As part of its fiscal-year-end enforcement surge, the SEC filed charges against three former executives of Pareteum Corporation, a telecommunications and cloud software company, for fraudulent revenue recognition practices—a settled action against the former controller and a complaint against the former CFO and former Chief Commercial Officer (also, formerly CEO). As described in the complaint, the SEC charged the former executives with orchestrating a fraudulent scheme to overstate revenue by recording revenue from non-binding purchase orders and concealing the practice from the company’s auditors. From 2018 through mid-2019, the SEC alleged, the defendants’ improper revenue recognition practices resulted in the company’s overstating revenue by “approximately $12 million for fiscal year 2018 (60% of the ultimately restated revenue), and by approximately $30 million for the first and second quarters of 2019 (91% of the ultimately restated revenue).” In addition, the former CFO, the SEC charged, did not establish sufficient internal accounting controls to assess whether revenue should be recognized under GAAP. According to the press release, Pareteum previously settled with the SEC on accounting and disclosure fraud charges in 2021 and filed for bankruptcy in 2022. Notably, the U.S. Attorney’s Office for the SDNY has announced parallel criminal charges against the former CFO and CCO. According to the Associate Director of Enforcement for the SEC’s Philadelphia Regional Office, as the SEC alleged in its complaint, “Pareteum’s executives artificially inflated Pareteum’s revenue numbers to create the illusion of robust revenue growth….Investors should be able to trust public companies to issue truthful and accurate financial statements, and we will hold accountable any executives who abuse that trust and defraud investors.”
Background. According to the SEC, the company offered various services such as SIM card services, WiFi service and a Cloud platform. Its customers were typically businesses that purchased from Pareteum SIM cards with customizable service plan options and then sold the SIM cards with service plans to downstream users under their own brands.
In its 2018 Form 10-K, Pareteum stated that it recognized revenue in accordance with ASC 606, which, the company stated, “requires entities to recognize revenue when control of the promised goods or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” However, the SEC alleged, that’s not exactly what happened. Instead, “Pareteum recognized revenue based on non-binding purchase orders and without any regard to whether Pareteum satisfied any performance obligations.” In many cases, there was not even a real contract with a customer. Nor were there effective internal accounting controls: the SEC alleged that there were no “revenue recognition policies and procedures in place to require sufficient review of the purchase orders’ payment terms or collectability, and there was no formal process in place to provide reasonable assurance that Pareteum’s performance obligations under a purchase order had been satisfied, as ASC 606 requires.”
For example, as alleged in the Order, for mobile bundled services customers, once a new customer signed a contract and master services agreement, Pareteum would draft a purchase order, which the customer then signed, reflecting the number of SIM cards the customer intended to purchase, with an estimated cost for the associated average monthly service plan they aspired to sell to downstream consumers. Importantly, however, in most cases, the full cost stated in the purchase order was just an estimate that would not be due unless the customer sold the product to downstream consumers. As a result, the SEC alleged, the company’s general practice was not to send invoices for the full amount of the purchase order, but instead to send monthly invoices for the actual monthly usage amounts, “further demonstrating that the customer was not responsible for the full purchase order amount.” Nevertheless, the company recognized revenue for the entire amount listed in the purchase order, “without regard to whether the order was even a contract under step 1 of ASC 606, and without checking whether any of Pareteum’s performance obligations under the purchase order had been met. Pareteum recognized the total revenue of each purchase order regardless of whether the SIM cards had been shipped or whether a platform had been set up by Pareteum sufficient to even allow the SIM card service plans to work.” According to the complaint, the CCO, who supervised the company’s salespeople, “directed the sales department personnel to focus on getting signed purchase orders from customers,” and then forwarded them to the CFO, the SEC alleged, knowing—and sometimes even directing—that they be recognized in full. In addition, the former CFO did not “put in place sufficient internal accounting controls to assess whether the required performance obligations had been met prior to Pareteum recognizing revenue, and in practice, such checks often were not properly done.” The SEC charged that the former executives were “reckless in not knowing that the requirements for proper revenue recognition had not been met and yet continued to authorize or accept decisions to recognize millions of dollars of revenue improperly,” even though the funds were not yet owed by the customers and, therefore, were not collectable.
