United States of America
In the Matter of
Thomas D. Costello,
|ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS AND IMPOSING A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted against Thomas D. Costello ("Costello" or the "Respondent") pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").
In anticipation of the institution of these proceedings, Costello has submitted an Offer of Settlement ("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 in which the Commission is a party, and without admitting or denying the findings herein, except that Respondent admits the jurisdiction of the Commission over him and over the matters set forth herein, Respondent has consented to the entry of this Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order ("Order") as set forth below.
On the basis of this Order and the Offer submitted by Respondent, the Commission finds1 that:
1. Thomas D. Costello, 38, of Evanston, Illinois, was Akorn, Inc.'s controller from March 31, 2000 to November 15, 2002. From March 31, 2000 to approximately late February 2001, he supervised the accounts receivable department.
2. Akorn, a Louisiana corporation headquartered in Buffalo Grove, Illinois, manufactures and markets diagnostic and therapeutic pharmaceuticals, surgical instruments and related products and provides contract manufacturing services. Akorn files reports with the Commission pursuant to Section 13(a) of the Exchange Act. During the relevant time period and through June 25, 2002, Akorn's stock traded on the Nasdaq National Market System. On June 25, 2002, Akorn's stock was delisted from Nasdaq based on the company's failure to provide audited financial statements in its 2001 Form 10-K, filed on April 16, 2002.
3. In its 2000 Form 10-K, Akorn issued audited financial statements that were not accurate and were not in accordance with generally accepted accounting principles. Specifically, Akorn carried on its books at least $7 million in accounts receivable that were impaired or uncollectible. Although Akorn subsequently created a reserve for these uncollectible accounts in its first quarter 2001, it claimed that the reserve was only the result of a "change in estimate" based on new information, rather than properly disclosing that the reserve was the result of ongoing, serious problems with the company's books and records and internal controls.
4. Beginning in at least 2000, Akorn failed to promptly and completely record and reconcile cash and credit remittances, including from its top five customers, to invoices posted in its accounts receivable sub-ledger. These top five customers, wholesale drug distributors, comprised forty-three percent of Akorn's sales and sixty percent of its accounts receivable during 2000. Akorn's problems resulted from numerous internal control and books and records deficiencies that prevented the company from accurately recording, reconciling and aging its receivables. Akorn's contractual relationships with its top five wholesale customers provided for an array of complicated credits in the form of rebates and chargebacks. The wholesaler's purchasing practices combined with Akorn's complicated credit system created a confusing accounting environment for Akorn. Often, the wholesalers deferred paying individual Akorn invoices upon receipt. Instead, the wholesalers periodically made lump-sum payments applicable to numerous invoices and simultaneously withheld claimed credits. In addition, when Akorn failed to timely act on credits to which customers thought they were entitled, the customers took the credit themselves and reduced payment on their next remittance to Akorn. Computer problems, rapid growth, heavy staff turnover, and unsupervised and inexperienced accounts receivable staff further contributed to Akorn's reconciliation difficulties. Accordingly, many remittances from Akorn's top five customers were not timely reconciled, i.e., payments and credits received were not timely applied to the corresponding, individual open invoices. Indeed, Akorn frequently recorded payments as a separate entry in its systems without making any offsetting entries with respect to the corresponding individual invoices. Akorn was also aware that problems with its computer systems often caused invoices that had been at least partially paid to be shown open in full.
5. In their management letter dated February 25, 2000, Akorn's auditors described management's failures during 1999 to review accounts receivable aging in detail, to reconcile accounts receivable timely, and to collect outstanding balances effectively and efficiently, and further noted the misapplication of credits and payments. During a review of this management letter with Akorn's auditors in May 2000, Costello acknowledged problems with the accounts receivable and informed the auditors that management's goal was significant collection resolution by June 30, 2000, and complete cleanup by August 31, 2000.
