UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7344 / September 30, 1996 SECURITIES EXCHANGE ACT OF 1934 Release No. 37746 / September 30, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 833 / September 30, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9117 ------------------------ In the Matter of : ORDER INSTITUTING CEASE-AND-DESIST : PROCEEDING PURSUANT TO SECTION 8A 3NET SYSTEMS, INC. : OF THE SECURITIES ACT OF 1933 : AND SECTION 21C OF THE SECURITIES Respondent. : EXCHANGE ACT OF 1934, MAKING : FINDINGS AND IMPOSING A CEASE-AND- : DESIST ORDER ------------------------ I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute a cease- and-desist proceeding 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 3Net Systems, Inc. ("3Net" or "Respondent"). Accordingly, IT IS HEREBY ORDERED that said proceeding be, and hereby is, instituted. II. In anticipation of the institution of this proceeding, Respondent has submitted an Offer of Settlement ("Offer") to the Commission 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 Respondent admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Respondent consents to the entry of the findings and Order Instituting Cease-And-Desist Proceeding Pursuant To Section 8A Of The Securities Act Of 1933 And Section 21C Of The Securities Exchange Act Of 1934, Making Findings And Imposing A Cease-And-Desist Order ("Order"). ==========================================START OF PAGE 2====== III. On the basis of this Order and Respondent's Offer of Settlement, the Commission finds-[1]- that: A. RESPONDENT 3Net is a Delaware corporation with offices in Sacramento, California and develops computer systems for medical laboratories. 3Net's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and was traded on NASDAQ until 1995. 3Net was formed in August 1989 to develop new computer laboratory software known as FAILSAFE. One year after its initial public offering, on August 13, 1993, 3Net announced that new investors had taken over management of 3Net. B. FALSE AND MISLEADING DISCLOSURES IN 3NET'S FORM S-18 AND FISCAL 1992 FORM 10-KSB On August 4, 1992, 3Net filed its Form S-18 registration statement ("Form S-18") for its initial public offering, which was declared effective on August 10, 1992. The offering raised $5 million for 3Net. The Form S-18 registration statement was materially false and misleading, making false statements about FAILSAFE and omitting material facts about FAILSAFE necessary to make other disclosures about the software not misleading, and reporting materially inflated revenue for 3Net's fiscal year ended June 30, 1991, the nine months ended March 31, 1992, and its fourth quarter of fiscal 1992.-[2]- 3Net's fiscal 1992 Form 10-KSB, filed with the Commission on November 23, 1992, also reported materially inflated fiscal 1991 and 1992 FAILSAFE revenue. ---------FOOTNOTES---------- -[1]- The findings herein are made pursuant to Respondent 3Net's Offer of Settlement and are not binding on any other person or entity named as a respondent in this or any other proceeding. -[2]- 3Net's Form S-18 included audited financial statements for fiscal 1990 and 1991 and unaudited financial statements for the nine months ended March 31, 1992. Audited financial statements for the fiscal year ended June 30, 1992, were not required because the Form S-18 was declared effective within 45 days of the end of fiscal 1992. In the Form S-18's Management's Discussion and Analysis, 3Net disclosed anticipated revenues, based on unaudited financial statements, for the fourth quarter of fiscal 1992. ==========================================START OF PAGE 3====== 1. Omissions and False Statements About FAILSAFE The Form S-18 was materially false and misleading, including, but not limited to, making false statements about FAILSAFE and omitting material facts about FAILSAFE necessary to make other disclosures about FAILSAFE not misleading. Specifically, 3Net, in its Form S-18, stated truthfully that 3Net "intended to focus its future sales and marketing efforts on FAILSAFE." 3Net's S-18 also included three false and misleading statements. 3Net, in its Form S-18, stated that 3Net's revenue had shown steady annual growth and that it expected its "revenues to continue to grow . . . due to expansion of its product line-- particularly sales of . . . FAILSAFE." 3Net, in its Form S-18, stated that FAILSAFE had five applications "that can operate independently or as part of an integrated system." 