This note is the first in a series that will illustrate some companies the Securities and Exchange Commission has charged over the years for revenue recognition. We focus on revenue manipulation because it represents about 60 percent of all enforcement actions for accounting manipulation.
Regulators target revenue recognition because it is the easiest accounting manipulation to prove (relatively) and thus offers the highest chance of successful enforcement action.
Our first guinea pig is Marvell Technology Group, a topical stock at the centre of the current mania for AI stocks. Perhaps less well known, the SEC charged this company twice for account manipulation: first in 2008 for expense manipulation and again in 2019 for revenue manipulation.
This company offers a good opportunity to test our fraud detection software over a long run of years. Marvell is interesting because it illustrates that companies can change. Enforcement action by a securities regulator is rarely fatal and can motivate companies to improve their governance, as occurred with Marvell.
Also important, Marvell illustrates that investors are usually quick to forgive account manipulation, provided future earnings are not perceived to be at risk.
Our purpose is to illustrate common traits exhibited by companies likely to be targeted by regulators as revenue manipulators.
Since our focus is revenue recognition, this case study focuses on the second SEC charge in 2019. Our intent is to use Marvell to illustrate common traits exhibited by companies likely to be targeted by the SEC, and hence other regulators, for revenue manipulation.
These traits register as red flags in Transparently.AI’s fraud-detection system. If a company is flying a sizeable number of red flags pertaining to revenue recognition, it will eventually attract the attention of regulators.
Once targeted by an enforcement action, companies typically experience a significant decline in their stock price. It is therefore only prudent that investors and creditors should seek to identify and avoid companies with elevated risk of enforcement action.
In the discussion to follow, we focus on past occurrences. We draw no inference from past transgressions about the current operations of Marvell. From a governance perspective, the Marvell of 2023 is quite a different company than it was in 2015.
What is Marvell Technology?
Marvell Technology is a fabless semiconductor company. It engages in the design, development, and sale of integrated circuits. The company was founded by the husband-and-wife team of Sehat Sutardja and Weili Dai in January 1995. Originally a Bermuda company with headquarters in Santa Clara, California, Marvell is now based in Wilmington, Delaware.
Sutardja served as Marvell's President and CEO from the company's inception and served as the co-Chairman of the Board of Directors from 1995 to December 2003, when he became the company's sole Chairman. Dai was a director of Marvell from 1995 through May 2007 and was Chief Operating Officer of Marvell from April 2006 to May 2007.
Marvell's traditional revenue is split between chips for storage and chips for communication applications. The company's product portfolio includes system-on-a-chip devices, and devices for data storage and switches.
It also offers wireless baseband infrastructure, security processors, wireless networking, storage controllers for hard and solid-state disk drivers, storage accelerators, host bus adapters, and system on chip products. The company’s products are used in the data infrastructure markets such as automotive, carrier infrastructure, data centers and enterprise networking and consumer markets.
Marvell Technology is presently a hot stock after the company’s CEO told investors at a conference in May that revenue from its artificial intelligence unit would grow four-fold in the next couple of years. As with Nvidia and AMD, investors are excited by the prospects for this company.
Marvell backdating allegations
But Marvell’s business environment was not always as exciting as it is today. Conditions after the tech wreck in 2000 were challenging for chip companies. Most went into survival mode. Marvell was no exception.
On May 22, 2006 Marvell was identified in a Merrill Lynch research report questioning the timing of sixteen companies' stock option grants
Interesting allegations surfaced. On May 22, 2006 Marvell was identified in a Merrill Lynch research report questioning the timing of sixteen companies' stock option grants, suggesting that companies may have been engaged in backdating.
Backdating is the act of assigning an employee stock option with a date preceding its actual issuance. This allows the exercise price of the option to be established at a price lower than the company's stock price on the date of assignment. As a result, the assigned option becomes "in the money," increasing its value for the holder.
On July 3, 2006 Marvell announced in its 8-K filing that it was conducting an internal review of stock option practices, also revealing that it had received an ‘informal inquiry letter’ from the SEC.
