UNITED STATES OF AMERICA
|In the Matter of
|ORDER INSTITUTING PUBLIC CEASE-AND-DESIST PROCEEDING, MAKING FINDINGS AND ISSUING A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission ("Commission") deems it appropriate that a public cease-and-desist proceeding be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Cylink Corporation ("Cylink" or the "Company" or the "Respondent").
Accordingly, IT IS HEREBY ORDERED that a cease-and-desist proceeding against Cylink be, and hereby is, instituted.
In anticipation of the institution of this proceeding, Cylink has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein except that Cylink admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Cylink consents to the issuance of this Order Instituting Public Cease-and-Desist Proceeding, Making Findings and Issuing a Cease-and-Desist Order Against Cylink Corporation ("Order").
On the basis of this Order and the Offer, the Commission makes the following findings:
Cylink is a Santa Clara, California corporation that develops, markets and supports computer network security products to allow the secure transmission of information. Cylink's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and is quoted on the NASDAQ Stock Market.
This matter involves financial reporting fraud by former executives of Cylink. Beginning in the fourth quarter of 1997 and continuing through the first two quarters of 1998, as Cylink struggled to meet quarterly revenue targets, former Company executives engaged in wide-ranging revenue irregularities to boost improperly the Company's revenue.
Cylink's problems began when the Company's then-Chief Financial Officer ("CFO") fraudulently directed that Cylink recognize revenue on two transactions in the fourth quarter of 1997. In the first, Cylink recognized $3.7 million in revenue on product it stored in a third-party warehouse relating to an order from a small international distributor. The transaction was contingent on the distributor's ability to obtain a letter of credit. When the distributor failed to obtain a letter of credit prior to the end of December 1997, former Cylink executives decided to store the product in the warehouse. Cylink's former CFO also directed that Cylink falsify its internal records to reflect open credit, rather than letter of credit, as the payment terms. Finally, the former CFO directed that Cylink recognize revenue on the transaction in fiscal 1997, even though Cylink did not release the product to the distributor but rather maintained control of the product in the warehouse pending receipt of a letter of credit. In the second transaction, Cylink's former CFO directed that the Company recognize approximately $900,000 in revenue on a transaction in which Cylink granted a distributor the right to exchange a new Cylink software product for other, better-established Cylink hardware products. The former CFO knew or was reckless in not knowing that recognizing revenue in light of the exchange right was inconsistent with the Company's revenue recognition policy and Generally Accepted Accounting Principles ("GAAP").
The fraud continued during the first two quarters of 1998, as Cylink failed to meet management's revenue goals for the new year. To mask the revenue shortfalls, former Cylink executives resorted to a variety of fraudulent practices, including recording revenue: on transactions in which customers retained the right to exchange Cylink software products for hardware; on two transactions with a particular distributor even though Cylink had reason to believe that the distributor had no ability to pay for the product; on shipment of product to a third-party warehouse, even though Cylink agreed not to bill its customers until some later date; and on transactions where Cylink did not have the product the customer ordered and instead sent other product, not requested by the customer, to a third-party warehouse. Cylink's then-CFO played a key role in the fraud during 1998, as did the Company's then-Vice President of Sales and its then-Director of North American Sales.
As a result of the fraud, Cylink materially misstated its financial results in filings with the Commission on Form 10-K for the year ended December 31, 1997 and on Forms 10-Q for the quarters ended March 29, 1998 and June 28, 1998. In February and April of 1999, Cylink restated these financial statements. For fiscal 1997, the restatement's main impact was on earnings from discontinued operations, which Cylink restated from $4.5 million to $3.2 million (a 41.7% overstatement). For the quarter ended March 29, 1998, Cylink restated revenue from $15.8 million to $8.0 million (a 97.5% overstatement). For the same period, Cylink restated net income from continuing operations from $1.1 million to a net loss from continuing operations of $3.4 million. For the quarter ended June 28, 1998, Cylink restated revenue from $18.0 million to $12.4 million (a 45% overstatement). For the same period, the Company restated net income from $1.7 million to a net loss of $1.7 million.
