United States of America
In the Matter of
Edison Schools, Inc.,
|ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS PURSUANT TO SECTION 21C, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission ("Commission") deems it appropriate to institute cease-and-desist proceedings against Respondent Edison Schools, Inc., ("Respondent" or "Edison") pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").
In anticipation of the institution of these proceedings, Edison has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying any of the findings contained herein, except as to the jurisdiction of the Commission over it and over the subject matter of these proceedings, which are admitted, Edison consents to the entry of this Order Instituting Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order ("Order"). The Commission has determined that it is appropriate to accept the Offer of Edison and accordingly is issuing this Order.
Accordingly, IT IS HEREBY ORDERED that proceedings pursuant to Section 21C of the Exchange Act be, and hereby are, instituted.
On the basis of the foregoing, the Commission finds1 that:
A. Edison Schools, Inc., a Delaware corporation with headquarters in New York City, manages elementary and secondary public schools under contracts with school districts and charter school boards located in 22 states and Washington, D.C. From its IPO on November 17, 1999, to the present, Edison's common stock has been registered pursuant to Section 12(g) of the Exchange Act and is quoted on the NASDAQ.
B. Edison has filed reports with the Commission that have not disclosed certain information regarding Edison's business operations. Specifically, Edison has not disclosed that a portion of its reported revenues included payments that did not reach Edison and were made by school districts to teachers and other providers of services in Edison's schools. Certain filings have contained additional erroneous information, which is described at greater length below. Finally, Edison has not implemented an adequate system of internal controls, and has maintained books and records that contained certain inaccuracies.
C. Edison is restating certain items and reclassifying its past financial statements in accordance with recent accounting literature, and will be ordered to comply with certain undertakings. Among other things, Edison will be ordered to comply with its undertaking to establish an internal audit function, a function that did not previously exist at the company.
D. Edison manages approximately 130 schools under agreements with 62 school boards and charter holders. In exchange for implementing Edison's program and agreeing to Edison's management, which includes unique curriculum and teaching methods and a longer school day and year, schools pay a fee, averaging approximately $6,500 for each student enrolled in one of its schools. ("Per Pupil Fee"). Management agreements entered into between Edison and school boards or charterholders usually state that Edison is responsible for paying the costs of running the schools from Per Pupil Fees. Thus, with the exception of the three school districts referred to in paragraph Q, Edison's margin under the management agreements is the net of Per Pupil Fees less the costs of operating the schools.
E. Teachers in Edison schools are generally employees of the districts in which they teach, and, in 40% of Edison's schools, members of bargaining units that have collective bargaining agreements with districts. Edison and the districts agree that teachers assigned to Edison's schools will adhere to Edison's program and management systems, and, among other things, receive compensation that reflects the additional hours of instruction it requires, as well, as in some cases, other stipends, performance-based incentives, and stock options reflecting the additional responsibilities of teachers in Edison's schools. In many cases, particularly where non-charter schools are concerned, teachers are paid directly by school districts.
F. In some districts, Edison is responsible for paying expenses for non-instructional services, such as food, transportation and custodial help ("non-instructional expenses"). Where Edison bears this responsibility, Edison either pays vendors and other service providers (including the districts themselves) directly, or "buys back" the services from the districts, which directly pay the vendors.
G. District-Paid Expenses - The teacher salaries and non-instructional expenses paid directly by districts (collectively "District-Paid Expenses") comprise a substantial portion of the expense of operating Edison schools. These funds never reach Edison, but are expended by districts directly and then deducted from the districts' remittances to Edison.
H. Accounting Treatment of District-Paid Expenses - Under Generally Accepted Accounting Principles ("GAAP"), expenses paid on behalf of an issuer, in which case the issuer is the primary obligor for the expenses, should be considered as the issuer's expenses. In such circumstances, revenues must be presented on a gross basis, to include these expenses. Issue 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent," prepared by the Emerging Issues Task Force of the Financial Accounting Standards Board ("EITF 99-19"), as clarified by Topic D-103, which will become effective as EITF 01-14 for Edison's quarter ended on March 31, 2002 ("D-103"). Under this recent accounting guidance, Edison must report revenue on a gross basis to include those District-Paid Expenses for which it is the "primary obligor" for the expense. Where Edison is not the primary obligor for the expenses, Edison must report revenues on a net basis to exclude such expenses. The choice between treatment of revenues on a gross or net basis does not affect net income.
