UNITED STATES OF AMERICA
|In the Matter of
MICRO WAREHOUSE, INC.,
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 A
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative 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 Micro Warehouse, Inc. ("Respondent").
In anticipation of the institution of these administrative proceedings, Micro Warehouse has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Solely for the purposes 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 set forth below, except as to the jurisdiction of the Commission over itself and over the subject matter of these proceedings, which it admits, the Respondent consents to the entry of this Order Instituting 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 a Cease-and-Desist Order ("Order").
The Commission makes the following findings:1
A. Respondent and Responsible Officers
Micro Warehouse is a Delaware corporation with its principal executive offices in Norwalk, Connecticut, and its warehouse in Ohio. Micro Warehouse sells personal computers, software, accessories and peripherals through catalogs, the Internet, and telemarketing. Micro Warehouse was formed in 1987 and held its initial public offering in 1992. Micro Warehouse's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act, and trades on the NASDAQ national stock market. Eric Furman ("Furman") was Micro Warehouse's corporate controller and chief accounting officer until he resigned in November 1996. Furman was responsible for all accounting matters at Micro Warehouse, including preparation of financial statements. Stephen Hieber ("Hieber") reported to Furman and was a senior accounting manager until he resigned in 1997.
Beginning in at least early 1994 and continuing through the second quarter of 1996, through the actions of Furman and Hieber, Micro Warehouse engaged in a fraudulent scheme to create the illusion that each quarter the company's financial results met or exceeded projections and analysts' expectations. Furman and Hieber inflated the profits which Micro Warehouse reported to the public by falsifying the company's books and records. The falsified records related mainly to Micro Warehouse's expenses and liabilities for accounts payable.
As a result of the scheme, Micro Warehouse overstated profits before tax by approximately $12 million in 1994, $21.5 million in 1995 and $11.5 million in 1996. Micro Warehouse included materially false and misleading financial statements in its 1994 and 1995 Forms 10-K and its 10-Qs for 1994, 1995 and the first two quarters of 1996, as well as in three registration statements filed with the Commission. The narrative sections of these filings, along with several Micro Warehouse earnings announcements, contained materially false and misleading statements as well.
Senior management learned of the scheme in September 1996 and Micro Warehouse disclosed potential problems to the public soon thereafter. In February 1997, Micro Warehouse filed restated 10-Ks for the years 1992 through 1995. The aggregate amount of the restatement was a pre-tax charge to income of $41.8 million.
C. The Fraudulent Scheme
Furman and Hieber took advantage of an obsolete computer accounting system at Micro Warehouse to perpetrate the scheme. Micro Warehouse published a number of different catalogs of computer products, and each catalog was treated as a separate "division" within the company, with its own computer accounting system and physical warehouse space. Corporate headquarters and the divisions used an accounting and operating software package known as MACS ("Mail order And Catalog System"). MACS had no system-based link between the different divisions and thus, for financial statement purposes, the activity of each division had to be summarized, adjusted and aggregated with that of the other divisions each month. These monthly adjustments provided Furman and Hieber with the opportunity to falsify Micro Warehouse's books and records.
Accounting for Inventory and Accounts Payable
During 1994 to 1996 each Micro Warehouse division had two liability accounts for the payables associated with inventory purchases, a temporary account and a permanent accounts payable account. The temporary account -- called "Accrued Inventory" -- was intended to function as a "clearing" account to establish a liability for inventory physically received into the warehouse, but for which a vendor invoice had not yet arrived. Clerks at the warehouse entered a credit into Accrued Inventory on receipt of each shipment of goods from company suppliers (entering the credit increased the balance of the Accrued Inventory account and thereby increased the company's overall level of debt, because the account was a "liability account" in accounting usage). When an invoice arrived from a supplier, clerks in the accounting department re-entered the liability into the permanent Accounts Payable account, and relieved Accrued Inventory with an offsetting debit. All inventory shipments went through this two step process. Theoretically, at any point in time, the credit balance in the Accrued Inventory account should have equaled the value of inventory received at the warehouse but for which an invoice had not yet arrived. As it represented a revolving debt of the company, the Accrued Inventory account should always have been in a credit balance. For financial reporting purposes, the Accrued Inventory balance was combined with the Accounts Payable line item on Micro Warehouse's balance sheet.
