UNITED STATES OF AMERICA
In the Matter of
|ORDER INSTITUTING PROCEEDINGS, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission deems it appropriate that public cease-and-desist proceedings against Respondent Nesco, Inc. ("Respondent," "Nesco," or "the company") be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement ("Offer") that 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 in which the Commission is a party, and without admitting or denying the findings contained herein, except that Respondent admits the Commission's jurisdiction over it and over the subject matter of these proceedings, Respondent has consented to the entry of this Order Instituting Proceedings, Making Findings, and Imposing a Cease-and-Desist Order ("Order") as set forth below.
Accordingly, IT IS ORDERED that proceedings pursuant to Section 21C of the Exchange Act be, and hereby are, instituted.
On the basis of this Order and the Offer submitted by Respondent, the Commission makes the following findings1:
1. Nesco, Inc. is an Oklahoma corporation based in Tulsa, Oklahoma. Formerly known as National Environmental Services, Inc., Nesco employed a staff of over 300 in several states. The company performed environmental remediation services for numerous state agencies and constructed and serviced fueling systems for convenience stores, grocery stores, and gas stations. As of December 31, 2000, Nesco originally reported total assets of $43,054,000, with approximately 9.3 million shares outstanding. In July 2001, Fortune Small Business Magazine named Nesco one of America's 100 fastest growing small companies. At all relevant times, Nesco's common stock was quoted on the Nasdaq stock market and was registered with the Commission under Section 12(g) of the Exchange Act. Nesco was required to file periodic reports with the Commission pursuant to Section 13(a) of the Exchange Act. On November 26, 2001, Nesco filed a voluntary petition for reorganization pursuant to Chapter 11 of the United States Bankruptcy Code. The company remains in bankruptcy reorganization.
2. This matter involves an egregious financial-fraud scheme perpetrated by Nesco's former senior officers and serious failures in its internal accounting controls uncovered in an investigation following discovery of the scheme. Nesco's former chairman and CEO, Eddy L. Patterson, and its former controller and acting CFO (now deceased) (referred to herein as "controller"), grossly overstated the company's earnings by booking 28 false invoices totaling $2,153,986 in the fourth quarter of 2000 and one invoice totaling $183,385 in the first quarter of 2001. The false entries caused overstatements of pretax income of 400% in fiscal year 2000 and 175% in the first quarter of 2001. Nesco included these false receivables in its Form 10-KSB for the year ended December 31, 2000, and in its Form 10-QSB for the first quarter of 2001.2
3. A Nesco internal investigation in the third quarter of 2001, sparked by discovery of the bogus-invoice scheme, uncovered other misstatements in Nesco's 2000 financial statements. These misstatements materially affected Nesco's financial results for the period. First, through the failure to communicate throughout the company a change in its accounting method for revenue accrual, Nesco overstated work-in-process ("WIP")3 revenue by $923,244. Second, through recording errors, Nesco overstated its lease-contracts receivable by $460,466 and its accounts receivable by $308,830. Finally, through a failure to write off certain uncollectible accounts, Nesco overstated its accounts receivable by an additional $272,422. These failures also caused Nesco's assets for the first quarter of fiscal year 2001 to be materially overstated in its Form 10-QSB for the quarter.
Patterson Enlists Nesco's Controller in a Scheme
to Inflate its Income for Fiscal Year 2000
4. On or about January 19, 2001, Patterson enlisted Nesco's controller in a scheme to inflate Nesco's income for fiscal year 2000. Patterson concocted the scheme to conceal Nesco's poor financial performance from its shareholders, from its credit facility, and from a venture-capital firm from which Nesco was attempting to raise capital.
5. In furtherance of this scheme, Patterson directed the controller to create 28 false invoices totaling $2,153,986 and to enter them into Nesco's financial accounting system as valid accounts receivable for fiscal year 2000. The controller then instructed a low-level employee in Nesco's accounting department to physically create the bogus invoices. He further instructed the employee to backdate the invoices to dates ranging from December 19 to December 31, 2000, and not to mail them to the customers appearing on the invoices. Instead, the controller told the employee that they were "bill and hold" invoices. Further, in April 2001, the controller instructed the employee to create another false invoice in the amount of $183,385. This invoice was backdated to March 2001 and included in accounts receivable in Nesco's financial statements for the first quarter of fiscal year 2001.