6. Management did not reach that goal and, during the last half of 2000, accounts receivable remained a major problem. Akorn's accounts receivable manager told Costello in August or September 2000 that her department was unable to reconcile cash remittances and credit claims. She asked for additional staff to work on collections and for additional training for existing staff. Costello did not provide sufficient additional resources or training. Moreover, Costello did not supervise adequately the accounting staff.
7. Through late 2000 and early 2001, the accounts receivable manager informed Costello of Akorn's efforts to reconcile and collect $700,000 worth of open invoices from smaller customers dated mainly 1997 through 1999.2 By January 2001, Akorn was able to collect only approximately $200,000 of these open invoices. Some customers refused to pay the remaining invoices because of the age of the invoices and Akorn's inability to provide proof of delivery. Subsequently, in a memo dated January 31, 2001 to Akorn's auditors, of which Costello received a copy, the accounts receivable manager concluded that Akorn's failure to reconcile invoices "significantly affected the accounts receivable collectibles." She concluded that, with respect to both wholesaler and end-use customer accounts, there was "no evidence indicating prior implementation regarding credit and collections efforts [had] been effective thus far."
8. By early 2001, Akorn began to have serious cash flow problems, and it violated certain loan covenants with its primary lender. As a result, the company thereafter focused on reconciling and collecting its accounts receivable balance. On March 7, 2001, Akorn's chairman of the board directed: "All receivables will be analyzed thoroughly and a determination will be made on accuracy and any write-offs necessary. . . . A report will be presented before the end of March on any potential write-offs."
9.On March 15, 2001, a consultant hired by Akorn drafted a report to the chairman of the board concluding that he could not determine the collectibility of Akorn's accounts receivable and the magnitude of a potential write-off. Moreover, by March 2001, Akorn's management was aware that there was a substantial discrepancy regarding the amount owed by Akorn's largest customer. In February, this customer provided Akorn's management with its accounts payable aging summary. Akorn's open account receivable balance showed that the customer owed Akorn approximately $4 million, while the customer's open accounts payable balance showed Akorn actually owed it approximately $800,000. Akorn's management also learned, by mid March, that this customer had taken approximately $1 million in rebate credits that Akorn believed were improper, but to which the customer believed it was entitled. Costello was relieved of responsibility for accounts receivable in approximately late February 2001, but retained responsibility for drafting Akorn's financial statements. During the course of his duties, Costello knew that Akorn had retained an accounts receivable consultant. Costello also was periodically and informally kept apprised of Akorn's management's communications with Akorn's largest customer.
10. In furtherance of its end of the year audit for 2000, Akorn's auditors prepared a detailed summary of Akorn's unreconciled accounts receivable as of September 30, 2000, in late February 2001. Using Akorn's accounts receivable data base, Akorn's auditors analyzed the roughly $26 million in gross accounts receivable and determined that Akorn had approximately $7.23 million in purportedly open unreconciled invoices dated 1999 and older in its accounts receivable portfolio. Akorn's auditors discussed the results of the analysis with Costello prior to Akorn's filing of its 2000 Form 10-K as Costello retained the responsibilities of preparing Akorn's Form 10-K and coordinating Deloitte's audit.
11. Costello, with other members of Akorn management, signed the management representation letters to Akorn's auditors, in connection with the 2000 audit. In the first representation letter to Akorn's auditors dated February 23, 2001, the date the auditors completed their field work, Costello, with other members of Akorn management, acknowledged that the company "is responsible for determining and maintaining the adequacy of the allowance for doubtful accounts receivable" and represented that "the allowances are adequate to absorb currently estimated uncollectible receivables in the account balances." In the second representation letter to Akorn's auditors dated April 17, 2001, Costello, with other members of Akorn management, represented that "no events had occurred [since February 23, 2001] that have a material effect on the financial statements that are in the filing [the 2000 Form 10-K] or that should be disclosed in order to keep those statements from being misleading." Costello did not gain an understanding of the accounts receivable consultant's March 2001 beliefs regarding the collectibility of accounts receivable and the magnitude of any write-offs of those accounts and therefore failed to share with Akorn's auditors the consultant's progress. Costello's failure was based on his responsibility to inquire regarding the accounts receivable consultant's progress given that Costello was responsible for drafting Akorn's 2000 Form 10-K. Further, Costello orally represented to Akorn's auditors that the exceptions Akorn's auditors found during its attempt to confirm Akorn's receivables would be eliminated once Akorn reconciled its accounts.
