Counsel of Record:
UNITED STATES DISTRICT COURT
SECURITIES AND EXCHANGE COMMISSION
KENNETH WILCHFORT, CPA, and
03 Civ. No. _________
Plaintiff, the Securities and Exchange Commission (the "Commission"), alleges for its Complaint as follows:
1. This action seeks injunctive relief against two auditors, Defendants Kenneth Wilchfort and Marc Rabinowitz in connection with Cendant Corporation's ("Cendant") and its predecessor, CUC International Inc.'s ("CUC") false financial statements filed with the Commission. (Pre-merger CUC and post-merger Cendant are hereinafter referred to collectively as the "Company.")
2. From at least 1995 through 1998, certain members of CUC's and Cendant's senior and middle management devised and operated a fraudulent scheme that inflated the Company's quarterly and annual operating income reported to the Commission and to the public. CUC and Cendant fraudulently inflated their income figures in order to meet the earnings expectations of Wall Street analysts and thereby artificially maintain or increase the price of their stock. For the three fiscal years ended January 31, 1996, January 31, 1997, and December 31, 1997 (the "Relevant Periods"), the Company inflated its operating income by an aggregate amount of over $500 million.
3. Defendants Kenneth Wilchfort and Marc Rabinowitz are partners at Ernst & Young LLP ("E&Y") who were responsible for audit and accounting advisory services provided to CUC and Cendant. By virtue of the acts and omissions alleged herein, each Defendant aided and abetted the Company's violations of Section 13(a) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. § 78m(a)] and Rules 12b-20, 13a-1, and 13a-13 [17 C.F.R. §§ 240.12b-20, 240.13a-1, and 240.13a-13] promulgated thereunder which require public companies to report accurate financial information to the Commission and the public.
4. This Court has jurisdiction over this action pursuant to Sections 21(d) and (e) and 27 of the Exchange Act [15 U.S.C. §§ 78u(d) and (e) and 78aa].
5. The Defendants, directly or indirectly, made use of the means and instrumentalities of interstate commerce, of the mails, or of the facilities of a national securities exchange in connection with the acts, practices, and courses of conduct alleged herein.
6. Kenneth Wilchfort, CPA, age 50, is a partner at E&Y. Until approximately 1999, Wilchfort worked in the Assurance and Advisory Business Services ("AABS") practice of E&Y's Stamford, Connecticut office. Wilchfort served as the CUC audit engagement partner from 1990 through the third quarter of 1996. Thereafter, as mandated by rotation requirements set by the SEC Practice Section of the American Institute of Certified Public Accountants, Wilchfort ceased serving as audit engagement partner. He continued to serve CUC and Cendant as "Senior Advisory Partner."
7. Marc Rabinowitz, CPA, age 46, is a partner at E&Y. Until approximately 1998, Rabinowitz worked in the AABS practice of E&Y's Stamford, Connecticut office. Rabinowitz was the audit engagement partner for CUC and the former CUC portion of Cendant from the third quarter of 1996 until April 1998.
8. CUC, a Delaware corporation that had its headquarters in Stamford, Connecticut, was principally engaged in membership-based consumer services, such as auto, dining, shopping, and travel "clubs." CUC's largest division, Comp-U-Card, marketed individual memberships in these clubs. CUC's securities were registered pursuant to Section 12(b) of the Exchange Act and traded on the New York Stock Exchange ("NYSE").
9. HFS, a Delaware corporation that had its headquarters in Parsippany, New Jersey, was principally engaged in the business of controlling the rights to franchise brand names in the hotel, real estate brokerage, and car rental businesses. Its securities were registered pursuant to Section 12(b) of the Exchange Act and traded on the NYSE.
10. Cendant is a Delaware corporation with its headquarters in New York City. On December 17, 1997, HFS merged into CUC, and thereafter CUC changed its name to Cendant. Cendant provides membership-based and Internet-related consumer services and owns the rights to franchise brand names in the hotel, residential real estate brokerage, car rental, and tax preparation businesses.
11. Cendant's common stock and certain other of its securities are registered pursuant to Section 12(b) of the Exchange Act and trade on the NYSE. Certain additional securities issued by Cendant are registered pursuant to Section 12(g) of the Exchange Act.
12. Ernst & Young LLP is a national accounting firm with headquarters in New York, New York. During the Relevant Periods, E&Y provided audit services to CUC or Cendant. CUC and Cendant were audit clients of E&Y's Stamford, Connecticut office.
