SafeNet: A Case of Fraudulent Financial Reporting

Carol Argo participated in the awarding of stock options at SafeNet and found herself in trouble. On one hand, it would appear that Carole Argo was simply following company policy with respect to the granting of stock options. It might appear that she was simply maintaining the procedures of her superior, Anthony Caputo, Chair of the Board and CEO, by selecting previous dates as the stock options grant dates. This procedure, in and of itself, does not violate any of the applicable accounting standards (see Appendix A for a basic description of stock options and backdating). So what is the problem? Why did she resign? Why did she not stay with the company and fight her case? Why did the SEC and the U.S. Department of Justice (DOJ) press charges? Where did she go wrong? Was she being unjustly targeted?

THE CASE

In 2004, SafeNet, a publicly traded corporation whose mission it was to protect users (their customers) from computer fraud, boasted of higher than expected earnings for the year. They materially misstated their financial statements, proxy statements, registration statements, and press releases. SafeNet materially misstated their net income or loss for the years 2000 through 2005 by 4, 32, 25, 27, 400, and 200 percent, respectively (SEC 2007b). In an attempt to meet earnings expectations, SafeNet knowingly and willingly backdated stock options without reporting the related compensation expense. As the chief operating officer (COO) and the interim chief financial officer (CFO), Carole Argo was the

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first executive charged, and both civil and criminal charges were pressed (Schwankert 2007).

Carole Argo

Carole Argo, CPA, at 45 years old, was living the dream of most accountants. Prior to employment with SafeNet, Argo worked seven years in public accounting that included work with one of the Big 4 as an audit manager. She also worked eight years as the VP of Finance and Controller for a privately held company, and one year as the CFO of a public company (SEC

2001-2006, Proxy Statement 2005, 7). These 16 years of Argo's life were certainly successful, as she continued to move up the corporate ladder.

Argo went to work at SafeNet in 1999 and served five years as SafeNet's Senior VP and CFO (see Table 1). In January 2000, she was appointed to serve as the corporate treasurer and secretary.

She concurrently served in these positions while serving as the Senior VP and CFO. In June 2004, Argo was promoted to the position of President and COO of the company (Business Wire 2004). She began serving as the interim CFO in April 2006. Argo's annual salary was $315,404 plus

50,000 stock options in 2005. She had unexercised stock options worth slightly more than $3,000,000 as of December 31, 2005 (SEC 2001-2005, 2005 10-K, 10-11).

In May 2006, the SEC informed SafeNet, Inc. of the investigation into SafeNet's stock options policies (SEC 2001-2006, Proxy Statement, 9). Argo and her supervisor, CEO Anthony

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Caputo, both resigned in October 2006 (Terry 2006). The SEC filed a complaint against Argo in August 2007, citing several instances of fraudulent reporting (SEC 2007a). Concurrent to the civil suit filed by the SEC, the U.S. Department of Justice (DOJ) filed criminal charges against Argo (Schwankert 2007; Taub 2007).

The Company

SafeNet, Inc. (SafeNet) was founded and incorporated as Industrial Resource Engineering, Inc. in 1983 by two security engineers in Timonium, Maryland. In 1988, the company reincorporated in Delaware under the name of Information Resource Engineering (IRE). Although incorporated in Delaware, IRE maintained headquarters in Maryland. The company's stockholders voted to change the company name to SafeNet, Inc. in November 2000 (SEC 2001-2005, 10-K 2001, 2).

SafeNet was a publicly traded corporation with a mission to protect users (their customers) from computer fraud. According to Anthony Caputo, Chair of the Board of Directors, CEO, and President (during the time Argo was the CFO), ''we [SafeNet] are a security company. We'll make our technology available in any form to meet the customer's needs'' (D'Onofrio 2003).

SafeNet's primary focus was ''hardware and software information security products and services'' (SEC 2001-2005,

10-K 2005, 2). A selection of their products included anti-piracy applications, biometrics, USB tokens/smart cards, virtual private network (VPN) hardware and software, encryption (WAN, VPN,

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SSL, VPN, two-factor authentication, wireless VPN), and communications security. They focused on securing identities, communications, and applications.

SafeNet's strategy included the acquisition of other organizations, both domestic and foreign, that complemented their vision of providing computer security hardware and software. These acquisitions served to increase their customer base, product offerings, and/or proprietary rights. For example, in June 2005, the purchase of MediaSecurity, Inc. extended SafeNet's security services and products to the recording and motion picture industries (SEC 2001-2005, 10-K 2005).

