SECURITIES ACT OF 1933
Release No. 8338 / November 13, 2003
Securities Exchange Act of 1934
Release No. 48778 / November 13, 2003
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1911 / November 13, 2003
Administrative Proceedings
File No. 3-11333
In the Matter of GATEWAY, INC. Respondent. |
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ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933 AND SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS, AND IMPOSING CEASE-AND-DESIST ORDER |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted 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 Gateway, Inc. ("Respondent" or "Gateway").
II.
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Cease-and-Desist Order, as set forth below.
III.
On the basis of this Order and Respondent's Offer, the Commission finds1 that:
Respondent
1. Gateway, Inc. ("Gateway" or the "Company") is incorporated in Delaware and headquartered in San Diego, California. Gateway is a direct marketer of personal computers ("PCs") and related products. Its stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and trades on the New York Stock Exchange. On April 30,1999, Gateway registered a shelf offering with the Commission on a Form S?3 registration statement, pursuant to which it issued and sold 30,000 shares of its common stock to a software developer for $3,000,000 on September 15, 2000.
Summary
2. This case involves misleading disclosure and false financial information reported by Gateway to meet or exceed Wall Street analysts' expectations in 2000. Through its second and third quarter Forms 10?Q and press releases, Gateway gave the impression that it, unlike its competitors, was resilient to decreased PC sales in an increasingly saturated market. Gateway also misrepresented or failed to disclose significant trends in its business, such as the facts that PC sales growth was declining; that, by the end of the third quarter, only a small percentage of net income was associated with PC sales; and that revenue and earnings included various "one-offs," or nonrecurring items. In addition, Gateway employed improper accounting actions that inflated Gateway's reported revenue by 6.5% and pre?tax income by as much as 30% during the third quarter of 2000. Before Gateway filed its Form 10?K for the period ended December 31, 2000, it amended its 2000 Forms 10?Q to restate its financial statements.
Background
3. In 1999, Gateway took steps to diversify its revenue stream beyond sales of traditional PCs by offering other products and services, such as software, peripherals, Internet access services, and training and support programs. Gateway called these non?PC products and services "beyond-the-box." As part of this strategy, Gateway expanded into the business of financing consumer loans.
4. By the end of 1999, beyond-the-box income made up 20% of Gateway's total pre?tax income. During a conference call with analysts announcing its fourth quarter 1999 earnings, Gateway noted that the beyond-the-box strategy was an "indicator of [Gateway's] ability to continue delivering consistent results," but that its "bread and butter [had] long been the PC," which accounted for "the lion's share of [Gateway's] revenue and income stream." Gateway also announced that at year?end 1999, for every PC sold to a consumer, an average of three non?PC items were attached to the sale.
Undisclosed Consumer Financing Program
5. In December 1999, Gateway initiated an "outbound" program to contact applicants who had been previously declined for credit and to offer them a pre?approved loan to purchase a Gateway PC. Consumer loans made in the outbound program were distinguished from the customary "inbound" loans generated when a potential customer contacted Gateway and subsequently was offered credit.
6. In the second quarter of 2000, Gateway undertook an aggressive outbound financing program directed to customers whose applications for credit in Gateway's inbound program had been rejected. Although Gateway initially commenced the second quarter program as a test, with the intention of financing only $10 million of such high?risk credits, as sales results began to slip in the quarter, Gateway continued the program and took on a substantial amount of these high?risk customers to bolster sales.
7. On May 25, 2000, employees from Gateway's subsidiary bank delivered a presentation to Gateway management, in which they estimated the loan losses for a $5 to $10 million test program at 38% (which was approximately equivalent to the profit margin on the PC package included in the program). The bank employees told Gateway management that there were inherent risks in any new sub?prime consumer loan program, and that management should expect variations from the loss estimates, which could be as high as 50%.
8. By June 8, 2000, Gateway had generated $10 million in outbound loans. It continued the outbound program with the revised goal of originating $20 million of these high?risk loans. On June 10, 2000, Gateway considered whether to continue the campaign beyond $20 million. Gateway management inquired whether one of the division heads could meet his revenue target of $975 million without the incremental revenue from the outbound campaign. The division head replied that he was counting on $30 million from the outbound program to meet his revenue target. Accordingly, Gateway management instructed the consumer finance team to continue the campaign to $30 million.
9. On June 16, 2000, a "scoresheet" circulated within Gateway, indicating that Gateway could miss consensus analysts' expectations for revenue by as much as $80 million. The outbound program was therefore continued throughout the end of the quarter. This decision was made by Gateway management based on Gateway's need to achieve more revenue in the quarter. Ultimately, the outbound program generated $112 million, or 5%, of Gateway's second quarter revenue of $2.14 billion.
