Monday, December 18, 2006

How many WorldComs in Your Future? -- Shame on You, Chris Cox!

Essayist and philosopher George Santayana knew too well the nature of men when he first wrote the now banal words, “Those who cannot remember the past are condemned to repeat it.”

Save for shareholder activists, those in academia, and the usual politicians pandering for votes—the 10Q Detective foresaw back in 2002 that the S.E.C never had the conviction to hold back the tide of the better-financed business lobbyists— Sarbanes-Oxley had a limited shelf life.

Responding to criticism that regulators had overreacted to years of corporate scandals—WorldCom, Adelphia, Enron, Tyco, to name a few—the
S.E.C. took its first steps to ease regulations on businesses.

Hidden among a flurry of deregulatory orders and proposals issued last week to “lower costs to public companies,” were proposals submitted to enfeeble the enforcement of existing disclosure and financial reporting rules. Specifically, the S.E.C. acquiesced to businesses demands by proposing that small capitalization companies be given back some control in restricting their auditors from engaging in what the executives “viewed as expensive and unnecessary audits” of financial activities that had “minimum impact on financial statements” (Section 404).

We ask our readers to indulge us—read some bullet points lifted from the recent Proxy Statement of Global ePoint (GEPT-$0.52), a manufacturer of digital surveillance and detection solutions—and, then see if you agree with S.E.C. Chairman Christopher Cox when he said last week that looser interpretation of existing auditing rules would not reduce investor protection:

Related Parties Transactions

  • Global transacts a substantial majority of its business with companies that are owned or controlled by Mr. John Pan, Chairman, President, Chief Financial Officer and largest stockholder, who beneficially owns 4.95 million shares, or almost 25 percent of the common stock. According to Global, “these transactions allow the Company to leverage sales opportunities and component and sub-system purchasing relationships of these related companies.”

Management believes that Global can achieve the benefits of economies of scale associated with shared facilities, administration, and sales, and the benefits associated with the use of the related parties’ network of global contacts, sales opportunities and purchasing power.

Facilities Leasing Arrangement

  • Global shares office and warehouse facilities in buildings owned or controlled by Mr. John Pan, which facilities are also partially occupied by another company controlled by Mr. Pan. Global also uses and pays rent to Mr. Pan for the use of its manufacturing and assembly equipment. Global recorded occupancy costs and equipment rental expenses to Mr. Pan totaling $519,000 and $492,000 for the fiscal years ended December 31, 2005 and 2004, respectively. Occupancy costs paid to Mr. Pan were based on the square footage occupied and a price per square foot verbally agreed upon.

Sale Arrangements

  • During 2005 and 2004, Global sold approximately $18.0 and $7.6 million, respectively, of products and contract manufacturing services to related parties. Included in these amounts were sales of $17.6 and $7.2 million, respectively, to Avatar Technology Inc. and $0.2 and $0.3 million, respectively, to Prophecy Technology LLC. This represented 55% and 36% of overall sales for the year ended December 31, 2005 and 2004, respectively.

Avatar provides distribution of computer components around the world, as well as consumer PCs in selected markets. In both 2005 and 2004, Avatar secured major contracts for consumer PCs with a large retail chain in Latin America and, as a result, subcontracted the manufacturing of the consumer PCs to us. Global’s contract manufacturing division generated sales of approximately $17.6 and $7.2 million in 2005 and 2004, respectively, from Avatar for consumer PCs, all of which were ultimately delivered to retail stores of Avatar’s customers throughout Latin America.

Prior to joining Global ePoint in August 2003, Mr. Pan was the founder, Chief Financial Officer, President, and a director of Avatar Technology, Inc., and he remains a consultant to that company.

Mr. Pan is also a founder, President and Chief Financial Officer of Prophecy Technology LLC, positions he has held since September 1992.

Purchases From Related Parties

  • During 2005 and 2004, Global purchased from related parties components and finished products totaling approximately $15.3 and $5.7 million, respectively. According to management, “The related parties can generally purchase components in greater quantity than Global can on its own and thereby can pass through to the Company the more favorable pricing due to its volume discounts.” Of total purchases from related parties, a majority constituted purchases of various component parts, such as memory, CPUs, hard drives and motherboards, and finished products from Avatar and Prophecy. Of the total purchases in 2005 and 2004, approximately $10.8 and $1.7 million, respectively, were from Avatar, and approximately $4.4 and $4 million, respectively, were from Prophecy. These aggregate costs represented about 53% and 35% of overall cost of goods for the year ended December 31, 2005 and 2004, respectively.

Other Related Party Transactions

  • In June 2004, Global borrowed $1.0 million from John Pan. The aggregate interest rate was 7.25% as of December 31, 2005; the outstanding loan and accrued interest totaled $1.1 million. Global is required to accrue interest payments each month until the principal balance is paid in full, which must occur no later than December 2006.
  • In addition to being the largest customer of and supplier to Global, Mr. Pan is also paid an annual wage in his role as Chairman, Chief Financial Officer and President of Global. In fiscal year 2005, his salary was increased approximately 20 percent to $245,000, plus an annual bonus of up $147,000 (based on Mr. Pan’s satisfaction of annual performance conditions to be determined by the Compensation Committee).

In our view, Global ePoint epitomizes how weakening the internal auditing control at small capitalization companies does a potential disservice to investors.

The past is history; The future is a mystery – Allan Johnson

The future for investors of small cap companies is no mystery to us—more corporate fraud.

The 10Q Detective is not alleging that Global ePoint, a provider of vending machines for the sale of instant-winner lottery tickets in a former life, was—or is—guilty of any fraud or corporate abuses.

Weakening internal control systems and lowering the bar for financial reporting standards does little to promote corporate transparency. Christopher Cox and the S.E.C.—shame on you!

Editor David J. Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.

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