United States: SEC Enforcement Action For Materially Misleading Projections In The Face Of Red Flags And Other Actions

Last Updated: August 20 2018
Article by Cydney Posner

In case anyone needed a reminder from the SEC, this case against Sonus Networks, its CFO and VP of Sales may well serve as one: per the SEC's Associate Director of Enforcement, a company needs to have a "reasonable basis" if it makes public projections or estimates about future financial results: "The investing community expects that when companies choose to provide public financial projections, there is a reasonable basis underpinning those projections....When a company ignores red flags or takes steps to make public financial projections inaccurate we will take appropriate action."

As described in the Order, in this case, in January of 2015, the company issued a press release and, in February, the CFO gave prepared remarks, both confirming that the company was comfortable with the consensus analyst estimate for first quarter of 2015 revenues. However, at the time, the CFO was "aware of information which undermined the ... estimate for Sonus's Q1 2015 revenue. This information included: (1) the large amount of revenue for deals that Sonus had pulled forward from 2015 in order to achieve its Q4 2014 revenue estimates; (2) lower than normal backlog at the beginning of Q1 2015; and (3) a gap of $11 million, as of January 8, 2015, between the $74 million Q1 2015 revenue estimate and the expected revenue from the deals that Sonus's salesforce had indicated would 'be won and booked' in Q1 2015." Notably, the Order does not indicate that the SEC took issue with much earlier public statements about targets and projections for that quarter that were made in the prior year and based on a different analysis.

The Order indicates that, to achieve its revenue guidance for Q4 2014, the company decided, through incentives, to "pull forward" deals initially projected to close in 2015. However, internal communications indicated, the CFO recognized that pulling deals forward into the earlier period "would create risk for achieving Sonus's Q1 2015 revenue estimate....'" In an October 7, 2014 internal communication, he stated "that 'all this activity in 4Q will just drain the swamp in 1Q . . . i think we're just postponing the inevitable.'" Further, the company's backlog at the beginning of the first quarter was much lower than was typically the case in prior first quarters, which was known to create risk for achieving the Q1 estimate. When the VP Sales raised with the CFO his concerns regarding achievement of the estimate, his concern was dismissed, and the CFO maintained that "'the sales team needs to figure out how to get [to the estimate]–and if they can't, we have the wrong sales team.'"

Consistent with its regular practice, when the company checked its third-party tracking tool to verify the revenue forecast, there was a gap of approximately $11 million between the estimate and the deals the sales force had classified as "Committed Pipeline" on the tool. However, for its press release, the Order indicates, the company did not rely on this data and instead continued to rely on the top-down product-level revenue analysis. In the days leading up to the press release, in internal conversations, the CFO "expressed concern that Sonus was not in a position to reaffirm its comfort with the consensus analyst estimate"; nevertheless, the CFO indicated that the company "was in a box" and needed to confirm the estimate in its press release. According to the Order, "at the time he made this statement, [the CFO] acted negligently as he knew or should have known that expressing comfort with the... consensus analyst revenue estimate was materially misleading."

According to the Order, at a subsequent sales conference in January, the sales force was instructed to reclassify enough deals to close the gap between the revenue estimate and the Committed Pipeline on the tracking tool. Deals with a value of $12.4 million were reclassified, notwithstanding objections from "many members" of the sales force, one of whom characterized the "ask" as "[t]hey put a gun to our head at the sales conference and mandated we flip to commit." Following the conference, according to the Order, the sales force continued to warn the executive team regarding the risky nature of the reclassified deals, and reports continued to show declines in the Committed Pipeline, as most of the reclassified deals did not close during Q1.

In prepared remarks for a February conference call, the CFO repeated the same expectation for quarterly revenue, and the same was repeated in the Outlook section of a related press release, which was included with an 8-K. The VP of Sales confirmed to the senior executive team that the estimate was reasonable. According to the Order, when he confirmed the estimate, the VP Sales "acted negligently as he knew or should have known that the... guidance for Q1 2015 revenue was materially misleading."

Finally, in late March, the Order indicates, the company issued a press release revising the revenue estimate down by about a third. After the announcement, the share price dropped by over 33%. The Order notes that employees purchased company stock through a purchase plan in February at the higher price.

The company, CFO and VP Sales all consented to the entry of the SEC's Order, which found that they violated Section 17(a)(2) of the Securities Act, and that the company violated, and the CFO and VP Sales caused the company to violate, the reporting provisions of the Exchange Act, and ordered they each pay penalties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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