3Net, in its Form S-18, stated that one customer's FAILSAFE system was fully operational and that six customers had purchased and were currently installing FAILSAFE. However, 3Net, in its Form S-18, omitted to disclose that, as of August 10, 1992 (the effective date of the Form S-18), 3Net had experienced significant problems developing FAILSAFE and had not successfully implemented FAILSAFE for any customers. 3Net's statement in its Form S-18 that one customer's FAILSAFE system was fully operational was false. By August 10, 1992, 3Net had not implemented a FAILSAFE system for that customer. 3Net's statement, in its Form S-18, that six customers had purchased and were currently installing FAILSAFE was misleading. 3Net, in its Form S-18, omitted to disclose that, by the time of the public offering, 3Net had repeatedly failed to implement FAILSAFE for two of the customers, and the four remaining customers were waiting for FAILSAFE to operate live elsewhere before allowing 3Net to implement FAILSAFE at their sites. 3Net, in its Form S-18, also omitted to disclose that a lawsuit filed against 3Net by one of its customers related to 3Net's failure to implement FAILSAFE. 2. Inflated Fiscal 1991 and 1992 Revenue 3Net, in its Form S-18, improperly reported $1.043 million of fiscal 1991 FAILSAFE revenue for three FAILSAFE contracts, and $1.4 million of fiscal 1992 FAILSAFE revenue for seven FAILSAFE contracts. 3Net, in its fiscal 1992 Form 10-KSB, improperly reported $1.043 million of fiscal 1991 FAILSAFE revenue for three contracts, and $1.012 million of fiscal 1992 FAILSAFE revenue for ==========================================START OF PAGE 4====== the same three contracts.-[3]- The FAILSAFE contracts called for purchase and sale of both FAILSAFE software, and third party hardware used to operate the FAILSAFE software. a. Inflated Fiscal 1991 Revenue For fiscal 1991, 3Net reported $2.9 million of revenue, improperly including $1.043 million of FAILSAFE revenue for three FAILSAFE customers, thus overstating revenue by 57%. 3Net officers misrepresented to 3Net's auditors that one FAILSAFE implementation was nearly complete in April 1992 and was 60.64% complete by the end of fiscal 1991, and that another FAlLSAFE implementation was 57.5% complete by the end of fiscal 1991. Based on these misrepresentations, 3Net's auditors advised 3Net that Generally Accepted Accounting Principles ("GAAP") allowed 3Net to account for these FAILSAFE contracts, and one other FAILSAFE contract, using the percentage of completion method under contract accounting. The auditors relied on American Institute of Certified Public Accountants Statement of Position ("AICPA SOP") 91-1 entitled "Software Revenue Recognition" and AICPA SOP 81-1 entitled "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." GAAP outlines two different methods of recognizing contract revenue. The first method, "percentage of completion," applies only when management can reliably estimate progress toward completion of a contract. Thus, management must be able to reliably estimate the total costs required to complete the contract for the contract to qualify for the percentage of completion method. See AICPA SOP 81-1, 23. The second method, "completed contract," is required when management cannot reliably estimate progress toward completion and the contract therefore does not qualify for the percentage of completion method. The completed contract method requires the company to postpone recognizing revenue until the contractual obligations have been met. See AICPA SOP 81-1, 30. Based on false representations of 3Net's officers that 3Net had successfully implemented FAILSAFE for one customer, and the auditors' corresponding belief that 3Net had determined total FAILSAFE costs and its FAILSAFE contracts could qualify for the ---------FOOTNOTES---------- -[3]- 3Net's books do not separately identify fiscal 1991 and 1992 cost of sales for the three FAILSAFE customer contracts. Therefore, the net effect on results of operations for fiscal 1991 and 1992 from improperly recognizing revenue and corresponding cost of sales and net income for the three contracts cannot be determined. ==========================================START OF PAGE 5====== percentage of completion method of revenue recognition, the auditors also advised 3Net that percentage of completion for hardware and software could be measured separately. The auditors recommended that revenue for hardware be recognized upon shipment and that revenue for software be recognized as installations progressed. The auditors based their advice on a provision of GAAP allowing different measurement methods for different components of a contract accounted for under the percentage of completion method. See AICPA SOP 91-1, 90. 