Major Case 4 Cendant Corporation The Merger of HFS and CUC HFS Incorporated (HFS) was principally a controller of franchise brand names in the hotel, real estate brokerage, and car rental businesses, including Avis, Ramada Inn, Days Inn, and Century 21. Comp-U-Card (CUC) was principally engaged in membership-based consumer services such as auto, dining, shopping, and travel "clubs." Both securities were traded on the NYSE. Cendant Corporation was created through the December 17, 1997, merger of HFS and CUC. Cendant provided certain membership-based and Internet-related consumer services and controlled franchise brand names in the hotel, residential real estate brokerage, car rental, and tax preparation businesses. Overview of the Scheme The Cendant fraud was the largest of its kind until the late 1990s and early 2000s. Beginning in at least 1985. certain members of CUC's senior management implemented a scheme designed to ensure that CUC always met the financial results anticipated by Wall Street analysts. The CUC senior managers used a variety of means to achieve their goals, including: Manipulating recognition of the company's membership sales revenue to accelerate the recording of revenue. Improperly using two liability accounts related to membership sales that resulted from commission payments. Consistently maintaining inadequate balances in the liability accounts, and, on occasion, reversing the accounts directly into operating . . - income. income. With respect to the last item, to hide the inadequate balances, senior management periodically kept certain membership sales transactions off the books. In what was the most significant category quantitatively, the CUC senior managers intentionally overstated merger and purchase reserves and subsequently reversed those reserves directly into operating expenses and revenues. CUC senior management improperly wrote off assets including assets that were unimpaired-and improperly charged the write-offs against the company's merger reserves. By manipulating the timing of the write offs and by improperly determining the nature of the charges incurred, the CUC senior managers used the write-offs to inflate operating income. As the scheme progressed over the course of several years, larger and larger year- end adjustments were required to show smooth net income over time. The scheme added more than $500 million to pretax operating income during the fiscal years ended January 31, 1996; January 31, 1997; and December 31, 1997. Page 538 SEC Filings against CUC and Its Officers SEC complaints filed on June 14, 2000, alleged violations of the federal securities laws by four former accounting officials, including Cosmo Corigliano, CFO of CUC; Anne M. Pember, CUC controller: Casper Sabatino, vice president of accounting and financial reporting, and Kevin Kearney, director of financial reporting. The allegations against Corigliano included his role as one of the CUC senior officers who helped engineer the fraud, and he maintained a schedule that management used to track the progress of their fraud. Corigliano regularly directed CUC financial reporting managers to make unsupported alterations to the company's quarterly and annual financial results. The commission alleged that Corigliano profited from his own wrongdoing by selling CUC securities and a large number of Cendant securities at inflated prices while the fraud he helped engineer was under way and undisclosed. The commission alleged that Pember was the CUC officer most responsible for implementing directives received from Corigliano in furtherance of the fraud, including implementing directives that inflated Cendant's annual income by more than $100 million, primarily through improper use of the company's reserves. According to the SEC, Pember profited from her own wrongdoing by selling CUC and Cendant stock at inflated prices while the fraud she helped implement was under way and undisclosed. Sabatino and Kearney, without admitting or denying the commission's allegations, consented to the entry of final judgments settling the commission's action against them. The commission's complaint alleged that Sabatino was the CUC officer most responsible for directing lower-level CUC financial reporting managers to make alterations to the company's quarterly financial results. In the first of the three separate administrative orders, the commission found that Steven Speaks, the former controller of CUC's largest division, made or instructed others to make journal entries that effectuated much of the January 1998 income inflation directed by Pember. In a second, separate administrative order, the commission found that Mary Sattler Polverari, a former CUC supervisor of financial reporting at the direction of Sabatino and Kearney, regularly and knowingly made unsupported alterations to CUC's quarterly financial results. In a third administrative order, the commission found that Paul Hiznay, a former accounting manager at CUC's largest division, aided and abetted violations of the periodic reporting provisions of the federal securities laws by making unsupported journal entries that