THOMAS C. NEWKIRK
Attorneys for Plaintiff
UNITED STATES DISTRICT COURT
NATURE OF THE ACTION
1. This is an accounting fraud case involving the financial statements of The North Face, Inc. ("The North Face") for its 1997 fiscal year and interim 1998 periods. The North Face was formerly a publicly held company that was registered with the SEC during the period relevant to this action pursuant to Section 12(g) of the Securities Exchange Act of 1934. The North Face common stock was traded in Nasdaq until August 2000, when the company was acquired by VF Corporation. The North Face filed false and misleading financial statements for its fiscal years 1997 through 1998.
2. The North Face is a manufacturer and retailer of outdoor apparel and equipment. During 1997 through 1998, The North Face's chief financial officer, Christopher Crawford, and sales vice president, Todd Katz, engaged in a series of schemes to artificially inflate The North Face's financial results. As a result, The North Face artificially inflated its revenue and gross margin recognition by fraudulently recognizing revenue on barter transactions and by fraudulently recording consignment sales as completed, regular sales.
3. Crawford and Katz tried to conceal the true nature of the improperly reported transactions from The North Face's accountants and auditors. Crawford made, directly or indirectly, material misrepresentations and omissions to the auditors in an attempt to hide his misconduct. Katz also made, directly or indirectly, material misrepresentations and omissions to the accountants and auditors in an attempt to hide his misconduct.
4. By virtue of the facts alleged herein, each defendant, among other things, violated, or aided and abetted violations of, anti-fraud, books and records, reporting, and lying to auditors provisions of the federal securities laws.
JURISDICTION, VENUE AND INTRADISTRICT ASSIGNMENT
5. The Commission brings this action pursuant to Sections 21(d) and 21(e) [15 U.S.C. 78u(d) and 78u(3)] of the Securities Exchange Act of 1934 ("Exchange Act").
6. This Court has jurisdiction over this action pursuant to Sections 22(a) of the Securities Act [15 U.S.C. 77v(a)] and Sections 21(e) and 27 of the Exchange Act [15 U.S.C. 78u(e) and 78aa].
7. Venue is proper in this District pursuant to Section 22(a) of the Securities Act [15 U.S.C. 77v(a)] and Section 27 of the Exchange Act [15 U.S.C. 78aa].
8. Assignment to the San Francisco Division is appropriate pursuant to Civil Local Rule 3-2(d) because a substantial part of the events or omissions which give rise to the claims in this case occurred in the County of Alameda, California.
9. Christopher Crawford, age 45, was Chief Financial Officer of The North Face from August 1997 until March 1999, and General Manager of California Operations until July 1999. He was licensed as a certified public accountant in Oregon during the relevant time period and resides in California.
10. Todd Katz, age 39, was Vice President, North American Sales at The North Face from January 1997 until January 2000. He resides in Colorado.
11. The North Face was a Delaware corporation with its headquarters in San Leandro, California and Carbondale, Colorado. The North Face is now a wholly-owned subsidiary of VF Corporation, but during the relevant time period it was a publicly-traded company whose common stock was registered with the Commission pursuant to Section 12(g) of the Exchange Act and was traded on the Nasdaq National Market System.
STATEMENT OF FACTS
The Barter Sales
12. The North Face entered into two major barter transactions in 1997 and 1998. The barter company The North Face dealt with typically "buys" excess inventory in exchange for trade credits. The trade credits can be redeemed only through the barter company, and most often the trade credits are used to purchase advertising, printing, or travel services.
13. The North Face began negotiating a potential barter transaction in early December 1997. The basic terms were that the barter company would purchase $7.8 million of product, the full wholesale price, with trade credits. In addition, The North Face would have the right to veto the barter company's sale of the product if The North Face thought the proposed customer was an unacceptable channel for the brand.