13. During the Relevant Periods, CUC and Cendant's management engaged in a multifaceted scheme to fraudulently inflate the Company's reported income. The Company improperly adjusted financial results for quarterly and year-end periods to ensure it met Wall Street analyst expectations. These fraudulent practices continued after the merger between CUC and HFS.
14. CUC and Cendant used various improper methods to inflate their annual results. These included manipulation of (1) merger related restructuring charges and reserves; (2) reported cash balances; (3) membership cancellation rates; and (4) intentionally overstated January 1997 income included in the Company's December 31, 1997 financial statements. The first method became increasingly significant during the last years of the scheme, when the Company needed ever-larger adjustments in order to keep inflating annual earnings to the levels expected by analysts.
15. On April 15, 1998, after the markets closed, Cendant announced that it had uncovered accounting irregularities and would need to restate its financial statements. On July 14, 1998, Cendant announced that the accounting irregularities were more extensive than had been originally stated and that the Company would restate its consolidated financial statements for the previous three years. On September 29, 1998, Cendant filed restated financial statements reducing the Company's operating income for the years ending January 31, 1996, January 31, 1997 and December 31, 1997 by over $500 million.
16. During the Relevant Periods, CUC and Cendant made materially false statements to the Defendants and E&Y about the Company's true financial results and its accounting policies. CUC and Cendant made these false statements to the Defendants and E&Y to mislead the Defendants and E&Y into believing that the Company's financial statements conformed with generally accepted accounting principles ("GAAP"). For example, as late as March 1998, senior Cendant management discussed plans to fraudulently use over $100 million of the Cendant Reserve to create fictitious 1998 income, which was also concealed from Defendants and E&Y.
17. Also during the Relevant Periods, CUC's and Cendant's's materially false statements to the Defendants and E&Y included the management representation letters, signed by senior members of CUC's and Cendant's management, that it provided to E&Y in connection with its audits and reviews, as well as oral and written representations to E&Y concerning, among other things, the creation and utilization of merger-related reserves, the adequacy of the reserve established for membership cancellations, the collectabilty of rejected credit card billings, and income attributable to the month of January 1997.
18. CUC and Cendant's management's written representations for the calendar 1997 audit all falsely stated, among other things, that the Company's financial statements were fairly presented in conformity with GAAP and that the Company made available all relevant financial records and related data to E&Y. Those written representations were materially false because the financial statements did not conform with GAAP and, as discussed further below, the Company's management concealed material information from the Defendants and E&Y.
19. In addition to providing the Defendants and E&Y with false written representations, CUC and Cendant also adopted procedures to hide its income-inflation scheme from the Defendants and E&Y. Some of the procedures that CUC and Cendant employed to conceal its fraudulent scheme from the Defendants and E&Y included: (1) backdating accounting entries; (2) making accounting entries in small amounts and/or in accounts or subsidiaries the Company believed would receive less attention from E&Y; (3) in some instances ensuring that fraudulent accounting entries did not affect schedules already provided to E&Y; (4) withholding financial information and schedules to ensure that E&Y would not detect the Company's accounting fraud; (5) ensuring that the Company's financial results did not show unusual trends that might draw attention to its fraud; and (6) using senior management to instruct middle and lower level personnel to make fraudulent entries.
20. However, notwithstanding CUC and Cendant's repeated deception, Defendants improperly failed to detect the fraud. As set forth below, Defendants were aware of numerous practices by CUC and Cendant indicating that the financial statements did not conform with GAAP and, as a consequence, they had a duty to withhold their unqualified opinion and take appropriate additional steps.
21. During the Relevant Periods, the Company completed a series of significant mergers and acquisitions and accounted for the majority of them using the pooling-of-interests method of accounting. In connection with this merger and acquisition activity, Company management purportedly planned to restructure its operations. GAAP permits that certain anticipated costs may be recorded as liabilities (or reserves) prior to their incurrence under certain conditions. However, here CUC and Cendant routinely overstated the restructuring charges and the resultant reserves and would then use the reserves to offset normal operating costs-an improper earnings management scheme.
22. The Company's improper reversal of merger and acquisition related restructuring reserves resulted in an overstatement of operating income by $217 million during the Relevant Periods.