3Net, using the percentage of completion method of recognizing contract revenue, reported $674,840 of fiscal 1991 hardware revenue for the three FAILSAFE contracts and, recognized software revenue of $368,302 for two of the FAILSAFE contracts.-[4]- As of August 1992, however, 3Net had not completed any of the FAILSAFE contracts, and 3Net had not determined the FAILSAFE costs to complete. Further, 3Net had no other means of reliably estimating progress toward completion for FAILSAFE, as 3Net lacked the systems necessary to estimate and track progress on FAILSAFE development. Thus, 3Net could not reliably estimate FAILSAFE progress toward completion and its FAILSAFE contracts did not qualify for the percentage of completion method of contract revenue recognition. Instead, 3Net should have used the completed contract method for the three FAILSAFE contracts. Had it done so, 3Net would not have reported revenue in fiscal 1991 for either the hardware or the software for the three FAILSAFE customers, because none of these contracts had been completed by the end of fiscal 1991. Moreover, the revenue for the hardware and software should not have been accounted for separately. The provision of GAAP allowing different revenue measurement methods for different components of a contract accounted for under the percentage of completion method did not apply to the three FAILSAFE contracts because the three contracts did not qualify for the percentage of completion method. Further, the three FAILSAFE contracts allowed the customers to return the hardware if 3Net did not provide software that conformed to contract specifications. As of the end of fiscal 1992, 3Net had not provided the required conforming ---------FOOTNOTES---------- -[4]- The third FAILSAFE contract related to a customer that had filed a lawsuit against 3Net for failing to provide FAILSAFE. The auditors limited revenue on this contract to cash that the customer paid 3Net for hardware and did not permit 3Net to recognize any software revenue for this customer for fiscal 1991. ==========================================START OF PAGE 6====== software to any of the three FAILSAFE customers and these three customers, therefore, had the right to return the hardware.-[5]- ---------FOOTNOTES---------- -[5]- Two provisions under GAAP not considered by the auditors or 3Net precluded 3Net from recognizing hardware revenue for the three FAILSAFE contracts prior to 3Net's implementing the software. First, GAAP precluded recognizing revenue if the customer had the right to return the product and the seller owed significant obligations for future performance on the contract. See AICPA SOP 91-1, 53, 67-68. In this case, the three FAILSAFE contracts allowed the customers to return the hardware if 3Net did not provide the software that conformed to the contract specifications. As of the end of fiscal 1992, 3Net also owed its three FAILSAFE customers the significant obligation for future performance on their contracts of providing FAILSAFE software. 3Net, therefore, should not have recognized revenue for the hardware shipped to the three FAILSAFE customers during either fiscal 1991 or fiscal 1992 because 3Net had not satisfactorily implemented the software. Second, GAAP allows for segmenting contract phases for certain contracts with phases that are separately negotiated, and that are to be performed without regard to the performance of other contract phases. See AICPA SOP 81-1, 39. GAAP explains that income recognized for such contracts may differ from the income negotiated if such contract phases with different profit rates are accounted for together. See AIPCA SOP 81-1, 39. Segmentation allows separate revenue recognition for the different contract phases if certain criteria are met. See AIPCA SOP 81-1, 39-42. 3Net's three FAILSAFE contracts did not qualify for segmenting, even though the three FAILSAFE contracts met some segmenting criteria (such as different profit rates for the hardware and software components). The three FAILSAFE contracts are not the kind of contracts described in AICPA SOP 81-1, 39. The customers and 3Net did not separately negotiate the hardware and software contract phases, and 3Net could not perform the hardware phase without regard to the software phase. The three FAILSAFE customers negotiated and contracted for integrated laboratory computer systems comprised of laboratory software that operated on IBM hardware, and did not agree to accept the hardware without the software. In fact, one customer in December 1991 and another customer in late August 1992 demanded full refunds (continued...) ==========================================START OF PAGE 7====== b. Inflated Fiscal 1992 Revenue In its Form S-18, 3Net reported revenue of $3.2 million for the nine months ended March 31, 1992, and reported "anticipated revenue" of $750,000 to $800,000 for the fourth quarter of fiscal 1992. In the Form S-18, 3Net, however, inappropriately included $1.4 million of FAILSAFE revenue from seven customers for fiscal 1992, overstating fiscal 1992 revenue by at least 57%. In its fiscal 1992 Form 10-KSB, 3Net reported revenue of $3.1 million. 