14. Crawford asked The North Face's auditors for advice on how to account for a barter sale, before the sale was made. The auditors provided Crawford with the accounting literature describing generally accepted accounting principles ("GAAP") relating to non-monetary exchanges. Based on the literature and information provided by the auditors, Crawford knew, or was reckless in not knowing, that it was a violation of GAAP to recognize profit on the trade credit portion of a barter transaction.
15. Crawford, however, structured the transactions to recognize profit on the trade credits. First, he required the barter company to pay a portion of the purchase price in cash. Crawford agreed that The North Face would guarantee that the barter company would receive at least a 60% recovery of the total purchase price when it re-sold the product. In exchange for the guarantee, the barter company agreed to pay approximately 50% of the total purchase price in cash and the rest in trade credits. This guarantee took the form of an oral side agreement that was not disclosed to the auditors.
16. Second, Crawford split the transaction into two parts, one to be recorded in the fourth quarter of 1997, the other to be recorded in the first quarter of 1998. Crawford structured the two parts of the barter sale so that all of the cash consideration and a portion of the trade credits would be received in the fourth quarter. Furthermore, the barter credit portion of the fourth quarter transaction was structured to allow profit recognition for the barter credits despite the objections of the auditors, as set forth below. The consideration for the 1998 first quarter transaction consisted solely of trade credits.
17. On December 29, 1997, The North Face recorded a $5.15 million sale to the barter company. The barter company paid $3.51 million in cash and issued $1.64 million in trade credits. The North Face recognized its full normal profit margin on the sale. On January 8, 1998, The North Face recorded another sale to the barter company, this time for $2.65 million in trade credits, with no cash consideration. Again, The North Face recognized its full normal profit margin on the sale.
18. As structured by Crawford, the revenue and margin associated with the trade credit portion of the 1997 fourth quarter transaction were below the auditors' materiality threshold. Crawford split the barter transaction into two parts, with all of the cash in the fourth quarter transaction, so as to be able to record the transaction with full profit margin recognition. He knew, or was reckless in not knowing, that (1) it was a violation of GAAP to record full margin on the trade credit portion of the sale and (2) that the auditors would consider the amount of the non-GAAP fourth quarter profit recognition immaterial and would not insist on any adjusting entry for correction.
19. As structured by Crawford, the amount of profit margin on the trade credit portion of the fourth quarter transaction was about $800,000. This was just below the auditors' materiality threshold for the 1997 audit. (The North Face reported $4.9 million and $2.1 million of operating income and net income respectively for the fourth quarter.) As a result, (a) the auditors proposed an adjustment to reverse the trade credit revenue recognition; (b) Crawford rejected the adjustment; and (c) the auditors passed on the proposed adjustment, concluding that the amount was immaterial.
20. Crawford also booked full margin on the $2.65 million 1998 first quarter transaction despite knowing that the auditors had objected to such treatment during the 1997 year-end audit. The margin recorded from the first quarter transaction was material to The North Face's first quarter results-it changed what would have been a loss for the quarter into a gain.
21. Crawford did not inform the auditors of the January 8, 1998 first quarter transaction until after the auditors had completed the 1997 audit. The auditors did not learn of the January 8, 1998 transaction until March 1998. Thus, when the auditors passed on any adjustment for the fourth quarter transaction, they were unaware that a second transaction had taken place, and of course, unaware that Crawford had recognized full margin on the second barter transaction.
22. During the 1997 audit, Crawford concealed two other material terms and conditions of the barter transactions from the auditors, including: (1) the unwritten guarantee; (2) the fourth quarter transaction was part of a larger sale.
23. In mid-1998 through 1999, The North Face sales force was actively trying to re-sell the product purchased by the barter company because the barter company was unable to sell any significant portion of the inventory. The North Face finally decided, in January and February of 1999, to re-purchase the remaining inventory from Icon. Crawford negotiated the re-purchase price for the remaining inventory.
