Q13 Q13 Q13
Livingston Haynes, P. C.
This case concerns alleged violations of Section 10A of the Securities Exchange Act by Livingston Haynes, P. C. ("L H"), Kevin Howley, and William W. Wood in connection with L H's 2005 and 2006 year-end audits and quarterly interim reviews of the financial statements of LocatePlus Holdings Corporation ("LocatePlus"). The SEC filed charges against L H, Howley, and Wood on June 6, 2011. 1
L H is an accounting and auditing firm registered with the PCAOB. The firm provides tax preparation services, as well as services to public companies registered with the commission and to private equity clients. L H served as the auditors on LocatePlus's audits and interim reviews for the fiscal years 2005 and 2006, from which L H received approximately $227,800 in fees.
Violations of Securities Exchange Act of 1934
Howley served as the engagement partner and Wood served as the concurring partner on the engagements. On October 14, 2010, the commission filed a complaint against LocatePlus alleging, in part, that LocatePlus's former CEO and CFO fraudulently inflated the company's publicly reported revenue in its periodic filings with the commission for at least FY2005 and FY2006. The complaint alleges that, as part of LocatePlus's fraud, its CEO and CFO were involved in the following action related to a fictitious customer called Omni Data Services, Inc. ("Omni Data"):
• LocatePlus improperly recognized revenue from Omni Data. The improper Omni Data revenue was included in LocatePlus's financial statements that were part of quarterly and annual reports for FY2005 and FY2006 and were included in filings with the commission.
• In total, LocatePlus falsely reported more than $6 million from Omni Data for FY2005 and FY2006, representing over 25 percent of LocatePlus's total revenue for those two years.
The SEC also charged L H with the following in connection with its audits of LocatePlus for the years 2005 and 2006:
• L H, Howley, and Wood failed to include procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts, and thus each of them violated Section 10A(a)(1) of the Exchange Act.
• L H, Howley, and Wood became aware of multiple allegations of illegal acts at LocatePlus, including allegations that the Omni Data revenue was fictitious, yet they failed to determine whether it was likely that an illegal act had occurred. Based on this conduct, each of them violated Section 10A(b)(1) of the Exchange Act.
• During the course of L H's 2005 and 2006 year-end audits of LocatePlus, L H and Howley individually became aware of red flags indicating that the Omni Data revenue was fictitious, yet the company failed to ensure that the very risky area was audited properly.
• L H and Howley failed to plan the audits properly, test the Omni Data revenue adequately, obtain sufficient competent evidential matter to serve as a basis for L H's audit reports, exercise due professional care, apply skepticism, and properly assess the risks of material misstatement due to fraud.
Facts of the Case
LocatePlus is a provider of public information made available via either a CD ROM-based product or via a proprietary, Internet-accessible database. The LocatePlus product contains searchable information on individuals throughout the United States, including, for example, social security numbers, prior residences, and real estate holdings. In addition to direct purchasers, LocatePlus sells its product through "channel partner" arrangements, by which third parties access their databases in consideration for a royalty.
In 2005 and 2006, LocatePlus claimed to have secured a significant "channel partner" arrangement with Omni Data, a company that purportedly conducted its business over the Internet. Under the terms of the alleged agreement, Omni Data had unlimited access to LocatePlus's data via the Internet in exchange for a royalty fee of $300,000 per month. The agreement also stated that LocatePlus would build and maintain a website for Omni Data in exchange for $500,000.
In fact, Omni Data was a sham customer of LocatePlus created by the CFO and CEO to record false revenue. Through this fraudulent scheme, Omni Data would "buy" services from LocatePlus and make purported "payments" to LocatePlus. The CFO and CEO then caused LocatePlus to record these fictitious payments as revenue in its financial results, which were included in periodic filings with the SEC.
To fund these purported payments to LocatePlus, the CFO and CEO funneled approximately $2 million in cash to Omni Data through a series of transactions which included a "round- trip" transaction in which LocatePlus made a $650,000 payment to an entity controlled by the CFO, who then transferred $600,000 to Omni Data, which then paid the $600,000 back to LocatePlus as purported payment for services.
LocatePlus made numerous false and misleading statements regarding, among other things, its revenue in a number of periodic filings with the commission. For FY2005 and FY2006, LocatePlus improperly recognized $3.6 million and $2.7 million, respectively, in fictitious revenue from Omni Data. This caused LocatePlus to overstate its 2005 annual results by 46 percent and its 2005 quarterly results by 53 percent for the first quarter, 44 percent for the second quarter and 43 percent for the third quarter. LocatePlus overstated its 2006 annual results by 28 percent and its 2006 quarterly results by 41 percent for the first quarter, 34 percent for the second quarter and 36 percent for the third quarter.
