Author: Enforcement Highlights

SEC Uses Books and Records and Internal Control Regulations to Extend Reach of Actions Beyond Fraud

Last year, we predicted that the SEC would increase its use of administrative proceedings to enforce strict liability violations such as books and records and internal controls. See Mary P. Hansen & William L. Carr, The Future of SEC Enforcement Actions: Negligence Based Charges Brought in Administrative Proceedings, The Investment Lawyer, Vol. 21, No. 9 (September 2014). In a recent action, announced on April 1, 2015, the SEC did just that.

According to the SEC, Timothy Edwin Scronce, the majority owner and CEO of privately held TelWorx Communications, LLC (“TelWorx”), falsified TelWorx’s books to inflate its revenues leading up to and after the acquisition of TelWorx by a public company, PCTEL, Inc. (“PCTEL”). Exchange Act Rel. No. 74626 (Apr. 1, 2015). In particular, prior to the acquisition, Scronce directed TelWorx’s Controller, Michael Hedrick, to inflate the value of certain inventory and to invoice certain orders before they had shipped and then reverse the invoices so they could be invoiced again during the subsequent quarter. After the acquisition, Scronce instructed Hedrick to create dummy invoices for orders that Scronce himself intended to make to further conceal his conduct. In addition, once Scronce learned that a large order that had been postponed would not be placed in time to help meet the quarterly results, he instructed the Vice President of Sales and Tech Services, Marc J. Mize, to solicit a straw vendor that would purchase the product on an intermediate basis with the intent to prematurely recognize the income from this sale. The timing on this transaction ultimately would not obtain the benefit Scronce intended, and he instructed Mize and another employee to reverse the invoice and to enter a revised, false purchase order into the system. All of these actions caused PCTEL to materially overstate its income during the relevant period.

Based on these allegations, the SEC instituted proceedings against Scronce for violation of (1) “Section 10(b) of the Exchange Act and Rule 10b-5 thereunder which prohibit fraudulent conduct in connection with the purchase or sale of securities”; (2) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (3) “Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading”; (4) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (5) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act.” Without admitting or denying the findings, Scronce agreed to disgorgement in the amount of $376,007; prejudgment interest in the amount of $29,212.47; and a civil monetary penalty in the amount of $140,000, and to a ten-year ban on acting as an officer or director of any issuer.

The SEC did not stop there, though. It also charged Hedrick and Mize for violation of (1) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (2) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (3) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act,” none of which requires the SEC to prove that an individual acted with scienter. In addition, the SEC charged Hedrick with causing Scronce’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder and with causing “PCTEL’s violations of Section 13(a) of the Exchange Act and rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading.”

Hedrick and Mize, like Scronce, agreed to resolve the charges without admitting or denying the findings. Each of them agreed to pay civil monetary penalties in the amount of $25,000. Notably, these sanctions do not reflect that Hedrick was charged with causing Scronce’s and PCTEL’s fraud violations, while Mize was only charged with strict liability violations.

We expect the SEC to continue using books and records and internal control charges to pursue companies and senior executives who play a role in fraudulent schemes, even where an individual did not act intentionally or even recklessly.

SEC “Claws Back” Bonuses and Stock Sale Profits From CFOs of Public Company Charged With Accounting Fraud

On February 10, 2015, the SEC announced settlements with two former chief financial officers of Saba Software, a Silicon Valley software company, that require the CFOs to repay Saba more than $500,000 in bonuses and profits from stock sales earned subsequent to Saba’s false filings. Notably, the SEC did not allege that either former officer violated the federal securities laws in any fashion, nor was there evidence of either officer’s knowledge of, or complicity in, the underlying conduct that prompted the company to settle accounting fraud charges lodged against it by the SEC in September 2014. See Press Release, SEC Announces Half-Million Dollar Clawback from CFOs of Silicon Valley Company that Committed Accounting Fraud (Feb. 10, 2015).

The first CFO, William Slater, a former accountant who served as CFO from November 2011 through February 2013, and the second, Peter E. Williams III, a California attorney who served as CFO from March 2004 through July 2007 and again on an interim basis from October 2011 through January 2012, agreed to reimburse the company approximately $337,000 and $142,000, respectively, pursuant to Sarbanes-Oxley Section 304(a).

Section 304(a) provides that in the event an “issuer,” as defined under the Securities and Exchange Act of 1934, is required to issue a restatement of its accounting records as a result of misconduct under the securities laws, the issuer’s CEO and CFO “shall reimburse the issuer” for any bonus, “incentive-based,” or “equity-based” compensation, or for the profits from the officers’ personal sale of any of the issuer’s securities during the 12-month period following the first issuance of each allegedly violative financial statement. See 15 U.S.C. § 7243(a).

