legato, revenue was later reduced to $67,931,000 and the Company reported net income of $1,396,000. Actual revenue and net income had been overstated by approximately 6% and 146%, respectively. The single largest restated transaction involved the purported sale of an ELA to a reseller that specialized in sales to federal government agencies.
During the summer of 1999, Legato approached a reseller that specialized in sales to federal government agencies with a proposal to sell a large quantity of Legato software to a government entity. The reseller had a pre-existing relationship with the entity that would permit Legato to expedite the transaction (which required compliance with government procurement regulations). In mid-September 1999, Legato's former Vice President of North American Sales sent a proposal to the reseller. Under the terms of the proposal, the reseller would order $7 million worth of software and services from Legato, with payment due 90 days after receipt of Legato's invoice; in return, the reseller would receive a sizeable commission and become the exclusive reseller of Legato products for the government entity. The software prices that Legato offered the reseller, however, were contingent upon the parties agreeing upon and signing an acceptable "order letter" by September 30 that specified the price and payment terms for the software, with the parties thereafter negotiating a definitive reseller agreement.
The transaction hit a stumbling block when the reseller's attorney refused to sign a draft of the order letter because it did not grant the reseller the right to cancel its obligation to pay Legato the $7 million due under the agreement if the parties did not negotiate a mutually acceptable reseller agreement within 30 days. Legato's former Executive Vice President for Sales instructed the former Legato Sales Vice President for North America to provide the reseller with a side letter providing this right of cancellation to the reseller. The side letter, which was drafted by Legato's former Vice President of North American Sales and by an employee of the reseller, stated:
"Per our discussion the following is a clarification of the intent of the order letter dated 9-30-99 between Legato and [reseller]: The order letter meets the GAP [sic] requirement 97-4 [sic] for revenue recognition. The order letter allows Legato to recognize revenue for our third quarter ending 9-30-99.... In the unlikely event that we do not reach "`mutually agreeable terms and conditions", [reseller] will have the right to terminate the order letter and all obligations. This contingency may not be expressly stated in the order letter, because of the impact on revenue recognition. However, you have my assurance that in the event that we can not [sic] reach terms we will not hold you to the commitment to pay referenced in the order letter." (emphasis added/name of reseller removed)
Legato's former Vice President of Sales for North America signed the side letter and sent it by email and telefax to the reseller on September 29, and 30, respectively, as well as to Legato's former Executive Vice President of Sales, but he did not forward it to Legato's legal or finance departments. On September 30, after receiving the side letter, the reseller transmitted an order letter to Legato to purchase $7 million worth of software and support services-the biggest sale in Legato's history. Wise, relying on the purchase order letter, authorized Legato to recognize $5.7 million in revenue for this transaction in its third quarter. This revenue was later reversed when Legato restated its results, and the transaction was ultimately cancelled by mutual agreement between Legato and the reseller.
3. Fourth Quarter Ended December 31, 1999
On January 19, 2000, Legato issued a press release announcing the preliminary results of its fourth quarter and fiscal year ended December 31, 1999. The Company reported $71,221,000 in revenue and $3,052,000 in net income for the fourth quarter of 1999. As a result of adjustments in the restatement by Legato, revenue was later reduced to $65,127,000, and the Company reported a net loss of $359,000. Actual revenue was overstated by approximately 9%.
(a) Contingent Fourth Quarter Sales to Resellers
In December 1999, as part of an effort to increase revenue for the fourth quarter, Legato's former Vice President of Sales for North America negotiated another $3 million "pre-buy" transaction to a reseller to cover five ELA transactions for end-users that were in the Legato sales forecast. These transactions were subject to a side agreement memorialized in the form of a spreadsheet that was emailed to Legato's former Vice President of Sales for North America from the reseller's Vice President of Sales. The spreadsheet modified Legato's standard "net 30" payment terms by providing that the reseller would pay $750,000 within 60 days, with the balance (approximately $2,250,000) due on payment to the reseller by the end customer. Legato's former Vice President of Sales for North America informed his immediate superior in the sales department about these special terms, but the modified payment terms were not referenced on the purchase orders transmitted by the reseller to Legato and were never provided to Legato's finance department by Legato's sales personnel.
Also during the fourth quarter, another former Legato sales employee sent emails either granting or approving contingent payment terms for five reseller transactions that contributed approximately $1.4 million in revenue to Legato's fourth quarter results. These transactions were contingent because they permitted the reseller to rotate or return software if it could not ultimately be sold to an end-user. One email, in particular, demonstrates the salesperson's understanding of the effect of contingent terms on Legato's ability to recognize revenue on transactions with such terms: "Gentlemen's agreement to rotate within 90 days. This can't be on the P.O. as it won't allow us to recognize the revenue." The revenue from this sale was later reversed when Legato restated its results.
(b) Wise Fails to Take Reasonable Steps
Concerning Legato's Prior Reseller Transactions
Beginning in the third quarter and continuing in the fourth quarter of 1999, Legato's collections department experienced problems collecting from certain resellers who had purportedly purchased ELAs from Legato during the second quarter. Wise was told of serious collections problems with several Legato resellers. As it turned out, many of these resellers were refusing to pay Legato because they had entered into contingent deals for which the contingencies had not been fulfilled. Although Wise was told about the collections problems, he failed to investigate them adequately to determine whether the deals were subject to any undisclosed contingencies. Instead, in December 1999 he wrote off more than $1.5 million in receivables from these resellers. Later that same month, he authorized Legato to recognize approximately $3.4 million in new revenue on fourth quarter deals with these resellers. All of this revenue was subsequently restated due to undisclosed contingencies.
