UNITED STATES DISTRICT COURT
Securities and Exchange Commission,
PAUL A. ALLAIRE, G. RICHARD THOMAN,
Civil Action No. 03 CV 4087
The Securities and Exchange Commission ("the Commission") alleges for its Complaint as follows:
1. In a fraudulent scheme that lasted from 1997 to 2000, the defendants, senior executives of the Xerox Corporation ("Xerox"), including its former chief executive officers and its former chief financial officer, misled investors about Xerox's earnings to polish its reputation on Wall Street and to boost the company's stock price. These results also benefited the defendants with higher compensation and higher prices for personal sales of stock. This complaint alleges that the defendants' fraudulent conduct is responsible for accelerating the recognition of equipment revenues by approximately $3 billion and increasing pre-tax earnings by approximately $1.4 billion in Xerox's 1997-2000 financial results.
2. Relying on what Xerox internally called "one-time actions," "one-offs," "accounting opportunities" and "non-operational actions," the defendants imposed accounting adjustments on operational results for the purpose of increasing equipment revenues and inflating earnings in financial results reported to the public. These accounting devices (hereinafter referred to generally as "accounting devices" or "accounting actions") distorted the true picture of Xerox's business performance, always with the result that Xerox reported greater earnings in the time period than would have been reported absent these devices. Many of these accounting devices violated the established standards of generally accepted accounting principles ("GAAP"). All of them should have been disclosed to investors in a timely fashion because they constituted a significant departure from Xerox's past accounting practices and misled investors about the quality of the earnings being reported. The accounting devices improved Xerox's earnings, equipment revenues and margins in each quarter and year during 1997 through 2000, and allowed Xerox to meet or exceed Wall Street expectations in nearly every reporting period from 1997 through 1999. By 1998, nearly three out of every ten dollars of Xerox's annual reported pre-tax earnings and up to 37 percent of its reported quarterly pre-tax earnings came from undisclosed changes to its historic accounting practices and estimates.
3. The most significant and pervasive category of these accounting devices accelerated the recognition of revenues from leases of Xerox equipment through mostly non-GAAP accounting. Because these accounting devices pulled forward revenues and earnings from future periods, they portrayed Xerox's business and growth as far more robust in 1997-99 than they in fact were, but they also negatively affected the company's reported results as underlying sales and business conditions worsened starting in late 1999 and later periods. In addition to these accounting devices, the senior Xerox financial executives also overstated the company's earnings by using cookie jar reserves and interest income from tax refunds in reckless violation of GAAP.
4. Collectively, the defendants knowingly or recklessly prepared and filed with the Commission quarterly and annual financial statements which failed accurately to reflect the business performance of Xerox during 1997 through 2000 and failed to inform Xerox shareholders and the investing public that these statements were not prepared in accordance with GAAP. Xerox also routinely held conference calls and meetings with Wall Street analysts to discuss its quarterly and annual financial results in which senior corporate officers falsely portrayed the company's earnings performance. All of these public disclosures were false and misleading because the defendants failed to disclose the material impact that the accounting devices had on Xerox's actual financial performance.
5. From 1997 through 2000, the defendants' salaries and bonuses were based in part on meeting revenue and earnings targets. They also received profits during that period from the sale of Xerox stock, the price of which predictably rose in response to the company's publicly reported high earnings growth.
6. The Commission requests that each defendant be permanently enjoined from further violations of the antifraud and other provisions of the federal securities laws as alleged herein and that each defendant disgorge ill-gotten gains, pay prejudgment interest thereon and pay a substantial monetary penalty. In addition, the Commission requests that the defendants who were the most senior officers of Xerox, each be barred from serving as an officer or director of any public company.
7. The Commission brings this action pursuant to Section 21(d) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78u(d)].
8. This Court has jurisdiction over this action pursuant to Sections 21(d) and 27 of the Exchange Act [15 U.S.C. §§ 78u(d) and 78aa].
9. The defendants, directly and indirectly, have engaged in, and unless restrained and enjoined by this Court will continue to engage in, transactions, acts, practices, and courses of business that violate or aid and abet violations of Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and/or 13(b)(5) of the Exchange Act [15 U.S.C. §§ 78j(b), 78m(a), 78m(b)(2)(A), 78m(b)(2)(B) and 78m(b)(5)] and Rules 10b-5, 12b-20, 13a-1, 13a-13 and/or 13b2-1 thereunder [17 C.F.R. §§240.10b-5, 240.12b-20, 240.13a-1, 240.13a-13 and 240.13b2-1].
10. Xerox is a Stamford, Connecticut-based company incorporated in New York which manufactures, sells and leases document imaging products, services and supplies in the United States and 130 other countries. In 2000, Xerox employed approximately 92,500 people worldwide, 50,000 of them in the United States. For the year ended December 31, 2001, Xerox reported total revenues of $17 billion and a net loss of $71 million.
11. Xerox is a public company whose securities are registered with the Commission pursuant to Section 12(b) of the Exchange Act and it is required to file periodic reports with the Commission pursuant to Section 13 of the Act. Its securities are listed on the New York and Chicago Stock Exchanges and also are traded on the Boston, Cincinnati, Pacific Coast, Philadelphia, London and Switzerland exchanges. Throughout the relevant time period, Xerox's stock was covered by Wall Street analysts who routinely issued quarterly and annual earnings estimates.
12. On April 18, 2002, Xerox consented to an order enjoining it from future violations of the securities laws and rules alleged to have been violated in a Complaint filed by the Commission [SEC v. Xerox Corporation, 02 CV 2780 (DLC) (S.D.N.Y.) (filed April 11, 2002)]. As part of the settlement by Xerox, the company agreed to pay a civil penalty of $10 million. In consenting to the settlement, Xerox neither admitted nor denied the allegations of the Commission's Complaint.
13. Defendant Paul A. Allaire, age 64, a resident of Roywayton, Connecticut, was chairman of the board and a director of Xerox at all relevant times. He also was the chief executive officer ("CEO") of the company until April 1999, when he was succeeded by G. Richard Thoman ("Thoman"). Allaire again assumed the title of CEO in May 2000 after Thoman left the company and remained CEO through August 2001. He retired from Xerox on December 31, 2001. As chairman, CEO or director, Allaire signed all four annual reports filed with the Commission on Forms 10-K for the years 1997-2000 that contained false and misleading descriptions of the financial performance and condition of Xerox. Allaire also made statements to the press and presented reports to Wall Street analysts announcing Xerox's financial performance, including earnings growth, without disclosing that a substantial reason for the reported results was accounting devices rather than operating success. From 1997 through 2000, Allaire was paid over $7.7 million in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $5.2 million in profits attributable to the fraud from the sale of Xerox stock during this period.
14. Defendant G. Richard Thoman, 58, a resident of Greenwich, Connecticut, joined Xerox as chief operating officer and a director in July 1997. He was promoted to chief executive officer in April 1999. He left the company in May 2000. Prior to joining Xerox, Thoman was senior vice president and chief financial officer at IBM Corporation. Among other positions, Thoman was president and CEO of Nabisco International from 1992 to 1994 and was chairman and co-CEO of Travel Related Services for American Express from 1989 to 1995. As COO, CEO and as a director of Xerox, Thoman signed annual reports, letters to shareholders and Forms 10-K for 1997, 1998 and 1999 containing false and misleading descriptions of the financial performance and condition of Xerox. Thoman also made false and misleading statements to the press and statements to Wall Street analysts in which he announced Xerox's financial performance without disclosing that Xerox's reported financial results were materially increased from certain of the accounting devices described herein. From 1997 through his departure in 2000, Thoman was paid approximately $4.2 million in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $4.3 million in profits attributable to the fraud from the sale of Xerox stock during this period.
15. Defendant Barry D. Romeril, age 59, a resident of Norwalk, Connecticut, is a citizen of the United Kingdom and was a member and fellow of The Association of Chartered Certified Accountants in the United Kingdom. He served as the chief financial officer ("CFO") of Xerox from 1993 until he retired from the company in December 2001. Romeril also was an executive vice president from 1997 to early 1999 and then Vice Chairman. Before joining Xerox, Romeril was finance director for British Telecom.