C. Cylink's Restructuring and Management's Goals for 1998
Historically, Cylink had two major businesses: the encryption division, which sold encryption hardware products; and the wireless division, which sold wireless communications products. In the latter half of 1997, Cylink management made two decisions that would transform the Company. First, Cylink decided to sell its wireless division. Cylink completed this sale in March 1998. (As discussed below, pressure to meet the revenue goal for this division in the quarter prior to its sale ultimately led Cylink to recognize improperly revenue on an important transaction in the fourth quarter of fiscal 1997.) Second, the Company shifted the focus of its encryption business from hardware to software products. As part of this effort, in September 1997 Cylink acquired an Israeli encryption software firm. At the time, the encryption software firm had one primary product, PrivateWire, a software product for encrypting data over the Internet.
Prior to its acquisition by Cylink, the encryption software firm had generated only a few million dollars in PrivateWire sales. Despite this, Cylink management decided to rely heavily on PrivateWire to meet the Company's growth targets for 1998. Cylink set a fiscal 1998 revenue target for the Company of approximately $100 million, more than twice Cylink's total revenue for fiscal 1997.
Cylink quickly fell behind its revenue goals in the first and second quarters of 1998. To mask this revenue shortfall, Cylink improperly recorded revenue on several transactions in each quarter. As discussed in detail below, Cylink's former CFO, Vice President of Sales and Director of North American Sales were responsible for this wrongdoing.
D. The Year Ended December 31, 1997: Cylink Filed Materially False and Misleading Financial Statements on Form 10-K
On March 30, 1998, Cylink filed with the Commission its Form 10-K for the year ended December 31, 1997. In the financial statements included in the Form 10-K, Cylink reported revenue of $49.3 million, income from discontinued operations of $4.5 million and a net loss of $58.8 million. As a result of the adjustments in the restatement, revenue was reduced to $47.7 million, income from discontinued operations was reduced to $3.2 million and the net loss widened to $61.7 million. Originally reported revenue and earnings from discontinued operations were overstated 3.4% and 41.7%, respectively; the originally reported net loss was understated by 4.8%.
Cylink's revenue goal for the fourth quarter of 1997 was $25 million, consisting of $10 million from its wireless division and $15 million from its encryption division. As originally reported, Cylink met its revenue goal, but only barely, and only because Cylink's former CFO directed that the Company improperly recognize revenue on two transactions: a $3.7 million order for the wireless division and a $900,000 order for Cylink's new software product for the encryption division.
1. The Fourth Quarter Wireless Bill and Hold Transaction
In November 1997, Cylink's wireless division received a $3.7 million purchase order from a small distributor based in the Middle East. The distributor's prior orders had been much smaller, in the range of $50,000 to $100,000. Moreover, the distributor did not have a written contract to resell the goods. As a result, Cylink's credit department approved the order contingent on the delivery by the distributor of a letter of credit in favor of Cylink.
By late December, the distributor had not provided a letter of credit. Nevertheless, late that month Cylink shipped product for the order to a third-party warehouse. Cylink decided to ship the product to the warehouse on its own, not in response to any request by the distributor. Moreover, at the time Cylink shipped the product to the warehouse, there was no fixed schedule for the delivery of the product from the warehouse to the distributor.
Also in December, Cylink's former CFO directed that the terms of the distributor's order be changed on Cylink's internal order processing system from "letter of credit" to "120 days open credit." With the product shipped to a warehouse and Cylink's internal records changed to reflect open credit terms, in fiscal 1997 Cylink recognized some $3.7 million in revenue on the order.
Although Cylink shipped the product to the warehouse in December 1997, Cylink did not relinquish control of the goods. Instead, the product remained in the warehouse under Cylink's control through the end of March 1998, when Cylink sold its wireless division to another company.
Revenue recognition during fiscal 1997 was improper because this transaction failed to comply with the requirements for bill-and-hold transactions, in which a vendor ships goods to a third-party location (such as a warehouse) on behalf of a customer, rather than to the customer itself. In order to recognize revenue upon shipment to the third-party location, a vendor must analyze a number of factors, including whether: the buyer, rather than the seller, has requested the bill and hold arrangement; the buyer has a substantial business purpose for the request; and there is a fixed schedule for delivery of the goods. In addition to considering these and other factors, the vendor must also consider the issue of control. If the vendor retains control of the product, that is an indication that revenue realization has not occurred. Financial Accounting Standards Board ("FASB") Statement of Concepts No. 5, Para. 83. See also Accounting and Auditing Enforcement Release No. 108 (Aug. 5, 1986). All of the factors stated above weighed against recognizing revenue: the distributor did not request shipment to the warehouse; there was no business purpose from the buyer's perspective for the warehouse arrangement; there was no fixed schedule for delivery to the distributor, and Cylink retained control of the product in the warehouse pending receipt of a letter of credit from the distributor. Accordingly, revenue recognition was improper on a bill-and-hold basis.
