Monday, July 25, 2005

KPMG Tagged as "Virtual Pushover" in Xerox Decision.

Judge Alvin W. Thompson (D. Conn.) has denied all of the motions to dismiss in the Xerox securities class action, which brings ’34 Act claims against the company, six of its executives, and KPMG. According to Plaintiffs, Xerox "was able to meet Wall Street's earning expectations only by engaging in massive accounting fraud." In doing so, Defendants "used a smorgasbord of methods to misstate Xerox's earnings, revenues and margins in virtually every reporting period throughout the Class Period." Xerox's "improper accounting methodologies throughout the Class Period included" what its auditor "KPMG referred to" as "half-baked revenue recognition," and rampant abuse of "Cookie Jar Reserves," just to name a couple. In fact, "without such accounting manipulations, Xerox would not have met earnings expectations in 11 of 12 quarters during 1997-1999 . . . Moreover, by 1998, almost $ 3 of every $ 10 of annual pre-tax reported earnings and up to 37 percent of Xerox's reported quarterly pre-tax earnings were generated through undisclosed accounting manipulations." Internally, Xerox "approved of and expressly directed the use of ‘accounting actions’" when referring to the accounting manipulations. In fact, a former Xerox Assistant Treasurer (who was fired when he attempted to expose the fraud), "stated that many executives at Xerox had developed the attitude ‘There is no accounting standard we can't beat.’" How's that for a marketing slogan?

Initially, Xerox tried to blame everything on its "Mexican subsidiary," (sounds a little like the runaway bride, doesn’t it), but eventually that ruse was exposed. By the time the dust of two restatements settled (along with what was at the time the largest SEC fine in history), Xerox shareholders were stuck with "a total reduction in profits of nearly $ 2.4 billion for the years 1997 to 1999." Ouch.

Given these facts, the court appears to have had little trouble denying each Defendant’s motion to dismiss. The court found that the factual allegations "make it clear that this is not a case of a client innocently relying on advice from its accountants," as the "Xerox Defendants knew the company was underperforming and used accounting manipulations to bridge the gap between actual versus desired financial results," the CFO "informed Xerox senior management, including both the chief executive officer and the chairman of the Board of Directors, that without the benefit of the accounting actions, Xerox had essentially no growth through the late 1990s, that the directives as to the accounting manipulations emanated from Xerox senior management," "that many of the Xerox Defendants' accounting manipulations involved violations of simple and unambiguous accounting principles, and in specified instances, the Xerox Defendants were told by their accountants that the accounting action violated GAAP but proceeded with the action anyway," "that the Xerox Defendants insisted that KPMG replace its senior audit engagement partner when he refused to sign off on one of their proposals," and "filed a minimal restatement and came out with a press release saying they had cleaned everything up, knowing full well that the staff of the SEC still had serious problems with Xerox's accounting."

As for the six executives’ knowledge, the court said "the plaintiffs do not allege scienter on the part of the Individual Defendants simply by virtue of the positions those individuals held at Xerox, but rather by virtue of the fact that Xerox's senior management orchestrated the scheme to disguise the company's true operating performance and the directives as to the accounting manipulations emanated from Xerox senior management at corporate headquarters."

Finally, the court denied KPMG’s request to dismiss the case, as "the factual allegations in the Complaint do, in fact, portray KPMG as a virtual pushover in its dealings with the Xerox Defendants, which at a minimum went along with accounting practices it knew to be clear violations of GAAP, and which, even after it was clear early in 2001 that there were very serious concerns about Xerox's accounting practices and it was apparent that it was questionable--at best--whether Xerox took seriously its obligation to comply with applicable accounting rules, was intimidated into signing off on a minimal restatement of Xerox's financial statements that accounted for only a small portion of Xerox's overstatements of revenues and pre-tax earnings."

C'mon guys, don't be so negative. Look at the bright side. At least there should be plenty of copiers available for all those documents those pesky owners (a/k/a shareholders) will soon be subpoenaing.

You can read the decision, issued July 13, 2005, at 2005 U.S. Dist. LEXIS 14427.

Nugget: "The PSLRA does not require a plaintiff to prove his case in his complaint. And, it is appropriate to recall that the heightened standard of pleading scienter was meant simply to prevent strike suits and other abuses that had arisen in securities fraud litigation. . . . Plaintiff generally must frame the facts respecting the defendant's mental state (i.e., the scienter element of the claim) without the benefit of discovery, and therefore, most often, allegations about a defendant's culpable state of mind must be drawn from limited state of mind evidence augmented by circumstantial facts and logical inferences."

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