16. As Xerox's CFO, Romeril participated in the preparation of Xerox's financial statements and footnotes and was responsible for insuring that they were complete, accurate and prepared in accordance with GAAP. He also participated in the preparation of the Management's Discussion and Analysis portion of the company's annual SEC filing to insure its accuracy. Nevertheless, Romeril allowed Xerox to file public financial reports with the Commission that contained information that was not in conformity with GAAP, that failed to identify failures in Xerox's internal controls and engaged in other actions which caused the financial statements to be materially false and misleading. Romeril was responsible for the filing with the Commission of 12 quarterly reports on Forms 10-Q and four annual reports on Forms 10-K for the period 1997-2000, each of which contained false and misleading financial information or omitted material information. Romeril also signed each of the foregoing annual reports which included annual financial statements. In addition, Romeril made statements to the public and to Wall Street analysts about Xerox's financial condition and performance that were false and misleading because he failed to disclose the impact of Xerox's non-GAAP accounting devices and other material business transactions described herein. From 1997 through 2000, Romeril was paid over $2.5 million in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $2.8 million in profits attributable to the fraud from the sale of Xerox stock during this period.
17. Defendant Philip D. Fishbach, age 61, a resident of Rochester, New York, was corporate controller from 1995 until he retired in April 2000. In that capacity he was responsible for Xerox financial reporting, reporting to Romeril, and for insuring that Xerox's financial statements and footnotes were accurate. He also was among those at Xerox who reviewed Management's Discussion and Analysis portion of the company's annual SEC filing for accuracy. He understood that one of his duties was to be sure Xerox's filings with the SEC would provide complete and accurate information about Xerox's business, including its financial performance. Nevertheless, Fishbach allowed Xerox to file public financial reports with the Commission that contained information that was not in conformity with GAAP, that failed to identify failures in Xerox's internal controls and engaged in other actions which caused the financial statements to be materially false and misleading. Fishbach signed nine Forms 10-Q that Xerox filed with the Commission during 1997-1999 and each of the company's 1997, 1998 and 1999 Forms 10-K. From 1997 through 2000, Fishbach was paid over $800,000 in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $600,000 in profits attributable to the fraud from the sale of Xerox stock during this period.
18. Defendant Daniel S. Marchibroda, age 63, a resident of Madison, Connecticut, was a certified public accountant. He reported to Fishbach as assistant controller. He assumed that position in 1991 and held it until January 2000, when he became vice president of finance for Xerox European operations. He retired from Xerox in December 2000. As assistant controller, Marchibroda was directly responsible for preparation of Xerox's consolidated financial reporting, including footnotes, and for the financial section of the annual report to shareholders. He also was among those at Xerox who reviewed the Management's Discussion and Analysis for accuracy. He understood that one of his duties was to provide complete and accurate information in Xerox's filings with the Commission so that investors could understand Xerox's business, including its financial performance. Marchibroda signed the 1997 and 1998 Forms 10-K filed with the Commission by Xerox's financing subsidiary, Xerox Credit Corporation, in his capacity as that subsidiary's principal accounting officer. From 1997 through 2000, Marchibroda was paid over $500,000 in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $270,000 in profits attributable to the fraud from the sale of Xerox stock during this period.
19. Defendant Gregory B. Tayler, age 45, a resident of Toronto, Ontario, Canada, is a Canadian chartered accountant. He was Xerox's director of accounting policy from March 1997 to April 1999 and assistant treasurer from May 1999 to March 2000. Tayler served as vice president and controller of Xerox from April 2000 through November 2001 and became corporate treasurer in November 2001. Tayler is currently providing, among other things, transition assistance to Xerox Canada's CEO. As director of accounting policy, Tayler reported to Marchibroda and helped prepare Xerox's financial statements and advised other senior managers in the U.S. and around the world on company accounting policies and GAAP during a period in which the company greatly increased its reliance on the accounting devices described herein. Tayler also participated in meetings attended by Marchibroda and Fishbach to discuss the contents of Management's Discussion and Analysis section of Xerox's annual filings with the Commission. As Xerox's controller, he was responsible for the year 2000 financial reporting and reported directly to Romeril. Tayler signed three Forms 10-Q Xerox filed with the Commission during 2000 and signed Xerox's 2000 Form 10-K. From 1997 through 2000, Tayler was paid over $600,000 in salary and bonuses, a portion of which was based on meeting revenue and earnings targets. He also realized approximately $75,000 in profits attributable to the fraud from the sale of Xerox stock during this period.
20. In their respective roles as Xerox executives, the defendants collectively failed to accurately report the financial condition of Xerox from 1997 through 2000, including publication of the company's year 2000 financial report. Instead, they defrauded Xerox shareholders and the investing public by overstating Xerox's true equipment revenues by approximately $3 billion and its true pre-tax earnings by approximately $1.4 billion during the four-year period. They did so by using undisclosed manipulative accounting devices at the end of each financial reporting period to "close the gap" between Xerox's actual underlying earnings and its internal targets and those of Wall Street analysts.
21. Xerox defendants Allaire and Romeril, along with Thoman, set a "tone at the top" of the company which equated business success with meeting short-term earnings targets. Romeril directed or allowed lower ranking defendants in Xerox's financial department to make accounting adjustments to results reported from operating divisions to accelerate revenues and increase earnings. Fishbach, Marchibroda and Tayler, each of whom was responsible at different times during the relevant period for review and use of accounting procedures and for preparation of financial reports, adopted and applied accounting devices for the purpose of meeting earnings goals and predictions of outside securities analysts. Allaire and Thoman then announced these results to the public through meetings with analysts and in communications to shareholders, knowingly or recklessly celebrating that Xerox was enjoying substantially greater earnings growth than true operating results warranted.
22. Xerox resorted to a variety of accounting devices during the period 1997-2000. Principal among them were accounting devices that accelerated the recognition of equipment revenue and increased earnings from leases of Xerox copiers that historically were recorded in future periods. All of the defendants knew or were reckless in not knowing that Xerox employed the most material of these accounting devices but failed to disclose their financial impact to investors. These accounting devices also violated GAAP and constituted changes in accounting estimates or accounting methods that under GAAP and the Commission's rules were required to be factually supported and disclosed to investors. At Romeril's direction or with his approval, Xerox accountants regularly made favorable changes in estimates having a materially positive impact on the company's earnings, even though such changes were not supported by changes in economic or business circumstances. Romeril, Fishbach, Marchibroda and Tayler knew or were reckless in not knowing that such changes violated GAAP and should have been disclosed under GAAP, but nonetheless failed to disclose such information to shareholders and investors in Xerox's periodic filings and other public disclosures. The aggregate impact of such undisclosed changes in estimate on pre-tax earnings for 1997 through 2000 was in excess of $700 million.
23. The defendants also used undisclosed business transactions to accelerate the recognition of equipment revenue and earnings that they knew or should have known concealed financial and operating weaknesses. In addition, Romeril, Fishbach and Marchibroda knowingly or recklessly used excess or cushion reserves and income from tax refunds to manage earnings in violation of GAAP, and Tayler was aware of the improper use of the largest of these reserves. All of these accounting actions materially misrepresented Xerox's financial performance and undermined the comparability of prior and current reporting periods.
24. The "tone at the top" created by Allaire, Thoman and Romeril pressed Xerox management to achieve aggressive internal performance targets tied to bonus programs in order to meet earnings and revenue growth expected by Wall Street. In a June 1998 memo, for example, Allaire and Thoman told Xerox's operations committee, which consisted of the company's senior business and financial executives, that "very disappointing results" created
no alternative but to again emphasize how critical it is that we achieve an acceptable quarter two performance. We have proclaimed Xerox as a changed company double digit revenue growth, solid earning increases and done consistently with this latter emphasis on consistency being high profile in recent investor communications. Please review all possible avenues of improvement in June....
Similarly, in September 1998, Romeril told the president of Fuji Xerox in Japan, and informed Allaire and Thoman, that Fuji's potential third quarter results would be a "terrible blow" to "satisfying our shareholder expectations" and that "[i]n circumstances like these, we put a full-blown effort to evaluate what action-accounting and other-we can take to mitigate the operational numbers." (emphasis added).
25. This "tone at the top" fostered the use of accounting devices to "close the gap" between underlying and desired financial results. For example, in a September 1997 e-mail copied to Fishbach, Marchibroda, and Tayler, Romeril asked the controller of Xerox Europe about his progress in assessing a potential accounting device (that became known as margin normalization) and stated: "This could be the crucial opportunity for making Quarter 3. I cannot see a higher priority in terms of once-offs." Similarly, in a May 1998 memo to Allaire, Thoman, Fishbach and others, Xerox's executive vice president of customer operations noted that second quarter 1998 results were expected to be "$38 million worse than plan," and that he would work with Fishbach to identify "other non-operational actions to close the gap." Also, in Romeril's September 1998 communication with Fuji Xerox, Romeril informed Fuji Xerox's president that Fishbach would liaise with his counterpart in Japan and that Tayler would travel to Japan to discuss possible accounting devices that Fuji Xerox could use to "improve" its poor third quarter 1998 results and "mitigate the operational numbers." Likewise in a September 1999 memo, Fishbach told Romeril that projected 1999 profits were below market expectations and attached a "Performance Profit" assessment that noted that a business unit "could need margin normalization [one of Xerox's accounting devices] to cover potential business base shortfalls."
