UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7387 / February 6, 1997 SECURITIES EXCHANGE ACT OF 1934 Release No. 38251 / February 6, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 879 / February 6, 1997 ADMINISTRATIVE PROCEEDING File No. 3-9240 ------------------------- : In the Matter of : ORDER INSTITUTING CEASE-AND-DESIST : PROCEEDING PURSUANT TO SECTION 8A WILLIAM T. MANAK : OF THE SECURITIES ACT OF 1933 AND : SECTION 21C OF THE SECURITIES Respondent. : EXCHANGE ACT OF 1934, MAKING : FINDINGS AND IMPOSING A CEASE-AND- : DESIST ORDER ------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate to institute a cease-and-desist proceeding pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against William T. Manak ("Manak" or "Respondent"). Accordingly, IT IS HEREBY ORDERED that said proceeding be, and hereby is, instituted. II. In anticipation of the institution of this proceeding, Respondent has submitted an Offer of Settlement ("Offer") to the Commission which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceeding brought by or on behalf of the Commission, or in which the Commission is a party, and without admitting or denying the findings contained in this Order, except that Respondent admits the jurisdiction of the Commission over him and over the subject matter of this proceeding, Respondent consents to the entry of this Order Instituting Cease-And-Desist Proceeding Pursuant To Section 8A Of The Securities Act Of 1933 And Section 21C Of The Securities Exchange Act Of 1934, Making Findings And Imposing A Cease-And-Desist Order ("Order"). . III. On the basis of this Order and Respondent's Offer of Settlement, the Commission finds that: A. THE ISSUER 3Net Systems, Inc. ("3Net") is a Delaware corporation with offices in Sacramento, California. 3Net develops computer systems for medical laboratories. 3Net's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and was traded on NASDAQ until 1995. 3Net was formed in August 1989 to develop new computer laboratory software known as FAILSAFE. One year after its initial public offering, on August 13, 1993, 3Net announced that new investors had taken over management of 3Net. B. RESPONDENT Manak was 3Net's president, chief executive officer, and a director from August 1989 through August 1993, and owned 47.8% of 3Net's common stock before, and 23.9% of its common stock after, 3Net's initial public offering. Manak managed 3Net's business, maintained customer relationships, and oversaw software development and implementation. C. FALSE AND MISLEADING DISCLOSURES IN 3NET'S FORM S-18 AND FISCAL 1992 FORM 10-KSB On August 4, 1992, 3Net filed its Form S-18 registration statement for its initial public offering, which was declared effective on August 10, 1992. Manak reviewed and authorized to be signed on his behalf 3Net's Form S-18. The offering raised $5 million for 3Net. The Form S-18 was materially false and misleading, making false statements about FAILSAFE and omitting material facts about FAILSAFE necessary to make other disclosures about the software not misleading, and reporting materially inflated revenue for 3Net's fiscal year ended June 30, 1991, the nine months ended March 31, 1992, and the fourth quarter of 3Net's fiscal 1992. 3Net's fiscal 1992 Form 10-KSB, filed with the Commission on November 23, 1992, also reported materially inflated fiscal 1991 and 1992 FAILSAFE revenue. 1. False Statements And Omissions About FAILSAFE The Form S-18 was materially false and misleading in that it included materially false statements about FAILSAFE and omissions of material facts about FAILSAFE necessary to make other disclosures about FAILSAFE not misleading. Specifically, while the Form S-18 stated that 3Net "intended to focus its future sales and marketing efforts on FAILSAFE," it also included three false and misleading statements, however, that: (a) 3Net expected its "revenues to continue to grow . . . due to expansion of its product line -- particularly sales of . . . FAILSAFE"; (b) FAILSAFE had five applications "that can operate independently or as part of an integrated system"; and (c) one customer's FAILSAFE system was fully operational and that six customers had purchased and were currently installing FAILSAFE. In fact, Manak knew from meetings with customers during the fall of 1991 and the spring of 1992, from letters he received in October and December 1991 from one of 3Net's major customers, and from letters he received in May and August 1992 from another of 3Net's major customers, that 3Net had been unable to implement FAILSAFE for its customers. The Form S-18, however, omitted to disclose 3Net's inability to implement FAILSAFE. Manak also knew, from correspondence from October 1991 through December 1991 with one of 3Net's major customers, that the customer had filed a lawsuit against 3Net for 3Net's failure to implement FAILSAFE for that customer. The disclosure in 3Net's Form S-18 about this lawsuit failed to explain that the lawsuit related to 3Net's failure to implement FAILSAFE. Manak further knew that the "FAILSAFE system" that the Form S-18 stated was fully operational for one customer was not really a FAILSAFE system. Manak knew that 3Net implemented free of charge for one customer a previously existing application written in an entirely different programming language than FAILSAFE, that had not been rewritten as a FAILSAFE application. In addition, Manak knew, but failed to disclose in the Form S-18, that 3Net's six paying FAILSAFE customers had ordered FAILSAFE applications that 3Net was still trying to develop. Accordingly, Manak knew that 3Net's statement in the Form S-18 that one customer's FAILSAFE system was fully operational was false, and that the statement omitted material related disclosures. 