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Securities and Exchange Commission v. Mark Leslie


January 13, 2012


The opinion of the court was delivered by: Jeremy Fogel United States District Judge

E-Filed 1/13/2012


Defendant Kenneth E. Lonchar ("Lonchar") seeks partial summary judgment with respect to Claims One, Two, and Five asserted against him by Plaintiff Securities and Exchange Commission 21 ("the SEC").*fn1 Lonchar contends that to the extent that those claims are based upon his alleged 22 "smoothing" of revenue and earnings, the SEC cannot prove the requisite element of legal 23 materiality. The Court has considered the briefing and admissible evidence, as well as the oral 24 argument presented at the hearing on December 9, 2011. For the reasons discussed below, the 25 motion will be denied.

July 29, 2010 ("July 29 Order") and need not be set forth in full here. In brief, the SEC brought this 4 action against several former officers, directors, and executives of Veritas Software Corporation 5 Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange 7

Act"). Lonchar, the sole remaining defendant, served as Veritas's chief financial officer ("CFO") 8 from April 1997 until he resigned in October 2002. 9 CFO. First, the SEC accuses Lonchar and others of artificially inflating the company's revenue with respect to a September 2000 transaction in which Veritas agreed to increase the licensing fee it had quoted to America Online, Inc. ("AOL") by $20 million while simultaneously contracting to 13 purchase $20 million worth of advertising from AOL. In 2003, Veritas announced that it would 14 restate its financials relating to the AOL transaction. Second, the SEC accuses Lonchar of engaging 15 in accounting manipulation in order to "smooth" revenue and earnings between 2000 and 2002.

Lonchar allegedly: (1) manipulated the company's deferred revenue balances to make it appear that 17 deferred revenue increased quarter-over-quarter; (2) directed that a portion of the company's earned 18 professional service revenue go unrecognized so that license revenue appeared to be a larger 19 percentage of total revenue; and (3) maintained excess quarterly accrued loss balances in order to 20 establish a "cookie jar" reserve that could be released when needed to bump up the company's net 21 income and earnings per share. In 2004, Veritas announced that it would restate its financials for 22 the years 2001 and 2002, including the corresponding interim periods, and for the first three quarters 23 of 2003 ("the 2004 Restatement"). The company's stock dropped significantly on this news. 24

In its July 29 Order, the Court granted in part and denied in part Lonchar's motion for partial 25 summary judgment with respect to claims based upon the AOL transaction. Lonchar now seeks 26 partial summary judgment with respect to certain claims based upon the "smoothing" allegations, in 27 particular, claims under § 10(b) of the Exchange Act, § 17(a) of the Securities Act, and Rule 13b2-2 28 promulgated under the Exchange Act (Claims One, Two, and Five).


The circumstances underlying this lawsuit are described in detail in this Court's order of ("Veritas" or "the company") in 2007, alleging fraud and record keeping violations under the 6

The claims against Lonchar are grounded in two distinct courses of conduct he undertook as standard applied to a motion seeking summary judgment with respect to the entire case. Urantia 4 Foundation v. Maaherra, 895 F. Supp. 1335, 1335 (D. Ariz. 1995). "Summary judgment is proper 5 where no genuine issue of material fact exists and the moving party is entitled to judgment as a 6 matter of law." Samuels v. Holland American Line-USA Inc., 656 F.3d 948, 952 (9th Cir. 2011) 7


The standard applied to a motion seeking partial summary judgment is identical to the (citing Fed. R. Civ. P. 56(a)). "In considering a motion for summary judgment, we must draw all 8 reasonable inferences in favor of the nonmoving party." Id. "The central issue is 'whether the 9 evidence presents a sufficient disagreement to require submission to a jury or whether it is so one-10 sided that one party must prevail as a matter of law.'" Id. (quoting Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 251--52 (1986)).