On October 2, 2006, Marvell issued an after-market press release stating that measurement dates for certain stock option grants likely differed from the recorded dates and that the company would need to restate financials.
In a separate release, Marvell warned that net revenue for 3QFY07 would be down 10% and expenses would be higher due to costs related to stock option grant accounting.
Stock plunge
Marvell stock fell 40% between May 22 and October 23 of 2006.
At this time, Sutardja and Dai were the sole members of Marvell's Stock Option Committee, which granted all stock options to non-executive employees.
On May 2, 2007, the company demoted Dai from COO to Director of Business and Marketing. On the same day Marvell's CFO, George Hervey resigned. Unvested stock options granted to both Dai and Hervey were cancelled.
In its Form 10-K filed on July 2, 2007 for the fiscal year ended January 27, 2007, Marvell announced that its internal review found that 74% of Marvell's option grants were backdated such that the original measurement dates were lower than the appropriate measurement dates for 97% of remeasured grants.
The Special Committee findings also stated that Dai, Sutardja and Hervey all received backdated grants. The review also found that the minutes of Stock Option Committee meetings, of which there were 53, were false because no meetings were held and that Dai played a central role in grants by the Stock Option Committee.
Following the publication of the findings, Sutardja remained CEO of Marvell and a member of the Board, however, he stepped down as Chairman of the Board.
False financial information
Marvell subsequently restated its financial statements from FY2000 through FY2007 Q1.
The SEC eventually charged Marvell and its former chief operating officer on May 8, 2008 for reporting false financial information to investors
As a consequence of these events, the SEC eventually charged Marvell and its former COO Dai on May 8, 2008 for reporting false financial information to investors by improperly backdating stock option grants to employees.
The SEC’s complaint alleged that:
“Marvell provided potentially lucrative "in-the-money" options (granted at below-market prices) to employees. Rather than report compensation expenses to shareholders, as required at the time for these "in-the-money" options, Marvell backdated the options to dates with lower stock prices, and falsely represented that the options had been granted "at-the-money" (at market price) on earlier dates.”
According to the SEC's complaint, filed in federal district court in San Jose, “the scheme allowed Marvell to overstate its income by $362 million from its fiscal years 2000 through 2006. “
Linda Chatman Thomsen, the Director of the SEC's Division of Enforcement at the time, said: "Marvell's long-running backdating scheme involved a senior executive who regularly signed minutes of meetings that never occurred.”
Marvell and Dai settled the SEC's charges without admitting to or denying the allegations and paid penalties of US$10 million and US$500,000, respectively.
For the sake of brevity, we have not shown the manipulation risk reports generated by our system prior to 2008. We will revisit these reports when we turn our attention to expense manipulation.
(It will be interesting to see how many of the companies identified in the Merrill Lynch research report were also flagged by our system. But that is for another day.)
In the case of Marvell, a quick inspection will reveal that the system reports prior to 2006 showed higher manipulation risk than in the subsequent period. In particular, the system flagged compensation irregularities for a number of years.
Galleon insider trading
In 2010, Marvell was in the news again. A Financial Times article of December 24, 2010 with the header, “Former Wall Street analyst admits fraud”, linked Marvell employees to the Galleon insider trading case, perhaps the biggest insider trading case of all time. Buried in the article, was the following:
“From 2007 through to March 2009, Mr Motey received non-public information from an employee at Marvell Technology Group and other Marvell sources about the company and its customers, according to court papers.”
The Motey in question was Karl Motey, the former analyst identified in the story headline. In August 11, 2011 we find a follow-up article: “Ex-Marvell manager on insider trading charge.” Stanley Ng, an accountant at Marvell Technology, was eventually convicted.
One of his key responsibilities at Marvell was filing the company's quarterly financial information to the SEC, meaning that he was almost certainly engaged in the preparation of the accounts.
In isolation, the fact that a senior employee was charged with fraud carries little implication about his employer except perhaps to indicate poor internal controls. But, viewed in conjunction with the previous SEC charge, it should have raised an eyebrow among investment and credit analysts.
