UNITED STATES OF AMERICA
In the Matter of
|ORDER INSTITUTING PUBLIC |
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
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be, and they hereby are, instituted against John Lerlo ("Respondent" or "Lerlo") pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").
In anticipation of the institution of these administrative proceedings, Respondent has submitted an Offer of Settlement ("Offer"), 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 in which the Commission is a party, and without admitting or denying the findings, except as to the Commission's jurisdiction over him and over the subject matter of the proceedings, which are admitted, Respondent
consents to the entry of this Order Instituting Public Administrative Proceedings 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").
On the basis of this Order and Respondent's Offer, the Commission makes the findings set forth below:1
John Lerlo, age 46 is, and at all relevant times was, the Plant Manager at American Bank Note Holographics, Inc.'s ("ABNH") Huntington Valley, PA manufacturing facility.
1. ABNH, a Delaware corporation with its principal executive offices located in Elmsford, New York, is engaged in the origination, production, and marketing of mass-produced secure holograms. ABNH was, until July 1998, a wholly-owned subsidiary of American Banknote Corporation ("ABN"). On or about July 14, 1998, ABNH became a public company through an initial public offering ("IPO") that raised approximately $107 million, the proceeds of which went entirely to ABN. ABNH's IPO was effected pursuant to a Registration Statement ABN caused ABNH to file on Form S-1 with the Commission. ABNH's stock was registered pursuant to Section 12(b) of the Exchange Act and traded on the New York Stock Exchange until it was suspended from trading in August 1999. Currently, ABNH's stock trades on the OTC Bulletin Board.
2. ABN, at all relevant times, was a public holding company whose stock was registered pursuant to Section 12(b) of the Exchange Act and traded on the New York Stock Exchange. Through its subsidiaries, ABN, among other things, supplied stored-value telephone cards and magnetic-strip transaction cards and printed business forms, checks, and counterfeit-resistant documents of value such as money orders, passports, foreign currency, and stock and bond certificates. ABN filed for Chapter 11 bankruptcy on December 8, 1999. Currently, ABN's stock trades on the OTC Bulletin Board.
ABN and ABNH, through a number of their former senior managers and others, systematically and fraudulently inflated the revenue and net income of ABN and ABNH, from 1996 through 1998. ABN and ABNH engaged in a number of improper practices that materially increased annual andquarterly revenue and net income in a departure from generally accepted accounting principles ("GAAP"). The practices included, among other things, the improper recognition of revenue on "bill and hold" sales. To avoid detection of the scheme, ABN and ABNH actively deceived ABN's independent auditors by, among other things, altering corporate records and reporting false production, sale, and shipment data.
On Tuesday, January 19, 1999, ABNH announced that it would restate results for the second and third quarters of 1998 and that it expected that revenues and net income for the fourth quarter of 1998 would be significantly lower than that of the fourth quarter of 1997. ABNH's stock fell approximately 69% from its January 19, 1999 close of $15.125 to a January 20, 1999 close of $4.625. ABN's stock fell approximately 14% from its January 19, 1999 close of $1 5/16 to a January 20, 1999 close of $1 1/8. On Monday, January 25, 1999, ABNH announced that it would restate its results for each of the first three quarters of 1998 and that its financial statements as of December 31, 1997, and December 31, 1996 should no longer be relied upon. The announcement further depressed each company's stock price.
As a result of the foregoing, ABNH's Registration Statement on Form S-1 contained materially false and misleading financial statements for its fiscal years 1996 and 1997, as well as for its interim quarters for fiscal year 1997 and for the first quarter of its fiscal year 1998. ABNH also included materially false and misleading financial statements in its Forms 10-Q which it filed for the second and third quarters of fiscal year 1998. As for ABN, as a result of the foregoing, it included materially false and misleading financial statements in its Forms 10-K for fiscal years ended December 31, 1996 and 1997, and in its Forms 10-Q which it filed for the first three quarters of fiscal years 1997 and 1998.
In connection with a 1997 year-end "bill and hold" transaction, Lerlo, at the behest of ABNH's former President, backdated, and changed quantities on, ABNH receiving documents to reflect that holograms produced by a subcontractor in January 1998 actually were completed and delivered to ABNH by December 31, 1997. Also at the urging of ABNH's former President, Lerlo provided him with a false affidavit confirming that the falsified receiving documents were correct. ABNH's former President then provided the falsified receiving documents to ABN's auditors to convince them that revenue could be recognized in fiscal year 1997 for all the holograms the subcontractor had produced. Finally, in January 1999, Lerlo participated in the creation of two memoranda containing false information related to the 1997 year-end "bill and hold" transaction. Lerlo knew, at the time, that ABNH's former President was going to provide these memoranda to ABNH's auditors.