26. Xerox increasingly used accounting actions to maintain its reported financial performance in the face of intense competition in the late 1990s and a market demanding stellar earnings. Period after period, Xerox's reported results increasingly depended on undisclosed accounting devices that Allaire, Thoman, Romeril, Fishbach, Marchibroda and Tayler knew or should have known distorted the underlying performance of Xerox's business.
27. The impact of this growing dependence on Xerox's significant operating units was identified in internal Xerox reports, memos, e-mails and meetings during 1997-2000. For example, in June 1998, Romeril assessed Xerox's major earnings-generating market in Brazil and informed Allaire, Thoman, Fishbach and others that Xerox Brazil contributed "10% of Xerox revenue/15-20% of Xerox profits" and that accounting devices were "huge" for Brazil in 1997, having added $180 million on top of "Underlying" profits of $400 million, or 31% of Brazil's total reported profits in 1997. Romeril informed his colleagues that "underlying" profits for Brazil were expected to be $425 million in 1998, but that $210 million more had to be found in "one-timers" to meet plan. In November 1998, according to an employee's contemporaneous notes of an internal annual plan meeting attended by Allaire, Thoman, Fishbach and others, Romeril reported that over the past four years Brazil had "$700M of unreal profits" from "non-marketing actions" and that the "[c]onceptual framework [of] our profile is illusory . . . the profits are there the question is the timing of when you take them." At the same meeting, according to the notes, Romeril emphasized that meeting high earnings targets was critical to senior management, noting that Allaire and Thoman were "out on a limb re consistent performance -- must perform mid to high teens earnings growth...."
28. Similar information was reported concerning Xerox's market in Europe. In August 1998, Fishbach told Thoman that although Xerox Europe's "operational" growth was 2 percent, "the growth that is likely to be reported is closer to 10% given headquarters adjustments for margin normalization and other accounting items." For the first quarter of 1999, defendants received a Financial Performance Summary that described Xerox Europe's results for the quarter and stated that equipment revenue had grown nearly one percent, but would have declined 6.9 percent without accounting adjustments to bring forward revenue which would otherwise not be recognized until future reporting periods. In October 1999, Xerox's vice chairman reported to Romeril and Thoman that Xerox Europe's underlying operational results, without accounting devices and restructuring, "have been deteriorating since 1995 and are very different than the reported results." The vice chairman provided Romeril and Thoman a chart from Xerox Europe's president illustrating operational results with and without the use of accounting devices. Likewise in January 2000, the president of Xerox Europe informed Thoman, Romeril and others that Europe's pre-tax profits had been "declining since 1996," that declines in 1999 profits were "driven by prior year once-offs [including accounting devices], the benefits of which started to reverse during 1999," but that "this declining trend has been fully contained in the reported profit" in part through the use of such accounting devices.
29. Moreover, the defendants received similar news about how corporate-wide revenues and earnings met targets because of Xerox's accounting actions. For example, in a November 1999 internal strategy committee meeting, Romeril told Thoman and other Xerox executives that when accounting actions and certain other items were stripped away from Xerox's overall consolidated reported revenues, Xerox was essentially a "no growth" company from 1998-1999. That same month, at Thoman's request, Romeril provided Thoman, Fishbach, and others with documents showing the historical impact of accounting actions and certain other items in order to show the company's "true operating economics." In November 2000, Allaire viewed a slide presentation showing the effect on earnings of accelerating revenue through various accounting devices. A financial summary calculated that such actions increased profit before tax by $458 million in 1999 and by $47 million in the third quarter of 2000, and would decrease profit by $57 million in 2001. At approximately the same time, Allaire, Romeril and Tayler received a "causal report" noting that among the reasons for poor third quarter 2000 earnings was "the impact of prior year actions (Arrow). . ." Arrow was the name of an internal system Xerox used starting in January 2000 to track particular accounting devices, including the impact of the accounting devices described below called ROE, margin normalization and PAS transactions.
30. The defendants knew or were reckless in not knowing the material impact that the accounting devices had on Xerox's equipment revenues, margins and earnings. Xerox management and Romeril's accounting department monitored and frequently quantified the impact of the accounting devices. Allaire, Thoman, Romeril, Fishbach, Marchibroda and Tayler were all frequently informed of the impact of the most significant of these devices through, among other things, quarterly "causal reports" and monthly and quarterly Financial Performance Summaries that frequently detailed the impacts of the accounting actions on Xerox's underlying results. Romeril, Fishbach, Marchibroda and Tayler often participated in quarterly and year-end closing meetings where accounting devices were often reviewed. Allaire, Thoman, Romeril and others participated in senior strategy and operations committee meetings where senior managers of Xerox's operating units often discussed and highlighted dependence on accounting devices. Romeril, Fishbach, Marchibroda and Tayler also received information from KPMG during quarterly and year-end closing meetings that quantified top-level adjustments.
31. Despite this knowledge, the defendants knowingly or recklessly painted a false portrait of Xerox's financial condition in the periodic reports it filed with the Commission covering 1997-2000. As a result, the defendants aided and abetted Xerox's filing of reports with the Commission that included materially false and misleading financial information or that failed to disclose information which would make the reported information not false and misleading.
32. Allaire, Thoman and Romeril also falsely told investors, directly and through conference calls with Wall Street analysts, that the company was an earnings success story and that its performance would continue improving quarter-after-quarter with higher revenues and earnings. For example, although Xerox required accounting devices to realize first quarter earnings targets in 1997, Allaire continued making bold public projections as he had earlier in the year: "Xerox Corp. is likely to see double digit earnings growth in 1997 `and beyond' said Chairman and CEO Paul Allaire." (AFX Newswire, May 15, 1997.) Reliance on accounting actions had quadrupled by the second quarter of 1997 when this projection was reported. By the third quarter of 1997, a Xerox press release quoted Allaire as saying: "Our performance increasingly demonstrates the benefits of our strategic investments in new products and sales coverage and the Xerox leadership in digital and color." (P.R. Newswire, October 23, 1997.) No mention was made of the material increase to earnings from accounting actions Allaire was informed of.
33. In July 1998, Thoman told analysts "our 16 percent earnings increase was achieved despite the more difficult economic conditions impacting Fuji Xerox and Brazil, as well as the strong dollar" but did not disclose that a material increase to earnings resulted from accounting devices, not sales. Lehman Brothers told its investors after Xerox's earnings were released and Thoman's presentation that "revenue growth was better than expected" in the quarter, "paced by stronger equipment sales." Allaire described the company's second quarter 1998 results in a Xerox press release issued on the Business Wire on July 23, 1998, stating: "The explosive growth in revenues from our expanding family of digital copiers drove double digit revenue growth for the third straight consecutive quarter and we delivered another quarter of strong double digit earnings growth consistent with our objectives." By the third quarter of 1998, when Xerox used accounting actions to report significant earnings increase over the prior quarter, Allaire told the public "we delivered another quarter of strong double-digit earnings growth consistent with our objective . . . ." (Business Wire, October 22, 1998.)
34. In describing year-end results for 1998, Thoman publicly stated that Xerox was on the threshold of a period in which "we'll deliver profitable revenue growth and significantly improved shareholder value." Yet Thoman failed to inform investors of Xerox's significant reliance on accounting devices to meet its earnings for the year. The 1998 annual report, signed by Allaire, Thoman, Romeril and others, informed shareholders and the public that "growth in these revenues is primarily a function of the growth in our installed population of equipment, usage and pricing. The balance of our revenues is derived from equipment sales." No mention was made of extensive reliance on the material accounting devices.
35. In a Xerox press release reporting first quarter 1999 results, headlined "Xerox Earnings Up 14 percent in First Quarter; Tenth Consecutive Quarter of Double Digit Operating Earnings Growth," Thoman told investors "we are very confident that revenue growth will improve as the year progresses. The focus of our entire organization is on accelerating revenue growth by delivering industry-specific solutions and services to major customers and broadening our participation in general markets through indirect channels, including retail, agents, telebusiness, and e-commerce." Three months later, Thoman said in a Xerox press release celebrating a 15 percent earnings increase for the second quarter of 1999 that "we delivered another quarter of strong earnings growth." Xerox attributed the growth to 34 percent growth in "the company's rapidly expanding document outsourcing business" and 26 percent growth of digital product revenues.