must prove that the misstatements in question were material. SEC v. Leslie, No. C 07-3444, 2010 15 reasonable investor would assign to the withheld or misrepresented information." United States v. 17 (1988)). "To be material, 'there must be a substantial likelihood that the disclosure of the omitted 19 fact would have been viewed by the reasonable investor as having altered the 'total mix' of 20 information made available.'" Id. (quoting Basic, 485 U.S. at 231-32). In a securities fraud action, 21 materiality is a "fact-specific issue[]" that "should ordinarily be left to the trier of fact," although 22

Cir. 1994) (internal quotation marks and citation omitted). 24

Before turning to the merits, the Court will address Lonchar's evidentiary objections. First, Lonchar objects to the SEC's reliance upon deposition transcripts and investigative testimony 27 transcripts on the basis that the SEC failed to submit a signed reporter's certification with each 28


This Court has held that to prevail on the claims that are the subject of this motion, the SEC WL 2991038, at *28 (N.D. Cal. July 29, 2010). "Materiality depends on the significance that a Reyes, 577 F.3d 1069, 1075 (9th Cir. 2009) (citing Basic Inc. v. Levinson, 485 U.S. 224, 240 18 "summary judgment may be granted in appropriate cases." Kaplan v. Rose, 49 F.3d 1363, 1375 (9th 23 A. Lonchar's Evidentiary Objections 25 transcript.*fn2 The SEC represents that it is prepared to produce witnesses at trial who can testify from 2 personal knowledge as to the contents of the transcripts. This representation is sufficient for 3 purposes of a motion for summary judgment. See Fraser v. Goodale, 342 F.3d 1032, 1036-37 (9th 4 Cir. 2003) (holding that a party opposing summary judgment need not produce evidence that would 5 be admissible at trial as long as the party could present the evidence in admissible form at trial). 6

Moreover, the Court notes that Lonchar himself has cited a number of the same deposition 7 transcripts to which he objects, that certain of the investigative testimony transcripts were 8 authenticated during depositions, and that the SEC has provided certifications of the remaining 9 transcripts in response to Lonchar's objection. 10 cited evidence and therefore should be stricken. The Court declines to strike material from the briefs. However, while the Court has considered all of the argument presented by both sides, the 13 Next, Lonchar asserts a lack of foundation for witness testimony regarding financial 15 documents where the witness did not prepare the documents. "Personal knowledge, however, is not strictly limited to activities in which the declarant has personally participated." Washington Cent. R. 17 Co., Inc. v. Nat'l Mediation, 830 F. Supp. 1343, 1353 (E.D. Wash. 1993). "Based on personal 18 knowledge of the files and records, a declarant may testify to acts that she or he did not personally 19 observe but which are described in the record, including requests or statements by third persons 20 made to someone other than the declarant." Id.; see also Londrigan v. FBI, 670 F.2d 1164, 1174-75 21 (D.C. Cir. 1981) (FBI agent that reviewed file had personal knowledge sufficient to support 22 statements about certain aspects of an investigation in which he had not participated). 23 24 workpapers are inadmissible hearsay. However, the records are admissible as business records 25 under Federal Rule of Evidence 803(6). See In re, Inc., No. CV 01-11115, 2011 26 Lonchar also argues that a number of statements in the SEC's brief are not supported by the Court has based its ruling on the motion on the evidence in the record . 14 Lonchar contends that the company's restated financials and the outside auditor's WL 291176, at *5 (C.D. Cal. Jan. 25, 2011) (restated financials are business records under Federal 27 Rule of Evidence 803(6)); In re Worldcom, Inc. Sec. Litig., No. 02 Civ. 3288 DLC, 2005 WL 2 375313, at *8-9 (S.D.N.Y. Feb. 17, 2005) (restated financials and outside auditor's workpapers are 3 business records). The case relied upon by Lonchar, Paddack v. Dave Christensen, Inc., 745 F.2d 4 1254 (9th Cir. 1984), is distinguishable. In Paddack, the subject documents were special audit 5 reports prepared in anticipation of litigation, not restated quarterly and annual reports or 6 corresponding auditor's workpapers prepared in the ordinary course of business. 7

8 makes the additional objection that the document should be stricken as illegible. The Court agrees 9 that the paper copy of this exhibit is illegible. However, the SEC has electronically filed a copy of 10 the document in "pdf" format that may be viewed on a larger scale to assist reading. Enlarging the pdf document renders the exhibit legible with respect to the relevant data.

