When confronted with government inquiries, public companies commonly grapple with the issue of when events have escalated to the point that they are subject to disclosure obligations—or, further yet, require recognition as a loss reserve in the financial statements. Is one or both of these requirements triggered when the government initially informs the company of the inquiry’s existence? When the magnitude and frequency of the government’s informational requests provide reasonable notice of a full-blown investigation? When the government rejects the company’s efforts to discontinue the investigation? Or when the government and company commence settlement discussions? While the seminal moment when each of these obligations solidifies can be quite fact-specific, the Division of Enforcement provided its own guidepost last week as to when disclosure and loss recognition become necessary.
On January 29, the SEC announced settled charges with four public companies for failing to maintain adequate internal control over financial reporting (ICFR). According to the respective orders, each of these companies repeatedly disclosed material weaknesses involving “certain high-risk areas of their financial statement presentation” over numerous annual reporting periods. Yet, despite these public acknowledgments, the SEC alleged that these companies took “months, or years, to remediate their material weaknesses,” even after being contacted by the SEC. In addition to cease-and-desist orders, the SEC levied monetary penalties against each company ranging from $35,000 to $200,000.
In announcing these settlements, the SEC emphasized that these proceedings were predicated on the registrants’ unreasonable delays in remediating the disclosed internal control deficiencies, rather than the disclosures themselves. Melissa Hodgman, an Associate Director in the SEC’s Enforcement Division, stated in the press release accompanying these settlements that, “Companies cannot hide behind disclosures as a way to meet their ICFR obligations. Disclosure of material weaknesses is not enough without meaningful remediation. We are committed to holding corporations accountable for failing to timely remediate material weaknesses.” Consistent with Ms. Hodgman’s comments, none of the settlements provided any suggestion that these companies had materially misstated or omitted any ICFR weaknesses, or their effort to remediate the weakness that were reported.
Without admitting or denying the SEC’s allegations, these four companies settled the separately filed actions summarized below:
- An NYSE-traded metals manufacturer disclosed material weaknesses on its Forms 10-K for 10 consecutive fiscal years from 2008 through 2017. These weaknesses related to the adequacy of accounting resources, segregation of duties and supervision, as well as procedures for the approval of related party transactions. The company’s remedial efforts, which began in 2016 and remained ongoing, involved the hiring of a Sarbanes-Oxley consultant and the design and testing of controls after the SEC’s outreach. The company settled violations of Exchange Act Section 13(b)(2)(B) and Rules 13a-15(a) and 13a-15(c) thereunder, and accepted a $200,000 civil penalty. Exchange Act Rel. No. 84996 (Jan. 29, 2019).
- A NASDAQ-traded dairy food producer disclosed on its Forms 10-K for the ten fiscal years between 2007 and 2016 material weaknesses pertaining to deficient and undocumented financial reporting procedures, inadequate financial statement review, and deficient journal entry and account reconciliation procedures. The company’s remediation, which began in 2013 and was completed in 2017, included the retention of two Sarbanes-Oxley consultants to develop and implement a remedial plan. The issuer agreed to settle violations of Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B) and Rules 13a-1, 13a-15(a) and 13a-15(c) thereunder, in addition to a $200,000 civil penalty. Exchange Act Rel. No. 84995 (Jan. 29, 2019).
- A NASDAQ-traded technology services provider disclosed material weaknesses on seven straight Forms 10-K during fiscal years 2011 through 2017. These involved deficiencies in the design and operation of internal controls related to its financial close and reporting processes. Although the company retained Sarbanes-Oxley consultants in both 2012 and 2015 to assist with control testing and devise a detailed remediation plan, it did not fully implement these corrective measures until 2018 – approximately two years after the SEC initially contacted the company. The settlement order identified violations of Exchange Act Section 13(b)(2)(B) and Rule 13a-15(a). The company incurred a civil penalty of $100,000. Exchange Act Rel. No. 84998 (Jan. 29, 2019).
- An OTC-traded biotechnology company disclosed “general and sweeping” material weaknesses on nine Forms 10-K from fiscal years 2008 through 2016. These weaknesses included the segregation of duties over authorization, review and recording of transactions, as well as the financial reporting of such transactions. Between 2012 and 2017, the company fully remedied these weaknesses by significantly increasing its accounting staff, implementing new controls, outsourcing information technology and – after being contacted by the SEC – engaging a Sarbanes-Oxley consultant. The company settled violations of Exchange Act Section 13(b)(2)(B), and Rule 13a-15(a) and accepted a $35,000 civil penalty. Exchange Act Rel. No. 84994 (Jan. 29, 2019).
Given the ostensive lack of urgency that these registrants demonstrated over many years, there may be inclination to view them as outliers and discount the significance of these settlements, despite the SEC’s clear intention to add substance to these enforcement results by announcing them collectively. A closer inspection offers a different perspective. Indeed, these enforcement actions appear to be part of a broader messaging to public companies, as evidenced by recent statements from SEC Chief Accountant Wesley Bricker. In the press release accompanying these settlements, Mr. Bricker declared that, “Adequate internal controls are the first line of defense in detecting and preventing material errors or fraud in financial reporting. When internal control deficiencies are left unaddressed, financial reporting quality can suffer.” This comment mirrored remarks that he presented last December, which detailed current SEC and PCAOB developments.