2. Inflated Fiscal 1991 and 1992 Revenue The Form S-18, which Manak reviewed and commented on and for which Manak served as a signatory, also improperly reported $1.043 million of fiscal 1991 FAILSAFE revenue for three FAILSAFE contracts, and $1.4 million of fiscal 1992 FAILSAFE revenue for seven FAILSAFE contracts. Similarly, 3Net's fiscal 1992 Form 10- KSB improperly reported $1.043 million of fiscal 1991 FAILSAFE revenue for three contracts, and $1.012 million of fiscal 1992 FAILSAFE revenue for the same three contracts. The FAILSAFE contracts called for purchase and sale of both FAILSAFE software and third party hardware used to operate the FAILSAFE software. a. Inflated Fiscal 1991 Revenue In 3Net's fiscal 1991 Form S-18, 3Net reported $2.9 million of revenue, improperly including $1.043 million of FAILSAFE revenue for three FAILSAFE customers, thus overstating revenue by 57%. Manak knew that 3Net had not implemented FAILSAFE for any of its customers, yet Manak misrepresented to 3Net's auditors that one FAILSAFE implementation was nearly complete in April 1992. Based in part on this misrepresentation, 3Net's auditors advised 3Net that Generally Accepted Accounting Principles ("GAAP") allowed 3Net to account for this FAILSAFE contract, and two other FAILSAFE contracts, using the percentage of completion method under contract accounting. The auditors relied on American Institute of Certified Public Accountants Statement of Position ("AICPA SOP") 91-1 entitled "Software Revenue Recognition" and AICPA SOP 81-1 entitled "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." GAAP outlines two different methods of recognizing contract revenue. The first method, "percentage of completion," applies only when management can reliably estimate progress toward completion of a contract. Thus, management must be able to reliably estimate the total costs required to complete the contract for the contract to qualify for the percentage of completion method. See AICPA SOP 81-1, . 23. The second method, "completed contract," is required when management cannot reliably estimate progress toward completion and the contract therefore does not qualify for the percentage of completion method. The completed contract method requires the company to postpone recognizing revenue until the contractual obligations have been met. See AICPA SOP 81-1, . 30. Based in part on Manak's false representation that 3Net had successfully implemented FAILSAFE for one customer, and the auditors' corresponding belief that 3Net had determined total FAILSAFE costs and its FAILSAFE contracts could qualify for the percentage of completion method of revenue recognition, the auditors also advised 3Net that percentage of completion for the FAILSAFE system hardware and software could be measured separately. The auditors recommended that revenue for hardware be recognized upon shipment and that revenue for software be recognized as installations progressed. The auditors based their advice on a provision of GAAP allowing different measurement methods for different components of a contract accounted for under the percentage of completion method. See AICPA SOP 91-1, . 90. Using the percentage of completion method of recognizing contract revenue, 3Net recognized and reported $674,840 of fiscal 1991 hardware revenue for the three FAILSAFE contracts, and recognized and reported software revenue of $368,302 for one of the FAILSAFE contracts. As of August 1992, Manak knew that 3Net had not completed any of the FAILSAFE contracts, and that 3Net had not determined the costs to complete the FAILSAFE software and the related customer contracts. Further, Manak knew that 3Net was unable to reliably estimate progress toward completion for FAILSAFE. Manak also knew that 3Net was unable to estimate reliably completion dates for one of the major FAILSAFE customers because of problems in understanding that customer's requirements, complications with the operating system used for FAILSAFE and other operating software, and changes in features that the customer requested. In fact, because management could not reliably estimate FAILSAFE progress toward completion, its FAILSAFE contracts did not qualify for the percentage of completion method of contract revenue recognition. Instead, management should have used the completed contract method for the three FAILSAFE contracts. Had it done so, management would not have reported revenue in fiscal 1991 for either the hardware or the software for the three FAILSAFE customers, because none of these contracts had been completed by the end of fiscal 1991. Moreover, the revenue for the hardware and software should not have been accounted for separately because the provision of