Improper Use of SPEs: The SEC’s Complaint (2011) against Basin Water, Inc. alleg
ID: 2576992 • Letter: I
Question
Improper Use of SPEs: The SEC’s Complaint (2011) against Basin Water, Inc. alleged: “The Defendants Materially Overstate Basin’s Q2 2007 And Year-To-Date Revenues By Engaging In A Sham $3.8 Million Sale To A Special Purpose Entity They Directly Or Indirectly Cause To Be Created” (section F). After review- ing the signals for Enron’s schemes of using SPEs to understate debt and to overstate earnings, identify the signals of the improper use of unconsolidated
affiliates, or SPEs, that were present in the Enron case and can allegedly be found in Basin Water’s notes to its financial statements. Explain why those signals could have been indica- tions that Basin Water may have alleg- edly overstated its sales and under- stated its loss.
Explanation / Answer
By reviewing case of “The Defendants Materially Overstate Basin’s Q2 2007 And Year-To-Date Revenues By Engaging In A Sham $3.8 Million Sale To A Special Purpose Entity They Directly Or Indirectly Cause To Be Created” (section F) : The identified the signals of improper use of unconsolidated affiliates or SPE to understate debt and to overstate earnings are as follows:
Tekulve caused basin to recognize $2.1 Million inrevenue in Q3 2007 relating to the purported sale of units to WSS based on the percentage of completion method for reconizing revenue. Recognition of this revenue was improper however,
Basin did not have definitive agreement with WSS, additionaly, the WSS aagreement contained materially diiferent terms such as a lower purchase price of $38,45,073 and payment of the $25,000 down paymnet of at Dec27,2007 closing date.
WSS had not made the initial down payment of $25,000 required by the WSS Letter "to be held in escrow pending execution of definitive documentation" and in fact, never paid it·
Collectability was not probable in that WSS had no assets and was dependent on a $2.1 million loan from a third party, National City Energy Capital, LLC based in Cincinnati, Ohio, . and the initial closing date of the loan was December 31, 2007, as set forth in the September 28,2007, correspondence from National City to WSS which Tekulve received that same day;
Delivery by Basin of the systems, which were being 5 manufactured, had not occurred.
Explain why those signals could have been indica- tions that Basin Water may have alleg- edly overstated its sales and under- stated its loss?
On or about October 31, 2007, pursuant to a request by Basin's auditor, Basin's Director of Finance, Hansen, prepared a memorandum, or "white paper," which, after being reviewed and approved by Tekulve on or about November 1, was provided to Basin's auditors.
The memorandum purported to justify recognition of revenue based on the September 10,2007, WSS Letter signed by Tekulve on September 24. The memorandum was materially misleading in part because it failed to disclose that WSS was an SPE with no operations which Basin caused to be created for the sole purpose of creating purported revenues. Additionally, the memorandum misleadingly states that "collectability is reasonably assured" because WSS "is backed by National City, a large Chicago bank," when National City was, in fact, National City Energy Capital LLC, based in Cincinnati, Ohio;
and because the $25,000 deposit had been made into an escrow account when in fact no such deposit had been made. In fact, as stated above, the National City financing and $25,000 escrow deposit never occurred. The recognition of revenue from the WSS transaction did not comply with GAAP, and these revenues were material to Basin's financial statements.