24. Crawford settled on a final re-purchase price by the end of February. The re-purchase price included $690,000 to satisfy the guarantee for both parts of the entire original sale. Crawford did not disclose the re-purchase to the 1998 audit team, even though the audit was not complete at the time of the re-purchase.
25. During the first week of March 1999, the auditors asked for additional information about the barter transaction to complete the 1998 audit. In response to this request, Crawford continued to mislead the auditors by failing to disclose that the product had been repurchased, that there was a guarantee, that the 1997 and 1998 transactions were linked, and that the company sales force had negotiated almost all of the orders received by the barter company.
26. Crawford did not disclose any of this information until he learned that the auditors were about to fax a confirmation letter to the barter company that specifically asked if any of the product had been returned or repurchased. Crawford then called the chair of The North Face's audit committee, to explain that he had withheld information from the auditors. A meeting was scheduled for later that day for Crawford to make "full disclosure" to the auditors about the barter transactions.
27. Even at the "full disclosure" meeting with the auditors, Crawford was not completely truthful. He did finally disclose the repurchase and the link between the 1997 and 1998 transactions. He did not, however, disclose that there was a guarantee, nor did he disclose that the company's employees had negotiated most of the orders for the product.
The Consignment Sales
28. The North Face had a network of what it called variously "wholesale distributors" or "premium dealers" or "Territory 68"; these were primarily small operations that diverted The North Face product into "gray market" export channels.
29. In the third quarter of 1998, Katz, the vice president of sales, arranged a $9.3 million consignment sale to a Territory 68 customer based in Texas. The Texas customer was a one-person operation owned by an individual who ran his business from a home office. He had no other facilities and the only employee was a part-time bookkeeper. Prior to the third quarter of 1998, the Texas customer had not placed an order with The North Face for more than $1 million; his total orders for 1996 were $1 million and for 1997 were just $90,000.
30. The consignment terms of the third quarter sale were concealed and the sale was improperly recorded by the company as a normal sale-with immediate, improper recognition of revenue and full profit margin. Statement of Financial Accounting Standards No. 48, "Revenue Recognition When Right of Return Exists," does not allow the seller to recognize revenue [or, therefore, profit] when the customer can return the product and payment to the seller is contingent upon resale by the customer. Thus, recognition of revenue and profit for a contingent sale is improper since payment to the seller being contingent upon resale by the customer is the essence of a consignment sale.
31. The third quarter sale to the Texas customer began as a proposed consignment sale in late August 1998 for approximately $1 million. Katz directed a sales representative to (a) offer to pay all storage costs for the customer; (b) allow the customer to return any product he was unable to sell; and (c) promise the customer that he did not have to pay for the product unless he was able to sell it. Based on these terms, the Texas customer agreed to the consignment sale. The Texas customer did not place an order for specific items-The North Face was to select the product to be included in the sale. The North Face selected a third-party warehouse near the Texas customer to store the goods, and made all of the arrangements for the storage and shipping of the goods, without the Texas customer's involvement.
32. Without consulting the Texas customer, Katz "increased" the sale from $1 million to $9.3 million. The sale was booked and the product shipped at the very end of the quarter. This third quarter transaction was the largest single sale in the history of the company. It instantly made the Texas customer one of the top customers for the entire year. The Texas customer never sent or signed a purchase order for the sale-indeed he was not aware that the amount had increased to $9.3 million until December 1998, several months after The North Face recorded the transaction.
33. Crawford was reckless in not knowing of the true terms of the Texas consignment sale. Although Katz told Crawford that the Texas customer would be able to sell the product, Crawford knew, before the transaction was recorded, that the company had agreed in advance to pay the Texas customer's storage costs. Crawford also knew that payment by the consignment customer depended on the customer's ability to re-sell the product because the credit department advised Crawford, before the sale, that customer did not have the ability to pay for the product.
34. During the audit of The North Face's 1998 financial statement in early 1999, its independent auditor raised certain questions and requested that The North Face conduct an internal investigation into various issues. The auditors were to be informed of the results of the investigation. The North Face's audit committee conducted an investigation and was assisted by an accounting firm different from the independent auditor as well as company employees and outside counsel. The sale to the Texas customer was included in the internal investigation.