More fundamentally, revenue recognition was improper because a key term of the transaction had not been fulfilled-the distributor had failed to provide a letter of credit. Although Cylink's former CFO directed that the Company change the credit terms on the order from letter of credit to 120 days open credit, the CFO did not in fact intend to release the product to the distributor until the distributor had supplied a letter of credit. In addition to the reasons stated above, because a key term of the transaction remained unfulfilled, revenue recognition was improper in fiscal 1997.
2. The Fourth Quarter Software-for-Hardware Exchange Transaction
Cylink restated a transaction from the fourth quarter of 1997 that involved the shipment of approximately $900,000 of PrivateWire, Cylink's new encryption software product, to a Japanese distributor. Cylink had acquired PrivateWire just a few months earlier when it bought the encryption software firm. The sale to the Japanese distributor was Cylink's first significant PrivateWire deal.
To obtain this order, Cylink granted the distributor the right to exchange PrivateWire for any of Cylink's encryption hardware products. The exchange provision was contrary to Cylink's revenue recognition policy, which stated in part that "[r]evenue from sales to distributors is recognized upon shipment; no right of return, stock rotation or price protection is given."
The exchange provision also made it improper to recognize revenue under GAAP. In order to recognize revenue where a right of return is granted, GAAP requires that the seller be able to make a reasonable estimate of the amount of future returns and to establish a reserve for any costs or losses associated with the expected returns. FASB Current Standards R75.107, 108. In this case, because PrivateWire was a new product, Cylink had no basis for estimating the amount of future returns or the costs or losses associated with such returns. Nevertheless, Cylink improperly recognized $900,000 in revenue on this transaction in fiscal 1997.
E. The Quarter Ended March 29, 1998: Cylink Filed Materially False and Misleading Financial Statements on Form 10-Q
On May 13, 1998, Cylink filed with the Commission its Form 10-Q for the quarter ended March 29, 1998. In the financial statements included in the filing, the Company reported revenue of $15.8 million for the period. As a result of the adjustments in the restatement, revenue was later reduced to $8 million. Thus, originally reported revenue was overstated by 97.5%. The Company also originally reported net income from continuing operations of $1.1 million, which was later restated to a net loss from continuing operations of $3.4 million.
1. Cylink's Revenue Goal for Q1 1998
Cylink's former management undertook to radically reshape the Company in 1998. In March 1998, Cylink completed the sale of its wireless division. At the same time, the Company tried to shift the focus of its remaining core encryption business from its traditional hardware products to software. In so doing, Cylink counted heavily on its ability to market PrivateWire, the encryption software product it acquired in late 1997.
In the midst of these changes, Cylink's former management originally set the Company's 1998 revenue goal at $100 million, compared to fiscal 1997 revenue of $49.3 million (prior to the restatement). As part of this plan, the Company's initial goal for first quarter encryption revenue was $17.5 million.
First quarter revenue quickly fell behind plan, and Cylink later reduced its Q1 encryption revenue target slightly to $16 million. Nevertheless, Cylink entered the last week of the quarter with a significant revenue shortfall. According to an internal report dated March 25, 1998, Cylink needed to record another $5.483 million in encryption sales in the following four days to meet its revenue target.
2. Faced with a Significant Q1 1998 Shortfall, Former Cylink Executives Schemed Fraudulently to Boost Cylink's Revenue
In the last week of the quarter, Cylink closed several transactions that should not have been recorded as revenue, including two that accounted for $2.3 million in revenue (a 28.8% overstatement). In the first of these, Cylink improperly recognized revenue on the shipment of encryption hardware product to a warehouse on behalf of a domestic end-user. In the second, Cylink improperly recorded revenue on shipments of PrivateWire software to a warehouse on behalf of a distributor, even though the distributor had no ability, in the absence of a resale, to pay for the product. To induce the distributor to place the order, Cylink granted the distributor the right to exchange the software for Cylink hardware products.
a. The First Quarter Domestic End-User Transaction
In late March 1998, Cylink received a $1.3 million purchase encryption hardware order from a domestic end-user. That month, Cylink shipped product for the order to a third-party warehouse and recognized $1.3 million in first quarter revenue. It was improper for Cylink to record this transaction as revenue during Q1 1998 because: Cylink failed to comply with the requirements for bill-and-hold revenue recognition; and Cylink was unable during Q1 to manufacture all the product needed for the order and, instead, partially filled the order with product that the customer did not request.