3Net, however, falsely recognized $1.012 million of FAILSAFE revenue in the Form 10-KSB, thereby overstating its fiscal 1992 revenue by 48%.-[6]- 3Net had not completed any FAILSAFE implementations by the end of fiscal 1992, and could not estimate its progress toward completion for its FAILSAFE contracts. Even so, 3Net continued to improperly use the percentage of completion method to recognize $1.012 million of FAILSAFE revenue for three customers during fiscal 1992. Had 3Net properly used the completed contract method, no FAILSAFE revenue would have been recognized as none of these contracts was completed by the end of fiscal 1992. 3Net's unaudited financial statements for the three quarters ended March 31, 1992, included in its Form S-18, also improperly reported revenue of $427,000 for the four other FAILSAFE customers. As of the end of fiscal 1992, FAILSAFE had not operated at any of these customer sites, as these customers were waiting for FAILSAFE to operate live elsewhere before continuing with their own implementations. Accordingly, 3Net should not have reported any revenue for these customers during fiscal 1992. C. APPLICABLE LAW ---------FOOTNOTES---------- -[5]-(...continued) for both hardware and software when 3Net failed to deliver adequately performing software. Accordingly, under AICPA SOP 81-1, 39-42, segmentation was inappropriate. Had 3Net appropriately applied the completed contract method of revenue recognition, it would have recognized the negotiated income as each of the three FAILSAFE contracts were completed. -[6]- The auditors required 3Net to reverse already reported revenue and to exclude all of the FAILSAFE revenue for certain customers from the audited fiscal 1992 financial statements included in the fiscal 1992 Form 10-KSB. ==========================================START OF PAGE 8====== 1. Antifraud Violations: 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 and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful for any person in the offer and sale, or in connection with the purchase or sale, of any security, to employ any device, scheme or artifice to defraud, to make untrue statements of material fact, to omit to state material facts or to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person through means or instruments of interstate commerce or the mails. Generally, information is material if there is a substantial likelihood that a reasonable investor would consider it important to an investment decision. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Scienter is required to establish violations of Section 17(a)(1) of the Securities Act; scienter is not required to establish violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act; scienter is required to establish violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. See Aaron v. SEC, 446 U.S. 680, 701-702 (1980). The Supreme Court has defined scienter as "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976). The Ninth Circuit has expressly held that recklessness satisfies the scienter requirement, and defines recklessness as "an extreme departure from the standards of ordinary care, and which presents a danger of misleading [investors] that is either known to the defendant or is so obvious that the actor must have been aware of it." Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc), cert. denied, 499 U.S. 976 (1991). 3Net violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. 3Net, in connection with raising $5 million from its initial public offering, filed with the Commission on August 4, 1992 a Form S-18 registration statement that: (1) falsely stated that one customer's FAILSAFE system was fully operational; (2) omitted material facts about problems and delays with FAILSAFE development necessary to make statements in the Form S-18 about the availability of FAILSAFE and status of customer implementations not misleading; (3) omitted to disclose that a lawsuit filed by one of 3Net's customers against 3Net related to 3Net's failure to implement FAILSAFE; and (4) reported materially inflated revenue for fiscal 1991, the nine months ended March 30, 1992 and the fiscal 1992 fourth quarter, by falsely including FAILSAFE revenue. 