10. Gateway's second quarter of 2000 Form 10?Q and July 13, 2000 press release were misleading because they failed to disclose the percentage of its sales generated by the high?risk outbound campaign. Investors were not informed that Gateway's revenue and growth would have been significantly lower without the inclusion of the financing to high?risk customers. Gateway announced that its consumer sales in the second quarter had increased 32% over 1999, giving the false impression that Gateway's revenue was increasing via sales to the same credit class of customers who had purchased PCs in prior periods. By the end of the second quarter 2000, the sub?prime loans amounted to $153 million, or 32% of Gateway's total portfolio, compared to 0% at the end of the second quarter 1999. Gateway's failure to disclose these facts obscured a material negative trend in consumer demand. See Regulation S-K, Items 303(a)(3)(ii) and (b)(2) (registrant required to disclose known trends or uncertainties it believes will have material unfavorable impact on income from continuing operations). Gateway also failed to make certain disclosures required under Regulation S-X, including the balance of its consumer finance receivables, the amount of its loan loss provision, its loan loss reserve, and its reserve methodology.
Improper Gain on Sale of Loans to Gateway's Loan Service Provider
11. Besides making sales through the outbound program, Gateway management searched for other avenues to improve Gateway's second quarter 2000 results. On June 3, 2000, Gateway management instructed its staff to investigate a potential sale of $50 million of Gateway's high quality consumer loans receivable to the lending entity that serviced Gateway's consumer loans. Management indicated that Gateway would need the sale "for the quarter."
12. On June 30, 2000 Gateway sold the $50 million in high quality loans receivable to its loan service provider, but only after loaning the provider $50 million at a below?market interest rate. Without the loan from Gateway, the loan service provider would not have agreed to the deal. The loan service provider's payment to Gateway for the loans was made by wire transfer on June 30, simultaneous with Gateway's remission of the $50 million to the provider.
13. Gateway's sale of the loans receivable made no business sense; it was economically disadvantageous. Internal Gateway e-mail indicates that the purpose of the sale was to generate a gain in the quarter. Moreover, while Gateway made only $4.3 million on the loan sale (without taking into account the financial effect of the loan Gateway provided to the lending entity), it would have realized an additional $10 million in income (based on present value) had it kept the loans. Put otherwise, Gateway sold its future stream of income at less than its present value in order to realize instant income.
14. Gateway treated the sale of the loans receivable and the loan to the loan service provider as separate unrelated transactions. However, the interrelationship of the transactions was evident. To properly record the transaction under Generally Accepted Accounting Principles ("GAAP"), Gateway should have allocated a sufficient portion of the amounts received from the loan service provider to the loan receivable to permit recognition of interest income on the loan receivable at market interest rate over the life of the loan. Accounting Principles Board Opinion ("APB") No. 21, "Interest on Receivables and Payables" ¶ 7 (unstated rights or privileges). Gateway did not do so. Rather, Gateway recorded a gain of $4.3 million on the sale. The gain on the sale of the loans resulted in an increase to earnings per share ("EPS") of over a penny. Had the transaction been recorded in conformity with GAAP, there would have been no gain on the sale in the second quarter. Moreover, Gateway should have disclosed that the sale was a one?time event affecting quarterly earnings. Regulation S?K, Item 303(a)(3)(1) and (b)(2).
15. In April 2003, Gateway filed an amended Form 10-K for the year ended December 31, 2002, in which Gateway restated its financial results for 2000 and 2001 to reflect the appropriate accounting for this transaction.
Second Quarter Reported Financial Results
16. With the assistance of the PC sales made through high?risk consumer loans and the sale of the portfolio to the loan service provider, on July 13, 2000, Gateway announced quarterly EPS of $.37 per share, 32% over the second quarter 1999 and exceeding consensus analysts' estimates by a penny. Gateway further announced revenue of $2.14 billion, 12% over the second quarter 1999 - missing expectations for revenue by just $8 million. Gateway also reported that consumer PC revenue grew 32%, and unit sales grew 39% year-over-year. Finally, Gateway reported that beyond-the-box income made up 40% of overall income, meeting its "previously stated goal for the fourth quarter a half?year ahead of schedule." These misleading revenue, earnings, and growth claims were later incorporated in Gateway's Form 10?Q for the second quarter.
Third Quarter Market Pressures Drive Gateway to More Aggressive Measures to Increase Revenue and Earnings
Gateway and Industry Trends
17. In the third quarter of 2000, Gateway faced a larger gap between true operating results and expected results. As early as May 2000, Gateway's market research group projected that, based on current trends in demand, the Company's third and fourth quarter forecasts were "extremely aggressive and [would] require additional efforts to achieve." As of July 2000, the market research group predicted a gap of 21.8% between the Company's initial forecast and projected results based on current demand trends. In early August, Gateway executive staff met to discuss the Company's financial results for July and the third quarter projections. In that meeting, participants received a presentation indicating that, for the month of July, sales growth over the prior year was 9%. One meeting participant noted that such data indicated that "PC growth was slowing." Other Gateway internal documents reflected that unit growth was only 6% for July, a sharp contrast to reported unit growth of 39% in the second quarter.
18. Nevertheless, on August 3, 2000, Gateway management informed analysts that July was a "solid" month. From this conference call, analysts believed that Gateway's consumer sales "remained robust" and that consensus revenue growth of 16% was achievable. On September 6, 2000, Gateway management told analysts that market conditions would not "[stand] in the way of Gateway's plan to accelerate revenue growth in the second half [of 2000]."