I. Edison's Revenues - Throughout its existence, Edison has included all District-Paid Expenses in its reported revenues and in its reported operating expenses. In other words, Edison has counted as revenue the full amounts that districts are obligated under the management agreements to pay as Per Pupil Fees (collectively, "Per Pupil Funding"). In its filings with the Commission, Edison did not disclose that there was any off-set from Per Pupil Funding for District-Paid Expenses.
Edison's Non-Disclosure of District-Paid Expenses
J. Edison records as revenue the total amount of Per Pupil Funding as calculated at the beginning of the year, spreading it pro rata over eleven months of its fiscal year, which ends on June 30. (No revenue is booked for July.) Changes in enrollment result in monthly adjustments. Edison records as Direct-Site Expenses both the expenses it pays directly and the District-Paid Expenses. At year end, Edison reconciles recorded revenue with cash received. The ratio of District-Paid Expenses to Edison's reported revenues is reflected in the chart below:
|First Six Months|
|District Paid Expenses||64||100||154||72||108|
K. In its filings with the Commission, Edison has not disclosed the existence and amounts of these District-Paid Expenses. Instead, Edison has inaccurately stated in its Management Discussion & Analysis that it "receives" all Per Pupil Funding. In its most recent Form 10-Q, Edison disclosed, for the first time, that
[W]e generally arrange for teachers in our contract schools to be paid by clients on our behalf. Where such arrangements exist, the client deducts the amounts they have expended on our behalf from the amount owed to us when remitting payment.
Edison has never disclosed the amounts of these District-Paid Expenses.
L. The significance of Edison's non-disclosure of these off-sets in prior periods is demonstrated by the facts concerning two of Edison's clients, one of its oldest, and one of its most recent. Edison reported significant amounts of gross revenue for providing educational services to districts that pay Edison little cash, if any.
M. For example, "District A" paid Edison no cash at all in FY 2001, under an agreement with Edison that allows the district to withhold payment each year until the point at which all revenues due under the management agreement exceed District-Paid Expenses. Edison is then entitled to any surplus. In FY 2001, there was no surplus, according to District A, because the expenses paid to operate Edison's schools exceeded the amount of Per Pupil Fees due Edison under the management agreement. Based on these circumstances (which are the basis of an ongoing dispute between Edison and the district), District A made no payments at all to Edison. Notwithstanding the agreement allowing District A to withhold payment until the point at which there was a surplus due, Edison invoiced District A monthly in FY 2001 for the Per Pupil Fees specified in its management agreement with the district. These invoices totaled approximately $7.5 million. Edison recorded the entire amount invoiced, $7.5 million, as gross revenue for FY 2001, also recording expenses of $8 million.
N. A second district, "District B," has paid Edison only $400,000 in FY 2002, even though Edison has recorded over $17 million in revenues from District B for the first two quarters of FY 2002, along with over $18 million in expenses. District B's agreement with Edison differs from that of District A, in that District B agreed to make quarterly payments to Edison of the net amount they projected would be due for the year, assuming a certain level of enrollment and after subtracting District-Paid Expenses. Before the start of the school year, Edison and District B agreed that the net amount due for the year would be $1.6 million, entitling Edison to quarterly payments of $400,000. For the first quarter of 2002, District B paid the $400,000 due under this agreement. For that quarter, Edison's revenues of approximately $97 million included over $8 million in revenue from District B. (Reported expenses of $109 million included over $7 million in District-Paid Expenses related to District B.) During the second quarter of 2002, District B determined not to pay Edison any amounts for the second, third and fourth quarters, because it became clear that actual enrollment in Edison's schools in District B was below projected enrollment, and annual projected revenues were therefore less than projected District-Paid Expenses. For the second quarter of FY 2002, when Edison received no cash payments from District B, Edison reported revenues from District B of over $9 million and over $11 million in expenses.
