This is an update of a Street Sweeper article that originally ran on December 20, 2010.
On December 20, 2010, the Securities and Exchange Commission (ďSECĒ) filed a Complaint in the U.S. District Court for the Northern District of Georgia charging Joseph M. Elles (ďEllesĒ), a former Executive Vice President of Atlanta-based childrenís clothing marketer Carterís Inc., with engaging in financial fraud and insider trading. The SEC alleges that Ellesís misconduct caused an understatement of Carterís expenses and a material overstatement of its net income in several financial reporting periods.
NOTE: DEFENDANT ELLES IS PRESUMED INNOCENT UNLESS AND UNTIL PROVEN GUILTY. ALL CHARGES ARE MERELY ALLEGATIONS AT THIS TIME.
The SEC Complaint charges that from 2004 to 2009, Elles fraudulently manipulated the dollar amount of discounts that Carterís granted to its largest wholesale customer ó Kohlís Corporation (ďKohlísĒ), a large national department store ó in order to induce Kohlís to purchase greater quantities of Carterís clothing for resale.
In the clothing industry, such discounts are referred to as ďaccomodations,Ē and are used to defray costs related to inventory clearance and sales promotions. Ultimately, the accomodations arranged by Ellles allowed Kohlís to achieve a target profit margin on its purchases from Carterís.
Cast of Characters
According to the Complaint:
Joseph M. Elles, 55 and a resident of Las Vegas, Nevada, was hired by Carterís in 1996 as Vice President of Regional Accounts and, thereafter, promoted in 1997 to Executive Vice President of Sales-a position he held until his termination from Carterís in March 2009. As Executive Vice President of Sales, Elles supervised all of the individual Vice Presidents who managed Carterís retail and mass channel customer accounts, and reported directly to Carterís President. Elles was terminated from the Company as of March 2009.
Carterís, Inc. is an Atlanta-based public issuer and the self proclaimed ďlargest branded marketer in the U.S. of apparel exclusively for babies and young children.Ē The Company sells clothing under the Carterís brand names, as well as private label apparel, through its own stores and oth-er retailers. In fiscal 2009, the Company generated net income of $116 million on sales of$1.59 billion. Since October 2003, Carterís common stock has been registered with the Commission under Section 12(b) ofthe Exchange Act and listed on the NYSE.
Kohlís Corporation is a public issuer and retailer based in Wisconsin. Kohlís operates over a thousand department stores in 49 states. At the time of Ellesí misconduct, Kohlís was Carterís largest wholesale customer in terms ofvolume of purchases
See, Kohlís webpage promoting Carterís products
See, Carterís homepage
According to the Complaint, Elles concealed his misconduct by persuading Kohlís to defer subtracting the discounts from payments until later financial quarters. In furtherance of this alleged scheme, Elles is charged with creating and signing false documents that misrepresented to Carterís accounting personnel the timing and amount of those discounts.
The SEC contends that accounting rules require that ďaccomodationsĒ be recorded as an expense in the period when the related sale is recognized. When properly implemented, an accommodation essentially functions as an expense that reduces the revenue otherwise realized by Carterís from the sale to which the accommodation relates.
In contrast, Ellesí alleged scheme misrepresented that the expense occurred in a later fiscal quarter when Kohlís deducted the payments from Carterís, rather than in the earlier quarter when the sale was recognized. Consequently, it is alleged that Elles caused the understating of expenses in some quarters and the subsequent overstatement of income in the corresponding quarters.
Paragraph 36 of the Complaint sets forth the value of the secretly deferred ďaccomodationsĒ from the immediately prior fiscal year into the year noted:
Not only is Elles charged with the financial manipulations cited above, but between May 2005 and March 2009, he exercised options and sold 200,814 shares of Carterís stock, realizing a pre-tax profit of $4,739,862. Each of these stock sales occurred prior to Oct. 27, 2009, when Carterís initially disclosed the fraud, after which the companyís common stock share price dropped 23.8 percent. After discovering Ellesís actions and conducting its own internal investigation, Carterís was required to issue restated financial results for the affected periods
Summing It Up
The Complaint alleges that Elles violated Section 17(a) of the Securities Act of 1933, and Sections 10(b) and 13(b)(5) of the Securities Exchange Act of 1934 and Rules 10b-5 and 13b2-1, and aided and abetted violations of Sections 13(a) and 13(b)(2)(A) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1, 13a-11 and 13a-13. The SEC is seeking permanent injunctive relief, disgorgement of ill-gotten gains with prejudgment interest, financial penalties, and an officer and director bar against Elles.
