Joaquin M. Sena
Attorneys for Plaintiff
UNITED STATES DISTRICT COURT
Plaintiff Securities and Exchange Commission alleges:
1. This case involves revenue recognition fraud at Critical Path, Inc., a San Francisco-based e-mail outsourcing firm. In late 2000 and early 2001, defendant David A. Thatcher, Critical Path's president, engaged with other persons in a scheme to inflate the company's revenues and earnings. Thatcher was aware of or participated in the negotiation of eight transactions for which Critical Path improperly recorded revenue of approximately $10.8 million for the third and fourth quarters of fiscal 2000. Defendant Timothy J. Ganley, a vice president of sales, played a role in one of these transactions, a fictitious sale for which Critical Path improperly recorded revenue of $2 million in the fourth quarter of 2000. Ganley then illegally sold 1,300 shares of Critical Path stock on January 11, 2001-one week before Critical Path announced its inflated fourth quarter and fiscal year 2000 financial results-based on information he possessed about the fraud and the company's true financial condition.
2. As a result of the revenue recognition fraud, Critical Path filed materially incorrect financial statements with the Commission on November 14, 2000 for the quarter ended September 30, 2000, and on January 18, 2001 issued a press release announcing materially incorrect financial results for the quarter and year ended December 31, 2000. The fraud was uncovered in February 2001. In April 2001, Critical Path restated its financial results for the third quarter and revised results for the fourth quarter and full year 2000, as follows:1
3. By engaging in the acts alleged in this complaint, Thatcher and Ganley violated, or aided and abetted violations of, the antifraud, books and records, internal accounting controls, and reporting provisions of the federal securities laws, and unless enjoined by this Court will continue to do so.
4. This Court has jurisdiction pursuant to Sections 21(d) and (e), 21A and 27 of the Securities Exchange Act of 1934 (Exchange Act) [15 U.S.C. Sections 78u(d) and (e), 78u-1 and 78aa]. The Commission requests that the Court permanently enjoin both defendants from engaging in further violations; impose civil penalties upon them for participating in the accounting fraud; bar Thatcher from acting as an officer or director of any reporting company; and order Ganley to disgorge the amount by which he was unjustly enriched, plus prejudgment interest, and pay civil penalties for insider trading.
5. Defendants, directly or indirectly, used the means or instrumentalities of interstate commerce, or of the mails, or the facilities of a national securities exchange in connection with the transactions, acts, practices, and courses of business alleged in this complaint.
6. Certain of the acts, practices, and courses of conduct constituting the violations of law alleged in this complaint occurred within this judicial district.
7. Assignment to the San Francisco Division is appropriate pursuant to Civil Local Rule 3-(d) because a substantial part of the conduct alleged in this complaint occurred in the County of San Francisco, in the Northern District of California.
8. Defendant David A. Thatcher, age 46, was president of Critical Path, Inc. from January 31, 2000 until he left the company in February 2001. For part of that period-from approximately December 6, 2000 until approximately January 3, 2001-Thatcher was also Critical Path's acting chief financial officer. He was a member of Critical Path's board of directors from May 1997 until March 1998, and again from May 1998 through November 1998. From December 1998 until January 2000, Thatcher was Critical Path's executive vice-president, secretary, and chief financial officer. As chief financial officer, he signed Critical Path's reports on Form 10-Q filed with the Commission for the first three fiscal quarters of 1999. Throughout his employment at Critical Path he was licensed as a CPA (inactive) in California. From approximately 1981 until 1989, Thatcher worked as an auditor for the public accounting firms Touche Ross and Price Waterhouse. Thatcher resides in Rancho Santa Fe, California.
9. Defendant Timothy J. Ganley, age 45, was a vice president of sales of Critical Path from August 1999 until February 2001. He joined Critical Path as a sales director in November 1998. Ganley resides in Aptos, California.
10. Critical Path is a California corporation with principal offices in San Francisco. From its initial public offering in March 1999 to the present, Critical Path's common stock has been registered with the Commission pursuant to Section 12(g) of the Exchange Act [15 U.S.C. Section 78l(g)] and has been quoted on the Nasdaq Stock Market. The company is a provider of Internet messaging infrastructure products and services.
MID-2000: CRITICAL PATH PREDICTS IT WILL BE PROFITABLE IN THE FOURTH QUARTER
11. On July 19, 2000, Critical Path reported a loss for the second quarter of fiscal 2000 of $20.2 million or thirty-four cents per share (excluding special charges). When the company's chief executive officer announced these results, he predicted that for the fourth quarter of 2000 Critical Path would, for the first time, report a profit (excluding special charges).