Pember had directed. Hiznay consented to the issuance of the commission's order to cease and desist from future violations of the provisions, In a fourth and separate administrative order, the commission found that Cendant violated the periodic reporting, corporate record-keeping. and internal controls provisions of the federal securities laws, in connection with the CUC fraud. Among other things, the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the commission, as a result of the long-running fraud at CUC. Simultaneous with the institution of the administrative proceeding, and without admitting or denying the findings contained therein, Cendant consented to the issuance of the commission order, which ordered Cendant to cease and desist from future violations of the provisions. On February 28, 2001, the SEC filed a civil enforcement action in the U.S. District Court for the District of New Jersey against Walter A. Forbes, the former chair of the board of directors at CUC, and E. Kirk Shelton, the former vice chair, alleging that they directed a massive financial fraud while selling millions of dollars' worth of the company's common stock. For the period 1995-1997 alone, pretax operating income reported to the public by CUC was inflated by an aggregate amount of over $500 million. Specific allegations included: Forbes, CUC's chair and CEO directed the fu . . Forbes, CUC's chair and CEO, directed the fraud from its beginnings in 1985. From at least 1991 on, Shelton, CUC's president and COO, joined Forbes in directing the scheme. Forbes and Shelton reviewed and managed schedules listing fraudulent adjustments to be made to CUC's quarterly and annual financial statements. CUC senior management used the adjustments to pump up income and earnings artificially, defrauding investors by creating the illusion of a company that had ever-increasing earnings and making millions for themselves along the way. Forbes and Shelton undertook a program of mergers and acquisitions on behalf of CUC in order to generate inflated merger Page 539 and purchase reserves at CUC to be used in connection with the fraud. Forbes and Shelton sought out HFS as a merger partner because they believed that the reserves that would be created would be big enough to bury the fraud. To entice HFS management into the merger, Forbes and Shelton inflated CUC's earnings and earnings projections. Forbes and Shelton profited from their own wrongdoing by selling CUC and Cendant securities at inflated prices while the fraud they had directed was under way and undisclosed. The sales brought Forbes and Shelton millions of dollars in ill-gotten gains. . After the Cendant merger, Forbes served as Cendant's board chair until his resignation in July 1998. At the time of the merger, Shelton became a Cendant director and vice chair. Shelton resigned from Cendant in April 1998. Specific Accounting Techniques Used to Manage Earnings MAKING UNSUPPORTED POSTCLOSING ENTRIES In early 1997, at the direction of senior management, Hiznay approved a series of entries reversing the commissions payable liability account into revenue at CUC. The company paid commissions to certain institutions on sales of CUC membership products sold through those institutions. Accordingly, at the time that it recorded revenue from those sales, CUC created a liability to cover the payable obligation of its commissions. CUC senior management used false schedules and other devices to support their understating of the payable liability of the commissions and to avoid the impact that would have resulted if the liability had been properly calculated. Furthermore, in connection with the January 31, 1997 fiscal year-end, senior management used this liability account by directing postelosing entries that moved amounts from the liability directly into revenue.? In February 1997, Hiznay received a schedule from the CUC controller setting forth the amounts, effective backdates, and accounts for a series of postclosing entries that reduced the commissions payable account by $9.12 million and offsetting that reduction by increases to CUC revenue accounts. Hiznay approved the unsupported entries and had his staff enter them. They all carried effective dates spread retroactively over prior months. The entries reversed the liability account directly into revenues, a treatment that, under the circumstances, was not in accordance with GAAP. KEEPING REJECTS AND CANCELLATIONS OFF-BOOKS: ESTABLISHING RESERVES During his time at CUC, Hiznay inherited, but then supervised, a longstanding practice of keeping membership sales cancellations and rejects off CUC's books during part of each fiscal year. Certain CUC membership products were processed through various financial institutions that billed their members' credit cards for new sales and charges related to the various membership products. When CUC recorded membership sales revenue from such a sale, it would allocate a percentage of the recorded revenue to cover estimated cancellations of the specific membership product being sold, as well as allocating a percentage to cover estimated rejects and chargebacks.' CUC