The Fraudulent Scheme
Between January 1994 and June 1996, Furman and Hieber made numerous "manual" debit entries into the Accrued Inventory account. These "manual" debit entries, which lowered the credit balance in the account, were entries which did not correspond with the receipt of inventory or with any other legitimate business activity or accounting function, or they were entries which grossly exaggerated a legitimate accounting adjustment. Therefore the debit entries were fraudulent. Double-entry accounting procedures required Furman and Hieber to make an offsetting credit entry, and they typically made this entry to the Cost of Goods Sold account. These manual credit entries, like their corresponding debit entries, were either grossly exaggerated or did not relate to any legitimate business activity or accounting function. By this very simple method, Furman and Hieber artificially reduced the company's expenses and thereby falsely increased the profits reported in the company's periodic income statements (also known as profit and loss statements). At the same time, these manual entries had the effect of lowering liabilities and increasing retained earnings in the company's balance sheets.
Furman and Hieber made the majority of the manual entries during the monthly closings of Micro Warehouse's books. After clerks reconciled company accounts at month end, Furman and Hieber met to review the preliminary monthly financial statements. If, based on historical trends and internal sales data, the company's monthly results did not match up with what was expected by Furman and by financial analysts who followed Micro Warehouse, Furman and Hieber made a manual debit entry to Accrued Inventory, with the offsetting credit entry to Cost of Goods Sold. These entries artificially reduced expenses for the month and caused Micro Warehouse to report to the public higher profits than actually achieved (revenues were not effected). In some months, Micro Warehouse achieved results which were better than expected by financial analysts and therefore Furman and Hieber input the reverse: a manual credit entry to Accrued Inventory and a debit to Cost of Goods Sold. This artificially increased expenses and caused Micro Warehouse to report lower profits than actually achieved. In this way, Furman and Hieber managed the profits Micro Warehouse reported to the public.
On an annual and quarterly basis, the total fraudulent manual debits entered by Furman and Hieber into Accrued Inventory were as follows:
Debit Entries to
|1Q 94||$9,745,000||$ (881,866)||n/a|
|1Q 96||$ (1,386,000)||$ 10,137,175||n/a|
As the above table demonstrates, the fraudulent manual debit entries into Accrued Inventory constituted a substantial and material portion of the profits reported by Micro Warehouse to the public during the periods in question.
Misleading Micro Warehouse's Auditors
Micro Warehouse retained a national accounting firm to audit its books and records for the years ended December 31, 1994, and December 31, 1995. Furman was the primary contact person for the audits, and Hieber assisted Furman on occasion. To prevent the auditors from discovering the numerous manual debit entries, and therefore the fraudulently inflated profits, Furman made materially false statements to the auditors regarding the Accrued Inventory account, and also omitted to state material facts necessary in order to make the statements that he did make to the auditors not misleading to them. In connection with the review of the Accrued Inventory account, Furman failed to inform the auditors that Micro Warehouse made periodic adjusting entries to account for internal transfers of inventory. Therefore the auditors tested only the routine entry and relief of inventory into Accrued Inventory, and did not test the periodic adjusting entries. In both the 1994 and the 1995 audits, the auditors questioned the declining balance in the Accrued Inventory account, and Furman responded falsely that the balance was declining for a number of unrelated reasons, such as changes in the purchasing terms set by certain suppliers and a lower level of purchasing at year end. In fact, as Furman knew, the balance in the Accrued Inventory account was declining because of the fraudulent scheme. Consequently, the auditors failed to uncover the manual debit entries to the Accrued Inventory account or the inflated profits. At the conclusion of the audits, the accounting firm rendered audit reports containing unqualified opinions which stated that the financial statements of Micro Warehouse for the years ended December 31, 1994, and December 31, 1995, were fairly stated in all material respects and in conformity with generally accepted accounting principles.
Micro Warehouse Makes False Public Statements
Following the audits for the years ended December 31, 1994, and December 31, 1995, Micro Warehouse filed Forms 10-K for those years with the Commission. The financial statements in both of those documents were materially false and misleading because, among other things, profits were overstated in the income statements and retained earnings were overstated in the balance sheets. The narrative sections of those documents also contained materially false and misleading statements and omissions pertaining to the results of the company's operations and other matters. In addition, the press releases issued by Micro Warehouse in conjunction with the filing of the Forms also contained materially false and misleading statements and omissions. Micro Warehouse filed Forms 10-Q for the first three quarters of 1994 and 1995, and the first two quarters of 1996 which also contained materially false and misleading statements relating to the company's profits and liabilities. In October 1994, September 1995 and December 1995, Micro Warehouse filed registration statements with the Commission. These documents contained materially false and misleading statements and omissions which were similar to those found in the Forms 10-K.
