SEC Settles With Korean Semiconductor Company Over Accounting Fraud Charges

By:
Chris Gaetano
Published Date:
May 3, 2017
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The Securities and Exchange Commission has agreed to a settlement with South Korean semiconductor company over charges that it overstated revenues for two years in a row to meet high-pressure sales targets. The SEC said that the CFO, Margaret Sakai, directed or approved several fraudulent practices in order to do this. For example, MagnaChip recognized revenue on sales of incomplete or unshipped products, and the company delayed booking obsolete or aged inventory to manipulate its reported gross margin. MagnaChip also engaged in roundtrip transactions to manipulate accounts receivable balances, and concealed from auditors that there were side agreements with distributors to induce them to accept products early.

“MagnaChip engaged in a panoply of accounting tricks to artificially meet its financial targets,” said Jina L. Choi, Director of the SEC’s San Francisco Regional Office.  “Companies that sell stock in the U.S. markets should prioritize a robust accounting culture that is entirely truthful with investors.”

The SEC said that, after its March 11 IPO, the company's senior-most executives placed immense pressure on employees to meet the revenue and gross margin targets MagnaChip communicated to its Board and to the public, as company leadership wanted to demonstrate the firm's financial strength and stability after emerging from a prior bankruptcy. The SEC said that employees had objected to these targets several times, but in each case management refused to lower them. Executives would hold weekly sales meetings where they would berate personnel for failing to meet certain targets. Consequently, employees throughout the company's sales, finance and manufacturing departments resorted to committing fraud in order to meet revenue and gross margin targets. The SEC said this was well-known throughout the company, but these practices were condoned by the then-CFO, or even directly ordered by her. 

Without admitting or denying the findings in the SEC’s order, MagnaChip agreed to pay a $3 million penalty and Sakai agreed to pay a $135,000 penalty.  Sakai also agreed to be barred from serving as an officer or director of a public company and from appearing or practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies.

This is not the first time aggressive sales targets have led to fraudulent practices, even recently: the recent Wells Fargo scandal, where the banks created millions of phantom accounts, is seen to have come about due to the extremely high-pressure sales culture that was endemic to the organization. Managers were said to routinely pressure their subordinates to open false accounts or sign people up for credit cards in order to meet sales incentives, which made up a large portion of compensation for branch managers and district managers. 

British grocery chain Tesco had a similar high-pressure environment leading up to its $420 million restatement in in 2014, which led to millions in fines and penalties, as well as criminal charges for three of its top executives. The chain had been experiencing three straight years of disappointing financial results, according to the Guardian, and so buyers and finance teams were under immense pressure to deliver on targets promised to investors, resulting in widespread practices like delaying payments to suppliers before key financial reporting periods. 

Toshiba, meanwhile, was reeling from the 2008 financial crisis, leading it to place focus on meeting unrealistic profit targets and demanding subordinates meet them. This ultimately resulted in the company having to adjust its operating profits by $1.2 billion. The three most recent CEOs were seen as having played an active role in inflating the company's profits, with accounting fraud being a regular occurrence after workers failed to meet the challenges set by them. 

The Consumer Financial Protection Bureau, in CFPB Compliance Bulletin 2016-03, noted that incentives can, when properly implemented and monitored, benefit all stakeholders and the marketplace as a whole. However it warned that they can also be a vector for consumer risk and fraud, especially if they are part of a high-pressure culture of unrealistic targets. Poorly-designed  programs, said the bulletin, can create incentives for workers to pursue overly aggressive marketing, sales, servicing or collection tactics (and, no doubt, accounting tricks would fall under these results too). 

This is because incentives will change how people operate: having a system of incentives and rewards opens up opportunities to game it. An academic study from Harvard Business School on how loan officers approve loans found that the nature of the incentive actually changed participants' perceptions of whether an application was a risky proposition or a safe bet. Participants (209 experienced loan officers) were given one of three incentive schemes: those who got a bonus for originating any loan at all, those who got a small bonus for well-performing loans and a small penalty for unsuccessful loans, and a third group that had a similar incentive scheme as the second, but their rewards and penalties were much bigger. 

Those who got bonuses to simply originate as many loans as possible issued higher ratings than those whose incentives were tied to the loan's success. The researchers found this was not just because they wanted to maximize their bonus, but that they actually believed that the application was more worthy. Meanwhile, those whose incentives had both high rewards and high penalties were found to have been much more conservative in approving loans, and were actually better at determining which applications were bad prospects. 

"Incentive contracts distort judgment and beliefs, even among trained professionals with many years of experience. Loans evaluated under more permissive incentive schemes are rated significantly less risky than the same loans evaluated under pay-for-performance," said the study abstract. 

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