In September 2014, the SEC charged Saba with accounting fraud, and the company agreed to a settlement. The company was required to restate its financial records for the years 2008–2011 and for parts of 2012. In connection with the settlement with Saba, the SEC alleged that two Saba vice presidents had overseen a practice of misstating the hourly work of international consultants, both pre-booking and underbooking time statements, in order to adhere to prearranged time estimates. The practice violated GAAP and allegedly led to an overstatement of Saba’s revenues by approximately $70 million. The vice presidents responsible for the misconduct agreed to a collective disgorgement of approximately $55,000 and a collective penalty of $100,000, while the company agreed to pay a $1.75 million fine. At the time of the settlement, Saba’s CEO agreed to reimburse the company for more than $2.5 million in bonus, incentive, and equity-based pay that he received during the 12-month periods following the original issuance of the financial statements containing the alleged fraud. See Press Release, SEC Charges Software Company in Silicon Valley and Two Former Executives Behind Fraudulent Accounting Scheme (Sept. 24, 2014).

The SEC claims that “Section 304 does not require that a chief financial officer [or chief executive officer] engage in misconduct to trigger the reimbursement requirements.” William Slater, CPA and Peter E. Williams, III, Securities & Exchange Act of 1934 Release No. 74240, File No. 3-16381 (Feb. 10, 2015) at 5. Indeed, despite no evidence of fault or liability, Mr. Williams, who served as interim CFO for only four months between 2011 and 2012, was forced to reimburse the company for more than $140,000 in compensation he had received as a result of the allegedly violative financial statements.

This draconian clawback provision went into effect in 2002, although the SEC declined to actively enforce it until 2009. That year, the enforcement division settled accounting fraud charges with CSK Auto and four of its former executives, but in that case, it did not stop there. As former SEC Director of Enforcement Robert Khuzami announced in a December 8, 2009 speech, the SEC sought “to clawback more than $4 million in bonuses and stock sale profits from the former CEO, despite the fact that he was not alleged to have personally participated in the underlying financial wrongdoing.” Khuzami noted that, going forward, the SEC would use this “powerful enforcement tool” in “appropriate circumstances” in order to prevent CEOs and CFOs from “personally profit[ting] from misstated financial filings” and to incentivize these officers “to ensure the accuracy of [their] compan[ies’] financials.” Robert Khuzami, Remarks at AICPA National Conference on Current SEC and PCAOB Developments (Dec. 8, 2009).

Though Khuzami touted the new priority of the enforcement of this provision in another speech, see Robert Khuzami, Remarks at AICPA National Conference on Current SEC and PCAOB Developments (Aug. 5, 2009)  (“This is the first Section 304 action seeking to clawback compensation from an officer that was not alleged to have personally participated in the underlying financial wrongdoing.”), it is unclear when and why the staff will deem officers “appropriate” targets for clawbacks. In fact, because the provision requires no proof of culpability on the part of the corporate officers, the employment of this enforcement tool is particularly difficult to forecast.

Looking ahead, because Section 304(a) does not provide for a private right of action that would allow shareholders to seek reimbursement from CEOs and CFOs, see Cohen v. Viray, 622 F.3d 188, 193-194 (2d Cir. 2010), the SEC remains the exclusive enforcement entity of this powerful provision. There is some indication that we may see an expansion of requirements related to companies’ internal clawback policies through the implementation of Dodd-Frank, see Kara M. Stein, Remarks at the “SEC Speaks” Conference (Feb. 21, 2014) (“We also need to finalize rules about executive compensation, including provisions requiring issuers to have policies in place to claw back compensation.”), but in the meantime, enforcement will remain at the SEC’s whim.

Third Circuit Clarifies Extraterritorial Reach of Federal Securities Laws

The Third Circuit recently clarified the extraterritorial limits of the federal securities laws, as the U.S. Supreme Court defined in Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). See United States v. Georgiou, Nos. 10-4774, 11-4587, 12-2077, __ F.3d __, 2015 WL 241438 (3d Cir. Jan. 20, 2015). George Georgiou and his co-conspirators made zero-sum trades between brokerage accounts in Canada, the Bahamas, and Turks and Caicos to artificially inflate the value of four “target stocks” that were available for trade in the U.S. through two interdealer quotation systems, the OTC Bulletin Board (“OTCBB”) and the Pink Sheets. Id. at *1. Georgiou used the fraudulently inflated value of his ownership interest in the target stocks as collateral to obtain loans that he would never repay, ultimately costing his creditors and the other stockholders of the target stocks millions of dollars. Id. On appeal, Georgiou argued that his convictions could not stand because they were based on the extraterritorial application of the federal securities laws. Id.