36. All of these public disclosures were false and misleading because they failed to disclose the material impact that the accounting devices had on the company's actual financial performance. On each of the occasions when Allaire, Thoman or Romeril touted Xerox's earnings to the public, each knew, or was reckless in not knowing, that reported earnings were materially increased by accounting devices directed from Xerox headquarters which were not the result of increased sales of Xerox products. Further, each of them knew, or was reckless in not knowing, that use of non-operational accounting devices was never disclosed to the public, although disclosure was material to informing Xerox shareholders and the public of the quality of the reported earnings and so that the public could make meaningful comparisons to prior Xerox earnings before reliance on accounting actions.
37. Initially, Xerox resorted to the undisclosed accounting devices to add only a penny or two to quarterly earnings to meet Wall Street estimates. However, as Xerox found it increasingly difficult to meet quarterly analyst estimates based on revenues as the company had historically accounted for them, reliance on accounting devices became more pronounced, accounting for a growing percentage of reported earnings.
38. As a condition of settling the April 11, 2002 complaint brought by the Commission, Xerox agreed to restate its financial accounting from 1997 through 2000 in accordance with GAAP. In July 2002, Xerox issued a restatement that included adjustments for the accounting devices described herein, as well as other items that do not form the basis of the allegations against the defendants in this Complaint. The restatement resulted in an adjustment of over $6 billion of equipment revenues and $1.9 billion of pre-tax earnings for 1997-2000.
39. The undisclosed use of accounting devices used by Xerox accounted for 4 percent of Xerox's reported first quarter pre-tax earnings in 1997 and between 14 percent and 37 percent of reported quarterly pre-tax earnings thereafter through 1999. Similarly, the impact of these accounting devices on Xerox's reported annual earnings grew from 19 percent in 1997 to 27 percent in 1998, and constituted 25 percent of 1999 reported pre-tax earnings. The charts below detail the impact of accounting devices on Xerox's reported earnings in each quarter and year from 1997-1999. The blue or darker portion of each bar represents earnings as historically calculated by Xerox. The yellow or lighter portion is the additional reported before tax earnings that resulted from undisclosed changes in accounting, including the use of devices that did not comply with GAAP. (The total amounts reflected in the two charts below exclude the inventory, restructuring and asset impairment charges Xerox recorded in the second quarter of 1998.)
40. Had Xerox reported its revenues and earnings consistent with its accounting in earlier years, Xerox would have failed to meet Wall Street earnings-per-share expectations in 11 of 12 quarters in 1997-1999. The chart below illustrates how accounting devices "closed the gap" between earnings measured in accordance with GAAP and Xerox's historical accounting practices and estimates ("Underlying EPS"), and earnings compared with non-GAAP and new accounting practices and estimates (accounting devices plus Underlying EPS) designed to meet the company's earnings targets and Wall Street's expectations ("First Call Consensus EPS").
(Note: The percentage impact on EPS may be slightly lower than the percentage impact on pre-tax earnings because pre-tax earnings excludes equity income, minority interests and other adjustments, while EPS calculations do not). The same information is shown below measured annually.
41. Xerox adopted or increased its reliance upon the following accounting devices which caused a material acceleration in the company's reported equipment revenues and an increase in earnings, making the company appear to have sold or leased more equipment than it would have reported under its prior accounting practices: (a) return on equity (ROE); (b) margin normalization; (c) price increases and lease extensions; (d) increases in residual values of leased equipment; (e) undisclosed material increases in the sale of future revenue streams; (f) manipulation of reserves; (g) manipulation of tax-related interest income, and (h) failure to disclose factoring transactions. A description of each of these devices is provided below.
42. Use of these accounting devices distorted Xerox's public financial reports, which were supposed to reflect the economic reality of Xerox's business. Investors were not informed that a material component of Xerox's business results was new and untested improper accounting devices highly subject to manipulation. The defendants did not require Xerox to disclose that Xerox had changed its methods of accounting in material respects from prior years, and Romeril, Fishbach, Marchibroda and Tayler misrepresented that Xerox was recording earnings and revenues in a manner consistent with GAAP, which fairly reflected the results of company operations. Further, despite Xerox's claimed inability to reasonably estimate the fair value of its products without resort to unreliable accounting estimates, the defendants represented that Xerox maintained internal controls that would produce financial statements in accordance with GAAP.
43. The defendants misled company shareholders and the public. Xerox Annual Reports to shareholders in each year 1997-99 stated:
Xerox Corporation management is responsible for the integrity and objectivity of the financial data presented in its annual report. The consolidated financial statements were prepared in conformity with generally accepted accounting principles and include amounts based on management's best estimates and judgments. . . . The Company maintains an internal control structure designed to provide reasonable assurance . . . that the financial records are adequate and can be relied upon to produce financial statements in accordance with generally accepted accounting principles.... The Company monitors its internal control structure with direct management reviews and a comprehensive program of internal audits. In addition, [KPMG LLP], independent auditors, have audited the consolidated financial statements and have reviewed the internal control structure to the extent they considered necessary to support their report . . . .
44. Romeril signed each of these statements on behalf of Xerox management. Allaire signed the statements for 1997 and 1998 on behalf of Xerox management. Thoman signed the 1999 statement on behalf of Xerox management. Each defendant participated in the preparation of the financial statements for the purpose of publishing them and knew or was reckless in not knowing that these statements by Allaire, Romeril and Thoman were materially false and misleading.
45. The following table illustrates the annual gross impact on pre-tax earnings from the accounting devices that the defendants used to "close the gap" between Xerox's actual operating results and its earnings targets each year during 1997-2000. This table also shows the annual net impact of these accounting devices on pre-tax earnings. (The hyphens in the table indicate accounting devices that are not the subject of this Complaint.)
|Residual Value Increases||36||45||15||0||96|
|ACT Interest Income||41||99||12||5||157|
|Total Gross Impact||$691||$1,146||$1,519||$663||$4,019|
|Total Net Impact||$323||$611||$487||$(41)||$1,380|
*This gross amount does not reflect the reversal of $89 million made during the second half of 1999.
**Included in the gross amounts are the effects of improperly timed reserve releases of $78 million which affected only interim periods within a fiscal year.
46. From 1997 to 2000, Xerox repeatedly and improperly changed the manner in which it accounted for lease revenue. These accounting changes pulled forward nearly $3.1 billion in equipment revenue and pre-tax earnings of $760 million from 1997 through 2000. Xerox never disclosed that these gains were a result of accounting changes rather than improved operational performance.
47. Xerox sells copiers and other office equipment outright to its customers for cash, but more frequently enters into long-term lease agreements in which customers pay a single negotiated monthly fee in return for the equipment, service, supplies and financing. Xerox refers to these arrangements as "bundled leases" and the monthly payment as "Total Cost of Ownership" ("TCO"). Beginning at least in the early 1990s, bundled lease transactions constituted the majority of its sales revenue. The primary method by which Xerox reported greater revenue and earnings to close the gap to meet Wall Street expectations was reallocation of TCO leasing revenue to the copier or other leased equipment (known internally as "the box").
48. Financial Accounting Standard ("FAS") 13, an Original Pronouncement of the Financial Accounting Standards Board ("FASB"), sets forth the rules accountants must follow under GAAP in accounting for lease revenue. Under FAS 13, monthly payments due under ordinary leases are recognized only as they are earned during the term of the lease. But FAS 13 requires equipment leases meeting certain criteria to be accounted for as if the lessor sold the equipment and provided financing for the sale. This "sales-type" lease accounting results in immediate revenue recognition of a large portion of the lease payments representing the fair value of the equipment, with the smaller portion recognized gradually as interest income over the lease term. Thus, for Xerox's bundled sales-type leases, GAAP required Xerox to immediately recognize revenue from the equipment sale at the equipment's fair value, but to recognize revenues from financing, services (such as equipment maintenance) and supplies (such as toner and paper) over the term of the lease.
49. Under Xerox's historical accounting methods, local operating units assigned the fair value to the equipment and assigned lease revenues to financing, service and supplies according to internal estimates made at the time the sales-type lease was entered into based on terms of the contract, competitive pricing and market finance rates. This system of allocating revenues was deemed satisfactory for accounting for sales revenues with only minor changes until the mid-1990s.
50. By 1997, Xerox internally claimed that the operating level allocation of box, service and financing revenues was unreliable and misleading. Xerox internally claimed that it was unable reasonably to assign a fair value to equipment sold under a sales-type lease contemporaneously with the sale, as it had in the past.