IV. LEGAL ANALYSIS
A. Micro Warehouse Violated the Antifraud Provisions of the Exchange Act
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit a person, in connection with the purchase or sale of a security, from making an untrue statement of material fact or from omitting to state a material fact necessary in order to make statements made, in light of the circumstances under which they were made, not misleading. To violate Section 10(b) and Rule 10b-5, a person must act with scienter, Aaron v. SEC, 446 U.S. 680, 695 (1980), which has been defined as, "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Both willful and reckless conduct satisfies the scienter requirement. See, e.g., IIT v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980); Rolf v. Blyth Eastman Dillon & Co., Inc., 570 F.2d 38, 46 (2d Cir.), cert. denied, 439 U.S. 1039 (1978). To establish a corporation's scienter, the mental states of its officers may be imputed to the corporation. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1096 n.16 (2d Cir. 1972).
A fact is material if there is a substantial likelihood that a reasonable investor would consider the information to be important. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). Among the facts that may be considered material is the misrepresentation of a company's earnings. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833,849 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
Micro Warehouse violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder when it filed with the Commission Forms 10-K for the years ended December 31, 1994, and December 31, 1995, and Forms 10-Q for 1994, 1995 and the first two quarters of 1996 that were materially false and misleading. Each of those public filings was materially false and misleading because, among other things, the profits, expenses, and liabilities reported in the financial statements included within the filings were materially misstated as a result of the fraudulent scheme. Moreover, the earnings announcements corresponding to those filings were also materially false and misleading. Furman and Hieber knew, or were reckless in not knowing, that they were engaged in a fraudulent scheme that caused the financial statements to be materially false and misleading. Their state of mind may be imputed to Micro Warehouse.
B. Micro Warehouse Violated the Antifraud Provisions of the Securities Act
Section 17(a)(1) of the Securities Act prohibits a person, in the offer or sale of securities, from making untrue statements of material fact or from omitting to state material facts. See, e.g., U.S. v. Naftalin, 441 U.S. 768 (1979). In addition, Section 17(a)(2) of the Securities Act prohibits a person, in the offer or sale of securities, from obtaining money by means of untrue statements of material fact or omissions of material fact. Section 17(a)(3) prohibits a person, in the offer or sale of securities, from engaging in any transaction, practice or course of business that operates or would operate as a fraud upon a purchaser.
In October 1994 Micro Warehouse filed with the Commission a registration statement on Form S-3 which incorporated Micro Warehouse's materially false and misleading 1994 quarterly financial statements. In September 1995 Micro Warehouse filed with the Commission a registration statement on Form S-3 which incorporated Micro Warehouse's materially false and misleading financial statements for the year ended December 31, 1994, and for the first two quarters of 1995. In December 1995 Micro Warehouse also filed with the Commission a registration statement on Form S-4 which incorporated its materially false and misleading financial statements for 1994 and for the first three quarters of 1995. With each of these filings Micro Warehouse violated Section 17(a) of the Securities Act.
C. Micro Warehouse Violated the Reporting Provisions of the Exchange Act
Section 13(a) of the Exchange Act requires that issuers with securities registered pursuant to Section 12 of the Exchange Act file such information and documents as the Commission shall prescribe by its rules and regulations. Rules 13a-1 and 13a-13 require issuers to file annual and quarterly reports, respectively. Rule 12b-20 requires that these periodic reports contain such further information as is necessary to make the required statements, in the light of the circumstances under which they are made, not misleading. The filing of a periodic report containing materially false or misleading information constitutes a violation of these provisions. SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979); SEC v. Kalvex, Inc., 425 F. Supp. 310, 316 (S.D.N.Y. 1975).
Micro Warehouse violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder by filing annual reports on Form 10-K for the years ended December 31, 1994, and December 31, 1995, and quarterly reports on Form 10-Q for the first three quarters of 1994 and 1995, and the first two quarters of 1996, that contained materially false and misleading financial statements.
D. Micro Warehouse Violated The Record-Keeping and Internal Control Provisions of the Exchange Act
Section 13(b)(2)(A) of the Exchange Act requires issuers to make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer. Micro Warehouse violated Section 13(b)(2)(A) of the Exchange Act as a result of Furman and Hieber making fraudulent manual entries into Micro Warehouse's Accrued Inventory and Cost of Goods Sold accounts in 1994, 1995 and 1996. These fraudulent entries caused Micro Warehouse to issue financial statements which overstated profits and which otherwise contained materially false and misleading statements.
Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles. Micro Warehouse violated Section 13(b)(2)(B) of the Exchange Act by failing to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that only manual entries prepared in conformity with generally accepted accounting principles were input into its Accrued Inventory and Cost of Goods Sold accounts.
Based on the foregoing, the Commission finds that Micro Warehouse violated Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.
In view of the foregoing, the Commission finds that it is appropriate to accept Micro Warehouse's Offer. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Micro Warehouse, Inc. cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934, and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.
By the Commission.
Jonathan G. Katz
|1||The findings herein are made pursuant to the Offer and are not binding on any other person or entity in this or any other proceeding.|
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