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Compliance Lessons from a Fraudulent Unicorn

With a name like HeadSpin Inc., you would probably expect nothing less than what has transpired over the past few months with the former Silicon Valley darling and unicorn. According to a Securities and Exchange Commission (SEC) Press Release, in August 2021, the SEC sued Manish Lachwani, the company’s former Chief Executive Officer (CEO), stating he “engaged in a fraudulent scheme to propel HeadSpin’s valuation to over $1 billion by falsely inflating the company’s key financial metrics and doctoring its internal sales records.” Lachwani, “controlled all important aspects of HeadSpin’s financials and sales operations, significantly inflated the value of numerous customer deals and fraudulently treated potential deal amounts that he had discussed with customers as if they were guaranteed future payments.” He created fake invoices and altered genuine invoices to make it appear as though customers had been billed higher amounts.
Lesson No. 1 – (with a nod to Elizabeth Holmes) Don’t Be a Fraudulent Unicorn
All of this was done so Lachwani could garner additional investor monies through Series B and Series C funding rounds which would eventually drive the company’s value over the $1 billion mark so it could obtain magical unicorn status. Lachwani is alleged to have enriched himself by selling $2.5 million of his HeadSpin shares in a fundraising round during which he made misrepresentations to an existing HeadSpin investor. All of this brought the attention of the SEC.
Lesson No. 2 – The Most Important Internal Control is Segregation of Duties
 How could Lachwani get away with such shenanigans in an entity allegedly worth over $1 billion? In addition to lying, cheating, creating fraudulent invoices and other forms of creative financing, he abrogated one of the most basic internal controls in compliance (and finance) – segregation of duties (SODs). According to the SEC Complaint (Lachwani Complaint), “Lachwani was able to carry out his fraudulent scheme for years because he controlled and managed all the key aspects of HeadSpin’s financials and sales operations, and he kept HeadSpin employees in those different departments isolated from each other. For instance, virtually all the information provided to HeadSpin’s bookkeeper, including the supporting documentation for claimed revenue amounts, flowed through Lachwani.”
The Lachwani Complaint specifically noted, “Lachwani dictated the inflated revenue numbers each quarter to HeadSpin’s bookkeeper, who recorded those numbers in the company’s financial statements. He frequently sent the numbers without supporting documentation (like contracts and invoices) notwithstanding the bookkeeper’s regular requests for such backup, and he sometimes sent her fake or altered invoices that he had created, including the three fictional invoices related to Customer 2 and a doctored invoice related to Customer 1.”
Lesson No. 3 – Returning the Money to Those Harmed is Very Significant
 All of this played out last week when Lachwani’s former employer HeadSpin settled a SEC enforcement action via a Complaint (HeadSpin Compliant). What relief did the SEC receive? (It is awaiting Court approval.) The SEC asked for “an order permanently enjoining Defendant from directly or indirectly violating Section 10(b) of the Exchange Act”. There was no request for monetary fine, penalty or profit disgorgement. How did HeadSpin achieve this notable goal? Through its remediation efforts.
The two critical remedial steps were to get rid of the corrupt (now former) CEO Lachwani and to repay investors from the Series B and Series C funding rounds. The HeadSpin Complaint stated, “HeadSpin revised its valuation from approximately $1.1 billion down to approximately $300 million. The company also returned approximately 70% of principal to investors in the Series B and C funding rounds through a recapitalization process. The company further offered to return the remaining funds in the form of promissory notes with one percent interest. Approximately 31 investors chose to retain their HeadSpin stock instead of exchanging for promissory notes.”
This is obviously a step more than profit disgorgement. Here the money was returned to those who invested based upon the fraudulent misrepresentations. Additionally, HeadSpin offered to return money to additional investors beyond the Series B and Series C investors.
Lesson No. 4 – Structural Remedial Measures are Critical
Another set of remedial steps were generally described in the SEC Press Release announcing the HeadSpin resolution. The Press Release note, “HeadSpin’s remedial actions also included hiring new senior management, expanding its board, and instituting processes and procedures designed to ensure transparency and accuracy of deal reporting and associated revenues.” This was phrased slightly differently by HeadSpin, who said in their Press Release, “Upon learning of the alleged actions approximately two years ago, the Company immediately replaced its CEO, strengthened its leadership team, appointed an external auditor and implemented numerous financial and internal controls and corporate governance practices.”
What remediation did HeadSpin engage in which persuaded the SEC not to ask for financial penalties? There are several key actions every compliance professional should study.