23. The Defendants provided accounting advice as well as audit services to CUC and Cendant in connection with the establishment and use of restructuring reserves. For example: the Defendants advised the Company about cost categories that were typical components in corporate restructurings, including those cost categories that Defendants knew were subjective in nature and for which audit evidence, other than management's representation, was difficult to obtain. The Company included in restructuring reserves the cost categories that were subjective and difficult to test. The Defendants excessively relied on management representations concerning the appropriateness of the reserves and performed little substantive testing despite evidence that the reserves were improperly established and utilized.
24. The most egregious examples of CUC and Cendant's improper establishment and use of restructuring reserves involved reserves that were recorded in connection with the (1) December 1997 CUC/HFS combination and (2) fiscal-year January 31, 1997 combinations involving Ideon Group, Inc., Davidson & Associates, Inc., Sierra On-Line, Inc., and Plextel Telecommunications, Inc.
25. Cendant recorded over $500 million in merger, integration, asset impairment and restructuring charges for the CUC-side costs purportedly associated with the merger of HFS and CUC ("Cendant Reserve"). The Company recorded a significant portion of this amount for the purpose of manipulating its earnings for December 31, 1997 and subsequent periods and, in fact, Cendant had plans, which it did not disclose to Defendants and E&Y, to use a material amount of the reserve to artificially inflate income in subsequent periods.
26. In the course of providing accounting and auditing services, Defendants failed to recognize evidence that the Company's establishment and use of the Cendant Reserve did not conform with GAAP.
27. For example, CUC and Cendant provided E&Y with contradictory drafts of schedules when E&Y requested support for the establishment of the Cendant Reserve. The Company prepared and revised these various schedules, at least in part, as a result of questions raised and information provided by the Defendants.
28. The schedules were inconsistent with regard to the nature and amount of the individual components of the reserve, i.e., component categories were added, deleted, and changed as the process progressed. While the component categories changed over time, the total amount of the reserve never changed materially.
29. Despite this evidence, the Defendants did not obtain adequate analyses, documentation or support for changes they observed in the various revisions of the schedules submitted to support the establishment of the reserves. Instead, they relied excessively on frequently changing management representations.
30. The Company planned to use much of the excess Cendant Reserve to improperly increase operating results in future periods. During the year ended December 31, 1997, the Company wrote off $104 million of assets that it characterized as impaired as a result of the merger. Despite the size and timing of the write-off, Defendants never obtained adequate evidence that the assets were impaired as a result of the merger and, therefore, properly included in the Cendant Reserve. In fact, most of the assets were not impaired as a result of the merger.
31. In the fiscal year ended January 31, 1997, CUC recorded approximately $180 million in merger, integration, restructuring, and litigation charges associated with its combinations with Ideon, Davidson, Sierra On-Line, and Plextel (collectively, "Ideon Reserves"). As with the Cendant Reserve, the Company improperly recorded a significant portion of this amount, inflating its reported income for fiscal year ended January 31, 1997 and subsequent periods by $119 million.
32. Defendants obtained insufficient evidence to support the establishment and use of the Ideon Reserve and did not sufficiently follow-up on evidence that indicated it was not established or used in conformity with GAAP.
33. In connection with the establishment of the Ideon Reserve, the Company provided E&Y with inconsistent draft schedules relating to the establishment of the Ideon Reserve. For example, the litigation portion of the reserve was established at $90 million. By the end of the following quarter, the amount was reduced by the Company to $70 million-without any reduction to the $180 million total charges associated with the combinations. Instead, the Company increased the other categories by $20 million without adequate support.
34. Similarly, the Company provided E&Y with multiple, conflicting and sometimes contradictory draft schedules purportedly supporting the use of the Ideon Reserve. The Company prepared and revised these various draft schedules, at least in part, as a result of questions raised, and advice provided, by the Defendants. The Defendants did not seek and did not receive sufficient factual support for many of the components of the draft schedules provided by the Company.
35. For example, during the period ended December 31, 1997, the Company settled the bulk of the outstanding litigation for approximately $19 million-significantly less than the amount that had been reserved. As a result, Defendants expected a large balance remaining in the Ideon reserve at December 31, 1997 for the unused litigation portion of the reserve.
36. Nonetheless, the Company provided E&Y with a schedule reflecting a near zero balance for the reserve. Cendant explained this discrepancy by claiming that during calendar year 1997, there were concurrent, equal, and offsetting favorable developments in the litigation and unfavorable developments in the integration costs related to the transaction. The Company further claimed that these purportedly off-setting developments occurred simultaneously over the course of the preceding three quarters so that none of the 10-Q reports for the preceding three quarters needed to be amended.
