UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 37879 / October 28, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 848 / October 28, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9175 --------------------------- : ORDER INSTITUTING PUBLIC : ADMINISTRATIVE PROCEEDING In the Matter of : PURSUANT TO SECTION 21C OF : THE SECURITIES EXCHANGE ACT ALAN G. LEWIS, : OF 1934, MAKING FINDINGS, : AND IMPOSING A CEASE-AND- Respondent. : DESIST ORDER --------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that a public administrative and cease-and-desist proceeding be, and hereby is, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Alan G. Lewis ("Lewis" or "Respondent") violated Section 13(b)(5) of the Exchange Act and Rules 13b2-1 and 13b2-2 thereunder and caused violations of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20 and 13a-1 thereunder. II. In anticipation of the institution of this proceeding, Lewis has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except that Respondent admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Respondent consents to the issuance of this Order Instituting Public Administrative Proceeding Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and the imposition of the relief set forth below. ==========================================START OF PAGE 2====== III. On the basis of this Order and Respondent's Offer, the Commission finds the following:1/ A. RESPONDENT Respondent Lewis was, from October 1993 to July 24, 1995, Controller of Midisoft Corporation ("Midisoft" or "the Company"). B. ENTITY INVOLVED Midisoft, founded in 1986, is a Washington State corporation with its principal place of business in Issaquah, Washington. Midisoft develops and markets interactive, audio-based software applications for the Microsoft Windows and multimedia applications market, including software that allows users to produce and manipulate music on a personal computer. The Company's common stock has been registered with the Commission pursuant to Section 12(g) of the Exchange Act since July 1993 and is quoted on The NASDAQ Stock Market. For the most recent fiscal year, ended December 31, 1995, the Company posted revenues of $5,420,000, a net loss of $12,132,000 and a net loss per share of $2.60. As of March 16, 1996, with 4,662,988 shares outstanding and a closing price per share of $3.00, Midisoft had an aggregate market value of $13,988,964. C. CONDUCT LEADING TO MIDISOFT'S MATERIALLY MISLEADING FORM 10- K FOR FISCAL 1994. Midisoft's original Form 10-K for the year ended December 31, 1994 overstated the Company's revenues by $811,000. Compared to Midisoft's restated revenues for the year of $4,898,000, this amounted to an overstatement of 16.8%. Moreover, when compared to Midisoft's restated revenues for the fourth quarter of 1994 of $685,297, Midisoft's original Form 10-K overstated the Company's revenues by 123.2%. This overstatement was primarily the result of two types of conduct. First, the Company recognized revenues on goods that it did not ship to a customer prior to the end of fiscal 1994. This resulted in a revenue overstatement of $292,000. Second, the Company recognized revenue on transactions for which products were timely-shipped, but for which, at the time of shipment, Midisoft had no reasonable expectation that the customer would accept and pay for the products. Midisoft accepted most of these products back as sales returns during the first three months of 1/ The findings herein are made pursuant to Respondent's Offer and are not binding on any other person or entity in this or any other proceeding. ==========================================START OF PAGE 3====== 1995, prior to the time the Company issued its original Form 10-K for fiscal 1994. In total, as a result of this conduct, Midisoft's original Form 10-K overstated the Company's revenues by $458,000.2/ 1. Midisoft Improperly Recognized Revenue on Goods That Did Not Ship to a Customer Prior to The End of Fiscal 1994. In late December 1994, Midisoft sales personnel obtained purchase orders from certain Midisoft customers based on the understanding that Midisoft would not deliver the products ordered unless and until the Company received further instructions from the respective customers. Midisoft's internal accounting policy, as set forth in the Company's original Form 10-K for fiscal 1994, stated that the Company recognized revenue on sales to distributors, resellers and other end-users only when products were shipped to those customers. Nevertheless, despite the contingent nature of the December 1994 orders, Lewis and certain other Midisoft officers and employees determined that Midisoft would recognize revenues on these transactions during the fiscal year ending December 31, 1994. To do this, they determined, would require that Midisoft: (1) prepare the goods for shipment prior to the end of the fiscal year; and then (2) hold the goods at an off-site location until the Company received further instructions from its customers. Accordingly, Midisoft proceeded to store a total of $292,000 in goods relating to the contingent purchase orders at a freight forwarding company. Lewis then obtained phony shipping documents from the freight forwarder that made it appear that all of the goods had been shipped to Midisoft customers on or prior to December 31, 1994. In fact, during the first three months of 1995 Midisoft shipped to its customers only approximately $76,000 of the total of $292,000 in goods stored at the freight forwarder. 