3Net also reported materially inflated FAILSAFE revenue in its fiscal 1992 Form 10-KSB for fiscal years 1991 and 1992. ==========================================START OF PAGE 9====== 3Net acted with scienter. For purposes of establishing scienter, 3Net's officers' mental states are imputed to 3Net. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1096 n.16 (2d Cir. 1972). 3Net, through its officers, knew that it had not implemented FAILSAFE for any customers and knew of the problems in developing and implementing FAILSAFE. Yet, in the Form S-18, 3Net omitted to disclose the problems in developing and implementing FAILSAFE and misrepresented that FAILSAFE was fully operational for one customer. 3Net, through its officers, further knew that 3Net improperly recognized and reported FAILSAFE revenue in the Form S-18, overstating 3Net's fiscal 1991 revenue by $1.043 million or 57%, and overstating 3Net's fiscal 1992 revenue by $1.4 million or by at least 57%, and thus acted with scienter. 3Net, through its officers, also knew that 3Net improperly recognized and reported FAILSAFE revenue in its Form 10-KSB, overstating 3Net's fiscal 1992 revenue by $1.012 million or 48%. 2. Reporting Violations: Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 Thereunder Section 13(a) of the Exchange Act and Rule 13a-1 thereunder require issuers with securities registered pursuant to Section 12(g) of the Exchange Act, such as 3Net, to file with the Commission annual reports on Form 10-K or Form 10-KSB. The filings must be accurate; therefore, an issuer violates these provisions if it files a Form 10-KSB that contains materially false or misleading information. SEC v. Falstaff Brewing Corp., 629 F.2d 62 (1978) cert. denied, 440 U.S. 913 (1979); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978) cert. denied, 440 U.S. 913 (1979). Rule 12b-20 under the Exchange Act similarly requires that these reports contain all material information necessary to make the required statements made in the reports not misleading. No showing of scienter is required to establish a violation of Section 13(a) of the Exchange Act. See Savoy Industries, Inc., 587 F.2d at 1167. 3Net violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder by filing a materially false and misleading Form 10-KSB that overstated its fiscal 1992 revenue by over $1 million or 48%. 3. Record Keeping Violations: Section 13(b)(2)(A) of the Exchange Act Section 13(b)(2)(A) of the Exchange Act requires every issuer that has securities registered pursuant to Section 12(g) of the Exchange Act, such as 3Net, to "make and keep books, records, and accounts, which in reasonable detail, accurately and fairly reflect the transactions . . . of the issuer." 3Net violated Section 13(b)(2)(A) of the Exchange Act in that its books, records, and accounts inaccurately reflected 3Net's transactions. 3Net's books and records improperly included over ==========================================START OF PAGE 10====== $2 million of FAILSAFE revenue--over $1 million in fiscal 1991 and over $1 million in fiscal 1992. 4. Internal Controls Violations: Section 13(b)(2)(B) of the Exchange Act Section 13(b)(2)(B) of the Exchange Act requires every issuer that has securities registered pursuant to Section 12 of the Exchange Act, such as 3Net, to devise and maintain a system of internal accounting controls sufficient to reasonably assure, among other things, that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. 3Net violated Section 13(b)(2)(B) of the Exchange Act. 3Net failed to maintain the required internal accounting controls necessary to properly report its FAILSAFE revenue in accordance with GAAP. D. CONCLUSION Accordingly, based on the foregoing, the Commission finds that 3Net violated Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20 and 13a-1 thereunder. IV. Based upon the foregoing, the Commission deems it appropriate to impose the sanctions specified in the Respondent's Offer of Settlement. Accordingly, IT IS HEREBY ORDERED that pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act that Respondent 3Net 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), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20 and 13a-1 thereunder. By the Commission. Jonathan G. Katz Secretary