THATCHER AND OTHERS INFLATE CRITICAL PATH'S THIRD QUARTER REVENUES
12. In late September 2000, to meet consensus revenue and earnings estimates for the third quarter issued by analysts who followed the company, Thatcher and other Critical Path personnel engaged in two transactions that the company should not have reported, but did report, as revenue in its financial statements filed with the Commission in its report on Form 10-Q.
13. One of the two transactions was a $3.09 million barter transaction that Thatcher, along with others at Critical Path, negotiated with a business software company. On September 28, 2000, the counter party agreed to buy out an existing periodic royalty obligation to Critical Path for $2.85 million and to buy another$240,500 of software. In exchange, Thatcher signed an agreement obligating Critical Path to buy about $4 million of software and services from the business software company, $2.6 million more than Critical Path was set to purchase just days before.
14. To recognize revenue from this barter transaction-an exchange of goods and services in which the two sides were contingent on one another-in conformity with Generally Accepted Accounting Principles (GAAP), Critical Path had to (a) value the exchange at the fair value of either the software it received from, or the software it sent to, the business software company, and (b) ascribe a value to the software it was receiving that reasonably reflected its expected use of the software.4 Thatcher knew, or was reckless in not knowing, that the dollar amounts assigned to the two transactions were not based on fair value, and that the dollar amounts had increased not because Critical Path needed much of the software it was purchasing but because Critical Path needed more revenue in the third quarter.
15. To make the two transactions look like they were not contingent on one another, Thatcher, along with other Critical Path personnel, arranged for the parties to prepare two separate contracts, exchange checks for the full amounts owed, and make their payments to each other on different days.
16. Critical Path recorded a $3.09 million sale to the business software company as revenue for the third quarter. Thatcher knew, or was reckless in not knowing, that Critical Path should not have recorded, but did record, this transaction as revenue. In April 2001, after completing an internal investigation and annual audit, Critical Path permanently reversed the entire $3.09 million.
17. The second of the two transactions was also completed just before the third quarter ended. An Internet portal company agreed to purchase $536,000 worth of Critical Path software, but only on the condition that payment terms be extended from 30 days-Critical Path's standard payment terms-to 100 days. In a September 20, 2000 e-mail to the Internet portal company, Thatcher stated: "If cash terms are specifically extended, then revenue recognition is correspondingly extended. Understanding your need for optics to the investment community, can we agree to say payment terms of thirty days with the understanding that we will not collect this for say 100 days (getting the optics through the end of this quarter and the end of next quarter)? Given your cash position (approx $170 mil), no one will notice this." Thatcher later put this agreement to extend payment terms to 100 days in a side letter, and intentionally failed to provide the side letter to Critical Path's finance department or to disclose to that department that he had extended payment terms. Critical Path included the revenue from this transaction in its third quarter financial statements. After completing its internal investigation and annual audit, Critical Path reversed the entire $536,000 amount-because of, among other things, the extended payment terms Thatcher had granted in his secret side letter-with plans to recognize the revenue in a later period.
18. By including in third quarter revenue these two (and other) later-restated transactions, Critical Path exceeded consensus earnings estimates for the quarter. On October 19, 2000, Critical Path announced third quarter revenue of $45 million and a loss of fourteen cents per share (excluding special charges), beating consensus estimates. On November 14, 2000, the company filed financial statements with the Commission for the quarter ended September 30, 2000 that improperly included revenue from the later-restated transactions.
THATCHER AND OTHERS CONCLUDE THAT CRITICAL PATH WILL PROBABLY NOT BE ABLE TO MEET ITS FOURTH QUARTER GOALS BY LEGITIMATE MEANS
19. In October 2000, Critical Path's chief executive officer publicly stated that the company was increasing its fourth quarter revenue estimate from $54 million to $56 million and reiterated his earlier prediction that the company would earn its first quarterly profit-one cent per share. On November 2, Critical Path issued a press release reiterating that guidance.
20. By the final week of December 2000, however, Thatcher and others at Critical Path believed that there was no legitimate means by which the company could achieve the revenue and earnings goals the company had announced. Thatcher told the company's sales chief to get approximately $4 million in "back pocket" deals (meaning fictitious sales that would be recorded as revenue only if needed). Thatcher also told the sales chief that when the purported customers failed to pay, Critical Path could use its bad debt reserve to absorb the losses.
21. Thatcher knew, or was reckless in not knowing, that GAAP (in particular, AICPA Statement of Position 97-2) required that Critical Path satisfy the following four criteria prior to recognizing revenue on the sale of its software: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the vendor's fee is fixed or determinable, and (iv) collectibility is probable. With the delivery criterion in mind, on December 27, 2000 Thatcher e-mailed the sales chief: "Make sure that any deals which may be completed after year end have had software shipped before year end."
