<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------
Form 8-K
CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number 1-10308
------------
August 28, 1998 (August 27, 1998)
(Date of Report (date of earliest event reported))
Cendant Corporation
(Exact name of Registrant as specified in its charter)
Delaware 06-0918165
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
6 Sylvan Way, Parsippany, New Jersey 07054
(Address of Principal Executive Office) (Zip Code)
(973) 428-9700
(Registrant's telephone number, including area code)
None
(Former name, former address and former fiscal year, if applicable)
================================================================================
<PAGE>
ITEM 5. OTHER
Audit Committee Report. On August 27, 1998, Cendant Corporation (the "Company")
announced that the Audit Committee of its Board of Directors had presented to
the Board of Directors its report on the investigation into the accounting
irregularities uncovered in the former CUC businesses and its conclusions
regarding responsibility for those actions. Reference is made to Exhibit 99.2
for a copy of the full report of the Audit Committee which is incorporated
herein by reference in its entirety. A summary of the Audit Committee Report is
attached hereto as Exhibit 99.1.
Delay in Form 10-K/A Filing and Postponement of Annual Meeting. On August 27,
1998, the Company also announced that it expected to file its restated
financial statements on a Form 10-K/A in late September due to additional
revisions to its accounting policies as requested by the Securities and
Exchange Commission (the "SEC"). The Company has completed preparation of
preliminary restated financial statements for its 1997, 1996 and 1995 fiscal
years. These financial statements are consistent with the Company's earlier
disclosures regarding the extent and nature of accounting errors and
irregularities at business units of the former CUC International Inc. ("CUC").
However, the SEC has requested the Company to implement further changes in the
Company's revenue recognition accounting policy for individual memberships as
part of the SEC's ongoing review of revenue recognition accounting policies by
all companies that sell services with a full refund offer. The accounting
policy change requested by the SEC goes beyond those believed necessary and
appropriate by Deloitte & Touche LLP and Arthur Andersen to correct accounting
irregularities and errors.
The Company also announced that it has postponed its Annual Meeting of
Shareholders scheduled for October 1, 1998 until a later date.
The press releases relating to the foregoing announcements are filed herewith
as Exhibits 99.4 and 99.5, respectively, and are incorporated by reference
herein in their entirety.
ITEM 7. EXHIBITS
Exhibit
No. Description
- ------- -----------
99.1 Summary of Conclusions of the Audit Committee Report
99.2 Audit Committee Report
99.3 Addendum to the Audit Committee Report
99.4 Press Release: Cendant Audit Committee Reports to Board of
Directors on Its Investigation into Accounting Irregularities,
dated August 27, 1998.
99.5 Press Release: Cendant to Delay 10-K Filing, dated August 27, 1998.
2
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
CENDANT CORPORATION
By: /s/ James E. Buckman
---------------------
James E. Buckman
Senior Executive Vice President
and General Counsel
Date: August 28, 1998
3
<PAGE>
CENDANT CORPORATION
CURRENT REPORT ON FORM 8-K
Report Dated August 28, 1998 (August 27, 1998)
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
99.1 Summary of Conclusions of the Audit Committee Report
99.2 Audit Committee Report
99.3 Addendum to the Audit Committee Report
99.4 Press Release: Cendant Audit Committee Reports to Board of
Directors on Its Investigation into Accounting Irregularities,
dated August 27, 1998.
99.5 Press Release: Cendant to Delay 10-K Filing, dated August 27,
1998.
4
<PAGE>
ADDITIONAL CONCLUSIONS OF THE AUDIT COMMITTEE
OF CENDANT CORPORATION WITH RESPECT TO
INVESTIGATION INTO ACCOUNTING IRREGULARITIES
------------------------------------------------
The Report prepared for the Committee by Willkie Farr & Gallagher and
Arthur Andersen LLP has reviewed much of the evidence obtained with respect to
whether or not members of senior management of the former CUC International,
Inc. ("CUC") including Walter Forbes, Chairman of the Board and Chief Executive
Officer, and Kirk Shelton, President and Chief Operating Officer, had or may
have had knowledge of the irregularities detailed in the Report.
It is the view of the Committee that certain additional conclusions
based on the work of the Committee and its professionals should be reported to
the full Board. First, Walter Forbes and Kirk Shelton, because of their
positions, had responsibility to create an environment in which it was clear to
all employees at all levels that inaccurate financial reporting would not be
tolerated. The fact that there is evidence that many of the senior accounting
and financial personnel participated in irregular activities and that personnel
at many of the business units acquiesced in practices which they believed were
questionable suggests that an appropriate environment to ensure accurate
financial reporting did not exist. Second, senior management failed to have in
place appropriate controls and procedures that might have enabled them to
detect the irregularities in the absence of actual knowledge of those
irregularities. Third, Walter Forbes and Kirk Shelton, the
<PAGE>
Company's most senior managers, had a responsibility to fully understand the
sources and the true level of CUC's profitability. To the extent that they were
unaware of the irregularities, the amount by which CUC's earnings were inflated
as reported in the Restatement suggests that they did not adequately inform
themselves as to the sources and level of profitability of the Company. For
these reasons at least, Walter Forbes and Kirk Shelton are among those who must
bear responsibility for what occurred at CUC.
August 24, 1998
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<PAGE>
PRIVILEGED & CONFIDENTIAL
SUBJECT TO ATTORNEY-CLIENT AND
ATTORNEY WORK PRODUCT PRIVILEGES
REPORT TO THE AUDIT COMMITTEE
OF THE BOARD OF DIRECTORS
OF CENDANT CORPORATION
PREPARED BY:
WILLKIE FARR & GALLAGHER
-AND-
AUGUST 24, 1998 ARTHUR ANDERSEN LLP
<PAGE>
TABLE OF CONTENTS
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Page
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I. FACTUAL BACKGROUND................................................ 1
A. April 15 Announcement ....................................... 1
B. Overview of the Investigation ............................... 2
C. Audit Committee Special Meetings............................. 5
II. RESTATED FINANCIAL STATEMENTS..................................... 6
III. EXECUTIVE SUMMARY................................................. 9
IV. CUC INTERNATIONAL, INC............................................ 18
A. CUC's Business............................................... 18
B. CUC Management............................................... 20
1. Executive Officers...................................... 20
2. Financial Officers and Personnel of CUC and
Comp-U-Card Division.................................... 23
C. Ernst & Young................................................ 26
D. CUC's Audit Committee........................................ 27
E. Budgets...................................................... 28
1. The Annual Budgeting Process............................ 28
2. The Quarterly Budgets................................... 29
3. The January 31, 1998 Consolidated Budget................ 30
4. January 31, 1998 Comp-U-Card Budget..................... 31
F. Contacts with Analysts and Investors......................... 31
G. Interim Financials........................................... 32
1. Monthly Financials...................................... 32
2. Quarterly Financials.................................... 34
H. Monthly Business Review Meetings............................. 38
I. The Acquisition of Davidson, Sierra and Ideon and the
Establishment and Utilization of Related Merger Reserves.... 38
(i)
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PAGE
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V. CUC/HFS MERGER.................................................... 45
A. Terms of the Merger.......................................... 45
B. Due Diligence and the Period Prior to the Closing............ 46
VI. CENDANT........................................................... 51
A. Management................................................... 51
B. The Cendant Merger Reserve................................... 51
C. February 4 Earnings Release.................................. 54
D. The Events of Late February and March 1998................... 56
1. Change in Reporting Structure........................... 56
2. The March 6 Meeting..................................... 57
3. March 9 and 10.......................................... 62
E. The Departures of Shelton, Corigliano and Lipton............. 67
F. The April 9 Meeting in Parsippany............................ 68
VII. TOPSIDE ADJUSTMENTS TO CUC QUARTERLY FINANCIALS................... 71
A. The General Practice......................................... 72
1. Quarterly Topside Adjustments........................... 72
2. Reversals of Topside Adjustments and Subsequent
Cumulative Adjustments.................................. 81
B. Unsupported Topside Adjustments Made During 1997............. 84
1. Topside Adjustments to Income Statement and Balance
Sheet in the First Three Quarters of Fiscal Year
Ended January 31, 1998.................................. 84
2. Unsupported Entries to CUC Calendar Quarter Figures
for 1997 Which Were Contained in January 29, 1998
Form 8-K................................................ 90
C. Unsupported Topside Adjustments Made in 1996................. 94
D. Unsupported Topside Adjustments Made in 1995................. 96
(ii)
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PAGE
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E. Other Information Pertaining to Knowledge of the
Unsupported Topside Entries.................................. 98
VIII. IRREGULARITIES INVOLVING REVERSALS OF MERGER RESERVES
INTO INCOME....................................................... 100
A. General Accounting Rules for Proper Establishment and
Utilization of Pooling and Purchase Reserves................. 100
B. Improper Reversals of $115 Million of Merger Reserves
Into Income at December 31, 1997............................. 103
1. Reversals of $55 million of Reserves into Comp-U-Card
Division Income......................................... 103
a. Reversals of $40.3 million in Reserves Directly
to Comp-U-Card Division Income..................... 104
b. $3 million Re-establishment of Ideon Reserve....... 110
c. Transfer of $48.4 million from Ideon Reserve to
Intercompany Accounts.............................. 111
d. Transfer of $15 million in Intercompany Credits
to Comp-U-Card Division Revenues................... 115
2. Use of Intercompany Accounts to Increase Income of
Other Subsidiaries by $50,254,000....................... 118
a. Transfer of Reserves to Intercompany Accounts...... 118
i. Ideon Reserve ($33,254,000)................... 118
ii. Transfer of $17 million from Cendant
Reserve to Intercompany Accounts.............. 119
b. Use of Intercompany Account to Increase Revenues
of NUMA, NAOG and NCCI by $28,854,000.............. 120
c. Use of Intercompany Account to Increase Software
Income by $5.4 million............................. 125
d. Use of Intercompany Account to Increase FISI
Revenues by $10.5 million.......................... 129
(iii)
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PAGE
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e. Use of Intercompany Account to Increase Welcome
Wagon Income by $2.5 million....................... 134
f. Use of Intercompany Account to Increase WorldEx
Income by $3 Million............................... 135
3. Reversal of $9.5 million of Spark Purchase
Reserve into Spark Revenues............................. 136
4. Summary of Unsupported Reserve Reversals into Income
at Year-End 1997........................................ 141
C. Improper Reversals of $59 Million of Merger Reserves(and
other Liabilities) into Income at January 31, 1997........... 142
1. Reversals of $35.2 million of Ideon Reserves to
Decrease Comp-U-Card Division Expenses.................. 143
2. Reversals of $7.8 million of Ideon Reserves to
Decrease Welcome Wagon and NCCI Expenses................ 145
3. Reversal of $12.6 million of Ideon Reserve and
Other Liabilities to Decrease SafeCard Expenses......... 147
4. Reversal of $2.2 million Plextel Reserve to Decrease
Comp-U-Card Expenses.................................... 150
5. Reversal of $1.1 million of Ideon Reserve to Reduce
Sierra Operating Expenses............................... 153
6. Summary of Unsupported Merger Reserve and Other
Reversals into Income at Year-End 1997.................. 154
D. Improper Reversals of $10.7 Million of Merger Reserves into
Income at January 31, 1996................................... 154
1. Reversal of $6.3 million of CUC Europe and Sentinel
Purchase Reserves into Income........................... 154
2. Reversal of $2.3 million of Welcome Wagon Purchase
Reserves into Income.................................... 157
3. Reversal of $2.1 million of Essex Reserves into Income.. 157
E. Other Information Pertaining to Knowledge of Merger
Reserve Reversals............................................ 160
(iv)
<PAGE>
PAGE
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IX. OTHER IMPROPER UTILIZATIONS OF MERGER RESERVES.................... 164
A. Improper Utilization of Cendant Reserve for Class Action
Settlement Payments.......................................... 164
B. Writeoff of $39.6 million of EPub Assets Against the
Cendant Reserve.............................................. 165
C. Charge of $30 million CNA Payment to Cendant Reserve......... 171
D. Writeoff of $3.7 million of LTPC Receivables Against
Cendant Reserve.............................................. 176
E. Writeoff of $17.3 million of NLG Goodwill Against
Cendant Reserve.............................................. 177
F. Writeoff of $2.3 million of NLG Computer Costs
Against Cendant Reserve...................................... 181
G. NLG Purchase Reserve Adjustments............................. 183
H. Writeoff of $3.2 million of BCI Capitalized Software Costs
Against Cendant Reserve...................................... 187
I. Writeoff of $1.75 million Breach of Contract
Settlement Against Cendant Reserve........................... 188
J. Writeoff of $3.75 million of First Data Corporation
Goodwill Against Cendant Reserve............................. 189
K. Writeoff of Dining Out Tonight Club Goodwill and Control
Rights Against Cendant Reserve............................... 190
L. Writeoff of $2.5 million of Time Warner Joint Venture
Against Cendant Reserve...................................... 191
M. Charging of Walter Forbes' Plane Expenses to Cendant
Reserve...................................................... 192
N. Software Upgrade Charged to Cendant Reserve.................. 194
O. Essex Severance Expenses Charged to Cendant Reserve.......... 195
P. Writeoff of Robinson, Lerer Expenses to Cendant Reserve...... 196
Q. Retained Earnings Shortfall Charged to Cendant Reserve....... 197
R. E&Y Audit Fees Charged to Cendant Reserve.................... 198
(v)
<PAGE>
PAGE
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X. IRREGULARITIES IN CONNECTION WITH REVENUE RECOGNITION............. 199
A. The Stated Policy of the Company............................. 199
B. General Practices and Systems................................ 200
C. Specific Comp-U-Card Revenue Recognition Practices........... 202
1. Deferral of Expenses in Programs that Recognized
Revenue Immediately..................................... 202
2. Reclassification of Revenue from Deferred
Programs to Immediate Recognition Programs.............. 206
3. Delay of Expenses....................................... 211
D. Conclusions Regarding CUC's Revenue Recognition Practices.... 211
E. Persons with Knowledge....................................... 212
F. The Annual Effect............................................ 213
XI. IRREGULARITIES CONCERNING THE MEMBERSHIP CANCELLATION RESERVE..... 214
A. Establishment of the Membership Reserve...................... 214
B. "Rejects in Transit"......................................... 215
C. Understatement of Membership Reserve......................... 219
D. Fiscal 1996 and 1997 Adjustments............................. 223
1. Fiscal 1996............................................. 224
2. Fiscal 1997............................................. 226
E. Calendar 1997................................................ 228
F. Calendar 1998................................................ 233
G. Income Statement Impact...................................... 233
XII. OTHER IRREGULARITIES.............................................. 239
A. Commissions Payable.......................................... 239
1. Understatement of Commissions Payable................... 239
(vi)
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PAGE
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2. Improper Reversals of Commissions Payable into Income
Through Unsupported "P" Entries......................... 241
a. Improper "P" Entries in Fiscal 1997................ 241
b. Improper "P" Entries in Calendar 1997.............. 243
3. Income Statement Impact of the Irregularities Associated
with the Commissions Payable............................ 244
B. Reversal of Sierra Deferred Tax Asset into 1997 Income....... 244
C. BCI Fiscal 1996 Writeoff of Profit-Sharing Receivable
against Membership Reserve................................... 248
D. $18 Million Deferred Marketing Costs......................... 250
E. FISI Capitalization of Costs for the Solicitation of
New Business for Fiscal Year 1997............................ 252
F. The Improper Deferral Adjustments at Sentinel................ 255
G. Topside Adjustments to Hebdo Mag at December 31, 1997........ 257
H. The Improper Segment Numbers for 1997........................ 258
(vii)
<PAGE>
I. FACTUAL BACKGROUND
A. April 15 Announcement
On April 15, 1998, Cendant Corporation ("Cendant" or the "Company")
reported that it had discovered potential accounting irregularities in certain
former CUC International, Inc. ("CUC") business units and that it expected to
restate annual and quarterly net income and earnings per share for 1997 and
might restate certain other previous periods related to the former CUC
businesses. The release stated that based on then available information, the
effect on 1997 results was expected to be a reduction of net income prior to
restructuring and unusual charges of approximately $100-$115 million and
earnings per share by about 11(cent)-13(cent), respectively.
In connection with the discovery of the potential irregularities,
Cendant's Audit Committee (the "Audit Committee") was asked to conduct an
investigation of the irregularities, their effect on the reported financial
results of Cendant and CUC, and the identity of individuals having involvement
in or knowledge of the irregularities.(1) The Audit Committee retained the law
firm of Willkie Farr & Gallagher ("Willkie Farr" or "Counsel") to assist in the
investigation and Willkie Farr retained the accounting and consulting firm of
Arthur Andersen LLP ("AA").
- --------------
(1) The members of the Audit Committee are Frederick D. Green (Chairman),
Robert E. Nederlander, Robert P. Rittereiser and E. John Rosenwald, Jr.
<PAGE>
B. Overview of the Investigation
Documents at multiple locations were reviewed. These documents, which
include information downloaded from computers, were located at Cendant's
offices (former CUC offices) at 595 and 707 Summer Street, Stamford,
Connecticut; at CUC archive facilities; at its Comp-U-Card division(2)
("Comp-U-Card division" or simply "Comp-U-Card") office, in Trumbull,
Connecticut; and at the offices of various CUC subsidiaries located throughout
the country and in Europe.(3)
- --------------
(2) Following the merger between CUC and HFS Incorporated ("HFS") on December
17, 1997, the operations of the Comp-U-Card division of CUC became part
of Cendant Membership Services, Inc. ("CMS"). CMS is a subsidiary of
Cendant and conducts the operations of the former CUC business units. The
former Comp-U-Card division is now known as Cendant Membership Services.
Nonetheless it will be referred to herein as "Comp-U-Card" or the
"Comp-U-Card division."
(3) The former CUC subsidiaries are now subsidiaries of Cendant. The
subsidiaries whose documents were reviewed include Benefit Consultants,
Inc. ("BCI"), in San Carlos, California; CUC Europe ("CUC Europe") in
Slough, England; Entertainment Publications, Inc. ("EPub"), in Troy,
Michigan; Essex Corporation ("Essex"), in New York, New York;
FISI*Madison Financial Corporation ("FISI"), in Brentwood, Tennessee;
National Card Control, Inc. ("NCCI"), in Crozier, Virginia; National
Leisure Group, Inc. ("NLG") in Woburn, MA; North American Outdoor Group,
Inc. ("NAOG"), in Minnetonka, Minnesota; NUMA Corporation ("NUMA") in
Akron, Ohio; Spark Services, Inc. ("Spark"), in Stamford, Connecticut;
Cendant Software, a division comprised of Davidson & Associates, Inc.
("Davidson"), in Torrance, California, and Sierra On-Line, Inc.
("Sierra"), in Bellevue, Washington; Welcome Wagon ("Welcome Wagon") in
Trumbull, Connecticut; and Coktel Europe ("Coktel"), in Paris, France.
-2-
<PAGE>
Documents and/or downloaded computer information provided by E. Kirk
Shelton, former President and Chief Operating Officer of CUC, Cosmo Corigliano,
former Chief Financial Officer ("CFO") of CUC, certain former CUC directors,
Cendant personnel in Parsippany, New Jersey, and Ernst & Young, LLP ("E&Y")
were also reviewed.
Numerous interviews were conducted. Such persons included most of the
principal officers of CUC and many other employees located at CUC's Stamford
offices, including those having significant responsibility for financial or
accounting matters; directors of CUC; officers and employees of CUC's
Comp-U-Card division in Trumbull and of fourteen subsidiaries (BCI; Davidson;
CUC Europe; EPub; Essex; FISI; NAOG; NCCI; NLG; NUMA; Sierra; Spark; Welcome
Wagon; and Coktel); former HFS officers, directors and/or employees;
representatives of E&Y, CUC's former auditors; representatives of Deloitte &
Touche, LLP ("D&T"), Cendant's auditors; and certain other persons. A total of
81 people were interviewed by Counsel, some of whom were interviewed on more
than one occasion.(4) In addition, AA held numerous discussions with Company
personnel on matters relating to the investigation.
- --------------
(4) A list of persons interviewed by Counsel is attached as Appendix Ex. 1.
-3-
<PAGE>
Three persons believed to have highly relevant information were not
interviewed: Corigliano(5), Anne Pember(6), the Senior Vice President and
Controller of CUC, and former Controller of the Comp-U-Card division, and Paul
J. Hiznay(7), former Accounting Manager of the Comp-U-Card division.
Certain other former officers and/or employees of CUC who might have
useful information also were not interviewed.(8)
- --------------
(5) In a letter to the Board of Directors of Cendant dated April 17, 1998,
Corigliano stated that he had "never knowingly engaged in any accounting
or other financial wrongdoing or irregularity or advised or assisted
anyone else to do so."
Corigliano, through his counsel, stated his willingness to appear for an
interview if he were provided in advance with a precise specification of
the particular accounting irregularities at issue, the reasons why
Cendant believes those matters are incorrect, the basis for any claim of
knowledge or participation by Corigliano in the irregularities, and other
support believed to have existed to show that he acted improperly. In
this regard, he wanted affidavits or other statements that employees or
others have adopted that allegedly implicate Corigliano. He also
requested copies of all documents which would be shown to him at his
interview in advance of the interview. His counsel stated that he
believed that Corigliano was in a different position than others that had
been interviewed and was entitled to this information in advance of an
interview because of the circumstances of his termination, which in his
counsel's view were unfair.
After extended discussions between counsel, it was ultimately concluded
that it would be inappropriate to interview Corigliano subject to these
conditions.
(6) Several requests were made to Pember's counsel for an interview. Those
requests were declined.
(7) Hiznay did not respond to attempts by Cendant to reach him at his home by
letter and telephone.
(8) Stuart L. Bell, CUC's CFO prior to Corigliano, offered, through his
counsel, to respond to written questions, but
(Footnote Continued)
-4-
<PAGE>
In addition, AA, over a period of 16 weeks and expending in excess of
3,700 person-days, conducted investigations with respect to accounting
irregularities; analyzed financial statements, financial documents, accounts
and account elements, and accounting transactions involved in certain
accounting irregularities; identified the apparent causes of such accounting
irregularities; and analyzed certain CUC subsidiary accounting systems, records
and transactions.
C. Audit Committee Special Meetings
Following the commencement of the investigation, the Audit Committee
held many special meetings to receive reports from AA and Willkie Farr as to
the progress of the investigation and to discuss the information it received.
- -------------------------------------------------------------------------------
declined to be interviewed. Just prior to the completion of this Report,
new counsel for Bell re-opened discussions about a possible interview,
but no interview took place.
Bell has stated, through counsel, that he has not been involved with any
of CUC's annual financial statements since January 31, 1994 or any
quarterly statements since October 31, 1994 and that during his tenure
the company's accounting policies and practices were all undertaken in
accordance with generally accepted accounting principles.
-5-
<PAGE>
II. RESTATED FINANCIAL STATEMENTS
The Company has restated its financial statements (the "Restatement")
for the three years ended December 31, 1997 (the "Restatement Period"). The
Restatement corrects for the effect of errors and irregularities at the former
CUC business units. The Restatement was audited by D&T.
The amount of the Restatement is greater than the sum of the items
discussed in this Report. This is because the Restatement amount includes
accounting errors as well as irregularities.(9) AA's work focused on
identifying and
- --------------
(9) During the Restatement Period, the American Institute of Certified Public
Accountants (AICPA) issued a new standard in the area of fraudulent
financial reporting. Statement on Auditing Standards No. 82,
"Consideration of Fraud in a Financial Statement Audit" (SAS 82), was
issued in February, 1997 and is effective for periods ending on or after
December 15, 1997 (in the case of CUC, SAS 82 applies to calendar 1997).
This pronouncement points out that the primary factor which distinguishes
accounting fraud from error is whether the underlying action that results
in the misstatement in financial statements is intentional or
unintentional. SAS 82 contains the following definition:
"Misstatements arising from fraudulent financial reporting are
intentional misstatements or omissions of amounts or disclosures in
financial statements to deceive financial statement users. Fraudulent
financial reporting may involve acts such as the following:
o Manipulation, falsification, or alteration of accounting records
or supporting documents from which financial statements are
prepared
o Misrepresentation in, or intentional omission from, the financial
statements of events, transactions, or other significant
information
-6-
<PAGE>
quantifying accounting irregularities.(10) During the investigation certain
misstatements were identified which
- -------------------------------------------------------------------------------
o Intentional misapplication of accounting principles relating to
amounts, classification, manner of presentation, or disclosure"
Prior to SAS 82 the relevant standard was contained in Statement on
Auditing Standards No. 53, "The Auditor's Responsibility to Detect and
Report Errors and Irregularities" (SAS 53), which had been effective for
periods beginning on or after January 1, 1989 (in the case of CUC, SAS 53
applies to fiscal 1996 and fiscal 1997). This pronouncement also makes
the same distinction (based on intent) between accounting errors and
"irregularities." SAS 53 defines the term "irregularities" as follows:
"The term 'irregularities' refers to intentional misstatements or
omissions of amounts or disclosures in financial statements.
Irregularities include fraudulent financial reporting undertaken
to render financial statements misleading, sometimes called
management fraud, and misappropriation of assets, sometimes
called defalcations. Irregularities may involve acts such as the
following:
o Manipulation, falsification, or alteration of accounting
records or supporting documents from which financial
statements are prepared
o Misrepresentation or intentional omission of events,
transactions, or other significant information
o Intentional misapplication of accounting principles relating
to amounts, classification, manner of presentation, or
disclosure"
In this Report, the term "accounting irregularities" refers to
misstatements that meet the SAS 82 and SAS 53 definitions of "fraudulent
financial reporting" and "irregularities," respectively, within the
applicable time periods.
(10) The Foreign Corrupt Practices Act of 1977 ("FCPA") imposes certain
accounting requirements on public corporations. Specifically, section
102, "Accounting Standards," states that public corporations shall:
(Footnote Continued)
-7-
<PAGE>
appeared to be unintentional. Specifically, AA was informed by employees of the
former CUC units that these misstatements had not been directed in a manner
consistent with the irregularities discussed in this Report.
Having satisfied itself that these items were errors, AA provided this
information to both the Company and to D&T. D&T identified additional erroneous
misstatements through the performance of its audit procedures. The Company
corrected these errors in preparing the Restatement. AA did no further work in
relation to these errors.
- -------------------------------------------------------------------------------
(A) make and keep books, records, and accounts, which, in reasonable
detail, accurately and fairly reflect the transactions and
dispositions of the assets of issuer; and
(B) devise and maintain a system of internal accounting controls
sufficient to provide reasonable assurances that -
(i) transactions are executed in accordance with management's
general or specific authorization;
(ii) transactions are recorded as necessary (I) to permit
preparation of financial statements in conformity with generally
accepted accounting principles or any other criteria applicable to
such statements..."
As more fully discussed in this Report, the books and records of CUC
contained material misstatements during the Restatement Period that were
the result of accounting errors and irregularities.
-8-
<PAGE>
III. EXECUTIVE SUMMARY
Throughout the Restatement Period numerous accounting irregularities
and improper accounting practices occurred at CUC11 which had the effect of
inflating revenues or decreasing expenses. The irregularities were pervasive.
The information that has been obtained indicates that the purpose of
many of the irregularities was at least to conform CUC's publicly-reported
results to Wall Street's earnings expectations. During the Restatement Period,
operating income was improperly inflated by an aggregate of approximately $500
million before taxes, which represents more than one-third of the total
operating income reported by CUC. See Appendix Ex. 2. Further, operating income
was inflated during the Restatement Period in 17 of the 22 operating units of
CUC. Thus, the irregularities touched the large majority of the company.
The irregularities increased in amount during the Restatement Period
and included the following:
1. Topside Adjustments to Quarterly Results
At each of the first three fiscal quarters since 1995, CUC inflated
its operating income by increasing revenues and/or
- --------------
(11) As set forth above, after December 17, 1997 the former CUC business units
were operated under the corporate title Cendant Membership Services, Inc.
("CMS"), a subsidiary of Cendant. Hereafter, references to CUC include
the former entity as well as CMS during the period after December 17.
-9-
<PAGE>
decreasing expenses of its largest business unit, the Comp-U-Card division in
Trumbull, Connecticut, without any valid basis. See Section VII below.
So-called "topside" entries were made by accounting personnel at corporate
headquarters to increase accounts receivable and revenues, or to decrease
accounts payable and expenses, even though (as these personnel acknowledged)
there was no actual receivable supporting the entry giving rise to the
revenues, and no actual reduction of a payable obligation to justify the
reduced expense. The topside entries were not recorded on any general ledger,
thereby creating a discrepancy between the adjusted figures and those reflected
on the company's actual books and records.
The amount of these quarterly adjustments increased during the
Restatement Period, from $31 million pretax income in 1995 to $87 million in
1996 to $176 million in 1997.
The amount of the income adjustments at each quarter closely mirrored
the amount needed to bring CUC's results into line with Wall Street earnings
expectations, e.g., if actual income in a particular quarter was 10(cent) per
share and consensus analysts' expectations were 18(cent) per share, then
adjustments of approximately 8(cent) were made, without support, to increase
earnings.
The inflated earnings results were then publicly reported and
presented to the CUC Board of Directors at each quarter. Because these results
were often above the combined budgets of CUC's individual business units for
the quarters, the consolidated quarterly budget figures presented to the Board
that
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accompanied the financial results were frequently increased at corporate
headquarters to eliminate any substantial variance.
In addition to adjusting the company's income at each quarter to meet
Wall Street expectations, CUC also made quarterly unsupported topside
adjustments to its balance sheet, particularly to show a greater cash balance
than the company actually had on its books. These adjustments were generally
made in conjunction with the earnings adjustments described above.
2. Irregularities Involving
Utilization of Merger Reserves
As a result of the quarterly topside adjustments to earnings, there
was a substantial gap between what was reported to the public and what was
recorded on the company's books. To help close this gap, CUC made various
year-end adjustments to its books to increase revenues or decrease expenses. In
1997 these largely took the form of reversals of previously established merger
and restructuring reserves into income, by decreasing the reserves and
correspondingly increasing income (again either by increasing revenues or
decreasing expenses) through numerous unsupported journal entries. In what the
information obtained shows to have been a carefully planned exercise,
unsupported journal entries to reduce reserves and increase income were made
after year-end and backdated to prior months; merger reserves were transferred
via intercompany accounts from corporate headquarters to various subsidiaries
and then reversed into income; and reserves were transferred from one
subsidiary to another before being taken into income. Approximately $115
million of merger reserves were improperly reversed into income
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at year-end 1997 in these and other fashions. See Section VIII below.
CUC also improperly utilized merger reserves by writing off assets as
impaired against reserves when the assets were not in fact impaired or where
such impairment was unrelated and not coincident to any merger. See Section IX
below.
The improper usage of merger reserves occurred in 1995 and 1996 as
well, albeit on a lesser scale than in 1997.
In addition, there is evidence that CUC intended to utilize a portion
of the reserve established in connection with CUC's merger with HFS on December
17, 1997 to inappropriately increase earnings in 1998 and perhaps in future
periods as well.
3. Irregularities in Connection
With Revenue Recognition
CUC also improperly recorded revenues on an accelerated basis in
relation to its recognition of the expenses associated with those revenues. See
Section X below. Although CUC's stated policy was to match revenues and
expenses, a proper matching was not achieved. A large element of the
mismatching was attributable to CUC's having arbitrarily re-labeled revenues
from certain products of its Comp-U-Card division where revenues and expenses
were roughly matched over the membership period, to other products where
revenues were recognized immediately while related expenses continued to be
deferred.
The impact of CUC's improper revenue recognition practices was to
inflate earnings by approximately $27 million pretax in 1995, $23 million in
1996 and $41 million in 1997. There is evidence that one such practice, the
mislabeling of
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products to accelerate revenue recognition, began in the latter half of 1994.
4. Irregularities Concerning
the Membership Cancellation Reserve
Comp-U-Card's membership cancellation reserve -- the provision for
potential membership cancellations and credit card rejections -- was
substantially understated as of the beginning of the Restatement Period.
Despite this, from time to time during the Restatement Period that cancellation
reserve was improperly reduced, and income increased, through unsupported and
backdated journal entries. See Section XI below.
To obscure the understatement of the cancellation reserve, and the
improper reversals of that reserve into income, CUC engaged in various other
irregular accounting practices during the Restatement Period. These included
the delayed recording of credit card rejects and the creation of fictitious
accounts receivable. The delayed recording of credit card rejects predated the
Restatement Period. The rationale for that practice prior to the Restatement
Period could not be determined.
The positive income statement impact of these practices on the
company's reported income during the Restatement Period actually declined, from
$48 million pretax in 1995 to $19 million in 1996 and $12 million in 1997. That
is because the majority of the income statement benefit from the understatement
of the cancellation reserve occurred at some undetermined point prior to the
Restatement Period, when rejects were initially not written off to the reserve
or adequately reserved for. The precise
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reasons for the historical understatement of the cancellation reserve could not
be determined.
5. Other Irregularities
Other accounting irregularities and improper accounting practices,
including those relating to the commissions payable account and various
miscellaneous improper adjustments and entries, are detailed in Section XII
below.
6. Information as to Which Persons
Had Knowledge of Irregularities
Although, as detailed in the Report, the numerous unsupported entries
were effected in many instances by employees of CUC subsidiaries (often with
knowledge that there was no apparent support for the making of such entries),
the directions for the making of the improper entries came from CUC corporate
headquarters.
The information obtained during the investigation indicates that Cosmo
Corigliano, Chief Financial Officer of CUC since early 1995, and prior thereto
Corporate Controller of the Comp-U-Card division, directed the unsupported
topside adjustments to increase quarterly income and knew about or directly
participated in certain of the other irregular activities discussed in this
Report. The evidence also indicates that Anne Pember, the Controller of CUC
(and formerly Corporate Controller of the Comp-U-Card division), who reported
directly to Corigliano, gave the directions that resulted in the improper
reversal of a substantial amount of merger reserves into income and the
recording of other improper entries.
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Certain other financial and accounting personnel including Casper
Sabatino, Vice President of Accounting and Financial Reporting; Kevin Kearney,
Director of Financial Reporting from July, 1995 to March, 1997, after which he
became a Controller of a CUC subsidiary; Steven Speaks, Controller of the
Comp-U-Card division after June, 1997; and Mary Sattler, Supervisor of
Financial Reporting for CUC, all indicated that they participated in certain of
the irregular activities and directed others to record improper entries which
are discussed in this Report.
More than 20 present and former employees from various CUC business
units in the United States and Europe, including the major operating units of
the company, have said that they were instructed by persons at CUC corporate
headquarters to engage in the activities discussed in this Report.
E. Kirk Shelton, the President and Chief Operating Officer of CUC, to
whom Corigliano reported, made himself available for several interviews.
Shelton reported to Walter Forbes, the Chief Executive Officer and Chairman of
the Board. Shelton denied knowledge of any accounting irregularities, including
those discussed in the Report. There is evidence, which Shelton disputes, that
in March, 1998 he advanced a plan that involved the improper reversal of merger
reserves into revenues in 1998. Moreover, Shelton has stated that he authorized
more than $500,000 of airplane expenses incurred by Walter Forbes in 1995 and
1996 to be charged to the reserve established in connection with the CUC/HFS
merger in 1997. This
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was not a proper charge and has been reversed in the Restatement. Shelton said
that when he authorized the charge he did not know how it related to the
merger. He said he was told to do so by Corigliano. Information pertaining to
Shelton's possible knowledge of certain other matters that were investigated is
discussed below.
Walter Forbes made himself available for an interview on two occasions
and denied knowledge of any accounting irregularities and improper practices.
The Report discusses Walter Forbes' statements with respect to the matters that
were investigated and certain other information pertaining thereto.
Also discussed in the Report is the evidence pertaining to whether or
not other persons may have had knowledge of irregularities or other improper
practices.
Neither Pember nor Corigliano were able to be interviewed for
reasons described in the Report. Had we been able to interview these
individuals, they might have contradicted statements made about them by others,
provided explanations for their actions, indicated the extent, if any, to which
they acted at the direction or with the knowledge of others or generally
provided additional information relevant to an understanding of the matters
investigated. We also were unable to interview Stuart L. Bell for reasons
discussed in this Report.(12) He was the Chief Financial Officer from 1981 to
early 1995. Corigliano
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(12) See n.8, supra.
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reported to Bell prior to becoming Chief Financial Officer. Paul J. Hiznay,
former Accounting Manager of the Comp-U-Card division, who reported to Pember,
also could not be interviewed for reasons discussed earlier.(13)
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(13) See n.7, supra.
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IV. CUC INTERNATIONAL, INC.
A. CUC's Business
Prior to its merger with HFS on December 17, 1997 (the "merger" or
"Cendant merger"), CUC was a membership-based consumer services company
providing members with access to a variety of goods and services. It also
offered consumer software through certain businesses which it acquired during
1996.
The membership business offered goods and services such as shopping,
travel, auto, dining, home improvement, lifestyle, vacation exchange, credit
card and checking account enhancement packages, financial products and discount
programs. CUC categorized the membership services offered as individual,
wholesale and discount programs.(14) The company's membership activities were
conducted through its Comp-U-Card division and, as of December, 1997, through
approximately 20 wholly-owned subsidiaries located throughout the United States
and Europe.
CUC maintained corporate offices at 707 and 595 Summer Street in
Stamford, Connecticut. In 1997, the offices of the following executives were
located on the third floor at 707 Summer Street: Walter A. Forbes, CUC's
Chairman and Chief Executive Officer ("CEO"), Shelton, Corigliano, Amy N.
Lipton, General Counsel, John H. Fullmer, Chief Marketing Officer,
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(14) In its annual report for the year ended January 31, 1997, CUC defined
these categories.
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Anthony L. Menchaca, President of the Comp-U-Card division, Christopher K.
McLeod, CEO of CUC Software (the "Software division") and Laura P. Hamilton,
head of Investor Relations.
CUC's corporate financial and accounting personnel, including Pember
but not Corigliano, were located approximately one block away at 595 Summer
Street (the corporate financial and accounting department in Stamford is
occasionally referred to herein as "CUC Corporate", or simply "Corporate"). In
addition, one of CUC's subsidiaries, Spark, maintained its offices at 595
Summer Street.
The Comp-U-Card division, CUC's largest business unit, was located in
Trumbull, Connecticut. Its financial and accounting personnel were located at
these offices. The office of the division president, however, was on the third
floor at 707 Summer Street, Stamford. In addition, the accounting office of
another CUC subsidiary, Welcome Wagon, was located in Trumbull although the
subsidiary's headquarters were in Memphis, Tennessee.
The general ledger for the Comp-U-Card division also served as the
general ledger for CUC Corporate.(15)
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(15) CUC used a fiscal January 31 year end and quarters ending January 31,
April 30, July 31 and October 31. In this Report, CUC's "fiscal 1998"
refers to the year ended January 31, 1998; "fiscal 1997" refers to the
year ended January 31, 1997, and so forth. Following the merger of CUC
and HFS, Cendant reported on a calendar year basis.
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B. CUC Management
1. Executive Officers
At the time of the merger, all of CUC's principal executive officers
had been with the company for more than ten years.
a) Walter Forbes
Walter Forbes, one of the founders of CUC in 1973, was CEO and
Chairman of the Board from 1976 and 1983, respectively, until the merger.
Between 1995 and 1997, Walter Forbes was also Chairman of the Executive
Committee of CUC's Board. After the merger, he became Chairman of the Cendant
Board and resigned that position in July, 1998.
Reporting to Walter Forbes were Shelton, McLeod, President of
the Comp-U-Card division from 1988 to 1995, and later Chief Executive Officer
of the Software division from 1997 to present, and Bell, CUC's CFO from 1981
until 1995. Walter Forbes headed the Office of the President, a group of the
key CUC executives, which included Shelton, McLeod and Bell until he
resigned.16
b) E. Kirk Shelton ("Shelton")
Shelton came to CUC as Senior Vice President in 1981. In the early
1990's, Shelton became President and Chief Operating Officer of CUC, positions
he held until the merger with HFS. He
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(16) The Office of the President was merely a collective name for the group of
executives who comprised it.
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became a member of the CUC Board of Directors and its Executive Committee in
1995. After the merger, Shelton became Vice Chairman and a director of Cendant.
Throughout his tenure with CUC, Shelton reported to Walter Forbes.
Reporting to Shelton were Corigliano (after he became CFO in 1995), Lipton
(beginning in 1995), the Presidents of BCI, EPub, Essex and FISI, Fullmer
(beginning in 1996), and Menchaca (beginning in early 1997).
c) Christopher K. McLeod ("McLeod")
McLeod came to the Comp-U-Card division as Vice President of
Merchandising in 1983, and while at CUC always reported to Walter Forbes. In
1988, McLeod became President of the Comp-U-Card division and a member of the
Office of the President. He headed the Comp-U-Card division until 1995. From
June, 1995 until January, 1997 his sole titular responsibilities were within
the Office of the President, although he continued to oversee the operations of
the Comp-U-Card division and several other businesses, including CUC Europe,
ETS, Getko, NAOG, NUMA, Spark, Welcome Wagon and Wright Express. McLeod became
CEO of CUC's Software division in early 1997. McLeod became a member of CUC's
Board of Directors around 1991 and a member of CUC's Executive Committee in
1995. McLeod is currently the CEO of Cendant Software division and Executive
Vice President of Cendant.
d) Amy N. Lipton ("Lipton")
Lipton came to CUC in 1987 as its first lawyer. She was Vice President
and CUC's General Counsel until the merger.
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After the merger, Lipton became General Counsel of CMS as well as Deputy
General Counsel and Executive Vice President of Cendant.
Lipton reported to Bell until his departure in 1995, and then to
Shelton. After the merger, she reported to James E. Buckman ("Buckman"),
General Counsel of Cendant.
e) Anthony L. Menchaca ("Menchaca")
Menchaca came to CUC in July 1985 and held a variety of positions
thereafter. In 1995, he became president of the Comp-U-Card division, and
reported to McLeod. When McLeod became CEO of the Software division in early
1997, Menchaca began reporting to Shelton and continued to do so until April,
1998. After the merger, Menchaca continued to run Comp-U-Card and in April,
1998 he was named Co-Chairman of what is now known as Cendant's Alliance
Marketing Group, comprising Comp-U-Card and the other former membership
businesses of CUC.
f) John H. Fullmer ("Fullmer")
Fullmer came to CUC in April, 1980 and held a variety of positions
over the years in the areas of marketing, sales and product development. He
became Executive Vice President of the Comp-U-Card division in March, 1991, and
Chief Marketing Officer of CUC in April, 1996, titles he held until the merger.
In April, 1998, he became Co-Chairman of the Alliance Marketing Group, along
with Menchaca. He is also the Chief Marketing Officer for Cendant.
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2. Financial Officers and Personnel of CUC and Comp-U-Card Division
a) Stuart L. Bell ("Bell")
Bell was CFO of CUC from 1981 until his departure in January, 1995.
Bell was a member of the Office of the President along with Shelton and McLeod.
Corigliano replaced Bell as CFO when he left CUC. Bell reported to Walter
Forbes.
b) Cosmo Corigliano ("Corigliano")
Corigliano was Corporate Controller of the Comp-U-Card division from
the mid-1980's until he became CFO of CUC in early 1995. Prior to coming to CUC
in 1983 as Assistant Controller, Corigliano was employed with Ernst & Young.
Corigliano was CFO until the merger. After the merger, he became CFO of CMS.
Corigliano's employment was terminated in mid-April, 1998.
As CFO of CUC, Corigliano reported to Shelton. Reporting to Corigliano
were Casper Sabatino, Vice President of Accounting, Pember, Corporate
Controller of the Comp-U-Card division (and later Controller of CUC), Kim Ames,
Vice President of Internal Audit, and Hamilton, head of Investor Relations.
c) Anne M. Pember ("Pember")
Pember replaced Corigliano as the Corporate Controller of the
Comp-U-Card division in April, 1995. During her tenure as Controller of
Comp-U-Card, Pember maintained an office in Trumbull and reported to
Corigliano. She also maintained an office in Stamford and spent considerable
time there as well. In June, 1997 she was promoted to Senior Vice President and
Controller for CUC and worked full-time at the Stamford office at 595 Summer
Street, continuing to report to Corigliano.