19. On September 15, 2000, Gateway management received a document from the financial planning department - entitled "Gap to Consensus" - illustrating a significant gap between Gateway's actual results and analysts' estimates, and quantifying the effect of various transactions on that gap. The document indicated that, through the end of August, Gateway had achieved only $1.4 billion of $2.5 billion in revenue necessary to meet analysts' expectations and had achieved only $.06 EPS of the analyst-estimated $.46 EPS. The document further indicated that unit sales through the end of August were up only 5%, and revenue only 4%, over the same period in 1999. The document projected that, taking into account the likely income contribution from September sales ($.09 EPS), and various corporate items ($.22 EPS), Gateway likely would achieve only $.36 EPS - 10 cents shy of analysts' expectations. It also referenced various items "being worked" to bridge the gap.
20. On September 17, 2000, a Gateway executive sent an e?mail to senior staff informing them that they were "coming down to the wire" on the third quarter results. He told them that, based on current forecasts, the Company was likely to come in $110 million short of analysts' revenue expectations for the third quarter 2000 and that, as of the end of August, the Company had generated only $.06 of the $.46 necessary to meet consensus analysts' EPS estimates. The executive referenced several potential "gap closures" that would be discussed in a staff meeting on September 18, 2000.
21. During this same period, other PC companies were informing the investment community that demand was slowing and providing downward guidance. On August 10, 2000, one of Gateway's competitors reported slower-than-expected sales growth for the quarter ended in July, and shipment increases of only 22%, compared to an increase of 55% during the same period of 1999. On September 13, 2000, a maker of components and PCs lowered its revenue forecast by 13% and its EPS forecast by 11%, attributing the revised forecast to seasonal weaknesses in consumer electronics and PC demand. Another company announced on September 21, 2000 that its revenue and earnings for that quarter would fall below expectations. The next day, the price of Gateway stock fell to $54.50, from the previous day's close of $59.45. On September 28, 2000, yet another company warned that its quarterly profits would miss previous forecasts, due to disappointing sales of computer products. Gateway's stock price fell to $48.25 on September 29, 2000 from the previous day's close of $52.90.
22. Gateway did not inform analysts that it anticipated that it might not meet expectations for third quarter revenue and earnings. Rather, Gateway engaged in the activities described below to bridge the gap between analysts' expectations and Gateway's true financial results.
Undisclosed Increased Consumer Financing
23. Gateway continued to support slipping PC sales in the third quarter with its outbound program with riskier customers. Early in the third quarter, Gateway exhausted its list of declined credit applicants who met the second quarter's criteria. In order to continue the outbound program and to generate revenue, Gateway's bank screened the remaining applicants within Gateway's declined applicant pool in order to target the least risky applicants remaining in the pool. The third quarter outbound program was dubbed internally at Gateway the "DDS program," which stood for "deep, deep sh[--]." A bank employee estimated losses for the program at over 50%, but informed management that projected loss rates were a "mere guess and that [losses] could be catastrophic."
24. The outbound program in the third quarter generated $84 million, or 4%, of Gateway's quarterly revenue. In its October 12, 2000 press release and Form 10?Q for the third quarter, Gateway announced that it had exceeded consensus analysts' expectations for revenue by $30 million. Gateway would not have met expectations had it not engaged in the outbound campaigns to high?risk customers, a fact that Gateway did not disclose. Further, Gateway announced that its consumer sales had increased 27% over the third quarter 1999, giving the false impression that its third quarter 2000 sales were of the same quality as its third quarter 1999 sales.
25. Gateway's third quarter press release and Form 10?Q failed to provide information concerning the deteriorating quality of Gateway's consumer loan portfolio. At the end of the third quarter, the sub?prime loan receivables had risen to $243 million, or 37%, of Gateway's total portfolio. Furthermore, the portfolio included outbound loans on which Gateway anticipated losses of more than 50%. All of these facts were significant trends that should have been disclosed under Regulation S?K, Item 303(a)(3)(i) and (b)(2).
Improper Change in Loan Loss Reserve Methodology
26. By September 15, 2000, Gateway's "Gap to Consensus" spreadsheet reflected that one of the items being worked to close the gap was Gateway's loan loss reserve. Gateway anticipated generating $10 million in operating income by reducing expenses from reducing the reserve that had been established in prior quarters.
27. Early in the third quarter of 2000, the increasingly risky nature of the outbound program, as well as the significant increase in the reserve due to the aggressive outbound program in the second quarter, began to attract the attention of management. Consequently, on July 31, 2000, Gateway's financial management and officers of Gateway's bank met to discuss the portfolio. One of the topics was whether there was a "shortage in the loan loss reserve." From that meeting, Gateway's senior financial managers determined to adopt a new methodology. The new methodology did not follow from actual loss curves but rather adopted a straight-line approach to loss provisioning. Under the new method, the reserve was reduced by $34.5 million from what would have been recorded under Gateway's prior methodology.