GANLEY AND OTHER SALESMEN ARRANGE A $2 MILLION FICTITIOUS SALE; THATCHER ALTERS A CUSTOMER'S E-MAIL
22. The sales chief and other Critical Path sales personnel, including Ganley, implemented the plan to get back pocket deals. On or about December 29, 2000, two Critical Path salesmen called a former Critical Path employee who was working for a ticket brokerage firm to ask him to sign a product evaluation agreement to help Critical Path with its year-end numbers. On or about January 4, 2001, Ganley told the former employee that two salesmen would bring him a final agreement to sign, and assured him that chances were 99 percent that the contract would never be used (meaning included in Critical Path's revenue). Ganley also told the former employee that, even if the contract were used, Critical Path would not ship any product to, or invoice, the ticket brokerage firm. The former employee received from Critical Path a software license agreement providing for the ticket brokerage firm to pay Critical Path $2 million. On January 5, 2001, the former employee signed the agreement and backdated his signature to December 29, 2000, and then returned the signed, backdated agreement to Critical Path.
23. In spite of Ganley's assurances to the contrary, Critical Path shipped the product to the ticket brokerage firm. When the former employee informed Ganley of this, Ganley told him to throw the product away and not let anybody see it.
24. In mid-January 2001, Critical Path's finance department requested proof from the ticket brokerage firm that it could pay for its purported $2 million purchase. On January 16 the former employee e-mailed a Critical Path salesman a summary of the ticket brokerage firm's capitalization, which showed that it had received $250,000 in a private placement two months before. The salesman forwarded the e-mail to Thatcher. Thatcher altered the e-mail to say that the customer had received funding in the amount of $12,500,000. Thatcher forwarded the altered e-mail to Critical Path's finance department, believing that it would be provided to Critical Path's auditors, and believing that the altered e-mail would deceive the auditors about the customer's ability to pay Critical Path.
25. When Critical Path initially announced its fourth quarter results in January 2001, it included in revenue the $2 million recorded for the purported software license agreement with the ticket brokerage firm. In April 2001, after completing the internal investigation and annual audit, Critical Path permanently reversed this revenue.
THATCHER AND OTHERS PARTICIPATE IN OTHER FICTITIOUS, CONTINGENT, AND BACKDATED TRANSACTIONS
26. In early January 2001, Critical Path personnel, with Thatcher's knowledge and consent, engaged in two other transactions for which Critical Path improperly recorded revenue totaling $4.346 million in the fourth quarter. One of the transactions-with a near-bankrupt Internet shopping provider, from which $2.125 million revenue was recorded-was fictitious. The other transaction-with a company that provides Internet access to schools, from which $2.221 million revenue was recorded-included two secret side letters that allowed the company to void the transaction at its sole discretion. Thatcher authorized the use of a side letter in that transaction. He also understood that the $2.221 million contract had been backdated to December 2000. After completing the internal investigation and annual audit, Critical Path permanently reversed the revenue from both of these transactions.
27. Also, with Thatcher's knowledge and consent, Critical Path employees closed in early January 2001 and backdated to December three sales agreements valued at a total of $825,000. Critical Path included these sales in the fourth quarter results it initially announced. In April 2001, after completing the internal investigation and annual audit, Critical Path permanently reversed this revenue.
28. On or about January 11, 2001, Critical Path employees, with Thatcher's approval, backdated to December a $750,000 sale just made to a multimedia software company. Critical Path's new CFO (who had reported for work on January 3, 2001) learned that the contract had been backdated and did not permit the sale to be included in fourth quarter results.
CRITICAL PATH MATERIALLY OVERSTATES RESULTS BUT STILL MISSES FOURTH QUARTER ESTIMATES
29. After the Nasdaq Stock Market closed on January 18, 2001, Critical Path announced unaudited condensed consolidated operating results for the fourth quarter and year 2000 "prepared and presented in accordance with generally accepted accounting principles." The results the company announced for the fourth quarter were materially overstated but still below consensus estimates for both revenue and earnings. Critical Path had forecast a one cent per share profit on revenue of $54 to $56 million. It now reported a net loss of $11.5 million for the quarter (excluding special charges), or sixteen cents per share, on revenue of $52 million. On news of the missed quarter Critical Path's stock price plummeted. By the close of the first full day of trading after the announcement, it had dropped 55%, from $20 to $9.
