Russell D. Duncan (Lead Counsel)
Attorneys for Plaintiff
UNITED STATES DISTRICT COURT
Plaintiff Securities and Exchange Commission ("Commission") alleges:
1. Defendant Terry W. Davis, who held various senior finance positions at Network Associates, Inc., a Santa Clara, California based manufacturer and supplier of computer programs and hardware, engaged in a scheme to, among other things, overstate Network Associates' revenues and earnings, and thereby inflate Network Associates' stock price, in violation of the federal securities laws. As a result of the conduct of Davis and others, Network Associates filed false and misleading financial statements with the Commission from at least the second quarter of fiscal 1998 through at least the fourth quarter of fiscal 2000. On March 26, 2003, Network Associates announced that it would delay filing its 2002 Form 10-K, due March 31, 2003, and, for the second time in less than a year, restate its financial results for 1998 through 2000.
2. During the relevant period, Davis, who held various positions including Vice President and Corporate Controller, actively participated with other Network Associates employees in a multi-part scheme to artificially inflate the revenue generated from the sale of its products to distributors. The scheme included:
3. Davis took action to conceal the fraud. For example, in many instances, Davis improperly recorded, or caused others to improperly record, the payments to distributors in Network Associates' books and records. Davis, encouraged by at least one other senior employee at Network Associates, made a series of fraudulent entries in Network Associates' general ledger to release a tax-related reserve in order to disguise the distributor payments and discounts and increase inadequate sales reserves.
4. During the time that Davis was aware that Network Associates' reported revenues had been artificially inflated through this fraudulent scheme, he sold Network Associates stock for proceeds of approximately $1.4 million.
5. By engaging in the acts alleged in this complaint, Davis violated, or aided and abetted Network Associates' violations of, the antifraud, books and records, internal accounting controls, and reporting provisions of the federal securities laws, and unless enjoined by this Court, may do so in the future. The Commission requests that the Court permanently enjoin Davis from engaging in further violations, order an accounting, order disgorgement plus prejudgment interest, impose civil penalties based upon his conduct described above, and bar Davis from acting as an officer or director of any reporting company.
JURISDICTION, VENUE, AND INTRADISTRICT ASSIGNMENT
6. This Court has jurisdiction over this action pursuant to Sections 21(d) and (e), 21A, and 27 of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78u(d) and (e), 78u-1, and 78aa].
7. Venue properly lies in this Court pursuant to Section 27 of the Exchange Act [15 U.S.C. § 78aa] because Davis transacted business in this judicial district, because offers and sales of the securities at issue in this case took place in this judicial district, and because certain of the acts and transactions constituting the violations in this case occurred within this judicial district.
8. Davis made use of the means and instrumentalities of interstate commerce in connection with the acts alleged in this complaint.
9. A substantial part of the events that gave rise to the claims occurred in Santa Clara County, California. However, a related criminal case against Davis, concerning the same or substantially similar conduct as alleged herein, has been or will be simultaneously filed in this Division. United States of America v. Terry W. Davis.
10. Davis began working in the tax department at Network General Corporation in September 1992 and was named its Corporate Tax Director in 1997. In December 1997, Network General and McAfee Associates, Inc. combined to form Network Associates, Inc., and Davis remained as Network Associates' Corporate Tax Director. In September 1999, Davis was promoted to Vice President and Corporate Controller. In July 2000, Davis was given the added title of Senior Vice President of Corporate Finance. From January to April 2001, Davis served as acting-Chief Financial Officer, after which he remained Controller and Senior Vice President of Corporate Finance until his termination on April 24, 2002. During the relevant period, Davis resided in Mountain View, California and then San Jose, California.
11. Network Associates, Inc., (registered with the Commission as Networks Associates, Inc.) is a Delaware corporation with principal offices in Santa Clara, California, that manufacturers and sells computer programs and hardware relating to network security, anti-virus, and network management. Network Associates' fiscal year ends on December 31. Its common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act [15 U.S.C. § 78l(b)]. During the relevant period, Network Associates traded on the Nasdaq National Market under the symbol "NETA." On February 12, 2002, Network Associates moved from the Nasdaq National Market to the New York Stock Exchange and began trading under the symbol "NET."
THE REVENUE INFLATION SCHEME
12. In the second quarter of fiscal 1998, Network Associates changed its method of distributing its products to customers and the manner in which it recognized revenue. Instead of selling directly to end-user customers through its own sales force, Network Associates began using distributors who purchased product from Network Associates and then sold the product to resellers, who in turn, sold the product to end-users. At this time, Network Associates also adopted a revenue recognition policy under which the company recorded revenue at the time of the sale to the distributor, less a reserve for returns. This is commonly referred to as the "sell-in method" of accounting.