28. Gateway viewed the reserve as an "opportunity" available to "offset other shortfalls." The change in the reserve methodology in the third quarter resulted in an increase in pre?tax income of $34.5 million, causing an overstatement of EPS of $.067, in a quarter when Gateway claimed to have precisely met consensus expectations of $.46 EPS.
29. Gateway's change to its loan loss reserve methodology in the third quarter of 2000 was improper under GAAP in that Gateway failed to employ a consistent approach between periods.2 Moreover, a change in methodology would be appropriate only if the new approach were demonstrably preferable to the old approach. APB No. 20, "Accounting Changes" ¶¶ 15 and 16. The new methodology was demonstrably less preferable because it encompassed a straight-line approach to loss provisioning, which is inconsistent with a typical pattern of loan losses in a consumer loan portfolio. Gateway was further required to disclose any significant changes in any accounting principles, or estimates inherent in the preparation of financial statements, in its interim financial statements. Regulation S-X §10-01(a)(5). Gateway's change in methodology was significant, in that it reduced the reserve by $34.5 million from what would have been recorded under the prior method, and increased EPS by $.067. Also, as in the second quarter, Gateway's Form 10-Q failed to provide certain disclosures required under Regulation S-X, including the amount of its loan loss provision, its loan loss reserve, and changes in its reserve methodology.
30. In March 2001, Gateway amended its Form 10-Q for the third quarter of 2000, in which Gateway restated its financial statements for that quarter to reflect that it had restated its loan loss reserve for that quarter after adopting a new, revised loan loss reserve methodology.
Improper Revenue Recognition on Sale with Contingency
31. Another item reflected as a potential gap closer on the September 15, 2000 "Gap to Consensus" spreadsheet, and the September 17 e?mail to Gateway's senior staff, was a potential $10 million sale to a vendor financing company. In the summer of 2000, Gateway had commenced discussions with this vendor financing company concerning the possibility of this company financing some of Gateway's customers who had poor credit. Specifically, the parties contemplated that Gateway would provide the vendor financing company with referrals to customers who had been declined for credit by Gateway, and the vendor financing company would find an underwriter to service the loans.
32. The parties reached a deal on September 22, 2000. Under a Reseller Agreement and a Referral Agreement, the vendor financing company agreed to purchase approximately $21 million of PCs. Gateway was required to refer sufficient customers to the vendor financing company to facilitate resale of the PCs by December 31, 2000 to end customers, or the vendor financing company could terminate the agreement and Gateway would have to take any remaining PCs back. The vendor financing company was not obligated to pay for any PC until 24 hours after it was shipped from a warehouse to an end customer, or within 120 days from September 22, 2000, whichever came first. Further, Gateway later agreed to amend the contract to extend the payment terms to March 31, 2001, thus permitting the vendor financing company to defer any payment until the products actually were shipped to end customers.
33. Before the end of the third quarter, Gateway shipped the PCs to warehouses and improperly recognized revenue of almost $21 million. This transaction increased Gateway's third quarter reported. revenue by $21 million.
34. Gateway's purported sale of PCs to the vendor financing company failed to meet requirements for revenue recognition under GAAP because, at the end of the quarter, Gateway had not fulfilled its contractual obligation to refer customers to the vendor financing company to facilitate its resale of the PCs. Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" ("CON 5") ¶83 (revenue considered earned when entity substantially accomplished what it must to be entitled to benefits represented by revenue).3
35. In March 2001, Gateway amended its Form 10-Q for the third quarter of 2000, in which Gateway restated its financial statements for that quarter to reflect that Gateway had restated this transaction.
Improper Bill-and-Hold Sale
36. Gateway also solicited an arrangement with one of its larger customers, a rent-to-own consumer leasing company, in mid-September 2000. As with the vendor financing company, the September 17, 2000 e-mail to Gateway's senior staff referenced a potential "pull forward" to the consumer leasing company of $10-20 million as a way to help bridge Gateway's revenue gap. A potential pull forward of $10-20 million also was referenced on a September 18, 2000 version of the "Gap to Consensus" spreadsheet.
37. In April 2000, Gateway commenced a relationship with the consumer leasing company that included the consumer leasing company's agreement to purchase PCs from Gateway to rent to its customers. Initially, the consumer leasing company issued a blanket purchase order for PCs for each of its stores throughout the country. It then placed smaller purchase orders with Gateway based on the needs of a particular store. Gateway then shipped the PCs directly to the store that sought them and invoiced the corporate office of the consumer leasing company for the order.
38. On September 21, 2000, Gateway's sales representative sent an e-mail to the consumer leasing company confirming that the consumer leasing company would issue a purchase order for $16.5 million of PCs, for which it would receive a 5% discount, that the consumer leasing company would be billed by September 30, 2000 and would take the PCs by October 31, 2000. The e-mail did not reference warehousing arrangements. The parties agreed that the consumer leasing company would not take the product until the fourth quarter, after it issued subsequent purchase orders from individual stores, as had been its practice. They also agreed that the consumer leasing company would be invoiced and pay on the subsequent store purchase orders, not the $16.5 million purchase order.
