SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 16728 / September 27, 2000
Accounting and Auditing Enforcement Release No. 1312
SECURITIES AND EXCHANGE COMMISSION v. JOHN DAWS, THOMAS BUTLER AND MARK FOLIT, United States District Court for the Northern District of California, Civil Action No. C00-20797 EAI
The U.S. Securities and Exchange Commission today filed an action in federal district court in San Francisco against three former officers of Silicon Valley-based Cylink Corporation ("Cylink" or the "Company") for their roles in a financial reporting fraud that overstated Cylink's results by millions of dollars in 1997 and 1998. In a separate action, the Commission brought charges against Cylink for related violations. According to the filings, in order to meet Cylink's ambitious revenue goals, former Cylink officers led the Company to recognize revenue on numerous transactions that violated Cylink's own revenue recognition policy, generally accepted accounting principles or both. Cylink overstated its quarterly revenue by as much as 97.5% during the period of the fraud, according to the filings.
Named in the Commission's federal court suit were: former Chief Financial officer John Daws, age 56, of Orinda, California; former Vice President of Sales Thomas Butler, age 52, of Pebble Beach, California; and former head of North American Sales Mark Folit, age 39, of New York, New York. The Commission's complaint charges each defendant with securities fraud (Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder); circumvention of Cylink's internal controls and falsification of records (Section 13(b)(5) of the Exchange Act and Rule 13b2-1 thereunder); and aiding and abetting Cylink's violations of the periodic reporting and books and records provisions (Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder) of the federal securities laws. In addition, the complaint charges Daws with failing to devise and maintain adequate internal accounting controls (Section 13(b)(2)B) of the Exchange Act) and failing to provide material information to Cylink's outside auditors in connection with Cylink's 1997 audit (Exchange Act Rule 13b2-2).
In a separate action, the Commission instituted, and simultaneously settled, administrative cease-and-desist proceedings against Cylink. The Commission's Order Instituting Proceedings ("Order") finds that Cylink materially misstated its financial results for the fourth quarter of fiscal 1997 and the first two quarters of fiscal 1998 and directs Cylink to cease and desist from violations of the periodic reporting, internal controls and books and records provisions. Cylink consented to issuance of the Order without admitting or denying its findings.
The Commission's complaint alleges that during the first two quarters of fiscal 1998, Daws, Butler and Folit led Cylink fraudulently to recognize millions of dollars in revenue. For example, the complaint alleges that in the second quarter of fiscal 1998, Cylink recognized over $900,000 in revenue on a transaction that was not final because the customer still had up to 90 days to cancel the order. In another instance alleged in the complaint, Cylink recognized revenue on orders from a distributor even though the defendants had reason to believe the distributor could not pay for the product. The complaint also alleges that Cylink recognized revenue on software product orders that were contingent on the customers' rights to exchange the software for Cylink hardware products. Under both the Company's revenue recognition policy and generally accepted accounting principles, it was improper for Cylink to recognize revenue on these transactions.
The complaint further alleges that Daws led Cylink fraudulently to recognize revenue on a fourth quarter fiscal 1997 transaction that was not final because Cylink's customer had not provided a letter of credit to support the order. Despite the absence of a letter of credit, Cylink shipped product for this order to a warehouse, stored it there for several months pending receipt of the letter of credit, and improperly recognized revenue on the transaction during fiscal 1997.
After the fraud was uncovered, Cylink issued restated financials that sharply reduced its results for the periods in question. For the first quarter of fiscal 1998, the Company restated revenue from $15.8 million to $8 million (a 97.5% overstatement) and net income from continuing operations of $1.1 million to a net loss from continuing operations of $3.4 million. For the second quarter of fiscal 1998, the Company restated revenue from $18 million to $12.4 million (a 45% overstatement) and net income of $1.7 million to a net loss of $1.7 million. Finally, for the fourth quarter of fiscal 1997, Cylink restated net income from discontinued operations from $4.5 million to $3.2 million (a 41.7% overstatement).
The complaint seeks injunctions against each defendant, as well as disgorgement of personal profits received as a result of the fraud, plus monetary penalties.