51. Instead, for public financial reporting purposes, but not for operating purposes, Xerox substantially departed from its past practices and used an approach that over-rode the value determinations recorded at the time of sale and modified them with formulas which management could frequently change. Xerox's method was to "derive" its equipment's fair value by first lowering the value of the financing and service components of its leases as calculated at the operational level and subtracting those amounts from the total lease payments to develop the amount of equipment revenue to recognize in its books. Under this approach, because deferred financing and service revenues were lowered by corporate headquarters, the amount remaining and categorized as the fair value of the equipment was increased. The result was to increase current reported revenue but reduce revenues to be recognized in future periods. This methodology departed from GAAP. Xerox, however, did no testing to determine if its traditional manner of allocation was unreliable or if the new methodology accurately reflected the fair value of its copiers. Nor did Xerox disclose to the public that it had altered its method for calculating current revenues.
52. One device used by Xerox management to manipulate revenue recognition was called "ROE" (for "return on equity"), which shifted a portion of finance income so that it was recognized immediately as equipment revenue. Beginning in 1997, the company used ROE more expansively than it had in years past. The second device, called "margin normalization," shifted a portion of service income so that it, too, could be recognized immediately as equipment revenue. Starting in 1997, Xerox implemented various forms of margin normalization in Xerox Europe, Brazil and other Latin American subsidiaries. Xerox's use of ROE and margin normalization to derive the fair value of its equipment directly contradicted the requirements of FAS 13 and systematically overstated equipment revenues and lease income and understated financing and service revenues. In addition to these accounting devices, Xerox also prematurely recognized revenues from price increases it negotiated with existing customers and retroactively increased the estimated "residual value" of equipment (the estimated value of equipment at the end of the lease term), two accounting devices which were also impermissible under GAAP.
53. Romeril directed or authorized his subordinates to exploit accounting opportunities inherent in the ROE method. Xerox justified reducing its estimate of the fair value of financing by claiming that financing should produce no more than a 15 percent return on the equity of its finance operations, regardless of the interest rate stated in an individual lease or internally calculated at the time of sale. A desired return on the finance division's equity always had been a factor in Xerox's accounting for its finance charges. During 1997-2000, Xerox used its ROE model in a manner that mechanically discounted lease payments at a finance rate that had little relation to market interest rates available to the customer, the actual return on financing to Xerox, or the price at which the equipment actually sold. This method of deriving the equipment revenue for sales-type leases did not comply with GAAP.
54. Throughout 1997-2000, Xerox always assumed a 15 percent ROE for determining the finance component of its sales-type leases, in all geographies where the method was applied and under all financial and economic conditions, despite significant volatility in the returns actually earned by leasing companies in this period. Indeed, this target ROE was nothing more than the approximate average return of a handful of various finance companies wholly-owned by other public companies whose businesses were completely unrelated to Xerox or the manufacturing of copiers and which had a wide range of reported returns on equity from below 6 percent to over 22 percent.
55. Between 1997 and 2000, Xerox continually changed the underlying factors and assumptions used to calculate the ROE formula and expanded the use of the formula to new geographic areas, all of which resulted in larger and larger portions of finance income being reallocated to equipment revenue for immediate recognition. For example, a lease recorded as generating $15,000 per year in revenue at the operational level was increased at the corporate level for financial reporting purposes by 6 percent in 1997 and 13 percent in 2000. In this way, millions more of equipment revenues were reported each quarter -- none of which resulted from the sale of a single additional copier or other Xerox product. Compared to the equipment revenues that would have been reported based on allocations recorded at the operational level, Xerox's ROE formula pulled forward $2.2 billion in equipment revenue and $301 million in pre-tax earnings for the period 1997 through 2000. Despite this material impact on financial results, no disclosure of this unusual accounting method was made to investors and Xerox did no testing to determine if its ROE methodology resulted in economically realistic financial reporting based on the fair market value of the equipment or on prevailing equipment finance rates in different markets.
56. In most cases, application of ROE was a topside adjustment directed by corporate headquarters. Operating units allocated lease cash flows to the box, service and finance components according to long-established procedures. But before the financial results were reported publicly, each of Xerox's regional headquarters, using data supplied by accounting at corporate headquarters under Romeril, recalculated these allocations using a method designed to achieve a target of no more than a 15 percent return on the equity of Xerox's financing operations, ignoring the real interest rates prevailing where the equipment was leased and artificially eliminating the volatility in its return on equity that a competitive market would inevitably produce. Initially, use of the ROE formula was limited to the United States and to Xerox Brazil. As the pressure to meet earnings targets grew, and competition made selling copiers more difficult, ROE was expanded to Xerox Europe in 1998.
57. Xerox's corporate treasury department, with the authorization or involvement of Romeril, Fishbach, Marchibroda and Tayler, was responsible for approving changes to the ROE model. Marchibroda helped to develop and geographically extend application of the ROE formula, after first obtaining concurrence from Romeril and Fishbach, and was aware of the impact of the formula on earnings. He directed that the CFOs for Xerox's markets in Latin America, the U.S. and Europe assess the impacts of proposed changes to an assumption underlying the ROE model prior to implementation and inform him of the impact of the changes on profits, a process that Marchibroda referred to as "profit scoping." Tayler counseled European and Japanese executives of Xerox concerning application of ROE in those regions and Tayler helped assuage concerns raised by KPMG in Tokyo about the anticipated use of ROE in Asia, although the methodology ultimately was not adopted by Xerox in Japan. As director of accounting policy and, later, as controller, Tayler continued to act as a supportive resource for Xerox executives around the world who had questions about application of ROE and margin normalization.
58. Each of the defendants was aware of and condoned the use of ROE. All of the defendants received documents such as Financial Performance Summaries and other financial reports that frequently identified the impact of ROE adjustments. Allaire, Romeril and Thoman also attended meetings with senior Xerox operations managers where the impact of ROE adjustments on Xerox's reported results were discussed. Also, Romeril, Fishbach, Marchibroda and Tayler attended quarterly and year-end closing meetings with KPMG auditors where the impact of ROE was often quantified and the topic of disclosure was discussed. Although all of the defendants knew or were reckless in not knowing that the topside adjustments were responsible for materially increasing equipment revenues, profit margins and earnings, none caused Xerox to disclose the use or impacts of the accounting devices to investors. Thoman, Romeril, Fishbach, Marchibroda and Tayler even ignored concerns raised by KPMG in early 1999 and/or early 2000 about the adequacy of management's assessment of whether the impact and changes of accounting devices required disclosure. KPMG, however, ultimately issued an unqualified audit report for these periods.
59. The use of the ROE adjustments grew larger and larger during 1997-2000. Altering assumptions in the ROE formula produced lower and lower assumed finance, or "discount," rates. Lower discount rates enabled Xerox to account for more and more of the contractual lease payments up front as equipment revenue. But the use of such lower discount rates was unsupported by either verifiable objective evidence or economic reality. None of the defendants ordered any investigation to test the company's claim that the implicit discount rate adjustments were necessary to arrive at the actual prevailing equipment finance rates appropriate to the customer. Thus, the effect of the implicit discount rate adjustment on any individual lease transaction's interest rate or equipment price was never calculated and compared to market rates or market prices. Yet, the unrealistic discount rates produced by the ROE formula were increasingly apparent in the operational markets in which ROE was used.
60. Throughout this period, Romeril, Fishbach, Marchibroda and Tayler knew, or were reckless in not knowing, that the ROE formula produced results that were contrary to economic reality in the local markets in which ROE was applied. In fact, the ROE formula reduced rates used to prepare the company's publicly reported financial statements by as much as 6 percentage points. In some reporting periods, the ROE formula produced rates on Xerox's five-year leases that were below three-year U.S. Treasury Bill rates and, in some cases, below rates at which top-tier U.S. companies could borrow money for 30 days. In certain reporting periods, the discount rates that were applied to Xerox's leases in the United States fell below Xerox's own incremental borrowing costs.
61. The failure of the ROE method to produce realistic market finance rates was particularly pronounced in Brazil. There, market finance rates that framed the actual price and term negotiations with Xerox's lease customers never appeared in Xerox's accounting records. For example, Xerox recorded all of its Brazilian leases in early 1997 assuming a finance rate of 8 percent, then dropped the rate to 7 percent in the third quarter of 1997, and then reduced the rate again to no more than 6 percent beginning the first quarter of 1998 and continuing through the second quarter of 2000. The ROE formula generated rates even as low as zero percent in certain periods in 1999. These ROE-derived finance rates were based primarily on the costs of Xerox's U.S. finance operations, rather than the currency and costs in Brazil which were dictating the economic reality of Xerox's lease contracts. By comparison even to the short-term inter-bank borrowing rates in Brazil, which fluctuated between 37% and 18% during 1997 to mid-2000, Xerox's ROE formula produced clearly absurd results. Had Xerox used the short-term inter-bank rates in Brazil as an estimate of prevailing finance rates, equipment revenues reported for Brazil would have been reduced by an estimated total of approximately $757 million during 1997-2000.