The company grew tremendously after its inception in 1983. ''Information Resource Engineering is now growing by leaps and bounds,''stated analyst Steve Bronson (Kendall 1996). Bronson also stated that he expected ''accelerated growth to continue'' and forecasted revenues to increase in 1996 by $19 to $21 million over the 1992 revenue of $3 million (Kendall 1996). By the year 2000, SafeNet reported gross revenues of $28.8 million. Gross revenues increased to $66 million in 2003, and exceeded $260 million by 2005. The number of employees increased from 124 in 1999 to 1,043 in 2005. In addition, the number of employees working outside of the U.S. increased by 20 percent. The number of shares outstanding increased to 25 million in 2005, an increase from the 6.7 million shares outstanding in 1999 (SEC 2001-2005, 10-Ks 2000, 2003, and 2005). The market values of shares held by nonaffiliates was $166 million in 1999, compared to $713 million in 2005. SafeNet operated around the globe,

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with 44 subsidiaries in five states and 15-20 other countries (SEC 2001-2005, 10-K 2005, Exhibit V21).

SafeNet's markets in 2005 included financial institutions, U.S. federal government agencies (Department of Defense, Homeland Security, Internal Revenue Service), and original equipment manufacturers. SafeNet provided security services to such organizations as Cisco Systems, Microsoft, Texas Instruments, and Citigroup.

In 2001, SafeNet's stock price remained steady while at the same time, most other tech stocks were ''nose-diving'' (Hughlett 2001). During a 2003 interview, Caputo was asked how they avoided the technology bust of 2000-2001 (D'Onofrio 2003). Caputo

replied that because they did not believe the technology bubble

would last forever, they did not overspend. He stated that with just a

couple of bad quarters, they merely had minor tweaking to get

them back on track. In that same interview, Caputo was asked to

explain the losses of $9.6 and $2.2 million in the first and second

quarters of 2003, respectively. He stated that net income is a

function of generally accepted accounting principles (GAAP). The

underlying implication was that GAAP does not always reflect

actual operations. Caputo further stated that SafeNet's operating

income ''has been increasing very rapidly, essentially doubling''

(D'Onofrio 2003). By the third quarter of 2004, SafeNet reported a

242 percent increase in revenues over the third quarter of the

previous year. Net income increased from $2.7 to $9.6 million

(Baltimore Business Journal 2004).

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Corporate Structure (SafeNet's Proxy Statement 2006)

SafeNet had nine members on their Board of Directors by 2006. Anthony Caputo was the Chair of the Board. The board had three subcommittees (audit, compensation, and nominating), each comprised of members from the Board of Directors.

As the CEO of the company, Caputo also headed up the management team (see Figure 1). He had served as the CEO since 1987. Argo, as the President, served as the second in command behind Caputo on the management team (executive officers). In 2006, Argo was also the COO and the interim CFO. Three senior VPs also served on the management team.

Good TimesStock and Stock Options

SafeNet's common stock performed well in the early 2000s relative to the NASDAQ (see Figure 2). SafeNet's stock returns exceeded the market's returns from 2000 through 2004.

Argo was well rewarded for SafeNet's performance. Argo's raises and bonuses increased by 150 percent from 2000 to 2003 (see Table 2). For this same period, the CFO of Juniper Networks (a competitor) received a 128 percent raise. Argo's compensation (salary and bonuses) for 2003 was 0.27 and 0.54 percent of total assets and total revenues, respectively. Competitor CFOs' compensation was less than 0.10 percent of total assets and 0.20 percent of total revenues. In 2003, Argo's compensation of $355,000 was comparable to competitor Juniper Network's CFO of $317,345. However, SafeNet's total assets and total revenues

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were less than 10 percent of Juniper's total assets and total revenues. Argo's stock options increased in market value by 267 percent. Argo's unexercised stock options had a market value of nearly $5 million by 2004 (see Table 3).

As the President and COO, Carole Argo focused most of her energies on SafeNet's global operations. Argo's primary focus was mergers and acquisitions. As the CFO, Argo was responsible for all accounting, finance, and treasury functions. These responsibilities included recommending stock options awards to the Board of Directors' Compensation Committee.

Argo (with Caputo) urged the Compensation Committee to produce a standardized stock options program, related to the FASB Interpretation No. 44 (effective July 1, 2000; FASB 2000). More specifically, Argo (and Caputo) requested a program that would avoid charges to compensation expense (SEC 2007b). The Compensation Committee delegated the authority of the stock options award program for nonexecutive officers to the CFO, CEO, and secretary. The executives were responsible for identifying recipients, the number of options, and the exercise price. The Compensation Committee maintained final approval.

Actions by the Compensation Committee signaled the final step of the granting process for stock options awards to the executive officers and other senior officers (SEC 2007b). All recommendations were subject to change and not final until the Compensation Committee gave their approval. Evidence to this end appears in the recommendations for stock options awarded in 2001.

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In 2001, Caputo was awarded 50,000 options, contingent upon signing his employment contract (SEC 2007b). Caputo refused to sign the contract unless he was awarded an additional 100,000 options. Two months after the initial contract offer, the Compensation Committee agreed to add the extra 100,000 stock options. Caputo then signed the contract.