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Pember was employed with Ernst & Young from 1981-1983, and came to CUC
in March, 1989. After the merger, Pember did not assume a new title and
continued in her role as Senior Vice President while management reorganized her
CUC responsibilities into a new position.
d) Casper Sabatino ("Sabatino")
Sabatino joined CUC as the Manager of Financial Reporting in 1985. He
was promoted to Director of Financial Reporting in approximately 1988 and then
to Vice President of Accounting and Financial Reporting in June, 1991. Sabatino
currently is the Vice President of Business Development for Cendant.
Prior to 1998, Sabatino reported principally to Corigliano and Pember.
Since March, 1998, Sabatino has reported to Scott E. Forbes ("Scott Forbes"),
Executive Vice President of Finance and Chief Accounting Officer of Cendant.(17)
e) Kevin T. Kearney ("Kearney")
Kearney joined CUC in 1993 as Manager of Financial Reporting in the
corporate office in Stamford, reporting to Sabatino. Prior to coming to CUC,
Kearney worked for Ernst & Young for approximately four years. Kearney was
promoted to Director of Financial Reporting around July, 1995, and continued
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(17) Scott Forbes is no relation to Walter Forbes.
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to report to Sabatino. He became the Controller of Spark in March, 1997 and
remains in this position.
f) Kathleen M. Mills ("Mills")
Mills came to CUC as a junior accountant in the Comp-U-Card division's
revenue accounting area in 1991 and remained in that position until July, 1993.
Mills was the Supervisor of the Financial Reporting Department of CUC from
July, 1993 to October, 1995. Mills was promoted to Manager of Financial
Services of CUC in October, 1995 and remained there until June, 1997.18
g) Mary Sattler ("Sattler")
Sattler came to CUC as Supervisor of Financial Reporting in December,
1995 and remained in that position until the merger. Prior to coming to CUC,
Sattler was employed as a Staff Accountant at Ernst & Young. Sattler is
currently the Manager of Financial Reporting of Cendant.
Sattler reported to Kearney who reported to Sabatino prior to
Kearney's move to Spark in 1997. After June, 1997, Sattler reported to Pember.
h) Steven P. Speaks ("Speaks")
Speaks joined SafeCard Services, Inc., a subsidiary of Ideon based in
Cheyenne, Wyoming, as Controller for Client Services in July, 1993 and
thereafter held various positions
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(18) Subsequently, Mills became the Analysis Manager in the Marketing
Department for the Comp-U-Card division. Mills held the position of
Analysis Manager of CMS until her departure in mid-1998.
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within Ideon. In late 1996, subsequent to CUC's acquisition of Ideon, Speaks
accepted Pember's offer to work for the Comp-U-Card division in Trumbull, and
relocated to Trumbull in April, 1997. Speaks replaced Pember as Controller of
the Comp-U-Card division when Pember left the division in June, 1997. Speaks is
currently Vice President and Controller for Comp-U-Card.
Speaks reported to Pember from April, 1997 until she left the company.
Speaks then reported briefly to Menchaca and then to Mark Metcalfe, who
replaced Menchaca as President of Comp-U-Card.
i) Bruce B. Tolle ("Tolle")
Bruce Tolle joined CUC as a Supervisor of the General Ledger of the
Comp-U-Card division in 1997. Tolle was promoted to the position of Manager of
the General Ledger of CMS in March, 1998.
Tolle reported to Paul J. Hiznay ("Hiznay"), Accounting Manager,
before Hiznay left CUC in October, 1997. After Hiznay left, Tolle reported to
Speaks.
C. Ernst & Young ("E&Y")
E&Y was CUC's independent public accountant. E&Y was first retained
prior to the time CUC went public in 1983 and subsequently conducted each of
the company's annual audits. E&Y also conducted reviews of CUC's quarterly
financial statements. Several of CUC's employees responsible for accounting and
financial matters had previously worked at E&Y including Corigliano, Kearney,
Pember and Sattler.
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The partner in charge of the audits for the years ended December 31,
1997 and January 31, 1997 was Marc Rabinowitz and the review partner was Louis
Scherra. Ken Wilchfort had previously been the audit partner on the CUC
account. Simon Wood was the Senior Manager on the December 31, 1997 audit and a
manager on the January 31, 1997 audit.19
D. CUC's Audit Committee
For many years prior to the merger, CUC's audit committee included
Burton C. Perfit ("Perfit") (Chairman), T. Barnes Donnelly ("Donnelly") and
Stephen A. Greyser ("Greyser"). Perfit joined the audit committee in 1982;
Donnelly and Greyser were audit committee members for more than ten years.
Regular audit committee meetings were held three times a year.
In recent years, the meetings were usually attended by Corigliano,
Bell (before he left in 1995), Kim Ames (Vice President of Internal Audit,
whose office is located in Nashville, Tennessee) and representatives of E&Y.20
The minutes of the audit committee meetings for the years 1995 through
1997 (which have little detail), and the
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(19) The E&Y Stamford audit team for the January 31, 1997 audit included,
among others, Joe Caparelli, principal; Simon Wood, manager; Bruce Botti,
manager; and Mark Picarella, senior. The E&Y Stamford audit team for the
December 31, 1997 audit included, among others, Simon Wood (senior
manager); Picarella; Botti; and Jeanine Dolan.
(20) Pember is recorded in the minutes as attending one audit committee
meeting on June 10, 1997.
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interviews conducted with each of the audit committee members, indicate that
none of the accounting irregularities which are the subject of this Report were
brought to their attention.
E. Budgets
1. The Annual Budgeting Process
Each subsidiary or division would develop its own budget and send it
to Stamford for review. The budget process typically began around November and
was completed by sometime in January of the following year for approval by the
Board, prior to the beginning of the new fiscal year.
The subsidiaries submitted their annual budgets to various senior CUC
executives, depending upon the executives' area of responsibility, during
December or early January. The Comp-U-Card division budget was prepared by
Comp-U-Card's accounting personnel and reviewed by the division's president.
Upon completion, it was widely distributed within CUC including to Corigliano,
Pember, Fullmer, McLeod, Menchaca, Shelton and others.(21)
It is unclear whether the company's subsidiary and divisional budgets
were regularly consolidated into a company-wide annual budget. Some form of
budget, or collection of individual budgets, was presented to the Board for
approval at the January Board meetings. After approval of the budget(s) by
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(21) Walter Forbes was not on the distribution lists we have seen.
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the Board, certain senior CUC executives, including Walter Forbes and Shelton,
typically received a large binder containing the individual subsidiaries'
budgets and more detailed backup.(22)
2. The Quarterly Budgets
At each quarterly Board of Directors meeting, a package was presented
reflecting the quarterly budget for each of several business segments within
CUC, including Individual, Wholesale and Coupon Memberships, Software, and
International. No annual budget figures were shown in these materials. The
package contained a comparison of the financial results of the various segments
to the quarterly budget figures for that same quarter, as well as for the
equivalent quarter from the prior year. See Appendix Ex. 3. CUC Corporate
obtained quarterly budget information from the various business units. Sattler
and Sabatino have stated that the quarterly budget information presented to the
Board did not accurately reflect the budget information which CUC Corporate had
obtained from the business units. As discussed below, changes were made to make
the budget for the quarter appear generally consistent with reported results,
which were higher than the company's actual results.(23)
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(22) Walter Forbes said he did not review these materials.
(23) As contrasted with the budget, which was supposed to be set once at the
beginning of the year and not change thereafter, many of CUC's business
units also prepared "forecasts" which changed from month to month. The
forecasts contained updated numbers that represented current best
estimates of financial performance for the year.
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3. The January 31, 1998 Consolidated Budget
Although some CUC board members recalled having seen and approved a
consolidated budget for the year ended January 31, 1998 at the January, 1997
Board meeting, we have not found such a budget in the company's files nor has
it been obtained from any other source.(24) A January 31, 1998 budget document
was presented to HFS in early May, 1997, prior to the signing of the Merger
Agreement. See Appendix Ex. 6.(25) CUC executives have said that the document
was consistent with the way CUC typically broke out its operating results
(i.e., by individual membership, wholesale, discount and software), and that
the total budgeted EPS of $.89 was consistent with CUC's earnings target for
the year.
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(24) The minutes from the January 19, 1997 Board meeting (Appendix Ex. 4)
indicate that the Board approved the company's various "budgets" at that
meeting, but the "budgets" are not identified. Sabatino, who said he had
prepared consolidated budgets in prior years, said that he did not do so
in January, 1997 for the year ended January 31, 1998 due to time
constraints and that whatever consolidated budget may exist would have
been prepared and kept by Corigliano on his computer. There is one
undated document obtained from Corigliano's computer (Appendix Ex. 5)
which purports to be a "budget summary," both on a consolidated basis and
by business unit, for the year ended January 31, 1998. No one interviewed
could identify the document. It reflects lower consolidated numbers ($459
million pre-tax operating income) than the pre-tax operating income CUC
ultimately reported for the year ended December 31, 1997 (about $640
million).
(25) The preparer of this document has not been identified.
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4. January 31, 1998 Comp-U-Card Budget
The Comp-U-Card division's budget for the year ended January 31, 1998
projected $611 million in total revenues and a "gross profit" (revenues less
expenses) of about $84 million. See Appendix Ex. 7. This was a modified cash
budget, i.e., reflecting revenues and expenses prior to certain accrual
adjustments that were necessary to state the results in accordance with
Generally Accepted Accounting Principles ("GAAP").26
F. Contacts with Analysts and Investors
Many analysts regularly followed CUC. Hamilton, CUC's Vice President
of Investor Relations, maintained files containing reports prepared by many of
these analysts. According to Hamilton, the analysts at Bear Stearns, William
Blair, Goldman Sachs and Merrill Lynch were considered by CUC to be among the
more important that regularly followed the company.
Hamilton, Walter Forbes and Corigliano were the CUC officers
principally responsible for investor relations. CUC did not have regular
conference calls with analysts. Rather, CUC's practice was to have one-on-one
discussions with the analysts, which were generally conducted by either
Hamilton or Corigliano,
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(26) With the exception of Comp-U-Card and EPub, which reported on a modified
cash basis, CUC's subsidiaries reported on the accrual basis of
accounting.
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or sometimes both. Any public presentations or speeches were generally made by
Walter Forbes.
G. Interim Financials
CUC performed what it referred to as a "soft close" at month-end and
quarter-end. Only at year-end did the company undertake a "hard close."(27) CUC
financial and accounting personnel have stated that a soft close was used at
month-end and quarter-end because it was too time-consuming to go through the
procedures of a hard close on an interim basis and because that was the way CUC
had always done it.
1. Monthly Financials
On a monthly basis, each of the various business units compiled its
financial results into a "reporting package" which was sent to CUC Corporate in
Stamford for consolidation. The reporting packages contained a balance sheet, a
detailed income statement, a cash flow statement and in some cases other
information such as a forecast and comparisons to budget. See, e.g., Appendix
Ex. 8.
The reporting packages typically were directed to Sattler (and her
predecessor, Mills) in Stamford, but copies of the Comp-U-Card package and the
packages of at least certain
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(27) "Soft close" was understood to mean the preparation of financial
statements without performing certain analysis and without recording
certain adjusting entries required to make such financial statements more
accurate. A hard close would include such analysis and adjustments.
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other subsidiaries were also sent to others including Pember, Corigliano,
Sabatino, McLeod, Shelton, Menchaca, and Ames.(28)
The data from each subsidiary and division was input into a
consolidating model on a monthly basis, typically by Sattler. The consolidating
model consisted of an Excel spreadsheet into which the subsidiaries' monthly
financial results were entered manually. Sattler condensed the financial
information sent from the subsidiaries into four lines of revenues(29) and three
lines of expenses.(30) Most of the reporting packages contained a summary page
(or pages) which organized the information in a uniform manner in order to
facilitate the consolidation.
In most months other than the last month of the fiscal quarter,
Sattler did not input the Comp-U-Card division's monthly results because it was
too time-consuming.
Sattler printed out a consolidating balance sheet and income statement
after she had input the subsidiaries' monthly reporting figures. This document
showed the results for each business unit (but usually not Comp-U-Card), which
were tallied
- --------------
(28) Walter Forbes said he was on the distribution list for at least some of
the packages but he has no recollection of receiving or reviewing them.
(29) Membership and service fees; software revenues; licensing and royalties;
and other income.
(30) Operating, Marketing and General and Administrative Expenses.
-33-
<PAGE>
to a total consolidated number for CUC (excluding Comp-U-Card). Sattler said
that without the Comp-U-Card results the monthly consolidating reports were
largely meaningless. She said that no one in the company ever reviewed her
monthly consolidating reports. She kept all of these printouts in binders in
her office (each month had its own binder), and did not distribute the monthly
consolidating report to anyone. Sattler explained that the only reason for
inputting the packages on a monthly basis was to expedite the preparation of
the quarterly report.
2. Quarterly Financials
a) Quarterly Consolidating Report
The process for preparing the CUC internal quarterly financial reports
was similar to that for the monthly financials. After each quarter, Sattler
inserted a quarterly section into the spreadsheet, and at year end, she
inserted a year-end section. The quarterly and annual numbers were
self-generating and automatically tallied. Sattler and/or Mills would print the
quarterly section of the Excel spreadsheet and circulate it to certain people
in the department.
Mills gave her quarterly consolidating reports to Sabatino, who said
he gave them to Corigliano. Sattler gave her reports to Kearney and Sabatino
(and later, Pember), one of whom would give them to Corigliano.(31) As explained
in greater detail
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(31) Sabatino said he personally gave Corigliano copies of the consolidating
reports. Sattler said that she occasionally gave a copy directly to
Corigliano.
-34-
<PAGE>
below, at the end of each of the first three quarters of fiscal 1996, 1997 and
1998 "topside" entries were made to the consolidating reports to increase
revenues and/or decrease expenses of the Comp-U-Card division, without any
factual support, in order to meet earnings targets for CUC.(32) These
adjustments created a discrepancy between the results for Comp-U-Card as
reflected on the quarterly consolidating reports, and the actual results of
Comp-U-Card as reflected in the original reporting packages it sent to
Stamford. After the adjustments were made and a revised consolidating report
was printed, that revised report did not reveal that any adjustments had been
made. For an example of a revised CUC quarterly consolidating report generated
by Sattler, see Appendix Ex. 9.
The revised consolidating report was circulated to Sabatino, Pember
(or Kearney prior to Pember) and Corigliano.(3)3 No information has been
obtained that others including Walter Forbes, Shelton, Menchaca, Fullmer or
McLeod saw the quarterly consolidating reports prepared by CUC Corporate in
either unadjusted or adjusted form, and each of those individuals said they had
never seen any such reports.
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(32) As discussed below, unsupported topside adjustments were also made to the
balance sheets of Comp-U-Card and other units.
(33) Sabatino said he personally gave copies of the revised reports to
Corigliano, and Sattler said she gave Corigliano copies directly from
time to time.
-35-
<PAGE>
During its quarterly reviews, E&Y was also given the revised
consolidating reports which contained (but did not disclose) the topside
adjustments. Sabatino and Sattler said that E&Y was not given any Comp-U-Card
interim or quarterly reporting packages.
b) Quarterly Consolidated Reports
The consolidated financial results of CUC as reflected in the revised
quarterly consolidating reports were released to the public in a quarterly
earnings press release and in a form 10-Q. These public reports incorporated
(but did not reveal) the unsupported topside adjustments referred to above.
Unlike the consolidating reports, which showed the performance of each
individual business unit (e.g., Comp-U-Card, BCI, EPub, etc.), the earnings
release and 10-Q showed only a single line for "Membership" which incorporated
the results of all business units (including Comp-U-Card), except for the
Software division. The software results were publicly reported in a separate
line labeled "Software."
Also at each quarter, the consolidated quarterly results of CUC, as
well as a comparison of those results to the quarterly budget, were presented
to the Board of Directors as part of a board package at the Board meetings.(34)
Sattler derived
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(34) Board package materials from fiscal 1996, 1997 and 1998 showing quarterly
financial results have been obtained. No financial report was included in
the board package for the nine months ended October 31, 1997. Sattler
said she did not prepare such a report due to time constraints.
-36-
<PAGE>
these consolidated financial results for the Board from the same Excel
spreadsheet that they used to create the quarterly consolidating reports. Thus,
the figures shown as "actual" results for CUC in the Board package included the
same unsupported topside adjustments which had been made to the quarterly
consolidating reports. However, those adjustments are not apparent in the board
package materials.(35)
Both Sabatino and Sattler also said that the quarterly budget figures
presented to the Board were altered so as not to show a substantial variance
between budget and actual. In general the changes were to increase the budget
figures to bring them more in line with the reported results of the company;
otherwise those results (due to the unsupported topside adjustments), would
have substantially exceeded the budget. Sattler said that she was informed by
Sabatino that these changes were directed by Corigliano, and Sabatino said that
he was directed by Corigliano to have these changes made. Sabatino said that
Sattler (or Kearney) would then make the changes and he would review them
before the package was presented to the Board.
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(35) The Comp-U-Card division's income results (the income results which were
impacted by the topside adjustments) were subsumed within the segment
category entitled "Individual Membership," which in the board package
materials included not only Comp-U-Card but also seven other business
units: NCCI, NAOG, Interval, NLG, Wright Express, NUMA and Spark. In
other contexts, CUC defined "individual membership" to include only
Comp-U-Card, NCCI, NAOG, NUMA and Spark.
-37-
<PAGE>
H. Monthly Business Review Meetings
Each month a member or members of CUC's senior management met
in-person or telephonically with key executives from the various subsidiaries
to discuss operations, results and goals.
According to Shelton, he attended business review meetings at many of
the subsidiaries, and occasionally Walter Forbes or Corigliano participated.
Shelton did not attend the Comp-U-Card business review meetings which were
overseen by the president of that division, most recently Menchaca, and prior
to him, McLeod.
I. The Acquisition of Davidson, Sierra and Ideon
and the Establishment and Utilization of
Related Merger Reserves
In July, 1996, CUC acquired all of the outstanding stock of Davidson
and Sierra. Davidson and Sierra develop, publish and distribute educational and
entertainment software, and accordingly were included within the CUC Software
division. In August, 1996, CUC also acquired all of the outstanding stock of
Ideon Group, Inc. ("Ideon"), a Jacksonville, Florida-based provider of credit
card enhancement services. Ideon had originally been incorporated as SafeCard
Services, Incorporated ("SafeCard"). Peter Halmos was a co-founder of SafeCard.
These acquisitions were accounted for under the pooling-of-interest method of
accounting.
As disclosed in CUC's financial statements, principally in connection
with these three mergers and the acquisition of Plextel Telecommunications,
Inc. ("Plextel") in early 1997, CUC
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<PAGE>
recorded a special charge to operations of approximately $179.9 million for the
year ended January 31, 1997 for merger, integration, restructuring and
litigation costs. This amount included $48.6 million relating to the Davidson
and Sierra mergers, $127.2 million relating to the Ideon merger and
approximately $4.1 million principally related to the Plextel acquisition (the
balance sheet account corresponding to the $179.9 million charge is referred to
hereafter as the "Ideon reserve").
A major component of the Ideon reserve was an amount (either $70
million or $90 million)(36) relating to approximately 15 lawsuits pending
between Halmos and Ideon, certain affiliates and certain other persons and
entities (the "Halmos lawsuits") and three class actions known as the Hekker,
Chambers and Binder class actions (the "Ideon class actions").
On June 13, 1997, CUC entered into an agreement to settle the Halmos
lawsuits. The agreement provided for the payment of $70.5 million to Halmos
over a six-year period consisting of one up-front payment of $13.5 million and
six subsequent annual payments of $9.5 million. In December, 1997,
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(36) There is some ambiguity based on conflicting internal CUC documents as to
whether the amount initially allocated for litigation was $90 million or
$70 million. The general ledger amount for the Ideon reserve is a single
number that does not show its various components. Schedules provided by
CUC to E&Y indicate the amount allocated to litigation was $90 million.
See Appendix Ex. 10.
-39-
<PAGE>
CUC reclassified, from the Ideon reserve to a new general ledger account, a
liability representing the present value of such subsequent payments which it
calculated to be $47.8 million.(37) The agreement also called for the transfer
to CUC of all rights that Halmos held with respect to his 50% interest in
SafeCard's CreditLine business, which CUC valued at approximately $45.8
million(38) and recorded as "goodwill" in August, 1997. At the same time it
recorded this goodwill as an asset, CUC also recorded a credit (increase) to
the Ideon reserve in the amount of $45.8 million.(39)
Subsequent to the settlement of the Halmos lawsuits, in October, 1997
CUC entered into an agreement to settle the Binder
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(37) This entry was recorded topside in October, 1997 and to the general
ledger in December, 1997.
(38) A document obtained from Pember's computer dated August 27, 1997
(Appendix Ex. 11) appears to reflect the manner in which the $45.8
million was calculated.
In a memorandum entitled "Valuation of CreditLine Assets" dated January
20, 1998, E&Y stated its belief that CUC's estimate of the value of
CreditLine was "not unreasonable," based on application of a multiple of
eight times pretax earnings of CreditLine. The earnings and multiple were
provided to E&Y by Pember. The memorandum stated that it "should not be
considered a valuation opinion." See Appendix Ex. 12.
(39) The entry to book the goodwill and increase the reserve was recorded by
Bruce Tolle, an accountant in Trumbull, on the instruction of Speaks.
Speaks said he received the directive to record these entries in these
amounts from Pember. See Appendix Ex. 13.
-40-
<PAGE>
class action for $3 million, and the Hekker and Chambers class actions for a
total of $15 million, subject to court approval.
As a result of the manner in which CUC accounted for the settlements
of the Halmos lawsuits and Ideon class actions, CUC represented to E&Y that it
effectively utilized for litigation only $18,608,000 of the original $179.9
million Ideon reserve (of which $70 million or $90 million had been provided
for litigation). This figure resulted from taking the difference between the
present value of the future payments owed to Halmos ($47,872,000) and the value
of CreditLine assets received ($45,764,000), or $2,108,000, then adding the
$13.5 million in cash paid upfront to Halmos and the $3 million for the Binder
class action.
In its publicly-filed 10-Q's during 1997 CUC reported the amount of
payments that had been made and charged, to date, against the Ideon reserve.
The 10-Q for the fiscal quarter ended April 30, 1997 reported that of the
original $179.9 million in the reserve, $96 million in payments had been made
(suggesting, although not stating, that a balance of about $84 million
remained); the 10-Q for the quarter ended July 31, 1997 reported that payments
to date were $125.9 million (suggesting a remaining balance of about $54
million); and the 10-Q for the fiscal quarter ended October 31, 1997 reported
that charges of $155.7 million had been taken against the reserve to date
(suggesting a remaining balance of about $24 million). See Appendix Ex. 14. E&Y
was later told that the charges through December 31, 1997 had virtually
exhausted the reserve.
-41-
<PAGE>
In fact, the remaining balances in the Ideon reserve as suggested in
the 10-Q's did not match the actual balances on Comp-U-Card's general ledger.
The balance in the Ideon reserve account at April 30, 1997, as reflected in the
general ledger, was $94 million, not $84 million; the balance at July 31, 1997,
as reflected in the general ledger, was $70.5 million, not $54 million; the
balance at October 31, 1997, as reflected in the general ledger, was
approximately $118 million,(40) not $24 million; and the balance at December 31,
1997 was approximately $64 million. See Appendix Ex. 15.(41)
During E&Y's audit of the December 31, 1997 financial statements of
CMS, E&Y was told that only approximately $18
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(40) If adjusted for a topside adjustment made in October, 1997 to reclassify
$47.8 million of the reserve to a separate liability account, the general
ledger balance as of October 31, 1997 would have been $70.5 million. The
discrepancies between the quarterly general ledger balance and public
filings have not otherwise been reconciled. Sabatino said Pember handled
the public disclosures of the Ideon reserve utilizations. The 10-Q's were
signed by Corigliano and Walter Forbes.
(41) Appendix Ex. 15 is a schedule prepared on January 9, 1998 by Eva
Viniczay, a staff accountant in Trumbull, showing general ledger activity
in the Ideon account. She confirmed that this document indicates that as
of that date, the December 31, 1997 balance in the Ideon reserve account
was $64,258,000. She stated that this number tied to the amount that
appeared in the general ledger as of January 9, 1998. The reason the
December 31, 1997 balance as conveyed to E&Y after year-end was
effectively zero was because certain unsupported post-close journal
entries were made in January, 1998 (subsequent to January 9) and
backdated to 1997 to reduce the balance. These entries are discussed in
detail in Section VIII.
-42-
<PAGE>
million of litigation expenses had been charged against the Ideon reserve in
1997. According to Simon Wood, upon learning this fact, Rabinowitz, Wilchfort
and Wood of E&Y called Corigliano. Corigliano told them that as a result of the
favorable settlement of the Halmos lawsuits, less of the reserve had been
needed for litigation, but that CUC had experienced greater than expected
merger-related integration costs and that the reserve amounts not utilized for
litigation had been reallocated to cover the additional integration costs. E&Y
told Corigliano that it would need support for this.
Among the support provided was a memorandum from Corigliano to files
dated March 11, 1998. See Appendix Ex. 16. This memorandum confirmed what Wood
said E&Y had been told by Corigliano. It stated that as a result of favorable
developments during the year with respect to the settlement of the Halmos
lawsuits, and anticipated insurance for the class action settlements and
unanticipated additional integration costs which had been incurred, substantial
portions of the Ideon reserve originally established to cover litigation were
reallocated to cover the unanticipated integration charges. The memorandum
stated that a total of $48 million had been reallocated from litigation to
integration costs and provided a breakdown of the amounts reallocated in each
fiscal 1998 quarter.(42) E&Y was also
- --------------
(42) The CUC officers with whom we discussed this issue, including Shelton,
Walter Forbes, Menchaca and Lipton, stated that they were not aware
during 1997 that any part of
(Footnote Continued)
-43-
<PAGE>
provided with another document itemizing by quarter the categories of
integration costs for which the reallocated $48 million purportedly had been
used. Appendix Ex. 17.(43)
As discussed below, a significant amount of the Ideon reserve was not
used appropriately to cover proper merger-related costs. Instead, approximately
$63 million of the Ideon reserve was improperly reversed into income at
year-end December 31, 1997.(44) A substantial amount of these reserves were
reversed directly into revenue accounts of CUC rather than being applied
against expenses that CUC allegedly had incurred.
- -------------------------------------------------------------------------------
the Ideon reserve had been reallocated from litigation to integration
costs and had no discussions with Corigliano to this effect.
(43) E&Y also prepared various schedules and roll-forward analyses of the
Ideon reserve utilizations based on information provided by CUC. See
Appendix Ex. 127.
(44) An additional $51 million had been inappropriately reversed into income
at year-end, January 31, 1997.
-44-
<PAGE>
V. CUC/HFS MERGER
A. Terms of the Merger
On May 27, 1997, CUC and HFS entered into a merger agreement. The
merger, which was described as a "merger of equals" in the May 27, 1997 press
release and the October 1, 1997 proxy statement, was approved by the
shareholders of both companies on October 1, 1997. The merger was completed on
December 17, 1997. CUC was the surviving entity and was renamed Cendant
Corporation.
Pursuant to the Plan for Corporate Governance (the "Governance Plan")
executed in connection with the merger, the Cendant Board was expanded to
twenty-eight members, fourteen of whom were appointed by CUC and fourteen of
whom were appointed by HFS. The Governance Plan provided that the compensation
and audit committees would each be comprised of two directors appointed by CUC
and two by HFS. It also established the managerial positions that the CUC and
HFS officers would occupy in the new entity and provided for the succession of
leadership in the year 2000.(45)
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(45) The Governance Plan provided that Walter Forbes would be Chairman of the
Board of Cendant until January 1, 2000, at which time he would become the
President and Chief Executive Officer; Henry Silverman ("Silverman")
would be President and Chief Executive Officer until January 1, 2000, at
which time he would become the Chairman of the Board; Michael Monaco
("Monaco") would be Vice Chairman and Chief Financial Officer of Cendant
until January 1, 2000; Corigliano would be CFO of CMS until January 1,
2000 when he would become CFO
(Footnote Continued)
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<PAGE>
As a result of the merger, senior management of both companies
received additional benefits including in most cases increased base salaries,
increased bonus compensation, improved severance benefits, additional stock
options, immediate vesting of certain options, and in the case of CUC
management, lapsing of restrictions on restricted stock and acceleration of
lump sum payments under the Senior Executive Retirement Plan.
B. Due Diligence and the Period Prior to the Closing
Prior to the signing of the merger agreement, HFS was provided with
limited access to non-public information concerning CUC's businesses. According
to the CUC officers who were interviewed, they and the Board were concerned
about HFS having competitive information if the merger were not consummated.
These concerns, they have stated, arose from the fact that HFS had been
negotiating for the purchase of Signature Financial/Marketing, Inc., a
membership business owned by Montgomery Ward which competed with CUC. They were
also concerned because CUC and HFS were competing in the resort timeshare
business.
- -------------------------------------------------------------------------------
of Cendant; Shelton would be Vice Chairman of Cendant; McLeod would be
Executive Vice President of Cendant and President of the Software
division (later renamed Cendant Software); Buckman would be General
Counsel of Cendant through January 1, 2000; Lipton would be General
Counsel of CMS and Deputy General Counsel and Executive Vice President of
Cendant until January 1, 2000 at which time she would become General
Counsel of Cendant.
-46-
<PAGE>
At a meeting attended by many of the senior officers of both companies
on or around May 9, 1997, CUC provided HFS with a document that included budget
information for the fiscal years ended January 31, 1998 and January 31, 1999
(the "due diligence budget").(46) See Appendix Ex. 6. This document projected
earnings per share of $.89 and $1.10 for the years ended January 31, 1998 and
January 31, 1999, respectively.
After the merger agreement was signed, Silverman, with various of
CUC's principal officers, visited many of CUC's subsidiaries. At those
meetings, Silverman stated that he was told that CUC's business units were not
experiencing any significant problems; to the contrary, each said they were
meeting or exceeding budget. HFS was advised during the period prior to the
closing that the software business was not likely to meet its budget.(47)
On December 11, 1997, Monaco and Scott Forbes of HFS attended a CUC
divisional controllers meeting in Stamford with Corigliano, Pember, and the
controllers for Comp-U-Card and each of the subsidiaries (other than for the
software unit). The various controllers presented materials showing their
forecasted results for the 12 months ended January 31, 1998 (i.e., the
- --------------
(46) It is not known who prepared this document.
(47) CUC's senior management stated during interviews that they were unaware
of any significant problems that existed at any of the units, other than
software, that were expected to adversely affect their financial
performance.
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<PAGE>
fiscal year that was by then largely completed), as well as their budget for
the December 31, 1998 calendar year. See Appendix Ex. 18.
Speaks said that a few days before the meeting he prepared his
presentation for Comp-U-Card (the "Original Presentation") and sent it to
Pember for her review. In relevant part, the summary schedule he prepared
showed the following (in 000's):
<TABLE>
<CAPTION>
Budget 12 Months
12/31/98 1/31/98
-------- -------
<S> <C> <C>
Revenue $ 748,231 $ 631,740
Operating Income $ 133,441 $ 91,510
</TABLE>
See Appendix Ex. 19. The $631.7 million in revenues forecast for fiscal 1998,
and $91.5 million in operating income, were generally consistent with the
budget on which Comp-U-Card had been operating throughout the year ($611
million revenues and $84 million gross profit, see Appendix Ex. 7).(48)
Speaks said Pember contacted him the night before the controllers'
meeting and told him she was working on his document and wanted to meet the
next morning to go over with him what she had done. The next morning, just
before the meeting, Pember and
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(48) Speaks explained that the budget on which he had been operating was a
modified cash basis budget, while the figures he prepared for his
December 11 presentation included the impact of GAAP accruals.
-48-
<PAGE>
Corigliano gave Speaks new numbers for Comp-U-Card revised substantially higher
(the "Revised Presentation") (in 000's):
<TABLE>
<CAPTION>
Budget 12 Months
12/31/98 1/31/98
-------- -------
<S> <C> <C>
Revenue $ 952,231 $ 831,740
Operating Income $ 215,405 $ 197,333
</TABLE>
See Appendix Ex. 20. Thus, forecasted revenues in the Revised Presentation were
exactly $200 million higher for fiscal 1998 than in Speaks' Original
Presentation, and operating income was more than $100 million higher. In the
Revised Presentation, budgeted revenues and operating income for the year ended
December 31, 1998, were $204 million and $82 million, respectively, higher than
in the Original Presentation.(49)
Speaks presented the Revised Presentation at the December 11 meeting.
Speaks said that he questioned Pember after the meeting and was told that the
adjustments were based on merger reserve activity and other topsides, and that
the information was presented on Comp-U-Card's financials because it was the
largest division.
Approximately three weeks later, on December 30, 1997, Speaks
distributed the "final budget for calendar year 1998" for
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(49) The revised Comp-U-Card budget figures were also included in a
consolidated CUC budget given to Monaco and Scott Forbes on December 11.
See Appendix Ex. 18.
-49-
<PAGE>
the Comp-U-Card division. See Appendix Ex. 21. The recipients of this budget
included Corigliano and Pember.(50) The December 30 budget included revenues of
$761 million (on a modified cash basis), similar to the $748 million in
calendar 1998 budgeted revenues shown in Speaks' Original Presentation prepared
for the December 11 meeting -- but nearly $200 million less than the budgeted
revenues he presented at that meeting in his Revised Presentation.
A document submitted to Parsippany in late January, 1998 by Sabatino
(for use in preparing Cendant's final budget) which contained the December 31,
1998 final budget numbers for the CUC business units, included revenues for the
Comp-U-Card division of $910 million and net income before taxes of $296
million. See Appendix Ex. 22.(51)
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(50) This budget was widely distributed to CUC personnel and most of its
principal executives including Fullmer, Lipton, McLeod, Menchaca and
Shelton. The distribution list does not include any of the HFS employees
or Walter Forbes.
(51) Although the figures appearing on this document are listed as "1997
actual," several witnesses confirmed they are 1998 budget figures.
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<PAGE>
VI. CENDANT
A. Management
As set forth above, the arrangements for the management of Cendant
were established by the Governance Agreement and were implemented following the
merger. Most of the former HFS and CUC principal executives remained with the
Company. The financial and accounting personnel of CUC and Comp-U-Card remained
in Stamford and Trumbull.52 The CUC personnel in Stamford continued to obtain
and consolidate financial information from the CUC business units, including
that for the year-end December 31, 1997 closing.53
B. The Cendant Merger Reserve
Principally in connection with the merger, CMS charged approximately
$556.4 million to operations as merger, integration, restructuring and
litigation charges during the year
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(52) Prior to the closing, CUC management had asked that Pember be retained.
On October 21, 1997, Shelton sent Silverman a memorandum with a copy to
Walter Forbes stating he and Walter Forbes believed that "keeping Anne
Pember in the accounting loop for the old CUC businesses makes sense."
See Appendix Ex. 23.
Shelton stated that the memorandum was written to preserve CUC's
reporting structure and key management personnel, and was not intended
merely to save Pember's job.
(53) D&T was selected as auditors for Cendant. E&Y audited the CMS financial
statements for the year ended December 31, 1997.
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ended December 31, 1997. Such costs were summarized in Note B to the December
31, 1997 CMS financial statements as follows:
<TABLE>
<CAPTION>
<S> <C>
Transaction costs $180,614
Impairment charges 133,884
Business terminations 89,900
Facility related costs 59,500
Provision for certain litigation matters 75,000
Other 17,500
--------
$556,398
========
</TABLE>
These charges were a portion of merger-related costs and other unusual
charges of $844.9 million associated with the Cendant merger and Hebdo Mag
merger which was completed on October 30, 1997 (the balance sheet account
corresponding to the $844.9 million charge is referred to hereafter as the
"Cendant reserve").
The bases for the CUC merger-related costs were described in Note B to
the December 31, 1997 CMS financial statements as follows:
Payments ($57.3 million) and write-offs of impaired assets related to the
above matters ($138.8 million) reduced the amount of the charge by
approximately $196.1 million.
Transaction costs related to the Merger consist primarily of payments
pursuant to pre-existing change in control agreements with CUC management
totaling approximately $106.3 million, with the remainder comprised of
professional fees and other expenses incurred in connection with the
transaction.
As a result of the Merger, the Company conducted a strategic
re-evaluation of its businesses, reviewing overall trends and
developments in relation to its business investments and industry
concentrations. In addition to identifying duplicate and overlapping
operations, this process highlighted business lines and customer
relationships which had diminished future value. As a result, the Company
recorded provisions for impairment relating to asset writedowns, business
terminations and facility related costs.
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<PAGE>
The impairment charges included $42.2 million for goodwill, $35.6 million
for other long lived assets, principally systems development, leasehold
improvements and equipment costs and $56.1 million for the writedown of
other assets, principally deferred marketing costs.
The impairment charges relating to goodwill principally related to one
business in the Company's membership segment and one business in the
Company's other segment. The charge was determined based on the estimated
cash shortfall of undiscounted cash flows of the entities identified over
the remaining amortization period.
Business terminations and facility-related costs consisted of accruals
for lease and equipment terminations for facilities and contract
terminations. In addition, asset writedowns in connection with these
activities were recorded as part of the impairment charge. No severance
accrual was recorded as part of this charge.
In addition, in connection with the Merger, the Company evaluated its
previously asserted and unasserted claims brought by third parties. As a
result of the combination of HFS and CUC, management's intended approach
with respect to these matters has changed and, accordingly, management
has established a $75 million provision relating to these matters.
As part of its audit of CMS's December 31, 1997 financial statements,
E&Y performed auditing work in connection with the establishment of the $556
million CUC portion of the Cendant reserve. E&Y has stated that much of the
support for the various component costs in the merger reserve was received from
Corigliano and Pember. Included in E&Y's workpapers is a document titled
"Cendant Merger and Related Costs and Other Unusual Charges Memorandum" which
E&Y has stated was provided to
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it by Pember (the "Cendant Reserve Memorandum").(54) See Appendix Ex. 24. The
memorandum contains a written explanation for the inclusion of most of the
costs that comprised the CUC portion of the Cendant reserve. E&Y's workpapers
contained other documents supplied to them by Pember and others relevant to the
establishment of the CUC portion of the Cendant reserve.
On February 2, 1998, representatives of E&Y and D&T met. During this
meeting E&Y discussed with D&T the component costs of the CUC portion of the
merger reserve and provided the company's justifications for those costs.
Certain members of former HFS management also met with E&Y, Corigliano and
Pember to discuss the Cendant reserve. Members of former CUC and HFS management
also met from time to time to discuss the components of the Cendant reserve.
In the Restatement, Cendant has reversed a substantial amount of the
charge taken for merger-related costs and other unusual items in connection
with the Cendant merger.
C. February 4 Earnings Release
After presenting results for the quarter and year-ended December 31,
1997 to the Audit Committee on February 3, 1998, Cendant issued a press release
announcing those results on February 4. The Cendant results included those for
the former CUC and HFS business units.
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(54) Various iterations of this document were found in the files of Pember.
Another iteration was identified (by Lipton) as containing Corigliano's
handwriting. See Appendix Ex. 25.
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In preparing CMS's December 31, 1997 financial statements, the results
for the month of January, 1997 (a month previously included in the January 31,
1997 year-end financials) were combined with those for the 11 months ended
December 31, 1997. Because CUC did not have monthly financials, it was
necessary for CUC to calculate its results for January, 1997 at the time it
prepared its December 31, 1997 financials. Sabatino made this calculation by
taking the results for the quarter ended January 31, 1997, dividing by three
and then making revenue and expense adjustments which he said were necessary to
appropriately account for particular matters which impacted January. In this
manner, CUC calculated its net after-tax income for January, 1997 at
approximately $66 million, an amount substantially higher than the income for
an average month in 1997. See Appendix 26.
E&Y was not able to confirm the reasonableness of the January, 1997
income figure. In its memorandum summarizing audit differences, it stated that
the January, 1997 after-tax income was overstated by $23 million, $16 million
of which was attributable to an error and $7 million of which was a judgmental
difference. It concluded that this amount together with the other items which
comprised the audit differences were not material. See Appendix Ex. 27.
In January, 1998, Tobia Ippolito, Vice President and Corporate
Controller of Cendant, also noticed that January, 1997 CUC income seemed high
in relation to other months. He discussed this with Rabinowitz and with
Sabatino prior to the Audit Committee meeting. Sabatino said at the time that
the January
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results were affected by some unusual events such as a one-time revenue event
relating to a joint venture with Mitsubishi and the late release of certain
software titles in January, 1997 instead of December, 1996. In the course of
the investigation, Sabatino told Counsel for the Audit Committee that the
January, 1997 results were contrived to take advantage of the change to a
calendar year and that he had warned Corigliano the anomaly would be apparent
to the auditors.
At the February 3 Cendant Audit Committee meeting both E&Y and D&T
were present. E&Y noted the issue with respect to the January, 1997 income and
said it had concluded that the amount was not material to CUC's results and
that it was prepared to waive a proposed adjustment for this item.(55)
D. The Events of Late February and March 1998
1. Change in Reporting Structure
In late February, 1998, Silverman told Walter Forbes and Shelton that
he wanted CUC's business units to switch their reporting from Pember to Scott
Forbes, so as to eliminate the two-step process of consolidating the results in
Connecticut and forwarding them to New Jersey. The former HFS personnel felt
they were not getting necessary information and cooperation from
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(55) Apparently at the time of the Audit Committee meeting, E&Y believed that
the January, 1997 income was overstated by approximately the high 20's of
millions of dollars and advised the Audit Committee of this somewhat
higher number. E&Y later concluded the number was $23 million.
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CUC Corporate. Walter Forbes and Shelton agreed to Silverman's request but
asked that implementation of the change be deferred until after the close of
the first quarter and release of the 10-K, a request to which Silverman agreed.
In the first week of March, 1998, after speaking with Scott Forbes,
Silverman told Walter Forbes and Shelton that the changeover in reporting
structure could no longer wait. Shelton and Walter Forbes acquiesced in
Silverman's request and on March 5, Shelton drafted a memorandum to the CUC
divisional controllers and others, stating that "effective immediately, Scott
Forbes will take responsibility for the consolidation of the numbers from the
former CUC divisions" and that "the reporting function will move from Anne
Pember to Scott Forbes and the divisional CFO's will move their finance
reporting relationship directly to Scott."
Silverman told Scott Forbes to go to Stamford to meet some of his new
direct reports and to meet with Shelton on transitional matters. The meeting
was held on March 6.
2. The March 6 Meeting
Recollections of what transpired at the March 6 meeting differ. Scott
Forbes said that when he entered the meeting Shelton, Corigliano, Pember,
Menchaca and Speaks were there. He said Shelton then handed him a schedule and
said that CUC wanted Scott Forbes to help them be creative in moving $165
million of Cendant merger reserves into income in 1998. According to Scott
Forbes, Shelton also suggested it was a good idea to move the reserves around
to various units so that they were not sitting on
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one division's books. Scott Forbes said Shelton also suggested that E&Y
continue to audit at least the Comp-U-Card division since that division was
where most of the reserve reversals were scheduled. Finally, Scott Forbes also
recalled Shelton suggesting that Cendant hire someone to be solely responsible
for managing the restructuring reserves.
The schedule that Scott Forbes was given that day (Appendix Ex. 28) is
entitled "Cendant Corporation Consolidated Budget 1998 Adjustments"
(hereinafter, the "March 6 schedule").(56) It shows $165 million of budgeted
"revenue adjustments" for the Comp-U-Card division throughout the year, and $37
million of additional revenue adjustments ($25 million at the Corporate office
and $12 million at BCI) for total revenue adjustments of approximately $202
million.
Scott Forbes said that after the meeting he called both Shelton and
Corigliano at home, but could not reach Shelton. He reached Corigliano and told
him that the reserve reversals seemed inappropriate and that he was going to so
advise Monaco. Scott Forbes said Corigliano did not try to dissuade him, but
suggested it would be a good idea if they met to go through the analysis.