GAAP allowing different revenue measurement methods for different components of a contract accounted for under the percentage of completion method did not apply to the three FAILSAFE contracts because the three contracts did not qualify for the percentage of completion method. Further, separate accounting of hardware and software revenues was not permitted because the three FAILSAFE contracts allowed the customers to return the hardware if 3Net did not provide software that conformed to contract specifications. As of the end of fiscal 1992, 3Net had not provided the required conforming software to any of the three FAILSAFE customers and these three customers, therefore, had the right to return the hardware. b. Inflated Fiscal 1992 Revenue In the Form S-18, 3Net reported revenue of $3.2 million for the nine months ended March 31, 1992, and reported "anticipated revenue" of $750,000 to $800,000 for the fourth quarter of fiscal 1992. 3Net, however, inappropriately included $1.4 million of revenue from its FAILSAFE customers for fiscal 1992, overstating fiscal 1992 revenue by at least 57%. In its fiscal 1992 Form 10- KSB, 3Net reported revenue of $3.1 million. 3Net, however, falsely recognized $1.012 million of FAILSAFE revenue in 3Net's Form 10-KSB, thereby overstating its fiscal 1992 revenue by 48%. Manak knew, but failed to inform 3Net's auditors, that 3Net had not completed any FAILSAFE implementations by the end of fiscal 1992, and could not estimate its progress toward completion for its FAILSAFE contracts. 3Net therefore continued to improperly use the percentage of completion method to recognize $1.012 million of FAILSAFE revenue for three customers during fiscal 1992. Had 3Net properly used the completed contract method, no FAILSAFE revenue would have been recognized as none of these contracts was completed by the end of fiscal 1992. 3Net's unaudited financial statements for the three quarters ended March 31, 1992, included in its Form S-18, also improperly reported revenue of $427,000 for the four other FAILSAFE customers. As of the end of fiscal 1992, Manak knew that FAILSAFE had not operated at any of these customer sites. Accordingly, Manak should not have allowed 3Net to report any revenue for these customers during fiscal 1992. D. APPLICABLE LAW 1. Antifraud Violations: Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful for any person in the offer or sale, or in connection with the purchase or sale, of any security, to employ any device, scheme or artifice to defraud, to make untrue statements of material fact, to omit to state material facts or to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person through means or instruments of interstate commerce or the mails. Generally, information is material if there is a substantial likelihood that a reasonable investor would consider it important to an investment decision. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Scienter is required to establish violations of Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Scienter is not required to establish violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act. See Aaron v. SEC, 446 U.S. 680, 701-02 (1980). The Supreme Court has defined scienter as "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976). The Ninth Circuit has expressly held that recklessness satisfies the scienter requirement, and defines recklessness as "an extreme departure from the standards of ordinary care, and which presents a danger of misleading [investors] that is either known to the defendant or is so obvious that the actor must have been aware of it." Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc), cert. denied, 499 U.S. 976 (1991). Manak violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Manak, in connection with raising $5 million in 3Net's initial public offering, caused to be filed with the Commission on August 4, 1992 a Form S-18 registration statement that: (1) falsely stated that one customer's FAILSAFE system was fully operational; (2) omitted material facts about problems and delays with FAILSAFE development necessary to make statements in the Form S- 18 about the availability of FAILSAFE and status of customer implementations not misleading; (3) omitted to disclose that a lawsuit filed by one of 3Net's customers against 3Net related to 3Net's failure to implement FAILSAFE; and (4) reported materially inflated revenue for fiscal 1991, the nine months ended March 30, 1992 and the fiscal 1992 fourth quarter, by falsely including FAILSAFE revenue. Manak also caused 3Net to report materially inflated FAILSAFE revenue for fiscal years 1991 and 1992 in 3Net's fiscal 1992 Form 10-KSB. Manak's omissions and misrepresentations were material. A reasonable investor would consider it important to know the true status of FAILSAFE and related customer contracts, and that a customer had filed a lawsuit against 3Net for failing to implement FAILSAFE, because the investor then would have known that the new software 3Net was relying on for continued growth of its revenue had been plagued with problems and had not been successfully implemented for any customers. This would have enabled an investor to assess the risk that 3Net would not be able to timely