B. Davis and Others Fraudulently Stuffed Network Associates' Distribution Channel While Immediately Recognizing Revenue
13. Throughout 1998 and continuing through 2000, senior Network Associates officers formulated quarterly revenue goals for the company. These goals were set in contemplation of analyst and market estimates and expectations and served as a basis for awarding executive bonuses if the goals were obtained.
14. Davis worked each quarter with Network Associates' sales managers to formulate a plan for meeting the revenue goals through targeted sales to distributors. These sales deals, referred to as "buy-ins" and memorialized in "buy-in letters," involved the distributor purportedly agreeing to purchase Network Associates' products each quarter in set, large dollar amounts. For example, if Network Associates' U.S. revenue target for a particular quarter was $150 million, Network Associates would negotiate buy-in deals with its largest U.S. distributors that, in the aggregate, met the targeted amount. Davis approved many of the buy-in deals and was aware of their payment terms.
15. The buy-in deals were key to Network Associates meeting its sales targets because the company immediately recognized the revenue from these purported sales. However, the buy-ins were largely a sham. Davis knew, or was reckless in not knowing, that the distributors: (i) were purchasing far more product than they could sell and (ii) would not have to comply with the stated terms of the buy-ins, including terms regarding purchase amount and timing for the payments. In short, Networks Associates was overselling its product to its distributors, while at the same time immediately recognizing revenue from these inflated sales.
16. Rather than take back the oversold product and reverse the recorded revenue, Davis and one or more Network Associates employees engaged in a wide-ranging accounting fraud that resulted in the company overstating its earnings and financial results. As described below, Davis participated in illicit practices including: (1) paying distributors to hold excess inventory and encourage future buy-ins deals; (2) offering deep discounts on amounts distributors owed to Network Associates; (3) inappropriately using "cookie jar" reserves in a tax account to (a) artificially inflate sales return reserves (to avoid corresponding decreases in sales revenue) and (b) make certain of the aforementioned payments to distributors; and (4) using a wholly-owned subsidiary, Net Tools, Inc., to purchase some of the excess inventory sold to distributors. In addition, with Davis' knowledge and approval or acquiescence, Network Associates entered into side agreements that, in effect, allowed certain distributors to sell products on consignment - by requiring payment only upon sale to an end-user - in violation of the terms of the buy-in agreements and distribution contracts.
DAVIS PARTICIPATED IN THE REVENUE INFLATION SCHEME
A. Davis Gave Disguised Payments
17. In order to reduce distributor returns and to obtain new buy-in arrangements, Davis authorized disguised payments to a distributor, as well as deep discounts and rebates on amounts that distributors purportedly owed under prior buy-in deals.
18. Throughout 1999 and 2000, Network Associates made frequent and undisclosed payments to a distributor, totaling approximately $121.3 million. For example, on November 22, 1999, Network Associates paid a distributor over $21 million in eight separate wire transfers. To hide the true purpose of the payments, Davis prepared eight letters that accompanied the wire transfers purporting to explain the payments as reimbursement for "marketing fund rebates and other promotional programs." In fact, the $21 million was not related to marketing programs, but rather compensated the distributor for, among other things, not returning excess inventory. Davis also signed a similar set of letters that accompanied $11.9 million in payments made to the same distributor on June 12, 2000. From August through October 2000, this distributor received additional undisclosed cash and wire transfer payments totaling $27 million.
19. One of Davis' motivations for making the disguised payments was to induce the distributors to not return unsold inventory to Network Associates. Davis knew that product returns, if properly accounted for in Network Associates' financial statements, would reduce revenues, making it difficult or impossible for Network Associates to meet its quarterly revenue targets.
Distributor Discounts and Rebates
20. In addition to cash payments, Davis and others also granted distributors deep discounts and rebates (typically based upon oral or written side agreements) to, among other things, induce distributors not to return inventory. For example, toward the end of the first fiscal quarter of 2000, a distributor demanded a fee for holding "excess inventory" of Network Associates products because this distributor already held over $54 million in excess Network Associates inventory. In response, in a March 8, 2000 side letter, Davis and others agreed to discount the distributor's payments by two percent of the $54 million in excess inventory -- or approximately $1.1 million. Less than three weeks later, on March 24, 2000 (the week before the end of the quarter), the distributor agreed to a buy-in deal, purportedly purchasing approximately $31.4 million in Network Associates' products.