39. On September 21, 2000, the consumer leasing company issued a purchase order for $16.5 million in PCs and peripherals. The purchase order provided that the equipment would be shipped to "local warehousing for subsequent distribution," and stated that the order was FOB destination. Gateway then "shipped" the products by segregating them in the third-party warehouses located adjacent to Gateway's manufacturing facilities - the same warehouses which housed the PCs for the vendor financing company. The consumer leasing company did not make any arrangements with the warehouses, or have any contact with the warehouses.
40. Gateway improperly recognized revenue of $16.5 million on the third quarter purported sale (and also failed to apply the 5% discount on the sale until the fourth quarter). Thus, Gateway increased its third quarter reported revenue by $16.5 million.
41. The transaction failed to satisfy three critical GAAP criteria for revenue recognition on a bill-and-hold transaction.4 First, revenue recognition was inappropriate because the consumer leasing company lacked any substantial business purpose for ordering the goods on a bill-and-hold basis. Second, Gateway had specific performance obligations concerning the purchase order that it did not discharge during the third quarter, including: (1) upon receipt of a second purchase order from the consumer leasing company, an obligation to remove the product from the warehouse inventory, send it back to Gateway's manufacturing facility for re-entry in Gateway's computer system, and then ship the product to the individual store specified on the order; and (2) an obligation to reverse the September 21, 2000 sale of the PC out of its system and issue a second invoice to the consumer leasing company. These specific performance obligations precluded revenue recognition. Third, revenue recognition was inappropriate because the consumer leasing company did not request that the transaction be on a bill-and-hold basis, and did not pay the cost for warehousing the inventory.
42. This transaction had a $.003 impact on EPS and a 0.69% impact on revenue for the third quarter of 2000.
Improper Revenue Recognition on Internet Service Bundles
43. Gateway looked to another unusual business transaction involving an Internet service provider ("ISP') to further bridge the gap in the third quarter. Gateway's relationship with the ISP began in 1999 when the parties entered into a strategic alliance. One of the critical components of that alliance was a bundling arrangement by which Gateway agreed to bundle Internet service with the sale of Gateway PCs. The initial agreement, entered into in December 1999, provided that the ISP would make an upfront bounty payment to Gateway of either $132.06 or $164.56 for each end user who purchased a PC bundled with a one?year Internet service package (a "bundled product") and registered for the service; and Gateway would pay the ISP $219.45 for each such end user. The price of the bundle was open to renegotiation on a quarterly basis. Gateway recorded the initial bounty payment received from the ISP per subscriber as revenue, and the $219.45 it paid to the ISP as cost of goods sold. Gateway did not disclose that it received direct bounty payments from the ISP for new subscribers, or that it recorded these payments as revenue.5
44. In July 2000, early in the third quarter, the parties entered into a letter agreement setting forth the bounty arrangements for the third and fourth quarters of 2000. That agreement provided that Gateway would continue to pay the ISP $219.45 per subscriber who purchased a bundled product and registered for the Internet service, but the ISP would increase its bounty payment to Gateway to $219.45 per registered user.
45. On September 14, 2000, an employee in Gateway's accounting department sent a Gateway executive an e?mail suggesting that Gateway "accelerate [its] revenue" relating to the ISP arrangement by recognizing revenue based on shipments of PCs bundled with the Internet service rather than recognizing revenue based on customers who actually registered for the Internet service. The employee further suggested that such a change "would bridge the gap."6 The Gateway executive contacted the ISP on September 22, 2000 and September 26, 2000 to request the ISP's agreement to change the third quarter bundling arrangement to provide for the respective bounty and service payments upon shipment of a bundle, rather than upon registration of a customer with the ISP. On September 28, 2000, representatives of Gateway and the ISP met in person at Gateway to discuss various aspects of the strategic alliance, including the change.
46. On September 30, 2000, a representative of the ISP notified Gateway that it had signed an amended agreement. Based on the notification, Gateway also signed a version of the amended agreement. That agreement, which was dated July 1, 2000, was identical to the agreement signed in July 2000 except that it provided that Gateway and the ISP would pay their respective $219.45 payments per end user who purchased a bundled product, rather than who registered for the Internet service. On October 1, 2000, a Gateway executive sent an e?mail to the ISP thanking the ISP for the "favorable accounting treatment."
47. There was no economic reason for the amendment to Gateway's previous third quarter agreement with the ISP other than to inflate Gateway's revenue. As to each party, the amendment did not affect the mutual $219.45 payments. Based on the amendment to the agreement, Gateway retroactively adjusted its revenue from the ISP bounties back to the beginning of the third quarter, increasing its third quarter revenue by $70 million, in a quarter in which it exceeded analysts' expectations for revenue by just $30 million. Without the revenue associated with the amended agreement, Gateway would not have met analysts' expectations.