Finally, Lonchar objects to certain of the SEC's citations on the ground that the SEC failed 13 to provide pin cites. The SEC has rectified this omission in response to the objections. 14 between 2000 and 2002, discussed as follows: 18

Both sides' experts describe deferred revenue as money that a company has collected before 20 it is earned -- for example, payment for products that have not yet been delivered. Such revenue is 21 not recognizable under Generally Accepted Accounting Principles ("GAAP"); instead it is carried 22 on the company's balance sheet as deferred revenue. The SEC presents the opinion of its 23 accounting expert, Lee Seidler, that deferred revenue is an indicator of future sales: if the deferred 24 revenue balance increases from quarter to quarter it indicates a likelihood of an increase in future 25 sales, while if the balance declines it indicates a potential decline in future sales. Williams Decl., 26 Exh. 19, Seidler Report, at 24. Douglas Newton, who was an assistant controller at Veritas during 27 the period in question, testified that deferred revenue was one of the "key indicators" that Lonchar 28 tracked. Williams Decl., Exh. 5, Newton Inv. Test., at 75-77. It was an item that Lonchar discussed With respect to a particular workpaper from outside auditor KPMG, Exhibit 52, Lonchar

Accordingly, all of Lonchar's evidentiary objections will be overruled.

B. Lonchar's Alleged Misconduct

The SEC presents evidence that Lonchar engaged in three types of accounting manipulation

1. Manipulation of Deferred Revenue Balances during analysts' calls. Id. at 77. Lonchar would state expressly to analysts that "deferred revenue is 2 up sequentially" over the prior quarter. Id. In general, Veritas's reported results reflected a trend in 3 which the deferred revenue balance increased quarter over quarter from 2000 through the second 4 quarter of 2002. Opp., Appx. A. 5 6 decrease from the prior quarter. Williams Decl., Exh. 5, Newton Inv. Test., at 74. Lonchar was 7 upset that he had not been informed of this fact earlier. Id. at 74-75. He directed Newton to diverge 8 from normal company practice and include in the deferred revenue balance items that had been 9 billed but not actually paid. Id. at 75-76, 79-80, 87. Normally, Veritas calculated its deferred 10 revenue balance by tallying all contracts for which the revenue was not yet "earned" and then subtracting unpaid contracts from that balance. Linsenmayer Decl., Exh. 9, Newton Depo., at 222-

23. Lonchar changed this practice for the second quarter of 2002 because "he was trying to manage 13 that [deferred revenue] number up." Williams Decl., Exh. 5, Newton Inv. Test., at 80. Newton 14 passed Lonchar's directive on to a lower level finance employee, Thu Pham, who executed it. Id. at 15 company's deferred revenue balance for the second quarter of 2002 violated GAAP. Williams 17

In the second quarter of 2002, Newton informed Lonchar that deferred revenue would 87-88. According to the SEC's expert, Seidler, the resulting inclusion of unpaid items in the Decl., Exh. 19, Seidler Report, at 25. Veritas's outside auditor, KPMG, caught the overstatement of 18 deferred revenue and raised it at an audit signoff meeting, which was attended by Lonchar, Newton, 19 and others. Williams Decl., Exh. 5, Newton Inv. Test., at 99-100. Because the monetary amount of 20 the overstatement was relatively small -- Newton remembers it being in the $5 million range, and 21 KPMG's later restatement summary indicated that it was in the $7 million range -- KPMG left it to 22 the company to decide whether to correct the overstatement of deferred revenue. See id. at 100; 23