CRITICAL PATH FORCES OUT THATCHER, GANLEY AND OTHERS;
30. On February 2, 2001, before the Nasdaq Stock Market opened, Critical Path issued a press release disclosing that its board had formed a special committee to conduct an investigation into the company's revenue recognition practices, and that it now believed that the results the company announced on January 18 might have been materially misstated. It further stated that the board had placed Thatcher and the company's sales chief on administrative leave. Nasdaq suspended trading in the stock pending the company's release of accurate financial results.
31. On or about February 5, Thatcher falsely told a reporter working on the Critical Path story, "As far as I know, all deals were legitimate deals." On February 9, Thatcher and the sales chief were forced to resign from Critical Path. A few days later, Critical Path fired Ganley and others.
32. Trading in Critical Path's stock resumed on February 15 after the company announced, on a preliminary basis, that it would revise its fourth quarter revenue downward by between $6.5 and $8 million, and that approximately $4.2 million of the revision would involve transactions that would never result in revenue. That day Critical Path's share price closed at $3.06, a decline of approximately 70% from $10.06, the last Nasdaq price before the trading halt.
CRITICAL PATH RESTATES ITS RESULTS
33. Critical Path's report on Form 10-K for fiscal 2000-filed with the Commission on April 5, 2001-restated and revised the company's financial results as shown in the chart in paragraph 2 above.
GANLEY'S UNLAWFUL INSIDER TRADING DURING
34. On January 11, 2001, a week before Critical Path's January 18 negative earnings announcement, Ganley sold 1,300 shares of Critical Path stock for proceeds of $31,885. Ganley sold these shares at least in part because he knew that the company had recorded a material amount of revenue in the fourth quarter from backdated and fictitious software license agreements, and that if the market learned of Critical Path's true financial results, the company's stock price would fall.
35. Ganley knew the company's blackout rules did not permit him to sell company stock on January 11. On November 30, 2000, all Critical Path employees had received an e-mail from the company's stock administrator saying that the trading window for Group A&B Insiders (which Ganley knew included mid-level sales managers like himself) would be closed from December 6, 2000 until the close ofbusiness on the second day following the company's announcement of its fourth quarter results. Also on November 30, 2000, the stock administrator e-mailed Critical Path's worldwide staff an "URGENT reminder re Insider Trading Policy" and attached to it a copy of Critical Path's insider trading policy, which warned against trading on material nonpublic information and prohibited Group B Insiders (which included Ganley) from trading during the first month of any calendar quarter when Critical Path's trading window was closed (which included January 2001).
36. As a result of Critical Path's February 2 and February 15, 2001 announcements that its previously disclosed financial results might have been materially misstated and would be revised downward, the company's stock price declined dramatically. Ganley avoided losses of $27,950 by selling 1,300 shares of company stock before that decline.
Thatcher and Ganley Violated Section 10(b) of the Exchange Act [15 U.S.C.
37. Paragraphs 1 through 36 are realleged and incorporated herein by reference.
38. Thatcher knowingly or recklessly participated in misrepresentations and omissions of fact with the intent of materially inflating Critical Path's reported third quarter 2000 revenue and earnings.
39. Thatcher and Ganley knowingly or recklessly participated in misrepresentations and omissions of fact with the intent of materially inflating Critical Path's publicly-announced fourth quarter and fiscal year 2000 revenue and earnings.
40. By reason of the foregoing, defendants Thatcher and Ganley violated Section 10(b)of the Exchange Act [15 U.S.C. Section 78j(b)] and Rule 10b-5thereunder [17 C.F.R. Section 240.10b-5].
Ganley Violated Section 10(b) of the Exchange Act [15 U.S.C. Section 78j(b)] and Exchange Act Rule 10b-5 [17 C.F.R. Section 240.10b-5]
41. Paragraphs 1 through 40 are realleged and incorporated by reference herein.
42. Ganley sold Critical Path stock on the basis of material nonpublic information concerning Critical Path's true financial condition, in breach of his fiduciary duty to Critical Path and its shareholders.
2. By reason of the foregoing, defendant Ganley violated Section 10(b) of the Exchange Act [15 U.S.C. Section 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. Section 240.10b-5].
Thatcher and Ganley Violated Section 13(b)(5) of the Exchange Act [15 U.S.C. Section 78m(b)(5)] and Exchange Act Rule 13b2-1[17 C.F.R. Section 240.13b2-1] and Aided and Abetted Violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. Sections 78m(b)(2)(A) and 78m(b)(2)(B)]
[Books-and-Records and Internal-Controls Violations]
44. Paragraphs 1 through 43 are realleged and incorporated herein by reference.
45. Thatcher deliberately circumvented existing internal accounting controls in order to falsify Critical Path's books and records. Ganley, based on the allegations above regarding the ticket brokerage deal reported for the fourth quarter of 2000, deliberately circumvented existing internal accounting controls in order to falsify Critical Path's books and records.