Scott Forbes called Monaco that evening and then they both called
Silverman and informed him what had happened. The next morning Scott Forbes
sent a fax to Monaco and Silverman
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(56) A version of this document also was downloaded from Pember's computer.
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which attached the March 6 schedule and stated, on the cover sheet, "Attached
are 2 pages provided to me by Kirk [Shelton] yesterday. These pages were [the]
basis for yesterday's discussion. Revenue - CUC represents 'reserve'
adjustments to 'Comp-U-Card.'" See Appendix Ex. 29.
Shelton recalled the meeting on the 6th differently. He recalled only
himself, Scott Forbes and Corigliano in attendance. Shelton said that
Corigliano did most of the talking and that he (Shelton) said little. He said
he did not recall asking Scott Forbes to help CUC be creative in moving
reserves into income. Shelton said Corigliano told Scott Forbes that CUC was
planning to hire an accounting person to track utilizations of the reserve, and
that Scott Forbes appeared to think that was a good idea.
With respect to the actual schedule, Shelton said he had not seen it
and knew nothing about it in advance of the meeting. He said that Corigliano
walked Scott Forbes through the analysis and explained that the total revenue
adjustment line ($165 million for Comp-U-Card division, $202 million for all of
CUC) was a catchall category for adjustments that would have to be made in
order to reconcile one version of the 1998 budget that was then extant, with
another (higher) version of the budget. He also recalled Corigliano explaining
that the adjustments were heavily weighted toward the first quarter (and showed
negative adjustments in the fourth quarter) because CUC anticipated more income
in the fourth than first quarter. Shelton said Scott Forbes seemed to think
this might work out well because HFS
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anticipated more first quarter income in 1998 and was comparatively "light" in
the fourth quarter, so that between the two companies Cendant's expected
quarterly income would be smoothed out.
Shelton did not recall saying anything to the effect that the revenue
adjustments represented part of the Cendant reserve that could be reversed into
income. He understood that a portion of the adjustments reflected merger
"saves" that previously had been discussed with HFS. In his interview, he said
that a large portion of the remainder (perhaps as much as $80-$90 million)
represented deferred gain from the sale of Interval,(57) and deferred revenue
from the servicing of its members, that had not been previously included in the
budget, at least to that order of magnitude. To the extent that the deferred
revenue and deferred gain from Interval was part of the Cendant reserve,
Shelton said it was understood by HFS and CUC that there were "chunks of
deferred gain" that would be coming into income in 1998 and beyond.(58) Further,
he said that everyone understood that the additional saves that the company
hoped to realize also would improve operating income for 1998.
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(57) Interval, CUC's timeshare business, was sold in December, 1997 as
directed by the Federal Trade Commission.
(58) Scott Forbes said that although he did not recall discussing Interval at
the March 6 meeting, he later came to understand that about $45 million
of the $165 million related to Interval.
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Speaks said he attended the March 6 meeting and said that those in
attendance were himself, Pember, Shelton, Corigliano, Scott Forbes and
(briefly) Menchaca.(59) Speaks said he was invited because Pember had told him
that morning that he would be responsible for managing and keeping track of the
Cendant reserve in the future and they had discussed hiring someone to help
track the charges.
Speaks said Shelton led the discussion at the meeting. He said Shelton
went through the schedule and noted that built into the budget were certain
amounts of reserves that CUC was intending to relieve and bring into income.
Speaks said that no support was provided at the meeting for any of these
amounts with the exception of revenue adjustments constituting deferred gain
from the sale of Interval.
Speaks said that Shelton noted that for the month of January, 1998
about $20 million had been added to Comp-U-Card revenue and/or taken out of
expenses from utilization of merger
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(59) Menchaca said that he arrived late at the meeting and was there only
about ten minutes. Menchaca recalled only that during the time he was
there the others were going through the schedule, which he understood
dealt with how merger reserves were to be applied by business unit. He
said that at some point prior to the meeting, he had expressed a concern
to Shelton that the January results for individual membership seemed
higher than expected, and Shelton had told him it was due to merger
reserves having been utilized. Shelton did not recall any such
conversation and said January results were not available prior to March 6.
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reserves.(60) According to Speaks, there was a discussion about the fact that
they now had to try to find documentation for the $20 million. He could not
recall specifically who said this.
Speaks also recalled saying that it would be a good idea to keep E&Y
as auditors of Comp-U-Card because he did not want to have to train a whole new
team of auditors in Trumbull. Speaks recalled Corigliano and Shelton also
saying it would be better to keep E&Y for this purpose.
Speaks said that neither Corigliano nor Pember said much at the
meeting. He did not recall anything in particular said by Scott Forbes, who
Speaks said appeared to be taking it all in.
3. March 9 and 10
After the meeting on March 6, the former HFS officers wanted to know
if CUC had taken merger reserves into income in 1997. On March 7, Silverman
called Corigliano to inquire whether there was any non-recurring income in the
1997 results, and if so how much. Silverman recalled Corigliano saying the
number might be as high as $100 million.
According to Shelton, Corigliano told him over the weekend that he had
assured the HFS people that the business was
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(60) Sattler confirmed that, at Pember's instruction, she made a topside
adjustment to add $20 million to the January, 1998 income of Comp-U-Card
before forwarding January's results to Parsippany. See Appendix Ex. 30.
All but $3.8 million of this adjustment (the amount relating to Interval)
was subsequently reversed prior to the Restatement.
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doing fine, but that they wanted some proof to this effect and that accordingly
he was preparing some sort of schedule for their review. Silverman said Walter
Forbes also assured him that there was no cause for concern because everything
in CUC's 1997 financials had been reviewed by E&Y.
A senior management meeting had previously been scheduled for March 9
at the Sheraton Hotel in New York.(61) In advance of that meeting, Silverman,
Walter Forbes, Scott Forbes, Shelton, Monaco and Corigliano met at the
Sheraton. Corigliano presented a document he had prepared that purported to
show a breakdown between "operating" and "non-operating" income for CUC's 1997
actual results, as well as for 1996 actual results and the 1998 budget. See
Appendix Ex. 31. The schedule showed that $144 million of CUC's 1997 net income
was attributable to "non-operating," or non-recurring, items.
Silverman expressed surprise and dismay over the percentage of
non-recurring income shown for 1997, and he indicated he felt he had been
misled by CUC as to this fact. He also said he had been misled by CUC in that
no one had told him that in order to meet budget in 1998 the company would have
to
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(61) On Sunday morning, March 8, Silverman held a meeting in his apartment
with various persons to discuss these issues. Present were Scott Forbes,
Monaco, Buckman, HFS Senior Vice-President Sam Katz, Martin Edelman, a
member of the executive committee of the Cendant Board, and (by
telephone) Stephen Holmes, a member of the executive committee of the
Cendant Board, all of whom were updated on the matter.
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take $165 million of reserves into revenues. Walter Forbes recalled Silverman
being upset about the amount of non-recurring income and Shelton recalled
Silverman expressing concern about the 1997 CUC numbers. At the conclusion of
the meeting, which Walter Forbes described as brief, and Silverman recalled as
lasting 45 minutes, it was decided that Shelton, Corigliano, Monaco and Scott
Forbes would go to Stamford to review the issues in greater detail.
In Stamford, Pember and Sabatino were brought into these discussions.
The utilization of the Ideon reserve was discussed. CUC provided a schedule
purporting to show that about $80 million had been utilized in 1996 and another
$95 million in 1997, such that virtually all but about $4 million of the
original reserve of $179.9 million was exhausted by the end of calendar 1997.
See Appendix Ex. 32. The schedule was reviewed and, according to Scott Forbes
and Monaco, support was provided.
Monaco and Scott Forbes said they were comfortable as to most of the
reserve utilizations, but did have questions with respect to about $25 million
of the items. According to Monaco and Scott Forbes, the CUC accounting
personnel said they were confident as to their ability to support those
utilizations.
Thereafter, Rabinowitz of E&Y came to CUC's office in Stamford and
discussed the utilization of the Ideon reserve.(62)
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(62) Shelton recalled that the meetings in Stamford took place on March 9 and
10 and that Rabinowitz was present on March 10.
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He also discussed the accounting treatment of the Halmos litigation and class
action settlements including the treatment of the CreditLine goodwill(63) and
the reallocation of a portion of the reserve originally earmarked for
litigation.(64) He said that of the total utilizations, E&Y had obtained
support for all but about $25 million. With respect to the remaining amount,
Rabinowitz said that E&Y had not obtained documentary support; however, E&Y had
previously concluded that the amount was not material.
In connection with its audit work, E&Y prepared a memorandum which
states:
In attempting to support the detailed expenses underlying each category's
value (see Pl-Ple), certain difficulties were encountered. It was noted
that management has not tracked the expenses running through the reserve
in enough detail to
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(63) Shelton recalled that Rabinowitz said that an E&Y valuation partner had
reviewed the $45 million value that had been placed by CUC on the
CreditLine rights it had acquired.
(64) In Note B to the CMS December 31, 1997 financial statements audited by
E&Y, the reclassification of the $48 million in litigation liability was
described as follows:
During the year ended December 31, 1997, the Company experienced
favorable developments with respect to certain outstanding litigation
matters. Such developments occurred as management changed its estimate
of expected integration and consolidation costs. As a result, the
Company reclassified its litigation liability by approximately $48.0
million to cover excess consolidation costs above management's
original expectation. The litigation and consolidation cost
developments occurred throughout the year.
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provide a sufficient audit trail with respect to certain integration
charges aggregating approximately $25.3 million. The Company feels
confident that all amounts charged against the reserve are proper merger,
integration and restructuring charges, and although E&Y has no reason to
believe otherwise, sufficient audit evidence is not available to make a
conclusive statement to that effect. (Note that such amount is not
material to either the Company's financial statements and/or its trends).
A management letter comment has been prepared for inclusion in the final
letter to the Audit Committee.
See Appendix Ex. 33.
At some point on March 9-10, there were additional discussions about
the schedule that Corigliano prepared showing operating and non-operating
income. Corigliano prepared a revised schedule which described the components
somewhat differently from the original schedule, although the totals were
similar. See Appendix Ex. 34. Various participants recalled Corigliano
providing explanations for the various items, some of which he described as
related to Ideon consolidation activities and others of which related to
certain accounting changes and cost saves. Shelton recalled that the items were
discussed with E&Y, but did not recall if E&Y received the actual schedules.
Rabinowitz did not recall discussing non-recurring income at the March 9
meeting.
According to Shelton, there was also further discussion with
Rabinowitz about the issue regarding January, 1997 income that had been raised
at the February 3 Audit Committee meeting. Rabinowitz said that E&Y was
comfortable with the treatment, that there were some judgment calls with
respect to this issue, but nothing that would prevent E&Y from signing off on
the audit.
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After the conclusion of the meeting with E&Y, Silverman was advised by
Monaco and Scott Forbes, and Walter Forbes was advised by Shelton, that E&Y had
provided comfort on the accounting issues. Following this series of meetings
the Audit Committee was informed of the $25 million issue with respect to the
Ideon reserve utilization.(65)
E. The Departures of Shelton, Corigliano and Lipton
Later in March, Silverman told Walter Forbes that he wanted Shelton,
Corigliano and Lipton to leave the company. Shelton said that he strongly
believed that Silverman's views about him were unwarranted and that he was
being forced out of the Company unfairly. Lipton said that her role with the
combined company had been substantially diminished ever since the merger and
under the circumstances she decided to leave.
On or about April 8 an e-mail circulated within CUC that Shelton,
Corigliano and Lipton were resigning. Cendant issued a press release and held a
conference call with analysts that began about 1:45 p.m. that afternoon.
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(65) The $25.3 million issue was not brought to the attention of the Audit
Committee on February 3. Rabinowitz said that he discussed the issue with
Corigliano prior to the meeting, told Corigliano to bring it to Monaco's
attention and was advised by Corigliano that he had done so. Monaco said
that he was not aware of this issue until it was brought to his attention
on March 9.
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F. The April 9 Meeting in Parsippany
As the conference call was taking place Scott Forbes was meeting in
Parsippany with Sabatino and Speaks to review in greater detail the Comp-U-Card
division's 1997 results and 1998 budget. See Appendix Ex. 35. Monaco joined the
meeting in progress. Over the course of the meeting Sabatino said that for each
of the first three quarters of 1997 he had recorded a series of "topside"
adjustments to increase quarterly earnings, totaling $176 million, which were
recorded in consolidating entries at CUC Corporate and not in any operating
units' books. Sabatino said these adjusting entries were reversed in the fourth
quarter, but that to compensate for the corresponding reduction in income from
these reversals CUC reduced $93 million of Ideon and Cendant reserves into
income without factual substantiation or support. Sabatino also said that
other, similar, adjustments were made by other CUC employees at the direction
of Pember.
Sabatino told Scott Forbes that the quarterly topside adjustments
(which, according to Sabatino, Corigliano had said were necessitated by CUC's
quarterly "soft closes,") had in fact been made to meet targets. He also
presented Scott Forbes with a spreadsheet (Appendix Ex. 36) which summarized
various of the above adjustments.(66)
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(66) Categories "A-C" and "F" on the spreadsheet, which are handwritten
notations made by Scott Forbes, relate to the $176 million in quarterly
topside adjustments in 1997 and the compensating book adjustments made at
year-end 1997. Category "E" relates to what Sabatino said were similar
book
(Footnote Continued)
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In addition, Sabatino told Scott Forbes about other arbitrary
adjustments that had been made to CUC's monthly 1997 results for purposes of
reporting on a calendar year (rather than fiscal year) basis.(67) Sabatino also
said that Corigliano had directed him to make adjustments to CUC's "segment"
results (e.g., for membership and software) on an inter-segment basis, again
without factual substantiation or support, in order to meet analysts'
expectations.(68)
At the April 9 meeting, Speaks said that Corigliano and Pember had
arbitrarily directed that certain membership products for which revenue
recognition was deferred be reclassified as products (such as Privacy Guard)
where revenues are recognized immediately, which had the effect of increasing
Comp-U-Card division's 1997 revenues by about $32.8 million above what they
would have been absent such reclassification. Speaks also told Scott Forbes
that even apart from the reclassification of membership products, CUC's revenue
recognition policies produced
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adjustments made in January, 1997 to compensate for previous topside
entries.
(67) Scott Forbes said Sabatino explained that the purpose of these monthly
adjustments (shown on Category "D" on the spreadsheet), was to show a
reasonable, smooth quarterly trend that otherwise would have appeared
skewed, once CUC's results were "calendarized," due to the months in
which the $176 million of quarterly adjustments had been made.
(68) See Category "G" on spreadsheet.
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a "mismatching" of revenues and expenses (i.e., an acceleration of recognition
of revenues relative to expenses).(69)
Silverman was informed of these developments.
Between April 9 and April 15 there was further investigation by
Cendant financial personnel concerning the information Sabatino and Speaks had
imparted on April 9. On April 14, Speaks and Sabatino signed affidavits
attesting to the facts they had communicated to Monaco and Scott Forbes. See
Appendix Exs. 37 and 38.(70)
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(69) Speaks said he had preliminarily determined that this mis-matching had a
multi-million dollar impact on earnings in 1997 and, if continued, would
have a similar impact on 1998. Scott Forbes asked Speaks to perform an
analysis showing what the impact on 1997 and 1998 would be if revenues
and expenses were matched correctly and if there were no
reclassifications of products as Speaks had described them.
(70) Speaks said that in the weeks prior to April 9, and especially when it
became clear that Pember and then Corigliano were leaving CUC, he became
increasingly concerned that he would be stuck with explaining to new
Cendant financial management certain CUC policies and practices that he
said Corigliano and Pember had directed him to follow. These included the
revenue recognition practices discussed in his affidavit, as well as
certain practices regarding the delayed booking of credit card "rejects"
which he brought to Cendant's attention on April 14. These practices are
discussed in detail in Sections X and XI of this Report.
Speaks said he encouraged Pember to get Corigliano and Shelton to speak
to new management about these issues and that Pember told him she had
raised the subject with Corigliano and Shelton. Speaks said that when he
saw nothing happening as a result of these efforts, he sent an e-mail to
Pember on March 31 again raising his concerns. See Appendix Ex. 105.
(Footnote Continued)
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VII. TOPSIDE ADJUSTMENTS TO CUC QUARTERLY FINANCIALS
Unsupported topside adjustments were made at the CUC Corporate level
during the consolidation of CUC's subsidiary reporting packages into quarterly
consolidated financial reports. These adjustments were made to make the
company's quarterly earnings appear to be higher than they actually were or to
adjust certain balance sheet accounts to desired amounts. These entries were
not recorded on any subsidiary's general ledger, which meant there was a
discrepancy between the results CUC reported publicly and the results appearing
on the company's books. The total cumulative adjustments to increase the
nine-month income during each year of the Restatement Period were as follows:
1997: $176 million
1996: $87 million
1995: $31 million(71)
The circumstances under which these topside entries were made and
their scope are described below.(72)
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Speaks said shortly before he informed Monaco and Scott Forbes about
various accounting practices, he spoke with Menchaca. According to
Speaks, Menchaca did not appear to know or understand what Speaks was
talking about, but was supportive and encouraged Speaks to tell new
management whatever Speaks thought they needed to know.
(71) Sabatino said he could not recall any unsupported topside adjustments
prior to 1995. He said he did not believe any unsupported topside
adjustments were made while Bell was CFO, and he said it was Corigliano
who first presented him with unsupported topside adjustments to be made.
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A. The General Practice
1. Quarterly Topside Adjustments
Sattler, whose tenure as Supervisor of Financial Reporting at CUC
began in December, 1995, said she received instructions at each quarter-end to
make topside adjustments to increase CUC income in the course of consolidation
of the company's quarterly financial results. These adjustments were made by
CUC at the corporate level, but not booked by Comp-U-Card, the division whose
income results were adjusted. In addition, topside adjustments were made that
impacted the balance sheet of Comp-U-Card and certain other subsidiaries, also
without being recorded on the books of the affected business units.
As discussed earlier, Sattler prepared the consolidating reports at
each quarter end, and provided a printout of the reports to Kearney and
Sabatino (and later Pember), one of whom then circulated the reports to
Corigliano. Mills gave her quarterly consolidating reports to Sabatino, who
said he gave them to Corigliano.
Sattler was instructed to alter the revenues and/or expenses of the
Comp-U-Card division in a revised consolidating
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(72) Topside adjustments are common at many corporations and do not suggest
impropriety. For example, appropriate topside adjustments not pushed down
to any subsidiary's general ledger include consolidation entries to
record cash in transit and many other items. Appropriate topside entries
pushed down to a subsidiary's general ledger include normal, recurring
expenses that are paid at the corporate level and later allocated to the
subsidiaries, such as income taxes.
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spreadsheet. Sattler said that she always received her instructions from either
Kearney, Sabatino or Pember, and was told the instructions had come from
Corigliano. Mills said she was asked to make similar topside adjustments and
received her instructions from Kearney and/or Sabatino. Both Kearney and
Sabatino said they received their instructions from Corigliano.(73)
The quarterly topside adjustments were made by manually adjusting the
figures for particular business units (generally the Comp-U-Card division) in
the consolidating spreadsheet.(74) Sattler explained that she would manually key
the adjustment into the cell of her spreadsheet for the third month of the
quarter in question (first, second and third quarter adjustments were made to
the April, July and October sections of the spreadsheet, respectively). For
example, if revenue for Comp-U-Card in a given quarter (as aggregated from the
monthly reporting packages) was $100 million, and the instruction was to
increase revenue by $60 million, Sattler would simply enter a "+60,000" in the
spreadsheet cell (the spreadsheets were all done in thousands of dollars).(75)
When the consolidating spreadsheet report was
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(73) Kearney also said he occasionally received the instructions from
Sabatino, but that he understood Sabatino to be acting on these occasions
at the direction of Corigliano.
(74) The manual consolidation process as well as other matters are addressed
in an Internal Control Supplement prepared by AA. See Appendix Ex. 128.
(75) While the adjustments were made to the April, July and October sections
of the spreadsheet, the monthly close for any given month was not
generally complete until
(Footnote Continued)
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printed out, the revenue column for Comp-U-Card would appear as "$160,000,"
without showing the adjustment, although the "+60,000" would still appear in
the cell in her computer. In this way, she was able to reconstruct, if
necessary, what adjustments had been made.(76)
Typically, Sattler was given handwritten instructions to increase
revenues and decrease expenses. See, e.g., Appendix Exhibit 39. For example,
for the first quarter of fiscal 1998 (ended April, 1997), she was given the
following entries:
Dr. Accounts Receivable $40,000,000
Cr. Revenue $40,000,000
Dr. Accounts Payable $7,444,000
Cr. Revenue $7,444,000
Dr. Accounts Payable $14,700,000
Cr. Marketing Expense $14,700,000
The income effect of these entries was to increase revenues by
$47,444,000 and decrease expenses by $14,700,000, for
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approximately two weeks following the end of the month. Therefore,
the topside adjustments were actually keyed into the spreadsheet in the
beginning of the next month (May, August and November).
(76) AA took a number of forensic steps to confirm the quarterly income and
balance sheet adjustments that had been made. These steps included
obtaining the original reporting packages of the subsidiaries and
Comp-U-Card division, comparing them with the consolidating Excel
spreadsheets and observing the adjustments made in the spreadsheets
themselves. These steps confirmed the information provided by Sattler and
others who were invloved in making the adjustments.
-74-
<PAGE>
an overall increase to income of $62,144,000. The monthly revenue for April was
calculated in the formulas in the Excel spreadsheet by taking the year-to-date
revenue amount at April 30, 1997 and subtracting out the monthly amounts for
February and March. The year-to-date revenue amount typed into the spreadsheet
was overstated by $47,444,000, thus overstating April revenue by the same
amount. In the same manner, the monthly marketing expense was calculated by
taking the year-to-date amount, which was understated by $14,700,000, and
subtracting out the February and March amounts.(77)
In certain quarters there would be no written instructions, but
Kearney or Sabatino would orally convey instructions to add (for example) a
"+60,000" to Comp-U-Card revenues and a "-20,000" to an expense line.
Once the adjustments were made in this manner, they were incorporated
into (but not disclosed in) the company's consolidated quarterly financial
reports provided to the Board, and the consolidated financial results released
to the public. The quarterly adjustments generally brought CUC's reported
income results into line with analysts' expectations.
Sattler said she was told, by Kearney and Sabatino, that Corigliano
had directed the quarterly adjustments be made to
- --------------
(77) Sattler also entered a corresponding "+40,000" in the cell for accounts
receivable and a "-22,144" in the cell for accounts payable in her
spreadsheet to account for the balance sheet impact of these adjustments.
-75-
<PAGE>
conform CUC's reported financial results to Wall Street earnings expectations.
She understood that there were specific analysts' target numbers for such
things as EPS, revenue, expenses and the ratio of operating and marketing and
G&A expense to revenues, and that each of the adjustments was calibrated to
meet those targets.(78) Sattler said she understood that when receivables were
increased topside to enable a credit to revenues, there was no actual
receivable behind that adjustment and no actual service had been performed by
CUC giving rise to the purported asset, i.e., the adjusted amounts were
fictitious.(79)
Sabatino said Corigliano gave him instructions to increase revenues by
a specific amount and/or to decrease expenses by a specific amount in order to
make up shortfalls between the actual results of the company and the results
Wall Street was expecting. Sabatino said Corigliano knew where he wanted to be
EPS-wise, and that his instructions regarding revenue and expense adjustments
correlated with the analysts' revenue and expense expectations for CUC.
Sabatino said that
- --------------
(78) Sabatino explained that the need to keep the ratios of operating and
marketing expenses to overall revenues constant was driven by
Corigliano's expressed desires.
(79) Mills did not say she understood the adjustments to be unsupported. She
said that although no one ever specifically told her the topside
adjustments were designed to meet Wall Street expectations, she assumed
that might have been one of the reasons because she noticed that after
the quarterly adjustments CUC always issued an earnings report that
essentially matched EPS targets.
-76-
<PAGE>
Corigliano told him to make sure that the ratios of various expense categories
(operating, marketing and G&A) to revenues remained consistent from quarter to
quarter, although the particulars of how the expense reduction was to be
allocated by category was generally left up to Sabatino, Kearney or Sattler.(80)
Sabatino said he was not given factual substantiation or support for
the topside adjustments. He said he recalled Corigliano saying that the
adjustments could be rationalized as compensating for CUC's "soft closes," in
that the quarterly results were only estimates and would have to be adjusted at
year-end for certain accruals and other adjustments that should have been made
in earlier periods. He also said that he recalled Corigliano saying that the
subsidiaries were merely behind where they needed to be and would make up the
difference by year-end.
The income statement topside adjustments were always made solely to
Comp-U-Card's results. Sabatino said there were two reasons for this. First,
Comp-U-Card was the largest revenue-producing unit within CUC and adjustments
of many
- --------------
(80) Sabatino said he generally received these instructions from Corigliano
orally, in face to face meetings, while they were reviewing the quarterly
consolidating reports. Sabatino said occasionally Corigliano would jot
some numbers down on a piece of paper to indicate the adjustments to be
made, but this was rare and such writings were likely not kept (none were
located in CUC's files during this investigation). Sabatino said that in
some quarters, particularly if Corigliano was traveling at the time,
Corigliano would convey his instructions for adjustments by telephone.
-77-
<PAGE>
millions of dollars were less noticeable if made at Comp-U-Card than if made
elsewhere. Second, Sabatino said that whereas E&Y compared the consolidated
quarterly results of other subsidiaries to their original reporting packages
during its quarterly reviews, it did not perform this exercise at Comp-U-Card.
Sabatino said that Pember, while she was Controller of Comp-U-Card, made sure
that E&Y did not receive the reporting packages or any trial balances at the
quarters (containing unadjusted general ledger revenues and expenses) that
might have been compared to the quarterly consolidating reports (containing the
topside adjustments). Sabatino and Sattler said E&Y did receive the quarterly
consolidating reports for the purpose of tying the consolidated number to the
results reported in the Form 10-Q's.(81)
Unsupported topside entries were also made to the balance sheet during
the quarterly consolidation which had the effect of inflating the company's
reported cash balance on its balance sheet. These adjustments were made
generally at the same time as the income statement adjustments and as part of
the same consolidation process. Like the income adjustments, the balance sheet
adjustments were made by Sattler through manual adjustments to the quarterly
sections of the consolidating spreadsheet.
- --------------
(81) Sabatino could not say that Corigliano had specifically directed that the
income adjustments be made exclusively at Comp-U-Card, although Sabatino
said this was always assumed.
-78-
<PAGE>
These balance sheet adjustments impacted the balance sheet only; there was no
resulting inflation of income.
Sabatino said the balance sheet adjustments were also directed by
Corigliano, who explained to Sabatino that he never wanted cash to appear too
low and never wanted receivables to appear too high (as the latter might imply
a collectibility problem). As a result, adjustments were made to increase
(debit) cash and decrease (credit) receivables, sometimes by as much as $200
million or more in a quarter, always at the Comp-U-Card division. Sabatino said
the balance sheet target adjustments he was given by Corigliano were more
general than the income statement adjustments; for example, he would be told
the approximate amount that cash on the balance sheet needed to be for the
quarter, and the particulars as to how this would be accomplished were left to
Sabatino.(82)
Topside balance sheet adjustments of generally lesser magnitude were
made at other subsidiaries to the deferred membership income account. Sabatino
said Corigliano viewed deferred membership income as denoting growth and that,
for presentation purposes, Corigliano told him to make certain target
adjustments to deferred membership income on a consolidated basis. As with the
cash/receivables adjustments, Sabatino said he was given more general target
- --------------
(82) Although the balance sheet topside adjustments were made in conjunction
with the income statement topside adjustments, there was no numerical
correlation between the two. However, to the extent the income
adjustments created receivables on the balance sheet, this did affect the
extent to which receivables were reclassified to cash on the balance
sheet.
-79-
<PAGE>
adjustments for deferred membership income as compared with the specific
revenue adjustments Corigliano gave him. It was left up to Sabatino which
subsidiaries' deferred membership income accounts would be adjusted.(83)
An example of the balance sheet adjustments is the following, which
Sattler made in early May, 1997 to CUC's April, 1997 balance sheet:
Dr. Cash $88,000,000
Cr. Receivables $88,000,000
Dr. Receivables (NLG) $8,000,000
Cr. Def'd Memb. Inc. (NLG) $8,000,000
The impact of these adjustments on CUC's balance sheet, together with
the adjustments to receivables and payables that were made as part of the
income statement topside adjustments to the first fiscal quarter, was as
follows (in 000's):
- --------------
(83) Sabatino said the deferred membership income adjustments were made at
subsidiaries other than Comp-U-Card because those adjustments would not
affect the deferred income amortization "grids" that Comp-U-Card provided
to E&Y at each quarter, which were complicated and required much work to
prepare. These grids are discussed at greater length in Section X below.
-80-
<PAGE>
<TABLE>
<CAPTION>
Actual Overstatement Reported
Balance (Understatement) Balance
------- ---------------- -------
<S> <C> <C> <C>
Assets
Cash 724,164 88,000 812,164
Receivables 633,253 (40,000) 593,253
Liabilities
Payables 433,180 (22,144) 411,036
Def'd Memb. Inc. 689,594 8,000 697,594
</TABLE>
As a result, the quarterly balance sheets provided to the Board and
the public showed a cash balance greater than the company actually had.
2. Reversals of Topside Adjustments
and Subsequent Cumulative Adjustments
After the quarterly topside adjustments to income were made, they were
generally reversed in the first month of the next fiscal quarter. Sattler would
manually accomplish this by making a reversing entry in the Excel spreadsheet.
In the example cited above, if the first quarter adjustment to income for
Comp-U-Card was "+60,000," then in the first month of the second fiscal quarter
(e.g., May) an entry of "-60,000" would be made, so that the unadjusted results
of Comp-U-Card shown on the spreadsheet now matched what was on Comp-U-Card's
books.(84) Then, at the close of the second quarter (July), Sattler would
receive instructions to make a new set of topside adjustments which would
- --------------
(84) Even though Sattler did not always input Comp-U-Card's results in her
spreadsheet on a monthly basis, if the month happened to be the first
month after the prior quarter, she generally would enter the reversing
entry for Comp-U-Card in that month. In the example in the text, the
Comp-U-Card column for May would include the "-60,000," and otherwise
would be empty.
-81-
<PAGE>
incorporate the prior quarter's adjustment (the "+60,000"), plus whatever
adjustments were being made to the second quarter's results. For example, if
Comp-U-Card's second quarter income was increased topside by $60 million above
actual results, the topside entry made at the close of the second quarter in
July would be "+120,000," representing the cumulative year-to-date topside
increases to income. The "+120,000" would then be reversed in the first month
of the third fiscal quarter (August) by entering "-120,000" into the
spreadsheet, and if another $60 million was added through topside adjustments
to third quarter income, the cumulative topside entry made to the final month
of the third quarter (October) would be "+180,000."(85)
Sattler said she understood the reason she was asked to reverse the
prior quarters' topside entries at the beginning of each new quarter was to
enable her superiors (Corigliano, Pember, Sabatino) to see CUC's actual,
unadjusted results in order to accurately gauge the extent to which CUC's
actual performance was meeting Wall Street expectations. Sabatino said there
were two
- --------------
(85) Unlike the income statement adjustments, the balance sheet adjustments
were self-correcting. When Sattler entered the next month's financial
information from the subsidiaries' reporting packages and generated a
consolidating balance sheet, that balance sheet would automatically
reflect actual cash balances. In order to retain the adjusted balance
sheet figures from the prior quarter, Sattler would have had to carry
forward the prior quarter's balance sheet adjustments and enter them
again in the next month, which she did not do. By not carrying these
adjustments forward in the following month, the adjustments were
effectively reversed in that month.
-82-
<PAGE>
reasons for what he termed the "cleansing" of the prior topside adjustments
through reversing entries, which he said he instructed Sattler to make. First,
he said he wanted Corigliano to see, at each quarter, the magnitude of the
cumulative topside entries that had been made to that point. Second, Sabatino
said it was important to maintain the "integrity" of the consolidating
statements so that they could be reconciled to the company's actual books at
any given point in time. If too many topside adjustments were made and not
reversed, he explained, it became too difficult and cumbersome to keep track of
them so as to be able to reconcile the consolidating statements to the actual
general ledger.
Each quarter, Sattler prepared a separate "P&L Reconciliation"
worksheet which compared the year-to-date revenues and expenses for Comp-U-Card
as reported on the general ledger (and after adjustment for proper accruals),
to the topside adjusted year-to-date results for Comp-U-Card. The difference
between the two figures was listed in a column entitled "Reserves." See
Appendix Ex. 40. Sattler said "that was the word that was always used for these
adjustments." Sabatino said the term "Reserves" in this worksheet referred to
"topside reserve reversals" and was "just a name put on it." A document
downloaded from Pember's computer indicates that "Reserves are being managed to
meet quarterly targets." Appendix Ex. 41.
In the fourth quarter of each fiscal year, all of the first three
quarters' topside adjustments were reversed, and adjusting entries -- including
reversals of merger and other
-83-
<PAGE>
reserves into income -- were then made to the general ledgers of the company in
order to make up the shortfall in income between actual and reported results.
The manner in which this was accomplished is discussed in later sections of
this Report.
B. Unsupported Topside Adjustments Made During 1997
1. Topside Adjustments to Income Statement and Balance Sheet in the
First Three Quarters of Fiscal Year Ended January 31, 1998
The cumulative impact of the 1997 quarterly adjustments was to
increase reported pretax income by $176 million for the nine months ended
October 31, 1997. A summary of these adjustments appears as follows:
<TABLE>
<CAPTION>
Quarter Cumulative P&L Impact
------- ---------- ----------
<S> <C> <C> <C>
Apr-97
Revenue $47,444 $47,444
Expense ($14,700) ($14,700) $62,144
-------
$62,144
Jul-97
Revenue $57,556 $105,000
Expense ($ 3,300) ($ 18,000) $123,000
-------
$60,856
Oct-97
Revenue $44,000 $149,000
Expense ($ 9,000) ($ 27,000) $176,000
-------
$53,000
</TABLE>
The above adjustments essentially brought CUC's net income per share
into line with Wall Street analysts' expectations. For example, the company's
actual first quarter
-84-
<PAGE>
net income was $32,068,000, or 8(cent) per share, after appropriate accruals.
Most analysts' expectations for the quarter were in the 17(cent)-18(cent)
range.(86) The topside adjustments made in May, 1997 to April, 1997 income,
which Sabatino said were directed by Corigliano, increased Comp-U-Card income
by $62,144,000 (or 9(cent) per share after tax), bringing CUC's net income per
share for the first quarter to 17(cent).(87)
Similarly, CUC's second quarter net income, per the reporting
packages, as adjusted for supported accruals, was $54,670,000, or 13(cent) per
share. Analysts' second quarter earnings expectations for CUC ranged from
21(cent)-25(cent).(88) According to
- --------------
(86) The following are various analysts' projections for the company's first
fiscal quarterly net income per share:
Analyst Date of Report EPS Forecast
------- -------------- ------------
Morgan Stanley 3/12/97 $0.17
Smith Barney 3/12/97 $0.17
Robertson Stephens 4/7/97 $0.17
Cowen & Co. 4/21/97 $0.18
Alex Brown 4/9/97 $0.18
Paine Webber 4/15/97 $0.21
Goldman Sachs 3/14/97 $0.17
Furman Selz 3/12/97 $0.17
Hambrecht & Quist 3/12/97 $0.17
(87) For a detailed breakdown of the 1997 first quarter adjustments, see
Appendix Ex. 42.
(88) The following are various analysts' projections for the company's second
fiscal quarterly net income per share:
Analyst Date of Report EPS Forecast
------- -------------- ------------
Smith Barney 5/28/97 $0.21
Robertson Stephens 7/15/97 $0.25
Cowen & Co. 5/28/97 $0.21
Paine Webber 7/31/97 $0.25
(Footnote Continued)
-85-
<PAGE>
Sabatino, Corigliano gave the instruction to increase CUC's second quarter
revenues by $57,556,000 and decrease expenses by $3,300,000.(89) In August
Sabatino instructed Sattler to increase Comp-U-Card's July revenues by
$105,000,000 ($47,444,000 carried over from the first quarter + $57,556,000)(90)
and decrease expenses by $18 million ($14,700,000 carried over from the first
quarter + $3,300,000 million) for a total cumulative year-to-date increase of
$123 million in pretax income as of the second quarter. The effect of the
second quarter adjustments on net income for the second quarter was to increase
income by $60,856,000 (or 9(cent) per share after tax), bringing second quarter
net income per share up to 22(cent).
- -------------------------------------------------------------------------------
Furman Selz 6/6/97 $0.21
Hambrecht & Quist 5/29/97 $0.21
(89) For a detailed breakdown of the 1997 second quarter adjustments, see
Appendix Ex. 42.
(90) The second quarter adjustment actually increased revenues by only
$97,556,000 ($57,556,000 for the second quarter + $40,000,000 which had
been reversed in the May section of the consolidating spreadsheet).
However, $7,444,000 of the first quarter adjustments had never been
reversed, thus as of the end of the second quarter, there was a total
increase in revenues of $105,000,000. Sattler recalled that $7.4 million
of the first quarter's topside adjustments was not reversed, because she
thought this was an entry that was supposed to be booked by Comp-U-Card
division. She is not sure what happened to the $7.4 million or why it was
not booked by Comp-U-Card. In any event, the $7.4 million was reversed in
early September, after the August monthly close, when Sattler reversed
the cumulative topside adjustments through the second quarter.
-86-
<PAGE>
Finally, CUC's third quarter net income, as adjusted for supported
accruals, was $68,161,000 or 16(cent) per share, compared with analysts'
expectations which were mostly in the 23(cent)-24(cent) range.(91) According to
Sabatino, Corigliano instructed that third quarter revenues be increased by $44
million and expenses be decreased by $9 million. In November, Sattler then made
topside adjustments to the October section of the consolidating spreadsheet by
increasing Comp-U-Card's revenues by $149 million ($105 million carried over
from the prior two quarters + $44 million) and decreasing its expenses by $27
million ($18 million carried over from the prior two quarters + $9 million) for
a total increase of $176 million in pretax income cumulatively for the year to
date. The net effect of these adjustments was to increase third quarter pretax
income by $53 million (or 7(cent) per share after tax), bringing third quarter
net income per share up to 23(cent).(92)
- --------------
(91) The following are various analysts' projections for the company's third
fiscal quarterly net income per share:
Analyst Date of Report EPS Forecast
------- -------------- ---'---------
Morgan Stanley 9/5/97 $0.23
Smith Barney 9/5/97 $0.23
Robertson Stephens 9/4/97 $0.24
Paine Webber 9/3/97 $0.28
Furman Selz 10/28/97 $0.23
Hambrecht & Quist 9/5/97 $0.23
(92) For a detailed breakdown of the 1997 third quarter adjustments, see
Appendix Ex. 42.
-87-
<PAGE>
In early January, 1998, after the December monthly close, Sattler
reversed all of the cumulative topside quarterly adjustments to income that
were made in 1997.(93) These reversals were made in the December section of the
consolidating spreadsheet.
CUC also made balance sheet adjustments throughout the first three
quarters of fiscal 1998 as described above. For example, in early November,
Sattler made the following adjustments to the October, 1997 Comp-U-Card
division, and other subsidiaries,' balance sheets:
- --------------
(93) According to Sattler and Sabatino, while CUC typically reversed the prior
quarter's topside entries in the first month of the following quarter,
CUC was busy during November, 1997 converting its quarterly financial
results from a fiscal to a calendar year for restatement in a form 8-K
(discussed below). Therefore, the third quarter income adjustments were
not reversed until the December consolidation figures were being prepared
in early January, 1998.
-88-
<PAGE>
Dr. Cash $200,000,000
Cr. Receivables $200,000,000
Dr. Receivables $75,000,000
Cr. Cash $75,000,000
Dr. Receivables (NLG) $13,000,000
Cr. Def'd Memb. Inc. (NLG) $13,000,000
Dr. Payables $50,000,000
Cr. Receivables $50,000,000
Dr. Receivables (NAOG) $5,000,000
Cr. Def'd Memb. Inc. (NAOG) $5,000,000
Dr. Receivables (Getko) $5,000,000
Cr. Def'd Memb. Inc. (Getko) $5,000,000
Dr. Receivables (CUC Europe) $2,000,000
Cr. Def'd Memb. Inc. $2,000,000
(CUC Europe)
The impact of these adjustments on the company's balance sheet (in
conjunction with the income statement adjustments) as of October 31, 1997 was
(in 000's):(94)
- --------------
(94) For a complete summary of the 1997 quarterly income and balance sheet
adjustments, see Appendix Ex. 43.
-89-
<PAGE>
<TABLE>
<CAPTION>
Actual Overstatement Reported
Balance (Understatement) Balance
------- ---------------- -------
<S> <C> <C> <C>
Assets
Cash 861,892 125,000 986,892
Receivables 687,415 (1,000) 686,415
Liabilities
Payables 540,819 (77,000) 463,819
Def'd Memb. Inc. 698,234 25,000 723,234
</TABLE>
2. Unsupported Entries to CUC Calendar
Quarter Figures for 1997 Which Were
Contained in January 29, 1998 Form 8-K
As a result of the merger between CUC and HFS, CUC was required to
report its 1997 quarterly results on a calendar basis, which it did in a Form
8-K dated January 29, 1998. In doing so, CUC booked certain additional
unsupported topside adjustments (the "calendar adjustments").
To facilitate the conversion to a calendar year, Sattler created a new
consolidating spreadsheet structured much the same as the one she had
previously been using. In November or early December, Sattler copied the
information for the months of February through October from the old fiscal year
spreadsheet into the new calendar year spreadsheet. For reasons discussed
earlier, Sattler often did not input Comp-U-Card's monthly reporting package
results into her consolidating spreadsheet for months which were not quarter
ends, including February, March, May and June of 1997. The individual months'
results for Comp-U-Card were later filled in for these months from the original
(unadjusted) reporting packages. In addition, the months of April and July,
which had previously included three months of earnings for Comp-U-Card, were
changed to include only the results from those respective months (including the
topside
-90-
<PAGE>
adjustments made to those months). The quarterly income and balance sheet
adjustments (and the reversals of the same) which had been made at earlier
points in 1997, as described above, thus remained part of the new spreadsheet.
Because January, 1997 was to be included in the December 31, 1997
financial statements, Sattler also created a new section for January at the top
of the new calendar spreadsheet. She obtained the results for January from the
various January 31, 1997 year-end subsidiary reporting packages, including the
one for Comp-U-Card which included a number of unsupported revenue and expense
adjustments to the general ledger made at the January 31, 1997 fiscal year-end.
Sattler then reversed her previous reversals of the first and second
quarter topside adjustments, which totaled $123 million.(95) By reversing the
reversals of the topside adjustments, the figures for CUC for the nine calendar
months included the effect of the first and second quarter topside adjustments
($123 million in income).(96)
As a result of the $123 million in topside adjustments made to April
and July, 1997, the new calendar quarters were
- --------------
(95) In May and August, 1997, Sattler had reversed the topside adjustments
originally made to the April and July, 1997 Comp-U-Card results.
(96) This $123 million adjustment is reflected on a document prepared by
Sabatino relating to the calendar adjustments. See Appendix Ex. 44.
Sabatino identified the handwriting on the document as Corigliano's.
-91-
<PAGE>
skewed and showed incongruous quarterly performance.(97) In an effort to
"smooth" the results of the new calendar quarters and portray the company's
earnings as steadily increasing throughout the calendar quarters to be shown in
the 8-K, CUC made certain unsupported topside adjustments in November, 1997.