In December 1997, ABNH obtained a large "bill and hold" order for approximately $8 million worth of holograms.2 Because ABNH lacked the capacity to manufacture and complete all of the holograms by year-end, it arranged to subcontract the manufacturing of approximately $6.9 million worth of holograms to another company. ABNH knew, however, that the subcontractor could not manufacture and complete all the holograms by year-end. First, the subcontractor did not have the capacity to manufacture all the holograms by year-end. Second, before ABNH could recognize the transaction as a valid "bill and hold" sale, the holograms had to be "completed." This required the holograms, which are initially produced in "rolls," (e.g., like a roll of paper towels), to be slit down to smaller "reels" (like a roll of paper towels cut into thirds, for example) and then numbered and separately labeled as belonging to the customer. ABNH knew that the subcontractor was engaged only to manufacture rolls because the subcontractor's facility lacked the capacity to slit the rolls into reels and then number the holograms. Consequently, ABNH knew that the holograms the subcontractor produced would not be "complete" until they were delivered to ABNH's facility and ABNH then slit, numbered, and labeled them as belonging to the customer.
As expected, the subcontractor did not finish producing unslit, unnumbered rolls of holograms until mid-January 1998. In fact, most of the rolls the subcontractor produced were delivered to ABNH's manufacturing facility in January 1998. ABNH, however, recognized revenue of approximately $6.9 million in fiscal year 1997 on this "bill and hold" transaction, approximately $6 million of which was fraudulent because it should have been recognized in fiscal year 1998. Although ABNH had a valid "bill and hold" agreement in place with the customer, the approximately $6 million in revenue was improperly recognized because it came from the sale of holograms that the subcontractor had not completed and delivered to ABNH by December 31, 1997.
ABN's auditors identified the $8 million "bill and hold" transaction as a major issue for its audit of ABNH's results for fiscal year 1997. Having fraudulently recognized approximately $6 million in revenue in connection with this transaction, ABNH undertook to mislead its auditors into believing that the holograms the subcontractor produced were completed and had been delivered to ABNH's manufacturing facility by year-end 1997.
During January 1998, Lerlo, at the behest of ABNH's former President, backdated, and changed quantities on ABNH receiving documents and also signed an affidavit confirming that the receiving documents, which Lerlo had knowingly falsified, were correct. ABNH's former President then provided the receiving documents to ABN's auditors to convince them that ABNH had received all of theholograms the subcontractor had produced by December 31, 1997. Lerlo was reckless in not knowing that by falsifying ABNH receiving documents he would cause ABN's and ABNH's financial statements to become materially false and misleading.
In late 1998 or early 1999, in connection with their work on the fiscal year 1998 audit, ABNH's auditors uncovered holograms designated as having been produced by ABNH's subcontractor in 1997, but marked with 1998 dates. In January 1999, ABNH's former President told Lerlo that ABNH needed to convince its auditors that the holograms marked with 1998 dates were produced in 1997. In response, Lerlo, at the request of ABNH's former President, participated in the creation of two memoranda, each dated January 14, 1999, which he knew falsely stated that some of the holograms the subcontractor had produced in 1997 were defective and had to be replaced in 1998. Lerlo knew these memoranda would be provided to ABNH's auditors and, in fact, they were.
Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, prohibit material misstatements or omissions, made with scienter, in connection with the purchase or sale of securities. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 860-62 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). Scienter is the "mental state embracing the intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). A fact is material if there is a substantial likelihood that a reasonable investor would consider the information to be important. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). Misrepresentation of a company's earnings, SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969), and the improper recognition of revenue in departure from GAAP, see Fine v. American Solar King Corp., 919 F.2d 290, 297, 300-01 (5th Cir. 1990), may be material.
Section 17(a)(1) of the Securities Act prohibits a person, in the offer or sale of any securities, from employing any device, scheme, or artifice to defraud. See, e.g., U.S. v. Naftalin, 441 U.S. 768, 771-72 (1979). In addition, Section 17(a)(2) of the Securities Act prohibits a person from obtaining money by means of untrue statements of material fact or omissions of material fact. Section 17(a)(3) prohibits a person from engaging in any transaction, practice or course of business that operates or would operate as a fraud upon a purchaser. Scienter is required to violate Section 17(a)(1) but not Sections 17(a)(2) and (a)(3). Aaron v. SEC, 446 U.S. 680, 694 (1980).
Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1 and 13a-13 require issuers with securities registered under Section 12 of the Exchange Act to file annual and quarterly reports with the Commission and to keep this information current. Such reports must be true and correct. See SEC v. Savoy Industries, 587 F.2d 1149, 1165 (D.C. Cir. 1978). Exchange Act Rule 12b-20 requires that such reports include all material information necessary to make the required statements, in the light of the circumstances under which they are made, not misleading. Pursuant to the instructions applicable to Form 10-Q, financial statements contained therein must conform to Regulation S-X, which, in turn, requires conformity with GAAP. 17 C.F.R. &sec; 210.4-01(a)(1).
Section 13(b)(2)(A) of the Exchange Act requires that every issuer of securities registered pursuant to Section 12 of the Exchange Act make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect its transactions and disposition of assets. Section 13(b)(5) of the Exchange Act provides that no person shall knowingly falsify any such book, record, or account or circumvent internal controls. Exchange Act Rule 13b2-1 also prohibits, directly or indirectly, the falsification of any book, record, or account subject to Section 13(b)(2)(A) of the Exchange Act. Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP.
Exchange Act Rule 13b2-2 prohibits an officer or director of an issuer from (a) making or causing to be made a materially false or misleading statement or (b) omitting or causing to be omitted a statement of a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading to an accountant in connection with a required audit or the preparation or filing of a required document or report.
In connection with its 1997 fiscal year-end "bill and hold" transaction, ABNH fraudulently recognized approximately $6 million in revenue in fiscal year 1997. ABN caused ABNH to file with the Commission a Registration Statement on Form S-1 in July 1998, and ABN filed with the Commission an annual report on Form 10-K for fiscal year 1997, and a quarterly report on Form 10-Q for the first quarter of fiscal year 1998, all of which contained, among other things, materially false and misleading financial statements because ABNH had improperly recognized revenue for this "bill and hold" transaction. As a result of the foregoing, ABN and ABNH violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. ABN also violated Sections 13(a) and 13(b)(2)(A) and (B) of the Exchange Act, and Exchange Act Rules 12b-20 and 13a-1. In addition, by providing ABNH's auditors with the two false memoranda that Lerlo participated in creating in January 1999, ABNH's former President violated Exchange Act Rule 13b2-2.
As a result of his conduct, Lerlo was a cause of ABNH's and ABN's violations set forth above and violated Section 13(b)(5) of the Exchange Act and Rule 13b2-1 thereunder. Lerlo was reckless in not knowing that by falsifying ABNH receiving documents in connection with ABNH's fiscal year-end 1997 "bill and hold" sale, he would cause ABN's and ABNH's financial statements to become materially false and misleading. In addition, Lerlo, at the request of ABNH's former President, assisted in creating two memoranda in January 1999, which he knew falsely stated that some of the holograms produced by the subcontractor in 1997 were defective and had to be replaced with new reels in 1998. Lerlo knew these memoranda would be provided to ABNH's auditors, and, in fact, they were. As a result of this conduct, Lerlo was a cause of ABNH's former President's violation of Rule 13b2-2.
Lerlo has submitted an Offer of Settlement in which, without admitting or denying the findings herein, he consents to the Commission's entry of this Order, which: (1) makes findings, as set forth above; and (2) orders Lerlo to cease and desist from committing or causing any violation, or any future violation,of certain provisions of the federal securities laws, as set forth below. As set forth in Lerlo's Offer of Settlement, Lerlo undertakes to cooperate with Commission staff in connection with this action and any related judicial or administrative proceeding or investigation commenced by the Commission or to which the Commission is a party.
Based on the foregoing, the Commission deems it appropriate to accept Respondent's Offer and impose the relief specified therein.
Accordingly, IT IS HEREBY ORDERED that pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, John Lerlo cease and desist from committing or causing any violation, or any future violation, of Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Exchange Act Rules 10b-5, 13b2-1, and 13b2-2, and that he cease and desist from causing any violation, or any future violation, of Sections 13(a) and 13(b)(2)(A) and (B) of the Exchange Act, and Exchange Act Rules 12b-20 and 13a-1.
IT IS HEREBY FURTHER ORDERED that Lerlo shall comply with his undertaking described in Section IV. above.
By the Commission.
Jonathan G. Katz
|1||The findings herein are made pursuant to the Respondent's Offer and are not binding on any other person or entity in this or any other proceeding.|
|2||Under GAAP, revenue is ordinarily recognized when, among other things, delivery has occurred. Revenue may also be recognized in a "bill and hold" transaction whereby a customer agrees to purchase the goods but the seller retains physical possession until the customer requests shipment to designated locations. The Commission's Accounting and Auditing Enforcement Release Number 108 states that revenue may be recognized on "bill and hold" sales only if certain conditions are met.|
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