L H performed LocatePlus's 2005 and 2006 year-end audits and quarterly reviews. The audit reports issued for both years included an explanatory paragraph (i.e., emphasis of matter) stating that LocatePlus's substantial net losses raise substantial doubt about the company's ability to continue as a going concern.
On December 10, 2004, LocatePlus's former auditor, resigned. In a resignation letter addressed to LocatePlus's audit committee chairman, LocatePlus's former auditor cited "concerns about the timeliness of information we received and about the reliability of certain representations of your company's management."
In January 2005, Howley was contacted to inquire about L H becoming LocatePlus's new auditors. On February 16, 2005, Howley and Wood visited the former auditor's offices and met with the partner formerly responsible for the LocatePlus engagement. The former auditor's audit partner detailed multiple reasons for its resignation, including (1) difficulty getting information from management, (2) management providing contradictory explanations to its questions, (3) management providing unsigned contracts as audit evidence, and (4) difficulty getting management to accept its proposed audit adjustments.
After L H's meeting with LocatePlus's former auditor, Howley, Wood, and L H's president met and determined to accept LocatePlus as a client. Because of the concerns expressed by LocatePlus's former auditor, however, L H determined to "use extensive care" and treat LocatePlus as a high-risk audit client.
During the 2004 audit, L H had difficulties getting information from LocatePlus's management about significant transactions, to the extent that, on April 11, 2005, L H pulled out of the field because they were unable to remain productive with the amount of information they had to work with.
Red Flags Discovered
During the course of its 2005 interim reviews of quarterly filings, L H became aware of multiple red flags concerning the revenue recognized from Omni Data and the resulting receivable on LocatePlus's balance sheet. In a June 1, 2005, e-mail from Howley to Fields, Howley noted that (1) L H was unable to find records for Omni Data on the Connecticut secretary of state's website (i.e., the state where Omni Data was purportedly located); (2) that the alleged president of Omni Data was not listed for any of the Omni Data entities that they did find; and (3) that L H could not locate a website for Omni Data, despite the fact that Omni Data was purportedly a business doing data sales over the Internet.
Howley accepted management's explanations for the inconsistencies. For example, in response to an L H inquiry about the scarcity of information available on Omni Data, LocatePlus's in-house accountant told Howley in a June 7, 2005 e-mail that "we don't make it common practice to research companies extensively with which we do business." In addition, in a June 9, 2005 e-mail, Fields claimed that "[Omni Data] does not have a corporate web site because they are trying to keep a low profile" and that Omni Data's web site was, in fact, under the name "findyourpeeps.com."
As of June 30, 2005, the Omni Data receivable was approximately $1.8 million reflecting revenue of the same amount recognized in 2005. No collections had been received as of June 30, 2005, from Omni Data for revenues earned in 2005.
Allegations of Illegal Acts
On or about August 26, 2005, Howley received a message that a former LocatePlus board member ("the informant") wanted to speak with him. During a telephone conversation with Howley shortly thereafter, the informant made a number of allegations of wrongdoing by LocatePlus and members of management. Among other things, the informant questioned the validity of the Omni Data transactions and indicated that the alleged president of Omni Data was a former girlfriend of the former CEO and chair of the board of directors. Shortly after the telephone conversation, Howley relayed the substance of the informant's allegations to Wood.
Between at least December 2005 and March 2006, the informant contacted Howley via telephone and e-mail on numerous occasions regarding his concerns about fraud at LocatePlus. During the course of multiple e-mail exchanges with Howley, the informant provided the following information:
• Omni Data revenue was phony and there was no evidence that Omni Data existed.
• Omni Data contract was signed five months before Delaware incorporation records showed that the company was incorporated.
• The alleged president of Omni Data was a "stooge set up by the CEO" to mask phony sales and was, in fact, a ballet teacher and the CEO's former girlfriend.
• The CEO told the informant that Omni Data was a startup that "might not be around."
• LocatePlus's audit committee chairman had a conflict of interest because he had pledged assets to secure a loan to the CEO.
• The CEO had been buying off LocatePlus's audit committee chairman through extending him high-interest loans made to the company (at 30 percent to 40 percent).
