U.S. Securities and Exchange Commission
Litigation Release No. 18741 / June 9, 2004
Accounting and Auditing Enforcement Release No. 2034 / June 9, 2004
Securities and Exchange Commission v. i2 Technologies, Inc., Civil Action No. 3:04-CV-1250, U.S.D.C./Northern District of Texas (Dallas Division)
In the Matter of i2 Technologies, Inc., Exchange Act Rel. No. 33-8428 (June 9, 2004).
SEC Settles Securities Fraud Case with i2 Technologies, Inc. Involving Misstatement of Approximately $1 Billion in Revenues
i2 Will Pay a $10 Million Civil Penalty
The Securities and Exchange Commission today announced a settled enforcement action against i2 Technologies, Inc. ("i2") in connection with alleged accounting improprieties and misleading revenue recognition by the Dallas-based developer and marketer of enterprise supply chain software and management solutions. i2 agreed to pay a $10 million civil penalty and nominal $1 disgorgement in a civil suit the Commission filed in the United States District Court for the Northern District of Texas (Dallas Division). As part of the settlement, but without admitting or denying the Commission's substantive findings or allegations, i2 consented to the entry of a cease-and-desist order finding that i2 committed securities fraud in accounting for certain software license agreements and in accounting for and improperly disclosing four "barter" transactions. As provided under the Sarbanes-Oxley Act of 2002, the penalty amount will become part of a disgorgement fund for the benefit of injured i2 investors.
In summary, the Commission's cease-and-desist order finds and civil complaint alleges that, for the four years ended December 31, 2001 and the first three quarters of 2002, i2 misstated approximately $1 billion of software license revenues. As a result, i2's periodic filings with the Commission and earnings releases during this period materially misrepresented i2's revenues and earnings.
Specifically, the order finds and complaint alleges that i2 favored up-front recognition of software license revenues, purportedly in accordance with generally accepted accounting principals ("GAAP"). i2's compensation structure fostered this preference, because compensation of sales and pre-sales personnel was largely based on the amount of revenue recognized and cash collected in the current period. However, as i2 knew or recklessly ignored, immediate recognition of revenue was inappropriate for some of i2's software licenses because they required lengthy and intense implementation and customization efforts to meet customer needs. In some cases, i2 shipped certain products and product lines that lacked functionality essential to commercial use by a broad range of users. In other cases, the company licensed certain software that required additional functionality to be usable by particular customers. On still other occasions, i2 exaggerated certain product capabilities, or entered into side agreements with certain customers that were not properly reflected in the accounting for those transactions. In each case, significant modification and customization efforts were necessary to provide the required functionality.
i2 also improperly recorded revenue from four barter transactions during the restatement period. These transactions involved third-party purchases of software licenses from i2, with i2 recognizing the revenue immediately, in exchange for i2's agreement to purchase from the other parties in the future a comparable amount of products or services. In some of these transactions, i2 paid a premium over the prevailing rates for those products or services, in an effort to equalize both sides of the deal. When i2 recorded revenue from these transactions, it could not determine the fair value of the items exchanged within reasonable limits. Accordingly, i2's up-front recognition of license revenue from these transactions was improper under GAAP. Moreover, i2's financial statements and Commission filings failed to disclose the true nature of these transactions, which improperly inflated i2's reported revenues by approximately $44 million.
The Commission also found and alleges that, during the summer of 2001, i2 received two documents flagging issues impacting software license revenue recognition. First, in June 2001, i2 generated a summary of revenue recognition risks, outlining such potential problems as identifying products to meet customer needs after licenses were signed; bundling wrong or incorrectly positioned products in deals; substantial underestimation of implementation services necessary to meet customer needs; the provision of development and customization services without separate formal agreements; and barter transactions.
Second, also in June 2001, i2 received the initial report of a Massachusetts Institute of Technology professor the company had hired to examine its business practices. The professor's report identified serious deficiencies within the organization, from shortcomings in its product and technology strategy to weaknesses in its sales practices, product release management, and quality assurance. Critically, this report indicated that i2's products had largely become "custom" software requiring considerable customization and modification, which would preclude up-front recognition of revenue from these licenses. Neither i2's auditors nor Audit Committee learned of the MIT professor's report until September 2002.
The cease-and-desist order finds and civil complaint alleges that i2 violated Sections 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(5) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder.
The Commission's investigation continues as to other individuals and entities.