Who, exactly, were the “other Marvell sources” that Mr Motey mentioned in his earlier testimony and why did they disappear from view as the case progressed? The eyebrow inches higher.
Marvell patent verdict
The next instalment of the Marvell saga unfolded in 2012, when the company was hit with a US$1.2 billion patent verdict. As the FT reported on Dec. 27 of that year:
“A jury has awarded $1.17bn in damages against Marvell, the US semiconductor maker, for infringing hard drive-related patents owned by Carnegie Mellon University.”
The company was ordered to pay triple damages for what was judged a ‘wilful infringement’. The case lasted just 17 days and “the jurors found in favour of CMU and against Marvell in all 24 questions asked of them in the jury form.”
According to the judgement, this was not a case of unintentional infringement, where technologies with different inception dates overlap. Wilful infringement occurs when someone deliberately copies a claimed invention and knew the entire time that the invention was patented. It is a nice way of saying IP theft in legalese.
Through this period, shareholders were not oblivious to problems at Marvell. The company faced several class action suits in the wake of its first SEC charge and the patent infringement. In April 2014, for example, shareholders filed a class action derivative complaint against the company and seven officers and directors.
Shareholder class action
This class action was dismissed on a technicality by the San Francisco court. The judge found the plaintiffs did not satisfy requirements for bringing derivative claims under the laws of Bermuda, where Marvell was then incorporated.
The judge also ruled that even if the plaintiffs could make a claim under Bermuda law, the shareholders' claimed injury was too speculative, essentially because the company had continued to pay dividends.
Nevertheless, the 70-page complaint would be compulsory reading for any analyst researching the company from 2014 onwards in the lead up to the second SEC charge.
The list of complaints relied heavily on the patent infringement. In an interesting section, the complaint notes that, “Marvell staff referred to their own chips as ‘coffee warmers’ because of their ineffectiveness, and used Carnegie Mellon's technology without licensing it … for nearly a decade, ignoring warnings from its own engineers, requests from Carnegie Mellon to negotiate a license for the patents, and even concerns and questions from a customer.”
The list of complaints went far beyond the issues we have discussed thus far. For example, it complained that after the internal review, the board of directors failed to strip CEO Sehat Sutardja of his chairman duties.
Moreover, it states that after settling with the SEC and agreeing not to serve as a director or officer in a public company for five years, “Dai received more than $15 million in compensation from Marvell in 2007 and 2008, and more than $6 million in 2012 … In 2013, after the ban had expired, Dai was given a $400,000 bonus and a $10,000 raise to her annual base salary of $510,000.”
We have not verified these claims. Most could be fact checked from public records. The point we are making is simply that by 2014 or 2015 any reasonable investor, creditor or even its auditor should have been wary of Marvell’s corporate governance.
Finally, in October 2015, PwC resigned as Marvell’s auditor
Finally, in October 2015 PwC resigned as Marvell’s auditor. The auditor said the company needed to broaden its audits and needed to “examine the tone at the top.” Media reports at the time expressed surprise that such a well-regarded company should see its auditor resign. “This is a head scratcher,” said one report.
Given the history of the company as we’ve outlined above, one wonders why the loss of its auditor should have come as a surprise.
In December 2015, Marvell simultaneously reported wider-than-expected losses and disclosed that the SEC and the Justice Department had launched separate probes into its accounting practices and other activities.
Internal probe
At the same time, the company also announced an internal probe by its Audit Committee into Marvell’s revenue recognition practices.
In May 2016, the chipmaker’s internal probe found “no fraud in the way the company had booked revenues” but noted that there was “significant pressure” from the management on sales teams to meet revenue targets.
The committee also questioned a patent that Sutardja had initially claimed as his before passing it onto the company. At the time, Sutardja personally held 360 patents.
At about the same time Marvell announced it would replace Sutardja and President Weili Dai. However, both remained on Marvell's board of directors.
Four long years after disclosing the SEC probe, Marvell finally agreed to settle SEC charges
On September 16, 2019 - four years after disclosing the SEC probe - Marvell agreed to pay $5.5 million to settle charges that it failed to disclose its practice of accelerating, or “pulling in,” sales scheduled for future quarters into current quarters in order to close the gap between its actual and forecasted revenues.