Calendar adjustments were input in each of the months of January through
September. The topside income adjustments remained in place for the months of
April and July, and calendar adjustments were then input on top of the topside
adjustments.(98)
Sabatino said that he prepared a number of spreadsheets to determine
the necessary amounts of each month's calendar
- --------------
(97) This incongruity is demonstrated in Appendix Ex. 45. As Appendix Ex. 45
shows, the company's reported (albeit adjusted) fiscal quarterly results
depict an apparently healthy upward trend from quarter to quarter with
reported earnings gradually rising from $108,979,000 in the first fiscal
quarter to $143,096,000 in the second fiscal quarter and then to
$162,002,000 in the third fiscal quarter. In contrast, the calendar
quarters for 1997 (prior to the calendar adjustments) depicted a
downward-sloping line from quarter to quarter with reported earnings
beginning at $132,073,000 in the first calendar quarter and then falling
to $113,369,000 in the second calendar quarter and then to $49,850,000 in
the third calendar quarter.
(98) In June, 1997, Sabatino had sent Corigliano a memorandum showing how the
reported results for the fiscal quarter ended April 30, 1997 compared
with the results for the calendar quarter ended March 31, 1997, depending
on whether the topside adjustments made in April, 1997 were included in
the March 31 quarter. See Appendix Ex. 46. Sabatino said that Corigliano
had asked for this information to evaluate the impact of the change in
accounting year on CUC. Sabatino stated that the adjustments he was
referring to in the memorandum to Corigliano were the unsupported topside
adjustments to income made in April, 1997.
-92-
<PAGE>
adjustment, and generally supervised these adjustments in consultation with
Pember and Corigliano.(99) The calendar adjustments for April and July were
booked in addition to the 1997 quarterly adjustments which had previously been
booked in those months, as described above. The figures for the remainder of
the months had not previously been adjusted prior to the calendar
adjustments.(100)
The first quarter calendar adjustment (combining the January, February
and March adjustments) amounted to a net decrease of $7,937,000 in income,
bringing EBIT to $124,136,000. The second quarter calendar adjustment
(combining the April, May and June adjustments) amounted to a net increase of
$39,462,000 in income, bringing EBIT to $152,831,000. Finally, the third
quarter calendar adjustment (combining the July, August and September
adjustments) amounted to a net increase of $93,300,000 in income, bringing EBIT
to $148,170,000.(101) Had the calendar adjustments not been made, the EBIT
results for the first three quarters would have been $132 million, $113 million
and $50 million, respectively.
- --------------
(99) For an example of one iteration of the spreadsheet which Sabatino created
and modified throughout November, 1997, to determine the calendar
adjustments, see Appendix Ex. 47.
(100) As described above, the May and August figures were "adjusted," but only
to reverse the April and July adjustments.
(101) For a detailed breakdown of the calendar adjustments, see Appendix Ex. 48.
-93-
<PAGE>
In January, 1998, as part of her normal process of reversing topside
entries at year-end, Sattler reversed all of the calendar adjustments and all
of the quarterly topside adjustments in the December section of the new
calendar spreadsheet, except for the January calendar adjustment, which had
increased January, 1997 income by $22,033,000. Sattler said that she did not
reverse the January calendar adjustment because she was never told to reverse
it and she never thought it was necessary to do so as it was not originally
part of the fiscal year to which the fiscal 1998 topside adjustments had been
made. She said that this $22 million calendar adjustment which was not
reversed, together with other unsupported adjustments made to Comp-U-Card's
books at January 31, 1997, contributed to a skewed January, 1997 Comp-U-Card
income figure which, as discussed above, E&Y questioned and was unable to
confirm was reasonable.
C. Unsupported Topside Adjustments Made in 1996
Unsupported topside adjustments to the income statement and balance
sheet were also made in 1996.(102) The cumulative income impact of these
adjustments was to increase reported pretax income by $87 million for the nine
months ended October 31, 1996. A summary of these adjustments appears as
follows:
- --------------
(102) For a complete summary of the income statement and balance sheet
adjustments in fiscal 1996, see Appendix Ex. 49.
-94-
<PAGE>
Quarter Cumulative P&L Impact
------- ---------- ----------
Apr-96
Revenue $15,000 $15,000
Expense ($27,195) ($27,195) $42,195
-------
$42,195
Jul-96
Revenue $16,700 $31,700
Expense ($23,650) ($50,845) $82,545
-------
$40,350
Oct-96
Revenue ($17,907) $13,793
Expense ($22,312) ($73,157) $86,950
-------
$ 4,405
The increases to net income per quarter from these adjustments
(excluding merger-related costs) were as follows (numbers do not necessarily
add up due to rounding): (103)
Unadjusted EPS EPS Adjustment Reported EPS
-------------- -------------- ------------
Q1 $0.11 $0.13 $0.25
Q2 $0.16 $0.08 $0.24
Q3 $0.17 $0.01 $0.18
In November, 1996, the first month after the end of the third quarter,
all of the fiscal 1997 quarterly topside income adjustments were reversed, as a
result of which the actual year to date results of the company matched what
appeared on Sattler's consolidating spreadsheets. However, to make up for the
reversal of $87 million of topside adjustments, CUC had to make other
- --------------
(103) See Appendix Ex. 50.
-95-
<PAGE>
unsupported adjustments to its books which are described later in this Report.
As can be seen from the above, the quarterly topside adjustments made
in fiscal 1997 boosted income primarily by decreasing expenses ($73 million) as
opposed to increasing revenues (only $14 million). In contrast, of the $176
million in quarterly topside adjustments in fiscal 1998, the majority of the
income impact ($149 million) came from increasing revenues as opposed to
decreasing expenses ($27 million). As will be seen later in this Report, the
unsupported adjustments made at January 31, 1997 and December 31, 1997, which
were made following the reversal of the topside adjustments, generally followed
these respective patterns.
In fiscal 1996, CUC also made balance sheet adjustments at each
quarter in the same manner as in 1997.
D. Unsupported Topside Adjustments Made in 1995
Topside adjustments to the income statement and balance sheet were
also made in 1995.(104) Throughout most of fiscal 1996 the consolidation process
was performed by Mills, until she was replaced by Sattler in December, 1995.
Mills reported directly to Kearney, who reported to Sabatino.
Unsupported topside adjustments were made to increase reported pretax
income by $31 million cumulatively for the nine
- --------------
(104) For a complete summary of the income statement and balance sheet
adjustments in fiscal 1995, see Appendix Ex. 51.
-96-
<PAGE>
months ended October 31, 1995.(105) A summary of these adjustments appears as
follows:
Quarter Cumulative P&L Impact
------- ---------- ----------
Apr-95
Revenue $ 4,500 $ 4,500
Expense ($13,807) ($13,807) $18,307
-------
$18,307
Jul-95
Revenue ($ 4,500) -
Expense ($17,493) ($31,300) $31,300
-------
$12,993
Oct-95
Revenue ($15,833) ($15,833)
Expense ($15,033) ($46,333) $30,500
-------
($ 800)
The increases to net income per quarter (excluding merger-related
costs) from these adjustments were as follows (numbers do not necessarily add
up due to rounding):(106)
Unadjusted EPS EPS Adjustment Reported EPS
-------------- -------------- ------------
Q1 $0.19 $0.09 $0.29
Q2 $0.16 $0.04 $0.21
Q3 $0.22 $0.00 $0.22
In November, 1995, the first month after the end of the third quarter,
all of the fiscal 1996 quarterly topside income
- --------------
(105) Mills could not recall any explanations she was given for the adjustments
she was asked to make. She said her recollection of these matters was not
good.
(106) See Appendix Ex. 52.
-97-
<PAGE>
adjustments were reversed, as a result of which the actual year to date results
of the company matched what appeared on Mills' consolidating spreadsheets.
However, to make up for the reversal of $31 million of topside adjustments, CUC
had to make other unsupported adjustments to its books which are described
later in this Report.
E. Other Information Pertaining to
Knowledge of the Unsupported Topside Entries
No one has stated that persons other than those referred to above knew
of any unsupported quarterly topside adjustments. The persons identified in
this Section who have admitted knowledge that unsupported topside adjustments
were made have not stated that any of the senior executives other than
Corigliano was aware of the adjustments. All of the senior executives of CUC
denied knowing of the unsupported topside adjustments.
No information has been obtained that anyone at the company other than
the Stamford accounting personnel saw or received the consolidating reports
which contained the unsupported topside adjustments, or the consolidating
reports which contained the original unadjusted results.(107)
- --------------
(107) Shelton received the monthly reporting packages described elsewhere in
this Report for Comp-U-Card and many of CUC's subsidiaries, including all
of the major business units. The reporting packages which Shelton
received in 1997 might have alerted him to the fact that the reported
quarterly results substantially exceeded the actual results of the
business units. Shelton has denied reaching any such conclusion based on
his review of the reporting packages or
(Footnote Continued)
-98-
<PAGE>
As stated at the outset of this Report, several persons who it is
believed have highly relevant information have not been interviewed,
principally Pember and Corigliano. Pember has declined to be interviewed and
Corigliano agreed to be interviewed subject to conditions which were not
appropriate. Corigliano has stated to the Cendant Board of Directors in writing
that he never knowingly engaged in any accounting or other financial wrongdoing
or irregularity or advised or assisted anyone else to do so. All of those
persons who have said that Corigliano had knowledge of the topside adjustments
have admitted their own participation in those irregularities and others.
Had we been able to interview Pember and Corigliano, they might have
contradicted statements made about them by others, provided explanations for
their actions, indicated the extent, if any, to which they acted at the
direction or with the knowledge of others or generally provided additional
information relevant to an understanding of the matters investigated.
- -------------------------------------------------------------------------------
that the reporting packages that he received would have enabled him to
do so.
-99-
<PAGE>
VIII. IRREGULARITIES INVOLVING REVERSALS OF
MERGER RESERVES INTO INCOME
A. General Accounting Rules for Proper Establishment
and Utilization of Pooling and Purchase Reserves
Two basic methods are used to account for business combinations:
pooling-of-interests and purchase methods.
In the pooling-of-interests method, the transaction is viewed as a
merger of the ownership interests into a single entity. The assets and
liabilities of the constituent companies are carried forward at their
previously recorded amounts and the reported incomes of the enterprises, before
and after the date of the transaction, are combined.
In the purchase method, the combination is viewed as one company
acquiring another. The purchase price of the acquired company is allocated to
the net assets obtained, and the incomes of the entities are combined only for
the periods after the acquisition date. The assets of the acquired company are
typically revalued to the current fair market value and the combined company
usually will record a new asset, called goodwill, representing the excess of
purchase price over the fair value of the assets acquired. The goodwill asset
will then be amortized, over its estimated useful life, as a reduction to
income on a prospective basis.(108)
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(108) The principal guidance on the accounting for the aforementioned types of
business combinations can be located in the following publications that
have been promulgated by
(Footnote Continued)
-100-
<PAGE>
A business combination often leads to provisions for restructuring
charges ("merger reserves"). Merger reserves are generally intended to cover
one-time, merger-related costs such as professional fees, anticipated losses on
asset impairments and disposals, costs to consolidate, relocate or eliminate
redundant operations and provisions for termination of employees. Merger
reserves are to be recorded as a one-time charge to a company's income
statement in the year that the merger occurs. The charge is generally recorded
and labeled as a special or unusual charge in the combined company's financial
statements. For a pooling-of-interests the typical journal entry to record a
merger reserve would be:
Dr. Special Merger Charge (Income Statement Expense)
Cr. Reserve (Balance Sheet Liability)
This produces a negative impact to income in the year recorded.
Under the purchase method the typical journal entry to record goodwill
would be:
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the standard-setting organizations of the accounting profession:
o Accounting Principles Board Opinion No. 16: Business Combinations;
o Emerging Issues Task Force Issue 94-03: Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity ("EITF 94-3");
o Emerging Issues Task Force Issue 95-03: Recognition of Liabilities
in Connection with a Purchase Business
(Footnote Continued)
-101-
<PAGE>
Dr. Goodwill (Balance Sheet Asset)
Cr. Reserve (Balance Sheet Liability)
There is no immediate income statement impact from such an entry, as
goodwill is amortized prospectively as an expense in a company's income
statement over a period not to exceed forty years.
The establishment of provisions for merger reserves is subject to the
use of estimates. Actual merger-related costs may differ from initial
estimates.
In the case of a business combination accounted for as a pooling, any
material excess of the estimate for merger reserves should be reversed to the
initial merger expense line item on a company's income statement in the period
the reversal occurred. For example, to reduce an excess merger reserve the
appropriate entry would be:
Dr. Reserve (Balance Sheet)
Cr. Special Merger Charge (Income Statement)
Although such an entry produces a positive impact to income in the
year recorded, the reason for that impact will be understood by the readers of
the financial statements.
In the case of a business combination accounted for as a purchase,
after a one-year period, excess or shortages in the merger reserves should be
reflected in a company's income statement.
- -------------------------------------------------------------------------------
Combination ("EITF 95-3").
-102-
<PAGE>
If excess provisions are identified within a one-year period, an
adjustment to goodwill is required. For example, to reduce an excess merger
reserve the appropriate entry would be:
Dr. Reserve (Balance Sheet)
Cr. Goodwill (Balance Sheet)
There is no income statement impact from such an entry.
For both methods any material modifications to previously established
reserves should be disclosed in the footnotes to the financial statements.
As discussed below, CUC improperly reversed merger reserves into
income during the Restatement Period.
B. Improper Reversals of $115 Million of Merger
Reserves Into Income at December 31, 1997
In January, 1998, CUC reversed approximately $115 million of
previously established merger reserves into operating income for the year ended
December 31, 1997, without factual justification or support and without
disclosure that it had done so. Approximately $63 million of previously
established Ideon reserves were reversed into income; approximately $37 million
of Cendant reserves were reversed into income; and approximately $15 million of
other merger reserves were reversed into income. The details and mechanics of
these merger reserve reversals are described below.
1. Reversals of $55 million of Reserves into Comp-U-Card Division
Income
Around January 15, 1998, Pember told Speaks that he would need to find
a home for an additional $55 million to be added to the Comp-U-Card division's
calendar 1997 income. More
-103-
<PAGE>
specifically, he was instructed to find a home on Comp-U-Card's books for about
$48 million in additional revenues and $7 million in reduced expenses. Speaks
was told that to offset this additional $55 million in income he would need to
reverse $36 million in Ideon reserves and $19 million in Cendant reserves that
existed on Comp-U-Card's general ledger (the actual breakdown proved to be
closer to $34 million and $21 million).
By the time Pember called him to carry out this task, Speaks had
already submitted his year-end financial reporting package to Sattler. He told
Pember it would be difficult to make the entries necessary to accomplish this
result without making them stick out for the auditors. Speaks asked Pember for
suggestions on how to book the entries and she provided him guidance.
Eventually he was able to find a home for $48,446,000 in increased revenue and
$7,000,000 in decreased expenses to be offset against the merger reserves, for
a total of $55,446,000 in additional income (a document prepared by Speaks in
April, 1998, and provided to Scott Forbes, summarizes the breakdown of the
additional $48 million in revenue and $7 million in decreased costs) (Appendix
Ex. 53).
a. Reversals of $40.3 million in Reserves
Directly to Comp-U-Card Division Income
Friday, January 16, 1998
As the first step, Pember instructed Speaks to decrease (debit) the
Ideon reserve by $19.6 million and to decrease the Cendant reserve by $20.7
million, for a total of $40.3 million in reserve reversals. Her instructions
are reflected in a one-page handwritten memorandum, which she gave him at a
meeting in
-104-
<PAGE>
Trumbull on Friday, January 16, 1998, which in relevant part indicates that
Speaks would need to "bring into revenue" $33.3 million and "reduce costs" by
$7 million (total $40.3 million increase in income), and to offset this
increased income by reducing the Ideon reserve by $19.6 million and reducing
the "HFS [Cendant] reserves" by $20.7 million (total $40.3 million). See
Appendix Ex. 54.(109) The instructions further indicated that $48.4 million of
the Ideon reserves were to be transferred to various intercompany accounts.
Speaks said that he was skeptical about the purpose of these instructions but
he did not challenge them at the time. He said Pember told him to just get it
done.
The mechanics of the above entries were then left to Speaks to carry
out. Speaks created a spreadsheet containing seven pages of improper journal
entries, 105 individual entries in total, that he had determined would be made
in order to carry out Pember's instructions. See Appendix Ex. 55.
After preparing these journal entries Speaks then prepared a four-page
"Balance Sheet Analysis" dated "January 17, 1998 1:17 a.m." See Appendix Ex.
56. Speaks said that this document, which he did not complete until after 1
a.m. that Friday night, showed the general ledger account balance as of January
16, 1998, before recording the unsupported entries. For example, the "current
balance" in general ledger account 23335 --
- --------------
(109) Speaks verified that the handwriting on this document is Pember's and
that she gave the memo to him.
-105-
<PAGE>
the Ideon reserve -- was $64,268,462.(110) Speaks said the purpose of this
analysis was to help him keep track of the account balances after the various
Pember-directed entries were recorded.
Saturday, January 17, 1998
On Saturday, January 17, the 105 entries were posted to the general
ledger. While the entries were manually entered on that day, they were
backdated to be recorded within the general ledger activity for the 1997
calendar year (e.g., August, 1997, September, 1997, etc.).
On Saturday morning, the 17th, Speaks asked Bruce Tolle, the general
ledger supervisor (who said he was in the office to work on other business), to
post to the general ledger the 105 entries that Speaks had created the day
before. Speaks told Tolle that the directive to post these entries had come
from Pember, and Speaks gave Tolle the specific entries to be made. Tolle could
not recall if Speaks gave him a hard copy of the actual journal entry forms or
if he told Tolle that the entries were on a shared directory (a common hard
drive) that he could access from his own computer to print out. In any event,
Tolle took the hard copies of the entries, manually filled in the journal entry
number, and keyed in the entries manually into the
- --------------
(110) This number is very close to the analysis of this account prepared on
January 9, 1998 by Eva Viniczay which lists the account balance as
$64,258,000, a $10,000 difference. See Appendix Ex. 15.
-106-
<PAGE>
general ledger. Tolle also stamped "posted" on all the journal entry forms.
This took about three hours.
Through a series of 92 individual "post-close" entries numbered
82-173, Tolle debited (decreased) the Ideon reserve account (No. 23335, or the
"35" account) by $19.6 million and debited (decreased) the Cendant reserve
account (No. 23333, or the "33" account), by $20.7 million for a total debit of
$40.3 million, consistent with Pember's instructions to Speaks. This series of
entries also reflected corresponding credits to various revenue or expense
accounts of Comp-U-Card division totaling $40.3 million, also consistent with
Pember's instructions to increase the division's income by that amount. See
Appendix Ex. 57.
Speaks said that initially he prepared the entries in rounded amounts
(e.g., $5 million each), but Pember told him that was not the right approach.
He then went back and prepared most of the entries in non-rounded numbers,
including pennies, and for relatively small amounts, all less than $3 million.
An example is journal entry number 82, which reverses $249,512.54 of the
Cendant reserve (the "33" account) into a revenue account at the Comp-U-Card
division (Sears Service Fee income), as follows:
Dr. Cendant reserve $249,512.54
Cr. Sears Service Fee Income $249,512.54
The entry was posted to the general ledger for the month of October,
1997.
At his interview, Tolle said he did not know what income earned from
"Sears Service Fee" (marketing of CUC products
-107-
<PAGE>
to Sears credit card holders) could have come from debiting a merger reserve
account. Tolle, an experienced accountant, could not explain, even
conceptually, how it would be logical to debit a merger reserve account and
credit Sears Service Fee revenues. At the time he did it, however, he said he
was so busy just keying in the numerous entries that he did not consider the
logic of the entries.
By way of further example, journal entry number 98 reflects that the
Ideon reserve ("35" account) was debited, and certain Comp-U-Card division
expenses in October, 1997 were credited (decreased), as follows:
Dr. Ideon reserve $401,311.52
Cr. Free Weekend Night $401,311.52
Tolle said that conceptually one might credit expense and debit merger
reserve at year-end if it were determined that a particular payment made during
the course of the year could have been, but was not, charged against the
reserve rather than as an expense (e.g., if a payment were credited to cash and
debited to expense and could have been taken against the reserve, it would be
appropriate to reduce both the reserve and expense accounts at year-end).
However, he said he was aware of no backup indicating that this was the case
with this entry (or any of the other credits to expenses that he input). He did
say that he had not focused on the fact that a merger reserve was being
debited, and that he had had a vague understanding at the time that perhaps a
membership cancellation reserve was being debited because of a determination by
someone that it was overstated.
-108-
<PAGE>
Tolle never totaled the amount of journal entries, but he did notice
that they were favorable to the income statement.
Although all of the above entries were posted on January 17, Tolle
backdated them (per Speaks' instructions) to the months of October, November
and December, 1997. Tolle was given no explanation for the backdating nor did
he ask for one. Speaks said the entries were backdated at the direction of
Pember. He explained that the entries were bunched into October, November, and
December, 1997 because E&Y had already been given a trial balance through
September, 1997, so making the changes for months prior to October would have
raised a red flag for the auditors.(111)
Tolle thought that these journal entries were unusual for a number of
reasons: (1) he did not typically key journal entries into general ledger
accounts; instead, journal entries are typically keyed into the general ledger
by staff accountants;
- --------------
(111) Speaks said that Pember became upset when she learned that he had
provided the September 30, 1997 trial balance to E&Y because it
effectively precluded Comp-U-Card from spreading the revenue adjustments
back to earlier periods. As a result, Speaks acknowledged, there was a
substantial gap (approximately $170 million) between the revenue amounts
shown for Comp-U-Card on its year-end financial reporting package for the
first three quarters of fiscal 1998 (which did not include the quarterly
topside adjustments discussed earlier in this Report), and the amounts
for that same period reflected on the topside-adjusted consolidating
reports prepared by Sattler during the year. Included among the materials
provided by E&Y were both the quarterly consolidating reports and the
year-end Comp-U-Card reporting package. See Appendix Ex. 58. Rabinowitz
and Wood of E&Y said that they do not recall being aware of the gap.
-109-
<PAGE>
(2) the large total dollar amounts involved; (3) the backdating of the entries;
and (4) the increases in revenue were not in the company's primary membership
product lines (e.g., Privacy Guard), but occurred in generally low volume
non-membership products (e.g., Sears Service Fee Income).(112) He said that the
auditors would typically not be as interested in adjustments affecting the
latter types of products.
Tolle told no one else about these entries. He said they would not
have come to anyone's attention in their normal course of business because they
were done "post-close" to affect the prior year's books, and hence would not
appear in any financial reports going forward.
b. $3 million Re-establishment of Ideon Reserve
Pember's handwritten instructions to Speaks indicated that, after
reducing the Ideon reserve by $19.6 million, he was to increase the reserve by
$3 million representing a correction in the accounting for the pending
settlement of the Binder class action. By way of background, in December the $3
million
- --------------
(112) Sears Service Fee, Texaco Service Income and similar accounts to which
the revenues were credited were wholesale programs under which CUC
provided servicing and charged Sears or Texaco a service fee per member.
Speaks said that because the revenues from these wholesale programs were
not amortized, revenues could be added to those accounts without
requiring Comp-U-Card to revise the amortization schedules for membership
programs that it had already prepared to be given to E&Y. He said Pember
specifically instructed him to increase revenues in these programs, as
reflected on her handwritten memorandum.
-110-
<PAGE>
settlement amount had been charged against the Ideon reserve to reflect the
funding of the settlement. The correction increased the Ideon reserve by way of
a credit to the account and a corresponding debit to a new "escrow" account
that was created on the balance sheet to act as a holding account for the $3
million cash settlement pending court approval. Pember's instructions read:
"reverse 3.0 to Balance Sheet new escrow A/C [account]." This $3 million credit
to the Ideon reserve is reflected in a journal entry, with an effective date of
December 31, 1997, approved by Speaks. See Appendix Ex. 59. Tolle recalls
keying in the entry, at either Speaks' or Pember's verbal instruction, around
this time.
The above accounting for this $3 million in escrow cash was
appropriate, but as discussed below the $3 million was inappropriately utilized
once it was re-established in the Ideon reserve.
c. Transfer of $48.4 million from
Ideon Reserve to Intercompany Accounts
Pember's handwritten memo that she gave Speaks on January 16 (Appendix
Ex. 54) further indicated that after the $19.6 million reversal of the Ideon
reserve and the $3 million crediting of the reserve for the Binder settlement,
the "Balance in the Ideon reserve SB [should be] 48,400" [$48.4 million]. This
is consistent with the fact that the general ledger balance in the Ideon
reserve at year-end 1997 was about $65 million, and the balance was now being
reduced by a net figure of $16.6 million ($19.6 million less $3 million),
leaving $48.4 million in the Ideon reserve account.
-111-
<PAGE>
As Pember's handwritten instruction goes on to state, Speaks was to
"transfer that $48,400 to Stamford Interco" and to "spread in increments," to
various subsidiary intercompany accounts -- specifically, $20 million to NAOG,
$20 million to NUMA, $3 million to NCCI and $5.4 million to "software," i.e.,
Davidson. This meant that the Ideon reserve would be debited a total of $48.4
million and the intercompany payable accounts with the various subsidiaries
would be credited $48.4 million. This was the first step in the reversal of
this reserve amount into CUC's 1997 income.
Pember's memo describes the purpose of these entries as an "allocation
for costs incurred at various divisions." Speaks said that Pember told him that
these divisions had incurred merger costs for which they needed to be
reimbursed by CUC Corporate. No support for this statement has been found. The
controllers at the subsidiaries in question have stated that they were unaware
of any merger-related expenses on their books for which they needed
reimbursement, and they had no discussions with Pember or anyone in Stamford on
that subject.(113)
Tolle prepared and posted the entries to accomplish these intercompany
transfers on the same Saturday (January 17)
- --------------
(113) NUMA, NAOG and NCCI are in the businesses, respectively, of genealogical
publications, hunting and fishing clubs and Credit card enhancement
packages. They have no overlapping business operations with Ideon,
Sierra, Davidson or Plextel and thus there is no reason Ideon reserves
should have been transferred to those subsidiaries.
-112-
<PAGE>
that he made the entries described earlier. Again, he was given the specific
entries by Speaks.
Consistent with Pember's handwritten instructions to Speaks, Tolle
posted a series of thirteen individual post-close journal entries (42-54) that
debited (reversed) the Ideon reserve by a total of $48.4 million and credited
various subsidiaries, by way of the corporate intercompany account, by a total
of $48.4 million (NUMA $20 million, NAOG $20 million, NCCI $3 million and
Davidson [Sierra] $5.4 million). See Appendix Ex. 60.
Speaks asked Tolle to backdate this set of journal entries and to
spread them throughout the year, from February through December, 1997. That
instruction is reflected, for example, by the typewritten number 2 (for
February) that appears on the far right of journal entry number 42. However,
after attempting to key this entry into the system, Tolle learned that CUC's
system would not accept backdated journal entries for any period earlier than
August, and he so informed Speaks. Thereafter, Tolle crossed out the number 2
signifying February, and handwrote the number 8 on the top of the column to
indicate that this particular entry would be posted to August, 1997. The
entries that had been earmarked for March were then put into September, and
April into October, and so forth.
The entries posted by Tolle on January 17 thus reversed $68 million of
the Ideon reserve as follows:
Dr. Reserve $68,000,000
Cr. Income (Comp-U-Card) $19,600,000
Cr. Interco (Subsidiaries) $48,400,000
-113-
<PAGE>
The $68 million reduction is consistent with a document from Pember's
computer, dated January 21, 1998 (Appendix Ex. 61), which indicated that among
the "opportunities" for creating additional operating income were $65 million
of Ideon reserves which were to be "spread [among] various div[isions] and
areas," as well as the $3 million escrow for the Binder class action.
As discussed below, $5.4 million of the $68 million reversed out of
the Ideon reserve consisted of a reserve amount that had been transferred in
December, 1997 from the Software division to CUC Corporate through an
intercompany account before being sent back to the Software division through
the intercompany transfer on January 17. In effect the Ideon reserve served as
a conduit which was only temporarily increased by this amount and then reduced
by the same amount. As a result, the net reduction to the Ideon reserve account
was actually $62.6 million ($68 million less $5.4 million).
The reduction of the Ideon reserve through the above entries left a
balance in the general ledger account at December 31, 1997 of approximately
$479,000. This is consistent with a notation in Pember's handwritten
instructions to Speaks (Appendix Ex. 54) that as a result of the above entries
there should be "about $500,000 left in [the Ideon reserve] balance." Speaks
also recalls Pember telling him that about $500,000 should be left in the Ideon
reserve to cover anticipated severance costs.
A contemporaneous analysis of general ledger activity in the Ideon
reserve account from February through December 31, 1997 was prepared on January
9, 1998, by Eva M. Viniczay, Comp-U-
-114-
<PAGE>
Card staff accountant, prior to the posting of $62.6 million of unsupported
journal entries on January 17. The analysis (Appendix Ex. 15) states that the
balance of the Ideon reserve, at that date, was $64.3 million, which is
consistent with the balance sheet analysis Speaks prepared on January 16. The
primary difference between the $479,000 on the general ledger and the $64.3
million in the Viniczay schedule is attributable to the unsupported post-close
journal entries.
A further general ledger analysis prepared by Viniczay, for the period
January through March, 1998 shows an opening balance of $479,000. See Appendix
Ex. 62. This opening balance should agree with the ending balance from the
prior year. However, the opening balance does not agree as a result of the
posting of the entries described above.
d. Transfer of $15 million in Intercompany
Credits to Comp-U-Card Division Revenues
Tuesday, January 20, 1998
As a result of the entries on January 17, Comp-U-Card now had on its
balance sheet $48.4 million of intercompany payables to various subsidiaries
that had resulted from reducing the Ideon reserve. The next step was to remove
$15 million of those intercompany credits from the balance sheet and to move
the $15 million into Comp-U-Card's 1997 income statement. Together with the
$40.3 million of merger reserves that had already been moved into income, this
next step would complete the objective of increasing Comp-U-Card's income by
$55 million. The mechanics are as follows:
-115-
<PAGE>
On January 20, 1998, Speaks received a one-page fax from Pember
containing handwritten instructions to credit various revenue accounts of
Comp-U-Card division in specific amounts, again backdated to the months of
October, November and December 1997.(114) The instructions also were to offset
these entries by debiting $15.1 million of the intercompany payables that had
just been credited on Saturday, January 17. See Appendix Ex. 63. Speaks gave
the fax to Tolle with instructions to prepare and post the entries.
Tolle believes that before he made these entries he received more
precise instructions, as reflected on another version of the January 20 Pember
fax, on which Tolle crossed out the figure $15.1 million and wrote in the
figure $15,146,000 to be credited to the revenue accounts.(115) See Appendix Ex.
64. His handwritten changes further indicate that the $15,146,000 in offsetting
debits was to be split between NUMA ($7,312,000) and NAOG ($7,834,000).(116) He
then prepared a spreadsheet (Appendix
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(114) Both Speaks and Tolle identified the handwriting and initials on the fax
as Pember's. The fax number from which the fax was originated corresponds
with Pember's Cendant (Stamford) business card.
(115) Tolle did not recall why he added $46,000 to the amount to be credited to
income.
(116) Tolle believes he may have been told to split the intercompany debits
roughly evenly between NUMA and NAOG, or he may have simply decided on
that split himself. In either event the split was apparently arbitrary.
-116-
<PAGE>
Ex. 65) reflecting the revised numbers from the handwritten Pember fax.
Wednesday, January 21, 1998
On January 21, 1998, using the spreadsheet he had prepared, Tolle then
generated the actual journal entry forms (P176-196) which, in summary, did the
following:
Dr. Interco (NUMA) $7,312,000
Dr. Interco (NAOG) $7,834,000
Cr. Revenue (Comp-U-Card) $15,146,000
See Appendix Ex. 66.
Tolle believes that he had a temporary employee key in the journal
entries, and that only Speaks, the temp and he were aware of the journal
entries. These journal entries were done without the knowledge and involvement
of the subsidiaries involved (i.e., NUMA and NAOG) because they were done
solely at the corporate intercompany level.
Tolle was unaware of any basis for the credits to various revenue
accounts of Comp-U-Card division that were offset by the debits to the
intercompany accounts reflected in journal entries P176-196. He did not ask to
be supplied with any such basis. No factual basis for these entries has been
found.
With the posting of these post-close entries, Pember's instructions to
reverse $55 million of merger reserves, and to find a home for an additional
$55 million in Comp-U-Card income, were now fully accomplished. Sattler
received a revised reporting package from Comp-U-Card with these income
adjustments booked, and changed her Excel spreadsheet accordingly.
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Tolle said he maintained hard copies of these post-close entries on
his desk, separate from the binders where pre-close journal entries were kept.
He kept them in a manila folder (because he had not had time to place them in a
binder) until AA arrived as part of the investigation into potential accounting
irregularities. At that time, Tolle placed the post-close journal entries into
a binder so that they could be reviewed.(117)
2. Use of Intercompany Accounts to Increase
Income of Other Subsidiaries by $50,254,000
CUC also increased the income of various other subsidiaries by
approximately $50 million through additional unsupported reversals of merger
reserves and adjustments to intercompany accounts.
a. Transfer of Reserves to Intercompany Accounts
As the first step in this process, CUC transferred $50,254,000 of
Ideon and Cendant reserves to various subsidiaries through intercompany
accounts.
(i) Ideon Reserve ($33,254,000)
As described above, $48,400,000 of the Ideon reserve was reduced on
January 17, 1998 and used to create intercompany payables to various
subsidiaries. Of that amount, $15,146,000 was utilized on January 21 to
increase Comp-U-Card income. This left
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(117) No one from E&Y asked Tolle or Speaks if they could see any post-close
journal entries, nor did they provide the entries to E&Y.
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<PAGE>
$33,254,000 of intercompany payables to
the various subsidiaries.
(ii) Transfer of $17 million from
Cendant Reserve to Intercompany Accounts
On January 21, the same day that he posted the journal entries that
increased Comp-U-Card's revenues by eliminating $15,146,000 of intercompany
credits, Tolle also created an additional $17 million of intercompany credits
to various subsidiaries by charging the Cendant reserve. The same January 20
Pember fax that contained the instructions to increase Comp-U-Card income by
$15.1 million (Appendix Ex. 64) also contained additional instructions to debit
the Cendant reserve $17 million and to credit intercompany payable as follows:
BCI $10.5 million, NUMA $1 million, Welcome Wagon $2.5 million and WorldEx $3.0
million (total $17 million). Tolle carried out these instructions by preparing
a series of journal entries (P197-208, P213-215) that were posted on January
21. See Appendix Ex. 67.(118)
The $17 million in new intercompany credits from reversal of the
Cendant reserve, together with the $48.4 million
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(118) Actually, Tolle misread the handwritten instruction to debit Cendant
reserve and credit intercompany $1.0 million to NUMA as $10 million,
resulting in a $9 million "over-debiting" of the reserve and
"over-crediting" of NUMA. He later discovered the error and, through
journal entries P213-P215, he re-credited the reserve $9 million and
debited intercompany NUMA $9 million, producing a net $1 million debit to
the reserve and credit to interco NUMA.
-119-
<PAGE>
in intercompany credits resulting from decreasing the Ideon reserve, meant that
a total of $65.4 million in intercompany credits had been created by reversing
the Ideon and Cendant reserves. Of that $65.4 million in credits, $15,146,000
was utilized to increase Comp-U-Card income, as described above, leaving
$50,254,000 in credits on the Comp-U-Card balance sheet. As discussed below,
all of those credits were used to increase various subsidiaries' operating
income, again without justification or support.
b. Use of Intercompany Account
to Increase Revenues of NUMA,
NAOG and NCCI by $28,854,000
Of the $50,254,000 in remaining intercompany credits, $28,854,000 was
utilized without support to increase the income (revenues) of NUMA, NAOG and
NCCI. Income of NUMA was increased $13,688,000, representing the difference
between the $21 million in intercompany credits to NUMA created earlier [$20
million from reversals of the Ideon reserve on January 17 and $1 million from
reversal of the Cendant reserve on January 21], less the $7,312,000 of credits
to NUMA which were reversed into Comp-U-Card income on January 21. Income of
NAOG was increased $12,166,000, representing the difference between the $20
million intercompany credits created from the reversal of Ideon reserves on
January 17 less the $7,834,000 of those credits reversed into Comp-U-Card
income on January 21. Finally, income of NCCI was increased $3 million, the
amount originally credited to NCCI on January 17 as part of the $48.4 million
in intercompany credits created from the Ideon reserve reversals.
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<PAGE>
Thus, the income of these three subsidiaries was increased by a total
of $28,854,000 ($3,000,000 + $13,688,000 + $12,166,000).(119)
The entries that accomplished this were recorded "topside" by Sattler.
That is, as Sattler explained, they were made in the "cells" of the Excel
spreadsheet she used to produce the consolidated financial statements, without
adjusting the general ledger of either Comp-U-Card division or the three
subsidiaries themselves. The overall effect of the entries is as follows:
Comp-U-Card:
Dr. Ideon reserve $27,854,000
Dr. Cendant reserve $ 1,000,000
Cr. Interco (NUMA, NAOG, NCCI) $28,854,000
NUMA, NAOG, NCCI (Top-Side):
Dr. Interco (Stamford) $28,854,000
Cr. Revenues (subsidiaries) $28,854,000
The net effect of these entries was to reverse nearly $29 million of
the Ideon and Cendant reserves into the income of NUMA, NAOG and NCCI as
reflected on the corporate consolidating reports.
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(119) Of this total, $27,854,000 came from the reduction of the Ideon reserve
on January 17 and $1 million resulted from the reduction of the Cendant
reserve on January 21.
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<PAGE>
With the completion of these entries, there were now $21.4 million of
intercompany account credits left on the Comp-U-Card balance sheet ($65,400,000
- - $15,146,100 - $28,854,000 = $21,400,000).
Sattler said that she was instructed by Pember to make these topside
entries. She acknowledged that this was the first time she was asked to make
topside adjustments to the revenues of any entity other than Comp-U-Card.
Because these entries were made topside by Sattler, the subsidiaries
had no knowledge of them at the time.
Unlike the $55 million in Comp-U-Card income that was retroactively
booked to calendar 1997, the $29 million in topside adjustments to the three
subsidiaries' results were not made to calendar 1997's books, which had already
been closed by the time the entries were made. Therefore, Sattler knew that it
was necessary for these entries to be "pushed down" to the subsidiaries' books
in calendar 1998 (i.e., booked via push-down entries to each of their general
ledgers) in order to make retained earnings roll.
It was typical for CUC, as for other corporate parent companies, to
allocate to subsidiaries at year-end various expenses incurred at the corporate
level, such as management fees or federal and state income taxes. Accordingly,
Sattler sent a series of memoranda on April 6, 1998, to the controllers and/or
CFOs of each of the various subsidiaries (including NUMA, NAOG and NCCI)
instructing them to debit (reduce) their retained earnings and to credit
intercompany payable to Corporate for
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allocation of management fees and income taxes -- in effect to reimburse
Corporate for the subsidiary's allocable portion of those fees and tax
payments. See Appendix Ex. 68. As part of the same series of memoranda, Sattler
also instructed the controllers/CFOs of NUMA, NAOG and NCCI to credit
(increase) their retained earnings and to debit (increase) intercompany
receivable from Corporate ("intercompany Stamford"). The amounts corresponded
with the amounts of intercompany credits to each subsidiary that remained on
Comp-U-Card's balance sheet ($3 million to NCCI, $13,688,000 to NUMA,
$12,166,000 to NAOG).
The explanation for these entries was "To record year-end allocation."
The memorandum does not indicate that these entries had anything to do with any
reversals of reserves into income. The memo further indicated that the entries
were to be posted in the month of March, 1998 and that those entries that
"would normally be charged to the P&L can be charged directly to Retained
Earnings to avoid opening last year's books." Crediting revenue would have
increased revenue for the current year (1998), whereas crediting retained
earnings had the effect of increasing retained earnings for the net income
effect of revenues recorded topside in the prior year (1997). Although it is
not unusual for expenses to be allocated by a corporate parent to its
subsidiaries, it is unusual for a parent to allocate revenues to its
subsidiaries.
Each of NUMA, NAOG and NCCI recorded the entries as instructed. The
controllers of NAOG (Kate Pope) and NCCI (Colleen Chaney) said in interviews
that the entries raised no
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<PAGE>
questions in their mind and they simply booked them without discussing them
with anyone. They both said they assumed the entries were for some kind of
allocation of corporate costs, similar to the tax and management fee
allocations. Pope added that she did not think about the entry because it did
not affect NAOG's P&L, only retained earnings. She did say she had never seen a
year-end push down entry of this kind, i.e., one labeled "to record year-end
allocation" without any explanation of the nature of the allocation.
Andrew Klaus, who received the Sattler memorandum as CFO of NUMA, said
the entry for "year-end allocation" did not make sense to him. He said he asked
Sattler for an explanation or rationale but received none.(120) The entry was
ultimately booked by one of his staff, but Klaus does not recall specifically
signing off on the entry.(121)
Sattler said that she sent this memorandum on her own initiative
because she knew that the entries would have to be booked in order for retained
earnings to roll. She did not show
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(120) Sattler recalled the conversation somewhat differently. She said Klaus
asked why the line item for federal income tax allocation to NUMA was so
high, and she pointed him to the entry for "year-end allocation," without
further elaboration or explanation.
(121) Each of the Presidents/CEOs of NUMA, NAOG and NCCI said they were unaware
of the April 6 Sattler memorandum and had never seen it.
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<PAGE>
the memo to anyone beforehand, but she said that Sabatino knew that the memo
was being sent.
c. Use of Intercompany Account to
Increase Software Income by $5.4 million
In December, 1997, Sattler contacted Brian Foster, corporate
accounting manager of the Sierra Division of CUC Software, and told him that
Pember wanted Sierra to calculate the "excess" that was remaining in an $11
million purchase accounting reserve that had been established in connection
with Sierra's April, 1997 acquisitions of Berkeley Systems ("Berkeley") and
Books That Work (the "Berkeley reserve"). Sattler said that Pember wanted
Sierra to transfer that excess to Corporate through the intercompany account.
The suggestion to do this originally came from Sabatino, who had told Pember in
October, 1997 that Sierra should transfer the reserve to Corporate "so we can
control it." See Appendix Ex. 69.
Foster calculated the remaining reserve needed to satisfy the
outstanding severance agreements and other acquisition costs not yet paid out
and determined that the "excess" Berkeley reserve was $5.4 million. Foster knew
there was excess because when the reserve was initially established he had
estimated a need for perhaps $6 or $7 million (primarily for severance costs),
but Sabatino had directed Fred Schapelhouman, then Sierra's chief accounting
officer, to record a reserve of $11 million ($6 million for severance and
relocation payments and
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<PAGE>
$5 million for lease cancellations and site closings).(122) Foster said
Schapelhouman gave him the $11 million figure to book and that when Foster
responded that it was excessive, Schapelhouman (who is no longer with the
company) told him the number had come from Corporate so he had to book it.
Sabatino said that he had been told by Corigliano to make sure that a reserve
in the range of $10 to $12 million got booked.
On January 4, 1998, (effective December 31, 1997) Sierra debited the
Berkeley reserve by $5.4 million and credited intercompany payable to Corporate
by $5.4 million.(123) The Comp-U-Card division then debited intercompany
receivable from Sierra $5.4 million and credited (increased) the Ideon reserve
- -- the
- --------------
(122) The $5 million was earmarked for site closings and lease cancellations
and did not make sense to Foster. He was unaware of any site closings
that were necessary in connection with the acquisition. There were some
downsizing/consolidation costs associated with Berkeley which Foster said
are nowhere near $5 million. He gave his best guess at about $500,000.
(123) Prior to transferring the excess reserve to Corporate, Foster had
contacted Jay Meschel, CFO of Cendant Software, and told him he was
concerned that even though Sierra was transferring its excess Berkeley
reserve to Corporate, it was still carrying goodwill from the Berkeley
acquisition on its books which required Sierra to take an ongoing "hit"
to income in the form of amortization of goodwill. Foster had asked
Sattler whether Corporate would be taking the goodwill along with the
excess reserve and she told him no. Foster thought that Meschel should
know this because, although Sierra did not need the reserve (and it made
no difference on a consolidated basis), anyone evaluating the Software
Division's operating performance should have an appreciation of the fact
that Sierra was required to amortize the $5.4 million of excess goodwill
prospectively.