62. As a result of increased competition in Xerox's markets in the 1990s, profit margins on Xerox equipment declined, especially outside the United States. Observing this margin slippage in equipment sales, Xerox, at Romeril's direction, reallocated anticipated leasing revenues around the world using an accounting device referred to as "margin normalization." Each of the defendants was aware of and condoned the use of margin normalization. This "margin normalization" method, which Xerox used to derive the equipment revenue for sales-type leases, did not comply with GAAP and resulted in artificially high equipment revenues and earnings reported by Xerox.
63. Margin normalization, like ROE, was a topside accounting device directed or approved by Romeril, Fishbach, Marchibroda and Tayler near the end of reporting periods. Sales and allocation of revenues were initially booked by operating units, which did not use margin normalization. Then, on a consolidated level, management in Stamford, Connecticut directed that revenue from service be reallocated to the box based upon what management asserted the margins ought to be, not as they were calculated locally. Xerox even made these reallocations retroactively to transactions that had already been publicly reported in its financial statements, also in violation of GAAP. When the methodology was first implemented in Europe in 1997, management reallocated revenue from service to the box so as to achieve equal gross margins on those two components. By the end of 1999, however, Xerox had changed the methodology so often that its reallocation of revenue resulted in a 17 percentage point gross margin differential between box and service with no economic or business circumstances justifying such changes. Margin normalization, in essence, meant that Xerox recalculated its revenues in Europe, Brazil, Canada, Mexico and Argentina to achieve relative profit margins on the service and box portions of its bundled leases modeled primarily on margins realized in the United States. Xerox ignored regional economic or business factors in making these calculations and, therefore, reported revenues and earnings that were not calculated based on economic realities.
64. Romeril's accounting department regularly directed changes in the formula for calculating anticipated revenue reallocated from service to the box. The total addition to equipment revenues pulled forward during 1997 through 2000 from margin normalization was $617 million. Of that amount, $358 million was recognized as pre-tax earnings.
65. Romeril, Fishbach, Marchibroda and Tayler were all directly involved in the implementation of and the changes to the margin normalization methodology and knew, or were reckless in not knowing, that margin normalization violated GAAP. They participated in and concurred in Xerox's decision to implement margin normalization in Europe in 1997, each was aware of or involved in modifying its application in Europe in subsequent quarters, and each knew, or was reckless in not knowing, that Xerox did not verify that the accounting methodology fairly reflected the fair value of equipment and services in those countries. Tayler, for example, knew that internal surveys showed that the majority of transactions in significant European markets -- France, United Kingdom and Ireland -- were cash sales or leases of equipment only, which could have provided a local benchmark for profit margins on the box. In the fourth quarter of 1999, Marchibroda approved of the extension of the European model of margin normalization to Brazil, Mexico and other Latin American countries. In 2000, while controller, Tayler permitted the use of the European model of margin normalization in Brazil and Mexico, as well as continued use of margin normalization and changes in its application in Europe.
66. Romeril, Fishbach, Marchibroda and Tayler also knew, or were reckless in not knowing, that Xerox at times applied margin normalization retroactively to previously reported transactions in violation of GAAP. In connection with the third quarter 1997 implementation of margin normalization in Europe, Marchibroda received a memo from Tayler advising that changes in estimates should normally only be applied prospectively, not retroactively.
67. All four, as well as Allaire and Thoman, received documents such as quarterly causal reports and other internal reports that frequently identified the impact of margin normalization adjustments. Allaire, Thoman and Romeril also attended meetings with Xerox senior operations managers where the impact of margin normalization adjustments on Xerox's reported results were often discussed. In addition, Romeril, Fishbach, Marchibroda and Tayler attended quarterly and year-end closing meetings with KPMG auditors where the impact of margin normalization was quantified and the topic of disclosure was discussed. Despite this knowledge, all of the defendants failed to disclose the nature and impact of these material accounting devices to investors and the public.
68. Xerox also used accounting that did not conform with GAAP to improperly accelerate the recognition of equipment revenues through price increases and extensions of existing leases. From 1997 through the second quarter of 1999, Xerox pulled forward approximately $300 million in equipment revenue, and $200 million in pre-tax earnings, for these items to close the gap between actual and expected financial performance. The net impact on pre-tax earnings for 1997-2000, which reflects the reversal of certain of these adjustments in 1999 and the reversing impact of the adjustments made in earlier periods, was $58 million.
69. Defendants Romeril, Fishbach and Marchibroda knowingly or recklessly participated in the use of this non-GAAP device to boost earnings in 1999. In the first two quarters of 1999, Xerox pulled forward approximately $131 million in equipment revenue and $101 million in pre-tax earnings from improper recognition of revenue from price increases and lease extensions.
70. In certain regions, principally Brazil, Xerox negotiated or unilaterally imposed price increases and lease extensions on existing lease customers. With limited exceptions not applicable here, GAAP, including FAS 13 and FAS 27, requires that additional income realized from renegotiation of existing leases be recognized over the remaining life of the lease. Xerox knowingly or recklessly violated these GAAP provisions by recognizing immediately the revenue from the price increases and lease extensions.
71. Romeril, Fishbach, Marchibroda and Tayler knew that this practice violated GAAP. In a February 1999 memo, for example, Tayler (as director of accounting policy) informed Marchibroda that Xerox's policy allowing such adjustments did not conform with GAAP. Moreover, in early 1999, Xerox's outside auditors from KPMG informed Romeril, Fishbach, Marchibroda and Tayler that Xerox's accounting for price increases and lease extensions did not comply with GAAP. KPMG and Romeril even met with the chairman of the Audit Committee shortly after the first quarter 1999 close and communicated KPMG's position that Xerox was improperly accounting for price uplifts and lease extensions. However, Romeril, Fishbach, Marchibroda and Tayler did not cause Xerox to comply with GAAP, but merely reduced the amount Xerox improperly recognized in the first two quarters of 1999. Even so, Xerox recognized $84 million of non-GAAP equipment revenue in the first quarter of 1999 and $47 million in the second quarter of 1999. Of this total of $131 million, Xerox reversed only $89 million in the second half of 1999, resulting in a net impact for 1999 of $42 million.
72. GAAP requires that at the inception of a lease, the lessor must establish and record the "estimated residual value" of the leased equipment, i.e., the estimated fair value of the equipment, if any, at the end of the lease term. FAS 13, as amended by FAS 23, prohibits increasing the estimated residual value for any reason after it is first established.
73. Despite this prohibition, from 1997 to 1999, Romeril, Fishbach, Marchibroda and Tayler knowingly or recklessly allowed Xerox to record adjustments of more than $95 million to make retroactive upward revisions to the net residual values of machines leased by its Europe, Brazil, United States, Argentina and Mexico operating units. These write-ups, which had the effect of reducing the cost of sales, were often recorded close to the end of quarterly reporting periods as a gap-closing measure to help Xerox meet or exceed internal and external earnings expectations. In some instances, the revisions increased the residual value of the machines by as much as 50 percent. In total, the revisions increased Xerox's reported pre-tax earnings by a net of $43 million during 1997-2000.
74. Fishbach and Marchibroda created an internal accounting policy that permitted retroactive write-ups of net residual values within the calendar year in which they were initially recorded. Marchibroda persuaded KPMG to accept the practice after receiving KPMG's initial counsel that it should be rejected. Romeril approved the policy, which required all upward adjustments to be approved by the assistant controller, who at the time was Marchibroda. Tayler, as director of accounting policy, was aware of this policy. Each of them knew or was reckless in not knowing that retroactive increases to the residual values of Xerox's machines violated GAAP, specifically FAS 13 as amended by FAS 23. This violation of GAAP contributed to Xerox materially misstating its financial results in numerous public filings, including its second and third quarter reports in 1997, its annual report for 1997, its third quarter report in 1998, and its annual report for 1998.
75. In 1999, at Romeril's direction, with the knowledge and support of Thoman, and with the assistance of Fishbach, Marchibroda and Tayler, Xerox pulled forward approximately $400 million in revenue and $182 million in profit before taxes by selling at a discount rights to future revenue streams from existing lease portfolios. This allowed Xerox to immediately recognize revenues which, under GAAP, the company otherwise would have had to recognize over the life of the leases. These transactions were known as "PAS" ("Portfolio Asset Strategy") transactions.