According to the SEC, to persuade customers to agree to the acceleration of sales, the company offered various financial incentives, such as “price rebates, discounted prices, free products, and extended payment terms, at times inconsistent with its revenue recognition policy.”
According to the SEC order, Marvell pulled in a total of $165 million in revenues across three quarters without disclosing the impact of that practice on the company’s revenues.
The SEC also alleged that “one employee with responsibilities related to Marvell’s accounting and financial disclosures cautioned senior management that the use of pull-ins could trigger disclosure obligations, citing prior SEC enforcement actions that targeted unusual sales practices. In response, the employee was directed to send an email to senior management indicating that there were no issues with the pull-ins.”
The fact that it took more than four years to resolve shows just how difficult it is for regulators to make enforcement actions stick.
Notably, in this case, the SEC did not allege that Marvell violated revenue recognition rules under GAAP. Rather, the charges focussed solely on the company’s lack of disclosure.
Details of the most recent SEC enforcement action can be found here.
Marvell through the eyes of our software
How would an investor or credit analyst using the transparently.AI platform have assessed Marvell from 2009 until news of the second SEC probe was announced in December 2015?
The short answer is that she would have found a fistful of red flags related to revenue manipulation in the detailed reports of the software system. It’s a system that is trained on millions of public financial data points to recognise the probability that something is amiss in a company’s accounts.
Returning to Marvell, recall that in this example, we are only looking for evidence of revenue manipulation. Red flags most commonly linked to revenue manipulation relate to accrual management, working capital, smoothing activity and business manipulation.
In most cases, a company that is genuinely engaged in fraudulent accounting will tend to raise red flags in other areas such as cash or income quality, corporate governance and gearing. However, red flags accruals, working capital, smoothing and business manipulation are most likely to excite the interest of regulators.
Let’s see how Marvell Technology Group stacked up on these four criteria between 2009 and 2016.
Accruals manipulation
First and foremost, if a company is manipulating revenue it should show up in the way they are managing their accruals. Accruals manipulation involves the use of non-cash accounting techniques that manipulate the timing and amount of revenue, expenses, and assets in the financial statements.
If a company is manipulating revenue, it will eventually show up in the way it manages accruals
Accruals are a normal part of doing business. For example, a company will typically book revenue before it receives the cash. The revenue is booked in the income account and the cash owing will show up as a receivable on the balance sheet. This is normal. Aggressive use of accruals, however, can signal manipulation.
Figure 1 shows the red flags raised that Marvell raised on our fraud-detection platform between 2009 and 2016.
Figure 1: Red flags for accruals management, 2009 to 2016
Source: Transparently.AI
Between 2009 and 2015, Marvell triggered red flags for accruals management in seven different categories. A red flag is triggered if a particular category rates as a significant risk, high risk or very high risk.
If enough red flags are triggered, the company will get a red flag for its overall accruals management. If a company is rated high or very high risk for its overall accruals management over a number of years, investors should expect that the company will be a potential target for regulatory enforcement.
In this respect, Captain Marvell was a shoe-in. It raised a red flag for accruals every year between 2011 and until 2015. Abnormal accrual activity ceased completely in 2010 and in 2016.
The year 2010 saw an exceptionally strong business recovery from the global financial crisis of 2008-09. Any company that needed to exaggerate revenue in 2010 was probably already bankrupt. The absence of red flags in 2016 can be explained by the fact that the SEC informed Marvell it was under investigation in late 2015.
Ironically, the complete absence of abnormal accruals management in 2010 and 2016 lends weight to the idea that accruals were abnormal in the remaining years.
Each category of abnormal accruals attempts to capture a different aspect of a company’s accruals management. In the Accrual-Sales Activity category, for example, the AI system looks at the pattern of accruals in conjunction with other red flags being raised by the system to assess the overall risk of accounting manipulation in relation to sales.
Manipulating sales
Between 2009 and 2015, the platform flagged a high or very high risk that Marvell was manipulating sales.
The story doesn’t end there.
