Chapter 6 Legal and Regulatory Obligations in an Ethical Framework 309

Case 6-5

Knowledge Ware, Inc.

The Complaint

On September 28, 1999, the SEC filed a civil injunctive action in federal court in Atlanta, Georgia, charging seven former executives of a computer software company, Knowl- edgeWare, Inc., with carrying out a multimillion-dollar finan- cial fraud scheme that materially inflated Knowledge Ware’s reported earnings during fiscal year ended June 30, 1994, and charging two of those defendants with also committing illegal insider trading. Those named in the complaint include Francis A. Tarkenton, who was CEO and chair of the board of directors of Knowledge Ware; Donald P. Addington, president and COO; Rick W. Gossett, a CPA and CFO of Knowledge- Ware; Lee R. Fontaine, also a CPA and manager of financial reporting at KnowledgeWare; William E. Hammersla III, who was Knowledge Ware’s vice president for direct sales in the northeastern United States; Eladio Alvarez, a district sales manager in KnowledgeWare’s Direct Sales group; and Edward Welch, a district sales manager in KnowledgeWare’s Reseller Channel Sales group.1

The KnowledgeWare fraud might not be large or interest- ing enough a study if it were not for the fact that the CEO and chair of the board of directors was former professional football star Francis A. Tarkenton. Tarkenton played quarter- back for the Minnesota Vikings for 13 years in the 1960s and 1970s. He is in the football Hall of Fame, although he had the dubious distinction back then of having led his team into three Super Bowl games—all ending in losses. Tarkenton was named the NFL’s Most Valuable Player in 1975.

Since retirement, Tarkenton had taken his trademark free- wheeling style of quarterbacking into the business world. He started as many as 30 separate companies, including a short- lived fast-food franchise called Scramblers. Today, Tarkenton runs several business Web sites and a sports-memorabilia Web site.

The commission’s complaint alleged that Tarkenton, Addington, Gossett, Fontaine, Hammersla, Alvarez, and Welch engaged in a fraudulent scheme to inflate Knowledge- Ware’s financial results to meet sales and earnings projec- tions. In all, KnowledgeWare reported at least $8 million in revenue from sham software sales. KnowledgeWare “parked” inventory with software resellers and other supposed cus- tomers that were given the right not to pay for the software, either orally or in “side letters” that were kept separate from the other sales documents. As a result of this scheme,

Securities and Exchange Commission, Litigation Release No. 16306, Securities and Exchange Commission v. Francis A. Tarkenton, Donald P. Addington, Rick W. Gossett, Lee R. Fontaine, William E. Hammersla III, Eladio Alvarez and Edward Welch, Civil Action File No. 1:99-CV 2497 (N.D. September 28, 1999), www.sec.gov/litigation/litreleases/lr16306.htm.

KnowledgeWare falsely reported record sales revenue and dramatic increases in earnings in press releases and in quar- terly reports filed with the commission and disseminated to the public in 1993 and 1994.

Even when KnowledgeWare later restated those quarterly results, the company continued to mislead the invest- ing public by claiming, in its annual report for fiscal year 1994 and other public documents, that the restatement resulted from a problem with the “collectibility” of reseller receivables—without disclosing that KnowledgeWare had created the problem by “selling” software and simultaneously granting the “purchaser” the right not to pay for it.

Violations of Law

Tarkenton, Addington, and Gossett directed the fraudulent scheme and made materially false and misleading state- ments to purchasers of KnowledgeWare stock. Gossett also made materially false and misleading statements to Knowl- edgeWare’s auditors. Hammersla, Alvarez, and Welch imple- mented the fraudulent scheme by creating the sham software sales. Fontaine further implemented the fraudulent scheme by helping prepare the financial statements and other materi- ally false and misleading portions of the quarterly reports. With the exception of Fontaine, each defendant received unwarranted incentive compensation as a result of the scheme. In addition, Hammersla and Alvarez engaged in ille- gal insider trading by using material nonpublic information regarding the status of KnowledgeWare’s prospective acqui- sition by Sterling Software, Inc., when they sold all their shares of KnowledgeWare stock in late August 1994.

Resolution of the Case

Tarkenton consented to the issuance of a final judgment per- manently enjoining him from (1) committing securities fraud in violation of Section 17(a) of the Securities Act of 1933 (Securities Act) or Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5; (2) falsifying corporate books and records or engaging in other conduct in violation of Section 13(b)(5) of the Exchange Act or Rule 13b2-l; and (3) engaging in conduct as a controlling person that would render him liable pursuant to Section 20(a) of the Exchange Act for violations of corporate reporting, record- keeping, and internal control provisions of the Exchange Act (Sections 13[a] and 13[b][2] and Rules 12b-20, 13a-l, and 13a-13). Tarkenton also agreed to pay a civil money penalty of $100,000 and disgorge $54,187, the amount of the incen- tive compensation he received in fiscal year 1994 on the basis of KnowledgeWare’s materially overstated quarterly earnings, plus prejudgment interest thereon.

310 Chapter 6 Legal and Regulatory Obligations in an Ethical Framework

Addington, Gossett, Fontaine, and Hammersla settled charges with the SEC for securities acts violations and agreed to civil monetary settlements and the disgorgement of incentive compensation received during fiscal year 1994. Hammersla also settled similar charges and made mone- tary and disgorgement payments. In addition, he agreed to pay civil money penalties totaling $21,575, consisting of a $10,000 penalty in connection with his financial fraud viola- tions and an $11,575 penalty in connection with his insider trading violations.

Postscript

In August 1994, Sterling Software—a Dallas-based software company that managed data processing center operations and was successful in network management—paid $143 million to acquire Knowledge Ware, which was absorbed into Ster- ling. Knowledge Ware did not enter the Sterling fold quietly, however. In January 1995 several former Knowledge Ware shareholders sued Tarkenton and other executives for secu- rities fraud and breach of contract. The investors alleged that Tarkenton had deliberately misrepresented Knowledge- Ware’s earnings between November 3, 1993, and August 29, 1994. Sterling was forced to allocate $15 million for legal fees, and court costs negatively impacted Sterling’s 1995 revenue. Nevertheless, Sterling did successfully integrate

KnowledgeWare into its growing roster of acquisitions. Tarkenton remained on Sterling’s board until 1997.2

Questions 1. Explain why revenue recognition rules were violated

based on the facts of the case. How do such violations relate to the standards for legal liability under the securi- ties acts?

2. Gossett and Fontaine are CPAs. Given the charges against them and settlement with the SEC, how did their actions violate provisions of the AICPA Code of Professional Conduct?

3. When the KnowledgeWare story of fraud broke in the press, many Viking fans and lifelong football fans of Tarkenton acted in disbelief stating that there had to be a mistake. After all, Tarkenton was their football hero for many years. Should we hold athletes to the same ethical standards as other people (a) in their chosen profession and (b) in their personal lives? Compare the reaction of Vikings fans to the public reaction after hearing about the sexual liaisons of Tiger Woods. Are these comparable situations?

2Available at www.fundinguniverse.com/company-histories/ KnowledgeWare-lnc-Company-History.html.