35. Katz conspired to conceal the real terms of the sale to the Texas customer from the company's audit committee, independent auditors and senior management. As part of the internal investigation it was conducting, the audit committee investigators arranged a conference call with the Texas customer in March 1999. The purpose of the call was to learn more about the third quarter 1998 transaction to determine if it was a bona fide normal sale. The participants in the conference call included Katz, other company employees, and accountants from the accounting firm assisting the audit committee.
36. Katz and a sales representative provided to the Texas customer a series of misrepresentations he was to make to the accountants-principally that the sale was a normal sale, but that he had lost a significant customer to whom he had expected to re-sell the product. The misrepresentations also included saying that (a) the Texas customer's clients were located in Latin America, (b) the Texas customer had the ability and the intent to pay the balance of the receivable on time (without payment depending on sales to third-parties), (c) he did not intend to return the product, (d) he had no right to return the product, and (e) the company had not agreed in advance to pay the storage costs. During the conference call, the Texas customer made the scripted misrepresentations.
37. Despite the misinformation provided in the conference call, questions remained about the transaction. The North Face CEO asked for a face-to-face meeting to address the remaining concerns about the sale. The Texas customer was flown to Aspen, Colorado at the company's expense to meet with the CEO. The Texas customer repeated essentially the same story to the CEO, portraying the sale as a normal sale.
38. The audit committee investigators, unaware that there was no purchase order for the sale to the Texas customer, or any other contemporaneous documentation of the terms of the sale, had requested to see documentation for the transaction during the internal investigation. During the Aspen trip, the Texas customer met with Katz at a hotel. Both were aware that no purchase order existed. At the hotel, they created a purchase order for the third quarter sale, back-dated it to September 1998, and the Texas customer signed the document. The fake purchase order was given to the CEO, Company employees, accountants from the accounting firm assisting the audit committee, and the auditors. There was no indication on the document that it had just been created and backdated, nor did Katz disclose that there had never been a contemporaneous purchase order.
39. The Texas customer returned the inventory in May 1999. Before doing so, however, the Texas customer signed a confirmation letter from The North Face's independent auditors falsely stating that he owned the product as of December 1998. Katz instructed a sales representative to ask the Texas customer to sign the false confirmation letter.
40. In the fourth quarter of 1998, Katz arranged a $2.6 million consignment sale to a Territory 68 customer based in California. Like the Texas customer, the California customer was essentially a one-person operation. The true terms of the sale were not disclosed and the sale was improperly recorded by the company as a normal sale-with immediate, improper recognition of revenue and full profit margin.
41. The North Face's independent auditors, in connection with their audit of the 1998 year-end financial statements, sent a confirmation letter to the California customer regarding the fourth quarter transaction. The letter was more detailed than a typical confirmation: it set for all of the elements of a bona fide normal sale and asked the California customer to confirm that the description of the transaction was accurate. The California customer knew that, other than the ostensible price of the product, each of the elements the auditors sought to confirm in the letter was false. Katz instructed a sales representative to ask the California customer to sign the false confirmation. After being assured that the company was not trying to change the consignment terms of the sale, the California customer agreed to sign the confirmation letter. The California customer signed the false confirmation letter and returned it to the auditors.
42. Crawford knew or was reckless in not knowing that The North Face improperly overstated its revenue and profits during 1997 and 1998, which resulted in The North Face filing materially false and misleading annual and quarterly reports with the Commission. Crawford also intentionally failed to provide material information about at least one of the barter transactions to the company's independent auditors.
43. Katz knew or was reckless in not knowing that The North Face improperly overstated its revenue and profits for the third and fourth quarters of 1998, which resulted in The North Face filing materially false and misleading quarterly and annual reports with the Commission. Katz further intentionally provided, or caused others to provide, false and misleading information about the consignment sales to the internal accountants and the company's independent auditors.