Williams Decl., Exh. 22, KPMG Restatement Issue Summary, at KPMG 98992. Lonchar did not 24 express any desire to do so. Williams Decl., Exh. 5, Newton Inv. Test., at 101. As a result, the 25 deferred revenue balance for the second quarter of 2002 did not decrease relative to the prior 26 quarter. See Appendix A to Opp. 27 28 3 fees. Linsenmayer Decl., Exh. 38, 2004 Restatement, at 54-57. Lonchar paid close attention to the 4 mix between license revenue and professional service revenue. Williams Decl., Exh. 6, Lucas Inv. 5 Test., at 540-41. In at least one analysts' call, Lonchar stated that a higher percentage of service 6 revenue resulted in a decrease in gross margin. Williams Decl., Exh. 11, Veritas Earnings 7

2. Failure to Recognize Earned Professional Service Revenue

Veritas derived revenue primarily from two sources: license fees and professional service Conference Call (July 16, 2002), at 4. In another analysts' call, he predicted that service revenue 8 would constitute just over twenty percent of total revenue and would gain about half a percentage 9 point of total revenue for each sequential quarter. Williams Decl., Exh. 10, Veritas Earnings 10 of total revenue he wanted to be license revenue and what percentage he wanted to be professional service revenue. Williams Decl., Exh. 5, Newton Inv. Test., at 114. When service revenue 13 exceeded what Lonchar had predicted and what he wanted to see, he directed that billing for 14 completed services be deferred into subsequent quarters. Id. at 114-15; Williams Decl., Exh. 6, 15 it was not recognized in the period in which it was earned constituted a violation of GAAP. 17 Conference Call (Jan. 24, 2001), at 5. Before each quarter end, Lonchar articulated what percentage Lucas Inv. Test., at 506-07. Seidler opines that this practice of "rolling forward" revenue such that

Williams Decl., Exh. 19, Seidler Report, at 23-24. 18 "Under GAAP, a company must set up a loss contingency reserve if a future loss is both 20 probable and reasonably estimable." SEC v. KPMG, 412 F. Supp. 2d 349, 364 (S.D.N.Y. 2006) 21 Accounting Standards Bd.1975) ("FAS 5")). "When such a reserve is created, it is charged to 23 current earnings." Id. at 365. Release of an accrual boosts current earnings by the amount of the 24 accrual. Id. "When a reserve is created without a sufficient likelihood that the relevant expense will 25 be incurred, it permits a company to draw on the reserve to cover expenses for which the reserve 26 was not created and thereby artificially boost its earnings in subsequent reporting periods." Id. 27

28 the accrual no longer was necessary or supportable. Williams Decl., Exh. 5, Newton Inv. Test., at 3. Excess Quarterly Accrued Loss Balances (citing Statement of Financial Accounting Standards No. 5: Accounting for Contingencies ¶ 8 (Fin. 22 Lonchar had a practice of directing that accruals remain on a "cushion schedule" even after 160. He micro-managed the cushion schedule: "he would say yes, book that, don't book that, or 2 whatever." Id. at 163. Newton had the impression that Lonchar constantly altered the accrual 3 numbers in order to achieve a desired result on the company's financial statements. Id. at 167-68. 4

KPMG reached the same conclusion: "In certain instances, accruals were recorded in historical 5 periods and released in later periods instead of the period when the accruals were deemed no longer 6 appropriate." Williams Decl., Exh. 23, KPMG Restatement Issue Summary, at KPMG 115318. 7

KPMG auditor Chris Dyer concluded that the purpose of the cushion schedule was "[s]o that if 8 management's numbers . . . for example, their earnings per share were not going to meet analysts' 9 expectations, it was available there for them to take some out and put it in the income, so that 10 earnings per share would meet analysts' expectations." Resp. re Objs., Exh. 5, Dyer Depo. at 279.