Although none of these settlement orders provided any particular indication why these companies did not remedy their material weaknesses in ICFR on a timely basis, these prolonged failures are often emblematic of other foundational problems plaguing a company. Financially troubled organizations are more susceptible to inadequacies in their internal controls because they lack the required capital to address material weaknesses quickly and fully, when they arise. Likewise, companies with shaky corporate governance structures may be unwilling to reallocate resources from corporate operations to address weaknesses promptly, or simply lack the expertise necessary to lead a company efficiently and effectively through the remedial process. The consequences from such shortcomings are only magnified when the material weaknesses are severe or institutionally pervasive.
The essential takeaway from these proceedings is that, while incremental remediation coupled with proper disclosure may delay the prospect of prosecutorial liability, it should not be perceived as a pathway to immunity. Companies need to implement decisive and comprehensive remedial actions when confronted with ICFR deficiencies, regardless of whether the SEC has taken the affirmative step of contacting the company. These actions include both internal initiatives (including senior management and staff modifications, and procedural enhancements and reviews designed to improve technical competence, segregate financial responsibilities, and foster timely and accurate reporting) and third-party investments (most notably, the use of outside consultants to assess and strengthen the company’s control environment).
Naturally, public companies already possess a variety of practical business incentives to remediate their ICFR problems in a timely fashion. Not only do prolonged material weaknesses increase the likelihood of significant disruption within an organization, they leave it vulnerable to stock price declines, debt and credit rating downgrades, and heightened auditor scrutiny. Now, if avoiding such negative market consequences were not motivating enough for registrants, these SEC settlements and related recent pronouncements concerning internal controls offer a distinct impression that the timely remediation of material weaknesses has become an emerging regulatory focal point.
SEC Chief Accountant Wesley Bricker spoke before the Baruch College Financial Reporting Conference on May 3, 2018. As in recent presentations, Mr. Bricker commenced these remarks by addressing briefly several hot button corporate accounting and disclosure obligations. This discussion included specific mention of the proper application of recently operative revenue recognition rules and the pending adoption of lease and credit loss standards, which will take effect in 2019 and 2020, respectively. Mr. Bricker then reserved a significant portion of his remaining commentary to emphasize the importance and responsibility of one particular group of professionals in advancing the quality of financial reporting: audit committee members.
Mr. Bricker’s initial reference to audit committees arose in the context of non-GAAP financial measures which, as he has stated previously, should be used as a supplement but not a substitute for financial reporting in conformity with generally accepted accounting principles. Mr. Bricker noted further that, when public companies intend to rely upon non-GAAP, it is imperative that they adopt “appropriate governance practices regarding the measures and policies and controls that prevent error, manipulation, or mischief with the numbers.” As to the particular importance of audit committees in the review and presentation of non-GAAP measures, he interjected:
Audit committees that clearly understand non-GAAP measures presented to the public – and who take the time and effort in their financial reporting oversight role to review with management the preparation, presentation, and integrity of those metrics – are an indicator of a strong compliance and reporting culture. Audit committees can review the metrics to understand how management evaluates performance, whether the metrics are consistently prepared and presented from period to period, and the related disclosure policies. Audit committees that are not engaging in these processes should consider doing so. A demonstration of strong interest in these issues can have a positive effect on the quality of disclosure.
Next, Mr. Bricker discussed the “positive effect on the quality of disclosure” that members of an audit committee provide in the context of market and other risk information. By way of illustration, he pointed to current economic variances, such an interest rate increases, which could materially impact corporate performance, adding that:
[S]ome businesses’ balance sheets, results of operations, and cash flows are particularly sensitive to changes in economic and market conditions such as changes in the liquidity in the markets, the level and volatility of market prices and rates, including for debt and equity investments, market indices, or business and other sentiments that affect the markets. I encourage those involved in the disclosure preparation and oversight process to be attentive to disclosures regarding changes in market risks.
Lastly, Mr. Bricker dedicated the final segment of his presentation to the importance of corporate governance, which he described as “intertwined with tone and culture – the understanding of ethical values, risks, and desired behaviors.” Again, he crafted his message to focus principally on the unique role that audit committees fulfill in the corporate structure:
Another lesson regulators and leaders in the profession have learned is the importance of independent, diverse thinking on corporate boards, and particularly, audit committees, brought by independent directors as an element of strong corporate governance. In addition to bringing valuable external perspective to board deliberations, these directors take on roles and responsibilities with substance and credibility because the directors are independent. Examples include resolving disputes between management and the external auditor as well as oversight of complex and sensitive investigations. Also, independent directors are often in the best position to deliver candid, sometimes tough, but critically important messages to management and other board members without fear of retribution. The strengthening of corporate audit committees with independent members is one of the most prominent, recent enhancements to the corporate governance scheme.