used these percentage allocations to establish a membership cancellation reserve. Over the years, CUC senior management had developed a policy of keeping rejects and cancellations of the general ledger during Page 540 the last three months of each fiscal year. Instead, during that quarter, the rejects and cancellations appeared only on cash account bank reconciliations compiled by the company's accounting personnel. The senior managers then directed the booking of those rejects and cancellations against the membership cancellation reserve in the first three months of the next fiscal year. Because rejects and cancellations were not recorded against the membership cancellation reserve during the final three months of the fiscal year, the policy allowed CUC to hide the fact that the reserve was understated dramatically at each fiscal year-end. At its January 31, 1997 fiscal year-end, the balance in the CUC membership cancellation reserve was $29 million; CUC accounting personnel were holding $100 million in rejects and $22 million in cancellations off the books. Failing to book cancellations and rejects at each fiscal yearend also had the effect of overstating the company's cash position on its year-end balance sheet. Accounting and Auditing Issues Kenneth Wilchfort and Marc Rabinowitz were partners at Ernst & Young (EY), which was responsible for audit and accounting advisory services provided to CUC and Cendant. During the relevant periods, CUC and Cendant made materially false statements to the defendants and EY about the company's true financial results and its accounting policies. CUC and Cendant made these false statements to mislead the defendants and EY into believing that the company's financial statements conformed to GAAP. For example, as late as March 1998, senior Cendant management had discussed plans to use over $100 million of the Cendant reserve fraudulently to create fictitious 1998 income, which was also concealed from the defendants and EY. CUC and Cendant made materially false statements to the defendants and EY that were included in the management representation letters and signed by senior members of CUC's and Cendant's management. The statements concerned, among other things, the creation and utilization of merger-related reserves the adequacy of the reserve established for membership cancellations, the collectability of rejected credit card billings, and income attributable to the month of January 1997.4 The written an The written representations for the calendar year 1997 falsely stated that the company's financial statements were fairly presented in conformity with GAAP and that the company had made available to EY all relevant financial records and related data. Those written representations were materially false because the financial statements did not conform to GAAP, and, as discussed further, the company's management concealed material information from the defendants and EY. In addition to providing the defendants and EY with false written representations, CUC and Cendant also adopted procedures to hide its income-inflation scheme from the defendants and EY. Some of the procedures that CUC and Cendant employed to conceal its fraudulent scheme included (1) backdating accounting entries; (2) making accounting entries in small amounts and/or in accounts or subsidiaries the company believed would receive less attention from EY: (3) in some instances, ensuring that fraudulent accounting entries did not affect schedules already provided to EY: (4) withholding financial information and schedules to ensure that EY would not detect the company's accounting fraud; (5) ensuring that the company's financial results did not show unusual trends that might draw attention to its fraud; and (6) using senior management to instruct middle- and lower-level personnel to make fraudulent entries. Notwithstanding CUC and Cendant's repeated deception, defendants improperly failed to detect the fraud. They were aware of numerous practices by CUC and Cendant indicating that the financial statements did not conform to GAAP, and, as a consequence, they had a duty to withhold their unqualified opinion and take appropriate additional steps. Page 541 Improper Establishment and Use of Merger Reserves The company completed a series of significant mergers and acquisitions and accounted for the majority of them using the pooling-of- interests method of accounting in connection with this merger and acquisition activity, company management purportedly planned to restructure its operations. GAAP permits that certain anticipated costs may be recorded as liabilities (or reserves) prior to their incurrence under certain conditions. However, here CUC and Cendant routinely overstated the restructuring charges and the resultant reserves and would then use the reserves to offset normal operating costs-an improper earnings management scheme. The company's improper reversal of merger and acquisition-related restructuring reserves resulted in an overstatement of operating income by $217 million. VERYONE The EY auditors provided accounting advice and auditing services to CUC and Cendant