Argo selected a grant date for Caputo's stock options that was nearly three months prior to the contract agreement date. The stock price on the signed contract date was $18.65 per share. The earlier (backdated) ''grant'' date stock price was $5.85 per share. SafeNet reported in their financial statements, and other reports to the SEC, that the exercise price and the market price on the grant date were the same ($5.85). Argo received an additional 25,000 stock options at the same time Caputo signed his contract. Again, $5.85 was reported as the exercise price and the market price on the grant date.

A message from Argo, to the new CFO, provides

additional evidence of SafeNet's stock options backdating policy.

Argo's message stated that their ''past practice has been to

aggregate options . . . for the quarter . . . [and] pick the best price''

(SEC 2007b). It appears the use of the earlier grant date, as the

actual grant date, was standard operating procedure. In the same

message to the CFO, Argo justified the policy by stating,

''Who wants to have an option priced . . . and then have the option

underwater² a month later'' (SEC 2007b). She later stated that it

was not her intent to get rich. Argo was attempting to attract and

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reward employees (Bishop 2008).

At the end of the quarter or during the next quarter, after selecting the lowest stock price date, the paperwork was sent to the Compensation Committee for approval. The top of the materials sent to the Compensation Committee contained the earlier date, with the ''approval'' date appearing to be the date selected in hindsight. The committee would approve the recommendations, despite the differences between the dates at the top of the paperwork and the ''approval'' dates.

SafeNet's annual financial statements referred to the use of the intrinsic value method of the Accounting Principles Board's (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB 1972) (see Appendix A) in the Notes to the Financial Statements. The company reported that because the exercise price and the market value of the stock were the same, compensation expense was not recorded and did not appear as a reduction in net income.

SOX Certifications (302 and 404, U.S. House of Representatives 2002)

During Argo's latter years as the CFO and later as the interim CFO, Argo certified that it was her responsibility (with the CEO, Anthony Caputo) to establish and maintain a system of internal controls. Argo certified the internal controls were designed to ensure all material information about SafeNet would be revealed to her. Argo certified that she evaluated the effectiveness of SafeNet's

internal controls and that the internal controls were working

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properly. Argo certified that she disclosed any significant deficiencies and material weaknesses in the internal control system. Argo also certified that she disclosed any fraud involving management to SafeNet's auditors and Audit Committee. Argo certified that, based on her knowledge, the annual reports submitted to the SEC did not contain any untrue or omitted information that would cause the report to be misleading (SEC 2001-2005,10-Ks, Exhibits). As the corporate secretary, Argo also attested to the fair presentation of SafeNet's proxy statements.

SEC Complaint and Litigation (SEC 2007b, 2007a)

Argo allegedly was involved in assigning a ''grant'' date to stock options on a basis other than that allowed by the relevant GAAP. The relevant GAAP during the period of the fraud was APB No. 25 Accounting for Stock Issued to Employees. APB No. 25 required the recording of Compensation Expense for the excess of the market value on the actual grant date over the exercise price. See Appendix A for a basic explanation of stock options and accounting for stock options.

The SEC Complaint (SEC 2007b) produced five cases that suggested fraudulent activity by Argo. In each case, the SEC provided evidence that Argo selected a grant date based on hindsight and determined the exercise price to be the same as the market value on the grant date. They alleged that she used the date during the quarter with the lowest or near lowest market price of SafeNet stock as the grant date, as opposed to the actual grant date. In each case cited by the SEC, the exercise price was less

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than the market value on the ''actual'' grant date.

The SEC charged Argo witheither knowingly or as reckless in not knowingmisleading investors, the SEC, auditors, and SafeNet's external auditors. She indicated the financial statements, registrations, and proxy statements were fairly presented and void of materially false and misleading statements or omissions. The SEC's overall charge was that by omitting the stock-options-related compensation expense, net income (loss) and earnings (loss) per share were materially overstated (understated).

The SEC filed a civil injunctive action against Carole Argo on August 1, 2007, for backdating stock options and failing to record the related compensation expense. The injunctive action specifically related to stock options that were ''in-the-money'' during the period 2001 to 2006 (SEC 2007a). The SEC further charged Argo with backdating other documents to conceal the in-the-money options grants. Argo was charged with (1) violating the antifraud provisions of the federal securities laws, (2) falsifying SafeNet's books and records, (3) circumventing SafeNet's internal controls, (4) misleading SafeNet's auditors, and

(5) causing SafeNet to issue false and misleading financial reports.

Criminal Charge

The U.S. Attorney, Michael J. Garcia, of the Southern District of New York and Ron Walker, the Inspector-in-Charge of the U.S. Postal Inspection Service New York Division, filed criminal charges against Carole Argo. They alleged Argo committed eight counts of securities fraud and conspiracy for backdating stock

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options (Schwankert 2007) and failing to record the related compensation expense. She faced a maximum sentence of 25 years in jail and a fine of $250,000 per count.