complete its FAILSAFE implementations. Manak acted with scienter. Manak knew that 3Net had not implemented FAILSAFE for any customers and knew of the problems in developing and implementing FAILSAFE. Nevertheless, in the Form S-18, Manak omitted to disclose the problems in developing and implementing FAILSAFE and falsely represented that FAILSAFE was fully operational for one customer. Manak further failed to disclose the problems in developing and implementing FAILSAFE to 3Net's auditors, causing 3Net to improperly recognize and report FAILSAFE revenue in the Form S-18, overstating 3Net's fiscal 1991 revenue by $1.043 million or 57%, and overstating 3Net's fiscal 1992 revenue by $1.4 million or by at least 57%. Manak also knew that 3Net recognized and reported FAILSAFE revenue in its Form 10-KSB for customers whose FAILSAFE implementations were not complete, resulting in overstating 3Net's fiscal 1992 revenue by $1.012 million or 48%. Manak thus either knew, or was reckless in not knowing, that 3Net falsely recognized and reported FAILSAFE revenue in its Form S-18 and fiscal 1992 Form 10-KSB, overstating 3Net's fiscal 1991 revenue by over $1 million and 57% and overstating 3Net's fiscal 1992 revenue by over $1 million and at least 48%. 2. Reporting Violations: Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 Thereunder Section 13(a) of the Exchange Act and Rule 13a-1 thereunder require issuers with securities registered pursuant to Section 12(g) of the Exchange Act, such as 3Net, to file with the Commission annual reports on Form 10-K or Form 10-KSB. The filings must be accurate. An issuer therefore violates these provisions if it files a Form 10-KSB that contains materially false or misleading information. SEC v. Falstaff Brewing Corp., 629 F.2d 62 (1978) cert. denied, 440 U.S. 913 (1979); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978) cert. denied, 440 U.S. 913 (1979). Rule 12b-20 under the Exchange Act similarly requires that these reports contain all material information necessary to make the required statements made in the reports not misleading. No showing of scienter is required to establish a violation of Section 13(a) of the Exchange Act. See Savoy Industries, Inc., 587 F.2d at 1167. 3Net violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder by filing a materially false and misleading Form 10-KSB that overstated its fiscal 1992 revenue by over $1 million or 48%. Manak caused 3Net's violations of Section 13(a) of the Exchange Act and rules 12b-20 and 13a-1 thereunder. As 3Net's president and CEO, Manak was responsible for assuring that 3Net made full and fair disclosure of its business and financial performance. Yet, in the Form S-18, Manak: (1) omitted to disclose the problems in developing and implementing FAILSAFE, and that a lawsuit filed by one of 3Net's customers against 3Net related to 3Net's failure to implement FAILSAFE; and (2) misrepresented that a FAILSAFE system was fully operational for one customer. Manak further knew that 3Net had not completed any FAILSAFE contracts, yet falsely told 3Net's auditors that one FAILSAFE contract was complete. In so doing, Manak caused 3Net to improperly recognize and report FAILSAFE revenue in the Form S-18, overstating 3Net's fiscal 1992 revenue by $1.4 million or by at least 57%. Manak also knew that 3Net recognized and reported FAILSAFE revenue in its Form 10-KSB for customers whose FAILSAFE implementations were not complete, thus overstating 3Net's fiscal 1992 revenue by $1.012 million, or by 48%. 3. Lying To The Auditor: Rule 13b2-2 Under The Exchange Act Rule 13b2-2 under the Exchange Act prohibits any officer and director of an issuer from, among other things, omitting to state any material fact to an accountant in connection with any required audit of the issuer's financial statements or the preparation of a report required to be filed with the Commission. Manak violated this rule by failing to disclose to 3Net's auditors material information affecting 3Net's financial statements. Manak failed to tell 3Net's auditors about the problems with FAILSAFE development and customer contracts and the dispute with one of 3Net's major FAILSAFE customers. Manak also falsely represented to the auditors that the FAILSAFE implementation for one major customer was substantially complete. Manak was, at the time, an officer and/or director of 3Net. The omitted information was material in that it resulted in overstating 3Net's revenue in fiscal 1991 by 57%, and in fiscal 1992 by at least 48%. E. CONCLUSION Based on the foregoing, the Commission finds that Manak violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rules 10b-5 and 13b2-2 thereunder, and caused 3Net to violate Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. . IV. Accordingly, the Commission deems it appropriate to accept the offer of settlement submitted by the Respondent. Therefore, IT IS ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Respondent Manak cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rules 10b-5 and 13b2-2 thereunder, and that Manak cease and desist from causing any violation or any future violation of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. By the Commission. Jonathan G. Katz Secretary