in connection with the establishment and use of restructuring reserves. The auditors excessively relied on management representations concerning the appropriateness of the reserves and performed little substantive testing, despite evidence that the reserves were established and utilized improperly. One example of auditor failures with reserve accounting is the Cendant reserve. Cendant recorded over $500 million in merger, integration, asset impairment, and restructuring charges for the CUC-side costs purportedly associated with the merger of HFS and CUC. The company recorded a significant portion of this amount for the purpose of manipulating its earnings for December 31, 1997, and subsequent periods, and, in fact, Cendant had plans, which it did not disclose to defendants and EY, to use a material amount of the reserve to inflate income artificially in subsequent periods. In the course of providing accounting and auditing services, the auditors failed to recognize evidence that the company's establishment and use of the Cendant reserve did not conform to GAAP. For example, CUC and Cendant provided EY with contradictory drafts of schedules when EY requested support for the establishment of the Cendant reserve. The company prepared and revised these various schedules, at least in part as a result of questions raised and information provided by the defendants. The schedules were inconsistent with regard to the nature and amount of the individual components of the reserve (i.c., component categories were added, deleted, and changed as the process progressed). While the component categories changed over time, the total amount of the reserve never changed materially. Despite this evidence, the auditors did not obtain adequate analyses, documentation, or support for changes that they observed in the various revisions of the schedules submitted to support the establishment of the reserves. Instead, they relied excessively on frequently changing management representations The company planned to use much of the excess Cendant reserve to increase operating results in future periods improperly. During the year ended December 31, 1997, the company wrote off $104 million of assets that it characterized as impaired as a result of the merger. Despite the size and timing of the write-off, the defendants never obtained adequate evidence that the assets were impaired as a result of the merger and therefore, properly included in the Cendant reserve. In fact, most of the assets were not impaired as a result of the merger. Cash Balance from the Membership Cancellation Reserve CUC and Cendant also inflated income by manipulating their membership cancellation reserve and reported cash balance. Customers usually paid for membership products by charging them on credit cards. The company recorded an increase in revenue and cash when it charged the members' credit card. Each month, issuers of members' credit cards rejected a significant amount of such charges. The issuers would deduct the amounts of the rejects from their payments to CUC and Cendant. CUC and Cendant falsely claimed to EY auditors that when it resubmitted the rejects to the banks for payment, it ultimately collected almost all of them within three months. CUC and Cendant further falsely claimed that, for the few rejects that were not collected after three months, it then recorded them as a reduction in cash and a decrease to the cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period and were entitled to a refund of at least a portion of the membership fee, as well as members who joined and were billed, but never paid for their memberships. At the end of each fiscal year, the company failed to record three months of rejects (i.c., it did not reduce its cash and decrease its Page 542 cancellation reserve for these rejects). CUC and Cendant falsely claimed to the defendants and EY that it did not record rejects for the final three months of the year because it purportedly would collect most of the rejects within three months of initial rejection According to CUC and Cendant, the three months of withheld rejects created a temporary difference at year-end between the cash balances reflected in the company's general ledger and its bank statements. The rejects were clearly specified on reconciliations of the company's numerous bank accounts, at least some of which were provided to EY and retained in its workpapers, CUC and Cendant falsely claimed to the defendants and EY that the difference between the general ledger balance and bank statement balance did not reflect an overstatement or cash and understatement in the cancellation reserve since it collected most rejects. In fact, the majority of rejects were not collected. By not recording rejects and cancellations against the membership cancellation reserve during the final three months of each fiscal year, CUC and Cendant dramatically understated the reserve at each fiscal year-end and overstated its cash position. CUC and Cendant thus avoided the expense charges needed to bring the cancellation reserve balance up to its proper amount and the entries necessary to record