Tuesday, October 31, 2006

Former Delphi CEO and Other Executives Charged by SEC with Securities Fraud

Delphi Corp. and a number of its former senior executives, most prominently CEO J.T. Battenberg and CFO Alan Dawes, were accused of securities fraud by the SEC in connection with the company's accounting for four transactions.  The SEC Litigation Release (here) describes the four items that affected the company's earnings, revenue, or cash flow:

In 2000, Delphi engaged in two fraudulent accounting and disclosure schemes, which had the purpose of and ultimately resulted in Delphi hiding a $237 million warranty claim asserted by its former parent company and inflating its net income by $202 million.

In the fourth quarter of 2000, Delphi entered into two improper inventory schemes, through which it agreed to sell approximately $270 million of metals, automotive batteries and generator cores to two third parties at year end, while simultaneously agreeing to repurchase the inventory in the following quarter for the original sales price, plus interest charges and structuring fees. The purpose and result of the schemes was for Delphi to inflate its cash flow from operations by $200 million, engineer $270 million in inventory reductions and improperly report $80 million in net income.

In the fourth quarter of 2001, Delphi solicited a $20 million lump sum payment from an IT company in return for Delphi providing new business to the IT company. Delphi agreed to repay the $20 million over five years, with interest, which made the payment, in substance, a loan to the IT company. However, in order to meet earnings forecasts for the quarter, Delphi improperly accounted for the $20 million payment as if it was a nonrefundable rebate on past business, rather than a liability.

From 2003 to 2004, Delphi hid up to $325 million in factoring, or sales of accounts receivable, in order to improperly boost non-GAAP, pro forma measures of Delphi's financial performance that were relied upon by investors, analysts and rating agencies. Hiding this factoring allowed Delphi to overstate materially its "Street Net Liquidity," a pro forma measure, during that two-year period. In addition, in one quarter, Delphi also manipulated the hidden factoring to create a false $30 million boost in its "Street Operating Cash Flow," another pro forma measure.

Note that the transactions appear at the end of the year, or bridge two years, so that the prior year's financial statements were dressed-up for Wall Street.  The numbers involved are not all that large, at least for a company with billions of dollars in annual revenues, but the deals provided the last little bit of earnings to make the quarterly/annual numbers, or hide problems in Delphi's auto parts business from Wall Street, at least for a little while.  The company entered bankruptcy in 2005, and by settling the SEC action it gets itself all ready to emerge from that process, most likely under the control of a private equity firm.  The firm will not have to pay a penalty, and the Litigation Release notes that Delphi's cooperation in the investigation earned it a pass on having to make a payment.

The 2000 warranty issue implicates Delphi's former parent, General Motors, in the accounting issues.  According to the SEC's complaint (here), Battenberg and Dawes met with GM executives to resolve a dispute about how much Delphi owed GM for warranty claims from before the spin-off.  At a meeting, GM executives apparently suggested "asymmetrical" accounting for the payment so that the effects on each company would appear differently.  Needless to say, such a suggestion, if true, would cast doubt on GM's books if it did not properly record the transaction in order to help Delphi hide the true nature of the $237 million payment to settle the claim.

Naming Delphi's former CEO Battenberg, who retired just before disclosure of the SEC investigation, shows that the SEC is serious about holding senior management responsible.  The only high level executive to settle the case was former CFO Dawes, who agreed to a a five-year ban from serving as an officer or director of a public company, and to pay disgorgement of $253,000, interest of $134,000, and a $300,000 penalty.  The company's former chief accounting officer and its treasurer are also named and have not agreed to settle.  Dawes will likely play a key role in the case, assuming he is cooperating.  There is an ongoing grand jury investigation of the transactions, and Dawes may have agreed to a guilty plea in that phase if there is sufficient evidence of criminal conduct, which would probably entail cooperation in any criminal and civil cases.  Once again, the former CFO can be the key witness in an accounting fraud case that targets the CEO of a company. (ph)

http://lawprofessors.typepad.com/whitecollarcrime_blog/2006/10/delphi_ceo_and_.html

Civil Enforcement, Fraud, Securities | Permalink

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