(1) Beginning in September 1999, Wise Was Told About Collections Problems on Legato's Second Quarter 1999 Deals with Resellers
Legato's standard payment terms were net 30 days. Thus, in August 1999, when several resellers failed to pay Legato for orders they had placed during the June 1999 quarter, Legato's accounts receivable department began contacting them. Among the resellers contacted were two firms that had ordered product from Legato in the second quarter subject to undisclosed extended payment terms and rights of return or rotation. When contacted by Legato's accounts receivable personnel in August 1999, these two resellers did not disclose the side agreements to Legato's personnel. Instead, the resellers said they would not pay until they closed deals with their end-customers, and in some cases requested authorization to return or rotate the products. Legato's accounts receivable clerks relayed these resellers' comments (as well as similar comments from other resellers) to their supervisor, who prepared collection report schedules summarizing some of these comments, which were sent to Legato's former Controller, and ultimately to Wise.
On September 3, 1999, Legato's former Controller sent an email to Wise that summarized the collection problems with these accounts. Later that month, Legato's former Director of Revenue sent Wise an email with a Large Deals spreadsheet attachment listing all of the deals with the two resellers in a column entitled "June Deals Still Open." The former Vice President of Channel Sales also told Wise that Legato would not be paid until one of their resellers got the order from the end customer. Wise failed to take adequate action to investigate the reason for the non-payment.
From September to November of 1999, Wise continued to receive spreadsheets on a monthly basis from the former Controller with a list of delinquencies for the second quarter transactions with the two resellers who had negotiated contingent payment terms, as well as other resellers. Wise did not make reasonable inquiries concerning these accounts.
(2) In December 1999, Wise Approved Additional Reseller Revenue For the Fourth Quarter Without Adequately Investigating Whether the Deals Were Subject to Undisclosed Contingencies
In December 1999, a former Legato sales executive told Wise that he was working to close five new ELA transactions through a reseller that would allow Legato to recognize $3 million in fourth quarter revenue. In response to this and other concerns about Legato's sales to resellers, and after a conversation with Legato's former CEO, Legato's former General Counsel drafted a form letter to confirm the payment terms of each reseller transaction. Wise then asked Legato's former head of sales to have the sales force transmit the letters to the resellers. The former head of sales told Wise-in late December-that the resellers who had received confirmation letters refused to sign them. Wise failed to act in a reasonable manner to insist and ensure that these letters were sent to the customers. Instead, Wise told Legato's head of sales to "vouch" for each transaction. Shortly thereafter, Legato approved several new reseller transactions for revenue recognition in the fourth quarter. Legato later reversed a total of $7.6 million in fourth quarter revenue from reseller deals due to undisclosed contingencies.
E. Legato's Lack of Adequate Internal Controls
The improper recognition of revenue by Legato was made possible, in part, by the Company's poor internal controls. Aside from summarizing its revenue recognition policy in its 1998 Form 10-K, Legato did not have a formal, written policy on when the Company should recognize revenue.
Legato's finance department also lacked many internal controls necessary to ensure that the Company's financial statements complied with GAAP. For example, Legato's accounting department (which was part of the finance department) was responsible for reviewing purchase orders for non-standard payment terms and return rights. The accounting department, however, failed to catch a number of invoices that included extended payment terms (i.e., terms which exceeded Legato's standard "net 30 days" terms), notations referring to "stock rotation" rights granted to customers, and terms that provided the reseller with a right to return the software licenses for "full credit." Moreover, Legato failed to provide adequate training to its accounting department employees about the Company's revenue recognition policy or how to identify terms that might make recognition of revenue improper.
F. Legal Conclusions
As described in Parts III(B) through (E) above, from the second quarter of 1999 through the end of the fiscal year ended December 31, 1999, Legato sales personnel engaged in repeated fraudulent conduct to improperly boost the Company's financial results. As a result of the fraud, Legato's financial statements for the periods ended June 30, 1999 and September 30, 1999 (which were filed with the Commission and disseminated to investors), as well as Legato's press release issued on January 19, 2000, were materially false and misleading. In addition, the Company failed to maintain books, records and accounts that, in reasonable detail, accurately and fairly reflected its transactions and dispositions of assets and failed to maintain a system of internal accounting controls sufficient to permit the preparation of financial statements in conformity with GAAP.
Based on the foregoing, the Commission finds that Legato violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13. In addition, the Commission finds that Wise violated Section 13(b)(5) of the Exchange Act, and that Wise caused Legato's 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.
IV.
In determining to accept Legato's Offer of Settlement, the Commission considered remedial acts promptly undertaken by Legato and cooperation afforded to the Commission staff.
V.
Based on the foregoing, the Commission deems it appropriate to accept the Offers submitted by Legato and Wise. Accordingly, IT IS HEREBY ORDERED pursuant to Section 21C of the Exchange Act that:
(1) Legato cease and desist from committing or causing any violations or any future 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; and,
(2) Wise cease and desist from committing or causing any violations or any future violations of Section 13(b)(5) of the Exchange Act and cease and desist from causing any violations or any future 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.
By the Commission.
Jonathan G. Katz
Secretary
http://www.sec.gov/litigation/admin/34-45962.htm
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