In Morrison, the Supreme Court limited Rule 10(b)’s application to two types of transactions: “(1) transactions involving ‘the purchase or sale of a security listed on an American stock exchange,’ and (2) transactions involving ‘the purchase or sale of any other security in the United States.’” Georgiou, 2015 WL 241438, at *4 (quoting Morrison, 561 U.S. at 273). The Third Circuit determined that Georgiou’s transactions were not of the first type, even though some of the purchases were executed by market makers operating within the United States, because the SEC does not consider the OTCBB and the Pink Sheets to be securities exchanges. Id. at *4–5.

The Third Circuit held, however, that Georgiou’s transactions were of the second type because they involved “the purchase or sale of any other security in the United States.” Id. at *4. Whether a transaction is domestic, the court observed, does not depend on “‘the place where the deception originated, but [the place where] purchases and sales of securities’ occurred.” Id. at *5 (quoting Morrison, 561 U.S. at 266). A purchase or sale of securities occurs “when the parties incur irrevocable liability to carry out the transaction,” such as “the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money.” Id. at *5–6 (citations omitted) (internal quotation marks omitted). The Third Circuit held that at least one transaction in each of the target stocks involved the purchase or sale of a security in the United States because “all of the manipulative trades were ‘facilitate[d]’ by U.S.-based market makers, i.e., an American market maker bought the stock from the seller and sold it to the buyer.” Id. at *6. Accordingly, the court affirmed Georgiou’s conviction under Section 10(b).

The take away: would-be fraudsters who think they can escape federal securities laws by setting up shop outside the U.S. to manipulate domestic securities should think again.

Commissioner’s Concerns About Civil Penalties Temper SEC’s Release of FY14 Enforcement Results

On October 16, the SEC publicized its preliminary enforcement results for fiscal year 2014. In what it described as a “successful enforcement year,” the Commission brought a record 755 actions and obtained $4.16 billion in penalties and disgorgement. These 2014 figures translate to an average of $5.5 million per action, which is 11% higher than the penalties and disgorgement obtained per action in fiscal year 2013 and a whopping 30% upsurge from just two fiscal years ago. It is not a coincidence that these developments correspond neatly with the appointment of Mary Jo White as SEC Chair in 2013. In fact, Chair White has been candid from the outset of her tenure about the Commission’s intention, under her direction, to “make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties—whether against companies or individuals—play a very important role in a strong enforcement program.”

It would appear, however, that at least one high-ranking SEC official has become uneasy during this era of heightened civil penalties. Speaking at the Securities Enforcement Forum in Washington, D.C., just two days before these results were released, Commissioner Michael S. Piwowar openly questioned whether the manner in which the SEC now administers penalties might be encroaching upon due process protections. As Commissioner Piwower explained:

In recent months, I have become concerned by the increasing number of staff recommendations that have not been accompanied by analysis of the principal factors described in the 2006 penalty statement. If we were a publicly-traded company, then we would likely be subject to an investigation if we knowingly permitted a misleading statement to remain outstanding without corrective disclosure. More importantly, we will have not accorded appropriate due process if we fail to follow our own publicly-announced framework for monetary penalties.

. . .

Thus, for purposes of transparency, clarity, and, most importantly, due process, the Commission should be forthcoming as to the appropriate analytical framework for corporate penalties.

The “2006 penalty statement” referenced in Commissioner Piwowar’s speech represents the Commission’s most recent effort to provide the investing public with “the maximum possible degree of clarity, consistency, and predictability in explaining the way that its corporate penalty will be exercised.” While this pronouncement set forth nine factors that may be weighed, the appropriateness of a penalty reportedly hinges on two principal considerations: – (1) whether the company received a direct benefit as a result of the violation and (2) whether the penalty will recompense or further harm the injured shareholders. This latter consideration, in particular, is inherently controversial. As the SEC acknowledged in the 2006 Statement, the penalties it imposes on public companies are costs frequently endured by innocent shareholders who already have been harmed by the company’s purported misconduct. Hence, SEC penalties should not be perceived as adding further insult to the financially injured.

Based on Commissioner Piwowar’s comments, the SEC may be drifting away from these factors, even though it has published no further guidance explaining which factors might now be disfavored or what other considerations could apply. If so, these recent developments cast a renewed spotlight on comments that Chair White made regarding the SEC’s 2006 Statement during a September 2013 speech to the Council of Institutional Investors. Most notably, Chair White stated:

While it is not a binding policy, the 2006 press release in my view sets forth a useful, non-exclusive list of factors that may guide a Commissioner’s consideration of corporate penalties, such as the egregiousness of the misconduct, how widespread it was, and whether the company cooperated and had a strong compliance program. The enforcement staff still references these factors as well as other inputs when analyzing and proposing their own recommendations to the Commission.

