Defendants Charged with Concealing Company’s Deteriorating Financial Condition and Embezzling Company Funds
Audrey Strauss, the United States Attorney for the Southern District of New York, and William F. Sweeney Jr., the Assistant Director-in-Charge of the New York Office of the Federal Bureau of Investigation (“FBI”), announced today the unsealing of an Indictment in Manhattan federal court charging MICHAEL PALLESCHI, the former Chief Executive Officer of FTE Networks, Inc. (“FTE”), and DAVID LETHEM, the former Chief Financial Officer of FTE, with conspiracy, securities fraud, and wire fraud, improperly influencing the conduct of an audit and aggravated identity theft. These charges stem from the defendants’ years-long scheme to inflate FTE’s revenue, to conceal liabilities and expenses, and to embezzle company funds. PALLESCHI was arrested this morning in the Northern District of New York and will be presented today in that district. LETHEM was arrested this morning in the Middle District of Florida and will be presented today in that district.
U.S. Attorney Audrey Strauss said: “When corporate executives sell their company’s stock to the public, they assume the responsibility under federal law of making full and accurate disclosures about their company’s financial condition to investors. Palleschi and Lethem instead chose to lie about FTE’s finances to make the company appear more financially healthy than it was, thus defrauding FTE’s stockholders and lenders. Instead of forthrightness with their investors, Palleschi and Lethem chose the easy way to cash in by obfuscating FTE’s true financial health through fake documents and forged signatures. This Office is committed to ensuring the integrity of our capital markets through vigorous enforcement of federal securities laws.”
FBI Assistant Director William F. Sweeney Jr. said: “Concealing a company’s true financials from investors is not only an unscrupulous business practice, but in the case of Palleschi and Lethem, as we allege today, it amounted to a federal crime. Financial fraud schemes are all too common, and in order to maintain investor confidence, we need to hold accountable those who perpetrate them.”
According to the Indictment unsealed today in Manhattan federal court:[1]
FTE was a telecommunications company based in Naples, Florida and Manhattan. As of December 2017, its stock traded on the NYSE American market. From 2014 to 2019, PALLESCHI was the chairman of FTE’s Board of Directors and its Chief Executive Officer. LETHEM served as FTE’s Chief Financial Officer from 2014 through 2019.
Fraud with Respect to Convertible Notes
From 2016 to early 2019, PALLESCHI and LETHEM caused FTE to issue approximately 70 notes with a total principal balance of more than $22 million to private lenders that the lenders could convert to FTE’s common stock, either upon demand or upon default. Issuers of such convertible notes must recognize on their financial statements liabilities and expenses that arise from the notes’ conversion features. PALLESCHI and LETHEM caused FTE to recognize only the principal amounts and resulting interest expense on the company’s books but not the substantial liabilities and expenses arising from the notes’ conversion features.
In furtherance of the scheme, PALLESCHI and LETHEM took several steps to conceal the notes’ conversion features:
Rather than provide FTE’s accountants and auditors with copies of the actual convertible notes, the defendants created fake notes with the same lenders, principal amounts and other terms as the convertible notes and gave the fake notes to the auditors and accountants. PALLESCHI and LETHEM created more than 35 such fake notes with a total principal balance of more than $14 million.
PALLESCHI and LETHEM also created fake resolutions of FTE’s Board of Directors that purportedly authorized the company to issue the convertible notes on which they forged the Directors’ signatures. The defendants then provided these forged Board resolutions to FTE’s lenders.
On four occasions in June 2017, LETHEM forged the signature of a representative of FTE’s transfer agent on letters that he provided to lenders. The transfer agent kept records of who owned FTE’s stock and held stock shares that the company had not yet issued. The forged letters purported to confirm that the transfer agent would hold a sufficient number of shares of FTE’s stock in reserve to pay a convertible lender in case the lender decided to convert a convertible note into FTE stock. These letters protected convertible lenders by ensuring that enough shares of FTE’s stock would be available to pay off the convertible notes. Convertible lenders generally required their borrowers to provide them with such letters before funding a convertible note.