First, although the customer issued a purchase order in March 1998, the customer also instructed Cylink to delay billing until Cylink shipped the product from the warehouse to an actual customer location. Cylink's former head of North American Sales communicated this fact to Cylink's CFO in late March 1998. The CFO did not object to the delayed billing arrangement but simply instructed that Cylink falsely document the transaction in the Company's internal records as "50% net 30, 50% net 180", meaning half the purchase amount due within 30 days and half due within 180 days after shipment to the warehouse. Cylink's former Vice President of Sales was also aware of the true terms of the delayed billing arrangement.
Second, Cylink was unable to build all the product for this order prior to the end of the first quarter. Instead, Cylink's former Vice President of Sales and its former head of North American Sales arranged to partially fill the order with approximately $365,000 in other, excess product that the customer had not requested. Cylink sent the unordered product (along with that portion of the order that it was then able to fill) to the warehouse at the end of March. In April, after Cylink was able to manufacture the correct product, the Company used it to replace the unordered product that remained in the warehouse.
Revenue recognition was improper. The transaction failed to qualify for revenue recognition on a bill-and-hold basis because the customer had no obligation to pay on shipment of the product to the warehouse. Instead, Cylink should have recognized revenue when the product was shipped from the warehouse to an actual customer site. In addition, for the approximately $365,000 in substituted product, revenue recognition was improper because the customer never agreed to pay for that product.
b. The First Quarter Distributor Transaction
In March 1998, Cylink recognized $1 million in revenue on the sale of PrivateWire software to a distributor that was attempting to sell encryption products to the government of Argentina. The transaction included the following terms: shipment to a bonded warehouse; 180-day payment terms; and the right to exchange the software for Cylink hardware products.
Revenue recognition was improper because the exchange provision was contrary to Cylink's revenue recognition policy. The exchange provision also made it improper to recognize revenue under GAAP. Cylink's former CFO knew of the exchange provision but nonetheless directed that the Company recognize revenue on the transaction.
Revenue recognition was also improper for a more fundamental reason: Cylink had no reason to believe that the distributor could pay for the product. Cylink had no basis on which to evaluate this distributor's creditworthiness because, despite requests from Cylink sales personnel, the distributor had refused to provide any information about its finances. In addition, the distributor had thus far failed to pay for its only prior order from Cylink, a December 1997 order for $450,000 in encryption hardware; indeed in early March 1998 the distributor specifically refused to accept delivery of this product because it could not pay for it. Under these circumstances, there was no reasonable basis for Cylink to believe that the distributor could pay for the product.
F. The Quarter Ended June 28, 1998: Cylink Filed Materially False and Misleading Financial Statements on Form 10-Q
On August 12, 1998, Cylink filed with the Commission its Form 10-Q for the period ended June 28, 1998. In the financial statements included in Cylink's Form 10-Q, the Company reported revenue and net income for the period of $18 million and $1.7 million, respectively. As a result of the adjustments in the restatement, revenue was later reduced to $12.4 million (an overstatement of 45%) and the net income was restated to a net loss of $1.7 million.
Cylink's revenue target for the second quarter was $18 million. Near the end of June, with only five business days remaining in the quarter, Cylink needed to close and ship nearly $6.8 million to meet the revenue target. Cylink met its target but only by recording revenue on many problematic orders it received during the last week of the quarter. Cylink invoiced at least $6.6 million in revenue during the last week of June, eventually restating $6.1 million of that amount. Among the transactions restated were the following three, which totaled $3.3 million in revenue (a 26.6% overstatement).
1. The Second Quarter Distributor Transaction
By the second quarter of 1998, Cylink's Argentina distributor had two outstanding purchase orders (from December 1997 and March 1998) but had not taken delivery of any product and had not paid for the orders. In each order, Cylink had granted the distributor the right to exchange product because the distributor had not determined what types or quantities of product it might be able to sell in Argentina. In fact, Cylink's former Vice President of Sales and former head of North American Sales knew that the distributor did not yet have a buyer for any of the product from either of its two earlier orders. Nonetheless, in late June 1998, the former head of North American Sales signed a letter offering this distributor 180-day payment terms, storage at a bonded warehouse for up to one year and the right to exchange software for hardware products. The distributor accepted and placed another $1 million purchase order for PrivateWire software and Cylink recognized the entire order as revenue in the second quarter of fiscal 1998. In the end, the distributor never took any product from this or any of its prior orders.