The SEC also announced that it has entered a non-prosecution agreementwith Carterís under which the company will not be charged with any violations of the federal securities laws relating to Ellesís unlawful conduct. In agreeing to the the non-prosecution agreement, the SEC noted that the considerations compelling that undertaking reflected
The Carterís non-prosecution agreement represents the first such agreement entered into by the SEC since the announcement of the SECís new cooperation initiative earlier this year. Under the terms of the agreement, Carterís agreed to cooperate fully and truthfully in any further investigation conducted by the SEC, as well as in the enforcement action filed against Elles.
Among the notable restrictions imposed upon Carterís by the agreement is that the company
[A]grees not to take any.action or to make or permit any public statement through present or future attorneys, employees, agents, or other persons authorized to speak for it, except in legal proceedings in which the Commission is not a party, denying, directly or indirectly, the factual basis of any aspect of this Agreement. . .
. . .
Prior to issuing a press release concerning this Agreement, the Respondent agrees to have the text of the release approved by the staff of the Division.
On September 21, 2011, an Atlanta, GA federal grand jury returned a 32-count indictment against Elles on charges of:
NOTE: An Indictment only contains charges and the defendant is presumed innocent unless and until proven guilty beyond a reasonable doubt in a court of law.
On March 20, 2012, a federal grand jury in Atlanta, GA, indicted Joseph Pacifico, 62, former President of Carterís from 2004 until December 2009, during which time he supervised Elles and the companyís wholesale sales accounts, including Kohlís. Pacifico was charged with:
The charges are part of a Superseding Indictment that charges Pacifico and Elles, 57, with 37 federal crimes relating to their alleged roles in accounting irregularities at Carterís. Largely reiterating the allegations and assertions in the SECís case, the Superseding Indictment alleges that from 2006 and into 2009, at the end of each fiscal year and at the end of several fiscal quarters, Elles agreed to pay the accomodations rebates (also known as ďmargin supportĒ) to Kohlís and other retailers. Elles was charged with manipulating Carterís accounting for millions of dollars in rebates to Kohlís by misrepresenting that the rebates related to sales made in current fiscal years or quarters, rather than the prior years or quarters in which the sales were actually made.
Allegedly, at least by April 2009 and continuing through November 2009, Pacifico was aware of the undisclosed rebates and he is charged with attempting to keep them hidden from other members of senior management, Carterís shareholders, internal and external auditors, and others. In furtherance of this alleged cover-up, prosecutors alleged that Pacifico lied to other members of senior management and other employees, signed false documents, and instructed subordinates not to relay information about the rebates to senior management or dissuaded them from doing so.
The net result of the underlying fraud and its attempted cover-up, was that from April 2009 through July 2009, Pacifico allegedly caused Carterís to materially misstate its net income and other items in its publicly filed financial statements and falsified and caused to be falsified certain corporate books and records. Allegedly, Elles caused Carterís to file materially false financial statements for several years and quarters from at least November 2006 through July 2009, and that he also falsified or caused to be falsified multiple corporate books and records during that period.
Pacifico and Elles face the following maximum prison terms and fines on these charges:
SEC v. Pacifico
On October 18, 2012, the SEC filed a Complaint in the United States District Court for the Northern District of Georgia, alleging that between 2004 and 2009, Elles, who reported to Pacifico, fraudulently manipulated the amount of discounts that Carterís granted to its largest wholesale customer (a national department store), as more fully set forth above. Further, theComplaint alleges that after discovering Ellesís scheme, Pacifico signed
The SEC is seeking permanent injunctive relief, financial penalties, and an officer and director bar against Pacifico.
Bill Singerís Comment
Based upon the commentary in both the SECís and the Department of Justiceís cases, it appears that the creative accounting devices used in this case may not be all that foreign a practice throughout the retail industry. With most major retailers such as JC Penney, Target, Walmart, and Macyís now publicly traded companies, the practices under scrutiny in Carterís could have far reaching impact. Itís one thing to operate two registers at a mom-and-pop retailer ó one for the IRS and the other for whoís gonna know. When youíre publicly traded and reporting to the SEC, the little tricks that go on in the boonies can have serious consequences when you have a trading symbol on the NYSE or NASDAQ.
With pressure to perform each quarter and with the uncertainties of the American consumer emerging from the Great Recession, who knows what sleights of hand are being performed in the C-suites in the retail sector. With Elles and Pacifico, the feds didnít allege that the public companies involved were necessarily complicit with the alleged violations or crimes. The gist is that these were the doings of the individuals charged. Still, you have to wonder whether there are a lot of nervous nellies hoping that no one starts poking around their store