CUC and Cendant's actual cash balances. The rejects, cancellation reserve balance, and overstatement of income amounts for the period 1996 to 1997 are as follows: ($ in millions) Date Rejects Cancellation Reserve Balance Understated Reserve/Overstated Income 01/31/96 $ 72 $37 $35 01/31/97 $100 $29 $28 12/31/97 $137 $37 $37 The EY defendants did not adequately test the collectability of these rejects and the adequacy of the cancellation reserve and instead relied primarilyon management representations concerning the company's successful collection history and inconsistent statements concerning the purported impossibility of substantively testing these representations. Membership Cancellation Rates The company also overstated its operating results by manipulating its cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period. A large determinant of the liability associated with cancellations was CUC and Cendant's estimates of the cancellation rates. During the audits, CUC and Cendant intentionally provided EY with false estimates that were lower than the actual estimated cancellation rates. This resulted in a significant understatement of the cancellation reserve liability and an overstatement of income. To justify its understated cancellation reserve, CUC and Cendant provided to EY small, nonrepresentative samples of cancellations that understated the actual cancellation rates. The defendants allowed the company to choose the samples. Ey did not test whether the samples provided were representative of the actual cancellations for the entire membership population. Page 543 Audit Opinion EY issued audit reports containing unqualified (i.e., unmodified) audit opinions on, and conducted quarterly reviews of the company's financial statements that, as already stated, did not conform to GAAP. The Securities Exchange Act requires every issuer of a registered security to file reports with the commission that accurately reflect the issuer's financial performance and provide other information to the public. For the foregoing reason, the firm aided and abetted violations of the securities laws. Legal Issues SEC SETTLEMENTS Between Hiznay's arrival at CUC in July 1995 and the discovery of the fraudulent scheme by Cendant management in April 1998, CUC and Cendant filed false and misleading annual reports with the commission that misrepresented their financial results, overstating operating income and earnings and failing to disclose that the financial results were falsely represented. The commission's complaint alleged that Sabatino, by his actions in furtherance of the fraud, violated, or aided and abetted violations of the anti-fraud, periodic reporting, corporate record-keeping internal controls, and lying to auditors provisions of the federal securities laws. Sabatino consented to entry of a final judgment that enjoined him from future violations of those provisions and permanently barred him from acting as an officer or director of a public company Kearney consented to entry of a final judgment that enjoined him from future violations of those provisions, ordered him to pay disgorgement of $32,443 in ill-gotten gains (plus prejudgment interest of $8,234), and ordered him to pay a civil money penalty of $35,000. Kearney also agreed to the issuance of a commission administrative order that barred him from practicing before the commission as an accountant, with the right to reapply after five years. Corigliano, Pember, and Sabatino each pleaded guilty to charges pursuant to plea agreements between those three individuals and the SEC. Pursuant to his agreement, Corigliano pleaded guilty to a charge of wire fraud, conspiracy to commit mail fraud, and causing false statements to be made in documents filed with the commission, including signing CUC's periodic reports filed with the commission and making materially false statements to CUC's auditors. Pember pleaded guilty to a charge of conspiracy to commit mail fraud and wire fraud. Sabatino, pursuant to his agreement, pleaded guilty to a charge of aiding and abetting wire fraud. In another administrative order, the commission found that Hiznay aided and abetted violations of the periodic reporting provisions of the federal securities laws in connection with actions that he took at the direction of his superiors at CUC. Among other things, the commission alleged that Hiznay made unsupported journal entries that Pember had directed. Additional orders were entered against lower-level employees The commission found that Cendant violated the periodic reporting, corporate record-keeping, and internal controls provisions of the federal securities laws in connection with the CUC fraud in that the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the SEC. On December 29, 2009, the SEC announced a final judgment against Forbes, the former chair of Cendant, arising out of his conduct in the Cendant fraud. The commission alleged that Forbes orchestrated an earnings management scheme at CUC to inflate the company's quarterly and annual financial results improperly during the period 1995 to 1997. CUC's operating income was inflated