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<PAGE>
"35" account on Comp-U-Card's general ledger -- by $5.4 million. Then, as
already discussed, Comp-U-Card reversed (debited) the Ideon reserve by $5.4
million on January 17 and credited intercompany payable to Davidson. The
entries were as follows:
Sierra:
Dr. Berkeley Reserve $5,400,000
Cr. Interco Stamford $5,400,000
Comp-U-Card
Dr. Interco (Sierra) $5,400,000
Cr. Ideon reserve $5,400,000
Dr. Ideon reserve $5,400,000
Cr. Interco (Davidson) $5,400,000
The effect of the above entries was to move the excess merger reserve
from Sierra's general ledger to Davidson's general ledger through the
Comp-U-Card division's general ledger.
On January 15, 1998, Davidson recorded the following entry:
Dr. Interco CUC $5,400,000
Cr. Misc. Income $5,400,000(124)
This is an irregular entry because it records revenue that resulted
from reversing the excess Berkeley reserve. The appropriate entry would have
been to debit or reverse the
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(124) In consolidation, Sattler reclassified the $5.4 million from
Miscellaneous Income to Membership Fees, a revenue line on the income
statement.
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<PAGE>
Berkeley reserve and to credit or reduce the goodwill asset on the balance
sheet (rather than credit income), as the goodwill had been recorded less than
one year earlier.
Pam Drake, Davidson's controller, said she had a staff accountant book
the entry after it was approved by Jay Meschel, Senior Vice President for
Finance (and functionally the CFO) of Cendant Software. She understood the
entry resulted from a reduction of the Berkeley reserve, which she said she
learned from either Meschel or Sabatino. She viewed the transaction as "most
odd" and recalled receiving no rationale for it. She said the decision to
credit income would have been made by someone in Corporate since "we wouldn't
make that kind of decision here." Meschel said that Sabatino and Pember
directed that the entry be a credit (increase) to software's 1997 income, but
he did not recall discussing the rationale for the entry with them or anyone
else.(125)
Foster said that when he transferred the excess reserve to Corporate
he had some concern that the reserve might be used to offset some non-merger
expenses, but he "never thought they'd go that far," i.e., simply reversing the
reserve into revenue (which he learned about after the commencement of this
investigation).
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(125) Sabatino said the directive to reverse the reserve into income came from
Pember.
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<PAGE>
Meschel said that when he discussed software's 1997 year-end results
with McLeod, they both took note of the fact that $5.4 million of the
division's income in 1997 (approximately $70 million EBIT) was attributable to
this merger reserve reversal and not to the operating results of the division
"per se." Meschel said this fact was noted as well in discussions he and McLeod
had with Pember and/or Sabatino after year-end regarding software's 1997
performance.(126) McLeod said he had no recollection of the transaction until
Foster brought it to his attention in the course of AA's on-site review as part
of this investigation.
With the completion of this entry, there were now $16 million of
intercompany credits remaining on the Comp-U-Card balance sheet ($21.4 million
- - $5.4 million).
d. Use of Intercompany Account to
Increase FISI Revenues by $10.5 million
As noted above, as part of the reversal of $17 million in Cendant
reserves on January 21, Comp-U-Card reversed $10.5 million of Cendant reserves
and credited intercompany to BCI by $10.5 million. A few days before this, on
or about January 12, Steve Pedersen, controller of BCI, and Mary Peterson,
BCI's assistant controller, participated in a conference call with Pember in
which Pember told them that they would need to record
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(126) Sabatino did not recall such a discussion.
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<PAGE>
journal entries which would, in substance, transfer $10.5 million from
Comp-U-Card to FISI through BCI.
By way of background, the businesses of BCI and FISI are interrelated.
BCI calculates for FISI a profit-sharing receivable representing the amount due
from insurance carriers under profit-sharing agreements between the carriers
and FISI, which acts as sales agent for BCI's accidental death and
dismemberment insurance products. BCI administers the billings, collections and
accounting for the profit-sharing agreements, and each month records an
estimate of the receivable due from the carrier as an asset in BCI's general
ledger. BCI then transfers the revenue to FISI each month by crediting
intercompany payable to FISI, which in turns debits a "due from" BCI
intercompany account and credits profit-sharing revenues on FISI's general
ledger.
In either the January 12 phone call or in another call that week,
Pember told Pedersen that CUC was negotiating a new contract with CNA, and that
as the result of the new deal, BCI should write down (i.e., reduce or credit)
the carrying value of the receivable by approximately $10.5 million. Both
Pedersen and Peterson recall Pember saying that the writedown would probably be
taken against some merger reserve (Pedersen thought the Cendant reserve;
Peterson simply recalled Pember saying the writedown would probably go to some
unspecified reserve).
Peterson recalled Pember saying that after writing down (crediting)
the receivable against the intercompany due from Corporate, BCI should then
write up (debit) the receivable and
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credit intercompany due to FISI $10.5 million. Peterson said she and Pedersen
opted to cut out the middle step because they wanted to keep the receivable off
BCI's books and because they understood the ultimate purpose to be to credit
FISI with the $10.5 million.(127) The entries that were eventually booked were
as follows:
BCI:
Dr. Due from Comp-U-Card $10,500,000
Cr. Due to FISI $10,500,000
FISI:
Dr. Due from BCI $10,500,000
Cr. Profit Sharing Revenue $10,500,000
Both Pedersen and Peterson said they were uncomfortable with booking
BCI's part of the transaction because they saw no justification or support for
it. Pedersen said he could not envision any scenario under which one could in
effect write off a receivable against a reserve and thereby increase income.
Peterson agreed that the transaction seemed odd. They ultimately booked the
transaction because it did not affect BCI's P&L. Pedersen said it was done at
the "urging and insistence" of Pember and Corigliano, with whom he said he also
spoke that week about the transaction.
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(127) It has been determined that, in fact, there was no writeoff or writedown
of the BCI profit-sharing receivable at year-end 1997.
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<PAGE>
On January 16, Pedersen wrote two memoranda to Peterson dated January
12, 1997 (he confirmed the date should have read 1998) which instructed her to
book two separate entries debiting intercompany from Stamford in the amounts of
$6.5 million and $4 million (for a total of $10.5 million), and crediting
intercompany to FISI in those same respective amounts.
See Appendix Ex. 70. The memoranda read:
Just got off the phone with Corporate where they tell me that some of
the insurance contracts which FISI/BCI deal with are being redone as
part of the Cendant merger. Per them, we need to make an entry based
on current info to reduce receivables by 10% as a result. As you know,
this will be passed directly on to FISI to correctly reflect company
P&L allocations...
Appendix Ex. 70.
Peterson and Pedersen both said the reason for the memoranda
essentially was to have something in the files that purported to justify the
entries. However, they both said there was no substance to the rationale
proffered in the memoranda; as Peterson stated, it bore no relation to reality.
Pedersen said he drafted the memoranda to be purposefully vague and that he
directed that the entries be done in two separate pieces to make it seem a
little less blatant.(128)
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(128) Pedersen said he told BCI's president, Vincent D'Agostino about the
entries before they were made. Pedersen told D'Agostino that he had been
asked by Corporate to make certain entries with which he was not
comfortable, but he provided D'Agostino little detail. D'Agostino had no
reaction, and left it up to Pedersen to determine whether they should be
made. D'Agostino did not recall a conversation with Pedersen on this
point.
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Peterson actually keyed in the entries on January 16, 1998. Pedersen
had told her he would key them himself if she was uncomfortable doing it, but
she said she would do it as long as there was documentation in the file.
Peterson spoke to Terry Johnson, controller of FISI, either before or
at the same time as the execution of the transaction. She informed him that BCI
was sending him $10.5 million per Pember's instructions, and that if he wanted
any details, he should request them from Pember. Peterson recalled no
particular reaction from Johnson; she simply assumed he booked his side of the
entry (i.e., the debit to intercompany and credit profit-sharing revenue),
although she did not know this for a fact.
Johnson confirmed that in early January, 1998, he received a call from
either Pember or Sattler (he believes probably Pember) instructing him to
record an additional $10.5 million in profit-sharing revenue on the books of
FISI. Johnson was given no explanation for this request, and he does not recall
asking any questions about the entry. He spoke with Peterson at BCI to confirm
that BCI had received similar instructions and that BCI was making a
corresponding entry on its books.
Johnson said that it was not unusual for there to be adjustments made
to the profit-sharing revenue account, since FISI typically tends to book
revenue conservatively and sometimes determines that there is additional
revenue to record. However, he recalled thinking at the time that the
additional $10.5 million to be booked seemed high. The total profit-sharing
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revenue booked for the month of December was approximately $18 million, and
Johnson recalled thinking that this amount seemed high even before he was asked
to book the additional revenue. He also could not recall a prior instance in
which anyone from CUC Corporate requested that an adjustment to FISI's profit
sharing revenue be made.
Johnson told Ken Keith, FISI's CEO, about the entry in connection with
Keith's review of the monthly financials. He could not recall the specifics of
their conversation or Keith's reaction. They did not discuss why the amount
booked for December was significantly higher than in prior months. Keith did
not specifically recall the transaction but said he would not have regarded it
as unusual because there is always a year-end adjustment to the profit-sharing
receivable.
With the completion of the above entries, there were $5.5 million in
intercompany credits remaining on the Comp-U-Card balance sheet ($16 million -
$10.5 million).
e. Use of Intercompany Account to
Increase Welcome Wagon Income by $2.5 million
In her year-end consolidation, Sattler also made a topside adjustment
to increase revenues of Welcome Wagon by $2.5 million by eliminating the $2.5
million intercompany credit that had been created by debiting the Cendant
reserve on January 21. The topside entries to Welcome Wagon's results were:
Dr. Interco $2,500,000
Cr. Revenue $2,500,000
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This entry was then pushed-down to Welcome Wagon, as directed in an
April 6, 1998 memorandum from Sattler to Ron Guggenheimer, Welcome Wagon's
controller, similar to the push-down entries Sattler gave to NUMA, NAOG and
NCCI that were discussed above. The instruction was to debit intercompany from
CUC Corporate and credit retained earnings. See Appendix Ex. 68.
Guggenheimer recalled that his staff accountants raised a question
about the memo because they thought it unusual that retained earnings would be
adjusted after year-end in this manner. Lisa Plucinski, the general ledger
accountant for Welcome Wagon, confirmed that she thought the $2.5 million entry
to credit retained earnings was unusual because it was post-close and because
Welcome Wagon's net income for 1997 was significantly lower than $2.5 million.
In the end, Welcome Wagon simply booked the entries because the instruction had
come in writing from Stamford.
Following this transaction, there remained a total of $3 million in
intercompany credits on the balance sheet created by the January 17 and January
21 merger reserve reversals.
f. Use of Intercompany Account to
Increase WorldEx Income by $3 Million
In her year-end consolidation, Sattler also made a topside adjustment
to increase revenues of WorldEx ("WEX") $3 million by eliminating the $3
million intercompany credit that had been created by debiting the Cendant
reserve on January 21. This entry was never pushed-down to WEX in the same
manner as the other entries described above, since WEX (a subsidiary of
Interval) was sold as part of the divestiture of Interval that
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occurred in December, 1997. The $3 million was accounted for within the
calculation performed on the sale of Interval and did not need to be credited
to retained earnings of WEX in order for retained earnings to roll.
With the completion of these entries, there were no remaining
intercompany credits on the balance sheet created by the January 17 and January
21 merger reserve reversals.
3. Reversal of $9.5 million of
Spark Purchase Reserve into Spark Revenues
Lastly, CUC increased income $9.5 million by reversing purchase
accounting reserves that existed on the general ledger of Spark. The entry that
accomplished this was not made "topside," but rather was made by Spark directly
to its general ledger. It was, however, directed to be made by Corporate,
without any documentation or support given to Spark.
The reserves that were reversed were established in connection with
the acquisitions in early 1997 of Tango Communications and Match.com, two
dating services, by Plextel, a dating service subsidiary of CUC. Plextel
changed its name to Spark following the acquisitions, both of which were
accounted for using the purchase method of accounting.
Kevin Kearney, controller of Spark, said that he was directed by
Corigliano to record $10 million of purchase accounting reserves for
anticipated professional, relocation, severance, and other acquisition-related
expenses -- $5 million each for the acquisitions of Tango and Match.com.
(Because the acquisition was accounted for as a purchase, not a pooling, the
establishment of these purchase accounting reserves did not
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affect P&L; upon crediting the reserve, the debit is to goodwill rather than
expense.) Kearney said he had given Corigliano or Pember an estimate of the
reserve he thought would be necessary and that the reserve he was asked to book
was more than what he had estimated, but he could not recall by how much.
Spark's president, Richard Fernandes, recalled having discussed the need for
reserves with Corigliano and Shelton, and that Spark ultimately was given a
larger reserve than what he and Kearney had requested, but like Kearney he
could not recall the differential. Kearney believed the reason for the
increased size of the reserves he was instructed to record was due to
Corigliano's and Fernandes' belief that there would be more acquisition costs
and expenses than originally predicted.
Kearney said that throughout 1997 Pember had been asking him to keep
her informed as to how much in the way of acquisition related expenses he
anticipated incurring, in order to determine how much reserve he needed. He
could not recall specifically, but said he believed that he gave Pember an
estimate in the range of $1.2 million for Match.com and less than $1 million
for Tango.
Kearney said that in July, 1997 Pember instructed him to add $2
million to the Tango reserve to bring the total of the two reserves to $12
million. According to Kearney, Pember said that she felt that lease
cancellation penalties and workers' compensation were underaccrued by $1
million each. Kearney did not receive any documentation supporting the
additional reserve. On July 31, 1997 he input a journal entry directly on-line
to
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increase (debit) goodwill and increase (credit) the purchase accounting
reserves by $2 million each (again no P&L impact).
In January, 1998, Kearney completed his year-end financial reporting
package and forwarded it to Sattler. The year-end income statement, dated
January 12, 1998, indicated net income of $13,906,200. Pember then contacted
Kearney and instructed him to reverse $9.5 million of the purchase accounting
reserves and credit that amount to revenue. Kearney made the adjustments
on-line with no written manual journal entry form prepared, as follows:
Tango:
Dr. Purchase Accounting Reserves $6,000,000
Cr. Interco Spark $6,000,000
Spark:
Dr. Interco-Tango $6,000,000
Cr. Member Service Fees $6,000,000
Match.com:
Dr. Purchase Accounting Reserves $3,500,000
Cr. Interco Spark $3,500,000
Spark:
Dr. Interco-Match.com $3,500,000
Cr. Member Service Fees $3,500,000
The effect of these entries was to reverse the purchase accounting
reserves of $9.5 million into Spark revenue.
Kearney then sent a revised reporting package to Sattler including a
year-end income statement dated January 19, 1998. The revised income statement
reflected net income of
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$23,406,200 -- $9.5 million more than shown in the original reporting package.
The adjusted income statement showed revenues for December, 1997 of
$11,876,500, as compared with December revenues of $2,376,500 in the original
package, again a $9.5 million increase.
Kearney said that Pember's instructions were out of the ordinary
insofar as she told him to credit the reserve reversal to revenue. The
appropriate entry for reversal of a purchase accounting reserve that is no
longer needed is to credit goodwill rather than income, if the reversal takes
place within one year after the acquisition is closed (as this did).
Kearney was given no rationale for the reserve reversal. He did not
question Pember about it but simply did what he was told. He said he assumed
there was a rationale for the reversal, and that his assumption was that
Corporate had charged its P&L for various expenses it incurred that properly
could have been taken against the Spark purchase reserve. However, Kearney said
he never received any factual or documentary support to this effect and neither
Pember nor Corigliano ever told him this was the justification. Nor could he
explain why, if the justification was to charge the reserve for expenses
incurred, the credit was to revenues rather than expense.
Kearney said he discussed the adjustment with Fernandes who told him
to make the adjustment if that was what Corporate was telling him to do.
Fernandes recalled the adjustment was in the neighborhood of $10 million and
was an increase to income (he
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did not recall that it specifically increased revenues). Fernandes could not
recall whether Kearney expressed a feeling at the time that the requested
adjustment was unusual, but he said he told Kearney there was no reason to
believe the adjustment was inappropriate because they worked for and trusted
Corigliano and Shelton. Neither Kearney nor Fernandes had any follow-up
conversations with anyone about the adjustment, although after it was made
Fernandes asked Kearney for a copy of the pre-adjusted income statement for his
files because he wanted to be able to make meaningful comparisons of operating
income at the next year-end.
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4. Summary of Unsupported Reserve Reversals
into Income at Year-End 1997
The following summarizes the inappropriate reversals into CUC income
that were accomplished in January, 1998 respecting 1997 calendar year income
(amounts rounded):
a. Direct Reversals of Merger Reserves into Comp-U-Card Income:
$40.3 million
($19.6 million from Ideon reserve; $20.7 million from
Cendant reserve);
b. Reversals of Merger Reserves into Comp-U-Card Income through
Intercompany Accounts:
$15.1 million (from Ideon reserve)
c. Reversals of Merger Reserves into Subsidiary Income through
Intercompany Accounts:
$50.2 million
($27.8 million from Ideon reserve, $17 million from Cendant
reserve, $5.4 million from Berkeley Reserve)
d. Reversal of Spark Reserve into Spark Income:
$9.5 million
e. Total Merger Reserve Reversals into Income:
$115.2 million
($62.6 million from Ideon reserve, $37.7 million from
Cendant reserve, $5.4 million from Berkeley Reserve, $9.5
million from Spark Reserve)
Of the $115 million in total merger reserve reversals, about $108
million were taken into revenue or other income accounts and only about $7
million were credited against expenses. This ratio is consistent with the fact
that the
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quarterly 1997 topside adjustments, in overwhelming part, increased revenues as
opposed to reducing expenses.
Based upon the information available, the reversal of the reserves to
increase revenues and decrease certain expenses, and the transfer of such
reserves to subsidiaries as described above, was (1) not consistent with the
expressed purpose of the reserves; (2) not supported by adequate (or any)
documentation; and (3) not understandable in terms of accepted accounting
practices. In particular, it is difficult to envision any scenario whereby a
merger reserve could be appropriately reversed into revenues, as occurred with
most of the above reversals.
The above unsupported entries, which in the aggregate increased CUC's
pre-tax income by $115.2 million for the year ended December 31, 1997, require
reversal in the restated financial statements.
As discussed below, CUC also improperly utilized the Ideon and Cendant
reserves, as well as other reserves, in other ways that principally affected
(or were designed to affect) other financial periods, but which also had an
impact on the year ended December 31, 1997.
C. Improper Reversals of $59 Million of Merger Reserves (and Other
Liabilities) into Income at January 31, 1997
Improper reversals of merger reserves (and other accrued liabilities)
also took place at CUC at fiscal year-end 1997. In late February, 1997, CUC
reversed approximately $59 million of Ideon reserves and other balance sheet
liabilities into operating income for the fiscal year ended January 31, 1997,
without factual justification or support and without disclosure
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that it had done so. Approximately $51 million of previously established Ideon
reserves and approximately $8 million of other reserves and liabilities were
reversed into income. The details and mechanics of these reserve reversals are
described below.
1. Reversals of $35.2 million of Ideon Reserves to Decrease
Comp-U-Card Division Expenses
During the fourth quarter of CUC's fiscal year ended January 31, 1997,
by way of seventy seven (77) individual journal entries posted in late
February, 1997, but backdated as of November and December, 1996 and January,
1997, CUC reduced the Ideon reserve by $35.2 million. See Appendix Ex. 71.
These journal entries, which were recorded in Trumbull at the Comp-U-Card
division, also decreased expenses of Comp-U-Card by a like amount.
The methodology by which the $35 million in merger reversals in
February, 1997 was accomplished was similar to the methodology employed in
January, 1998 and described in detail above. That is, "post-close" or "P"
journal entries were prepared and posted to the general ledger for the fiscal
year just closed (i.e., the year ended January 31, 1997). The journal entries
directly increased Comp-U-Card division income by debiting (decreasing) the
Ideon reserve, and by crediting (decreasing) expenses. Unlike what was done in
January, 1998, all of the entries posted in February, 1997 increased income by
decreasing expenses, as opposed to increasing revenues. As discussed earlier,
this is consistent with the fact that the majority of the quarterly topside
entries to income in fiscal 1997 were to decrease expenses as opposed to
increasing revenues.
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On February 26, 1997, the entries were posted to the months of
November, December and January -- the fourth quarter of fiscal 1997 -- as
follows:
Nov-96 Dec-96 Jan-97 Total Q-4
------ ------ ------ ---------
$12,052,167 $13,111,453 $10,004,973 $35,168,593
Because $10 million of these unsupported entries were posted to the
month of January, this had the effect of increasing the 1997 calendar year
results of CUC (and Cendant) by $10 million as well as increasing the fiscal
1997 results of CUC (year ended January 31, 1997) by $35 million, and requires
restatement for both periods.
The journal entries were approved by Paul Hiznay, former Comp-U-Card
accounting manager. No documentation supporting these entries has been located.
Computer generated schedules which agree with the unsupported journal
entries have been located(129) in the hard drive of Pember's computer. Sabatino
provided the actual journal entries, which he said he located in files Hiznay
had kept in Trumbull.(130)
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(129) With the exception of "P" entry 223.
(130) Sabatino said that in preparing for his April 9, 1998 meeting with Scott
Forbes, he determined that there were $30,359,000 of adjustments made in
January, 1997 to CUC's financial statements. This number is reflected as
item "E" on the original landscape schedule he gave to Scott Forbes. See
Appendix Ex. 36. Sabatino told Forbes on April 9 (and reiterated to
counsel for the Audit Committee) that he believed those adjustments
related to reductions of the Ideon reserve, similar to the unsupported
adjustments made
(Footnote Continued)
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2. Reversals of $7.8 million of Ideon Reserves to
Decrease Welcome Wagon and NCCI Expenses
In February, 1997, Sattler prepared and recorded as of January 31,
1997 a journal entry in the amount of $7.79 million that had the effect of
reducing the Ideon reserve by that amount and transferring reserves to Welcome
Wagon ($5 million) and NCCI ($2.79 million) through the intercompany accounts.
See Appendix Ex. 72. No support has been found for this journal entry, which
Sattler said was of the same nature and character as the unsupported entries
recorded at calendar year-end 1997.
The $5 million was used by Welcome Wagon to decrease operating
expenses. Welcome Wagon debited the intercompany account and credited various
expense accounts, in a journal entry dated February 27, 1997 and posted with an
effective date of January 31, 1997. Appendix Ex. 73. The $5 million credit was
broken up into eight separate accounts.
The entry was booked by Lisa Plucinski, general ledger accountant for
Welcome Wagon, based on a verbal instruction she received from Kearney in
February, 1997. Plucinski said Kearney provided her with the accounts and the
amounts. See Appendix Ex. 74. She said the entry made her uncomfortable because
it was increasing Welcome Wagon's income $5 million and Welcome Wagon had a net
loss that year. She said she told Brenda Farnsworth,
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at calendar year-end 1997. Part of the $30.4 million adjustment
identified by Sabatino relates to improper
(Footnote Continued)
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Welcome Wagon's controller, about her discomfort with the entries, and that she
booked them only after Farnsworth spoke to someone in Corporate and then signed
off on the entries.(131)
No support has been found for the $5 million operating expense
reduction. Kearney said that he was directed by Corigliano to record these
expense credits to the particular accounts and in the specified amounts. He
said Corigliano's stated rationale was that these adjustments were required as
Welcome Wagon had incurred several costs relating to the Ideon merger that were
not in the ordinary course of business.(132)
As noted, $2.79 million of the Ideon reserve was transferred from the
Comp-U-Card division to NCCI via the intercompany account.(133) CUC recorded a
topside adjustment of $2.79 million, in the NCCI column, as a direct reduction
of marketing expenses on the consolidating income statement for January, 1997.
In the spreadsheet "cell" for NCCI there appears
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reductions of the Ideon reserve; the rest relates to other unsupported
entries discussed elsewhere in this Report.
(131) Farnsworth (now Breitenbach) said she had no recollection of the
transaction, nor could she recall Plucinski raising any concerns with her
about any transactions around that time.
(132) However, Welcome Wagon has no overlapping operations with Ideon, Sierra,
Davidson or Plextel and there is no reason merger reserves should have
been transferred to Welcome Wagon.
(133) As with Welcome Wagon, NCCI has no overlapping business operations with
Ideon, Sierra, Davidson or Plextel and there is no reason Ideon reserves
should have been transferred to NCCI.
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this $2.79 million expense reduction, along with expense amounts of $156,000
and $594,000, producing a net decrease in expenses of $2.04 million. This $2.04
million amount was then "pushed down" to NCCI, which recorded a journal entry
"per Mary Sattler" to debit intercompany and credit retained earnings. See
Appendix Ex. 75.(134)
Because the $7.79 million of unsupported expense reductions for
Welcome Wagon and NCCI were made to the January, 1997 financials of CUC, the
impact is to both fiscal 1997 of CUC and calendar 1997 of Cendant.
3. Reversal of $12.6 million of Ideon Reserve and Other Liabilities to
Decrease SafeCard Expenses
In January, 1997, Pember, who was then controller of Comp-U-Card,
directed Speaks, who was then controller of SafeCard in Cheyenne, to prepare an
analysis of potentially non-realizable assets and available accrued liability
accounts on SafeCard's books. Speaks then prepared a schedule entitled "Balance
Sheet Opportunities (Risks)" (see Appendix Ex. 76) which detailed numerous
unrealizable assets and accrued liability accounts as of January 31, 1997.
Speaks said the liability accounts were intended to be "cushion" to offset
income charges for asset writeoffs. Such unrealizable assets typically would
have been written off as SafeCard operating expenses when they became
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(134) Colleen Chaney, NCCI's controller, booked the entry but had no
recollection of it.
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unrealizable or to any available reserves established for that purpose.
Based on Speaks' analysis, Pember instructed him to reverse accrued
liability accounts totaling $5,655,008 and to increase SafeCard operating
income by $6,970,992 by reversing the Ideon reserve. Pember instructed Speaks
not to write off the unrealizable assets as of January, 1997. Speaks said
Pember wanted to write off the liabilities to enhance fiscal 1997 net income,
whereas writing off the unrealizable assets would have reduced fiscal 1997
income.
The resulting entries served to reduce SafeCard operating expenses by
$12,626,000, which were offset against the Ideon reserve on Comp-U-Card's books
and against accrued restructuring and other liabilities on SafeCard's books.
To accomplish this, the Ideon reserve was reduced (debited) by
$6,970,992 on Comp-U-Card's books and that amount was credited to intercompany
payable to SafeCard. The entry was approved by Hiznay and keyed into the
general ledger of Comp-U-Card on February 26, 1997. See Appendix Ex. 77.
Speaks then prepared a complex series of post-close journal entries on
February 27, 1997 that reduced various SafeCard operating expenses by $12.6
million and either increased intercompany receivable from CUC or reduced
accrued liabilities on SafeCard's balance sheet. Appendix Ex. 78. Speaks said
the
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amounts and accounts were arbitrary and no supporting documentation exists.(135)
The entries were:
a. Entries made on the Ideon-Jacksonville
general ledger system
Dr. Due from CUC $4,329,768
Dr. Accrued Liabilities $3,820,631
Cr. Operating Expenses $8,150,399
b. Entries made on the Ideon Marketing Services-
Jacksonville general ledger
Dr. Due from CUC $ 32,600
Dr. Accrued Liabilities $702,000
Cr. Operating Expenses $734,600
c. Entries made on the SafeCard-Cheyenne
general ledger
Dr. Due from CUC $1,933,855
Dr. Accrued Liabilities $1,132,377
Cr. Operating Expenses $3,066,232
d. Entries made on SafeCard Travel general ledger
Dr. Due from CUC $674,769
Cr. Operating Expenses $674,769
e. Total:
Dr. Due from CUC $6,970,992
Dr. Accrued Liabilities $5,655,008
Cr. Operating Expenses $12,626,000
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(135) Speaks said it is possible that some modest portion of the expenses did
relate to the Ideon merger, but that there was no analysis or
documentation to support this assumption.
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The above entries therefore improperly inflated CUC's fiscal 1997
operating income by $12.6 million.(136)
The assets which Speaks had identified as "risks" as of January 31,
1997 were eventually written off against the Cendant reserve, at year-end
December, 1997, at Pember's instruction. Speaks said these assets, which
totaled $2.2 million, were already unrealizable long before the merger (as
early as 1995 or 1996).(137)
4. Reversal of $2.2 million Plextel Reserve to
Decrease Comp-U-Card Expenses
CUC improperly utilized $2.2 million of a special Plextel merger
reserve to offset Comp-U-Card costs, thereby improperly increasing income. The
somewhat complex chain of entries that accomplished this is described below.
Plextel was acquired by CUC in January, 1997 in a transaction
accounted for as a pooling-of-interests. As disclosed in CUC's January 31, 1997
10-K, the prior period financial statements of CUC were not restated to include
the results of Plextel, due to immateriality.
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(136) Because the above unsupported entries were posted to the month of
January, 1997, they also affected Cendant's calendar 1997 results.
(137) In addition, another $5 million of SafeCard assets were written off
against the Cendant reserve at year-end December 31, 1997. These assets
were also impaired well before that merger.
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In connection with the acquisition, CUC paid Plextel's investment
advisor, Communications Equity Associates (CEA), a fee of $2.2 million. In
January, 1997 the payment to CEA was properly charged, via intercompany
accounts, against the $4.1 million portion of the Ideon reserve relating to the
acquisition of Plextel, as follows:
Comp-U-Card:
Dr. Interco Plextel $2,200,000
Cr. Cash $2,200,000
Dr. Ideon reserve $2,200,000
Cr. Interco Plextel $2,200,000
Although the $2.2 million payment had already been reserved for as
part of the Ideon reserve and was charged against that reserve, Plextel
recorded another reserve in the amount of $2.2 million in February, 1997, as
part of a $4.35 million charge to operations. Plextel was instructed to record
this transaction in a February 14, 1997 memorandum from Kearney, who at the
time was working in the CUC Corporate accounting department in Stamford. See
Appendix Ex. 79.
Kearney's memorandum instructed Plextel to record the $4.35 million
charge (including the $2.2 million reserve) "as of 10/31/96." The effect of
this was that the charge was recorded in Plextel's pre-acquisition financial
statements (not CUC's financial statements) and, because CUC's financials were
not restated for the Plextel acquisition, CUC never recognized the charge as a
reduction to net income in its income statement.
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Kearney said he prepared the February 14, 1997 memo based upon
instructions from Corigliano and Sabatino. Sabatino said that Corigliano knew
of and approved the accounting treatment of the transaction.
The reserve recorded by Plextel was transferred to Comp-U-Card through
the intercompany account, then utilized by Comp-U-Card, through post-close
entries, to reduce operating expenses in November, 1996 and January, 1997. The
entries that accomplished this were:
Plextel (Spark):
Dr. Acquisition Cost Reserve $2,200,000
Cr. Due to CUC $2,200,000
Comp-U-Card:
Nov-96
Dr. Interco Plextel $1,089,000
Cr. Catalog Expenses $1,089,000
Jan-97
Dr. Interco Plextel $1,111,000
Cr. Freight Variance Expense $388,000
Cr. Wats-Shopping Expense $723,000
No support exists for the journal entries (P179 and P180) which
recorded the reductions to Comp-U-Card operating expenses. There is no evidence
that these reserves were used to offset actual expenses. These entries were
prepared and approved by Hiznay.
Because $1.1 million of the expense reductions were posted to
November, 1996 and $1.1 million were posted to January,
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1997, the impact to fiscal 1997 was $2.2 million and the impact to calendar
1997 was $1.1 million.
5. Reversal of $1.1 million of Ideon Reserve
to Reduce Sierra Operating Expenses
On January 8, 1997, and effective December 31, 1996, Comp-U-Card
charged the Ideon reserve $1.1 million and transferred that amount, through an
intercompany payable, to Sierra to cover "integration" costs purportedly
incurred by Sierra in the period leading up to and subsequent to the
acquisition of Sierra by CUC. The journal entry that recorded this transfer was
made by Sattler based on a schedule of costs prepared by Michael Conway, former
accounting manager for Sierra, with input by Schapelhouman (neither of whom is
still with the company).(138) See Appendix Ex. 80. The costs consisted of
estimated internal professional costs, allocated directors and officers
insurance costs and estimated allocated personnel costs.
Sierra then used the intercompany transfer it had received from
Corporate to offset costs that previously had been charged to expense. The
expense reductions were booked to the month of October, 1996. See Appendix Ex.
81. This had the effect of reducing expense and increasing fiscal 1997 income
by $1.1 million.
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(138) The source of this information is Suki Hayre, an accountant at Sierra who
said she had no direct involvement in preparing the schedule but had
knowledge of its origin. She said that both Conway and Schapelhouman
discussed the matter with Kearney.
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The costs which were offset against the intercompany transfer do not
qualify as merger-related costs but instead represent normal operating costs.
Because these costs should not have been charged against the Ideon reserve, the
charge is being reversed as part of the Restatement.
6. Summary of Unsupported Merger Reserve
and Other Reversals into Income at Year-End 1997
All of the above items, which in the aggregate increased CUC's pretax
income and reduced the Ideon reserve and other liability accounts by
$58,916,000 for the year ended January 31, 1997, require reversal on the
restated financial statements. In addition, the impact to the month of January,
1997, and hence to the year ended December 31, 1997, is $31,531,973, which also
is being reversed as part of the Restatement.
D. Improper Reversals of $10.7 Million of Merger
Reserves into Income at January 31, 1996
CUC improperly reversed approximately $10.7 million of merger-related
reserves into income for the fiscal year-ended January 31, 1996.
1. Reversal of $6.3 million of CUC Europe and
Sentinel Purchase Reserves into Income
In March, 1995, CUC acquired two European companies, CUC Europe, a
former licensee of CUC, and Credit Card Sentinel ("Sentinel").
In May, 1995, Sabatino instructed Mark Maybrey, Financial Director and
CFO of the newly-acquired CUC Europe, to record purchase accounting reserves
for the CUC Europe and
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Sentinel acquisitions on the books of CUC Europe. Those reserves totaled $2.15
million for CUC Europe, and $3.97 million for Sentinel. Sabatino provided
Maybrey with a list of entries to be recorded on CUC Europe's books to
establish the reserves.
Maybrey said that he was never asked to estimate CUC Europe's costs
resulting from either of the acquisitions. However, he said that any costs that
were incurred by CUC Europe would have been minimal. Maybrey was under the
impression that a large part of the costs incurred as a result of the merger
were incurred by CUC Corporate, although he acknowledged that many of the costs
listed on the schedule provided to him by Sabatino were costs that would only
have been incurred by CUC Europe (integration costs, for example). Maybrey did
not discuss the establishment of that reserve with anyone else at CUC Europe.
He believes that he recorded the entries himself.
On February 23, 1996, Sabatino instructed Bill Avery, the President of
CUC Europe, to send $1,800,000 of the CUC Europe purchase reserve back to CUC
via the intercompany account. Appendix Ex. 82. Avery then informed Maybrey, who
then directed Nigel Field, a member of his accounting staff, to send the
balance of the CUC Europe purchase reserve to CUC via the intercompany account.
Field then instructed another accounting staff person to book that adjustment
on CUC Europe's general ledger.
After being told that the CUC Europe reserves should be transferred
back to CUC via an intercompany account, Maybrey asked Sabatino what he should
do with the purchase reserve
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account related to Sentinel. Maybrey was told that he also should send back the
balance of the Sentinel reserve to CUC via the intercompany account. Maybrey
then directed Field to send the Sentinel reserve back to CUC via the
intercompany account.
The balance of the CUC Europe and Sentinel purchase reserves were sent
to CUC on the same intercompany entry dated February 27, 1996. See Appendix Ex.
83. That intercompany entry totaled $6,192,000.
On February 27, 1996, the CUC Europe and Sentinel purchase reserves
were taken into income at CUC through four post-closing entries totaling $6.323
million by debiting the international intercompany account and crediting
various expense accounts.(139) Those journal entries were backdated to the
months ended November 30, 1995, December 31, 1995 and January 31, 1996.(140)
Sabatino said he had conversations with Corigliano regarding reversing
those reserves into income, but could not recall any specifics. He said he
would not have directed that it be done without Corigliano's approval.
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(139) The difference between the reserve balance returned to CUC Corporate and
the amount taken into income has not been reconciled.
(140) Two of the four journal entry forms -- P141 and P143 -- were located.
Those forms were prepared by Sattler and approved by Hiznay. Appendix Ex.
84. The other two entries were confirmed by a review of general ledger
activity in the account.
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2. Reversal of $2.3 million of
Welcome Wagon Purchase Reserves into Income
In connection with the acquisition of Welcome Wagon and Gifts
International, Inc. (collectively "Welcome Wagon"), CUC set up $3.4 million of
purchase reserves at February 1, 1995. In post-close journal entries prepared
in February, 1996 (but backdated to October, 1995 and January, 1996), Welcome
Wagon reversed $2.3 million of the purchase reserves into income. Revenues were
increased by $1 million ($500,000 each to two different revenue accounts), and
expenses were decreased by $1.3 million (seven different accounts). See
Appendix Ex. 85. Sabatino said there was no support for these entries. As the
reversal of the reserve occurred less than a year after the reserve was
established, the appropriate treatment would have been to credit goodwill
rather than income.141
3. Reversal of $2.1 million of Essex
Reserves into Income
In January, 1995, CUC acquired Essex, a private company. Prior to the
close of the transaction, Essex's Executive Vice President and Chief Operating
Officer, Tom Albright, had discussions with Corigliano and Bell about the need
for Essex to establish certain reserves, including for the potential loss of
Essex's bank clients who had the right to terminate their contracts with Essex
upon a change of control.
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(141) Neither Plucinski, who booked the entries, nor Breitenbach, who approved
them, had any recollection of the entries.
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A reserve of $1,290,000 was recorded in December, 1994 to cover potential
client cancellations, software integration costs, marketing expenses and other
items. Albright said he thought the reserve was somewhat excessive but that he
was comfortable with about $900,000 of the amount.
In connection with the acquisition, in January, 1995 a purchase
reserve of $570,000 also was established on Essex's books. Albright said this
figure was provided to Essex based on goodwill calculations performed by
Corigliano.
In November, 1995, Elisa Lanthier, Vice President and Controller of
Essex, received a telephone call from either Corigliano or Sabatino instructing
her to reverse (debit) $1.1 million of the reserve established in December,
1994 and to decrease (credit) operating expenses, effective to October, 1995.
By this time Essex already had submitted its October, 1995 reporting package to
Stamford. Lanthier was told not to submit a revised October reporting package
but instead to make sure that the entries were reflected in the November
package to be submitted the following month.
After Lanthier informed Albright of these instructions, Albright said
he called Corigliano to inquire as to the justification for the reversal of the
reserve into income. Albright said he told Corigliano the expense credits were
not a clean offset to the reserves since the expenses being credited were not
related. Albright said Corigliano acknowledged this to be true but told him not
to worry because the amount was immaterial to CUC's overall operations and
would be taken care of
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at CUC Corporate in some manner. Albright said he told Kevin Crowe, Essex's
chairman, that CUC Corporate wanted Essex to make some entries that Albright
thought were less than pristine accounting, and that Crowe told him that if
Corporate wanted it done he should do it. The entries were booked.
Albright said that in December, 1995, he and Crowe traveled to
Stamford to discuss their fiscal 1997 budget, and they met with Shelton,
Corigliano and Sabatino. The fiscal 1997 budget (for the year ended January 31,
1997) projected expenses much higher than those shown on Essex's year-to-date
fiscal 1996 financials, and Albright said Shelton asked for an explanation for
the variance. Albright then said that this was due to the $1.1 million entry
Corigliano had asked Essex to book. Albright said Corigliano acknowledged that
to be the case and there was no further discussion on the point. Shelton did
not recall any discussion about this item.
In January, 1996, Lanthier received a telephone call from either
Corigliano or Sabatino instructing her to reverse approximately another $1
million of reserves into income, including the balance remaining from the
$1,290,000 reserve as well as the balance of the purchase reserve and other
reserves Essex had previously established. Again the credit to be made was to
operating expenses. Again Albright called Corigliano and said this was not a
proper offset, which he said Corigliano acknowledged. Corigliano again said the
amount was immaterial to CUC and would be taken care of at Corporate. The
entries were booked.
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Albright said there was no basis for the reversal of the reserves into
operating income. He said the reserves were no longer needed at the time they
were reversed (Essex in fact lost no clients due to the merger). The credit
should have reduced goodwill rather than having increased operating income.
E. Other Information Pertaining To
Knowledge of Merger Reserve Reversals
The above sections describe what persons interviewed have said about
their role in the reversal of merger reserves and what they have stated about
the knowledge and participation of others. Certain additional information is
summarized below.
Sabatino said that in years prior to 1997, he periodically prepared a
schedule for Corigliano listing all of the reserves, generally purchase
reserves, that had been established at each subsidiary. The schedule would
contain a column listing the "excess" in each reserve.(142) Sabatino said that
at year-end Corigliano would review the schedule and determine which reserves
should be taken into income. Sabatino said that sometimes Kearney would be
present for these discussions.
Sabatino said that in late 1997 he prepared a document for Corigliano
listing various "reserves available" to be taken into income at year-end 1997.
See Appendix Ex. 44. The document (which bears handwriting identified by
Sabatino as that of
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(142) We have been unable to locate any copies of these schedules.
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Corigliano) listed the "reserves available" as including $67 million of items
relating to Ideon. Sabatino said he prepared this document because he,
Corigliano and Pember knew CUC was facing a shortfall of actual to reported
earnings and they wanted to review what reserves were available to be taken
into income at year-end. Sabatino said that he, Corigliano and Pember reviewed
the document in a meeting shortly before December 31.
Sattler said that there was a meeting in Pember's office sometime in
January, 1998 to discuss the year-end adjustments that needed to be made to
merger reserves. She said that Pember, Corigliano, Sabatino and herself were in
attendance. Sattler said there was a discussion of reversing the Ideon reserve
into income at the meeting, that Pember discussed the adjustments that were
being made and that Corigliano approved them.
Sabatino said that a meeting took place sometime after year end in
which he and Sattler were present, and Corigliano and Pember were talking about
what adjustments should be made, and where they should be made. Sabatino also
said that the Ideon reserve, and how much of that reserve was remaining, were
discussed at the meeting.
On January 14, 1998 -- two days before she gave Speaks handwritten
instructions to reverse portions of the Ideon and Cendant reserves into income
- -- Pember sent Shelton and Corigliano an e-mail in which she discussed, among
other things, the status of her work to date in consolidating the year-end
results. In the e-mail, Pember stated in part that "with the
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exception of our 'reserve' adjustments, Mary [Sattler] is virtually done
today." Appendix Ex. 86. Both Sattler and Sabatino received a copy of the
e-mail. They said they understood the "reserve adjustments" referred to in the
e-mail to be those made in January, 1998 to increase 1997 income, as described
earlier in this Section.
Shelton responded to Pember on January 15 with a short e-mail which he
said was intended to boost her morale and which did not mention "reserve
adjustments." Appendix Ex. 86. With respect to Pember's e-mail, Shelton said
that he did not know what "reserve adjustments" meant. He had not heard the
term, nor did he ask anyone about it.
Sattler said that around this time she was also given a schedule by
Pember detailing a number of entries Sattler needed to make in order to reverse
merger reserves into income. See Appendix Ex. 87. That document, taken from
Pember's computer and dated January 15, 1998, appears to summarize most if not
all of the entries made in January, 1998 to reverse the Ideon and Cendant
reserves into 1997 income.
Both Shelton and Walter Forbes specifically said they had no knowledge
of any Ideon reserves or Cendant reserves having been reversed into income.(143)
Shelton said he knew that standard
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(143) Forbes said that he knew CUC had reserves that were appropriately taken
back in, but said he was not referring to anything specific but only to
the concept that if it is determined that reserves are unused because
they are not needed, they are put back into the appropriate account. He
(Footnote Continued)
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adjustments were made to the membership cancellation reserve on a periodic
basis, but he did not know of any other reserve adjustments.