2. Midisoft Failed to Reserve Adequately for Sales Returns and, Subsequently, Misled Its Auditors Regarding Such Returns. Midisoft maintains written distribution agreements with its distributors. These agreements generally allow the distributor wide latitude to return product to Midisoft for credit whenever the product is, in the distributor's opinion, damaged, obsolete, 2/ A third cause of the overstatement was the recognition of revenues on an Original Equipment Manufacturer contract for which Midisoft had failed to fulfill its contractual obligations prior to the end of fiscal 1994. This conduct resulted in an overstatement of revenue of $61,000. ==========================================START OF PAGE 4====== or otherwise unsalable. Given these broad rights of return, in order to recognize revenues on sales to its distributor customers, Midisoft must be able to estimate reasonably the likelihood of future product returns and must make an allowance for such returns against its recorded revenues.3/ In preparing Midisoft's financial statements for fiscal 1994, Midisoft accounting personnel submitted a proposed allowance for future product returns of $105,000. This figure was unreasonably low in light of the large levels of returns Midisoft received in the first several months of 1995, which were known to various officers and employees in Midisoft's Accounting and Sales Departments prior to the end of March 1995, the time Midisoft's independent auditors finished their field work on the Company's 1994 audit. For example, in January 1995, Midisoft received from five of its largest distributors returns of $197,532; of this total, more than $163,000 was the result of one credit memo issued. In February 1995, Midisoft received additional returns from these same five distributors of $123,051. Had Midisoft revised the allowance for sales returns to reflect this information, the Company would have had to reduce accordingly the amount of net revenue Midisoft could report for fiscal 1994. Instead, several Midisoft officers and employees acted to prevent Midisoft's auditors from discovering the higher levels of returns. As part of this scheme, certain Midisoft employees were instructed to prevent the auditors from touring that portion of the Midisoft headquarters where the returned goods were stored. In addition, Lewis altered records contained in Macola, the Company's computer accounting system, to falsely reduce the level of returns reflected in that system. In particular, in February 1995 Lewis altered Midisoft's accounting records so that the $163,000 credit memo noted above appeared to be for just over $49,000. When Midisoft's auditors subsequently asked for copies of certain credit memos, Lewis provided the auditors with a forged "cut-and-paste" memo which matched the alterations made to the Macola system. In fact, in 1995 Midisoft received a total of $458,000 in returns relating to fiscal 1994 sales in excess of the $105,000 the Company had provided for this purpose. Of this amount, Midisoft received returns of approximately $344,500 in the first quarter of 1995 alone, prior to the time the Company issued its original Form 10-K for fiscal 1994. Despite his involvement in the wrongful conduct discussed above, on March 31, 1995 Lewis signed a Management Representation letter to Midisoft's independent auditors in which he represented 3/ See Financial Accounting Standards Board, Accounting Standards R75.107. ==========================================START OF PAGE 5====== that he did not know of: (1) any material inaccuracies in Midisoft's 1994 financial statements; or (2) any irregularities involving management or employees who had significant roles in the Company's system of internal accounting controls. D. LEGAL ANALYSIS 1. Lewis Caused Midisoft to Violate Provisions Governing Issuer Reporting, Books And Records and Internal Accounting Controls. Pursuant to Section 21C of the Exchange Act, a person is a cause of a violation of the provisions of the Exchange Act if the violation occurs because of an act or omission which the person knew or should have known would contribute to such violation. For the reasons set forth below, Lewis caused Midisoft to violate Section 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. a. Issuer Reporting Provisions: Section 13(a) and Rules 12b-20 and 13a-1 Section 13(a) of the Exchange Act and Rule 13a-1 thereunder require that issuers whose securities are registered with the Commission pursuant to Section 12 of the Exchange Act file with the Commission accurate annual reports. Exchange Act Rule 12b-20 requires that such reports contain any additional information necessary to ensure that the required statements in the reports are not, under the circumstances, materially misleading. Thus, the filing of a periodic report that contains materially false and misleading statements or omissions constitutes a violation of the reporting provisions of the Exchange Act. Violations of the reporting provisions do not require a showing of scienter. SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1166-67 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Financial statements incorporated in Commission filings must comply with Regulation S-X, which in turn requires conformity with Generally Accepted Accounting Principles ("GAAP"). Statement of Financial Accounting Concepts No. 5 ("CON5"), entitled "Recognition and Measurement in Financial Statements of Business Enterprises," states that revenue should be recognized when it is both realized (or realizable) and earned. Paragraph 83 of CON5 states that revenue is realizable when a product is "exchanged for cash or claims to cash" and revenue is earned "when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues." In addition, Midisoft's own revenue recognition policy, as set forth in its original 1994 Form 10-K, required that it recognize revenue only after it shipped products to its customers. Midisoft violated Section 13(a) and Rules 12b-20 and 13a-1 when it filed a materially misleading Form 10-K for the year ==========================================START OF PAGE 6====== ended December 31, 1994. This report was misleading because it included revenues on goods that Midisoft: (1) had not yet shipped to customers; and (2) had either received or reasonably expected it would receive as returns from its customers. By including these revenues in its original Form 10-K, Midisoft violated both its own revenue recognition policies and GAAP. When compared with its restated 1994 Form 10-K, Midisoft's original 1994 Form 10-K overstated the Company's revenues by 16.8%. This misstatement was material. See Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (fact is material if there is substantial likelihood reasonable investor would consider it important in making investment decision); see also In re Gupta Corporation Securities Litigation, 