76. Although Xerox had entered into PAS transactions prior to 1999, that year it quintupled the amount of those transactions compared to 1998. The material increase in Xerox's 1999 PAS transactions resulted, in large part, from Xerox's inability to sustain a business model in Brazil that relied on sales-type leases. In 1999, Xerox Brazil changed its business model from its traditional sales-type lease model to one based on rental contracts. Because, under GAAP, the revenue from rental contracts cannot be recognized immediately, Xerox entered into PAS transactions to allow such immediate revenue recognition, which is permitted under GAAP.
77. Completing PAS transactions within a given quarter in 1999 was perceived as critically important within Xerox management as a means to close the gap between actual and expected results, and they had a material impact on Xerox's reported results in 1999. Employees were given bonuses for completing the transactions within a desired quarter. Even KPMG recognized that such transactions were used to "bridge the gap" and complained to Romeril that such quarter-end transactions were creating undue time pressures on KPMG's financial review.
78. All of the defendants knew or were reckless in not knowing that the increased use of PAS transactions compared to prior years resulted in a substantial and material increase in Xerox's results and earnings trends in 1999 and would have a negative impact on future periods. In early 2000, Thoman, Romeril and Fishbach attended a meeting of Xerox's Audit Committee during which Tayler reported that revenue from PAS transactions increased more than fivefold from 1998 to 1999 ($398 million in 1999 vs. $76 million in 1998) and Allaire, Thoman, Romeril, Fishbach and Tayler received Audit Committee materials that detailed this material increase in PAS transactions. Although these transactions had a material impact on the trend of Xerox's earnings, none were disclosed in Xerox's 1999 Form 10-K. Months earlier, in a memorandum to Romeril, Fishbach predicted that earnings goals for South America could be met only with "significant" PAS transactions. He raised the issue whether reliance on these possible deals would be "so significant as to require disclosure...." Despite the material impact of these transactions on the trend of Xerox's earnings, the defendants knowingly or recklessly failed to disclose this crucial information in its public filings and other public disclosures. These failures by the defendants violated disclosure obligations imposed by the antifraud provisions of the Exchange Act and Item 303 of Regulation S-K.
79. From 1997 through 2000, Xerox also increased its earnings by approximately $496 million through the release into income of excess or cushion reserves. This amount includes $78 million of improperly timed reserve releases which affected only interim periods within a fiscal year. Xerox's use of these reserves violated GAAP, and its knowing or reckless use of reserves for this purpose without disclosure was fraudulent.
80. FAS 5, "Accounting for Contingencies," allows a company to establish reserves only for identifiable, probable and estimable risks and precludes the use of reserves, including excess reserves, for general or unknown business risks because they do not meet the accrual requirements of FAS 5. When a reserve ceases to meet the accrual requirements of FAS 5, it must be immediately released into income. The systematic or timed release of excess reserves into income violates GAAP.
81. Romeril, Fishbach and Marchibroda knowingly or recklessly violated GAAP by repeatedly manipulating the release of approximately $415 million of the reserves Xerox used to close the gap between actual results and earnings targets during 1997-2000. Tayler also participated in the improper establishment of, and was aware of the improper release of, $100 million of these reserves. These actions caused Xerox's financial reports to be materially false and misleading.
82. In addition to the reserves, Romeril, Fishbach and Marchibroda knowingly or recklessly violated GAAP by manipulating the interest income from tax refunds that caused Xerox to improperly increase earnings by $157 million from 1997 through 2000. Rather than recognize the gain associated with the successful resolution of a dispute with the Internal Revenue Service upon the exhaustion of all legal contingencies, as required by GAAP, these Xerox defendants allowed the company to recognize the income over several years to meet earnings targets.
83. In June 1997, Xerox purchased the Rank Group plc's 20 percent stake in Rank Xerox Ltd., Xerox's European subsidiary. In connection with this purchase, and at KPMG's suggestion, Romeril, with the help of Marchibroda, Fishbach and Tayler, fraudulently established a $100 million reserve for "unknown risks" arising out of the transaction. In establishing the reserve, Xerox violated GAAP by failing to comply with FAS 5.
84. Romeril, Fishbach, Marchibroda and Tayler knew or were reckless in not knowing that the Rank reserve was created for "unknown risks associated with the transaction," as was documented in a memo by Tayler based, in part, on his conversation with the KPMG audit partner. In fact, the Rank Group indemnified Xerox for any liabilities arising from the sale.
85. KPMG UK, which performed the due diligence on behalf of Xerox preceding the acquisition, advised the U.S. headquarters of Xerox that the potential tax exposure arising out of the transaction was "remote to low." Romeril acknowledged on notes concerning the transaction that the "risks [to be covered by the Rank reserve] are substantively remote." Nevertheless, based in part on KPMG's encouragement, Xerox improperly booked a $100 million reserve in violation of FAS 5.
86. Beginning in mid-1998, Xerox, with the knowledge and approval of Romeril, Fishbach, Marchibroda and with the knowledge of Tayler, began charging expenses against the Rank reserve for items unrelated to the acquisition. The accounting department continued to draw on the reserve each quarter for expenses unrelated to the acquisition until it was exhausted at the end of 1999. Internally, Xerox referred to the reserve as an "Interdivisional Opportunity" that had the effect of boosting Xerox Europe's reported results as needed. Romeril, Fishbach, Marchibroda and Tayler knew or were reckless in not knowing that Xerox's use of the Rank reserve was not in conformity with GAAP and caused Xerox's financial reporting to be false and misleading.
87. Xerox fraudulently released into income approximately 20 other excess reserves totaling $396 million to improve earnings from 1997 through 2000. Approximately $315 million of these reserves were maintained on Xerox's corporate books controlled by Marchibroda and his staff. Staff in the controller's office tracked excess corporate reserves by preparing schedules called "Interdivisional Opportunities" and "List of Unencumbered & Other Reserves." Marchibroda and Fishbach reviewed these excess reserve schedules on a quarterly basis and knowingly or recklessly released the reserves in violation of GAAP to close the gap between operational earnings and Wall Street expectations. Romeril received various Xerox financial documents and KPMG documents that tracked the reserves on a quarterly and annual basis. They kept Romeril informed of these activities. Three of the largest reserves used to manipulate earnings are described below.
88. Vacation Pay Accrual Reserve: In 1993, Xerox changed its vacation policy by limiting the amount of vacation an employee could accrue. This policy change resulted in an over-accrual of vacation pay on Xerox's accounting records. By the end of 1996, the over-accrual had a balance of $30 million. During 1997, Xerox systematically and improperly released this over-accrual balance at a rate of $7.5 million per quarter. Romeril, Fishbach and Marchibroda knew or should have known of this systematic release through various Xerox documents that analyzed the impact of "one-off" items on actual and planned results. In addition, in June 1998, Fishbach and Marchibroda knowingly or recklessly manipulated Xerox's earnings by failing to order the release of an additional $41.9 million in excess vacation accrual and instead permitting release of $23.4 million in the fourth quarter of 1998 and $18.4 million in the first quarter of 1999 in order to manage earnings.
89. FAS 106 Reserve: Xerox created this reserve in 1993 when it adopted FAS 106, which relates to accounting for post-retirement benefits for employees. By the end of 1996, there was a FAS 106 excess reserve balance of $40 million. During 1997 and 1998, Xerox systematically released the reserve into income at the rate of $5 million per quarter until the reserve was exhausted. Romeril, Fishbach and Marchibroda knew or were reckless in not knowing of the systematic release of this reserve through various Xerox documents that analyzed the impact of "one-off" items on actual and planned results.
90. Whiskers Reserve: The Whiskers reserve had been on Xerox's books so long that neither Fishbach nor Marchibroda could identify its original purpose and Xerox could not produce any documentation to support it. Xerox used this reserve to increase its income from 1997 though 1999 by $31 million. Rather than reverse Whiskers, as is required by FAS 5, Marchibroda and his staff knowingly or recklessly used the reserve to cover operating and litigation expenses in 1998. In the third quarter of 1999, the controller's office released $16 million of the Whiskers reserve to cover taxes for Brazilian contract extension issues. Because KPMG identified the Whiskers reserve as an "excess" reserve, Romeril was aware that it was an "unencumbered" reserve on Xerox' books. Fishbach and Marchibroda knew or were reckless in not knowing of the use of the Whiskers reserve through "Interdivisional Opportunity" schedules and "List of Unencumbered Reserves and Other Reserves" schedules prepared by the staff of the controller's office.
91. From 1997 through 2000, Xerox released into income more than $150 million in tax-related interest that under GAAP Xerox should have recognized in 1995 and 1996. Romeril, Fishbach and Marchibroda knew or were reckless in not knowing that this money was used as needed to "bridge the gap" between actual and reported results.