McLeod said that at the end of 1997 he spoke to either Corigliano or
Shelton or both about his concern that because of the shortfall at the Software
division, CUC might not meet its 1997 budget targets. He recalled again that
either Corigliano or Shelton or both said that CUC would be able to hit its
year-end targets because some other business units were performing better than
budget and because CUC had reversed some reserves that were no longer
needed.(144) Shelton recalled no such discussion.
Lipton, Fullmer and Hamilton(145) each said they had no knowledge of
any reversals of merger reserves into income, or any practice to that effect
within CUC.(146)
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added that he was not aware whether there were any such reserves that had
been established which were not fully utilized.
(144) McLeod, who is not an accountant, said his understanding is that a merger
reserve may be adjusted to reflect the fact that a contingency is no
longer expected, and the reversal flows through the income statement,
although he said he had no understanding as to whether the impact should
be to ordinary as opposed to extraordinary income or some other income
category.
(145) As noted earlier, Menchaca said the first time he heard of any use of
merger reserves to improve income was from Shelton, in early March, 1998.
(146) Many documents obtained from Pember's computer and other files appear on
their face relevant to the issues described in this Section, but could
not be discussed with her. See Appendix Ex. 88.
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IX. OTHER IMPROPER UTILIZATIONS OF MERGER RESERVES
In addition to reversing merger reserves into income as discussed
above, other improper utilizations of merger reserves occurred.(147)
A. Improper Utilization of Cendant Reserve
for Class Action Settlement Payments
As discussed earlier in this Report, the Hekker and Chambers class
actions were settled by CUC in October, 1997 for a total of $15 million,
subject to court approval (the "Chambers settlement"). As part of the same
settlement, the Binder class action was settled for $3 million, also subject to
court approval (the "Binder settlement").(148)
The $15 million Chambers settlement liability should have been
considered within the Ideon reserve in CUC's 1997 financial statements. The
expense was first recorded on February 24, 1998, when it was charged against
the Ideon reserve, even though the reserve had been all but depleted by that
time. See Appendix Ex. 89. In effect a negative reserve was temporarily
created, since there was no balance remaining in the
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(147) Unless otherwise noted, it has been concluded that the items in this
Section fall into the category of irregularities.
(148) As noted earlier, the original charge against the Ideon reserve for the
Binder settlement was reversed and a new escrow account was created which
resulted in an increase to the Ideon reserve from about $65 million to
$68 million; virtually the entire $68 million was then reversed,
inappropriately, into CUC's 1997 income statement.
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Ideon reserve against which to charge the amount. On January 29, 1998, the $3
million Binder class action received court approval. The Chambers settlement
was not approved until May, 1998.
On March 11, 1998, as a result of court approval of the Binder
settlement, the $3 million escrow account that had been created to hold the
settlement payment was reversed (credited), and the Cendant reserve was charged
(debited) for this $3 million, effective February, 1998. On March 10, the $15
million charge against the Ideon reserve for the Chambers settlement (which
created a negative reserve) was reclassified to the Cendant reserve.(149)
The effect of these entries was to charge the Cendant reserve, rather
than the Ideon reserve, for the settlement costs. These settlement costs were
originally components of the Ideon reserve, and were unrelated to the Cendant
merger. The costs of settlement of these class actions should have been charged
against the Ideon reserve.
B. Writeoff of $39.6 million of EPub Assets
Against the Cendant Reserve
At year-end 1997 CUC wrote off certain assets of EPub(150) totaling
$39.6 million and charged the writeoff against
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(149) The journal entry to accomplish this was prepared by Tolle, who said he
was acting on verbal instruction from Speaks or Pember. See Appendix Ex.
90.
(150) EPub is located in Troy, Michigan, and solicits restaurants, hotels,
retailers and other merchants to offer services and/or merchandise at
discount prices. EPub then sells
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the Cendant reserve. It has been concluded that only approximately $24 million
of these assets were impaired and should have been written off, although not
against the Cendant reserve. The remaining assets of approximately $16 million
are not impaired and have been reinstated to the balance sheet.
According to Sandy Berry, Controller of EPub, in late October or early
November of 1997, Pember instructed her to compile a list of EPub's deferred
and impaired assets as of September 30, 1997. Pember's explanation for this
request, according to Berry, was that Cendant would be changing to cash basis
accounting. Berry said that she understood that, because of this change,
deferred costs would now be written off. Pember also said that the Cendant
merger presented an opportunity for EPub to clean up its balance sheet and
write off impaired assets.
Berry compiled the list, which totaled $51,040,545. To compile this
list, Berry spoke to the heads of EPub's various divisions to see if they had
non-performing assets. Berry said that she was only given about 24 hours to
compile the list and thus did not conduct a thorough review. At some point
thereafter, Pember reduced the value of one of the assets that was listed as
impaired, Deferred Merchant Division, from $22,900,000 to $11,450,000 (and the
associated total decreased from $51 million to $39.6 million). Berry stated
that she had no
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discount memberships to consumers entitling them to coupons for discounts
at participating establishments.
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knowledge that these assets were being written off against the Cendant reserve.
In January, 1998, CUC Corporate recorded entries to transfer these
assets to CUC Corporate through the intercompany account and to write them off
against the Cendant reserve. Sattler, at Pember's direction, made the necessary
entries at CUC Corporate as part of the year-end consolidation.
By memorandum dated February 6, 1998, Pember instructed Berry to
record conforming entries on EPub's December 31, 1997 financial statements
(back-dated to September 30, 1997) to reflect the $39.6 million writeoff, and
she did so in February, 1998. See Appendix Ex. 91.(151) The entries recorded
were to debit the intercompany account with CUC Corporate by $39.6 million, and
credit (reduce) the various assets by a total amount of $39.6 million. (EPub
has the ability to open its computer systems and backdate entries.)
According to Berry, in January, 1998, Pember had also instructed her
to record entries on EPub's books to reverse the calendar 1997 fourth quarter
amortization expense associated with the assets that were written off. These
entries were recorded
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(151) This memorandum contained instructions to other subsidiaries to make
similar transfers of assets to Corporate through the intercompany
account. Attached to this exhibit are the assets to be written off by the
respective subsidiaries. Several of these writeoffs are discussed later
in this Section.
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and had the effect of increasing EPub's 1997 income by $11.7 million, which
resulted from the $39.6 million writeoff.
Berry stated that she informed Marion Roberge, Executive Vice
President of EPub, and Alan Bittker, President of EPub, of the writeoffs. Berry
said that their general response was to defer to what the people at CUC
Corporate wanted to do.(152)
During the December 31, 1997 audit, the following information was
provided to E&Y in the Cendant Reserve Memorandum:
As a result of the merger with HFS, Entertainment publications has the
opportunity to partner with Microsoft in a new role which has
significantly changed the methodology under which Entertainment
operates. The negotiations with Microsoft(153)
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(152) Roberge stated that, at some point prior to the completion of the Cendant
merger, Berry informed her of a request by Pember to compile a list of
assets that could be written off as a result of the merger. Roberge
understood that the assets being written off were impaired in some
respect. Roberge did not remember anyone telling her that the list was
due to a change to cash basis accounting. Roberge did not recall what the
assets were written off against.
Bittker said that, at some point prior to mid-February, 1998, Berry
contacted him and asked for certain information relating to impaired
assets. Bittker could not recall Berry or anyone else mentioning to him
that assets were going to be written off.
5 EPub and Microsoft had entered into a contract in April, 1997 pursuant to
which EPub's sales force sold advertising for Microsoft's interactive
yellow pages called Sidewalk. EPub was to be paid its costs plus a
certain percentage of the advertising revenues. In late 1997 and early
1998, there were discussions between EPub and Microsoft about expanding
this business relationship. Among the subjects discussed was a potential
joint venture in which services offered by CUC and HFS would be marketed
on the internet. These discussions never came to fruition.
(Footnote Continued)
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are the direct result of Entertainment now having access to the
consumer base of 100 million names which are available through the HFS
franchise businesses. As a result of this opportunity, various
deferred assets will not provide the future benefit originally
anticipated. Those deferred assets are now being written off, due to
the nature of the new development effort needed within Entertainment.
In addition, certain other assets have no future value within the
Cendant businesses. Detail schedule attached.
Appendix Ex. 24.(154)
Berry stated that in connection with preparing the entries in February
to write off the assets, she performed additional research that led her to
question whether all of the impaired assets were in fact impaired. Berry stated
that she did not press her questions at that time because she was under the
impression that E&Y had reviewed and signed off on the writeoffs and she was
not experienced in accounting issues pertaining to mergers.
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In June, 1998, Cendant entered into another agreement with Microsoft
similar to the one EPub entered into in early 1997. Under this contract,
Cendant will continue to sell advertising for Sidewalk. Microsoft has
also agreed in a separate Termination Agreement, dated June 5, 1998, to
pay Cendant approximately $9 million for costs EPub had incurred under
the original contract for which it was not paid.
(154) E&Y prepared a memorandum titled "EPub Explanations" which sets forth
written explanations for various of the items included in the $39.6
million EPub writeoff. Appendix Ex. 92. It contains a note stating that
all explanations were provided by Corigliano and Pember.
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In early March, 1998, Berry said she learned that EPub's expenses were
still being deferred, contrary to the explanation Pember had given her for the
writeoff of deferred assets. She eventually raised her concerns with Scott
Forbes in a memo dated April 20, 1998. Berry was then instructed to re-evaluate
the propriety of these writeoffs. She later determined that $13,688,000 of the
$39.6 million was incorrectly written off, and these amounts should be
reinstated on EPub's financial statements.
AA has reviewed the work performed by Berry and has concluded that $16
million of the $39.6 million of assets written off are not impaired and should
be reinstated to the balance sheet. AA has also concluded that although the
remaining $24 million of assets were impaired, it was inappropriate to write
off any of those assets against the Cendant reserve, since none of these assets
were impaired by the merger. Instead, the remaining $24 million of assets
should be written off to operating expense (decreasing income) in the
Restatement Period in the years in which they became impaired. Those writeoffs
are as follows: calendar 1997 $10 million; fiscal 1997 $8 million; fiscal 1996
$6 million.
In addition, approximately $6 million of fourth quarter calendar 1997
expense amortizations that were reversed -- relating to the $16 million of
unimpaired assets written off to be reinstated to the balance sheet -- should
be recorded as an additional operating expense in 1997.
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C. Charge Of $30 Million CNA Payment To Cendant Reserve
Through a contract with CNA, FISI sold to financial institutions
accidental death and dismemberment insurance policies issued by CNA. Under the
terms of this agreement, FISI and CNA shared the profits earned on the policies
FISI sold based on a formula set forth in the agreement.
In December, 1997, CNA and FISI entered into a new contract (the "new
CNA contract") under which FISI was to receive a larger percentage of the
profits earned on these policies. The change in profit-sharing percentage was
made retroactive to September 1, 1997, and was to continue until August 31,
2000.
See Appendix Ex. 93.
In connection with the new CNA contract, CUC agreed to pay CNA $30
million. This commitment was set forth in a letter dated December 23, 1997,
signed by Shelton on behalf of FISI (the "CNA Letter"). This letter stated:
We refer to the Contingent Commission Agreement between Continental
Casualty Company and the Continental Assurance Company and FISI
Madison Financial Corporation ("Agent"), effective September 1, 1986
(the "Agreement"). In consideration of the sum of Thirty Million
Dollars ($30,000,000), to be paid by the Agent to Continental Casualty
Company in immediately available funds on the date hereof, Continental
Casualty Company and Continental Assurance Company hereby agree that,
in connection with the merger of CUC International Inc. and HFS
Incorporated, the Agreement shall be terminated effective as of
December 31, 1997 (the "Termination Date") and that the accidental
death and dismemberment policies issued to the Financial Services
Association will be amended to provide for their continuous renewal
through December 31, 2000.
Appendix Ex. 94.
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Ken Keith, President of FISI, explained that the parties entered into
an arrangement whereby CUC agreed to pay $30 million up front in return for
which CNA agreed to a lower percentage of the profits that would be fixed for
three years. Keith said that it was expected that the adjusted profit sharing
percentage would provide FISI with an additional $11,350,000 in revenues each
year for a total benefit of approximately $34 million. CUC was thus paying $30
million up front to receive additional revenues of $34 million over three
years.
CUC paid CNA the $30 million on December 30, 1997. The $30 million
payment was charged against (debited to) the Cendant reserve, via the following
entries on Comp-U-Card's general ledger:
Dr. Due From BCI $30,000,000
Cr. Cash $30,000,000
Dr. Cendant Reserve $30,000,000
Cr. Due From BCI $30,000,000
Sattler said that Pember instructed her to have the entries made. No entries
were recorded on the books of BCI or FISI relating to this transaction.
The effect of this accounting treatment was to record the $30 million
cost of renegotiating the more favorable contract as a one-time merger charge
rather than as a prepaid asset (capitalized costs) that would be amortized as
an ordinary expense over the life of the contract.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
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In connection with the merger of HFS and CUC, the CNA contingent
commission agreement between Continental Assurance company and FISI
was terminated in consideration for the sum of $30 million as of
12/31/97....
Appendix Ex. 24.
According to Rabinowitz, E&Y was told by Corigliano that CUC was
terminating the prior CNA contract and ending its relationship with CNA.
Rabinowitz and Wood both said they had no understanding or awareness that the
contract was being renewed.(155) Rabinowitz said E&Y viewed the $30 million as
an exit payment properly chargeable to the merger.
Shelton negotiated and signed the new CNA contract and the CNA Letter.
He said he understood that the FISI/CNA relationship was to continue. Shelton
said that the idea to restructure the contract originated from an earlier
suggestion by Silverman that BCI purchase reinsurance to protect its
profit-sharing receivable and then charge the reinsurance to the merger
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(155) E&Y received the signed CNA Letter stating that the contract was being
renewed. See Appendix Ex. 95. E&Y had earlier received a draft of this
letter which did not contain the renewal language. Appendix Ex. 96. A
note placed by E&Y on this draft stated that "per Cosmo Corigliano and
Anne Pember, the above agreement was signed by both parties in the above
format [i.e., without the renewal language]." Wood recalled Corigliano
saying that Shelton had the signed copy and that E&Y would get the signed
copy later.
Wood said that when he initialed the final signed version, he assumed it
was the same as the draft version he had read earlier, and he did not
notice that new language had been added indicating a renewal of the
contract. Rabinowitz also said that when he initiated the final signed
version he did not realize it contained the renewal language.
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reserve. Shelton said that when it was concluded that the reinsurance could not
be charged to the merger reserve, Silverman asked him if the CNA contract could
be restructured. Shelton said that after Silverman went on vacation in
mid-December Monaco called him many times and told him they needed to get the
contract signed. Shelton believed that he sent a copy of the new CNA contract
to Corigliano or Monaco after it was signed, but could not recall with
certainty. He said he sent a copy of the CNA Letter to Monaco and Corigliano.
Monaco said that he understood that a new contract was being
negotiated with CNA that would provide new economics.(156) He said that he did
not receive a copy of the CNA Letter or the new CNA contract from Shelton. He
said he did not receive a copy of those documents until March or April,
1998.(157) Silverman said that Shelton had proposed a restructuring of the
arrangements with CNA and the matter was left with Shelton. He said the
determination as to whether any payment to CNA could be charged to the merger
reserve was a matter for the accountants.
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(156) Monaco said that E&Y concluded that the CNA payment was properly
chargeable to the Cendant reserve and he relied on this.
(157) Monaco said Scott Forbes received a copy of the new CNA contract from BCI
in March or April. Monaco said that when he and Scott Forbes reviewed the
contract they concluded that the $30 million fee did not qualify as a
merger-related cost and they reinstated that fee as a deferred asset. He
also said that he learned at that time that the effective date of the new
economic arrangements was September 1, 1997, rather than year-end.
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It was inappropriate to offset the $30 million payment against the
Cendant reserve. Instead, this payment should have been recorded on the books
of BCI or FISI as a pre-paid asset and then amortized as an expense over the
life of the contract ($10 million a year for three years). The entries that
should have been made on Comp-U-Card division's general ledger upon payment of
the $30 million were:
Dr. Due from BCI/FISI $30,000,000
Cr. Cash $30,000,000
BCI's or FISI's general ledger:
Dr. Prepaid expenses $30,000,000
Cr. Due to Comp-U-Card $30,000,000
The entry that should now be made as of December 31, 1997 on BCI's or
FISI's general ledger:
Dr. Operating expense $3,333,333
Cr. Prepaid expense $3,333,333(158)
The last entry reflects the portion of the $30 million that should have been,
but was not, amortized during the period September 1, 1997 through December 31,
1997.(159)
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(158) Shelton said he had understood that the amended contract would have a
positive effect of about $1 million a month in 1997.
(159) Effective March 31, 1998, FISI recorded $2.5 million in amortization
expense, which represents the quarterly amortization of the $30 million
prepaid asset.
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D. Writeoff of $3.7 Million of LTPC
Receivables Against Cendant Reserve
Long Term Preferred Care ("LTPC"), a wholly-owned subsidiary of FISI,
sells long term care insurance. In mid-1997, Terry Johnson, Controller of FISI,
determined that approximately $3.7 million of receivables on the books of LTPC
were uncollectible. According to Johnson, in January, 1998, Pember asked him
whether there were any amounts on FISI's December 31, 1997 balance sheet that
needed to be "cleaned up." Johnson brought to her attention the $3.7 million of
receivables. These receivables were written off against the Cendant reserve as
of December 31, 1997 via a consolidating journal entry.
Pember, in a memorandum dated February 6, 1998 (Appendix Ex. 91),
instructed Johnson to write off these receivables to the intercompany account
and Johnson did so at the request of Pember. In April, 1998 these receivables
were written off against the Cendant reserve.
There was no basis to write off these amounts to the Cendant reserve
because the impairment of the assets was unrelated to the merger. They should
have been recorded in LTPC's 1997 income statement as operating expense.
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E. Writeoff of $17.3 million of NLG
Goodwill Against Cendant Reserve
SafeCard acquired National Leisure Group ("NLG")(160) in January of
1995. Approximately $17.3 million of goodwill related to this acquisition was
written off against the Cendant reserve through a consolidating journal entry
at year-end December 31, 1997. This amount was an estimate.
By memorandum dated February 6, 1998, Pember instructed James Citro,
Director of Finance and Controller at NLG, to transfer the balance of the
goodwill asset as of December 31, 1997 to CUC Corporate through the
intercompany account. Appendix Ex. 91. Citro said Pember told him that CUC
Corporate would keep the asset on its books going forward. Citro said that
Pember did not tell him that this asset was going to be written off. On March
4, 1998, an entry was prepared on NLG's books having the following net effect:
Dr. Intercompany $16,631,220
Cr. Goodwill $16,631,220
In March, 1998, CUC Corporate wrote the asset off against the Cendant
reserve.(161)
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(160) Upon the acquisition of SafeCard by CUC pursuant to the Ideon merger, NLG
became a wholly-owned subsidiary of CUC and is now a wholly-owned
subsidiary of Cendant. NLG sells travel and tour-related packages.
(161) The entry was recorded at the direction of Sattler who was acting on
instruction of Pember.
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The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
Tour company [NLG] was acquired as a result of the Ideon acquisition
in 1996. After aggressive management of this business it has continued
to provide negative cash flows when fully allocated. The year ended
12/31/97 was the first full year of management by CUC. During that
time the company was 40% below anticipated results. In conjunction
with the evaluation of the combined Company's business objectives
during the 4th quarter of 1997, the tour operating business was
determined to be one which will be maintained for competitive purposes
without investment or a high degree of management's attention.
Therefore, based on management's decision to maintain only the basic
business for competitive purposes and the undiscounted cash flows
which are not expected to improve based on management's approach to
this business, this asset was determined to be impaired.
Appendix Ex. 24.
Among the documentation provided by Pember to E&Y was an undiscounted
cash flow analysis for NLG for the period December 31, 1998, through December
31, 2004, after corporate allocations. Appendix Ex. 97. Included in these
allocations was 10% of the projected costs for CUC's Management and Information
Systems ("MIS"). The amounts allocated to NLG were $2,735,000 for the year
ended December 31, 1997, $2,787,000 for the year ended December 31, 1998, and
$3,066,000 for the years ended December 31, 1999 through December 31, 2004.
Without these MIS allocations NLG would have been projected to generate a
positive
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cash flow of approximately $1 to $2 million per year during this
period.(162)
The management representation letter to E&Y dated February 3, 1998,
signed by Walter Forbes, Shelton, Corigliano, and Pember, states, in part:(163)
LONG-LIVED ASSETS, INCLUDING INTANGIBLE ASSETS
The Company has recorded a charge of approximately $.5 billion
(pre-tax) in connection with the Company's merger-of-equals with HFS
Incorporated ("Merger") consummated on December 17, 1997. Based on the
new opportunities that have presented themselves to the Company,
certain determinations have been made with respect to the future use
of resources. Specifically, it was determined that National Leisure
Group . . . would no longer receive the level of financial support
previously provided. . . . Based on these events, a review was
performed on the carrying value of the excess of cost over net assets
acquired for these entities. Such review determined that the expected
undiscounted future cash flows of each of these entities would not
recover their respective unamortized goodwill, and therefore, such
goodwill
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(162) Current accounting standards would require a comparison of undiscounted
projected cash flows to the amount of recorded goodwill to determine if
such goodwill was fully realizable, or if all or a part of such goodwill
should be written off. In the event that undiscounted projected cash
flows are less than the amount of recorded goodwill, a writeoff would be
required. Such writeoff would be equal to the amount by which discounted
projected cash flows were less than the amount of recorded goodwill.
(163) A letter to E&Y dated February 3, 1998, signed by Silverman, Monaco and
Scott Forbes, states:
We have read the representations to you in the letter from the
Company, dated February 3, 1998, and are not aware of any information
that would change such representations.
Appendix Ex. 98.
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was considered to be impaired and written off through the
aforementioned charge. The estimates of future cash flows were based
on management's assumptions and represent their best estimates of the
cash flows expected to result from the use of the assets. As a result
of the Merger, reviews on the carrying value of all other long-lived
assets, including intangible assets, were performed and similar
write-downs of such assets were made where a determination was made
that such assets were impaired.
Appendix Ex. 99.(164)
Citro stated that he was not apprised of the writeoff until after
April 15, 1998. In his view, the asset should not have been written off because
it was not impaired.
Citro and Scott Hancock, Senior Vice President for CUC Travel to whom
NLG reported, said that they had not seen the undiscounted cash flow analysis
provided to E&Y. Citro said he could not understand how Corporate could
allocate such a large amount of MIS costs to NLG. He explained that NLG has its
own computer system that operates on a stand-alone basis. Citro did say that,
for a five-month period in 1997, an MIS employee worked at NLG on their
computer system. Citro did not think that this justified the 10% MIS allocation
to NLG.
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(164) Shelton said that he knew from conversations with Menchaca that NLG was
not performing well or was not a good fit. In signing the management
representation letter, he consulted with Corigliano who told him the
representations were consistent with the facts. Walter Forbes said that
in signing management letters he relied on the advice of others in
management.
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It has been concluded that this asset is not impaired and should be
reinstated on the books of NLG.
F. Writeoff of $2.3 million of NLG
Computer Costs Against Cendant Reserve
Prior to CUC's acquisition of Ideon in August of 1996, NLG acquired a
computer system at a cost of approximately $2.5 million. NLG was originally
depreciating this system over five years. The net book value -- approximately
$2.3 million -- was written off against the Cendant reserve through a
consolidating journal entry at year-end 1997.
Citro said that the asset was originally written off in August, 1996
at the time Ideon acquired NLG. For reasons of which Citro was unaware, the
asset was reinstated on NLG's books in September, 1996. However, NLG did not
continue to depreciate the asset.
Citro stated that when he started at NLG in December 1996, he was told
by Pember and Hancock that this system was going to be written off against the
Ideon reserve as of January 31, 1997. Citro said the rationale for writing off
the asset was that Ideon had greatly overpaid for the system. Citro said that
the software system was worth, at most, $750,000. However, the asset was not
written off in connection with the year ended January 31, 1997.
In November, 1997, in connection with preparing NLG's budget, Citro
contacted Pember and Hancock and asked whether the asset was going to be
written off at year-end January 31, 1998. Citro said that he raised this issue
because he did not want to include depreciation amounts for this asset in the
1998 budget.
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Citro said that he would not be able to meet projections for 1998 if he had to
include depreciation of this asset in the budget. Both Pember and Hancock told
Citro that the asset would be written off at year end and he did not need to
include depreciation for this asset in the 1998 budget.
Hancock said that it was his understanding that the costs were to be
written off at CUC Corporate against the Cendant reserve, although he recalled
no further details.
Pursuant to the memorandum from Pember dated February 6, 1998,
(Appendix Ex. 91), Citro transferred the asset -- $2,329,282.30 -- to CUC
Corporate through the intercompany account. On March 6, 1998, CUC Corporate
wrote this asset off against the Cendant reserve.
Citro stated that at the time he transferred the asset through the
intercompany account, he understood that it was going to be written off in its
entirety, although he was not sure whether the writeoff was going to be offset
against the Cendant reserve. He said that it was inappropriate to write off the
asset in its entirety since it is still being used by NLG.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
This asset represents systems development costs previously
capitalized, for a system that was never implemented. During the 4th
quarter 1997, in conjunction with the reasons documented above
[decision to continue tour operating business without additional
investment] the decision was confirmed to abandon the new systems
currently being developed for NLG.
Appendix Ex. 24.
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It has been concluded that this asset is not impaired and should not
have been written off against the Cendant reserve. In light of this, the asset
should be reinstated on NLG's balance sheet and depreciated over its remaining
useful life. In addition, the depreciation expense for the period September,
1996 through December, 1997 should be recorded in NLG's income statement.
G. NLG Purchase Reserve Adjustments
As noted above, SafeCard acquired NLG in January, 1995. Part of the
purchase price consisted of shares of SafeCard common stock having an aggregate
market value of $1.4 million, which SafeCard agreed to deliver to the sellers
of NLG in February, 1998, three years from the date of the acquisition.(165) As
a result, a liability of $1.4 million was properly recorded on NLG's balance
sheet.
Subsequently a dispute arose between Ideon and the sellers concerning
the compensation owed the sellers under the acquisition agreement. This dispute
was settled in September, 1996, about a month after CUC acquired Ideon. Under
the settlement, shares of CUC stock, rather than SafeCard stock, were to be
delivered, with the number of shares to be based on the average closing price
of CUC stock for the 15 trading days ending
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(165) The number of shares was to be based on the average closing price of
SafeCard common stock for the 15 trading days ending three days before
the acquisition closed.
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three days prior to August 7, 1996. This price was $23.07, taking into account
a subsequent stock split. As the settlement locked in the number of the shares
to be delivered in February, 1998, each party was subject to the risk of
appreciation or depreciation in the share price.
As part of the settlement, CUC also agreed to make a contingent cash
payment of up to $1 million based on NLG's achievement of targeted levels of
net operating income.(166) This cash payment was to be made in October, 1997;
50% of it to the sellers of NLG and 50% to NLG employees.
On February 27, 1997, Speaks, at the direction of Pember, wrote off
the $1.4 million liability and credited (decreased) SafeCard expenses in the
same amount as of January 31, 1997. This entry was part of the series of
entries previously discussed, in Section VIII above, which served to decrease
SafeCard's fiscal 1997 expenses by $12.6 million. As there was no basis for
these entries, the $1.4 million liability should be reinstated on the balance
sheet and expenses for fiscal 1997 should be increased by the same amount.
As of February, 1998, when the stock was due to be delivered under the
settlement agreement, the market value of the CUC shares to be delivered was
approximately $2.17 million. Additionally, Corigliano informed CUC in-house
lawyer Peter
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(166) There was also a deferred cash component to the original deal.
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McGonagle that he had verbally agreed to pay the sellers in cash
as opposed to stock, to avoid transaction costs associated with the stock
transfer. In the end, CUC paid the sellers $2,169,484 in cash as opposed to the
$1.4 million in stock it had agreed to pay under the original acquisition
agreement; an additional $770,000.
On February 27, 1998, CUC offset the $2,169,484 payment against the
Cendant reserve. The entry recorded was:
Dr. Cendant reserve $2,169,484
Cr. Cash $2,169,484
It has been concluded that this payment should not have been charged
against the Cendant reserve. Instead, $770,000 (the difference between the
amount paid and the $1.4 million liability recorded) represents additional
purchase price, and should have been recorded as additional goodwill and
amortized as an expense in future periods.
Based on NLG's achievement of targeted levels of net operating income,
in October, 1997, CUC also paid $495,150 to the sellers and $495,153 to NLG
employees pursuant to the contingent consideration provision of the purchase
agreement. The $495,150 paid to the sellers of NLG was charged against the
Ideon reserve. The entry recorded effective October 31, 1997 was:
Dr. Ideon reserve $495,150
Cr. Cash $495,150
As these payments were based on the future profitability of NLG at the time of
the purchase, they constituted additional purchase
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price and should have been recorded as additional goodwill and amortized as an
expense in future periods.
The payment to NLG employees was also charged to the Ideon reserve.
The entry recorded was:
Dr. Ideon reserve $495,153
Cr. Cash $495,153
This payment should have been recorded as compensation expense in 1997 as it
was made to employees, not the sellers, and did not represent satisfaction of a
liability to the sellers.
In addition, in connection with the acquisition in January, 1995,
Ideon agreed to pay bonuses to certain employees who remained with the company.
The total amount of the bonuses were paid in three installments and amounted to
approximately $800,000. The first installment was paid in early 1996 prior to
CUC's acquisition of Ideon. The second payment in the amount of $266,667 was
made in February, 1997. CUC charged the payment made in February, 1997 against
the Ideon reserve. The entry recorded in February, 1997 by Sattler was:
Dr. Ideon reserve $266,667
Cr. Cash $266,667
This payment should not have been charged against the Ideon reserve.
Instead, it should have been recorded to the income statement in 1996 as
compensation expense.
In January, 1998, the remaining $266,667 was paid. CUC charged this
payment against the Cendant reserve. The entry recorded effective as of
January, 1998, was:
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Dr. Cendant reserve $266,667
Cr. Cash $266,667
This payment should not have been charged against the Cendant reserve.
Instead it should have been recorded to the income statement in 1997 as
compensation expense.
H. Writeoff of $3.2 Million of BCI Capitalized
Software Costs Against Cendant Reserve
In January, 1998, Pember informed Pedersen of BCI that, in connection
with the Cendant merger, CUC intended to write off the costs BCI had incurred
through December 31, 1997, for the development of its computer software
programs. These costs totaled $3,191,000. CUC wrote off this amount against the
Cendant reserve as of December 31, 1997 in a consolidating journal entry. The
entry recorded was:
Dr. Cendant Reserve $3,191,000
Cr. Due to BCI $3,191,000
At the direction of Sattler the entry was booked to the Comp-U-Card
March general ledger. Sattler stated that Pember had instructed her to record
these entries.
Pedersen and Peterson received a memo from Sattler dated April 6,
1998, detailing the entry that BCI needed to record on its balance sheet. The
entry was:
Dr. Intercompany CUC $3,191,000
Cr. Prepaid Computer Equipment $3,191,000
BCI recorded this entry in April, 1998 as of March 31, 1998.
The amount written off consists of a net book value of approximately
$476,000 related to computer software that BCI currently uses, and
approximately $2,715,000 relating to computer
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software that BCI is currently developing and plans to implement during 1998 or
1999. Pedersen stated that he did not think the writeoff was appropriate, since
BCI is still using the current software and plans to implement the software
under development. Peterson agreed that the software was still viable.(167)
Because the existing software is still in use, and BCI intends to
implement the software under development in 1998 or 1999, there was no basis to
write off the software costs. Accordingly, the costs associated with the
software have been reinstated on BCI's balance sheet.
I. Writeoff of $1.75 Million Breach of Contract
Settlement Against Cendant Reserve
In February, 1998, a breach of contract dispute with a former CUC
vendor was settled for $1,750,000. The settlement amount was charged to the
Cendant reserve. Veronica Miller, the Comp-U-Card staff accountant who prepared
the journal entry, does not recall who instructed her to record the charge
against the Cendant reserve.(168)
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(167) Pedersen stated that he had little experience with reserves and
restructurings, and that it was possible that Cendant might have had
certain plans for BCI that would render the software useless, although he
was not aware of such plans. Peterson said she understood that these
costs were being written off against reserves or handled in some other
manner.
(168) Menchaca said he was aware of the settlement but was not aware it was
charged to the Cendant reserve and did not know of any reason it should
have been so charged.
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As this breach of contract claim is not related to the Cendant merger,
it should not have been written off against the Cendant reserve. Instead, it
should have been recorded to the income statement in the first quarter of 1998
as a general and administrative expense.(169)
J. Writeoff of $3.75 Million of First Data
Corporation Goodwill Against Cendant Reserve
First Data Corporation ("FDC") entered into a contract with CUC in
1994 to provide credit card services to American Express customers. As of
August, 1996, CUC recorded an intangible asset of $4,092,896 in connection with
this contract. In May, 1997, American Express awarded the service contract to
another company, effectively ending the relationship and therefore impairing
the asset on the balance sheet.
The asset was charged against the Cendant reserve via a topside entry
as of December 31, 1997. In a memorandum dated February 6, 1998 (Appendix Ex.
91), Pember instructed Speaks to write off the December 31, 1997 balance of
this asset against the Cendant reserve. The entry prepared by Speaks on
February 10, 1998 wrote off the net goodwill of $3,749,320 against the Cendant
reserve.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
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(169) The information developed has not enabled a conclusion to be drawn as to
whether this matter constitutes an irregularity.
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Rights to market various services to First Data Corporation's (FDC)
underlying credit card issuers. In conjunction with the evaluation of
the combined Company's business objectives, Cendant is in the process
of discontinuing this loss program.
Appendix Ex. 24.
This asset should not have been written against the Cendant reserve
because its impairment was unrelated to the merger. It should have been written
off to operating expense in the second quarter of 1997, when the asset became
unrealizable.
K. Writeoff of Dining Out Tonight Club Goodwill
and Control Rights Against Cendant Reserve
In 1991, CUC Publishing, a subsidiary of CUC, acquired the assets of
Dining Out Tonight Club, Inc. and Dine Out Tonight Club Distribution
Corporation (collectively "DOTC"), a company that published and sold coupon
books with cards that provided two-for-one meals at local restaurants. In
connection with the acquisition, CUC established goodwill of $934,134 and
contract rights of $4,433,371.
Until 1996, the coupon books were marketed directly in approximately
nine cities. During 1996, the marketing of the DOTC program was transferred to
EPub, at which time the program was changed and was offered in only a few
cities. By July, 1996, DOTC's product line ceased to exist.
Effective December 31, 1997, a topside journal entry was recorded to
write off $700,000 of the DOTC assets. In a memorandum dated February 6, 1998
(Appendix Ex. 91) Pember instructed Speaks to write off the balance of the
goodwill and contract rights. She also sent him a list of proposed journal
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entries that included a writeoff of this asset against the Cendant reserve. On
February 10, 1998, he prepared the journal entry to write these assets off in
the general ledger. Appendix Ex. 100. The entry credited the DOTC goodwill and
contract rights and debited the corresponding accumulated amortization
accounts, resulting in a net charge of $1,374,616 against the Cendant reserve.
Speaks said that he was unfamiliar with these assets, but wrote them off on
Pember's instructions.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
Small business acquired which contract rights will not be providing
value within the strategic direction of Cendant.
Appendix Ex. 24.
There was no basis to write off these assets against the Cendant
reserve. Rather the writeoff should have been recorded in CUC's income
statement as an operating expense in the period the assets became unrealizable,
which was the second quarter of 1996, when DOTC's programs changed and were
folded into EPub's operations.
L. Writeoff of $2.5 Million of Time Warner
Joint Venture Against Cendant Reserve
CUC entered into a joint venture agreement with Time Warner Cable in
1995 to test interactive cable television shopping. This program was
test-marketed in Orlando, Florida beginning in December, 1995. The project was
abandoned in December, 1996. CUC recorded an asset relating to this joint
venture which increased over time and which was $2,479,827 as of December 31,
1997. This amount represented costs CUC had
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incurred in connection with the joint venture. This amount was written off
through a consolidating journal entry as of December 31, 1997.
In February, 1998, pursuant to the February 6, 1998 Pember e-mail
(Appendix Ex. 91), Speaks prepared a journal entry to write off this asset
against the Cendant reserve. Speaks recorded the writeoff on February 10, 1998.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
This joint venture will be discontinued within the Cendant business
plans. Therefore all deferred costs are written off due to no future
revenue generation.
Appendix Ex. 24.
This program was abandoned and the asset was unrealizable no later
than December, 1996. There was no basis to write off this asset against the
Cendant reserve. It should have been recorded in CUC's income statement as an
operating expense in the fourth quarter of 1996, when it was no longer
realizable.
M. Charging of Walter Forbes'
Plane Expenses to Cendant Reserve
At its September 9, 1997 meeting, the Compensation Committee approved
the reimbursement of private plane charges of $596,881 for 1995 and 1996
submitted by Walter Forbes.
Walter Forbes signed an expense report for those costs, and
reimbursement was then made. The report is dated September 30, 1997. See
Appendix Ex. 101. The amount was charged against the Cendant reserve. At that
time, Shelton was the corporate officer who generally signed Walter Forbes'
expense reports. Shelton signed the report for the plane charges and wrote
"charge
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to merger reserve" on the expense report. Shelton could not explain how 1995
and 1996 plane expenses related to the Cendant reserve, and said that
Corigliano told him to charge it to that reserve. Shelton did not ask
Corigliano why that payment should be charged to the Cendant reserve. Shelton
said that he did not speak to Walter Forbes about charging those costs to the
Cendant reserve. Walter Forbes said that the notation "charge to merger
reserve" was not on the form when he signed it, and he did not learn that it
had been charged to the Cendant reserve until approximately April, 1998.
Menchaca identified the second approval signature on the form as his.
He said Shelton brought the form to him and said that a second signature was
needed but that Menchaca did not have to review anything relating to the
expenses because Shelton had already done so. Menchaca said the signatures of
Shelton and Walter Forbes were already on the form when he signed it. Menchaca
said he was virtually certain that when he signed the form, it did not have the
note indicating the expenses were to be charged to the merger reserve.
Based on the time period during which these charges were incurred,
this expense does not relate to the Cendant merger and therefore should not
have been charged against the Cendant reserve. Instead, it should have been
recorded in CUC's income
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statement as a general and administrative expense in the fourth quarter of
1997.(170)
N. Software Upgrade Charged to Cendant Reserve
During 1997, CUC hired a third party consultant, Epsilon, to install a
new analytical marketing software system to accommodate Cendant's new, larger
customer base. Upon completion of the installation, the customer marketing
division of Comp-U-Card will use the new system to analyze past customers'
activity for potential future marketing efforts. The Cendant reserve was
charged $2 million for this project.
The following explanation was provided to E&Y in the Cendant Reserve
Memorandum:
The database structure within Cendant membership services was
inadequate to support the volume of processes necessary to manage the
new list processing. The existing systems were eliminated and third
party consultants have been paid through 12/31/97 to upgrade the
systems.
Appendix Ex. 24.
Speaks said that the project will provide future benefits and the
system needed to be upgraded regardless of the merger; in addition, he is aware
of no software systems retired or to be retired. Accordingly, the costs should
have been capitalized and not charged to the Cendant reserve. The costs
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(170) This investigation has not addressed whether or not the expenses were
appropriately reimbursed, which is under separate investigation.
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are now being treated as construction-in-progress and will be depreciated over
the estimated useful life of the system when the installation is complete.
O. Essex Severance Expenses Charged to Cendant Reserve
In October, 1997, Essex Corporation, a subsidiary of CUC, underwent a
corporate restructuring.
Effective December, 1997, at the request of Pember, Elisa Lanthier,
Controller of Essex, recorded $458,132 in accrued severance to CUC Corporate
through the intercompany account in January, 1998. These charges consisted of a
$350,910 severance payment to Gerald Cunningham, Essex's then President, and
$107,222 for severance payments to be made to various individuals who were to
be terminated. The individuals were notified of their termination in January,
1998. The entry recorded on Essex's books on January 9, 1998 was debit
intercompany $458,132; credit various accruals. On January 13, 1998, CUC
Corporate wrote off this amount against the Cendant reserve as of December 31,
1997. The entry recorded on CUC's books was debit Cendant reserve $458,132;
credit intercompany $458,132.
It was improper to accrue the $350,910 severance payment made to
Cunningham as a restructuring charge, since, according to Lanthier,
Cunningham's termination from Essex was not related to the restructuring.
Instead, this amount should have been recorded in Essex's 1997 income statement
as a payroll-related cost.
The remaining $107,222 was related to the restructuring, but not the
Cendant merger. The restructuring
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charge should not have been accrued in 1997, because the departing employees
were not notified of their termination until January 30, 1998.(171)
P. Writeoff of Robinson, Lerer Expenses to Cendant Reserve
The strategic communications firm of Robinson, Lerer & Montgomery
("Robinson, Lerer") provided public relations services to CUC. During 1997,
Robinson, Lerer performed a substantial amount of work for CUC in connection
with the Cendant merger. Robinson, Lerer entered into a retainer agreement with
Cendant on or about January 23, 1998 under which it agreed to provide services
to Cendant during 1998 for a fee of $300,000. Hamilton signed the retainer
agreement on behalf of Cendant. Robinson, Lerer sent Cendant an invoice for the
$300,000 in February, 1998, which was paid in March and charged against the
Cendant reserve.
Hamilton said that she had a conversation with Silverman in December,
1997 or January, 1998 in which he told her to pay Robinson, Lerer up front and
charge that amount to the Cendant reserve. Cindy Hodnett, then the Manager of
Investment Relations at Cendant who reported to Hamilton, received the
Robinson, Lerer invoice in February. Approximately one week before she received
the invoice, Hodnett said she was told by
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(171) These costs could have been classified in the financial statements as
part of the line item that includes "Merger related costs and other
unusual charges", if notification had occurred in 1997.
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Hamilton that she would be receiving it and that Silverman had instructed that
this amount be charged against the Cendant reserve. Silverman denies that he
instructed Hamilton to charge the Robinson, Lerer retainer fee to the Cendant
reserve. In fact, he said that he told Hamilton that he did not want Cendant to
have retainer agreements with any public relations firms.
The retainer fees should not have been charged to the Cendant reserve.
Instead, those costs should have been accounted for as prepaid costs and
charged to Cendant's income statement as Robinson, Lerer rendered its
services.(172)
Q. Retained Earnings Shortfall Charged to Cendant Reserve
Sattler stated that for the year-ended December 31, 1997, retained
earnings as reflected on CUC's books were understated by $388,000. In order to
correct this, Sattler debited the Cendant reserve $388,000 and credited that
amount to retained earnings in a topside entry impacting the year ended
December 31, 1997. In a memo dated April 7, 1998, Sattler sent Tolle a list of
journal entries to post to the month of March, 1998, which included the
$388,000 credit to retained earnings. Appendix Ex. 102. The entry recorded in
the general ledger was debit Cendant reserve, credit retained earnings.
This entry was improper because the shortfall in retained earnings was
unrelated to the merger. The income
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(172) The information obtained has not enabled a conclusion to be drawn as to
whether this matter constitutes an irregularity.
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statement should be debited $388,000 and the Cendant reserve should be credited
that amount.
R. E&Y Audit Fees Charged to Cendant Reserve
On March 16, 1998, E&Y sent Corigliano a bill for $250,000 for
"professional services rendered in connection with the audit of consolidated
financial statements of Cendant Membership Services for the year ended December
31, 1997." On March 20, Cendant paid E&Y $750,000, including the $250,000
related to the regular audit of CMS. The $250,000 was charged against the
Cendant reserve. The bill approval form, dated March 18, 1998, which appears to
have been approved by Corigliano, states that that amount should be charged
against the Cendant reserve. Appendix Ex. 103. It is unknown who wrote the
Cendant reserve account number on the bill approval form or who authorized this
amount to be charged to the Cendant reserve.