As noted, the system flagged risk in six other accruals categories, most notably in the volatility of accrual in sales activities. This category analyses the interrelationship between changes in working capital, sales, and the cash generated from operations.
In any business, these three variables will demonstrate a near mechanical relationship if the accounts are giving a true and accurate picture of the workings of the business. Most companies are not sufficiently sophisticated to avoid disrupting this relationship when they inflate revenue and earnings. When there is volatility in the relationship, it might indicate manipulation.
On the basis of the accruals risk alone, investors and lenders should have been extremely wary of revenue manipulation in this company
In the case of Captain Marvell, the sustained very high risk associated with volatility of accrual in sales suggested an on-going inconsistence between the sales, working capital and cash generated by this business.
When combined with the sustained red flags accruals relating to sales and sales activities, the system was providing a very strong warning about the company.
On the basis of the accruals risk alone, investors and lenders should have been extremely wary of revenue manipulation in this company.
High working capital
For every abnormal accrual there is an impact on working capital since we are essentially booking transactions but not seeing any cash.
An abnormally high working capital requirement, or abnormal changes working capital in relation to other variables can point to revenue or some other type of manipulation.
For every abnormal accrual there is an abnormal impact on the cash generated by a business and its working capital
If combined with a high number of red flags for accruals, red flags on working capital should be read as an elevated warning that a company has a high risk of revenue and hence earnings manipulation.
Marvell Technology triggered red flags for working capital every single year from 2009 until 2016. Unlike accruals, which are at the discretion of management, working capital is the outcome of many forces, most of which are beyond management’s control.
Often working capital outcomes in one year will reflect accruals management decisions made in previous years. Thus, unlike accruals, the red flags for working capital did not suddenly turn off in 2010 and 2016.
Figure 2: Red flags for working capital, 2009 to 2016
Source: Transparently.AI
In total, Marvell triggered red flags in ten different categories. The nature of the red flags varied from year to year but day inventory outstanding and inventory turnover were consistently flagged in the latter years. Note also the change in accounts receivable in three of the final four years.
Red flags in inventory outstanding and turnover suggest that this company experienced a run of disappointing sales from 2013 onwards.
Inventory stuffing
Sales were almost certainly slowing and the company was slow to adjust, hence the abnormal inventory build.
In some situations, abnormally high inventory can also be a sign of manipulation. In a practice known as "inventory stuffing", a company might hold inventory to make it appear as if it has higher sales in the future.
Abnormally high inventory becomes a more concrete concern signal if combined with an unusual change in receivables. Marvell experienced an unusual change in receivables in 2013, 2015 and 2016 that was not consistent with the company's sales volume or business activity.
Abnormally high inventory becomes a more concrete concern signal if combined with an unusual change in receivables.
In 2013 and 2015, the change in receivables was unusually large and in 2016 it was unusually negative. In conjunction with abnormally high inventory, the change in receivables in 2013 and 2015 could be interpreted as a red flag of fictitious sales or inflated revenue.
This normally occurs if a company is providing extended credit terms to certain customers or engaging in other deceptive practices to boost reported sales.
The unusual fall in inventory that triggered the red flag in 2016 and might be interpreted as a sign that these practices reversed when the SEC began to see if Marvell had a hand in the cookie jar.
Smoothing activity
If a company in a cyclical industry manipulates revenue in bad years as a normal course of business, it will frequently delay revenue recognition in good years. This smoothing activity makes it easier to reach revenue targets in bad years and thus to present a picture of smooth consistent growth.
Some firms also hope that smoothing activity will help to partially hide aggressive use of accruals. Alas, smoothing activity makes account manipulation even more visible to a good forensic accountant or an AI fraud detection system.
Figure 3: Red flags for smoothing activity, 2009 to 2016
Source: Transparently.AI
Marvell Technology triggered an overall red flag for smoothing activity every year from 2009 until 2016 except, intriguingly, for 2015.
Smoothing activity makes it easier to reach revenue targets in bad years and thus to present a picture of smooth consistent growth
Unsurprisingly, the most common red flags raised by this company for smoothing related to income, accruals and volatility of accruals.