Pareteum’s accounts receivable balance ballooned by the end of 2018. Not wanting to raise red flags with Pareteum’s auditors, the SEC alleged, the former CFO and controller made an effort to send out invoices for all AR amounts. But in year-end audit testing, the auditor identified AR as a main risk area and sent out audit confirmations to many of Pareteum’s customers, including the vast majority that accounted for the overstated $12 million in revenue. According to the SEC, none of these customers should have been able to sign these confirmations, but the former CFO and Controller directed Pareteum sales employees to encourage customers to sign, advising customers that the amounts in the confirmation were just estimates and that the customers did not owe those amounts. With those assurances, many customers signed the false confirmations. The CFO also signed management rep letters to the auditors confirming that the 2018 financial statements were fairly presented in conformity with GAAP. When directly asked about the large AR balance by one audit manager, the CFO, the SEC alleged, “falsely blamed the large balance on administrative delay in sending out bills.”
The SEC also alleged that the company improperly recognized millions in revenue based on an unsigned, mid-negotiation 6.3 million euro purchase order to which the customer never ultimately agreed. According to the SEC, the former Controller, at the direction of the CCO (who did not provide any rationale), asked his accounting staff to recognize 20% of the purchase order in January 2019. As a result, approximately $1.4 million was recognized in the first quarter of 2019, even though the customer had not actually agreed to the purchase order and the company had not yet begun to perform any of its obligations. When the purchase order was ultimately signed, the order was for only 630,000 euros, not 6.3 million, and “was still just a consignment agreement and not recognizable revenue.” Nevertheless, the CCO directed that the Controller to continue “to recognize revenue off of the unsigned draft purchase order for 6.3 million euros,” for an aggregate of approximately $4.4 million. According to the SEC, the CFO “did nothing to question or reverse the large amounts of unsupported revenue already recognized” and instead directed that more revenue be recognized. When the SEC issued a subpoena to Pareteum requesting documentation supporting the revenue recognized for this sale, the former executives, the SEC alleged, “began attempts to cover up the improper revenue recognition.” And when a new employee raised concerns about revenue recognition practices, the CCO asked other employees “to hide information from the new employee.”
In its 2018 Form 10-K, the SEC charged, the company overstated revenue by 60% ($12 million), and in several Forms 10-Q overstated revenue by up to 102%. In addition, press releases attached to Forms 8-K were materially misleading “because they included, and often highlighted, the revenue amounts that were materially overstated.”
In October 2019, Pareteum’s Board of Directors determined that its revenue recognition practices violated GAAP, and the company announced that it was restating its financial statements for all of 2018 and the first two quarters of 2019. Its Audit Committee commenced an internal investigation. Its stock price dropped 59%. Two years later, the company agreed to a settlement with the SEC. In its restated 10-K, the company disclosed that it had identified material weaknesses in internal control over financial reporting, “including a lack of proper controls around recognizing revenue and an ineffective overall control environment due to issues with management’s ‘tone at the top.’”
Violations. As noted above, only the former Controller has settled with the SEC. He was charged with willful violation of Section 17(a) of the Securities Act, which prohibits fraudulent conduct in the offer or sale of a security; willful violation of Section 10(b) of the Exchange Act and Rules 10b-5(a) and (c) thereunder, which prohibit fraudulent conduct in connection with the purchase or sale of securities; willfully aiding and abetting and causing the violation of Section 10(b) by the CFO and the company; willful violation of Rule 13b2-2, which prohibits any officer or director from making false statements to an auditor; willfully aiding and abetting and causing the company’s violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11 and 13a-13 thereunder, which prohibit materially false periodic and other reports, Exchange Act Section 13(b)(2)(A), which requires accurate books and records and Exchange Act Section 13(b)(2)(B), which requires systems of internal accounting controls. The former Controller agreed to cease and desist, an officer and director bar, an SEC accountant bar and additional proceedings (during which he cannot challenge the Order) to determine what, if any, disgorgement, prejudgment interest and civil penalties were appropriate.
In the complaint, the SEC alleged that the CFO and CCO violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The CCO was also charged with aided and abetted the CFO’s and the company’s violation of Rule 10b-5. The CFO was also charged with violation of Exchange Act Section 13(b)(5) (failing to implement internal accounting controls) and Rules 13a-14 (false certifications), 13b2-1 (falsifying books and records), and 13b2-2 (false statements to accountants), as well as SOX 304(a) (clawback in the event of restatement). In addition, the CFO was charged with aiding and abetting the company’s violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11 and 13a-13 thereunder. In the complaint, the SEC sought cease-and-desist orders, officer and director bars, disgorgement and civil money penalties.
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