44. Crawford received compensation directly tied to the financial performance of The North Face. The North Face's reported earnings, and consequently their compensation, were improperly inflated by the improper recording of the barter and Texas consignment transactions. Crawford was unjustly enriched by the increased compensation.
FIRST CLAIM FOR RELIEF
Violations of Section 10(b) of the Exchange Act [15 U.S.C. 78j(b)]
45. Paragraphs 1 through 44 are re-alleged and incorporated by reference.
46. The Exchange Act prohibits the use of a manipulative or deceptive device in connection with the purchase or sale of a security.
47. By reason of the foregoing, Crawford and Katz violated, and unless restrained will violate, Section 10(b) of the Exchange Act [15 U.S.C. 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. 240.10b-5].
SECOND CLAIM FOR RELIEF
Aiding and Abetting Violations of Section 13(a) of the Exchange Act
48. Paragraphs 1 through 44 are re-alleged and incorporated by reference.
49. The Exchange Act and rules promulgated thereunder require every issuer of a registered security to file reports with the SEC which accurately reflect the issuer's financial performance and provide other information to the public.
50. By reason of the foregoing, Crawford and Katz aided and abetted, and unless restrained will continue to aid and abet, violations of Section 13(a) of the Exchange Act [15 U.S.C. 78m(a)] and Rules 13a-1 and 13a-13 thereunder [17 C.F.R 240.13a-1, and 240.13a-13].
THIRD CLAIM FOR RELIEF
Violations of Section 13(b)of the Exchange Act [15 U.S.C. 78m(b)] and
51. Paragraphs 1 through 44 are re-alleged and incorporated by reference.
52. The Exchange Act and rules promulgated thereunder require each issuer of registered securities to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the business of the issuer and to devise and maintain a system of internal controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements and to maintain the accountability of accounts.
53. By reason of the foregoing, Crawford and Katz aided and abetted, and unless restrained will continue to aid and abet, violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. 78m(b)(2)(A) and (B)].
54. By reason of the foregoing, Crawford and Katz violated, and unless restrained will violate, Section 13(b)(5) of the Exchange Act [15 U.S.C. 78m(b)(5)].
55. By reason of the foregoing, Crawford and Katz violated, and unless restrained will violate, Exchange Act Rules 13b2-1 and 13b2-2 [17 C.F.R. 240.13b2-1 and 240.13b2-2].
PRAYER FOR RELIEF
WHEREFORE, the SEC respectfully requests that this Court enter a judgment:
(a) permanently enjoining Crawford and Katz from violating Sections 10(b) and 13(b)(5) of the Exchange Act [15 U.S.C. 78j(b) and 78m(b)(5)] and Exchange Act Rules 10b-5, 13b2-1, and 13b2-2 [17 C.F.R. 240.10b-5, 240.13b2-1, and 240.13b2-2];
(b) permanently enjoining Crawford and Katz from aiding and abetting any violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act [15 U.S.C. 78m(a), 78m(b)(2)(A), and 78m(b)(2)(B),] and Exchange Act Rules 13a-1 and 13a-13 [17 C.F.R. 240.13a-1, and 240.13a-13];
(c) ordering Crawford to provide a complete accounting for and to disgorge the unjust enrichment he realized, plus prejudgment interest thereon;
(d) ordering Crawford and Katz to pay civil monetary penalties pursuant to Section 21(d)(3) of the Exchange Act [15 U.S.C. 78u(d)(3)] in respect of their violations;
(e) prohibiting Crawford and Katz from acting as an officer or director of a public company pursuant to Section 21(d)(2) of the Exchange Act [15 U.S.C. 78u(d)(2)]; and
(f) granting such other relief as this Court may deem just and appropriate.
Dated: February _____, 2003
Thomas C. Newkirk
Attorneys for Plaintiff