The cluster of smoothing signals exhibited by Marvell was precisely that which a company manipulating revenue might be expected to demonstrate.
The volatility of accruals refers to the degree to which the value of accruals fluctuates over time. Highly volatile accruals can be a warning sign that the reported financial results may not be accurate or may have been manipulated.
The reason for the absence of smoothing activity in FY2015, which ended on 30 September2015 is quite simple; the company gave up the pretense.
On September 11, 2015, Marvell reported a quarterly loss of US$382.4 million for its fiscal second quarter, whereas analysts on average had predicted a quarterly profit of US$11.9 million. With this loss announcement, there was no need to smooth numbers.
Business manipulation risk
Business manipulation involves decisions made during the financial year regarding business activities, as opposed to accounting manipulation which focuses on the treatment of accounts.
Management, for example, may make certain business decisions that enhance the accounts, such as manipulating sales and production activity by reducing its pricing to boost revenue.
In some situations, efforts to pull forward sales can be legitimate and proper but the company should clearly indicate when such activities have taken place because they are detrimental to future sales.
Another example is channel stuffing, which involves pushing excess inventory onto a distributor even if they don’t need it, to create the appearance of higher revenue. These sorts of actions lead to unusual inventory and cash behaviour, and are normally also detrimental to future sales.
Figure 4: Red flags for business manipulation, 2009 to 2016
Source: Transparently.AI
Marvell triggered red flags for business manipulation risk from 2010 until 2012, and again in 2014 and 2016.
Red flags were common in areas related to inventory behaviour, inventory activity, abnormal cash flow and sales activity versus cash. All of these items seek to examine whether the relationship between a company’s cash flows, inventories and sales performance appear typical both in relation to a company’s past behaviour and the way these variables behave at a company’s peers.
In the fraud detection software, for example, ‘inventory behaviour’ focuses on the relationship between inventories and sales, looking for what is typical drawing on what is typical at a company and its peers. ‘Sales Activity vs Cash’ employs modelling techniques to provide estimates of expected cash generation by firms given their selling activity.
The cluster of red flags associated with business manipulation in Marvell was, once again, consistent with a high risk of revenue manipulation
In both these examples, the software is looking for deviations between expected and actual movement in inventory or in cash flow.
The cluster of red flags associated with business manipulation in Marvell was consistent, once again, with a high risk of revenue manipulation. Companies with the red flags exhibited by this company might be manipulating results by changing sales terms to influence volumes and consequently earnings. Examples could include discounts, special offers and new credit terms. We estimate “normal” and “abnormal” behaviour with reference to a firm’s past activity, historic performance, sector-specific characteristics and other features.
As with the working capital signals, the red flags raised for 2016 reflected a sharp reversal in inventory behaviour and cash flow from previous years. In other words, it potentially reflected a possible unwind of previous manipulation, rather than actual manipulation.
Conclusion
If one examines the detailed reports for Marvell between 2009 and 2015, one finds red flags in other categories in addition to the four highlighted in this case study. Efforts to manipulate revenue and thus earnings will typically show up in other areas including corporate governance, cash quality, income quality and also gearing.
A company desperate to inflate sales will sometimes use debt, acquisitions, inventory write-off and disposals to literally buy their own sales through related party dealings or explain the loss of cash. There is some evidence of this risk in the red flags issued by Marvell.
Incentive to manipulate revenue can also show up in corporate governance and gearing. Marvell had a red flag for corporate governance from 2015 onwards and a red flag for gearing risk in all years except 2014 and 2015.
One item to look out for in the corporate governance score is abnormal use of options in compensation. If option use is extensive, reg flags will also flutter for investors and creditors on guard for improper revenue recognition because management incentive to inflate earnings will be high.
Looking at accruals management, working capital, smoothing activity and business manipulation signals, the fraud detection software presented evidence that Marvell had a high or very high risk of revenue manipulation.
When combined with red flags in other categories and the history of the company as it unfolded, any reasonable analyst investigating the market between 2009 and 2015 would have concluded that Marvell demonstrated a high risk of manipulating revenue.