21. Davis and other Network Associates employees also provided large rebates to distributors in the form of "price protection." Under price protection, Network Associates agreed to reimburse distributors for any discount the distributors gave to their customers to meet or beat prices of Network Associates' competitors. Consequently, the payments that distributors purportedly had agreed to make were reduced by the amount of the price protection reimbursements. For example, during the relevant period, with Davis' knowledge and approval or acquiescence, Network Associates granted a distributor approximately $184.6 million in price protection rebates on $1.1 billion invoiced by Network Associates.
22. Davis and other Network Associates employees also gave large discounts to distributors through Network Associates' "stock rotation" program. The program allowed distributors to exchange less-marketable Network Associates inventory that had been previously purchased by the distributors, for a new product order in the same dollar amount. The practical effect was that distributors were allowed to discount payments they were obligated to make by the dollar amount of the inventory exchanged. In 1999 and 2000, Network Associates granted to its largest distributor approximately $165.9 million in stock rotation discounts on a total of $744.6 million invoiced by Network Associates.
23. The discounts, rebates, and payments had a significant effect on Network Associates' actual cash collections from distributors. For example, Network Associates' largest distributor paid Network Associates only 1.7 cents for every dollar invoiced in year 2000. On average, from 1998 through 2000, the same distributor paid only 32 cents for every dollar it was invoiced from Network Associates.
24. As a public company, Network Associates was required to comply with, among other things, the Securities Act of 1933, the Exchange Act, and the regulations of the Commission. These laws and regulations are intended to protect the investing public by ensuring that public companies like Network Associates fairly, accurately, and timely report their financial results and condition. To ensure fair and accurate reports to the investing public, the federal securities laws and the Commission's regulations promulgated thereunder require public companies such as Network Associates to prepare and present its reports and financial statements in conformity with Generally Accepted Accounting Principles ("GAAP").
25. Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists (SFAS No. 48), requires that a seller's fees be "fixed or determinable at the date of sale" in order for it to have recognized revenue upon sale to its distributors. American Institute of Certified Public Accountants' Statement of Position 97-2 (SOP 97-2) further provides that a "fixed fee" is a "fee required to be paid at a set amount that is not subject to refund or adjustment." As a result of the discounts, rebates, and payments to distributors that were authorized and effected by Davis and others, Network Associates' fees during the relevant period were not "fixed or determinable" at the time it sold its products to distributors. Accordingly, Network Associates' failure to defer all revenue recognition until its distributors actually sold its products during 1998 through 2000 violated GAAP and rendered its financial statements filed with the Commission during that period materially misleading.
B. Davis Fraudulently Manipulated Tax Reserve
26. Davis, acting at the direction of at least one other senior Network Associates employee, used improperly inflated tax reserve accounts (referred to as a "tax cushion") to increase Network Associates' inadequate return reserves and, among other things, cover the costs of the distributor rebates, discounts, payments, and product returns, without reducing Network Associates' reported revenues. Davis knew that such reductions to revenues would have caused Network Associates to miss its quarterly revenue targets. Davis disguised these improper adjustments through a series of false entries in Network Associates' general ledger. Davis violated GAAP and SEC accounting rules by decreasing one reserve account (the tax reserve) and using the amount of such decrease to increase another reserve account (returns reserve).
27. Davis knew that the company had inadequately reserved for distributor discounts and rebates, especially those involving the "price protections" discussed above. Rather than reduce the revenue the company intended to report, Davis, at the direction of at least one senior Network Associates officer, made false and improper accounting entries on several occasions in order to release a tax reserve and, correspondingly, increase inadequate return reserves. In one instance in November 1999, Davis was directed to increase return reserves by $15 million through an inappropriate reduction in a tax-related reserve. Davis knew that if the $15 million had been properly accounted for as a reduction in revenue, Network Associates would have missed its revenue goal in the fourth quarter 1999.
28. Many of Davis' illicit tax reserve transfers correlated to cash payments to one Network Associates distributor. Specifically, over fifty percent of the $121.3 million paid to this distributor for discounts, rebates, and other payments was transferred by Davis out of tax reserve accounts.
29. On June 28, 2002, Network Associates restated its financial statements for 1998 through 2000 with regard to the tax reserve and sales return reserve accounts.
C. Davis Allowed Consignment Sales Agreements
30. While Network Associates recorded revenue as if its distributors were paying within the written terms of buy-in letters or distribution agreements, Davis and other Network Associates employees allowed oral side agreements that materially changed the distributors' payment obligations. With Davis' knowledge and approval or acquiescence, Network Associates' three largest U.S. distributors rarely paid Network Associates within agreed upon terms.