6. The fictitious invoices reflected false accounts receivable that had not accrued to Nesco and were completely unrelated to services actually performed by the company or billed to its customers. The resulting phantom revenue and income, however, were recorded in financial statements appearing in Nesco's Form 10-KSB for the fiscal year ended December 31, 2000 and in Nesco's Form 10-QSB for the first quarter of 2001. Accordingly, the scheme yielded for Patterson the intended effect of falsely inflating Nesco's income for the reporting periods.
Failed Internal Accounting Controls Further
Inflate Nesco's Income for Fiscal Year 2000
7. Other financial recording problems were endemic to Nesco during the 2000 fiscal year. These deficiencies, which were independent from Patterson's false-invoice scheme, resulted from significant control failures at the company. Specifically, a series of failed internal accounting controls and recording errors caused Nesco to overstate its pretax income for fiscal year 2000 by an additional $1,958,962, an overstatement exceeding 400%. This overstatement consisted of several elements. First, Nesco overstated its WIP revenue by $923,244 due to a failure to establish, implement, and enforce internal accounting controls ensuring the validity of recorded revenue. Second, Nesco overstated its accounts receivable by $575,252 as the result of a recording error in the amount of $302,830 and the failure to write off uncollectible accounts receivable in the amount of $272,422. Finally, Nesco overstated its lease-contracts receivable account for fiscal year 2000 by $460,466 resulting from a separate recording error.
Nesco Failed to Maintain Internal Accounting Controls over WIP Revenue
8. At all relevant times, a large part of Nesco's business involved environmental clean-up work and gas station construction for customers engaged in the retail fueling business. These were long-term projects, usually requiring at least several months to complete. On a number of these long-term projects, Nesco entered into "pay-for-performance" contracts with its customers. Under its pay-for-performance contracts, Nesco invoiced its customers only after reaching certain performance "milestones" specified in the contracts. Nesco invoiced its customers upon achieving four milestones-upon completion of 25%, 50%, 75%, and 100% of the job.
9. Before January 2000, Nesco's accounting policy allowed Nesco to recognize estimated revenue based on the actual percentage of performance achieved, regardless of whether the contractual milestones had been reached. If, for example, Nesco completed 15% of a pay-for-performance contract in a given quarter, then it could recognize estimated revenue for the quarter based upon 15% completion. Beginning in January 2000, however, Nesco adopted a new accounting method to recognize revenue on its pay-for-performance contracts. Under the new accounting method, Nesco could recognize revenue only when a performance milestone had been achieved that permitted the company to invoice its customers. Using the above example, Nesco could not recognize any revenue in the quarter under the new system because it would have completed only 15% of the job-below the minimum 25% milestone.
10. After Nesco adopted the new policy effective in fiscal year 2000, however, Nesco's environmental divisions in Oklahoma, South Carolina, and Kentucky recorded revenue on their environmental pay-for-performance contracts based on the old accounting method. By contrast, Nesco's environmental divisions in four other states made the accounting change and recorded WIP properly. Nesco's environmental divisions did not uniformly follow the new revenue-recognition policy because the company had not clearly communicated the accounting change to all of the divisions. As a result, on its pay-for-performance contracts, Nesco prematurely recognized WIP revenue of $923,244 in fiscal year 2000.
Nesco Failed to Maintain Internal Accounting Controls over Receivables
11. Nesco also overstated its fiscal year 2000 accounts receivable and lease-contracts receivable by a combined $1,035,718. This overstatement resulted from numerous recording errors and the failure to write off impaired, uncollectible accounts in accordance with generally accepted accounting principles ("GAAP"). First, Nesco improperly booked $272,422 in delinquent accounts receivable that should have been written off due to age and poor payment history.4 Second, Nesco erroneously booked a $308,830 account receivable twice in connection with a merger transaction in early 2000. Finally, Nesco committed a recording error on a multi-million dollar lease in 2000 that caused an overstatement of $460,466 in its lease-contracts receivable account for the period.
Discovery of the Scheme and Failed Internal Controls
12. In May 2001, Nesco hired a new chief financial officer. Shortly thereafter, the accounting-department employee enlisted by the controller revealed to the new CFO the false invoices she had created at Patterson and the controller's direction. The CFO immediately began an investigation. This internal investigation and subsequent audit exposed Patterson's false-invoice scheme and, further, uncovered Nesco's overstatements in revenue and receivables resulting from its failed internal accounting controls.