Ultimately, however, each Commissioner has the discretion, within the limits of the Commission’s statutory authority, to reach his or her own judgment on whether a corporate penalty is appropriate and how high it should be.

Interestingly, Commissioner Piwowar’s comments seem to reflect a general apprehension, at least on his part, to exercising discretion that is limited only by statutory constraints when the factors and “other inputs” used to determine the appropriateness of such penalties have not been disclosed publicly. To remedy this perceived problem, Commissioner Piwowar advocated that any revision to the 2006 Statement should be made through an interpretative release that would be subject to a notice-and-comment process. In his view, “This approach will satisfy any due process concerns, allow all interested persons to express their comments on the proposed framework, and provide a stronger defense of our approach should it be challenged in the future.”

Absent such an administrative undertaking or an unexpected reversal of policy, it likely will be left to the judiciary whether to impose any additional limitations on future SEC penalties. If the United States Court of Appeals for the District of Columbia’s decision in Collins v. SEC, No. 12-1241 (D.C. Cir. Nov. 26, 2013), provides any foresight, courts may be receptive to tethering future penalties so that they reasonably align with prior outcomes under similar circumstances. In Collins, the appellant challenged the SEC’s imposition of a penalty on grounds that it was arbitrary and capricious and violated the Excessive Fines Clause under the Eighth Amendment. Id. at *6. While the penalty was upheld, the appellate court made clear that the Commission cannot be “oblivious to history and precedent” and that a penalty could be deemed “arbitrary and capricious” if “the sanction is out of line with the agency’s decisions in other cases.” Id. at *8 (quoting Friedman v. Sebelius, 686 F.3d 813, 827-28 (D.C. Cir. 2012)). It remains to be seen, of course, what circumstances could trigger such a decision, although additional appeals – and judicial insights – seem likely in fiscal year 2015, particularly if the financial stakes continue to rise. In the meantime, the SEC appears more focused on making history and precedent, in part through the imposition of larger civil penalties, than being closely guided by it.

Commissioner’s Dissent May Signal Harsher Sanctions Against Accountants

Commissioner Luis A. Aguilar provided the most recent illustration of the SEC’s renewed emphasis on enforcement actions involving accounting and financial statement fraud when, on August 28, 2014, he issued a rare written dissent from the agreed-upon settlement in In the Matter of Lynn R. Blodgett and Kevin R. Kyser, CPA,File No. 3-16045 (Aug. 28, 2014). In Blodgett, the SEC charged the former chief executive officer and chief financial officer of Affiliated Computer Services, Inc. (“ACS”) with causing the company’s failure to comply with its reporting, record-keeping, and internal control obligations in violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, 13a-13, and 13a-14 thereunder. The two senior executives collectively paid nearly $675,000 in penalties, disgorgement and prejudgment interest to settle these cease-and-desist proceedings.

According to the SEC, ACS overstated revenue by $124.5 million in fiscal year 2009 by arranging for an equipment manufacturer to redirect through ACS certain preexisting orders that the manufacturer had already received from another company. These so-called “resale transactions” created the false appearance that ACS was involved in these transactions and, in violation of generally accepted accounting principles, generated revenue that allowed ACS to meet both company and analyst growth expectations. The SEC found that the senior executives, who certified the company’s Form 10-K and Forms 10-Q during this period, “understood the origination of these ‘resale transactions’ and their impact on ACS’s reported revenue growth,” but “did not ensure that ACS adequately described their significance in ACS’s public filings and on analyst calls.” Further, the SEC found that both senior executives personally benefitted from ACS’s overstated revenues because their bonuses were tied to the company’s financial performance.

In a Dissenting Statement published concurrent with the Order, Commissioner Aguilar singled out CFO Kyser’s “egregious conduct” and characterized the settlement with him as “a wrist slap at best.” Commissioner Aguilar expressed his belief that Kyser’s actions, “at a minimum,” also violated the nonscienter-based antifraud provisions under Sections 17(a)(2) and/or (3) of the Securities Act and warranted a suspension of Kyser’s ability to appear and practice before the Commission, pursuant to Rule 102(e) of the SEC’s Rules of Practice. As Commissioner Aguilar explained:

Accountants—especially CPAs—serve as gatekeepers in our securities markets. They play an important role in maintaining investor confidence and fostering fair and efficient markets. When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust. To this end, when these accountants engage in fraudulent misconduct, the Commission must be willing to charge fraud and must not hesitate to suspend the accountant from appearing or practicing before the Commission. This is true regardless of whether the fraudulent misconduct involves scienter.

