On June 7, 2022, the Securities and Exchange Commission announced that it had charged software company Synchronoss Technologies, Inc. and seven of its current and former employees in connection with an alleged long-running accounting fraud involving improper revenue recognition of more than $46 million across six quarters. All of those implicated settled with the SEC and agreed to pay a range of penalties, except for the former CFO and controller, who will litigate against the SEC in New York federal court. Synchronoss was ordered to pay a $12.5 million penalty.
While the SEC did not charge Synchronoss’s former CEO in connection with the alleged fraud, the SEC invoked Section 304 of the Sarbanes-Oxley Act to require him to reimburse the company for more than $1.3 million in stock sale profits and bonuses and to return previously granted shares of company stock. Section 304 is a clawback provision that permits the SEC to seek reimbursement from CEOs and CFOs for bonuses and incentive-based compensation they received if their company is later required to restate its financial statements as a result of misconduct.
The action is notable for the extent of individual accountability the SEC pursued, with the SEC charging the former general counsel and other executives, and for the SEC’s detailed description of alleged internal control failures at Synchronoss, including its failure to maintain a “corporate culture” that would have prevented the deviations from company policy that resulted in the alleged fraud.
This wide-ranging action underscores the Commission’s apparent willingness to go deep into a company where it identifies what it believes is a significant fraud, charging all those responsible and, in the case of the CEO, going after an executive under SOX 304 who was not himself culpable but was ostensibly in a position to prevent the fraud through implementation of more robust internal controls.
The Alleged Misconduct
Synchronoss licenses software and provides services to telecommunications companies, and allegedly engaged in the improper re-characterization of the agreements under which Synchronoss provided those services. The SEC has alleged no improprieties by Synchronoss’s business partners, focusing instead on how Synchronoss characterized its agreements. The alleged misconduct involved improper accounting practices relating to three sets of transactions.
- Synchronoss allegedly improperly recognized millions of dollars of revenue for purported sales of software licenses to one of its largest telecommunications customers (“Customer A”). According to the SEC, Synchronoss booked revenue for the sales by relying on a back-dated agreement signed by an employee of Customer A who Synchronoss knew lacked authority to bind the company. The former CFO allegedly misled the company’s auditor with respect to its dealings with Customer A and made false statements in revenue recognition memoranda.
- The former CFO and other Synchronoss employees allegedly misrepresented that an acquisition target’s agreement to a license agreement was not critical to the completion of the acquisition, which allowed Synchronoss to recognize the licensing fee as upfront revenue, rather than accounting for it as part of the acquisition.
- Synchronoss employees allegedly repackaged a multi-year “software-as-a-service” arrangement into separate agreements in order to facilitate Synchronoss’s improper recognition of revenue upfront, including through the use of “side letters” that obscured the fact that revenue being recognized upfront was contingent on future events.
In addition to the company’s $12.5 million penalty, the individual defendants settled to a range of penalties as high as $90,000, and the former general counsel was suspended from appearing as an attorney before the SEC for 18 months. The former CFO and controller, charged with intentional fraud and a range of other charges, will, as noted, litigate against the SEC.
The SEC’s action demonstrates its intent to seek increased individual accountability by pursuing multiple defendants, especially top executives and other “gatekeepers” (such as legal counsel).
Director Grewal said the case should “put public company executives on notice that even when they are not charged with having a role in the misconduct at issue, we will still pursue clawbacks of compensation under SOX 304 to ensure they do not financially benefit from their company’s improper accounting.” Companies and executives would therefore be well-advised to think through the “clawback” consequences of any restatements and, to the extent any issues resulted in charges of misconduct by the SEC, should be prepared for the SEC to take a hard line. Time will tell whether the SEC will be tempted to stretch the definition of what “misconduct” requires reimbursement where the underlying misconduct sounds only in negligence.
The specter of compensation clawback is also intended to incentivize executives to adopt and enforce effective systems of internal control over financial reporting. In detailing the company’s allegedly unreasonable internal controls, the SEC emphasized Synchronoss’s failure to maintain a “corporate culture” that might have prevented the alleged misconduct.
While not elaborated in the charging documents, the SEC’s reference to a deficient “corporate culture” may stem from the sheer number of employees charged and the extent of their alleged involvement in the misconduct at issue, which purportedly included coordinated efforts to mislead the company’s auditor and strong-arming customers into arrangements that allegedly facilitated improper revenue recognition. Several of the defendants had recently joined the company after an acquisition, underscoring the need to ensure that new employees are integrated into a company’s culture and control environment.
This action makes clear that a company’s internal controls for financial reporting should include, among other safeguards, a controls environment that is designed to develop a strong culture of compliance so that the company has strong answers if misconduct nonetheless takes place.
 While “misconduct” is not defined in the statute, the handful of courts that have considered this rarely-used provision have agreed that Section 304’s “clawback” requirement can be triggered by any misconduct at the issuer that requires it to restate its financial statements, even if the CEO or CFO did not participate in the misconduct. See, e.g., SEC v. Jensen, 835 F.3d 1100 (9th Cir. 2016); SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010). It remains unsettled whether the SEC could pursue a Section 304 clawback claim where the “misconduct” at issue does not involve intentional or reckless wrongdoing, such as a violation of the negligence-based antifraud provisions of Securities Act Sections 17(a)(2) and 17(a)(3).