improperly by an aggregate amount exceeding $500 million. The final judgment against Forbes, to which he consented without admitting or denying the commission's allegations, enjoined him from violating relevant sections of the securities laws and barred him from serving as an officer or director of a public Page 544 company CLASS ACTION LAWSUITS A class action suit by stockholders against Cendant and its auditors, led by the largest pension funds, alleged that stockholders paid more for Cendant stock than they would have had they known the truth about CUC's income. The lawsuit ended in a record $3.2 billion settlement Details of the settlement follow. By December 1999, a landmark $2.85 billion settlement with Cendant was announced that far surpassed the recoveries in any other securities law class action case in history. Until the settlements reached in the World Com case in 2005, this stood as the largest recovery in a securities class action case by far and clearly set the standard in the field. In addition to the cash payment by Cendant, which was backed by a letter of credit that the company secured to protect the class, the Cendant settlement included two other very important features. First, the settlement provided that if Cendant or the former HFS officers and directors were successful in obtaining a net recovery in their continuing litigation against EY, the class would receive half of any such net recovery. As it turned out that litigation lasted another seven years until the end of 2007-when Cendant and EY settled their claims against each other in exchange for a payment by EY to Cendant of nearly $300 million. Based on the provision in the Cendant settlement agreement and certain further litigation and a court order, in December 2008, the class received another $132 million. This brought the total recovered from the Cendant settlement to $2.982 billion. Second, Cendant was required to institute significant corporate governance changes that were far-reaching and unprecedented in securities class action litigation. Indeed, these changes included many of the corporate governance structural changes that would later be included within the Sarbanes-Oxley Act of 2002 (SOX). They included the following: . The board's audit, nominating, and compensation committees would be comprised entirely of independent directors (according to stringent definitions, endorsed by the institutional investment community, of what constituted an independent director) . The majority of the board would be independent within two years following final approval of the settlement. . Cendant would take the steps necessary to provide that, subject to amendment of the certificate of incorporation declassifying the board of directors by vote of the required supermajority of shareholders, all directors would be elected annually. . No employee stock option could be "repriced" following its grant without an affirmative vote of shareholders, except when such repricings were necessary to take into account corporate transactions such as stock dividends, stock splits, recapitalization, a merger, or distributions The Settlement with EY On December 17. 1999, it was announced that EY had agreed to settle the claims of the class for $335 million. This recovery was and remains today as the largest amount ever paid by an accounting firm in a securities class action case. The recovery from Ey was significant because it held an outside auditing firm responsible in cases of corporate accounting fraud. The claims against EY were based on EY's "clean" (.o., unmodified) audit and review opinions for three sets of annual financial statements, and seven quarterly financial statements, between 1995 and 1997. The district court approved the settlements and plan of allocation in August 2000, paving the way for Cendant and EY to fund the settlements. Approximately one year later, in August 2001, the settlements and plan of allocation were affirmed on appeal by the U.S. Third Circuit Court of Appeals. And in March 2002, the U.S. Supreme Court determined that it would not hear any further appeals in the case. QUESTIONS 1. Cendant manipulated the timing of write-offs and improperly determined charges in an attempt to smooth net income. Is income smoothing an ethical practice? Are there circumstances where it might be considered ethical and others where it would not? What motivated Cendant to engage in income smoothing practices in this case? 2. Analyze the actions taken by the company and its management from the perspective of the Fraud Triangle. 3. Describe the role of professional judgment in the audits by Ey. Did the firm meet its ethical obligations under the AICPA Code? Did it adhere to all appropriate auditing standards? 4. Trust is a basic element in the relationship between auditor and client. Explain how and why trust broke down in the Cendant case, including shortcomings in corporate governance. 5. Do you believe auditors should be expected to discover fraud when a client goes to great lengths, as did Cendant, to withhold evidence from the auditors and mask the true financial effects of transactions? Explain