. . . .

I am concerned that this case is emblematic of a broader trend at the Commission where fraud charges—particularly non-scienter fraud charges—are warranted, but instead are downgraded to books and records and internal control charges. This practice often results in individuals who willingly engaged in fraudulent misconduct retaining their ability to appear and practice before the Commission.

While Commissioner Aguilar’s comments may have represented the minority position in Blodgett, this public airing of differences triggered a prompt response from within the Commission. SEC Director of Enforcement Andrew Ceresney issued a press release the following day underscoring that accounting and financial fraud cases remain a “high priority” and noting that “financial reporting cases for 2014 so far have surpassed last year’s total number of cases by 21 percent.” Director Chesney also referenced the recent increase in investigations being conducted by the Financial Reporting and Audit Task Force, which the SEC formed in July 2013.

This documented upsurge in enforcement actions and investigations is consistent with the SEC’s stated policy initiatives for 2014. SEC Chair Mary Jo White warned registrants in January that the Commission would prioritize financial fraud with a particularized focus on the actions of auditors and senior executives. In doing so, she explained, the SEC intended to convey the message “that critical accounting issues are the responsibility of all those involved in the preparation and review of financial disclosures.” Now, less than eight months later, Commissioner Aguilar has sought to further strengthen this message by imposing tougher sanctions on accountants deemed to be at the center of the misconduct. Future settlements will demonstrate to the accounting industry—and the securities profession as a whole—whether his publicized appeal prompted significant change at the Commission.

SEC Establishes Dedicated Group to Focus on Private Funds

Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private funds have become the subject of heightened scrutiny by both the SEC’s Division of Enforcement and the Office of Compliance Inspections and Examinations (“OCIE”). Based on recent announcements, this trend is likely to continue.

In 2012, OCIE announced an initiative to conduct “Presence Exams” or focused, risk-based examinations of investment advisers to private funds who recently registered with the SEC. See the OCIE’s National Exam Program letter. More recently in the SEC’s 2014 CCO Outreach Program, the SEC announced that it had conducted 250 Presence Exams. The SEC added that many of the exams revealed “significant findings,” but did not disclose whether those findings led to enforcement referrals or were resolved in the deficiency letter process. The SEC reiterated that focus areas of the Presence Exams included: (1) investment conflicts of interest including personal and affiliates’ transactions and fees paid to advisers and expenses charged to funds; (2) marketing, including the use of placement agents and using past performance; (3) valuation; and (4) custody.

Recently, the SEC formed a new “group” within OCIE to focus on the approximately 1,500 newly registered advisers to private equity and hedge funds. The new group is being led by two “industry experts” hired by the SEC in the last few years and will include staff from four regional offices across the country. If the group is successful, the SEC intends to expand the unit to additional regional offices.

Traditionally, the SEC has created working groups or specialized units in the Division of Enforcement to focus on what it perceives to be high-risk areas, i.e., where investor funds are most at risk. The Division of Enforcement currently has five specialized units: (1) Market Abuse, (2) Asset Management, (3) Municipal Securities and Public Pensions, (4) Foreign Corrupt Practices Act, and (5) Complex Financial Instruments. These units were formed in significant part due to the criticism of the agency for failing to detect Bernie Madoff’s massive Ponzi scheme. Each of these units is led by a senior officer who reports to the Director of the Division of Enforcement and is staffed by members of regional offices across the country.

It is very likely that the new private equity group will coordinate closely with the Asset Management Unit as that unit has developed significant expertise with respect to hedge funds, investment advisers and private equity funds. One of the group’s leaders, Igor Rozenblit, was with the Asset Management Unit since 2010. Moreover, the Asset Management Unit has been very active in bringing “message” cases against the very funds that the new group is charged with policing.

In addition to forming the new group, the SEC has also asked Congress for additional funds to support its examination program. The SEC seeks to add 316 staff to its examination program. Currently, there are approximately 450 examiners, accountants and lawyers in 12 regional offices. If the SEC receives the additional funds, it could almost double the size of its examination staff allowing it to conduct significantly more exams and assist with more enforcement investigations.

In the last few months, the Division of Enforcement formed three other new “groups” to focus on different areas. Last summer, the SEC announced the creation of: (1) the Financial Reporting and Audit Task Force, (2) the Microcap Fraud Task Force, and (3) the Center for Risk and Quantitative Analytics. These groups, unlike the formal units, will not conduct investigation. They are intended to identify potential violations and make referrals to the investigative staff.

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