O. The examples of District A and District B demonstrate that revenues reported as total Per Pupil Funding do not fully describe the realities of Edison's operations. For example, Edison's revenues for its second quarter of 2002 were $133 million. Of this, over $11 million represented revenues to which Edison was contractually entitled from District A and District B, but little or none of which will result in cash payments Edison can expect to receive. (Correspondingly, the company recorded an equal amount of direct-site expense that it will not have to pay in cash.) Furthermore, Edison has additional expenses related to both districts, stemming from start-up costs and capital expenditures, such as for computers and textbooks.
P. Following an expedited review by its independent auditor, which took place within the context of an inquiry by the Commission staff into the company's accounting for District-Paid Expenses, and in light of recent clarifications of GAAP (described in paragraph H, supra), Edison has concluded that revenues should be reported on a net basis, to exclude District-Paid Expenses that relate to (a) salaries of teachers in seven districts, and (b) payments for non-instructional services in numerous districts. Revenues and expenses related to these categories will be reclassified on a net basis for past periods, and will be presented on a net basis beginning with Edison's third quarter of 2002.
Q. Fixed-Fee Arrangements: Edison's arrangements for three clients provide for a fixed fee to Edison, and grant Edison less control over the teachers than in other districts. Revenues for these three districts should have been reported net of certain costs. Edison has also concluded that revenues from a fourth district were improperly recorded in fiscal year 2002 because there is no written agreement setting forth the terms, although an oral agreement exists. As a result of both conclusions, Edison will reclassify revenues and expenses by the following amounts: 3rd quarter 2001: $1.3 million; 4th quarter 2001: $1.4 million; 1st quarter 2002: $1.7 million, and 2nd quarter 2002: $5.0 million. The total downward adjustment for revenues and expenses in FY 2001 relating to these changes is approximately $2.7 million.
R. Teachers' salaries: In three districts, management agreements provide that the districts retain a level of control over teachers' compensation to the extent that Edison cannot be considered a "primary obligor" for that expense. The revenues from these districts will be reclassified net of District-Paid Expenses relating to teachers salaries, with revenues reduced by the following amounts: FY 2000: $2.2 million; FY 2001: $4.3 million; 1st quarter 2002: $1.1 million; 2nd quarter 2002: $1.5 million.
S. Non-instructional services: Edison has agreements with numerous districts providing that it "buys back" from districts services provided by districts such as for transportation, food and custodial needs. Edison is not the primary obligor for the expense of these services. The revenues from a number of districts will be reclassified on a net basis, with revenues reduced by the following amounts: FY 1998: $3.8 million; FY 1999: $7.7 million; FY 2000; $13.4 million; FY 2001: $17.6 million; 1st quarter 2002: $4.6 million; 2nd quarter 2002: $11.1 million.
T. None of these reclassifications has any effect on Edison's reported income, as the change from gross to net treatment for these items involves a corresponding reduction in expenses as well. In each of its years as a public company, Edison has reported substantial losses, which remain unchanged. The aggregate effect of the reclassifications is as follows:
|1998||1999||2000||2001||1st quarter 2002||2nd quarter 2002|
|Revenues after reclassifications||65,630||125,085||208,972||350,508||89,745||115,637|
In order to improve its disclosure, both prospectively and historically, Edison will also disclose the amounts of District-Paid Expenses, and disclose that Edison receives Per Pupil Funding net of District-Paid Expenses.
U. Edison should have accelerated losses relating to two agreements with districts (including District A) because the company expected that over the life of the contracts there would be a total of $2.4 million in losses. Under GAAP, losses should be recorded as soon as the losses are probable and estimable, which was in the first quarter of 2001. (SFAS No. 5, "Accounting for Contingencies" ¶8.) Instead, Edison reported revenue and offsetting expenses for both districts in each quarter of 2001 and 2002. Edison is restating its first and third quarters of FY 2001 to reflect appropriate timing for the recognition of these losses.
V. The review of accounting practices by the company and its independent auditor has led Edison to restate two items that were originally accounted for incorrectly. First, the company improperly accounted for proceeds of a warrant purchased by a philanthropic organization as permanent equity. This item should have been recorded as a liability. Edison will restate past balance sheets to reflect a liability of approximately $2.5 million on its opening balance sheet for fiscal 1999, declining over time to approximately $600,000 at December 31, 2001. Second, the company did not properly account for the severance agreement of a senior company officer providing for the payment of $2.5 million, which was entered into in 1992. The company will restate its balances sheets and adjust retained earnings to reflect this liability, which has increased to $3 million because of amendments to the agreement.