The cushion schedule also was referred to as the "Ted" schedule, so named after one of Veritas's in- house attorneys following an employee's comment that "[i]f anybody finds these cushion schedules, 13 we're going to need an attorney." Id. 14

Lonchar repeatedly certified in representation letters that Veritas's financial statements for 2000 through 2002 were in conformity with GAAP and did not contain any fraud or intentional 17 misstatements. In 2004, Veritas restated its financials for the years 2001 and 2002, including the 18 corresponding interim periods, and for the first three quarters of 2003. Linsenmayer Decl., Exh. 38, 19 2004 Restatement. Among other things, the restatement corrected misreported deferred revenue and 20 professional service revenue, and reversed improper accruals. Id. The company's stock dropped 21 significantly on this news. 22

Lonchar contends that the SEC cannot prove that any of the above-described misstatements 24 were legally "material." As noted above, "[t]o be material, 'there must be a substantial likelihood 25 that the disclosure of the omitted fact would have been viewed by the reasonable investor as having 26 altered the 'total mix' of information made available.'" Reyes, 577 F.3d at 1075 (quoting Basic, 485 27 U.S. at 231-32). 28

4. Restatement of Financials

C. Materiality of Lonchar's Misrepresentations 23

2 manipulations were quantitatively negligible. Of the 200 adjustments that went into the 2004 3

While the parties dispute the precise calculations that should be used in quantifying the effect that 5 the alleged manipulations had on Veritas's financials, it appears that even under the SEC's approach 6 there was little or no measurable effect on the company's bottom line.*fn3 Lonchar directs the Court to 7 a number of cases in which minor impacts to revenue and earnings were deemed immaterial as a 8 matter of law. See, e.g., Garber v. Legg Mason, Inc., 537 F. Supp. 2d 597, 613 (S.D.N.Y. 2008) 9

Lonchar argues that taken separately or in the aggregate, the alleged accounting Restatement, sixty relate to the alleged "smoothing" practices described above. Mot., Appx. 1. 4

(omission from prospectus of distribution fees that accounted for only 0.4% of company's annual 10 revenue deemed immaterial as a matter of law); In re Duke Energy Corp. Sec. Litig., 282 F. Supp. 2d 158, 161 (S.D.N.Y. 2003) (inflation of total revenues by 0.3% was immaterial as a matter of law); Smith v. Circuit City Stores, Inc., 286 F. Supp. 2d 707, 720-21 (E.D. Va. 2003) (omission of 13 increased costs totaling 3.25% of company's net annual earnings was immaterial as a matter of law). 14

Even accepting for purposes of the present motion that the effect of the alleged 15 manipulations was quantitatively small, the real thrust of the SEC's claims is that the manipulations were qualitatively material because they altered indicators relied upon by analysts and the market in 17 evaluating Veritas for investment. "[T]he concept of 'materiality' is not limited to a percentage of a 18 company's total profits, but rather requires assessment of qualitative and quantitative factors so that 19 even quantitatively small amounts can still present a materially misleading picture of a company's 20 health." SEC v. Yuen, No. CV 03-4376MRP(PLAX), 2006 WL 1390828, at *37 (C.D. Cal. Mar. 16, 21 2006) (emphasis in original). "[V]arious '[q]ualitative factors may cause misstatements of 22 quantitatively small amounts to be material.'" Ganino v. Citizens United Co., 228 F.3d 154, 163 23 (1999)). In Ganino, the appellate court reversed the district court's ruling that a misrepresentation (2d Cir. 2000) (quoting SEC Staff Accounting Bulletin ("SAB") No. 99, 64 Fed.Reg. 45150, 45152 24 implicating fees totaling 1.7% of the company's total revenue was immaterial as a matter of law. Id. 2 at 162. The court noted that the Supreme Court has rejected a bright-line numerical rule, id. 3