31. Davis approved many of the buy-in deals and was aware of their payment terms. As Network Associates' Controller, he was responsible for recording the transactions associated with the buy-ins in the company's books and records, including the receipt of all distributor payments. Davis therefore knew, or was reckless in not knowing, that certain large U.S. distributors routinely ignored written contract terms that required payment within a certain period. Davis and others allowed these distributors to defer payment to Network Associates until after the distributors had resold Network Associates' products to their customers. In effect, Davis was allowing these distributors to sell on consignment, in violation of Network Associates' stated revenue recognition policy and GAAP.
32. Davis was also aware that another large U.S. distributor rarely paid within agreed-upon terms, but, instead, delayed its payment until Network Associates attempted to negotiate its next buy-in deal. In order to collect payment and consummate a new buy-in deal, Davis and other Network Associates employees routinely granted this distributor substantial payment discounts in oral or written side agreements.
33. Network Associates' recognition of revenue on its distributor sales transactions where, as here, distributors were not obligated to pay within terms, or where payment was contingent on the distributor's resale of the product, violated both GAAP and Network Associates' stated revenue recognition policy.
D. Net Tools, Inc.
34. In the third quarter of fiscal 1998, Network Associates began operating a wholly owned subsidiary, Net Tools, Inc. ("Net Tools"), to resell Network Associates' products to end-users. Net Tools was a shell company that served one primary purpose - to purchase inventory that Network Associates oversold to its distributors and resell that product. Network Associates induced distributors to enter into large buy-ins based on the understanding that the distributors could sell any excess inventory to Net Tools.
35. Distributors would demand - often in the last few days of the quarter and before agreeing to the next buy-in deal - that Network Associates, through Net Tools, purchase the distributors' unsold inventory. Davis, knowing Net Tools' purpose, relayed the distributors' demands to at least one other senior employee at Network Associates for approval, thus facilitating Net Tools purchase of inventory from Network Associates' distributors.
36. From its inception in June 1998, through August 1999, Net Tools purchased approximately $77.8 million in Network Associates' products from the company's distributors. Network Associates never disclosed the purpose of Net Tools, or the amount of Net Tools' purchases from Network Associates' distributors, in its filings with the Commission.
37. Network Associates used Net Tools to accelerate revenue recognition by enabling the company to recognize revenue upon the initial sale to the distributor while avoiding returns of inventory by the distributors. Fewer returns meant lower return reserves and, thus, higher reported revenue for Network Associates.
38. Network Associates' use of Net Tools as a reseller violated GAAP. Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists, prohibits the immediate recognition of revenue if, among other things, the seller (i.e., Network Associates) has "significant obligations for future performance to directly bring about resale of the product" for the distributor. Through Net Tools, Network Associates directly assisted distributors in the resale of its products.
DAVIS SIGNED FALSE MANAGEMENT REPRESENTATION LETTERS
39. On January 24 and March 30, 2001, Davis signed management representation letters that Network Associates presented to its independent auditors in connection with audits of Network Associates' consolidated financial statements as of December 31, 2000 and December 31, 1999. In both the January 24, 2001 letter, and the confirming March 30, 2001 letter, Davis falsely represented, among other things, that: (a) Network Associates' financial statements were prepared in accordance with GAAP, (b) there were no material transactions that were not properly recorded in Network Associates' accounting records underlying its financial statements, and (c) there had been no (i) fraud involving management or employees who had significant roles in internal control, or (ii) fraud involving others that could have a material effect on the financial statements. When Davis signed the management representation letters to Network Associates' independent auditors, he knew, or was reckless in not knowing, that they contained false statements and material misrepresentations.
DAVIS PROFITED FROM THE FRAUD
40. On February 15, 2002, Network Associates placed Davis on "sabbatical" with full salary and benefits. Network Associates fired Davis on April 24, 2002.
41. Between February 26 and March 8, 2002, while he was on his paid "sabbatical" and aware of the Commission's investigation, Davis exercised stock options and sold 90,463 shares of Network Associates' common stock for net proceeds of approximately $1.4 million.
42. Additionally, from 1998 through April 24, 2002, Network Associates paid Davis a base annual salary ranging from $115,500 to $250,000. From the time he was promoted to Vice President and Controller in September 1999, through December 2000, he was also paid quarterly bonuses totaling approximately $78,512 and awarded incentive stock options.
