UNITED STATES OF AMERICA
In the Matter of
Mercator Software, Inc.,
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Respondent Mercator Software, Inc. ("Mercator").
In anticipation of the institution of these cease-and-desist proceedings, Mercator 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 to which the Commission is a party, and without admitting or denying the findings contained herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, Mercator consents to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings and Imposing Cease-and-Desist Order ("Order") as set forth below.
On the basis of this Order and the Offer, the Commission finds that:
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.
This matter involves material understatements of expenses in Mercator's publicly released financial statements for the first and second quarters of 2000.1 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. Mercator's Chief Financial Officer at the time (the "CFO") and then-controller (the "Controller") each knew, or were reckless in not knowing, that certain expenses were not reported.2 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%. Accordingly, Mercator violated Sections 13(a) and 13(b)(2)(A) and 13(B)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.
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, the CFO placed substantial pressure on the Controller to continue to meet analysts' earnings expectations in reported financial results. As a result of that pressure, the Controller intentionally failed to record certain operating expenses which were material to both quarters. The CFO was informed of, or was reckless in not knowing of, the underreporting in both quarters.3
In addition to the CFO and the Controller 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. 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. At the time the Form 10-Q was filed, the Controller and the CFO 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.
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 wasinformed of such expenses in a timely manner. By the time the Form 10-Q was filed, however, both the CFO and the Controller 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 the Controller and the CFO 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. The CFO and the Controller did not include the $750,000 in expenses in financial statements filed with the Form 10-Q. The numbers reported in the Form 10-Q allowed the company to meet analysts' expectations. If all first quarter expenses had 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. Mercator's CFO and Controller 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.4
The Controller 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, the Controller expressed concerns to the CFO that expenses were likely to be higher than anticipated and second quarter revenue figures were turning out to be lower than anticipated. When the Controller 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, the Controller 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, the Controller informed the CFO about her decision not to record certain expenses in the second quarter. The CFO approved the Controller's 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, the CFO and the Controller excluded certain second quarter bonusexpenses from the financial statements. The total second quarter expenses which the Controller and the CFO decided to exclude was $850,000.
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.5 The preliminary figures that Mercator released on July 14, 2000 were misleading because they did not include the $850,000 in expenses that the Controller and the CFO 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%.6
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 the CFO. In the first quarter of 2000, the CEO began an active search for a replacement CFO. On August 1, 2000, the CFO 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, the Controller met informally with the new CFO. At that meeting the Controller 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 the Controller's 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 the CFO (who had previously been replaced on August 1, 2000) onadministrative leave and terminated his employment on August 20, 2000. Also on August 20, 2000, Mercator relieved the Controller 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%.
1. Mercator Violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 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 periodic reports 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.
2. Mercator Violated Sections 13(b)(2)(A) and 13(b)(2)(B) 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. Accordingly, Mercator violated Section 13(b)(2)(A) of the Exchange Act.
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. Mercator failed 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 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. Accordingly, Mercator violated Section 13(b)(2)(B) of the Exchange Act.
In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Mercator and cooperation afforded the Commission staff.
In view of the foregoing, the Commission deems it appropriate to accept the Offer submitted by Mercator and to impose the cease-and-desist order agreed to in the Offer.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Mercator Software, Inc. cease and desist from committing or 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
1 Mercator's first quarter ended on March 31, 2000. Its second quarter ended on June 30, 2000.
2 Neither the CFO nor the Controller are presently employed by Mercator. Simultaneously with the institution of these proceedings, the Commission is instituting settled cease-and-desist proceedings against the CFO and Controller for violations of the federal securities laws.
3 During the first and second quarters of 2000, the CFO was undergoing treatment for a serious illness.
4 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.
5 In its releases, Mercator disclosed that the pro forma figures were calculated excluding amortization of intangibles.
6 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%.
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