Nesco Restates its Financial Statements for Fiscal Year 2000
and the First Quarter of Fiscal Year 2001
13. Accordingly, in August 2001, Nesco filed an amended Form 10-KSB and an amended Form 10-QSB. These filings restated Nesco's financial statements for fiscal year 2000 and the first quarter of fiscal year 2001. At the time of the restatements, however, the company's internal investigation had not revealed the $460,466 lease-contract receivable recording error from fiscal year 2000 or the $183,385 bogus invoice from the first quarter of 2001. These overstatements were discovered in September 2001 and disclosed in Nesco's third-quarter filing for that year.
14. The amended Forms 10-KSB and 10-QSB disclosed that Nesco had overstated its accounts receivable by $2,729,238 and WIP revenue by $923,244, resulting in an asset and revenue overstatement of $3,652,582 for fiscal year 2000. The amended Form 10-KSB reduced Nesco's pretax income for fiscal year 2000 from $4,602,000 to $950,000, a reduction of almost 80%. The amended Form 10-QSB cut Nesco's quarterly accounts receivable figures by $2,509,000, from $14,499,000 to $11,990,000, reversing an approximately 20% overstatement of assets for the quarter that carried over from fiscal year 2000. Nesco's third-quarter Form 10-QSB, filed in November 2001, further disclosed that, in fiscal year 2000, Nesco's assets had been overstated by an additional $460,466 as a result of the recording error in lease-contracts receivable and that its assets had been overstated by $183,385 in the first quarter 2001 by an unsupported invoice.
15. In fiscal year 2000, the combined overstatements-resulting from Patterson's fraudulent-invoice scheme and Nesco's failed internal accounting controls-caused the company's pretax income to be overstated by $4,112,948, or over 840%. Nesco originally reported fiscal year 2000 pretax income of $4,602,000, but should have reported $489,052. In the first quarter of fiscal year 2001, the $183,385 false invoice overstated Nesco's quarterly pretax income by over 175%. Following the restatements, Nesco's stock declined from over $3 per share to below a penny per share. It was suspended from trading on the Nasdaq stock market for over six months and was ultimately delisted. Currently in bankruptcy, Nesco's stock is quoted in the Pink Sheets at under a penny per share.
Nesco's Remedial Efforts and Cooperation
16. In determining to accept Nesco's Offer, the Commission considered the substantial remedial efforts undertaken by the company, its cooperation with the Commission's investigation, and other mitigating factors. Upon discovering the misstatements, Nesco took immediate corrective actions. It immediately ousted Patterson, issued a press release disclosing the misstatements, issued restated financial statements, and launched an internal investigation to ensure that it had disclosed the whole scheme and any other financial mismanagement. Under new management, Nesco also enhanced its internal control procedures to ensure that receivables and revenue are recorded properly in the future. Moreover, Nesco fully cooperated with the Commission staff in its investigation of the company.
17. As a result of the foregoing, the Commission finds that Nesco violated Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder. Section 13(a) of the Exchange Act requires issuers to file periodic reports with the Commission containing such information as the Commission prescribes by rule. Exchange Act Rule 13a-1 requires issuers to file annual reports, while Rule 13a-13 requires issuers to file quarterly reports. Under Exchange Act Rule 12b-20, such reports must contain, in addition to disclosures expressly required by statute and rule, such other information as is necessary to ensure that the statements made are not materially misleading under the circumstances. Section 13(b)(2) of the Exchange Act requires issuers to maintain an adequate system of internal controls and to make and keep books, records and accounts which, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer.
In view of the foregoing the Commission deems it appropriate to impose the sanctions agreed to in the Offer.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Securities Exchange Act of 1934, that Respondent, Nesco, Inc., cease and desist from committing or causing any violation and any future violation of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.
By the Commission
Jonathan G. Katz
|1||The findings herein are made pursuant to Respondent's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding.|
|2||In a related matter, the Commission filed a civil action against Nesco's former chairman and CEO in federal district court in Tulsa, Oklahoma, resulting from his misconduct described herein. SEC v. Eddy L. Patterson, Civil No. 03-CV-302, N.D. OK (Tulsa Division) (May 7, 2003). See Lit. Rel. 18125.|
|3||Nesco's accounting system treated WIP as an unbilled receivable on environmental and construction contracts that were producing revenue for the company but that had not yet been billed to customers. Nesco's periodic filings with the Commission described WIP as "costs and estimated earnings in excess of billings on uncompleted contracts."|
|4||GAAP requires accrual of a reserve and a corresponding charge to income for an estimated loss from a loss contingency if the following two conditions are met: (a) information indicates that it is probable that an asset has been impaired; and (b) the amount of loss can be reasonably estimated. Accounting for Contingencies, Statement of Financial Accounting Standards No. 5 (Fin. Accounting Standards Bd. 1975).|
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