The audit fees relating to the regular year-end audit should not have
been charged against the Cendant reserve because they were not related to the
merger. Instead, they should have been recorded in the 1997 income statement as
general and administrative expenses.(173)
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(173) The information obtained has not permitted a conclusion to be drawn as to
whether this matter constitutes an irregularity.
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X. IRREGULARITIES IN CONNECTION WITH REVENUE RECOGNITION
A. The Stated Policy of the Company
CUC's stated policy for revenue recognition with respect to membership
products was to match revenues with related expenses. The significant
accounting policy footnote to the consolidated financial statements of CUC (and
Cendant following the merger) stated the following:
Membership fees . . . are recorded as deferred membership income upon
acceptance of membership, net of estimated cancellations, and
pro-rated over the membership period.
Membership acquisition costs are deferred and charged to operations as
membership fees are recognized. Such costs are amortized on a
straight-line basis as revenues are realized over the average
membership period (generally one to three years) (emphasis added).
Each month, the Comp-U-Card division(174) records revenue on its
general ledger for those customers who have requested to participate in one of
its membership programs. This occurs either when a customer joins a program for
the first time or when an existing member renews.
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(174) The discussion in this Section relates to the membership products within
the Comp-U-Card division. As part of its review of other subsidiaries AA
reviewed the revenue recognition practices of those subsidiaries. As no
irregularities were found, this Report does not separately address those
practices. Nonetheless the Company has determined to change certain of
the revenue recognition practices of certain subsidiaries and to correct
for the prior effect of those changes in the Restatement.
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For first time members, Comp-U-Card typically will offer a trial
period ranging from one-to-three months. During the trial period, the member is
entitled to all services normally provided by the program but is not actually
billed (i.e., the customer's credit card is not charged) until the trial period
ends and the customer has elected not to cancel.(175) Comp-U-Card offers members
full money-back refunds at any point during the membership period.
B. General Practices and Systems
Although the stated policy was to recognize all membership fees
ratably over the membership period, in practice there were some programs, such
as Privacy Guard and Dining, where Comp-U-Card recognized all the revenues on
an immediate basis at the time the member joined. Approximately 21% of
Comp-U-Card's total membership revenues in 1997 were derived from such
immediate recognition programs, excluding the effect of the "Allocations"
discussed below.
For other programs (e.g., Shopping, Auto, Travel), which supplied the
majority of its revenues, Comp-U-Card deferred the revenues and recognized them
ratably over the life of the program, including the trial period. For example,
for a 12-month membership program with a three-month trial period, Comp-U-Card
would recognize revenue ratably over a 15-month period (including
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(175) Certain programs do not offer trial periods, primarily those marketed
through the SafeCard division in Cheyenne, Wyoming.
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the first three months). At the time Comp-U-Card first records revenue it also
would record estimates of the amount of revenue that ultimately will not be
billed or will be refunded based upon the number of people expected to cancel
in the trial period and in the membership period. The revenues actually booked
to the general ledger are net of these "cancellation reserves."
The Comp-U-Card division maintains its general ledger system on a
modified cash basis. This modified cash basis general ledger recognizes all
revenue as soon as a member joins(176) (even if not yet billed) and recognizes
the expenses concurrently using a standard cost system. In order to convert the
modified cash basis revenues and expenses reflected on the general ledger to an
accrual basis -- and to recognize and defer the revenues/expenses in accordance
with the stated policy -- CUC utilized what it called the "Projection Model."
See Appendix Ex. 104. Through the Projection Model (an Excel spreadsheet) CUC
determined the amount of income and expense that would be recognized each month
and over the course of the year. Each month, accounting personnel in Trumbull
would extract the revenues and expenses by program from the general ledger and
manually key them into the spreadsheet. Data from the spreadsheet was used to
create amortization "grids," which
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(176) A member is considered to have "joined" as soon as he or she enters CUC's
membership database system, e.g., through positive response to a verbal
or electronic solicitation or by mailing in a coupon solicitation.
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<PAGE>
calculated the accrual adjustments necessary to convert the revenues and
expenses from a modified cash to accrual basis. In calculating the accruals,
the revenues and expenses automatically would be amortized into different
periods, depending on the particular program and the period of time over which
revenues and expenses for that program were recognized. The grids thereby
produced adjustments necessary to report earnings (revenues less expenses) in
accordance with GAAP.
The Trumbull accounting personnel would forward to CUC Corporate in
Stamford (generally Sattler) the accrual adjustments that were calculated from
the grids, and each quarter Sattler would make a topside adjustment to the
Comp-U-Card column in her consolidating reports to reflect this calculation.
The accrual adjustments eventually were recorded on the Comp-U-Card general
ledger in Trumbull.
C. Specific Comp-U-Card Revenue Recognition Practices
Comp-U-Card engaged in certain practices which were inconsistent with
the company's stated policy. Taken together, these practices resulted in a
mismatching of revenues and expenses and the premature recognition of income
during the Restatement Period.
1. Deferral of Expenses in Programs
that Recognized Revenue Immediately
From at least 1995 through 1997, CUC deferred certain expenses in
those Comp-U-Card programs where it recognized
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revenues immediately for new membership joins.(177) This practice resulted in
the recognition of expenses for such programs over a more extended period of
time than that over which revenues were recognized, thus producing an
overstatement of earnings in the periods when this practice was applied.(178)
The following chart shows the revenue and expense recognition policy
for programs in which recognition of new membership revenues and expenses
failed to "match":
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------
Program Revenue Expense Recognition(179)
(New Membership) Recognition
- ------------------------------------------------------------------------------
<S> <C> <C>
Dining Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Buyers Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Privacy Guard Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Health Saver Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Creditline Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Merchandise Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
Software Club Immediate Deferred over 12 months
- ------------------------------------------------------------------------------
</TABLE>
- --------------
(177) For renewal as opposed to new memberships on these immediate revenue
recognition programs, expenses were recognized immediately.
(178) We have not determined if such practice took place prior to 1995.
(179) In addition to the deferral of costs, amortization of these costs are on
a one-month lag.
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<PAGE>
Speaks said that notwithstanding this mis-matching, he was told by
Pember that revenue and expense accruals historically more or less matched on a
weighted average basis (i.e., in any given year, approximately 12 months of
revenues and 12 months of expenses were recognized). He understood that this
resulted from the fact that while revenues for some programs were recognized
immediately, in other cases expenses were actually recognized more quickly than
revenues (e.g., for some programs where revenues were recognized ratably over
15 months, expenses were recognized over 12 months).(180) Speaks was told by
Pember that E&Y was satisfied with this policy.
Rabinowitz of E&Y said he understood Comp-U-Card's policy was to
amortize revenues generally over the life of the membership, and expenses on a
weighted average basis over the life of the membership. He was aware that
certain programs such as Privacy Guard, Warranty and Health recognized revenue
for new members on an immediate basis, and that Comp-U-Card did not recognize
new solicitation expenses immediately on these
- --------------
(180) Until October, 1996, for 36-month programs, Comp-U-Card recognized the
revenue over 36 months and the expenses over 12 months. However,
following the merger in 1996 with Ideon, Comp-U-Card changed its policy
to recognize expenses for 36-month programs over 36 months (there was a
period from October, 1996 to December, 1997 where revenue was recognized
over 39 months).
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<PAGE>
programs.(181) He said he understood that overall, on a weighted average basis,
there was a matching of expenses and revenues.
Speaks said that in mid-1997 Pember asked him to perform an analysis
to determine the extent to which recognition of revenues and expenses actually
matched. He said Pember explained that this type of study was something that
E&Y had asked for in past audits (although not during the January 31, 1997
audit). Speaks performed various analyses between mid-1997 and early 1998,
which he described as very rough and approximate, showing that revenues were
being recognized approximately over a period of 11 months relative to 12 months
of expense recognition (i.e., revenues were recognized more quickly). His
analyses showed what he called "exposure" of about $21 million in fiscal 1998
and $42 million projected in calendar 1998, meaning that Comp-U-Card should
have been recognizing that amount of additional expense in the year in
question. Speaks said that Pember had given him analyses from prior years
(fiscal 1995 and fiscal 1996) showing exposure of only $7-$8 million per year.
Speaks viewed the results of his analyses as potentially troublesome
and said he brought them to the attention of Pember both in mid-1997 and in
early 1998. See, e.g., Appendix Ex. 105. According to Speaks, Pember said she
would
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(181) Speaks said this was clear, in any event, from the amortization grids
given to E&Y, since the new solicitation expense grids included expenses
for all programs, including the immediate revenue recognition programs.
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<PAGE>
talk to Corigliano, but Speaks said he never heard anything that transpired
between them.(182)
2. Reclassification of Revenue from Deferred
Programs to Immediate Recognition Programs
In the years 1995 through 1997, Comp-U-Card also improperly
transferred or reallocated revenue amounts from the deferred revenue
recognition programs to the immediate revenue recognition programs, resulting
in the improper acceleration of revenue recognition and non-compliance with
both the company's stated policy and GAAP.(183)
This revenue "shifting" occurred from eight different deferral revenue
programs into five different immediate revenue recognition programs:
- --------------
(182) Speaks said E&Y did not ask to see an analysis as part of its audit for
the year-ended December 31, 1997.
(183) This practice appears to have begun in August, 1994.
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<PAGE>
Programs From Which Programs To Which
Revenues Were Shifted Revenues Were Shifted
- --------------------- ---------------------
Travel (revenue recognized over Buyers (revenue recognized immediately)
12-15 months)
Shopping (revenue recognized Dining (revenue recognized immediately)
over 12-15 months)
Auto (revenue recognized over Privacy Guard (revenue recognized
12-15 months) immediately)
Hotline 36 (revenue recognized Health & Pet (revenue recognized
over 36 or 39 months) immediately)
FeeCard (revenue recognized Creditline (revenue recognized
over 12 months) immediately)
CCP (revenue recognized over 36
months)
Home (revenue recognized over
12-15 months)
Netmarket (revenue recognized
over 12-15 months)
The Projection Model illustrates these revenue shifts in a column
labeled "Allocation." See, e.g., Appendix Ex. 104.
Speaks said the reallocations were arbitrary and were directed by
Pember. He said the practice was followed before he joined the company and that
the pattern of reallocations from year to year was roughly the same. That is,
at the beginning of the year, the Projection Model would be programmed to
automatically reallocate revenues, in certain months and in certain amounts,
from deferred revenue recognition to immediate revenue recognition products. It
was also possible to manually reclassify revenues from one product to another
in the Projection Model.
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<PAGE>
Once revenues were reallocated to the immediate revenue grid, they
would automatically become part of the normal accrual adjustment calculated by
the amortization grids. The accrual adjustment, as noted above, would then be
sent to Stamford where Sattler would include it as one of the quarterly
adjustments in consolidation.
Speaks said that at a meeting with Corigliano and Pember in mid-1997,
he questioned why the reallocations were done. Corigliano told him that they
were done in order to achieve a matching of revenues with expenses. Speaks said
he did not speak with Menchaca about the reallocation practice.
Beginning in October, 1997, Loraine Orban ("Orban"), manager of
reporting and analysis for Comp-U-Card, assumed responsibility for the
preparation of the grids which produced the accrual adjustments. She said that
she assumed responsibility for the grids from Hiznay.(184) By the time Orban
assumed responsibility for the grids, a number of transfers among programs had
already occurred. She did not know who authorized these transfers or who
implemented them. Orban indicated that upon learning of the policy of
transferring amounts between programs she became uncomfortable with the concept
and asked Speaks about them. Speaks indicated that it was an issue of
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(184) Speaks believes that Pember oversaw preparation of the revenue and
expense grids for the years 1995 and 1996 and a portion of 1997. We have
not been able otherwise to confirm this fact.
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<PAGE>
company policy. Orban did not question Speaks any further on the issue.
Shortly after the Comp-U-Card budget for December 31, 1998 was
finalized around Thanksgiving, 1997, Speaks said he presented Corigliano and
Pember with a document he had prepared to illustrate the impact of the
reallocations. See Appendix Ex. 106. The document showed there was already an
increase in the amount of revenue recognized immediately because Privacy Guard
was ramping up. Specifically, the document showed that 27.5% of membership
revenues would be recognized immediately for the 12 months ending January 31,
1998, including the impact of $41.1 million in reallocations programmed into
the Projection Model as of October 31, 1997. The document further showed that
if the same reallocation pattern was followed in calendar 1998, the percentage
of immediate revenue would increase to 29%. Speaks said he recommended to
Corigliano and Pember that the reallocations be stopped and reversed, but that
they did not respond. Speaks said he had no further discussions with Corigliano
about reallocations.
For the 12 months ended December 31, 1997, Comp-U-Card reallocated
$58.1 million in revenues from deferred to immediate recognition programs, with
the majority of reallocations ($47,850,000) taking place in the fourth calendar
quarter. Of these fourth quarter adjustments, $6.5 million were made manually
to the Projection Model by Speaks, pursuant to the instructions he received
from Pember on January 16, 1998 (these were part of the same handwritten
instructions to reverse merger reserves
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<PAGE>
discussed earlier in this Report). Appendix Ex. 54. The reallocations
contributed to Comp-U-Card recognizing about 30% of its membership revenues in
calendar 1997 on an immediate basis.(185)
E&Y was not given the Projection Models which showed the reallocations
from deferred to immediate programs. Speaks said that E&Y did not get the
Projection Model. Speaks said that Kearney and Pember told him not to give the
Projection Model to E&Y.(186)
Rabinowitz and Wood said they were not aware that Comp-U-Card
reallocated revenues from one program to another, i.e., from deferred to
immediate.
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(185) As part of these same instructions, Speaks also manually transferred $3
million of renewal solicitation costs ($1 million and $2 million in
November and December, 1997, respectively), from immediate programs to
deferred programs within the Projection Model.
(186) An e-mail dated March 11, 1997 from Kearney, who was then in CUC
Corporate, to Pember states that:
Quarterly we give E&Y both revenue grids that are deferred, both cost
[expense] grids that are deferred, and that is it. They NEVER get the
immediate revenue grid.
See Appendix Ex. 107. Speaks could not explain what was meant by this,
and Kearney was not available to be questioned about it.
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<PAGE>
3. Delay of Expenses
From 1995 through 1997, the start of amortization of certain expenses
related to programs with deferred revenue recognition was delayed one
month.(187) For example, for a typical 12-month membership program with a
three-month trial period, Comp-U-Card would begin recognizing revenues in the
first month (then ratably over a 15-month period), and would not begin
recognizing the expenses until the second month (and then ratably over a
12-month period).(188) Although all expenses for such programs would be
recognized over a period of 13 months whereas revenues would be recognized over
15 months, this one-month delay was not in accordance with the company's stated
policy.
D. Conclusions Regarding CUC's Revenue
Recognition Practices
A proper revenue and expense recognition policy under GAAP should
achieve a matching of revenue and expenses. While CUC's stated policy was to
match revenues and expenses, its practices were not consistent with that
policy, and a proper matching was not achieved. No information has been
obtained that those responsible for establishing and implementing the practices
had empirical evidence supporting a reasonable belief that
- --------------
(187) We have not determined if such practice was applied prior to 1995.
(188) Rabinowitz said he was also aware that there was a one-month lag before
expenses were recognized and that they were then recognized over 12
months.
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<PAGE>
matching occurred, particularly in calendar 1997. With regard to CUC's practice
of reallocating revenues from deferred to immediate revenue recognition
programs, no reasonable explanation has been provided. It has been concluded
that this practice constituted an irregularity.
E. Persons With Knowledge
Without exception, all the CUC senior executives interviewed stated
that they were unaware of any "shifting" of revenue from deferred recognition
to immediate recognition programs. These persons included Walter Forbes,
Shelton, McLeod, Menchaca, Fullmer, Lipton and Hamilton.(189) All of them stated
that they believed that CUC followed its stated policy of matching revenues and
expenses.(190)
Both Shelton and McLeod said they were aware that for certain
programs, such as Dining and Privacy Guard, Comp-U-Card recognized revenue
immediately. They said they were not
- --------------
(189) McLeod, who oversaw the Comp-U-Card division for several years until
January, 1997, said that although he periodically saw the Projection
Model, the form of the model with the "Allocation" column showing the
shifting of revenues "looked new" to him. In fact, this column appeared
in the Projection Model at least as early as August, 1994.
Menchaca said that although he received the Projection Model, he did not
recall looking at any columns entitled "Allocation" and he did not know
(and would not have known) what the column meant even had he seen it.
(190) Both Monaco and Scott Forbes also said they were told by CUC that
revenues and expenses were matched in accordance with the stated policy.
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<PAGE>
specifically aware of how expenses were treated on the immediate revenue
recognition programs, although they believed that expenses generally matched
revenues.(191)
F. The Annual Effect(192)
The above-described practices resulted in an overstatement of income
during the Restatement Period as follows:
January 31, 1996: $26,730,000
January 31, 1997: $22,724,000
December 31, 1997: $41,420,000
- --------------
(191) Shelton said his understanding of company policy was that membership
revenue was categorized as deferred revenue and amortized on a straight
line basis over the life of the contract, generally one year. Expenses
and marketing costs also were deferred and amortized over the life of the
membership. In effect, the expenses and revenues were matched.
McLeod similarly said that he thought the general policy was to match
revenues and expenses over the course of the membership period, generally
over 12 months.
(192) In order to recalculate the proper revenue and expense amounts for the
years of 1995, 1996 and 1997, AA tested restated grids prepared by Speaks
and performed various procedures to verify the accuracy of these restated
grids.
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<PAGE>
XI. IRREGULARITIES CONCERNING THE MEMBERSHIP CANCELLATION RESERVE
CUC also made inappropriate use of its membership cancellation reserve
during the Restatement Period by periodically reversing that reserve into
income without support, and by recording other entries which obscured the
manner in which the reserve was used. These practices resulted in the
membership cancellation reserve being substantially understated during the
Restatement Period.
A. Establishment of the Membership Reserve
As discussed in Section X above, at the time Comp-U-Card records
revenue to the general ledger it establishes a reserve, and reduces revenue,
for the estimated number of members and related membership fees that will
cancel during the membership periods ("cancels"). Such reserves (hereafter the
"Membership Reserve") are based upon historical trends for each program.(193)
- --------------
(193) The entry that is initially recorded for "joins" totaling $1,000,000, and
assuming a cancel rate of 30%, is as follows:
Dr. Accounts Receivable $1,000,000
Dr. P&L Reserve (contra-revenue) $ 300,000
Cr. Membership Reserve $ 300,000
Cr. Revenue $1,000,000
At the end of the trial period, when the member is billed, the credit
card is charged and the accounts receivable balance is reclassified to
cash.
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<PAGE>
The Membership Reserve is also intended to cover any billings to a
member's credit card which are rejected by financial institutions. CUC has
arrangements with a number of financial institutions (principally banks such as
Chase, Citibank, etc.) (the "banks") whereby the banks will charge a member's
credit card for the annual fee (after the expiration of any trial period) and
remit the cash to CUC. A certain percentage of the billings will be rejected
for various reasons, including "soft" rejects (e.g., where the credit card is
temporarily over the credit limit) and "hard" rejects (e.g., the card is
invalid because the account has been closed, or the card has been reported as
lost or stolen). For "soft" rejects, CUC will periodically re-bill the account
("re-bills") until the billing is either accepted or finally rejected.
In some cases, a member will dispute a credit card charge, in which
case the bank will credit the member and charge CUC for the respective amount
("chargebacks"). (Hereafter, such rejects and chargebacks are referred to
collectively as "rejects.")
B. "Rejects in Transit"
After the trial period, if applicable, members are billed through the
banks, which charge the member's credit card. Any credit card charge that is
rejected is charged by CUC against the Membership Reserve. The entry is to
debit (reduce) the
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<PAGE>
reserve and credit (reduce) cash.(194) In the meantime, new revenues will have
been recorded for other new joins, and new reserves established for those
revenues, so that the reserve will constantly fluctuate up and down depending
on the level of new joins as well as rejects and cancels.
Until the reject is posted to Comp-U-Card's general ledger (i.e.,
while the reject is "in transit"), there will be a difference between what
appears on the company's books and what the bank statements show. The
difference would typically appear as a reconciling item on the bank cash
reconciliations (at month end) that the Comp-U-Card accounting personnel in
Trumbull prepared each month, for example as follows:
BANK BOOK
----------------------------------------------------
$900 $1,000
+$100 (rejects will post)
------ ------
$1,000 $1,000
This indicates that there are $100 worth of rejects, not yet posted to
the general ledger ("rejects will post") which account for the $100 difference
between the cash shown by the
- --------------
(194) To follow the previous example, if $200,000 of the $1,000,000 of joins is
rejected, then the entry would be:
Dr. Membership Reserve $200,000
Cr. Cash $200,000
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<PAGE>
bank and cash on Comp-U-Card's books. E&Y was provided such reconciliations at
each year-end audit. See, e.g., Appendix Ex. 108.
Basic accounting procedures would indicate that reconciling items in a
bank reconciliation (such as rejects in transit) should be journalized and
recorded in the general ledger each month as they are reported by the bank.
However, at some point prior to the Restatement Period, CUC developed a
practice whereby it would not write off any rejects to the Membership Reserve
for the last three months of each fiscal year. Instead, the company would
"hold" three months of rejects at year-end and book them in the first quarter
of the next fiscal year. This practice is evidenced by the following e-mail
from Hiznay to various personnel in Trumbull which is undated, but which
interviews indicate was sent in late 1997:
Hello all ! ! !
It is that time of year again when we hold all entries for rejects and
chargebacks.
For the months of October, November and December please prepare your
normal reject and chargeback entries WHEN THEY ARE NORMALLY DUE PER
THE CLOSE SCHEDULE but DO NOT SUBMIT THEM FOR KEYING.
. . .
As in past years we will hold these entries and book them
January-March of 1998.
. . .
These unbooked amounts will then appear as reconciling items on your
a/r and bank recs from October until they are fully booked next March.
See Appendix Ex. 109.
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<PAGE>
Accounting personnel in Trumbull, including at least one individual
who had been with CUC for nearly 10 years, said that this practice to delay the
posting of rejects had been in place ever since they came to the company and
was common knowledge among the Comp-U-Card accounting personnel.(195) No one was
able to identify the precise origin of the practice or its rationale. Speaks
said that he questioned both Pember and Corigliano about the practice and was
told it was simply longstanding company "policy."
- --------------
(195) Shelton said he had been aware of a longstanding practice to process
rejects on some sort of lag basis, but he did not know the mechanics
until mid-April, 1998. Although he did not know the origin of the
practice, he thought it may have begun at a time when CUC was having
difficulty re-billing members so the lag time allowed CUC to determine
which rejects actually became final. Shelton said he learned the
mechanics of the practice for the first time in a conversation with
Corigliano on or about April 13, 1998. Corigliano told Shelton that the
practice had no income statement impact because, despite the three-month
lag, CUC always booked 12 months' worth of rejects over a 12-month
period. Shelton said that Corigliano later told him that because of the
growth in the business, there was a growth in the number of rejects and
that the lag did produce some income statement impact.
Walter Forbes said he became aware of the "rejects" practice only after
this investigation commenced. McLeod said he was unaware of any practice
of delaying the booking of rejects, but said he could not see where it
would have any income statement impact. Menchaca said he was not aware of
the practice until Speaks brought it to his attention, on or about April
13, 1998.
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<PAGE>
C. Understatement of Membership Reserve
At January 31, 1995 the outstanding rejects and cancels were
approximately $44 million, which exceeded the Membership Reserve then on the
books ($33 million). It has been determined that the Membership Reserve that
should have existed on the books at that date was $108 million, based on
analyses performed by Cendant accounting personnel and tested by AA.(196) These
analyses (the "Membership Reserve Analysis") re-calculated the amount of
reserve necessary at various points in time for rejects and cancels on a
program-by-program basis, applying CUC's historical cancel rates.
The substantial understatement of the Membership Reserve at January
31, 1995 represented a buildup over many prior years. It would be difficult to
investigate the relevant facts and circumstances from those prior years;
accordingly, it is not possible to state with certainty the precise reason or
reasons for the historical understatement of the Membership Reserve. However,
it appears that at least as early as 1996 CUC was employing a formula for
justifying the amount of such reserve to the auditors at year-end, for which no
valid support exists. Under the formula, the "gross reserve" was established by
booking a reserve equal to 26% of two months of new revenue, plus 31.5%
- --------------
(196) These personnel included Speaks, who had responsibility for these matters
as part of his duties as controller of Comp-U-Card.
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<PAGE>
of one month of renewal revenue. From this gross amount CUC would subtract 20%
for commissions receivable (the commissions that would be due back to CUC from
banks in the event of rejects and cancellations). This calculation then
produced a "net reserve." See, e.g., Appendix Ex. 110.
According to Speaks, during the period he was transitioning from
SafeCard in Wyoming to Comp-U-Card in Trumbull in early 1997, and while the
January 31, 1997 audit was underway, he was instructed by Pember to employ this
formula justifying the Membership Reserve and to work with Hiznay to find
particular cancel rates to support the calculation to the auditors. Speaks said
that he and Hiznay would go through the cancel reports generated from the
cancel database and search for particular "user groups" (i.e., particular
programs, such as Privacy Guard, for a particular client, such as Citibank,
employing a particular solicitation method, such as direct mail) to support the
rates listed above. Once he located a set of cancel rates needed to support the
reserve, Speaks would request and obtain a separate printout of cancel reports
for only those groups and months that supported the reserve; these "selected"
rates were then given to the auditors and other, higher rates that other groups
may have had were withheld. See, e.g., Appendix Ex. 111.(197)
- --------------
(197) Greg Hilinski, who was responsible for generating the cancellation
reports, said he received requests from Pember, Hiznay and Speaks to
generate cancel rates for particular user groups that he understood were
to be supplied to the auditors. However, he said he did not know how his
reports would be used or explained to the
(Footnote Continued)
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<PAGE>
Workpapers provided by E&Y indicate that it concluded that the
Membership Reserve at year-end January 31, 1996 and January 31, 1997 was
adequate.198 See, e.g., Appendix Ex. 112.
By not booking rejects at year-end, and therefore not charging the
reserve at that time, CUC allowed the Membership Reserve to build at year-end
to a higher balance than otherwise would have been the case. This produced an
overstatement of the cash position on the balance sheet at year-end by the
amount of the unbooked rejects.
Speaks said that if rejects were not held in the above manner, the
Membership Reserve would have been very low (even in a negative or debit
balance) by year-end. AA has confirmed this to be the case for each of the
prior four fiscal years. The following chart shows the actual recorded general
ledger balance in the Membership Reserve at year-end, the amount of rejects in
transit (i.e., not yet posted), and the net actual reserve available (numbers
rounded to nearest millions):
- -------------------------------------------------------------------------------
auditors. He simply generated and printed out what he was asked for. He
also said he was never asked to alter any cancel rates or reports.
(198) We are not aware what conclusion, if any, was reached by E&Y on the
adequacy of the membership reserve at year-end December 31, 1997.
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<PAGE>
1/31/95 1/31/96 1/31/97 12/31/97
------- ------- ------- --------
Balance in Reserve 33 37 29 37
per Books
Rejects in Transit 31 72 100 137
Net Actual Reserve
Available 2 -35 -71 -100
As can be seen from the above, the Membership Reserve was insufficient
(or barely sufficient in fiscal 1995) to cover the outstanding rejects, much
less estimated cancels. By delaying the recording of rejects at year-end,
however, CUC was able to portray a relatively consistent and positive balance
in the Membership Reserve from year-to-year, when in reality there was a
negative (debit) balance.
It appears that at some point prior to January 31, 1995 CUC elected
not to write off the rejects to the Membership Reserve for a period of time and
also elected not to provide a reserve for those rejects. As a result, the
income statement would have been overstated at that time by the amount of those
rejects. In the Restatement Period, a portion of the income statement
overstatement is attributable to unsupported entries (discussed below) which
reduced the Membership Reserve and increased income. However, the majority of
the income statement benefit occurred prior to the Restatement Period -- at
some unidentified point -- when the rejects were initially not written off to
the reserve or an adequate reserve was not provided through the income
statement. The amount of rejects not written off each year increased steadily
over the Restatement Period.
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<PAGE>
As discussed below, CUC engaged in a variety of practices during the
Restatement Period designed to hide the deficiency in the Membership Reserve
and avoided taking any charge against income for that deficiency.
D. Fiscal 1996 and 1997 Adjustments
In fiscal 1996 and 1997, four types of adjustments were made that
affected the Membership Reserve: (1) the reversal of portions of the reserve
into income; (2) the recording of the rejects in transit that were held at
prior year-end; (3) recording of fictitious accounts receivable and increases
to the Membership Reserve that helped to obscure the foregoing; and (4)
reversals of the fictitious entries mentioned in (3) above.
Many of these entries appear to have been done for presentation
purposes. As detailed below, CUC took the asset (debit) that built up in the
cash account at year-end by virtue of the non-booking of rejects, and moved
that debit from account to account. Subsequent to year-end the debit was
recorded against the Membership Reserve, thereby reducing the reserve, and cash
was likewise credited (reduced). The company then would reclassify the debit in
the Membership Reserve into Accounts Receivable and credit (increase) the
reserve, as otherwise the reserve would appear very low. Before the auditors
were to come in for their year-end audit, CUC would reverse (credit) the
accounts receivable entries made earlier in the year, and debit (reduce) the
reserve. Simultaneously CUC would again stop recording rejects, which had the
effect of overstating cash and allowing the reserve to build back up to a level
that could be
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<PAGE>
supported to the auditors based on the company's Membership Reserve calculation
formula.
1. Fiscal 1996
At January 31, 1995 the company was holding the rejects for November
1994, December 1994 and January 1995, totaling approximately $31 million.
During February through May of 1995 (fiscal 1996), these rejects were properly
(although belatedly) written off to the Membership Reserve, as follows:
Dr. Membership Reserve $31,500,000
(24000 account)
Cr. Cash $31,500,000
Although these entries decreased the Membership Reserve, CUC
simultaneously (February through May, 1995) increased the reserve by debiting
an accounts receivable account ("Membership Tape In-Transit," account No.
12000), a balance sheet asset account, and then crediting (increasing) the
Membership Reserve, as follows:
Dr. Accounts Receivable $33,200,000
Cr. Membership Reserve $33,200,000
There is no support for these entries, which were approved by Pember
and Hiznay. The explanation on one of the journal entry forms is to adjust the
reserve for "cancels [rejects] in transit" (see Appendix Ex. 113), but there is
no basis for simply increasing accounts receivable and increasing the reserve
in such manner.
These entries were then reversed in November, 1995 through January,
1996, again in Pember and Hiznay-approved entries, as follows:
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Dr. Membership Reserve $33,200,000
Cr. Accounts Receivable $33,200,000
See, e.g., Appendix Ex. 114. Although this reversal had the effect of
reducing the Membership Reserve, by this time CUC had again begun to hold its
rejects, which allowed the reserve to build back up.
At January 31, 1996, CUC was holding the entries for rejects for
November 1995, December 1995 and January 1996. The total amount of unbooked
rejects was approximately $72 million, which amount was included as reconciling
items on the bank reconciliations at January 31, 1996.
Through a series of post-close or "P" entries, CUC then decreased the
Membership Reserve that appeared on its books as of January 31, 1996 by
approximately $18 million, and simultaneously increased income through credits
to various expense and revenue accounts (primarily expense accounts). These
entries were posted in February and March 1996 for the months of November 1995,
December 1995 and January 1996 as follows:
11/30/95 12/31/95 1/31/96 Total
-------- -------- ------- -----
$5,861,429 $5,858,096 $6,262,277 $17,981,802
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No support for these entries has been found.199 They had the effect of
inflating fiscal 1996 income by $18 million.
In addition, as discussed in Section XII below, CUC wrote off
approximately $14 million of BCI profit-sharing receivables against the
Membership Reserve at January 31, 1996.
As a result of the above reductions to the Membership Reserve, the
reserve balance at January 31, 1996 was $37 million.
2. Fiscal 1997
During February through May of 1996, the approximately $72 million in
rejects that were outstanding at year-end January 31, 1996 were written off to
the Membership Reserve, as follows:
Dr. Membership Reserve $72,000,000
Cr. Cash $72,000,000
Concurrently (through May 1996), CUC moved the debit to accounts
receivable and increased the Membership Reserve, through a series of entries
totaling $75 million, as follows:
Dr. Accounts Receivable $75,000,000
Cr. Membership Reserve $75,000,000
There is no support for these entries. They had the effect of making
the Membership Reserve appear to have a positive
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(199) It is not known who prepared or approved these entries, as the actual
journal entries have not been found. The entries appear on the general
ledger printout which does not indicate this information.
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balance, when it otherwise would have had a negative (debit) balance as a
result of the booking of outstanding rejects.
These entries were reversed in November 1996 through January 1997, $25
million each month, as the debit was recorded against the Membership Reserve,
as follows:
Dr. Membership Reserve $75,000,000
Cr. Accounts Receivable $75,000,000(200)
Although this had the effect of reducing the Membership Reserve, by
this time CUC had again begun to hold its rejects, which allowed the reserve to
build back up.
At January 31, 1997, CUC was holding the entries for rejects for
November 1996, December 1996 and January 1997. The total amount of unbooked
rejects was approximately $100 million, the majority of which was included as
reconciling items on the bank reconciliations at January 31, 1997.
Through a series of post-close or "P" entries, CUC then decreased the
Membership Reserve by approximately $15 million and simultaneously increased
income through credits to various expense and revenue accounts (primarily
expense accounts). See, e.g., Appendix Ex. 115. These entries were posted on
February 24, 1997, two days before the posting of numerous "P" entries that
inappropriately reversed the Ideon reserve and other
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(200) These entries were prepared and approved by Hiznay in late January, 1997.
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liabilities as described above in Section VIII. The actual entries were
approved by Hiznay and were located in his former office. A file containing
schedules corresponding with the accounts and amounts was found on Pember's
computer. The entries affected the months of November 1996, December 1996 and
January 1997 as follows:
11/30/96 12/31/96 1/31/97 Total
-------- -------- ------- -----
$6,723,000 $5,984,537 $2,386,404 $15,093,941
No support for these entries has been found.
E. Calendar 1997
During February through April of 1997, the approximately $100 million
in rejects that were outstanding at year-end January 31, 1997 were written off
to the Membership Reserve, as follows:
Dr. Membership Reserve $100,100,000
Cr. Cash $96,300,000
Cr. Accounts Receivable $ 3,800,000
Concurrently (through May 1997), CUC created accounts receivable and
correspondingly adjusted the Membership Reserve through a series of entries, as
follows:
Dr. Accounts Receivable $109,100,000
Cr. Membership Reserve $109,100,000
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There is no support for these entries, which arbitrarily increased
accounts receivable and correspondingly increased the Membership Reserve.(201)
Speaks confirmed that these accounts receivable were fictitious and
that the only purpose for booking them was to prevent a debit (i.e., negative)
balance in the Membership Reserve that otherwise would have existed after the
late rejects were booked. Speaks said that E&Y reviewed the Membership Reserve
on a quarterly basis and that these reviews would have revealed a debit
position in the Membership Reserve had it not been for the fictitious accounts
receivable entries.
The accounts receivable entries were then reversed in November, 1997,
through a series of entries made to the months of July, August and September,
1997:
Dr. Membership Reserve $109,100,000
Cr. Accounts Receivable $109,100,000(202)
Speaks said that these journal entries were booked to reverse the
prior fictitious journal entries.
Speaks said he questioned Pember and Hiznay about why such entries
(i.e., the fictitious accounts receivable and
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(201) These entries were also prepared and approved by Hiznay. See Appendix Ex.
116.
(202) The reversal entries (Appendix Ex. 117) were described on the journal
entry form as "reversals of prior year cancels in transit adjustment."
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reversals of same) were made, and they said that was just the way it had always
been done.(203)
In early November, 1997, in contemplation of an early audit sign-off
due to the CUC/HFS merger, E&Y was scheduled to test cash as of September 30,
1997, three months earlier than normal. Before this testing took place, Speaks
decided that Comp-U-Card would "un-book" the rejects that had been booked in
the normal course in July, August and September, 1997. He directed a series of
entries to be recorded that had the following effect:
Dr. Cash $111,800,000
Cr. Membership Reserve $111,800,000(204)
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(203) Richard Schwamb, CUC's Director of Treasury and Finance, and now
Cendant's Assistant Treasurer, also spoke with Pember about the rejects.
In the process of attempting to reconcile cash on CUC's general ledger
cash balances to the figures reported in the 10-Q's, he noticed a
discrepancy. In late fall of 1997 he said he was told by Pember that the
unreconciled difference was due to rejects that get reconciled every few
months thereby cleaning up the bank balances.
In December, 1997, after the Cendant merger closed, Schwamb told Terry
Kridler, HFS's Senior Vice President and Treasurer, and Don Ruston, HFS's
Assistant Treasurer, about his conversations with Pember. Kridler and
Ruston said they then spoke to Pember, who told them that certain rejects
which should have been written of to the Membership Reserve at year-end
were not, but that there was no income statement impact because cancels
and rejects were properly reserved for.
(204) The entries were approved by Speaks. See Appendix Ex. 118.
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Following this "un-booking" of the rejects for July, August and
September, Comp-U-Card accounting personnel then went back, at Speaks'
direction, and changed the bank reconciliations for those months to show the
amounts as "rejects will post."
Speaks said that he decided around this time that rather than hold
three months of rejects at year-end December, 1997 (as the practice had been
historically) Comp-U-Card would begin to record rejects on a constant
three-month lag. Thus, the rejects for July would be booked in October; August
rejects would be booked in November; and September rejects in December.
Meanwhile, October rejects would be held for three months and booked in
January; November rejects would be booked in February and December rejects in
March (consistent with the instructions in the Hiznay e-mail discussed above).
Under this new practice, the effect would be the same since CUC would still
have three months' worth of unbooked rejects at year-end.
The effect of "un-booking" the rejects from July through September was
to increase both cash and the Membership Reserve as of September 30, 1997,
thereby accomplishing as of that date what traditionally had been accomplished
by holding the rejects at year-end. This also meant that the bank
reconciliations as of September 30 would show large reconciling items for
"rejects in transit," representing the unbooked rejects for July, August and
September. For example, the September 30 bank reconciliation for just one
account showed unposted rejects totaling more than $30 million for the months
of July through September. See Appendix Ex. 119. However, Speaks said that E&Y
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was accustomed to seeing these reconciling items when it audited cash at prior
year-ends. Indeed, the following notation appears in E&Y's workpapers for the
cash confirmation it performed at September 30, 1997:
It should be noted that significant reconciling activity stemmed from
July 1997 and forward, due to the fact CUC records rejects 3 months in
arrears, as is Company policy.
Appendix Ex. 120.(205)
Speaks recalled that one of the E&Y auditors noticed the rejects in
transit and questioned Speaks about it during E&Y's September 30 audit of cash.
He told her that the company's policy was to hold those rejects for three
months before booking them, and that this had always been the policy. He said
he had no other conversations with anyone from E&Y on the topic.
Rabinowitz of E&Y (who initialed the workpaper quoted above), said he
recalled learning at some point that CUC held rejects for a short period of
time and that they would "cleanse themselves out" over a short period of
time.(206)
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(205) Speaks explained that in the years prior to calendar 1997, the rejects in
transit were shown individually by "file" in the bank reconciliations,
resulting in several pages of rejects for each bank reconciliation. In
mid-1997, to cut down on the length of the reconciliations, he instructed
his staff to begin aggregating the rejects into a single figure, by
month, for each account.
(206) It is unclear from Rabinowitz's interview whether he was aware that
rejects were held for three months.
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F. Calendar 1998
At December 31, 1997, CUC was holding the entries for rejects for
October through December, 1997. The total amount of unbooked rejects was
approximately $137 million. By delaying the booking of these rejects, CUC was
able to show a positive balance of approximately $37 million in the Membership
Reserve as of December 31, 1997 instead of the negative balance that would have
existed had the rejects been booked.
In January through April, 1998, the rejects that were outstanding at
December 31, 1997 were written off to the Membership Reserve. On April 14, 1998
Speaks brought CUC's "rejects in transit" practice to the attention of Scott
Forbes.207
G. Income Statement Impact
As noted above, the Company has recalculated, as part of the
Membership Reserve Analysis, the amount of the Membership Reserve that should
have been reflected on the general ledger of Comp-U-Card at various year-ends,
assuming proper application of the company's historical cancellation rates. The
correcting entry needed to increase the reserve, assuming timely recording of
all rejects, cancels and re-bills, is shown below (figures rounded to nearest
millions):
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(207) Unlike what took place at the end of fiscal 1996 and 1997, no portion of
the Membership Reserve was reversed into income at the end of calendar
1997.
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1/31/95 1/31/96 1/31/97 12/31/97
------- ------- ------- --------
Balance in Reserve 33 37 29 37
per Books
Rejects/Cancels 44 84 123 158
Adjusted Reserve -11 -48 -94 -120
Rebills (not booked) 0 0 0 32
Correcting Entry 119 119 119 119
(increase to reserve) 54 54 54
(IN BOLD) 19 19
12
Final Reserve
as adjusted
(per Membership
Reserve Analysis)
108 125 97 115
The above chart should be read as follows:
For the year ended January 31, 1995, Comp-U-Card had a net Membership
Reserve recorded of $33 million. There were rejects and cancels of $44 million
included in the bank reconciliations which should have been written off to the
Membership Reserve.(208) Once these rejects and cancels are recorded, the net
reserve is a negative (debit) balance of $11 million. Based on the Membership
Reserve Analysis, the net Membership Reserve should be $108 million. In order
to reach the $108 million, the following entry needs to be recorded:
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(208) $31 million of rejects in transit, $9.1 million of cancels and $3.4
million of other old rejects/cancels never recorded.
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Dr. Retained Earnings $119 million
Cr. Membership Reserve $119 million
The $119 million represents the cumulative impact of entries that
affected the P&L through January 31, 1995. As the years under restatement are
fiscal 1996, fiscal 1997 and calendar 1997, the $119 million entry, instead of
being a reduction to revenue in fiscal year 1995, is a reduction to Retained
Earnings.
For the year ended January 31, 1996, Comp-U-Card had a net Membership
Reserve recorded of $37 million. There were rejects and cancels of $84 million
included in the bank reconciliations which should have been written off.(209)
Once these rejects and cancels are written off to the reserve, the net reserve
is a negative (debit) balance of $48 million. Based on the Membership Reserve
Analysis, the net Membership Reserve should be $125 million, therefore an
adjustment of $173 million is required ($125 million plus $48 million). The
prior year's reserve has already been adjusted by $119 million leaving a
current year adjustment of $54 million to result in the proper ending balance
of $125 million. The correcting entry is therefore:
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(209) $72 million of rejects in transit, $10.7 million in cancels and $1.7
million of other old rejects/cancels that had never been recorded.
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Dr. Cancellation Expense $54 million
Cr. Membership Reserve $54 million(210)
For the year ended January 31, 1997, Comp-U-Card had a net Membership
Reserve recorded of $29 million. There were rejects and cancels of $123 million
included in the bank reconciliations which should have been written off.(211)
Once these rejects and cancels are written off to the reserve, the net reserve
is a negative (debit) balance of $94 million. Based on the Membership Reserve
Analysis, the net Membership Reserve should be $97 million, therefore an
adjustment of $191 million is required ($97 million plus $94 million). The
prior years' reserve has already been adjusted cumulatively by $173 million
leaving a current year adjustment of $19 million (rounded) to result in the
proper ending balance of $97 million. The correcting entry is therefore:
Dr. Cancellation Expense $19 million
Cr. Membership Reserve $19 million
For the year ended December 31, 1997, Comp-U-Card had a net Membership
Reserve recorded of $37 million. There were
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(210) In reality, only $48 million of this entry affects the P&L as the
remainder ($6 million) is a reclassification between the Membership
Reserve and other balance sheet accounts.
(211) $100.1 million of rejects in transit, $22.3 million of cancels and $.3
million of other old rejects/cancels never recorded.