92. In 1995, Xerox received a final favorable court decision that entitled Xerox to a refund of Advanced Corporation Tax ("ACT") it paid in the United Kingdom in 1974, and interest accrued on that refund. Xerox had paid this tax from 1974 through 1989, and the 1995 ruling meant Xerox also would be reimbursed for those taxes and receive accrued interest. By the end of 1996, Xerox knew it was entitled to approximately $237 million in accrued interest. Under GAAP, Xerox was required to recognize the full $237 million as income in 1995 and 1996. Instead, Xerox recognized only $80 million, and used the balance as another tool to "close the gap."
93. Romeril referred to this ACT interest as the "ACT Fund" and Xerox recognized the income on an as-needed basis over several years. Fishbach and Marchibroda knew that the ACT Fund was identified within Xerox as a "cushion," and the controller's office tracked it on its "List of Unencumbered and Other Reserves" and "Interdivisional Opportunities" schedules. Romeril, Fishbach and Marchibroda knew or were reckless in not knowing that the ACT Fund was used as necessary to help meet performance targets and Wall Street earnings expectations. For example, in 1998 Romeril noted that ACT interest was a source Xerox was drawing from to "offset" unrelated consulting expenses and "to meet plan."
94. Romeril, Fishbach and Marchibroda knew or were reckless in not knowing that Xerox's improper accounting for ACT interest overstated earnings in 1997-2000 by $157 million. Nevertheless, under their direction Xerox failed to disclose the impact of the ACT interest on its reported financial results.
95. Throughout 1998, analysts expected Xerox to increase its liquidity and called for a stronger year-end cash balance throughout 1999. However, due to poor business performance and liquidity pressures, Xerox was unable to generate the cash demanded by analysts as evidence of a healthy balance sheet. In an attempt to create liquidity, Xerox Treasury, in the fourth quarter of 1999, instructed its largest operating units to explore factoring transactions with local banks. In response, Xerox operations worldwide consummated $288 million of factoring transactions that materially improved the company's 1999 operating cash flows by approximately 24 percent and allowed Xerox to report a positive year-end cash balance of $126 million, instead of a negative number. Xerox failed to disclose these transactions in its 1999 financial statements.
96. Fishbach was aware of these transactions and their implications. Fishbach knew or was reckless in not knowing that these factoring transactions should have been disclosed to investors.
97. Paragraphs 1 through 96 are hereby realleged and incorporated herein by reference as if set forth fully.
98. Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder prohibit (a) employing devices, schemes, and artifices to defraud; (b) making untrue statements of material fact or omitting to state material facts necessary to make the statements made not misleading; and (c) engaging in acts, practices, and a course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.
99. Item 303 of Regulation S-K requires an issuer of securities to include in its Management's Discussion and Analysis ("MD&A") section of its periodic filings information that is necessary to an understanding of its financial condition, changes in financial condition and results of operations, among other things. Item 303 further provides that an issuer's management should discuss any known trends or uncertainties that have, or that reasonably expect to have, a material unfavorable impact on net sales, revenues, or income from continuing operations. Item 303 also requires that MD&A should focus specifically on material events or uncertainties known to an issuer's management that would cause a company's reported financial information not to be necessarily indicative of future operating results or future financial condition.
100. In violation of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, defendants Allaire, Thoman, Romeril, Fishbach, Marchibroda and Tayler knowingly or recklessly failed to disclose the material impact that ROE, margin normalization and PAS transactions had on Xerox's reported financial performance, and Romeril, Fishbach, Marchibroda and Tayler knew, or were reckless in not knowing, that ROE and margin normalization did not comply with GAAP. In addition, as described herein, Romeril, Fishbach and Marchibroda also knowingly or recklessly failed to disclose the material impact that upward residual value adjustments, price increases and lease extensions, and the use of cushion reserves and tax-related interest income had on Xerox's reported financial performance, all of which these defendants knew, or were reckless in not knowing, did not comply with GAAP. As further described herein, Fishbach also knowingly or recklessly failed to disclose the material impact that factoring transactions had on Xerox's 1999 cash position and cash flows. The financial information released without these disclosures constituted materially misleading statements and omissions because each of the defendants knowingly or recklessly misrepresented the company's equipment revenues and earnings as substantially greater than they were and failed to disclose that the reported results were achieved through accounting actions, most of which violated GAAP, rather than because of improved business performance. The repeated use of these accounting devices without disclosure for the purpose of meeting published earnings expectations, achieving bonus targets and other purposes constituted a scheme to defraud.
101. The aggregate impact of the undisclosed accounting devices resulted, among other things, in Xerox:
a. Increasing its pre-tax earnings from 1997-2000 by approximately $1.4 billion.
b. Increasing its equipment sale revenue by approximately $3 billion dollars and significantly increasing its quarterly equipment sale gross margins.
c. Portraying the false and misleading appearance of meeting or exceeding earnings expectations of Wall Street analysts in 11 of 12 quarters during 1997-1999.
d. Filing periodic reports with the Commission that included financial statements and disclosures that contained materially false and misleading statements and omissions, including 12 quarterly and four annual reports covering the period 1997-2000.
e. Painting the false appearance in its 1999 financial statements that it had a positive year-end cash balance from operations when, in fact, it would have had a negative cash balance except for $288 million in unusual undisclosed year-end factoring transactions.
102. In addition to failing to disclose the impact of its actions in its financial statements and periodic reports, defendants Allaire, Thoman and Romeril, directly or indirectly, made materially false and misleading statements or omissions about the company's financial performance in other public disclosures, including earnings releases and statements to shareholders and analysts.
103. Paragraphs 1 through 102 are hereby realleged and incorporated herein by reference as if set forth fully.
104. Section 13(b)(5) of the Exchange Act prohibits any person from knowingly circumventing or knowingly failing to implement a system of internal accounting controls or knowingly falsifying an issuer's books and records. Rule 13b2-1 prohibits any person from directly or indirectly falsifying, or causing to be falsified, an issuer's books and records.
As a result of the accounting devices set forth above, Romeril, Fishbach, Marchibroda and Tayler knowingly or recklessly violated Section 13(b)(5) of the Exchange Act and Exchange Act Rule 13b2-1.
105. Paragraphs 1 through 105 are hereby realleged and incorporated herein by reference as if set forth fully.
106. 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 factually accurate annual and quarterly reports. Exchange Act Rule 12b-20 provides that in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.
107. As a result of the accounting devices set forth above, each defendant named herein aided and abetted Xerox's violations of Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1, 13a-13, and 12b-20.
108. Paragraphs 1 through 108 are hereby realleged and incorporated herein by reference as if set forth fully.
109. Section 13(b)(2)(A) of the Exchange Act requires that issuers make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the issuer. Section 13(b)(2)(B) of the Exchange Act requires, among other things, that issuers maintain a system of internal accounting controls that permit the preparation of financial statements in conformity with GAAP.
110. As a result of the accounting devices set forth above, each defendant named herein aided and abetted Xerox in violating Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act.
WHEREFORE, the Commission respectfully requests that this Court:
A. Permanently restraining and enjoining each defendant from violating Section 10(b) of the Exchange Act and Rule 10b-5 thereunder;
B. Permanently restraining and enjoining Romeril, Fishbach, Marchibroda and Tayler from violating Section 13(b)(5) of the Exchange Act and Rule13b2-1 thereunder;
C. Permanently restraining and enjoining each defendant from aiding and abetting violations of Sections 13(a) and 13(b) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.
Order each of the defendants to disgorge the unjust enrichment realized by him plus prejudgment interest thereon.
Order each of the defendants to pay a civil penalty under Section 21(d) of the Exchange Act [15 U.S.C. § 78u(d)(3)].
Enter an order under Section 21(d)(2) of the Exchange Act [15 U.S.C. § 78u(d)(2)] barring each of defendants Allaire, Romeril, and Fishbach from acting as an officer or a director of any issuer required to file public reports pursuant to Sections 12 or 15(d) of the Exchange Act.
Grant such other relief as this Court may deem just and appropriate.
Robert B. Blackburn (RB-1545)
Securities and Exchange Commission
The Woolworth Building
New York, N.Y. 10279
James A. Kidney (JK-5830)
Paul R. Berger
Timothy N. England
C. Hunter Wiggins
Charles F. Wright
David M. Stuart
Counsel for the Plaintiff
Securities and Exchange Commission
450 Fifth St., N.W.
Washington, D.C. 20549-0911
(202) 942-4797 (Kidney)
(202) 942-4677 (Kreitman)
(202) 942-9581 (Fax)
Dated: June 5, 2003
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