(quoting Basic, 485 U.S. at 236 & n.14), and it held that a misrepresentation of even such a 4 relatively small amount could be material depending upon the circumstances of the particular case, 5 id. at 165. Other courts have reached similar conclusions. See, e.g., SEC v. Fuhlendorf, No. C09-6 1292, 2011 WL 999221, at *7 (W.D. Wash. Mar. 17, 2011) ("quantifying, in percentage terms, the 7 magnitude of a misstatement is only the beginning of an analysis of materiality") (quoting SAB No. 8 2005) ("An error that might not rise to the level of quantitative materiality might still have an impact 10 on software revenue growth or earnings per share such that it would be meaningful to readers of the financial statements, rendering the error qualitatively material."). Evidence of materiality "may be particularly compelling where management has intentionally misstated items in the financial 13 statements to 'manage' reported earnings." SEC v. Escala Group, Inc., No. 09 Civ. 2646 (DLC), 14 64 Fed. Reg. 45150 (1999)).

Here, Lonchar's materiality argument presents a very close question. The numbers in question are relatively small, and the SEC does not present particularly compelling evidence that the 18 public's perception of the company was affected by the alleged manipulations. As Lonchar points 19 out, the SEC does not offer testimony from any investor or broker on this issue. Nonetheless, the 20 Court concludes that considering the evidence as a whole and reasonable inferences that may be 21 drawn therefrom, a finder of fact could conclude that analysts and investors viewed Veritas's 22 deferred revenue trend, mix of license and service revenue, and ability to meet expectations with 23 respect to earnings per share, as significant indicators of the company's health. Thus, it is possible 24 that a reasonable finder of fact could conclude that Lonchar's "smoothing" of the reported data 25 relevant to these indicators was qualitatively material even if the numbers in question were 26 quantitatively small. 27

28 the SEC is asking the trier of fact to infer materiality wholly from the stock drop following the 2004 99); United States v. Hawkins, No. CR 04-106 MJJ, 2005 WL 1660984, at *19 (N.D. Cal. July 11, 9 2009 WL 2365548, at *9 (S.D.N.Y. July 31, 2009) (quoting SEC Staff Accounting Bulletin No. 99, 15 Lonchar argues that because the misrepresentations in question are quantitatively negligible, Restatement. He observes correctly that when complex factors are at play, "a drop in stock price, by 2 itself, does not establish that the decline was caused by the revelation of an earlier 3 misrepresentation." See United States v. Schiff, 538 F. Supp. 2d 818, 835 (D.N.J. 2008). In certain 4 circumstances, an expert may be necessary to help a jury sort through the various factors that may 5 have contributed to the stock drop. See United States v. Singer, No. 9:05-cr-00928, 2010 WL 6 146165, at *4 (D.S.C. Jan. 8, 2010). Lonchar asserts that the SEC cannot present the required 7 expert evidence in this case, because the Court has excluded the testimony of the SEC's expert on 8 legal materiality, Jeffrey Davis, see SEC v. Leslie, 2010 WL at *16, and it has ruled that the SEC's 9 accounting expert, Seidler, may not opine on the subject of legal materiality, see id., 2010 WL at 10 However, as is illustrated by the discussion above, this is not a bare stock drop case.

Moreover, while the Court has ruled that Seidler "may not testify as to legal concepts, the legal 13 interpretation of case law and statutes, or whether specific conduct was fraudulent, intentional, or 14 misleading in the legal sense," this ruling does not impact the admissibility of Seidler's testimony 15 for the purpose of helping a jury understand what Lonchar did and why it was significant from an accounting perspective. Although it is a close call, the Court concludes that this is not an 17 appropriate case in which to deviate from the general rule that materiality is a fact-specific issue that "should ordinarily be left to the trier of fact." See Kaplan, 49 F.3d at 1375. 19

Good cause therefor appearing:

(1) Lonchar's evidentiary objections are OVERRULED; and

(2) the motion for partial summary judgment is DENIED.


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