46. Thatcher, directly or indirectly, falsified or caused to be falsified, books, records, or accounts described in Section 13(b)(2) of the Exchange Act [15 U.S.C. Section 78m(b)(2)]. Ganley, based on the allegations above regarding the ticket brokerage transaction reported for the fourth quarter of 2000, directly or indirectly, falsified or caused to be falsified, books, records, or accounts described in Section 13(b)(2) of the Exchange Act [15 U.S.C. Section 78m(b)(2)].
47. Thatcher knowingly and substantially participated in a scheme to cause extensive false and misleading entries in Critical Path's books and records. Ganley, based on the allegations above regarding the ticket brokerage transaction reported for the fourth quarter of 2000, knowingly and substantially participated in a scheme to cause extensive false and misleading entries in Critical Path's books and records. By doing so, Thatcher and Ganley aided and abetted Critical Path's failure to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflected the company's transactions and dispositions of its assets.
48. Thatcher knowingly and substantially contributed to Critical Path's failure to maintain its internal accounting controls. Ganley, based on the allegations above regarding the ticket brokerage transaction reported for the fourth quarter of 2000, knowingly and substantially contributed to Critical Path's failure to maintain its internal accounting controls. By doing so, Thatcher and Ganley aided and abetted the company's failure to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with GAAP.
49. By reason of the foregoing, Thatcher and Ganley violated Section 13(b)(5) of the Exchange Act [15 U.S.C. Section 78m(b)(5)] and Exchange Act Rule 13b2-1 [17 C.F.R. Section 240.13b2-1], and aided and abetted violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. Sections 78m(b)(2)(A)and 78m(b)(2)(B)].
Thatcher Aided and Abetted a Violation of Section 13(a) of the Exchange Act [15 U.S.C. Section 78m(a)] and Exchange Act Rule 13a-13 [17 C.F.R. Section 240.13a-13]
50. Paragraphs 1 through 49 are realleged and incorporated herein by reference.
51. Thatcher knowingly and substantially participated in Critical Path's inclusion of financial statements that were not presented in conformity with GAAP in its report filed with the Commission on Form 10-Q for the quarter ended September 30, 2000.
52. By reason of the foregoing, Thatcher aided and abetted a violation of Section 13(a) of the Exchange Act [15 U.S.C. Section 78m(a)] and Exchange Act Rule 13a-13 [17 C.F.R. Section 240.13a-13].
PRAYER FOR RELIEF
WHEREFORE, the Commission respectfully requests that this Court:
Permanently restrain and enjoin Thatcher, and his agents, servants, employees, attorneys, and assigns, and those persons in active concert or participation with him, and each of them, from violating Sections 10(b) and 13(b)(5) of the Exchange Act [15 U.S.C. Sections 78j(b) and 78m(b)(5)] and Exchange Act Rules 10b-5 and 13b2-1 [17 C.F.R. Sections 240.10b-5 and 240.13b2-1], and from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. Sections 78m(a), 78m(b)(2)(A), and 78m(b)(2)(B)] and Exchange Act Rule 13a-13 [17 C.F.R. Section 240.13a-13].
Permanently restrain and enjoin Ganley, and his agents, servants, employees, attorneys, and assigns, and those persons in active concert or participation with him, and each of them, from violating Sections 10(b) and 13(b)(5) of the Exchange Act [15 U.S.C. Sections 78j(b) and 78m(b)(5)] and Exchange Act Rules 10b-5 and 13b2-1 [17 C.F.R. Sections 240.10b-5 and 240.13b2-1], and from aiding and abetting violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. Sections 78m(b)(2)(A) and 78m(b)(2)(B)].
Order each of the defendants to pay civil monetary penalties under Section 21(d)(3) of the Exchange Act [15 U.S.C. Section 78u(d)(3)].
Enter an order under Section 21(d)(2) of the Exchange Act [15 U.S.C. Section 78u(d)(2)] prohibiting Thatcher 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. Section 78l] or that is required to file reports pursuant to Section 15(d) of the Exchange Act [15 U.S.C. Section 78o(d)].
Order Ganley to disgorge all losses avoided from his unlawful trading alleged in this complaint, with prejudgment interest.
Order Ganley to pay civil monetary penalties under Section 21A of the Exchange Act [15 U.S.C. Section 78u-1].
Grant such other relief as this Court may deem just and appropriate.