Davis Violated Exchange Act Section 10(b) and Exchange Act Rule 10b-5
43. Paragraphs 1 through 42 are realleged and incorporated herein by reference.
44. Davis knowingly or recklessly made material misrepresentations and omissions of fact with the knowledge that such material misrepresentations would be included in Network Associates' reports and financial statements filed with the Commission.
45. By reason of the foregoing, Davis violated Exchange Act Section 10(b) [15 U.S.C. § 78j(b)] and Exchange Act Rule 10b-5 [17 C.F.R. § 240.10b-5].
Davis Violated Securities Act Section 17(a), Exchange Act Section 10(b)
46. Paragraphs 1 through 42 are realleged and incorporated herein by reference.
47. Davis sold Network Associates stock on the basis of material nonpublic information concerning Network Associates' true financial condition, in breach of his fiduciary duty to Network Associates and its shareholders.
48. By reason of the foregoing, Davis violated Section 17(a) of the Securities Act of 1933 [15 U.S.C. § 77q(a)], Exchange Act Section 10(b) [15 U.S.C. § 78j(b)] and Exchange Act Rule 10b-5 [17 C.F.R. § 240.10b-5].
Davis Violated Exchange Act Section 13(b)(5) and
49. Paragraphs 1 through 42 are realleged and incorporated herein by reference.
50. Davis deliberately circumvented existing internal accounting controls in order to falsify Network Associates' books and records.
51. Davis, directly or indirectly, falsified or caused to be falsified, books, records, or accounts described in Exchange Act Section 13(b)(2) [15 U.S.C. § 78m(b)(2)].
52. Davis knowingly and substantially participated in a scheme to cause extensive false and misleading entries in Network Associates' books and records.
53. Davis knowingly or recklessly made materially false statements to accountants in connection with their audits and reviews of Network Associates' financial statements.
54. By reason of the foregoing, Davis violated Section 13(b)(5) [15 U.S.C. § 78m(b)(5)] and Exchange Act Rules 13b2-1 and 13b2-2 [17 C.F.R. §§ 240.13b2-1 and 240.13b2-2].
Davis Aided and Abetted Violations of Exchange Act Section 13(a)
55. Paragraphs 1 through 42 are realleged and incorporated herein by reference.
56. Davis knowingly and substantially participated in Network Associates' inclusion of financial statements that were materially misleading and not presented in conformity with GAAP in its annual, quarterly, and other reports filed with the Securities and Exchange Commission from at least the second quarter of fiscal year 1998 (the period ended June 30, 1998) through at least the fourth quarter of fiscal year 2000 (the period ended December 31, 2000).
57. By reason of the foregoing, Davis aided and abetted violations of Exchange Act Section 13(a) [15 U.S.C. § 78m(a)] and Exchange Act Rules 12b-20, 13a-1, and 13a-13 [17 C.F.R. §§ 240.12b-20, 240.13a-1, and 240.13a-13].
WHEREFORE, Plaintiff Securities and Exchange Commission respectfully requests that this Court:
Issue an order of permanent injunction restraining and enjoining Davis, and his agents, servants, employees, attorneys, and assigns, and those persons in active concert or participation with him, and each of them, from violating Securities Act Section 17(a) [15 U.S.C. § 77q(a)], Exchange Act Sections 10(b) and 13(b)(5) [15 U.S.C. §§ 78j(b) and 78m(b)(5)], and Exchange Act Rules 10b-5, 13b2-1, and 13b2-2 [17 C.F.R. §§ 240.10b-5, 240.13b2-1, and 240.13b2-2], and from aiding and abetting violations of Section 13(a) [15 U.S.C. §§ 78m(a)], and Exchange Act Rules 12b-20, 13a-1, and 13a-13 [17 C.F.R. § 240.13a-13].
Order an accounting by Davis of all money, property, and other assets directly or indirectly derived from the conduct alleged herein.
Issue an order directing Davis to disgorge, with prejudgment interest, all ill-gotten gains resulting from his conduct alleged herein.
Issue an order directing Davis to pay civil monetary penalties under Exchange Act Sections 21(d)(3) and 21A of the Exchange Act [15 U.S.C. §§ 78u(d)(3) and 78u-1].
Enter an order under Section 21(d)(2) of the Exchange Act [15 U.S.C. § 78u(d)(2)] prohibiting Davis from acting as an officer or a director of any issuer that has a class of securities registered pursuant to Section 12 of the Exchange Act [15 U.S.C. § 78l] or that is required to file reports pursuant to Section 15(d) of the Exchange Act [15 U.S.C. § 78o(d)].
Grant such other and further relief as this Court may deem just and proper.
Plaintiff demands trial by jury.