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rejects and cancels of $158 million(212) included in the bank reconciliations
which should have been written off. Once these rejects and cancels are written
off to the reserve, the net reserve is a negative (debit) balance of $120
million. Based on the Membership Reserve Analysis, the net Membership Reserve
should be $115 million, therefore an adjustment of $235 million is required
($120 million plus $115 million). The prior years' reserve has already been
adjusted cumulatively by $192 million leaving a current year adjustment of $44
million to result in the proper ending balance of $115 million. However, the
company never recorded $32 million of re-bills relating to "soft" rejects. The
entry to record the re-bills is a debit to cash and a credit to the Membership
Reserve. Therefore the net adjustment for calendar 1997 is $12 million ($44
million less $32 million in unrecorded re-bills (amounts rounded)). The
correcting entry is therefore:
Dr. Cancellation Expense $12 million
Cr. Membership Reserve $12 million
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(212) $136 million of rejects in transit and $20.9 million of cancels never
recorded.
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<PAGE>
The above-described practices resulted in an overstatement of income
during the Restatement Period as follows:
January 31, 1996: $48 million
January 31, 1997: $19 million
December 31, 1997: $12 million
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<PAGE>
XII. OTHER IRREGULARITIES
A. Commissions Payable
When Comp-U-Card obtained new members, it was obligated to pay
commissions to banks and other institutions (the "clients"), through which such
members were obtained. Accordingly, Comp-U-Card created a liability
("commissions payable") at the time it recorded revenues to provide for those
commissions.
Comp-U-Card prepared analyses which improperly supported an
understated commissions payable liability on its year-end balance sheet. In
addition, Comp-U-Card recorded improper post-closing "P-entries" at year-end
fiscal 1997 reducing commissions payable and crediting various revenue
accounts. These year-end entries were booked even though the level of
Comp-U-Card's commissions payable on its balance sheet at the time was
understated.
1. Understatement of Commissions Payable
Comp-U-Card paid commissions to two general categories of clients:
direct clients and generic clients. Comp-U-Card's direct clients collected
membership fees directly from members and then deducted the amount of
commissions owed by Comp-U-Card prior to remitting the funds (in the first
month following the end of the trial period). In contrast, with generic
clients, Comp-U-Card had an outside entity bill and collect the membership fees
(in the month following the conclusion of the trial membership) and remit those
funds to Comp-U-Card. Comp-U-Card
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paid commissions owed to its generic clients the month after the membership
fees were billed, resulting in a one-month lag. Accordingly, Comp-U-Card was
required to maintain on its balance sheet a liability sufficient to cover its
commissions payable obligation for the next three months in the case of direct
clients and four months in the case of generic clients.
Toward the end of calendar 1997, Speaks said he noted a shortfall in
commissions payable and had begun to increase the commission expense to deal
with the shortfall. Speaks said that sometime between September and December,
1997, Pember instructed him to prepare a commissions payable analysis for E&Y
to support the commissions liability as of December 31, 1997.
Speaks said that Pember told him to use the same methodology she had
used to support the prior year's commissions payable general ledger balance for
January 31, 1997.(213) This methodology improperly assumed Comp-U-Card had only
one month of outstanding unpaid commission expenses for its generic clients
instead of four months. Speaks said that he knew the commissions liability
calculated by the analysis was understated, but he nevertheless provided it to
E&Y.(214)
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(213) The commissions payable analyses provided to E&Y for fiscal 1996 could
not be located.
(214) Speaks later noted his objection in an e-mail to Pember dated March 31,
1998. See Appendix Ex. 105.
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Revised commissions payable analyses, using appropriate assumptions as
to the number of months of outstanding unpaid commissions Comp-U-Card was
obligated to pay, were prepared by Speaks and other Comp-U-Card personnel and
tested by AA. These analyses demonstrate that Comp-U-Card's commissions payable
balance was understated by $14 million at January 31, 1996, by $20 million at
January 31, 1997 and by $26.3 million at December 31, 1997. These amounts
represent the understatement of the general ledger balance after the recording
of various post-closing entries, including certain improper reversals of
commissions payable into income during fiscal 1997, which are addressed below.
2. Improper Reversals of Commissions Payable into Income Through
Unsupported "P" Entries
a) Improper "P" Entries in Fiscal 1997
In February, 1997, Comp-U-Card recorded nine post-close entries on its
general ledger reducing the commissions payable liability and increasing
certain revenue accounts in the aggregate amount of $9,119,877.(215) According
to the journal
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(215) Three P-entries recorded in January, 1998 with effective dates in the
fourth quarter of calendar 1997 debited (reduced) commissions payable and
credited (increased) an accrued payroll account for a total amount of
$830,000. Additionally, two unsupported P-entries were also made at the
end of fiscal 1996. These entries were booked in February and March,
1996, but were both effective January 31, 1996. The entries debited
(reduced) the commissions payable and credited (increased) the Membership
Reserve by $5,500,000 and $522,000, respectively, for a total amount of
$6,022,000. While these entries were made without support,
(Footnote Continued)
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entry forms, the entries were approved by Paul Hiznay. While these entries were
all recorded on February 24, 1997, they were given effective dates of November
and December of 1996 and January of 1997.(216)
- -------------------------------------------------------------------------------
there was no immediate P&L impact from these five entries as all of the
accounts affected were balance sheet accounts. They did, however,
contribute to the chronic understatement of the commissions payable
liability.
(216) The nine entries were as follows:
P105 (effective November 30, 1996)
Dr. Commissions Payable $967,886
Cr. Credit Union Revenue $304,103
Cr. New Commission Income $663,783
P106 (effective November 30, 1996)
Dr. Commissions Payable $1,064,675
Cr. Credit Union Revenue $334,513
Cr. New Commission Income $730,162
P113 (effective November 30, 1996)
Dr. Commissions Payable $1,193,726
Cr. Credit Union Revenue $375,060
Cr. New Commission Income $818,666
P107 (effective December 31, 1996)
Dr. Commissions Payable $913,338
Cr. Credit Union Revenue $567,982
Cr. Gross New Comm. Revenue $345,356
P108 (effective December 31, 1996)
Dr. Commissions Payable $1,004,671
Cr. Credit Union Revenue $624,780
Cr. Gross New Comm. Revenue $379,891
P112 (effective December 31, 1996)
Dr. Commissions Payable $1,126,450
Cr. Credit Union Revenue $700,511
Cr. Gross New Comm. Revenue $425,939
P109 (effective January 31, 1997)
Dr. Commissions Payable $1,054,178
Cr. Credit Union Revenue $301,198
Cr. Gross New Comm. Revenue $752,980
(Footnote Continued)
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As mentioned above, the post-closing entries were made at a time when
Comp-U-Card's commissions payable was already understated.(217)
b) Improper "P" Entries in Calendar 1997
As discussed elsewhere in this Report, as a result of CUC's conversion
to a calendar year, the results for January, 1997 were included in calendar
1997. Three of the P-entries (Nos. 109 through 111) were made effective January
31, 1997. These entries, which total $2,849,131, contributed to an
overstatement of income and an understatement of the commissions payable
liability in calendar 1997.
- -------------------------------------------------------------------------------
P110 (effective January 31, 1997)
Dr. Commissions Payable $854,740
Cr. Credit Union Revenue $244,215
Cr. Gross New Comm. Revenue $610,525
P111 (effective January 31, 1997)
Dr. Commissions Payable $940,213
Cr. Credit Union Revenue $268,636
Cr. Gross New Comm. Revenue $671,577
(217) Even if there had been an excess in the commissions payable liability
which would have justified a reversal of that liability, the proper GAAP
treatment for such reversal would have been to credit "commission
expense" rather than the revenue accounts which CUC in fact credited.
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<PAGE>
3. Income Statement Impact of the Irregularities Associated with
the Commissions Payable
In order to correct for the irregularities associated with the
commissions payable, the improper year-end P-entries must be reversed and
additional adjustments must be made to bring the liability account to its
properly-stated level.
The reversal of the P-entries has a P&L impact of $9,119,877 in fiscal
1997 and $2,849,131 in calendar 1997. The amount of the remaining
understatement of the commissions payable after reversing the P-entries was
$8,003,000 for fiscal 1996, $4,843,000 for fiscal 1997 and $10,335,000 for
calendar 1997. The necessary correcting entries debit commission expense and
credit commissions payable by those respective amounts in each of those years.
Commission expense is considered a "new solicitation cost," and is included in
the company's amortization grids, discussed in Section X above in connection
with "Revenue Recognition."
B. Reversal of Sierra Deferred Tax Asset into 1997 Income
In mid-January, 1998, at about the same time the excess Berkeley
reserve was being moved into Software income as discussed in Section VIII
above, the Software division was further directed to reverse into income a $2.6
million valuation allowance of a deferred tax asset obtained via Sierra's
acquisition of Berkeley. The details are as follows.
In April, 1997, when Sierra acquired Berkeley, there was included on
Berkeley's pre-acquisition balance sheet a deferred tax asset of approximately
$2.6 million against which Berkeley maintained a 100% valuation allowance.
Sierra's
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accounting manager Brian Foster said that when Sierra established the opening
post-acquisition balance sheet of Berkeley this deferred tax asset was excluded
because he could obtain no backup supporting it from either Berkeley or from
Price Waterhouse, Berkeley's prior auditors. Ultimately, because the deferred
tax asset and the corresponding valuation allowance netted to zero, Foster
decided not to book any entry for the asset or the allowance on the opening
balance sheet.
Later, in November, 1997, Foster received a phone call from Pam Drake,
the Controller of Davidson, informing him that Drake had spoken with Sabatino
regarding the deferred tax asset and the valuation allowance. Drake informed
Foster that Sabatino wanted to have Sierra reinstate the deferred tax asset and
corresponding valuation allowance on Sierra's balance sheet. Foster resisted
the suggestion because he had never been able to find satisfactory backup for
the asset, and he told Drake that he did not want to make the entry. Drake, who
described herself as a go-between on this issue, went back to Sabatino, who
insisted upon the reinstatement of the asset on Sierra's books. Drake contacted
Foster and told him that Sabatino really wanted the entry made and would he
please put it on his books.
Foster believes that Sabatino contacted Drake (rather than Foster or
someone else at Sierra directly) because Davidson was viewed as the head of CUC
Software and had the most direct contact with CUC Corporate (Sabatino confirmed
that he viewed Drake as the point person for software accounting matters).
Foster believes he may have had a discussion in November with
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Meschel, the CFO for the Software division, regarding Sabatino's instruction to
reinstate the deferred tax asset and corresponding valuation allowance. Drake
said she spoke to Meschel about the request. Meschel said he recalled that the
request came from Pember and/or Sabatino but that he did not recall hearing
about any resistance from Foster to booking the entries.
On December 15, 1997, Foster booked the following entry:
Dr. Deferred Tax Asset $2,595,507
Cr. Valuation Allowance $2,595,507
This entry had no impact on Sierra's P&L.
Foster was uncomfortable with the entry primarily because he was
unable to see the support for it. In connection with reinstating the asset, he
had no discussions with anyone about the possibility that it would later be
reversed into income. However, given the lack of support for the entry, in
Foster's mind at the time, there was really no other reason to book such an
entry other than to later move it into income.
Shortly thereafter, in either late December, 1997 or early January,
1998, Foster received a call from Drake informing him that Sabatino wanted
Sierra to reverse the valuation allowance and credit the P&L. Foster said he
"threw a fit" because Sabatino had insisted only weeks prior that Sierra
reinstate the asset. Foster refused to book the entry and insisted on talking
to Meschel first. Foster spoke to Meschel and Drake, both of whom told Foster
that Sabatino wanted the transaction booked and that Foster had no choice but
to book it.
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(Drake confirmed that Foster was resisting booking the entry; Meschel and
Sabatino said they had no recollection of this).
Foster insisted on specific instructions from Sabatino himself and on
January 15, 1998, Sabatino provided, by e-mail, the instructions Foster asked
for. See Appendix Ex. 121. Sabatino told Drake and Foster in the e-mail to
record a journal entry to debit the deferred tax asset and to credit the income
statement, "I don't care where." Sabatino said he assumed the tax asset was not
already on software's books and he was not aware of the December 15 journal
entry that booked the tax asset and valuation allowance. His e-mail stated that
debiting the tax asset and crediting income was "better than establishing the
reserve [valuation allowance] and reversing it," although that is precisely
what happened since Foster had in fact booked the valuation allowance in
December and now had to reverse it into income to accomplish the directive in
Sabatino's e-mail.
After receiving the e-mail, Foster said he left a voicemail for
Meschel asking where on the P&L the credit should go. He received an e-mail on
January 15 from Drake's e-mail address (but signed "Jay" [Meschel]) stating
"Please book the credit as a revenue item, i.e., misc. income." See Appendix
Ex. 121.(218) On January 16, 1998, Foster booked the following entry:
- --------------
(218) Meschel had no recollection of the e-mail or indeed of anything relating
to this piece of the transaction whereby the valuation allowance was
reversed and income was credited. Meschel said that in order for him to
have sent
(Footnote Continued)
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<PAGE>
Dr. Valuation Allowance $2,595,507
Cr. Sales-Berkeley-Other Income $2,595,507.
Under purchase accounting standards, the proper accounting entry to
reverse a valuation allowance previously established, if the reversal is within
one year from the date of acquisition (which this was), would be to credit
goodwill, a balance sheet account, and not "miscellaneous income."(219)
Foster said he was extremely uncomfortable with this entry, but he
made it because he was specifically told to do so in writing by Sabatino. He
said that the transaction was "just wrong from the beginning." Sabatino said he
was acting on Pember's instructions.
Foster never spoke to anyone else other than Meschel or Drake about
this entry. McLeod said he was unaware of the entry until AA appeared on-site
at software's offices during this investigation, when Foster brought it to his
attention.
C. BCI Fiscal 1996 Writeoff of Profit-Sharing
Receivable Against Membership Reserve
As discussed earlier, BCI books a receivable each month for the amount
of revenue FISI will ultimately record from the profit-sharing arrangements
FISI has with various insurance
- -------------------------------------------------------------------------------
an e-mail from Drake's address he would have had to use her log-on
password and that he had never done so.
(219) Even if the reversal were more than one year from the acquisition date,
the credit would not have been to pre-tax income but rather to tax
expense.
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<PAGE>
companies. The amount booked is based in part on certain estimates, including
estimates of the number of insurance claims that will be made. According to
Steve Pedersen, in 1995 an unusually large number of claims were submitted. By
the fourth quarter of fiscal 1996, it became apparent to Pedersen that the
profit-sharing receivable on BCI's books was overstated by approximately $14
million and needed to be reduced by that amount prior to year end.
Pedersen spoke to Sabatino about how the writeoff should be booked.
Sabatino told Pedersen that CUC Corporate had reserves that could be used to
offset the writeoff, and he instructed Pedersen to write off the receivable
through the intercompany account. Sabatino did not inform Pedersen what
reserves would be used.
Pedersen asked a staff accountant at BCI to book the writeoff on BCI's
books in a number of different entries so as to make the writeoff appear "less
blatant." The entries made at BCI were:
Dr. Due from Stamford
Cr. Profit-Sharing Receivable
Set forth below are the number of entries recorded by month.
Month # of entries recorded Total $ (000's)
- ----- --------------------- ---------------
Nov. 1995 23 4,789
Dec. 1995 20 4,043
Jan. 1996 23 5,086
-----
Total 13,918
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Pedersen said the use of numerous entries was a "subtle bit of
subterfuge." He said that he was not trying to mask the fact that the writeoff
was being run through the intercompany account, since he saw nothing wrong with
using CUC's reserves to offset the writeoff. Rather, he said he was trying to
make the writeoff less obvious to E&Y, which closely scrutinized and frequently
questioned the amount BCI booked for the profit sharing receivable.
The receivable was in fact written off at Corporate against the
Comp-U-Card division's Membership Reserve. Entries were made in Trumbull to
debit the Membership Reserve and credit intercompany to BCI. Sabatino said the
decision to write off the profit-sharing receivable against the Membership
Reserve was made by Corigliano.
D. $18 Million Deferred Marketing Costs
On March 5, 1996, through three post-close entries (P1334-1336), CUC
improperly credited various Comp-U-Card expense accounts and debited the
marketing costs-in-process account by $17,950,000. The effective dates of these
entries ranged from November 1995 to January 1996 and thus inflated fiscal 1996
income by $17,950,000. See Appendix Ex. 122.
The marketing costs-in-process account is a pre-paid asset on the
general ledger. It is intended to house direct marketing costs prior to their
being transported to the "grids" that amortized such costs. The reason for
delaying the amortization is that costs incurred in any given month are
expected to generate new members sporadically over a three-month
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<PAGE>
period; thus, recognition of all of those costs when incurred would result in
too early a recognition of costs relative to revenues. Accordingly, a portion
of those costs (those expected to generate new members in future periods) are
capitalized to the balance sheet as an asset, and subsequently amortized into
the income statement.
The amount of marketing costs capitalized in this account is based on
standard cost calculations performed by CUC's marketing department, which
divides total year-to-date direct solicitation costs by the expected number of
new members in order to determine the standard direct solicitation cost per new
join. This standard is then multiplied by the actual number of year-to-date new
joins to determine standard year-to-date direct solicitation expense. Actual
year-to-date direct solicitation expense reflected in Comp-U-Card's income
statement is then adjusted to equal this balance. If the adjustment increases
direct solicitation expense then marketing costs-in-process is reduced
(credited), conversely, if the adjustment decreases direct solicitation cost
the marketing costs-in-process is increased (debited).
The particular expense accounts that were credited by the P-entries
discussed above were not the solicitation expense account which is normally
credited when the marketing costs-in-process account is debited. Rather, as
Speaks explained, the expenses credited were miscellaneous operating expenses
that have nothing to do with the marketing costs-in-process account. Speaks
said that crediting these expenses and debiting the
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marketing costs in-process account was not consistent with CUC policy.
Spreadsheets prepared by Pember, and printed off her computer, detail
the expense accounts and amounts that were credited. No support has been found
for crediting these unrelated expenses. Several of the accounts were credited
in the identical amounts. The journal entries were approved by Hiznay. These
entries should be reversed.
E. FISI Capitalization of Costs for the Solicitation
of New Business for Fiscal Year 1997
In early to mid-December of 1997, Pember informed Terry Johnson,
Controller of FISI Madison, that she wanted FISI to capitalize solicitation
costs incurred in 1997 for new business arrangements entered into with
financial institutions that year. Johnson explained that FISI enters into
contracts with banks pursuant to which FISI develops marketing materials that
are used by the banks to sell various financial products to their customers.
FISI incurs a number of up-front costs in developing these materials. Johnson
told Pember that he did not think it was a good idea to capitalize these costs
because FISI had historically expensed such costs when incurred and the costs
were relatively small. Johnson initially did not act on Pember's request.
Pember called Johnson in late December and repeated her request.
Johnson then compiled the 1997 third party solicitation costs for new
business totaling $753,679. After Johnson provided Pember with these figures,
she told Johnson that she also wanted to capitalize FISI's internal costs
relating to the solicitation
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<PAGE>
of new business, i.e., salaries, bonuses and travel and entertainment expenses.
According to Johnson, Pember said that the practice at the corporate level was
to capitalize such internal costs. Johnson then calculated these costs which
totaled approximately $1.5 million, which related to salaries and bonuses. This
figure represented approximately 50% of the compensation paid to FISI employees
who worked on new solicitations in 1997.
Pember then instructed Johnson to capitalize these solicitation costs
(the exact amount was $2,250,885) and amortize them over seven years. The
following entry was recorded at the direction of Johnson on January 19, 1998:
Dr. Deferred Marketing Costs $2,250,885
Cr. Various Expenses $2,250,885
The effect was to reduce 1997 expenses by $2,250,885 and move them to
the balance sheet.
Ken Keith, President of FISI, and Johnson stated that they were
uncomfortable capitalizing these costs, and were particularly uncomfortable
amortizing them over seven years. Johnson explained that FISI had never
deferred costs in the past. In addition, the contracts between FISI and the
banks typically had a term of only one or two years (although, if not
terminated, were self-renewing). Johnson and Pember discussed that in
connection with past acquisitions by FISI, FISI had to appraise similar
contracts between the company acquired and various financial institutions.
These appraisals indicated that the contracts lasted 10-12 years. Pember said
that in light of these
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<PAGE>
appraisals, seven years was a fair amount of time over which to amortize the
solicitation costs. Johnson stated that he did not press his concerns because
the amounts were relatively small.
Keith said he raised his concerns with Shelton, who told him that
Keith would have to talk to Silverman because Silverman wanted it handled this
way. Shelton did not specifically recall this conversation. He said that when
he and Silverman were at FISI in late 1997, Silverman suggested that FISI could
capitalize certain sales costs.(220) Silverman said he had no discussions about
the capitalization of sales costs by FISI.
Johnson stated that E&Y was aware of the approximately $2.2 million
adjustment. Johnson said he had a short discussion with E&Y (he cannot recall
with whom) about what components were being capitalized, the supporting
documentation, and the methodology used. He believes he told E&Y that a
component of the amount capitalized was salaries paid to FISI employees. E&Y's
workpapers appear to indicate that it identified this item as an error to be
corrected in its summary of audit differences at December 31, 1997, but that
the impact of the error was not material. See Appendix Ex. 27.
It has been concluded that the $2.2 million deferral of expenses was
inappropriate because salaries and bonuses should
- --------------
(220) Shelton did not state that they discussed the capitalization of salaries
and bonuses.
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<PAGE>
not be deferred and the entire deferral was otherwise not a consistent
application of accounting policy.
F. The Improper Deferral Adjustments at Sentinel
As mentioned earlier in this Report, CUC acquired Sentinel and CUC
Europe in March, 1995. Sentinel operates a membership program that provides
services to its members whose credit cards are lost or stolen.
During the Fall of 1995, Mandy Morris, a financial accountant at
Sentinel, and Joe Malia, the Finance Director at Sentinel, were told that they
needed to record additional deferred revenue of 431,000 British Pounds Sterling
("BPS") (approximately $653,000) and write off deferred costs of 2,418,000 BPS
(approximately $3,664,000) in order to conform the accounting policies of
Sentinel with those of CUC. Neither Morris nor Malia could recall who gave them
those instructions. They remembered talking to Kearney about this issue and
believe they also spoke with Sabatino at the time.
Soon thereafter, in a series of telephone conversations, Sabatino and
Kearney provided justifications for the increase in deferred revenue and
writeoff of deferred costs to Morris, Malia and Mark Maybrey, Financial
Director and Chief Financial Officer of CUC Europe. Morris, Malia and Maybrey
have said they did not agree with those justifications. Morris and Malia
traveled to Stamford and met with Sabatino and Kearney, and Kearney came to the
U.K. to discuss the proposed justifications. These meetings did not convince
Maybrey, Morris or Malia that CUC's analysis was proper. Kearney then recorded
his
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<PAGE>
justifications in a memo dated November 6, 1995 to Morris and Nigel Field, the
European reporting manager at CUC Europe. Appendix Ex. 123. That memo did not
produce any agreement.
Based upon their own analysis, Maybrey, Morris and Malia were able to
justify an increase to deferred revenue of only 57,688 BPS (approximately
$87,000) and a writeoff of deferred costs of only 871,363 BPS (approximately
$1,320,000).
Morris was then instructed to record the entire proposed adjustment of
2,849,000 BPS (approximately $4,317,000). Morris could not recall who gave her
those instructions. The entries she recorded on the books of CUC Europe were:
Dr. Goodwill 2,849,000 BPS
Cr. Deferred Costs 2,418,000 BPS
Cr. Deferred Revenue 431,000 BPS
She recorded those entries only on CUC Europe's books used for
consolidation. She did not record that amount on CUC Europe's statutory records
maintained pursuant to local requirement because CUC Europe's auditors, E&Y in
the U.K., did not agree with the entirety of the adjustments to deferred
revenue and deferred cost.
Morris suggested to either Kearney or Sabatino, she could not recall
which one, that 657,000 BPS (approximately $994,000), of the deferred cost
writeoff could be justified as relating to a company previously acquired by
Sentinel called CardWise. Sentinel acquired a database of names from CardWise
and then marketed its products to those individuals. Although Morris said she
believed that writing off the goodwill of
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<PAGE>
CardWise was proper, she also stated that at the time of the writeoff she was
aware that the CardWise database was generating revenues for Sentinel. After
making this suggestion, Morris was told by someone at CUC (she could not recall
who) to record the CardWise writeoff on CUC Europe's books (as part of the
total writeoff of deferred costs of 2,418,000 BPS).
The amount of the increase to deferred revenue and writeoff of
deferred costs is not supportable and should be reversed. The CardWise deferred
costs should not have been written off to goodwill because CardWise was viable
and generating revenue at the time it was written off.
G. Topside Adjustments to Hebdo Mag at December 31, 1997
The following entry was made topside on Hebdo's balance sheet and
income statement in consolidation at December 31, 1997 year-end:
Dr. Accounts Payable $3,000,000
Cr. G&A Expense $3,000,000
Although other topside balance sheet adjustments were made to other
subsidiaries' payables accounts at year-end, this one was unique in that it
affected accounts payable whereas the other adjustments affected intercompany
payable. Sattler, who made this entry at Pember's instruction, did not recall
why this entry was made. The entry was apparently not pushed down to Hebdo to
record after year-end. The entry appears on the same schedule of other
unsupported entries Pember gave Sattler in January, 1998 to record at year-end
(Appendix Ex. 87), which included the reversals of Ideon and Cendant reserves,
and the
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<PAGE>
intercompany transfers of those reserves to subsidiaries such as NUMA, NAOG and
NCCI. This entry appears to have no support.
H. The Improper Segment Numbers for 1997
The February 4, 1998 Cendant earnings release included combined
quarterly and yearly results for CUC and HFS by "segment," i.e., "Membership,"
"Travel," "Real Estate" and "Other," for calendar years 1997 and 1996. The same
yearly segment numbers were later included in the form 10-K filed on March 31,
1998.
On February 2, Scott Forbes received a fax from Corigliano containing
a schedule of revised, final 1997 revenues and EBITDA for CUC, quarterly and by
segment, that were to be combined with the HFS results and included in the
February 4 press release. Forbes asked his staff in Parsippany to check how
these revised numbers compared with the consolidated 1997 year-end numbers that
they had received from CUC about a week earlier. On February 3 Forbes received,
from his staff, a copy of the revised Corigliano schedule with handwritten
notations by his staff indicating the differences between the segment numbers
as revised by Corigliano, and the segment numbers CUC had provided the week
before. See Appendix Ex. 124.(221)
- --------------
(221) On January 21, 1998, Pember faxed Scott Forbes a memorandum indicating
revised actual fourth quarter CUC results, by various business
categories, and comparing them to prior forecasts recently given to HFS.
See Appendix Ex. 125. Although the totals for the actuals and prior
forecasts were approximately the same, Pember's memo shows a variance
from forecast for several business categories (such as individual
(Footnote Continued)
-258-
<PAGE>
There were some significant differences noted. Corigliano told Scott
Forbes that these differences did not materially affect the bottom line. Total
CUC revenues were within about $1 million of those previously shown and total
EBITDA was within about $4 million. Scott Forbes said that Corigliano told him
that the inter-segment adjustments were attributable to the fact that CUC had
done only "soft closes" throughout the year, as well as the fact that CUC had
switched from a fiscal to calendar year reporting basis. Scott Forbes said
Corigliano assured him that these were valid and ordinary course adjustments
and that the numbers were right.
On April 9, Sabatino told Scott Forbes (and reiterated in his April 14
affidavit) that the inter-segment adjustments lacked factual basis. He said the
adjustments were made to conform the segment results to segment information
presented to analysts in December, 1997, which information was also incorrect.
Sattler, who supplied the segment information for the presentation to analysts,
explained that it included unsupported segment adjustments to be consistent
with the unsupported quarterly and calendar topside adjustments that had been
made.(222)
- -------------------------------------------------------------------------------
membership and software), and attributes this to the fact that "we have
historically not focused on monthly forecasts, but the entire quarter."
Compare Appendix Ex. 126.
(222) The form 8-K filed on January 29, 1998 included information for
"Membership" and "Software." This information was also incorrect. Sattler
explained that in preparing this information she also needed to account
for the unsupported topside adjustments. She did so by adjusting the
Comp-U-Card division figures rather than those of all of the business
units as she had done in preparing the information for the analysts'
presentation. Therefore, there was a discrepancy between the form 8-K and
the press release.
<PAGE>
ADDENDUM TO REPORT OF THE AUDIT COMMITTEE
OF THE BOARD OF DIRECTORS OF CENDANT CORPORATION
On August 24, 1998, the Audit Committee (the "Committee") of the Board
of Directors of Cendant Corporation (the "Company") approved the Report
prepared by Willkie Farr & Gallagher ("Counsel" or "Willkie Farr") and Arthur
Andersen LLP ("AA), subject to the condition that the Form 10-K/A delivered to
the Committee in draft form on August 24, 1998 be unchanged in any material
respect from the final version as ultimately filed. On August 26, 1998, the
Company advised Counsel for the Committee that the final Form 10-K/A will not
be filed as soon as had been expected and will differ from the draft 10-K/A
with respect to certain matters involving revenue recognition which have been
the subject of recent discussions between the Company and the SEC. The Company
has advised that it is its view, with which Willkie Farr and AA concur, that
the changes to the draft 10-K/A will have no material effect on the Report.
Accordingly, the Committee hereby approves the Report as final, subject to its
right to review the final Form 10-K/A as filed and to ask Willkie Farr and AA
to determine whether amendments to the Report are appropriate.
<PAGE>
EXHIBIT 99.4
FOR IMMEDIATE RELEASE
---------------------
CENDANT AUDIT COMMITTEE REPORTS TO BOARD OF DIRECTORS
ON ITS INVESTIGATION INTO ACCOUNTING IRREGULARITIES
-- Report Chronicles Numerous and Pervasive Irregularities
Directed by CUC Corporate Executives
Aimed at Meeting Analyst Estimates --
-- Evidence of Attempt to Continue CUC Fraud in 1998 --
-- Says Forbes and Shelton Among Those Who Bear Responsibility --
PARSIPPANY, NJ, AUGUST 27, 1998 -- Cendant Corporation (NYSE: CD) today
announced that the Audit Committee of its Board of Directors has presented to
the Board its report on the investigation into the accounting irregularities
uncovered in the former CUC businesses and its conclusions regarding
responsibility for those actions. Cendant will file the full report on Form 8-K
and will send copies to the U.S. Attorney for the District of New Jersey and to
the staff of the Securities and Exchange Commission.
Earlier today, Cendant announced that the filing of its Form 10-K/A, which will
include its restated financial results for 1995 - 1997, has been delayed until
late September due to additional revisions of its accounting policies as
requested by the SEC.
The Audit Committee's report focused solely on accounting irregularities --
i.e., fraudulent financial reporting -- and chronicled in detail, through
numerous examples, how CUC's income, excluding merger-related and unusual
charges, was inflated by an aggregate of approximately $500 million before taxes
during the period 1995 - 1997 (the Restatement Period). The report said this was
accomplished through a wide range of irregular accounting entries directed by
CUC corporate executives at its Stamford, Connecticut headquarters and imposed
upon personnel throughout the company in an escalating attempt to ensure that
CUC's earnings would match analyst expectations.
1
<PAGE>
The report found that more than one-third of the total income, excluding
merger-related and unusual charges, reported by CUC during the Restatement
Period was deliberately and fictitiously manufactured. (This is consistent with
the restated financial results for 1995-1997 that Cendant released on August 13,
1998.) The report did not encompass the approximately $200 million of accounting
errors in CUC's accounting records which were also part of the 1995 - 1997
restated results.
The Audit Committee's report culminated more than four months of exhaustive work
by the Audit Committee's legal counsel, Willkie Farr & Gallagher, which
commissioned the accounting firm Arthur Andersen & Co. to perform a forensic
audit, and by Deloitte & Touche, the Company's auditors, assisted by Company
personnel. In addition to the scrutiny of all CUC's financial accounts, the
investigation encompassed several hundred hours of interviews with 81 witnesses
and the examination of numerous additional documents. In total, the report
included over 260 typed pages, supplemented by two volumes consisting of 128
additional exhibits.
Henry Silverman, Chairman, President and Chief Executive Officer of Cendant,
said, "This report brings to a close a difficult period for Cendant employees
and shareholders alike. The investigation has identified how a group of people
at CUC deliberately deceived and misled investors and business partners -- and
reveals a corporate culture that encouraged this behavior. We moved swiftly to
address these issues when they first came to light in April, and have put in
place a series of financial controls to ensure these improprieties cannot occur
at Cendant."
Among the report's key findings are the following:
o Irregularities Implemented to Meet Wall Street Estimates -- The report
stated that "the purpose of many of the irregularities was at least to
conform CUC's publicly-reported results to Wall Street's earnings
expectations."
"The amount of the income adjustments at each quarter closely mirrored
the amount needed to bring CUC's results into line with Wall Street
earnings expectations, e.g., if actual income in a particular quarter
was 10 cents per share and consensus analysts' expectations were 18
cents per share, then adjustments of approximately 8 cents were made,
without support, to increase earnings.
"The inflated earnings results were then publicly reported and
presented to the CUC Board of Directors at each quarter. Because these
results were often above the combined budgets of CUC's individual
business units for the quarters, the consolidated quarterly budget
figures presented to the Board...were frequently increased at corporate
headquarters to eliminate any substantial variance," the report said.
o Irregularities Directed from CUC Corporate Headquarters -- The
report stated, "Although...the numerous unsupported entries were
effected in many instances by employees of CUC subsidiaries (often with
knowledge that there was no apparent support
2
<PAGE>
for the making of such entries), the directions for the making of the
improper entries came from CUC corporate headquarters."
The report stated that Cosmo Corigliano, former Chief Financial Officer
of CUC, and Anne Pember, former Controller of CUC, were found to have
directed accounting irregularities to be entered. Neither Mr.
Corigliano nor Ms. Pember made themselves available to the independent
investigators, thereby limiting the information that could be obtained
about the role or participation of others.
Certain other financial and accounting personnel indicated they had
participated in irregular activities and directed others to record
improper entries. "More than 20 present and former employees from
various CUC business units in the United States and Europe, including
the major operating units of the company, have said that they were
instructed by persons at CUC corporate headquarters to engage in the
activities discussed in this Report," the report said.
o Responsibility of Forbes and Shelton -- The Committee concluded that
"Walter Forbes [Chairman of the Board and Chief Executive Officer of
the former CUC] and Kirk Shelton [President and Chief Operating
Officer] are among those who must bear responsibility for what occurred
at CUC."
"First, Walter Forbes and Kirk Shelton, because of their positions, had
responsibility to create an environment in which it was clear to all
employees at all levels that inaccurate financial reporting would not
be tolerated. The fact that there is evidence that many of the senior
accounting and financial personnel participated in irregular activities
and that personnel at many of the business units acquiesced in
practices which they believed were questionable suggests that an
appropriate environment to ensure accurate financial reporting did not
exist.
"Second, senior management failed to have in place appropriate controls
and procedures that might have enabled them to detect the
irregularities in the absence of actual knowledge of those
irregularities.
"Third, Walter Forbes and Kirk Shelton, the Company's most senior
managers, had a responsibility to fully understand the sources and the
true level of CUC's profitability. To the extent that they were unaware
of the irregularities, the amount by which CUC's earnings were inflated
as reported in the Restatement suggests that they did not adequately
inform themselves as to the sources and level of profitability of the
Company."
3
<PAGE>
o Numerous, Pervasive Irregularities -- "Throughout the Restatement
Period [i.e., 1995 - 1997], numerous accounting irregularities and
improper accounting practices occurred at CUC which had the effect of
inflating revenues or decreasing expenses. The irregularities were
pervasive," the report stated.
Among those irregularities were "topside" adjustments to inflate
operating income by increasing revenues and/or decreasing expenses;
quarterly unsupported adjustments to the company's balance sheet
"particularly to show a greater cash balance than the company actually
had on its books;" the improper utilization of merger reserves which,
among other objectives, helped close the "gap between what was reported
to the public and what was recorded on the company's books;" irregular
revenue recognition; understatement of the membership cancellation
reserve, and its improper reversal into income; as well as other
irregularities such as delayed recording of credit card rejects and the
creation of fictitious accounts receivable.
"Operating income was inflated during the Restatement Period in 17 of
the 22 operating units of CUC. Thus, the irregularities touched the
large majority of the company," the report said.
o Attempt to Continue Fraud in 1998 -- The report also stated, "In
addition, there is evidence that CUC intended to utilize a portion of
the reserve established in connection with CUC's merger with HFS on
December 17, 1997 to inappropriately increase earnings in 1998 and
perhaps in future periods as well."
EVENTS LEADING TO DISCOVERY OF FRAUD; WALTER FORBES' EXPENSES
- -------------------------------------------------------------
In addition to these conclusions, the report discusses evidence of a plan by CUC
executives that involved the improper reversal of merger reserves into revenues
in 1998. Also recounted are events which led to the eventual admission in April
by two CUC financial executives that adjustments had been made to meet financial
targets. This, in turn, led to the announcement by Cendant on April 15 that it
had discovered potential accounting irregularities and the commencement of the
investigation by the Audit Committee.
The report also discusses more than $500,000 of money paid to Walter Forbes in
September 1997 purportedly for his "undercharging" the company for trips he took
in 1995 and 1996 and which were charged at Mr. Shelton's direction to the
reserve established in connection with the CUC/HFS merger which closed in
December 1997.
Cendant has not concluded its review of Mr. Forbes' expenses, which is an issue
separate from the Audit Committee's investigation into CUC's accounting
irregularities and is not the subject of an Audit Committee investigation.
Cendant is investigating certain expenses recorded by Mr. Forbes during the
period 1995 to April, 1998, including the receipt of approximately $550,000 in
cash advances and approximately $1.5 million in aircraft, travel and lodging
allowances. The Company said it has not yet determined what action, if any, it
may take regarding these matters.
4
<PAGE>
Mr. Silverman said, "All of us at Cendant are now focused on the future and are
concentrating on the job of restoring confidence in our business. Our
outstanding employees have remained focused on building our business and on
showing to investors, business partners and customers each day how Cendant
uniquely can add value for them.
"As demonstrated by our 1998 results to date, our ongoing businesses continue to
perform extremely well. Each of the business units we inherited from HFS
performed on or ahead of plan, led by an unparalleled performance in our real
estate segment. We are confident that these businesses will continue to meet our
high expectations for the rest of the year and beyond. Cendant today is a
powerful engine of growth with additional potential which we are committed to
fulfill," Mr. Silverman concluded.
The text of the report's Executive Summary and Additional Conclusions will be
available on the Cendant website (http://www.cendant.com) and on PR Newswire.
The complete report may be obtained through the SEC's EDGAR website when the
Form 8-K is filed.
Cendant (NYSE:CD) is the world's premier provider of consumer and business
services. The Company operates in three principal segments: Travel Services,
Real Estate Services and Alliance Marketing. In Travel Services, Cendant is the
leading franchisor of hotels and rental car agencies worldwide; the largest
provider of vacation exchange services; a leading fleet management company, the
UK's largest private car park operator, and a leading motorist assistance group
in the UK. In Real Estate Services, Cendant is the world's largest franchisor of
residential real estate brokerage offices, a major provider of mortgage services
to consumers and a global leader in corporate employee relocation. In Alliance
Marketing, Cendant provides access to insurance, travel, shopping, auto, and
other services, primarily through direct marketing to customers of its affinity
partners. Headquartered in Parsippany, NJ, the company has more than 40,000
employees and operates in over 100 countries.
Certain matters discussed in the news release are forward-looking statements, as
defined in the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are subject to a number of known and unknown risks
and uncertainties including, but not limited to, the outcome of the pending
litigation relating to the previously announced accounting irregularities;
uncertainty as to the Company's future profitability; the Company's ability to
develop and implement operational and financial systems to manage rapidly
growing operations; competition in the Company's existing and potential future
lines of business; the Company's ability to integrate and operate successfully
acquired businesses and the risks associated with such businesses; the Company's
ability to obtain financing on acceptable terms to finance the Company's growth
strategy and for the Company to operate within the limitations imposed by
financing arrangements; uncertainty as to the future profitability of acquired
businesses; the ability of the Company and its vendors to complete the necessary
actions to achieve a Year 2000 conversion for its computer systems and
applications and other factors. Other factors and assumptions not identified
above were also involved in the derivation of these forward-looking statements,
and the failure of such other assumptions to be realized as well as other
factors may
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also cause actual results to differ materially from those projected. The Company
assumes no obligation to update these forward-looking statements to reflect
actual results, changes in assumptions or changes in other factors affecting
such forward-looking statements.
Media Contact: Investor Contact:
- -------------- -----------------
Cendant Corporation Cendant Corporation
Elliot Bloom Denise L. Gillen
973-496-8414 or 973-496-7303
Kekst and Company
Jim Fingeroth
Roanne Kulakoff
212-521-4800
# # #
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EXHIBIT 99.5
CENDANT TO DELAY 10-K FILING
----------------------------
- Restatement of Financial Statements to Eliminate Irregularities Complete -
PARSIPPANY, NJ, AUGUST 27, 1998 - Cendant Corporation (NYSE:CD) announced today
that it expects to file its restated financial statements to be included in a
Form 10-K/A in late September. Cendant has completed preparation of preliminary
restated financial statements for its 1997, 1996 and 1995 fiscal years. These
financial statements are consistent with the Company's earlier disclosures
regarding the extent and nature of accounting errors and irregularities at
business units of the former CUC International ("CUC").
The Company met with the staff of the Securities and Exchange Commission
("SEC") to discuss its proposed restatement. The staff has requested Cendant
implement further changes in its revenue recognition policy for individual
memberships as part of the SEC's ongoing review of revenue recognition by
companies that sell services with a full refund offer. The changes requested by
the SEC go beyond those believed necessary and appropriate by Deloitte & Touche
and Arthur Andersen to correct accounting irregularities and errors.
"Since we discovered accounting irregularities in the former CUC business units
in April, " stated Michael P. Monaco, Vice Chairman and Chief Financial
Officer, "we have endeavored to maintain open channels of communication with
all regulatory bodies, and in particular with the SEC. The SEC staff has given
us the opportunity to informally discuss our accounting restatements prior to
our formal filing. We believe the policies in our current restatements, the
product of months of work with Deloitte & Touche Supported by the work of
Arthur Andersen, conform with Generally Accepted Accounting Principles.
However, the staff has indicated that these revenue recognition practices,
historically implemented by Cendant and others, differ from the staff's view of
appropriate procedures. While we regret this delay, our investors, creditors
and customers will benefit from the knowledge that our accounting policies
reflect exhaustive efforts by Cendant and its independent accountants, as well
as input from regulators."
"The topics discussed with the SEC," continued Monaco, "do not affect the cash
results of this business. The discussions have not connection to correction of
the accounting irregularities previously disclosed. They revolve solely around
the Company's desire to use this opportunity to implement accounting policies
that best capture the economics of our individual membership business."
Cendant also said it expects the report of the independent investigation by its
Audit Committee into accounting irregularities in the CUC businesses to be
released later today. "Our Audit Committee's report is complete and is not the
subject of this dialogue with the SEC," reported Monaco. Cendant will also
postpone its annual meeting of shareholders as well, pending the filing of its
form 10-K/A.
Cendant (NYSE:CD) is the world's premier provider of consumer and business
services. The Company operates in three principal segments: Travel Services,
Real Estate Services and Alliance Marketing. In Travel Services, Cendant is the
leading franchisor of hotels and rental car agencies worldwide; the largest
provider of vacation exchange services; a leading fleet management company; the
UK's largest private car park operator; and a leading motorist assistance group
in the UK. In Real Estate Services, Cendant is the world's largest franchisor of
residential real estate brokerage offices; a major provider of mortgage services
to consumers; and a global leader in corporate employee
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relocation. In Alliance Marketing, Cendant provides access to insurance, travel,
shopping, auto, and other services, primarily through direct marketing to
customers of its affinity partners. Headquartered in Parsippany, NJ, the company
has more than 40,000 employees, operates in over 100 countries.
Media Contact: Investor Contact:
- -------------- -----------------
Cendant Corporation Cendant Corporation
Elliot Bloom Denise L. Gillen
973-496-8414 or 973-496-7303
Kekst and Company
Jim Fingeroth
Victoria Weld
212-521-4800
2