-End-

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SafeNet, Inc.: A Case of Fraudulent Financial Reporting

TABLE 1

Positions at SafeNet, Inc. Held by Argo and Caputo, 1999-2006

1999

2000

2001

2002

2003

2004

2005

2006

Senior VP

ARGO

CFO

ARGO

Argo

President

CAPUTO

ARGO

COO

ARGO

Treasurer

ARGO

Secretary

ARGO

CEO

CAPUTO

Chair, Board

CAPUTO

of Directors

TABLE 2

Argo's Salaries and Bonuses

Year

Argo

Salary

Bonus

Total

2004

$ 271,957

$ 226,600

$ 498,557

2003

$ 180,000

$ 175,000

$ 355,000

2002

$ 153,000

$ 175,000

$ 328,000

2001

$ 166,000

$

-

$ 166,000

2000

$ 161,000

$75,000

$ 236,000

TABLE 3

Stock Options Awarded to Argo

Number of

Weighted-

Per Share Year-

Unexercised Shares

Average Per

Aggregated

stock options

end market

Year

Share

Year-end Market

awarded

value

Exercise Price

Value

2004

100,000

$21.70

$36.74

$4,756,100

2003

50,000

$19.45

$30.67

$2,756,250

2002

0

$25.35

$1,496,250

2001

62,000

$7.47

$18.94

$802,665

2000

33,000

$19.92

$47.00

$1,778,500

1999

40,000

Exercised

(48,500)

Total

236,500

options

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SafeNet, Inc.: A Case of Fraudulent Financial Reporting

FIGURE 1

SafeNet Inc., Organization Chart

as of June 2006

Board of Directors

(with Subcommittees)

Anthony Caputo

Chair of Board

& CEO

Carole D. Argo

President &

COO

Chris Fredde

Steve Lesem

Sr. VP &

Carole Argo

Sr. VP of

GM Enterprise

Interim CFO

Worldwide

Security

Services

Division

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FIGURE 2

Stock Performance Chart

(adopted from SafeNet's proxy statement dated June 24, 2005).

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APPENDIX A

Stock Options

Stock options are benefits given by some companies to employees as a form of compensation. The options allow the recipient to buy a specified number of shares of stock for a specified price (aka exercise or strike price). The value of stock options is the ability to buy a share of stock at the exercise price, and then turn around and sell the share at a higher market price. For example, assume an employee has a stock option that has an exercise price of $20, when the market price of the stock is $25. If the employee buys the share of stock for $20, then sells the share of stock for the market price of $25, the employee has a gain of $5.

A backdated stock option is an option that is ''granted'' on a date that is earlier than the approval (actual grant) date. The benefit of backdating is the use of the market value on the earlier ''grant'' date as the exercise price. APB No. 25 allowed for this type of backdating. However, APB No. 25 required Compensation Expense to be recorded for the excess of the market price (on the approval date) over the exercise price (on the backdate). The excess is called the ''intrinsic value.''

As an example: A company awards stock options on January 15, when the market price of the stock is $45. Assume the market price of the stock on December 12 was $35. The company could ''backdate'' the option to December 12 and grant the stock option with an exercise price of $35. However, the intrinsic value of $10 (market price on the approval date [January 15] of $45 stock price on the backdate [December 12] of $35), must be recorded as Compensation Expense.

APB No. 25 was the relevant generally accepted accounting principle (GAAP) during the period described in the SafeNet case. APB No. 25 and the intrinsic value method were replaced

with ASC 718 (FASB 2014). ASC 718 requires an increase in compensation expense for the fair value of the stock.

1. List the type(s) of fraud committed by Argo at SafeNet. Explain your response.
2. List and discuss the elements of the fraud triangle as they relate to Carole Argo. The three elements of the fraud triangle pressure, opportunity, and rationalization appear in this case.
3. Describe the conditions at SafeNet, Inc. that allowed for the perpetration of this fraud.
4. Describe at least three specific internal control policies and/or procedures that would have helped to prevent the fraud described in the SafeNet case.
5. List the ''red flags'' mentioned in the case. Provide justification from the case for the flags you identified.
6. List and describe two internal controls that you believe might have helped to detect this fraud. Explain how the internal controls you listed would have helped to detect this fraud.
7. Please compare and contrast the corporate governance structure at SafeNet for these two periods (Pre-Sox and Post-SOX). Do you believe the post-SOX changes in corporate governance served the purpose of "preventing management fraud" in terms of Audit Committee, Compensation Committee, and Board of Directors?
8. Conduct research to determine the outcomes of the SEC v. Carole Argo and the U.S. DOJ v. Carole Argo. Describe the outcomes and the consequences imposed on Carole Argo. Document your sources.