PALLESCHI and LETHEM lied repeatedly to FTE’s auditors by falsely denying that the company had issued convertible debt. In April 2018, LETHEM falsely denied to the auditors that FTE had issued two specific convertible notes. Three days later, both PALLESCHI and LETHEM repeated this false denial to the auditors in a management representation letter related to the audit of FTE’s 2017 year end financial statements. PALLESCHI and LETHEM also falsely denied to the auditors in April 2018 and again in November 2018 that a $1.4 million note FTE had entered into in April 2018 was convertible. When the auditors asked to see a copy of the $1.4 million note, LETHEM falsely claimed that his sole electronic copy of the note was lost because the electronic file had become corrupted. When the auditors continued to ask for the note, LETHEM concealed that he had the note all along by sending the note to a company attorney and arranged for the attorney to send it back to him. LETHEM then forwarded the attorney’s email to a company Director, who forwarded it to the auditors with the notation that “[the attorney] found the note!” When the auditors then asked that the attorney review her files for other notes, LETHEM and the attorney falsely responded that the attorney did not know of, or possess, additional convertible notes.
As a result of this fraud with respect to convertible notes, the defendants caused FTE to understate its debt derivative liabilities and warrant derivative liabilities and to fail to recognize losses on conversion derivative liabilities and losses on issuance of notes in 2017 and 2018. For example, FTE’s year end 2017 financial statements understated FTE’s debt derivative liabilities by $48 million and warrant derivative liabilities by $16 million. FTE also failed to recognize a $35 million loss on conversion derivative liabilities and a $42 million loss on issuance of notes for the year ending 2017.
Fraudulent Revenue Recognition
PALLESCHI and LETHEM also caused FTE to recognize more than $13 million in fraudulent revenue:
This fraudulent revenue included more than $10 million in “unbilled” revenue that the defendants represented FTE had earned from services it had supposedly provided to a large customer that would not yet accept bills for those services. FTE never provided any such services.
In addition, the defendants caused FTE to recognize approximately $2.6 million as an account receivable for which there was no support. When FTE’s auditors said that the account receivable should be written off, PALLESCHI and LETHEM created a fake email from a representative of the customer saying that the customer would “expedite payments” for more than $1.5 million for projects completed by FTE in 2016 and 2017. The defendants caused this fake email to be sent to FTE’s auditors so that FTE could continue to recognize the receivable.
PALLESCHI and LETHEM caused FTE to recognize another $600,000 in accounts receivable for work the defendants falsely claimed FTE performed. When FTE’s auditor sought confirmation of this account receivable from the customer, LETHEM gave the auditor the name and email address of an FTE director who also was an employee of the customer. PALLESCHI and LETHEM then attempted to persuade the FTE director to sign the confirmation but the director refused to do so. LETHEM then emailed PALLESCHI in part “should I just send plan b?” Later that day, LETHEM emailed PALLESCHI an audit confirmation containing the director’s forged signature. A few days later, LETHEM emailed the auditor a confirmation containing the director’s forged signature.
As a result of the defendants’ fraudulent recognition of revenue, FTE’s financial statements overstated the company’s accounts receivable by between 18% and 120% for each of the quarters in 2017 and 2018 and by approximately 477% for 2016.
Embezzlement of Corporate Funds
PALLESCHI and LETHEM also embezzled corporate funds. This embezzlement included payments for private jet use, luxury automobiles, personal credit cards, unauthorized wire transfers and stock issuances. PALLESCHI and LETHEM used a bank account in the name of another entity to hide their diversion of corporate funds.
PALLESCHI, 46, of Naples, Florida; and LETHEM, 62, of Ft. Myers, Florida, are charged with 1) conspiring to commit securities fraud, wire fraud, making false statements in SEC filings and improperly influencing the conduct of audits, which carries a maximum sentence of 5 years in prison; 2) securities fraud, which carries a maximum sentence of 20 years in prison; 3) wire fraud, which carries a maximum sentence of 20 years in prison; 4) improperly influencing the conduct of audits, which carries a maximum sentence of 20 years in prison; and 5) aggravated identity theft, which carries a mandatory minimum term of 2 years in prison. The maximum potential sentences in this case are prescribed by Congress and is provided here for informational purposes only, as any sentencing of the defendants will be determined by the judge.
Ms. Strauss praised the investigative work of the FBI. Ms. Strauss further thanked the U.S. Securities and Exchange Commission, which today filed a parallel civil action.
The charges contained in the Indictment are merely accusations, and the defendants are presumed innocent unless and until proven guilty.