900 F. Supp. 1217, 1231 (N.D. Cal. 1994) (materiality of overstatement of revenues greater than 5% "is beyond question"). Lewis knew or should have known that the following of his actions would contribute to Midisoft issuing the materially misleading Form 10-K for fiscal 1994: (1) obtaining phony shipping documents relating to goods stored at a freight forwarder; (2) altering Midisoft's computer accounting system to reduce the level of sales returns shown on that system; (3) providing a forged credit memo to Midisoft's independent auditors; and (4) making the misrepresentations contained in the Management Representation letter. Accordingly, Lewis was a cause of Midisoft's violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. b. Books and Records and Internal Accounting Controls: Section 13(b)(2)(A) and 13(b)(2)(B) Section 13(b)(2)(A) requires that each issuer of securities registered pursuant to Section 12 of the Exchange Act make and keep books, records and accounts that accurately and fairly reflect the dispositions of its assets. Section 13(b)(2)(B) requires that each such issuer also devise and maintain a system of sufficient internal accounting controls sufficient. Lewis caused the Company to violate Section 13(b)(2)(A) by: (1) preparing records that reflected the sale during fiscal 1994 of assets that were not shipped to customers during that year but were, instead, held at a freight forwarder; (2) preparing records that reflected revenue resulting from the shipment of goods that Midisoft had no reasonable expectation its customers would accept and pay for, which goods were received as returns by Midisoft prior to the issuance of the Company's 1994 Form 10-K. The laxity of Midisoft's internal accounting controls is reflected by the fact that accounting personnel repeatedly were able to alter Midisoft's books and accounts to record revenues improperly and understate the level of returns received by the Company. Lewis was a cause of Midisoft's failure to maintain ==========================================START OF PAGE 7====== sufficient internal accounting controls, in violation of Section 13(b)(2)(B). 2. Lewis Also Violated Certain Books and Records, Internal Accounting Controls and Representations to Auditors Provisions. Section 13(b)(5) of the Exchange Act prohibits any person from knowingly circumventing or knowingly failing to implement a system of internal accounting controls or knowingly falsifying any book, record or account. Rule 13b2-1 thereunder similarly prohibits any person, whether indirectly or directly from falsifying or causing to be falsified any book, record or account. In addition, Rule 13b2-2 thereunder prohibits any officer or director from making or causing to be made any materially false statement or omission in connection with an audit of the filing of required reports with the Commission. Lewis violated Section 13(b)(5) and Rule 13b2-1 when he knowingly circumvented Midisoft's internal accounting controls to allow the Company to record revenues on: (1) goods that did not ship during the fourth quarter of 1994; and (2) goods that, although they were timely-shipped, were accepted back by Midisoft as returns in the first three months of fiscal 1995, prior to the time the Company filed its Form 10-K for the period. Lewis violated Rule 13b2-2 by his efforts to conceal Midisoft's improper revenue recognition from its independent auditors, including: (1) providing a credit memo to Midisoft's independent auditors that also falsely understated the level of returns received by the Company; and (2) signing a Management Representation letter for Midisoft's 1994 audit in which he falsely represented that he knew of no material misstatements in Midisoft's financial reports nor of any irregularities regarding any of the personnel with significant responsibility for Midisoft's accounting functions. 3. Lewis Caused the Violation of Section 10(b) and Rule 10b-5 Thereunder. Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit material misstatements or omissions made with scienter in connection with the purchase or sale of securities. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). The Ninth Circuit has held expressly that a mental state of recklessness is sufficient to satisfy the scienter requirement. Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990) (en banc) (as amended), cert. denied, 449 U.S. 976 (1991). Where the fraud alleged involves public dissemination in an annual report or other such document on which an investor would presumable rely, the "in connection with" requirement is ==========================================START OF PAGE 8====== generally met by proof of the means of dissemination and the materiality of the misstatement. SEC v. Rana Research, Inc., 8 F.3d 1358, 1362 (9th Cir. 1993) (issuance of press release coupled with public trading in stock met requirement); Savoy Industries, 587 F.2d at 1171 (filing of Schedule 13D coupled with public trading in stock satisfies requirement). Midisoft's original 1994 Form 10-K was materially false and misleading because it contained the $750,000 in revenues relating to goods not shipped during fiscal 1994 and sales returns in excess of the amount allowed for by the Company. In each instance, Lewis knew of or recklessly disregarded the fact that his actions would contribute to the issuance of this materially false report. Accordingly, Lewis was a cause of the violation of Section 10(b) and Rule 10b-5 thereunder. IV. On the basis of this Order and Respondent's Offer, the Commission finds that Lewis: 1. committed violations of 13(b)(5) of the Exchange Act, and Rules 13b2-1 and 13b2-2 thereunder; and 2. was a cause of the violations of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 10b-5, 12b-20 and 13a-1 thereunder. V. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Lewis cease and desist from committing or causing any violation and any future violation of Section 13(b)(5) of the Exchange Act, and Rules 13b2-1 and 13b2-2 thereunder and from causing any violation and any future violation of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 10b-5, 12b-20 and 13a-1 thereunder. By the Commission. Jonathan G. Katz Secretary