Wood read the informant's e-mails and discussed them with Howley prior to and during the course of the 2005 year- end audit. Wood also discussed the allegations with L H's president. Howley forwarded the e-mails from the informant to LocatePlus's audit committee chairman. In e-mail correspondence, Howley recommended to LocatePlus's audit committee chairman that the audit committee chairman should plan a meeting with the informant, the audit committee's legal counsel, and Howley to address the informant's allegations. The meeting never occurred.
A major issue in this case is the failure of L H to test the Omni Data revenue and receivable adequately. The issue involves both inappropriate accounting and the failure of the audit to identify material misstatements in the financial statements.
L H identified numerous risk factors indicating that LocatePlus had a high risk for fraud during the 2005 year-end audit. In a fraud "brainstorming" memo included in L H's 2005 audit work papers, L H specifically identified overstated and/or fictitious revenues/accounts receivable relative to Omni Data. The memo went on to state that "L H will approach the audit with much skepticism."
Despite having identified the Omni Data transactions as a high-risk area and being aware of the allegations that Omni Data was fictitious, L H, under Howley's direction, failed to obtain sufficient competent evidential matter that LocatePlus had delivered its product to Omni Data.
Although L H tested delivery of products and services for other LocatePlus's customers, it did not test delivery to Omni Data even though it accounted for approximately one-third of LocatePlus's revenue. For other customers, L H compared the amounts billed and recognized as revenue to LocatePlus's data usage logs to ensure that the customer had agreed to purchase the product and had actually used it.
However, L H never looked at the usage logs for Omni Data. Had L H reviewed Omni Data's usage logs, they would have discovered that there was no activity or usage in 2005. Instead, L H relied upon the executed agreement between LocatePlus and Omni Data and confirmation received from Omni Data regarding the monies earned and owed.
Questions persisted at L H throughout the 2006 year-end audit of LocatePlus about the existence and collectibility of the growing Omni Data receivable balance. As of December 31, 2006, the Omni Data receivable balance was $5.1 million representing approximately 88 percent of LocatePlus's total receivables. In a work paper included in L H's 2006 year-end audit work papers, L H noted that "there is questionability regarding the Omni Data receivable and the existence of Omni Data (whether it is a viable entity)."
The purported Omni Data agreement had been amended, as of October 1, 2006, to extend Omni Data's payment terms to $45,000 per month for the approximately $4.2 million outstanding balance. Under the original contract terms, payments were due 30 days from the invoice date. As a result of the amendment, LocatePlus reclassified $3.8 million of the Omni Data receivable from current accounts receivable to long-term accounts receivable. It also recorded a discount and an allowance on the receivable, which was approximately $1.9 million as of December 31, 2006.
Despite these developments and the open question as to whether Omni Data was a viable entity, L H failed to obtain sufficient competent evidential matter that the Omni Data transaction was properly stated in the financial statements.
Failure to Adequately Plan the 2005 and 2006 Year-End Audits
L H, under Howley's direction, failed to plan the 2005 and year-end audits of LocatePlus adequately by designing procedures that would account for the heightened risk of fraud and, specifically, for the possibility that the Omni Data revenue was fictitious, as had been alleged.
L H's testing procedures for the Omni Data revenue included relying on the confirmation process and the existence of an executed contract and checking cash receipts. Omni Data, however, was not paying within its contract terms and, as Wood acknowledged during October 6, 2010, testimony before the Commission, if LocatePlus "set up a dummy company," as had been alleged, then the confirmation process "would not be adequate evidence."
Failure to Evaluate Evidence Obtained by the Confirmation Process
In general, it is presumed that audit evidence is more reliable when it is obtained from knowledgeable independent sources outside the entity. During the 2005 year-end audit, L H failed to evaluate adequately the reliability of the audit evidence obtained by the confirmation process. Exhibit 1 elaborates on the inadequacies.
Failure to Assess the Risk of Material Misstatement Due to the Omni Data Transaction
Although L H became aware of the informant's allegations prior to and during the course of the 2005 year-end audit, it took few steps to investigate the informant's allegations during the audit. Moreover, to the extent to which L H developed any evidence regarding the informant's allegations, the evidence corroborated many of the informant's claims.
For example, L H searched Connecticut and Massachusetts corporate records, but found no evidence that Omni Data was incorporated. Howley attempted to contact the alleged president of Omni Data, but was initially unable to reach her as the first confirmation sent to Omni Data was returned as undeliverable.