W. Edison's accounting system has not kept pace with its rate of growth or the challenge of tracking amounts owed by 62 school districts in 22 states. While the company has improved its procedures in some respects, Edison does not have in place an adequate accounting system for billing school districts for net amounts owed to Edison. The company's usual practice, which generally accords with the management agreements, has been to bill districts monthly on a gross basis, demanding payment of the proportionate amount of per pupil funding agreed upon before the commencement of the school year. Until recently, none of the invoices set forth any deduction for District-Paid Expenses. Some districts do not even receive invoices from Edison. For example, neither of the two districts described above have received any invoices from Edison for all of FY 2002. (District A is not invoiced because of its arrangement to withhold any payment until per pupil funding outpaces expenses; District B invoices Edison quarterly, after discussions with Edison's staff, demanding payment of over $140,000 for the second quarter of 2002.)
X. Edison's inadequate control over the invoicing process and expenditure of funds by districts entails extensive discussions with districts throughout the year, resulting in a year-end reconciliation, conducted by Edison's regional business managers. The result is an inadequate and decentralized accounting system. Edison does not have any internal audit function to address weaknesses in its accounting system.
Y. The company has cooperated fully with the Commission staff. As part of this cooperation, Edison opened its books to the staff, made its senior officers available to the staff on a continuous basis, and devoted extensive time and resources to facilitating the review of its accounting policies and practices by its independent auditor.
Edison's Non-disclosure of District-Paid Expenses, and
Improper Accounting for the Warrant and Severance Agreement
Made its Financial Reports Inaccurate
Z. Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission materially accurate annual and quarterly reports. SEC v. Savoy Indus., 587 F.2d 1149, 1165 (D.C. Cir. 1978). Financial statements incorporated in Commission filings must comply with Regulation S-X, which in turn requires conformity with GAAP. The filing of a periodic report containing inaccurate information constitutes a violation of these regulations. See Savoy Indus., 587 F.2d at 1165.
Edison Violated the Record-Keeping and
Internal Controls Provisions
AA. Section 13(b)(2)(A) of the Exchange Act requires public companies such as Edison to make and keep books and records which accurately and fairly reflect its transactions and dispositions of assets. As discussed above, Edison failed to keep accurate books and records reflecting, among other things, the proper recording of accelerated losses relating to two school districts, the proceeds from the warrant and the severance payment. Edison violated Section 13(b)(2)(A) of the Exchange Act.
BB. Section 13(b)(2)(B) of the Exchange Act requires Edison to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP and to maintain accountability of assets. As described above, Edison's internal accounting controls were inadequate. Specifically, Edison does not have a system of internal accounting controls that maintains accountability for amounts actually due from districts. Thus, Edison violated Section 13(b)(2)(B) of the Exchange Act.
CC. The Commission finds that Edison violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.
ACCORDINGLY, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Edison:
A. Cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder; and
B. Comply with, and take steps to effect future compliance with, Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder upon the following terms and conditions which Edison has undertaken to implement:
1. Internal Auditor -- Within one month of the entry of this order, Edison shall add to its management a Director of Internal Audit who shall report to the Audit Committee of the company's Board of Directors. The Director of Internal Audit shall be an individual with appropriate qualifications and experience for the position and shall be hired after consultation with and approval by the Audit Committee. In addition, Edison shall create an Internal Audit Department appropriate for the company's size and business. The Director of Internal Audit shall appear before the Audit Committee at an in-person quarterly meeting to report on the activities and findings of the Internal Audit Department.
2. Edison may initially satisfy the undertaking in the prior paragraph by outsourcing the internal audit function to a qualified third-party. During such interim period, the persons performing the internal audit function shall work full-time on the company's premises. No less than three months from the date of this order the company shall hire a Director of Internal Audit who is a full-time employee.
3. Respondent shall require the Director of Internal Audit to prepare a report and deliver the report in one year from the date of entry of this order to the Audit Committee, with copies to the Commission and the company's independent auditor. The report shall describe steps taken by Edison to improve the company's system of internal accounting controls following entry of this order, detailing in particular any improvements in the company's procedures for recording revenues and losses, tracking expenses and invoicing clients.
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 any other proceeding.|
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