SEC Files Financial Fraud Action

by Dorsey & Whitney LLP

Financial fraud is an enforcement priority of the SEC. A financial fraud task force was formed in July 2013. Its purpose is to focus on this traditional staple of enforcement. A data analysis group was formed at the same time to give the task force a new big data type approach under which computers would aid with prospecting for fraudulent financial statement conduct. To date, few cases have been brought, although traditionally the complexity of these cases means it can take substantial amounts of time to complete the investigation.

One case brought in this area is In the Matter of AirTouch Communications, Inc., Adm. Proc. File No. 3-16033 (August 22, 2014). In addition to the firm, Hideyuki Kanakubo, the firm’s founder and former CEO, and Jerome Kaiser, its former CFO, were named as Respondents. AirTouch develops and sells telecommunications equipment designed to integrate mobile phones into landline systems within a consumer’s home. The firm’s shares are quoted in the OTC Pinks.

The scheme alleged in the Order has two facets. The first involved improper revenue recognition. Specifically, in early 2012 the company developed a new product called U250. It was designed for sale to Mexico’s largest provider of landline telephone services.

In July 2012 AirTouch entered into a contract with a Florida based provider of logistics and fulfillment services regarding the product. Under the arrangement about $1.7 million in U250 product would be held by the Florida entity. That entity would execute a Purchase Order for the equipment. At the same time, however, AirTouch and the Florida firm executed an Agreement under which no product would be delivered and no payment due unless and until the Mexican entity actually ordered and paid for the product.

In October 2012 AirTouch’s controller provided the firm’s outside independent accountant with a copy of the Purchase Order from the Florida company. The accountant was not provided with a copy of the related Agreement. Messrs. Kanakubo and Kaiser did not inform the outside accountant or the independent directors on the board about the Agreement when discussing the Purchase Order from the Florida entity. AirTouch did not receive any payment from the Florida company.

On November 14, 2012 the firm voluntarily filed a Form 10-Q for the third quarter of the year. It reported net revenues of $1,031,747, recognizing revenue from the Purchase Order. If that revenue had not been recognized, the firm would not have had positive revenue. Yet recognizing the revenue under the circumstances here was contrary to the firm’s stated revenue recognition policies and GAAP.

Second, the firm used the Purchase Order to secure a $2 million loan from a shareholder. During 2012 Messrs. Kanakubo and Kaiser solicited a short term bridge loan from an AirTouch Shareholder. That Shareholder was told in an October 2012 e-mail about the shipment of product under the Purchase Order to the Florida firm. The Shareholder was also furnished with a copy of the Purchase Order. The Shareholder was not furnished with a copy of the related Agreement. The firm and Shareholder entered into an agreement under which $2 million was loaned to AirTouch in return for a promissory note and stock options.

Subsequently, Mr. Kanakubo approved a $15,000 bonus to Mr. Kaiser for his work on raising capital. At the same time he awarded himself a bonus in the same amount in connection with unused vacation time.

In January 2013 the AirTouch board of directors initiated an internal investigation regarding the net reported revenues in the Form 10-Q for the third quarter of 2012. At the time Mr. Kaiser furnished the chairman of the audit committee with the Purchase Order but not the related Agreement. When the board of directors finally received the Agreement a restatement of the third quarter was directed. In February 2013 the firm filed a Form 8-K announcing the errors in revenue recognition and stating its intention to file an amended Form 10-Q. That filing has not been made.

The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The proceeding will be set for hearing.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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