Dive Brief:

• The Securities and Exchange Commission (SEC) charged the former CEO and CFO of FTE Networks, a telecom infrastructure company, with inflating revenue by as much as 108%, concealing the issuance of almost $23 million in convertible notes and misappropriating millions of dollars of funds for personal use. 
• Former CEO Michael Palleschi and former CFO David Lethem used falsified documents to issue the convertible notes with short-term maturities, steep interest rates and market-price-based formulas for conversion into shares.  
• The executives misled in-house accounting personnel and the company’s outside auditor about material terms of the notes, which were not properly accounted for or disclosed in FTE’s financial statements. The executives also inflated the company’s revenue by directing accounting staff to improperly recognize revenue and accounts receivable for nonexistent construction projects.  

Dive Insight:

“The defendants engaged in an egregious scheme to fraudulently inflate FTE’s revenues to portray a false picture of the company’s financial condition while misappropriating millions of dollars for their personal use,” said Eric Bustillo, director of the SEC’s Miami regional office.  

In the scheme involving convertible notes, which allow holders to convert repayment into company shares, potentially diluting existing shareholders, Palleschi and Lethem masked the notes as conventional promissory notes. Among other things, they created fake copies of the notes and forged director signatures on resolutions approving the action. 

“Typically, only businesses that have no other way to obtain financing resort to convertible notes, because they normally involve higher interest rates than conventional promissory notes and the conversion features can wreak havoc with a company’s stock price and dilute other shareholders’ holdings,” the SEC said. 

To mislead the company’s board about the notes, “Lethem created fake copies … that stripped any information that would identify the notes as convertible notes,” the complaint said.  

Both Palleschi and Lethem knew the risks associated with the notes, the SEC said, chief among them the massive interest payments and convertible features. “In fact, Palleschi and Lethem referred to the Notes as ‘toxic’ debt, a common term for convertible notes that reflects how devastating such notes can be for issuers and their shareholders,” the complaint said. 

To further conceal what they were doing, Lethem maintained two copies of the notes. “One was a correct copy,” the SEC said. “The other, which Lethem referred to as the ‘accounting’ copy, removed from the notes any references to the conversion rights and made it appear as if the notes were conventional promissory notes.”

Lethem provided only the accounting copy to the company’s accountants, who, in turn, improperly accounted for them in the company’s books. 

The executives also lied to FTE’s auditor about the notes. “When the auditor asked for copies of certain notes, Lethem refused to provide them and instructed FTE accounting personnel to lie that the notes were unobtainable,” the complaint said. 

As note holders began to convert their repayment rights into shares, company staff became suspicious. “Eventually, note holders converted the notes into so many shares that the company exceeded the total amount of shares it was authorized to issue on the New York Stock Exchange, which hastened discovery of the scheme,” the complaint said. 

Fictitious income

The fictitious income involved approximately $12.5 million of revenue and related accounts receivable from construction projects for which the company had not yet billed and from contracts for projects the company allegedly had completed and billed for, but which had not yet been paid. In fact, the SEC said, “FTE had not performed the work, and the revenue and receivables were wholly fictitious.”

Of the $12.5 million, $10 million was for the unbilled work, which FTE began to recognize to boost its poor performance. For one period, recognition of $5.8 million of the unbilled work in its financial statements resulted in the company overstating its revenue by 108% and its accounts receivable by 477%. “Without the unbilled work, FTE’s auditor would have likely called into question whether FTE was a ‘going concern’ — in other words, whether FTE was financially stable enough to meet its obligations and continue its business for the foreseeable future.” 

Over a two-year period, at Lethem’s direction and with Palleschi’s knowledge, FTE continued to add more fictitious revenue to the unbilled work balance, entirely for work supposedly done for one particular customer.

During the company’s periodic and year-end audits, the external auditor repeatedly questioned the validity of the unbilled work and receivables. In response, Palleschi, Lethem, and another officer provided the auditor with “numerous false or doctored documents and explanations to justify the fraudulently recognized revenue,” the SEC said.

Personal luxuries 

While these accounting schemes were happening, Palleschi and Lethem misappropriated millions from the company in the form of unauthorized and undisclosed salary increases, luxury car leases, private jet services, and other payments, the complaint said. 

Among other things, Palleschi used FTE funds to pay for approximately $427,000 worth of private jet flights for personal reasons, including family trips to Las Vegas costing $43,853 and Peru costing $184,387. Palleschi also allowed Lethem to use the private jet service for personal trips worth $50,686. 

Both Palleschi and Lethem also caused FTE to pay for multiple luxury car leases in amounts greater than what was authorized under their respective employment agreements.

Palleschi’s employment agreement authorized a monthly car allowance of $1,000, which he increased to $10,000 a month without authorization. He then caused FTE to pay for approximately $740,000 in car leases and storage fees, which included a Jeep that he used solely at his vacation home, three Audi sports cars, and a Dodge Ram. Lethem caused FTE to spend approximately $54,000 on an Audi, when he had no auto allowance whatsoever. 

The executives also caused the company to make unauthorized and undisclosed salary payments in excess of what each was entitled to receive.

For example, FTE paid Palleschi an authorized salary of $250,000 a year. Any changes to his salary and employment contract required board approval.

Yet, secretly, without even presenting a proposal to the board, Palleschi raised his salary from $250,000 to $1 million, the SEC said. “Palleschi circumvented the normal approval process and instead sent his ‘revised’ employment agreement directly to human resources with an instruction to accrue but defer payment on his new salary.”

The SEC is seeking permanent injunctions, penalties, and officer-and-director bars against Palleschi and Lethem, disgorgement and prejudgment interest, and a clawback of equity-based compensation paid to Palleschi during the alleged fraud.

Separately, the U.S. Attorney’s Office for the Southern District of New York announced criminal charges against Palleschi and Lethem for related misconduct.