SEC Charges VMware in “Reverse” Channel Stuffing Case

We have blogged about many SEC “pull forward” enforcement cases.  They all involve companies that “pull forward” orders scheduled for future periods to the current period to meet sales forecasts and expectations. (Check out this post for several example cases).  As the volume of these cases shows, “pull forwards” are a common way companies can try to mask revenue shortfalls.  Interestingly, in almost all these cases, there is no financial statement revenue recognition misstatement.  Goods are shipped and revenue is recognized in the proper period.  Most of these cases focus on companies not disclosing the impact of related management practices, including price reductions, extended payment terms and the potential impact on future period revenues.

In an interesting twist on this practice, on September 12, 2022, the SEC charged VMware with “managing” its backlog to move orders from current quarters to future quarters, the mirror image of a “pull forward.”  According to the SEC’s Accounting and Auditing Enforcement Release, this allowed VMware to meet revenue forecasts and related analysts’ expectations during a period where its business slowed relative to projections and its sales mix was shifting from a point in time license model to a revenue recognition over time subscription model.

The basis for this case is failing to disclose to investors how VMware “managed” its backlog.  Revenue was not misstated.  The case includes disclosures in Exchange Act reports, earnings calls and earnings releases. According to the AAER:

“Beginning with its Form 10-Q filed for Q1 FY19, VMware began disclosing in its filings that ‘[t]he amount and composition of [VMware’s] backlog will fluctuate period to period, and backlog is managed based upon multiple considerations, including product and geography,’ but the disclosure omitted material information regarding the discretionary nature of VMware’s backlog, the extent to which VMware controlled the amount of its backlog, and how backlog was used to manage the timing of the company’s recognition of total and license revenue. In actuality, VMware’s backlog practices during the relevant period were controlled for the purpose of determining in which quarters revenue would be recognized and had the effect of obscuring the company’s financial results and avoiding revenue shortfalls versus company financial guidance and analysts’ estimates in at least three quarters during FY20, as well as full-year FY20.”

The AAER focuses on disclosure:

“In making public statements regarding its backlog, VMware omitted material information regarding the extent to which the company controlled its quarter-end total and license backlog numbers through its use of discretionary holds, and the extent to which it used backlog to control the timing of revenue recognition generally. The managed backlog disclosure did not convey to investors the material information that backlog was used by VMware to manage the timing of revenue recognition based upon factors such as the company’s financial guidance and  analysts’ estimates. This information was necessary in order to make VMware’s statements regarding its backlog, in light of the circumstances under which they were made, not misleading.”

In key parts of the AAER, the SEC addresses materiality:

“VMware’s statements and omissions regarding its quarterly revenue and revenue growth, without disclosing the impact that the company’s discretionary backlog practices and revenue management had on reported revenue, materially concealed a substantial FY20 slowing in the company’s recognized revenue growth versus expectations. Reasonable investors would have considered the foregoing information to have been important in deciding whether to purchase VMware securities during the relevant period.”

“In addition, this was important information to analysts, who began questioning VMware’s backlog ‘drawdown’ following the company’s Q1 earnings call and continued to question the continual reductions in quarter-end backlog numbers throughout the remainder of the fiscal year. VMware recognized the materiality of the issue when preparing its Q&A scripts.”

VMware paid an $8,000,000 fine.  The company did not admit or deny the SEC’s findings.

As always, your thoughts and comments are welcome.

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