12. Costello assisted in drafting the financial statements, footnotes and management's discussion and analysis for Akorn's 2000 Form 10-K. He also calculated the reserve for doubtful accounts, but did not establish a reserve with respect to Akorn's top five customer accounts receivable.
13. On April 17, 2001, Akorn filed its Form 10-K for the year ended December 31, 2000, reporting annual net sales of $66.9 million and net income of $2.2 million or $0.11 per share. Akorn reported year end accounts receivable totaling $24.1 million, its largest asset. Despite its substantial problems with properly recording, reconciling and collecting its accounts receivable throughout 2000 and first quarter 2001, Akorn did not establish a reserve for any of its accounts receivable for its top five wholesale customers during fiscal year 2000, nor did it disclose any impairment of those receivables. Although Akorn had recorded $801,000 in its doubtful accounts reserve (roughly one fourth of which was carried over from 1999), that amount was comprised solely of accounts for its non-top five, end-use customers. Had Akorn appropriately recorded a reserve for its doubtful accounts, it would have posted a $2 million loss for its fiscal year ended December 31, 2000, rather than the $2 million profit it claimed in its 2000 Form 10-K.
14. On May 16, 2001, one month after filing its 2000 Form 10-K, Akorn issued a press release announcing that it was evaluating the extent to which it would need to make changes to its financial reserves, including its bad debt reserve, and that the changes would have a significant and adverse impact on earnings. The price of Akorn common stock dropped from $3.0937 to $1.7343 per share the day of the announcement, while the volume increased from an average of 70,280 shares per day in the prior five trading days to 1,092,500 shares on May 16, 2001.
15. In its first quarter Form 10-Q, filed on May 22, 2001, Akorn increased its reserve for doubtful accounts by $7.5 million or 10 percent of reported net sales for fiscal year 2000 and 126 percent of reported net sales for the first quarter 2001. The per share impact for the quarter was ($0.39). Following Akorn's filing, the price of Akorn's common stock declined further to close at $1.0937 on May 22, 2001, and $1.125 on May 23, 2001. Akorn explained the increase in its accounts receivable reserve as resulting from a change in estimate "[b]ased upon its recent unsuccessful efforts to collect past due balances." Akorn did not disclose anything about its lack of internal controls or its failure to accurately compute, age and monitor its accounts receivable.
16. Costello was responsible for drafting the financial statements and reviewed the calculation of reserve for doubtful accounts for Akorn's Form 10-Q for the first quarter of 2001. Akorn did not disclose the composition of its reserve account in its Form 10-Q, but the reserve was calculated based upon 100 percent of Akorn's entire accounts receivable for the years 1999 and prior and 50 percent of its entire accounts receivable for 2000. The first quarter 2001 Form 10-Q, which Costello assisted in drafting, inaccurately attributed the increased accounts receivable reserve just to a change in estimate based on recent collection efforts, rather than an error caused in large part by books and records and internal control problems.
17. As a result of the conduct described above, Costello violated Section 13(b)(5) of the Exchange Act which prohibits any person from knowingly failing to implement a system of internal accounting controls. Costello also violated Rule 13b2-1 which prohibits any person from directly or indirectly, falsifying or causing to be falsified, any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act. Costello knew that Akorn's accounts receivable staff was not accurately recording payments on Akorn's books and records and not timely reviewing credits and rebates taken by Akorn's customers. Costello knew that the receivables on Akorn's books and records included items that may not, in fact, be due to Akorn. Nevertheless, Costello knowingly failed to hire adequate staff or to provide necessary training and supervision despite requests for assistance by the accounting staff throughout 2000 and the first quarter of 2001.