L H discovered additional red flags regarding the Omni Data transaction during the 2005 interim reviews and year- end audit. For example, L H discovered that:
• The Omni Data receivable comprised approximately 76 percent of the overall accounts receivable, but LocatePlus had collected only $250,000 in payments in 2005 from Omni Data out of approximately $3.6 million in revenue recognized.
• Payments totaling approximately $10,000 from LocatePlus to the alleged president of Omni Data.
• Payments totaling approximately $325,000 to the CEO.
Although L H's work papers document the informant's allegations, they do not document the procedures specifically designed to assess these risks. In fact, L H's "Fraud Risk Assessment Form," for the 2005 year-end audit, which lays out procedures intended to facilitate compliance with auditing standards is blank.
Moreover, an item on L H's audit program (completed at the conclusion of the audit) specifically instructs that "[i]f you believe that fraud or an illegal act may have occurred, document the circumstances identified and apply the procedures for potential fraud or illegal acts in additional procedures section of this audit program."
The work paper states "none noted" next to the proposed procedure indicating that L H never applied the additional procedures in its own audit program. Howley testified that he reviewed this work paper.
L H's 2005 year-end work papers do not document that L H came to any conclusion about the merits of the informant's allegations. L H's 2006 year-end work papers document that the very existence of Omni Data was still an open question through the 2006 year-end audit and that L H did not come to a final conclusion about the informant's allegations until, at the earliest, April 2007.
Despite the numerous red flags and lingering questions about the existence of the Omni Data receivable, L H's 2005 year-end work papers also do not document an assessment of the risks of material misstatement due to fraud.
Despite being aware of the informant's allegations of fraud (and thus the risks of material misstatement), Howley did not undertake adequate audit procedures during the 2005 or 2006 year-end audit to assess these risks.
L H's 2005 year-end audit work papers document that L H accepted management's explanations for the red flags. For example, with regard to the Omni Data receivable, Howley accepted LocatePlus's management's representation that it was collectible despite L H's difficulties verifying its existence and Omni Data's failure to make payments under the terms of the purported contact.
With regard to the CEO payments, Howley accepted the explanation that the payments were "bonuses" approved by the board even though the bonuses did not go through LocatePlus's payroll system. In addition, L H did not obtain LocatePlus's board minutes to attempt to verify the explanation. Finally, with regard to the payments to the alleged president of Omni Data, Howley accepted LocatePlus's explanation that they were "referral fees" despite allegations that the alleged president was a figurehead installed by the CEO.
Alleged Professional Violations
The SEC charged that L H, Howley, and Wood engaged in improper professional conduct that violated Section 4C(a)(2) of the Exchange Act and Rule 102(e)(1)(ii) of the Commission's Rules of Practice. Under Rule 4C(b)(2) and Rule 102(e)(1)(iv) (B), the term "improper professional conduct" means, in part, "a single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted."
In light of the specific allegations that the Omni Data transaction was fictitious, L H's and Howley's failure to design testing procedures adequately to address that very risk, and Wood's concurrence in the approval of the issuance of L H's 2005 and 2006 audit reports when he knew that significant matters were unresolved, constituted highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which each knew, or should have known, that heightened scrutiny was warranted.
The failure of L H and Howley to plan the audits properly, test the Omni Data revenue adequately, obtain sufficient competent evidence to serve as a basis for L H's audit reports, and assess properly the risks of material misstatement due to fraud, and the failure of Wood to address these deficiencies also constituted highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which each knew, or should have known, that heightened scrutiny was warranted.
As a result of the conduct alleged in the SEC filing, L H, Howley, and Wood violated Section 10A(a)(1) of the Exchange Act, which requires each audit to include procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.
1. Do you think L H's actions with respect to LocatePlus and its alleged relationship with Omni Data illustrates a case of moral blindness? Explain with respect to the ethics of actions by LocatePlus and its effect on audit decisions by L H.
2. A critical element of the due care requirement is to approach an audit with professional skepticism. Evaluate the audit procedures and decisions made by L H with respect to this ethical standard.
3. Evaluate the legal liability of L H, Howley, and Wood using the legal concepts discussed in this chapter. Support your analysis with reasoning as to whether the auditors failed to exercise ordinary care, were grossly negligent, or committed fraud.
1 SEC, Accounting and Enforcement Release No. 3288, Administrative Proceeding File No. 3-14440, 6n the Matter of Livingston Haynes, P. C., Kevin Howley, CPA and William W. Wood, CPA. Available at www.sec.gov/litigation/admin/2011/34-64607.pdf.