48. It was improper under GAAP for Gateway to change the event triggering the recognition of revenue on the ISP bounty payments from registrations to shipments. First, revenue recognition was inappropriate because the revision to the agreement provided Gateway no net economic benefit. A basic tenet of GAAP is that a transaction or event should be accounted for in accordance with its economic substance. Statement of Financial Accounting Concepts No. 2, "Qualitative Characteristics of Accounting Information" ¶160 ("the quality of reliability, and in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form."). See also AICPA Codification of Statements on Auditing Standards, AU §411.06. Further, even if the change in the method of calculating the bounty revenue had satisfied the requirements of revenue recognition, Gateway would have been required to disclose it under Regulation S-X §10-01(a)(5), which requires disclosure of any significant change in accounting principle or practice.
49. In April 2003, Gateway filed an amended Form 10-K for the year ended December 31, 2002, in which Gateway restated its financial results for 2000 and 2001 which eliminated these sales from its reported results.
Sale of Fixed Assets Improperly Recognized as PC Revenue
50. Late in the quarter, a Gateway executive met with Gateway's financial management to discuss the likely third quarter results. One manager suggested that Gateway attempt to sell the computer equipment used in Gateway's internal operations to Gateway's outsourced information technology ("IT") services provider. The executive directed the manager to attempt to complete such a transaction before the end of the third quarter.
51. On September 22, 2000, Gateway approached the IT services provider and suggested that the provider purchase certain of the computer equipment used in the IT infrastructure at Gateway. Gateway suggested that the IT services provider purchase the equipment from Gateway, and simultaneously enter into a revised outsourcing contract to permit it to lease the equipment back to Gateway to recover its cash outlay. The IT services provider responded affirmatively. The deal was put together in a matter of days and signed on September 29, 2000. The deal required the IT services provider to pay Gateway $47.2 million for the hardware over a five?month period in five equal payments beginning October 30, 2000; the deal further permitted Gateway to lease the equipment back from the IT services provider over a 36?month period, by prepaying the IT services provider a $47.2 million payment on October 2, 2000. The structure of the transaction was designed to neutralize any financial impact to the IT services provider. Gateway improperly recorded revenue on the sale of $47.2 million on September 30, 2000. Without the revenue from this sale, Gateway would not have met consensus analysts' expectations for revenue.
52. Gateway's recording of revenue on the fixed asset sale departed from GAAP. Under Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements" ("CON 6"), revenues are "actual or expected cash inflows . . . as a result of [an] entity's ongoing major or central operations." Gateway's central or core operations involve the manufacture and sale of new PCs for use by end customers, not the sale and lease back of used assets. Indeed, because the assets sold to the IT services provider were not equipment generated through Gateway's central operations for sale, Gateway properly had capitalized them and was depreciating them in an appropriate manner over their estimated life. Thus, Gateway's sale of used assets could not properly be recorded as revenue. Rather, Gateway should have recorded the sale of fixed assets as a gain (or loss), reported it within "Other Income" on the Income Statement,7 and, in this case, deferred the gain over the 36 month period of the lease. Statement of Financial Accounting Standards No. 28, "Accounting for Sales with Leasebacks" ¶3.
53. Gateway's recording of revenue on the fixed asset sale departed not only from GAAP, but also from Gateway's own accounting policy.
54. In March 2001, Gateway filed an amended Form 10-Q for the third quarter of 2000, in which Gateway restated its financial statements for that quarter to reflect that Gateway had restated this transaction.
Improper Reduction of Legal Reserves
55. Also during the third quarter, Gateway arbitrarily and improperly reduced a reserve for potential patent infringement claims from $15 million to $8 million, resulting in an increase to income of $.015 EPS. The legal reserve was originally created, along with other intangible assets, as a purchase accounting adjustment in connection with Gateway's 1997 acquisition of a server company.
56. Gateway's initial establishment and subsequent reduction of the legal reserve was not in conformity with GAAP. First, Gateway's initial establishment of the reserve was improper because the liability was neither probable nor reasonably estimable. SFAS 5 ¶8. Accordingly, any reduction of the reserve in 2000 should have been accounted for as a correction of an error8 and excluded from the determination of net income. APB No. 20 ¶36; APB No. 9, "Reporting the Results of Operations," ¶18.
57. Further, even if the reserve had been appropriate when established, it was improper under GAAP to reduce the reserve in the third quarter. CON ¶5 88 requires that a recognized liability, such as a legal reserve, be measured at the amount initially recognized until an event that changes the liability or its amount occurs. No event occurred during the third quarter that triggered a change to the amount of the liability.
58. In April 2003, Gateway filed an amended Form 10-K for the year ended December 31, 2002, in which Gateway disclosed the reduction in this reserve.
Improper Retroactive Adjustment of Warranty Accrual
59. Also in the third quarter, Gateway improperly made a retroactive reduction of its second quarter warranty expense. During the third quarter, Gateway reassessed the costs associated with its product warranties and, based on the reassessment, adjusted its warranty accrual rate for business product sales. The application of the new warranty accrual rate retroactively to the second quarter, however, was inappropriate because changes in estimates apply only to the period of such a change and future periods, not to prior periods. APB 20 ¶31; APB No. 28, "Interim Financial Reporting" ¶26; Statement of Financial Accounting Standards No. 16, "Prior Period Adjustments" ¶13. Thus, in applying the change retroactively, Gateway departed from GAAP. The improper retroactive rate adjustment decreased Gateway's warranty expense for the third quarter by $4 million.