  1. The Board convened a special committee of independent directors to lead an investigation.
  2. The Board (through its investigation) identified the CEO as the person responsible for the illegal conduct and terminated his employment.
  3. Additionally, the Board removed key senior management, here the Chief Operating Officer (COO), General Counsel (GC) and Controller who, although not responsible for or a part of the illegal conduct, failed to carry out their responsibilities to prevent such wrongdoing.
  4. After this clean sweep, the Board brought in a new management team and retained subject-matter experts to correct prior deficiencies.
  5. The Board added new board members with appropriate subject-matter expertise.
  6. HeadSpin implemented new internal controls and policies and procedures.

Lesson No. 5 – Creative Lawyerin’ in Remediation Can Pay Big Results
There is one more strand that should be considered from the HeadSpin matter. After the Lisa Monaco speech in October, SEC Chair Gary Gensler announced her remarks are “broadly consistent” with his own view of how to deal with corporate offenders. The HeadSpin enforcement action may offer guidance of how the SEC may implement Gensler’s remarks, through providing creative remedial measures, such as repaying those injured directly. The bottom line is that creative lawyerin’ in the form of aggressive remediation, may get you significant cooperation credit leading to a no fine or penalty resolution.
 

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31 Days to More Effective Compliance Programs

Day 20 | Responding to investigative findings


There is nothing like an internal whistleblower report about a compliance violation, the finding of such an issue, or (even worse) a subpoena from the DOJ or notice letter from the SEC to trigger the Board of Directors and senior management attention to the compliance function and the company’s compliance program. Such an event can trigger much gnashing of teeth and expressions of outrage followed immediately by proclamations “We are an ethical company.” However, it may well be the time for a very serious reality check.
 You may find yourself in the position that you will have to have some very frank discussions about what to expect in terms of costs and time outlays. While much of these discussions will focus on the investigative process and those costs, these discussions will allow you to initiate the talk about remediation going forward and begin to explain why money must be budgeted for the remediation process.
One of the things rarely considered is how the investigation triggers the remediation process and what the relationship is between the two. When issues arise warranting an investigation that would rise to the Board of Directors level and potentially require disclosure to the government, there is usually a flurry of attention and activity. Everyone wants to know what is going on. In an interview with Russ Berland, CCO at Aventiv Technologies, he noted, “for that short moment in time, you have everyone’s full attention.” Yet it can still be “a tricky place, because you get your fifteen minutes to really get everyone’s full attention, and from then on, you’re fighting with everybody else for their attention, like the normal things in business life.”
Three key takeaways:

  1. A serious FCPA allegation gets the attention of the Board and senior management. Use this time to move the compliance program forward.
  2. Be aware of how your investigation can impact and even inform your remediation efforts.
  3. Be prepared to deal with the dreaded “where else” question.
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31 Days to More Effective Compliance Programs

Day 30 | Using a root cause analysis for remediation


We previously considered the Prong in the Evaluation that was not present in the Ten Hallmarks of an Effective Compliance Program; that being root cause analysis. The requirement was first raised in the 2017 Evaluation. It was then carried forward as a requirement in the FCPA Corporate Enforcement Policy, later in 2017. It was discussed again in the 2019 Guidance.
You should begin with the question of who should perform the remediation; should it be an investigator or an investigative team which were a part of the root cause analysis? Jonathan Marks, believes the key is both “independence and objectivity.” It may be that an investigator or investigative team is a subject matter expert and “therefore more qualified to get that particular recourse”. Yet to perform the remediation, the key is to integrate the information developed from the root cause analysis into the solution.
Marks further noted that the company may also have deficiencies in internal controls. More importantly, the failure to remediate gaps in internal controls “provides the opportunity for additional errors or misconduct to occur, and thus could damage the company’s credibility with regulators” by allowing the same or similar conduct to reoccur. Finally, with both the 2019 Guidance and FCPA Corporate Enforcement Policy, the DOJ has added its voice to prior SEC statements that regulators “will focus on what steps the company took upon learning of the misconduct, whether the company immediately stopped the misconduct, and what new and more effective internal controls or procedures the company has adopted or plans to adopt to prevent a recurrence.
Three key takeaways:

  1. The key is objectivity and independence.
  2. The critical element is how did you use the information you developed in the root cause analysis?
  3. The key is that after you have identified the causes of problems, consider the solutions that can be implemented by developing a logical approach, using data that already exists in the organization.