37. Although the Defendants had been aware of favorable litigation developments during the preceding quarters, this was the first time the Company told E&Y about the purported unfavorable integration developments. In fact, the Company had provided schedules during E&Y's reviews of the first two quarters that reflected neither any unfavorable integration developments nor any "reallocation" of reserves from litigation to integration categories.
38. Furthermore, Cendant was also unable to provide adequate support for this claimed turn of events. Indeed, at the end of the audit, E&Y concluded, "little audit evidence is available with respect to certain integration charges which total approx. $25.3 million." Thus, the Defendants concluded (and conveyed to Cendant's management, who thereafter told the audit committee before the Company filed its 10K) that Cendant could not produce sufficient evidence to support the treatment of certain charges or the actual quarter those charges purportedly had been incurred. Despite the lack of documentation to support the Company's claims, the Defendants caused or allowed E&Y to issue an audit report containing an unqualified opinion on the Company's financial statements.
39. Had Defendants checked the Company's general ledger, they should have detected that Cendant had made numerous back-dated, post-closing adjustments to the reserve that did not contain any description or reference to justify the entries. Moreover, they should have detected that the Company had not made any accounting entries during the first three quarters to record the purported increase in integration charges that purportedly offset the favorable litigation developments. Instead, the Defendants excessively relied on management's false and deceptive explanations despite other evidence to the contrary.
40. CUC and Cendant also inflated income by manipulating their membership cancellation reserve and reported cash balance. Customers of the Company usually paid for membership products by charging them on credit cards. The Company recorded an increase in revenue and cash when it charged the members' credit card. Each month, issuers of members' credit cards rejected a significant amount of such charges. The issuers would deduct the amounts of the rejects from their payments to CUC and Cendant.
41. CUC and Cendant falsely claimed to Defendants and E&Y that when it resubmitted the rejects to the banks for payment, it ultimately collected almost all of them within three months. CUC and Cendant further falsely claimed to Defendants and E&Y that for the few rejects that were not collected after three months, it then recorded them as a reduction in cash and a decrease to the cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period and were entitled to a refund of at least a portion of the membership fee, as well as members who joined and were billed, but never paid for their memberships.
42. At the end of each fiscal year during the Relevant Period, the Company failed to record three months of rejects, i.e., it did not reduce its cash and decrease its cancellation reserve for these rejects. CUC and Cendant falsely claimed to Defendants and E&Y that it did not record rejects for the final three months of the year because it purportedly would collect most of the rejects within three months of initial rejection.
43. According to CUC and Cendant, the three months of withheld rejects created a temporary difference at year-end between the cash balances reflected in the Company's general ledger and its bank statements. The rejects were clearly specified on reconciliations of the Company's numerous bank accounts, at least some of which were provided to E&Y and retained in its workpapers. CUC and Cendant falsely claimed to Defendants and E&Y that the difference between the general ledger balance and bank statement balance did not reflect an overstatement of cash and understatement in the cancellation reserve since it collected most rejects.
44. In fact, the majority of rejects were not collected. By not recording rejects and cancellations against the membership cancellation reserve during the final three months of each fiscal year, CUC and Cendant dramatically understated the reserve at each fiscal year-end and overstated its cash position. CUC and Cendant thus avoided the expense charges needed to bring the cancellation reserve balance up to its proper amount and the entries necessary to record CUC and Cendant's actual cash balances.
45. At January 31, 1996, the rejects totaled $72 million and the cancellation reserve balance was $37 million. At January 31, 1997, the rejects totaled $100 million and the cancellation reserve balance was $29 million. At December 31, 1997, the rejects totaled $137 million and the cancellation reserve balance was $37 million. Because these rejects were largely uncollectable, CUC and Cendant understated the reserve and overstated the Company's income during the Relevant Period by increments of $35, $28, and $37 million for these three period-ends respectively.
46. Defendants did not adequately test the collectability of these rejects and the adequacy of the cancellation reserve and instead relied primarily on management representations concerning the Company's successful collection history and inconsistent statements concerning the purported impossibility of substantively testing these representations.
47. The Company also overstated its operating results by manipulating its cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period. A large determinant of the liability associated with cancellations was CUC and Cendant's estimates of the cancellation rates. During the audits, CUC and Cendant intentionally provided E&Y with false estimates that were lower than the actual estimated cancellation rates. This resulted in a significant understatement of the cancellation reserve liability and an overstatement of income.