60. In March 2001, Gateway filed an amended Form 10-Q for the third quarter of 2000, in which Gateway restated its financial statements for that quarter to reflect that Gateway had restated this transaction.
Reported Financial Results and Street Reaction
61. After the close of the market on October 12, 2000, Gateway announced record third quarter profits of $152.6 million on revenue of $2.53 billion, precisely meeting analysts' expectations of $.46 EPS, and exceeding expectations for revenue by $30 million. Gateway claimed that it had "accelerated year-over-year revenue growth to 16 percent" - again precisely meeting expectations - and that the consumer unit had posted revenue growth of 27% over 1999.
62. In the analysts' call following the third quarter earnings release, Gateway stated that it "had a great quarter despite the noise in the marketplace." Gateway management highlighted the Company's revenue growth, and noted that the revenue of $2.530 billion was "30 million better than guidance." Gateway stated that the Company had "differentiated itself from its competitors and been able to post continued earnings growth in a more difficult market." Similarly, it claimed that the "combination of accelerating revenue and profit growth that leads the traditional PC industry further illustrates the difference in the Gateway business model." Management also stated that Gateway's EPS growth of 32% for the first three quarters of 2000 exceeded the 20% average of its competitors.
63. One financial analyst commented that Gateway had become "increasingly immune to the vagaries of the PC market." Another stated that Gateway's model "gives them an advantage over everyone." On October 13, 2000, Gateway's stock jumped from $43.63 to $53.11.
64. On November 14, 2000, Gateway filed its Form 10?Q for the third quarter of 2000 with the Commission. Like Gateway's earnings press release, the Form 10?Q reported income of $152.6 million on revenue of $2.53 billion, and EPS of $.46.
Misleading Disclosure of "Beyond-the Box" Sales Percentage
65. Gateway reported in its Form 10?Q and earnings release for the third quarter that "non?PC income was more than 50 percent of income, exceeding the fourth quarter 2000 target by five percentage points." Gateway made a similar disclosure in the analysts' call following the release, stating that the non?PC, or "beyond-the-box" income accounted for "almost 50 percent or 50 percent plus of profits." Gateway further stated that "[b]eyond-the-box performance of 50 percent exceeded our year?end goal of 45 percent." When asked about the state of consumer demand in the PC market, management stated "the sky is not falling," and claimed that "the market [was] still solid."
66. This disclosure was misleading. In fact, non?PC income actually amounted to 90% of net income. Gateway's failure to disclose the actual amount of income flowing from its non?PC products and services misled investors about the fact that the sale of PCs - Gateway's core business - was increasingly less profitable, and that Gateway's "bread and butter" business had declined. This disclosure therefore contributed to providing the public with a misleading view of Gateway's operating results.
Omission of Unit Sales Data
67. In its Form 10?Q and earnings release for the third quarter, for the first time, Gateway stopped reporting the number of PC units sold. Gateway's decision to cease to report the number of PC units sold was materially misleading, because it obscured the softening of consumer demand for PCs that Gateway experienced in the third quarter.
Internal Control Violation: Failure to Implement and Follow
Quarterly Cutoff Procedures
68. Gateway recorded revenue in a quarter on PCs shipped after midnight on the last day of the quarter. In its U.S. manufacturing plants, Gateway recorded revenue on PCs manufactured through the end of the night shift that began during the last day of the quarter, generally until 2:00 am. or 7:00 a.m. Moreover, Gateway management altered the manufacturing cutoff in Gateway's U.S. manufacturing facilities at times during 2000. At Gateway's European, Middle East, and Africa ("EMEA") division, units continued to be manufactured and counted in quarterly results for an entire weekend if that weekend included the last day of the quarter. Thus, at times, EMEA continued recording revenue for a full day after the quarter officially had ended in the manufacturing plants in the United States.
69. These practices represented a failure to devise and maintain internal controls, because Gateway's failure to observe consistent quarter end cutoff dates and times caused it to have accounting periods of different lengths from quarter to quarter.
70. Gateway resolved its improper revenue recognition created by the fiscal year 2000 manufacturing and shipping cutoff process through the adoption of Commission Staff Accounting Bulletin No. 101, "Revenue Recognized in Financial Statements" ("SAB 101"). Gateway applied SAB 101 in its 2000 financial statements included in a Form10?Q A and in its 2000 Form 10?K. Applying SAB 101 resulted in changing the Company's revenue recognition policy from shipment to delivery of products to its customers.