18. As a result of the conduct described above, Costello violated Rule 13b2-2 which prohibits an officer or director of an issuer from: (1) making materially false statements; or (2) omitting to state a material fact necessary to make statements made not misleading to an accountant in connection with an audit or in connection with the preparation of any document to be filed with the Commission. Costello misrepresented to Akorn's auditors Akorn's ability to compute, age and monitor its accounts receivable in the management representation letters for the 2000 audit. Costello also did not inform Akorn's auditors of the consultant's beliefs regarding the accounts receivable as he failed to gain an understanding of the consultant's progress despite his responsibility for drafting the 2000 Form 10-K. Costello also failed to disclose Akorn's management's communications with its largest customer. Costello further misrepresented that Akorn's accounts receivable reserve in its Form 10-Q for the 1st quarter of 2001 was a change in estimate. The first quarter 2001 Form 10-Q, which Costello assisted in drafting, inaccurately attributed the increased accounts receivable reserve just to a change in estimate based on recent collection efforts, rather than an error caused in large part by books and records and internal control problems.
19. As a result of the conduct described above, Costello caused Akorn's violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder which require every issuer of a security registered pursuant to Section 12 of the Exchange Act to file with the Commission, in accordance with such rules and regulations as the Commission may prescribe as necessary or appropriate for the proper protection of investors and to insure fair dealing in the security, such quarterly and annual reports as the Commission may prescribe. Akorn's 2000 Form 10-K materially misstated its accounts receivable balance or, alternatively, failed to disclose the impairment to its accounts receivable. In calculating Akorn's doubtful account reserve and drafting the 2000 Form 10-K, Costello should have known that the substantial problems with Akorn's accounts receivable books and records and internal controls prevented Akorn from knowing the exact composition and age of Akorn's receivables. Costello helped draft the Form 10-Q and reviewed the calculation of the reserve. Costello therefore caused Akorn to file the 2001 Form 10-Q, which did not correct Akorn's previous accounts receivable errors, but rather inaccurately attributed the increased reserve to a change in estimate based on recent unsuccessful collection efforts.
20. As a result of the conduct described above, Costello caused Akorn's violations of Section 13(b)(2)(A) of the Exchange Act which requires public companies to make and keep books and records which accurately and fairly reflect its transactions and dispositions of assets. Costello also caused Akorn's violations of Section 13(b)(2)(B) of the Exchange Act which requires public companies to devise and maintain a system of adequate internal accounting controls sufficient to provide reasonable assurance that, among other things, transactions were recorded as necessary to permit preparation of financial statements in conformity with Generally Accepted Accounting Principles ("GAAP") and to maintain accountability of assets. Akorn's accounting books and records and its internal accounting controls were insufficient to permit the preparation of Akorn's financial statements in conformity with GAAP. As an officer in charge of ensuring the accuracy of Akorn's books and records and sufficiency of its internal controls, Costello caused Akorn's violations of Sections 13(b)(2)(A) and (B) of the Exchange Act.
In view of the foregoing, the Commission deems it appropriate to accept the Offer submitted by Respondent. Accordingly, it is hereby ordered that:
Pursuant to Section 21C of the Exchange Act, Respondent Thomas D. Costello shall cease and desist from committing or causing any violations and any future violations of Section 13(b)(5) of the Exchange Act and Rules 13b2-1 and 13b2-2 thereunder, and from causing any violations and any future violations 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 It is typical, however, for companies like Akorn, which requires payment from customers within 30 or 60 days, to establish a reserve when invoices are past due by 30 days or more.
|Home | Previous Page||