48. To justify its understated cancellation reserve, CUC and Cendant provided to E&Y small, nonrepresentative samples of cancellations, which understated the actual cancellation rates. The Defendants allowed the Company to choose the samples. E&Y did not test whether the samples provided were representative of the actual cancellations for the entire membership population.
49. CUC's year-end was January 31. After the merger, Cendant adopted a December 31 year-end. The last fiscal year-end for CUC as a separate entity was January 31, 1997. The first post-merger year-end was December 31, 1997. Cendant's financial statements included CUC-side financial information for the 12 months ended December 31, 1997, rather than for an 11-month stub period. Thus, January 1997 activity was included twice in the audited financial statements in the Company's filings related to the year ended December 31, 1997-once for the period ended January 31, 1997 and again for the period ended December 31, 1997. The duplication was purportedly eliminated by taking a charge to retained earnings at December 31, 1997 for the January 1997 net income amount.
50. However, to enhance its financial performance for the year ended December 31, 1997, the Company fraudulently overstated its income attributable to CUC's activities of January 1997. For the quarter ending January 31, 1997, CUC's pre-tax income was approximately $147 million. Based on its long history with CUC and Cendant and knowledge of the Company's business, E&Y expected approximately one-third of the pre-tax income to be attributable to each of the three months that made up the quarter. To E&Y's surprise, Cendant claimed that CUC earned nearly 75%, or $109 million, of pre-tax income in January. In fact, there was no basis for this claim.
51. Cendant provided E&Y with a draft schedule to support its assertion that $109 million of pre-tax income was earned in January. When E&Y questioned or challenged items on the schedule, the Company revised the schedule, changing the nature and amounts of items included. These changes and revisions, while responsive to Defendants' questions or advice, at times were contradictory and inconsistent. Moreover, while the nature and amounts of scheduled items changed throughout this process, the aggregate value of scheduled items always remained the same. The Defendants accepted Cendant's representations with respect to all but $23 million and posted a final audit difference for the $23 million. E&Y had previously disclosed a preliminary $29 million audit difference to Cendant's audit committee. The Defendants concluded that the $23 million audit difference was not material and allowed E&Y to issue an unqualified opinion on the Company's financial statements, which included the entire $109 million as January 1997 income.
52. During the Relevant Periods, CUC and Cendant filed false and misleading periodic reports with the Commission. Those reports included, directly or by incorporation, audited financial statements that materially misrepresented the Company's financial results and significantly overstated its income from operations and its earnings.
53. For example, as a result of CUC and Cendant's fraudulent scheme, the Company's annual reports on Form 10-K misstated annual pre-tax income from operations by $127 million for the year ended January 31, 1996; by $122 million for the year ended January 31, 1997; and by $262 million for the year ended December 31, 1997.
54. Defendants issued audit reports containing unqualified audit opinions on, and conducted quarterly reviews of, the Company's financial statements that, as set forth above, did not conform with GAAP.
55. Plaintiff realleges and incorporates herein by reference paragraphs 1 through 54 above.
56. The Exchange Act and rules promulgated thereunder require every issuer of a registered security to file reports with the Commission that accurately reflect the issuer's financial performance and provide other information to the public.
57. By reason of the foregoing, Wilchfort and Rabinowitz aided and abetted violations of Section 13(a) of the Exchange Act [15 U.S.C. § 78m(a)] and Rules 12b-20, 13a-1, and 13a-13 [17 C.F.R. §§ 240.12b-20, 240.13a-1, and 240.13a-13] promulgated thereunder.
WHEREFORE, the Commission respectfully requests that this Court:
Permanently restrain and enjoin each of the Defendants, and his agents, servants, employees, attorneys, and assigns, and those persons in active concert or participation with him, and each of them, from aiding and abetting an issuer that files with the Commission a report required to be filed with the Commission, pursuant to Section 13(a) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §78m(a)], and the rules and regulations promulgated thereunder, in violation of Section 13(a) of the Exchange Act [15 U.S.C. § 78m(a)] or Rules 12b-20, 13a-1 or 13a-13 [17 C.F.R. §§ 240.12b-20, 240.13a-1 or 240.13a-13] promulgated thereunder.
Grant such other relief as this Court may deem just and appropriate.
Dated: April ________, 2003
Thomas C. Newkirk (DC Bar # 225748)
James T. Coffman
Matthew B. Greiner
Attorneys for PlaintiffSecurities and Exchange Commission
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