Additional Reporting Violation: Improper ISP Accounting
71. In addition to Gateway's improper revenue recognition on the Internet service bundles as discussed above, Gateway's recording of its bounty payments from the ISP as revenue throughout the year 2000 departed from GAAP. Gateway's recording of its bounty payments from the ISP as revenue throughout the year 2000 departed from GAAP. Gateway received bounty payments from the ISP based on either the number of bundled products shipped, or the number of customers who registered for the Internet service after receiving a bundled product, and Gateway made comparable payments to the ISP. As of July 1, 2000, the respective payments were in exactly the same amount - $219.45. Gateway accounted for this arrangement under the gross revenue recognition method, by recording the bounty payments as revenue and the payments to the ISP as cost of goods sold.
72. The accounting for arrangements in which a company sells goods or services to a customer, but the goods or services are provided by a third?party supplier, is governed by EITF 99?19, "Reporting Revenue Gross as a Principal versus Net as an Agent." Under net revenue reporting, a company reports the net amount retained, that is, the amount billed to a customer less the amount paid to a supplier. Gateway's arrangement with the ISP concerning the bundling of the Internet service with a Gateway PC meets two of the three indicators of net revenue reporting. The first indication of net revenue reporting is that the supplier, rather than the company seeking to report the revenue, is the primary obligor for the good or service. Because the ISP had primary responsibility for providing the Internet service, this factor weighs in favor of net revenue reporting. The second indication of net revenue reporting is that the company seeking to report revenue earns a fixed dollar amount per customer. This factor also weighs in favor of net revenue reporting because Gateway earned a fixed amount from each registration or shipment of the Internet service (i.e., the bounty payment). Under these circumstances, Gateway should have recorded the ISP payments on a net rather than a gross basis.
73. In April 2003, Gateway filed an amended Form 10?K for December 31, 2001, restating its 2000 and 2001 financial statements to record the ISP arrangement on a net basis, reducing reported 2000 sales by $337 million, or 3.6%, and its 2001 sales by $131 million, or 2.2%. Gateway had earlier filed in 2001 its Forms 10?Q A for the first three quarters of 2000, restating its financial statements.
74. None of the conduct described in any of the above paragraphs of this Order arose in the performance of a federal, state, or local government contract.
Legal Analysis
75. As a result of the conduct described above, Gateway violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b?5 thereunder, which prohibit making untrue statements of material fact or omitting to state material facts in the offer or sale, or in connection with the purchase or sale of securities. As described above, Gateway violated these provisions by filing a registration statement and periodic reports that misstated and misrepresented its financial condition and results of operations by overstating revenue and pre-tax income.
76. Further, as a result of the conduct described above, Gateway violated Section 13(a) of the Exchange Act and Rules 12b?20, 13a?1, and 13a?13 thereunder, which require issuers of securities registered pursuant to Section 12 of the Exchange Act to file accurate periodic reports on Forms 10?K and 10?Q. These reports must contain any material information necessary to make the required statements made in the reports not misleading. As previously discussed, Gateway filed periodic reports with the Commission that misstated its financial results.
77. Further, as a result of the conduct described above, Gateway violated Section 13(b)(2)(A) of the Exchange Act, which requires reporting companies registered under Section 12 of the Exchange Act to make and keep books and records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer. In the second and third quarters of 2000, Gateway's books and records were inaccurate as demonstrated by Gateway's restatements.
78. In addition, as a result of the conduct described above, Gateway violated Section 13(b)(2)(B) of the Exchange Act, which requires reporting companies to devise and maintain a system of internal accounting controls sufficient to reasonably assure that transactions are recorded and financial statements are prepared in conformity with GAAP. Gateway had insufficient internal controls to assure that it accounted properly for its revenue in the second and third quarters of 2000.
IV.
79. Gateway has undertaken and agreed to cooperate fully with the Commission in any and all investigations, litigation, or other proceedings relating to or arising from the matters described herein. In connection with such cooperation, Gateway has undertaken:
- To produce, without service of a subpoena, any and all non-privileged documents requested by the Commission's staff;
- To be interviewed by the Commission's staff at such times as the staff may reasonably direct and to appear and testify truthfully and completely without service of a subpoena in such investigations, depositions, hearings or trials as may be requested by the Commission's staff; and
- That in connection with any testimony of Gateway, or any current employee of Gateway, to be conducted at deposition, hearing, or trial pursuant to a notice or subpoena, Gateway:
- Agrees that any such notice or subpoena for appearance and testimony may be addressed to General Counsel, Gateway, Inc., 14303 Gateway Place, Poway, California 92064; and
- Agrees that any such notice or subpoena for appearance and testimony in any such action pending in a United States District Court may be served, and may require testimony, beyond the territorial limits imposed by the Federal Rates of Civil Procedure.
80. During the early stages of the staff's investigation, the Company's cooperation was not exemplary. In determining to accept Gateway's offer, however, the Commission has considered these undertakings, the limited duration of the violations, and the remedial measures undertaken by Gateway's current management and board of directors, including the recent restatement of Gateway's financial statements, and substantial actions that Gateway has taken to enhance Gateway's internal controls and corporate governance.
V.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent Gateway's Offer.
Accordingly, it is hereby ORDERED:
Pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, Respondent Gateway shall cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b?5, 12b?20, 13a?1, and 13a?13 thereunder; and
By the Commission.
Jonathan G. Katz
Secretary