The revenue recognition issues are the same as those for Cylink's first quarter deal with this distributor. It was improper for Cylink to recognize revenue on this transaction because the software-for-hardware exchange provision was contrary to the Company's revenue recognition policy. In addition, the exchange provision made it improper to recognize revenue under GAAP. Finally, revenue recognition was also improper because Cylink had no reasonable basis to believe that the distributor, in the absence of an order from an end-user, could pay for the product.
2. The Second Quarter End-User Transaction
At the end of the second quarter, Cylink's former CFO and former head of North American Sales approved a $1.3 million order from an end-user customer for encryption hardware. In accepting the order, Cylink agreed to ship the product to a bonded warehouse and store it there for up to one and one-half years before deploying it to various customer sites. In addition, Cylink agreed to delay billing until Cylink had deployed the product from the warehouse to the customer sites. Both the former CFO and the former head of North American Sales knew of and approved the terms of the transaction. Cylink recognized $1.3 million in revenue on this transaction in the second quarter of fiscal 1998.
Revenue recognition in the second quarter was improper because the transaction failed to comply with the requirements for bill-and-hold revenue recognition. The customer was not obligated to pay for the product upon shipment to the warehouse. Rather, the customer was only to be billed, and was only obligated to pay, when the product was shipped from the warehouse to the various customer sites. In addition, there was no fixed schedule for shipment of the product from the warehouse to the customer sites.
3. The Second Quarter Reseller Transaction
As Cylink neared the end of the second quarter, the Company was counting on an order from a reseller that had been working for some time to resell Cylink product to a particular end-user. The reseller was reluctant to place an order with Cylink because it still did not have a contract with its end-user. In late June, to induce the reseller to place an order, Cylink's former Vice President of Sales signed a letter that gave the reseller the right to cancel its order within 90 days. On this basis, the reseller issued Cylink a purchase order for $903,000 and Cylink recognized this entire amount as second quarter revenue.
Because it was subject to the 90-day cancellation clause, it was improper for Cylink to recognize revenue on this order in the June 1998 quarter.
G. Cylink's Lack of Internal Controls
The fraud at Cylink was made possible, in part, by the Company's poor internal controls. Aside from a general statement in its 1997 Form 10-K concerning the Company's basis for recognizing revenue, Cylink had no written policies governing revenue recognition. For example, the Company had no written policy regarding which positions in the finance department were responsible for reviewing revenue recognition transactions. Nor did the Company have a written policy regarding what documentation was necessary to determine whether a transaction was eligible for revenue recognition. Cylink also had no written requirement that senior finance department officials sign off on any unusual sales terms, such as large discounts or extended payment terms.
Moreover, Cylink failed to provide any training to inform employees about the Company's revenue recognition policy or about terms that might make revenue recognition improper. For example, Cylink's order administration department was responsible for tracking orders from intake to invoice through shipping and, in theory, was supposed to have all the documentation necessary to determine whether a transaction was eligible for revenue recognition. However, the order administration staff received no training or guidance as to how to spot problematic sales terms.
H. Legal Conclusions
As described in Parts III(B) through (G) above, from the fourth quarter of 1997 through the first two quarters of 1998, former Cylink executives engaged in repeated fraudulent conduct to improperly boost the Company's financial results. As a result of the fraud, Cylink's financial statements for each of these periods (which were filed with the Commission and disseminated to investors) were materially false and misleading. In addition, the Company failed to maintain books, records and accounts that, in reasonable detail, accurately and fairly reflected its transactions and dispositions of assets and failed to maintain a system of internal accounting controls sufficient to permit the preparation of financial statements in conformity with GAAP.
Based on the foregoing, the Commission concludes that the Company violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-13 and 13b2-1.
In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded to the Commission staff.
Based on the foregoing, the Commission deems it appropriate to accept the Offer submitted by Cylink. Accordingly, IT IS HEREBY ORDERED pursuant to Section 21C of the Exchange Act that:
Cylink cease and desist from committing or causing any violations or any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-13 and 13b2-1.
By the Commission.
Jonathan G. Katz
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