Viewed individually, none of Mr. Bricker’s comments qualify as groundbreaking statements from a high-ranking SEC official. Nonetheless, his repeated points of emphasis on the audit committee function during these prepared remarks appear noteworthy, given that his immediate audience, as he expressly recognized, consisted of a broader spectrum of professionals, including “investors,… auditors, preparers, standard setters, and academics [who are all] critical to advancing the quality of financial reporting.” The coming months may offer a better indication whether Mr. Bricker’s speech is simply a specific point of emphasis from the Office of the Chief Accountant or is perhaps intended to foreshadow a contemplated or ongoing enforcement initiative.
A June 15, 2017 settlement with two former executives of a publicly-traded, multinational freight forwarding and logistics company provides the most recent example of two emerging SEC enforcement initiatives in financial reporting and accounting-based actions that we spotlighted recently – a non-reliance on financial statement materiality and an absence of fraud-based allegations. Exchange Act Rel. No. 80947 (Jun. 15, 2017). According to the SEC, Eric W. Kirchner and Richard G. Rodick, the former chief executive officer and chief financial officer of UTi Worldwide, Inc. (“UTi”), purportedly were responsible for inadequate Management’s Discussion & Analysis (“MD&A”) disclosures in a Form 10-Q that UTi issued during fiscal year 2013. Without admitting or denying the findings, both agreed to settle purported violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-13, and 13a-14, thereunder, and to pay a $40,000 civil penalty.
According to the SEC’s Order, UTi began experiencing serious risks in liquidity and capital resources no later than the third quarter of fiscal year 2013 due to the problematic rollout of a proprietary operating system that hindered the timely transmission of invoices to its customers. These problems allegedly caused UTi to accumulate an unusually high amount of unbilled receivables, thereby delaying its ability to receive payment for both its freight services and significant transportation-related cash outlays that were eligible for customer reimbursement through invoicing. To manage its cash flow problem, UTi supposedly began delaying payment of its obligations and obtained amendments to certain loan covenants from its lead lender.
The Order alleged that Kirchner and Rodick were aware of these liquidity and capital difficulties, yet failed to ensure that UTi provided adequate information in the MD&A section of the third quarter Form 10-Q to allow investors and others to meaningfully assess the company’s financial condition and results of operations. While the SEC acknowledged that the MD&A made reference to a sharp year-to-date decline in UTi’s cash position (and had provided readers with the specific financial impact), it claimed that the company attributed this decline to the seasonal nature of UTi’s business rather than its ongoing billing delays. The Order further contended that, under Kirchner and Rodick’s direction, UTi only revealed the cause and extent of its invoicing problem during the following fiscal year. By that time, the company’s lead lender had notified UTi that it would provide no further loan amendments and the company’s outside auditor had amended its opinion on the annual financial statements for fiscal year 2013 to issue a going concern.
Consistent with other recent settlements, this enforcement action is noteworthy in that the claims related exclusively to the purported incompleteness of a public company’s financial disclosures rather than the material inaccuracy of its financial statements. Here, the Order stated that the MD&A section of the periodic filing gave rise to a Section 13(a) violation because it failed to satisfy Regulation S-K Item 303, which is intended to provide investors with “an opportunity to look at the company through the eyes of management.” The SEC claims that Kirchner and Rodick’s conduct caused UTi to run afoul of Item 303’s requirement that registrants disclose in their MD&A “any known trends or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”
This enforcement proceeding was also significant in that, similar to other financial reporting and accounting-related settlements during the latter stages of Mary Jo White’s tenure as SEC Chair, it was predicated entirely on strict liability-based claims. As in those previous settlements, this Order recited numerous instances in which the offending parties supposedly became aware of factual circumstances that were contrary to information provided in a later public filing, yet never attempted to assign any state of mind to the particular conduct alleged. There are many occurrences, of course, in which allegations grounded in knowledge or recklessness are simply unwarranted; nonetheless, this apparent pattern of heightened reliance on strict liability-based legal theories suggests that there may be certain instances in which the charges have been strategically designed to eliminate certain defenses and facilitate settlement. This particular proceeding offers a preliminary indication that this enforcement strategy may continue under Chair Jay Clayton’s leadership.
On February 3, 2017, the United States Court of Appeals for the Eleventh Circuit rejected an accountant’s argument that the imposition of both criminal charges and SEC sanctions on the basis of the same alleged conduct violated the Fifth Amendment’s Double Jeopardy Clause. This appellate court ruling illustrates that defendants in SEC investigations and enforcement proceedings must be mindful that the imposition of civil penalties, disgorgement, and permanent bars do not preclude the prospect of criminal prosecution.
Thomas D. Melvin (“Melvin”), a certified public accountant, agreed in April 2013 to pay the SEC a civil penalty of $108,930 and disgorgement of $68,826 to settle alleged violations of Sections 10(b) and 14(e) of the Securities and Exchange Act of 1934 and Rules 10b-5 and 14e-3 thereunder. According to the SEC, Melvin purportedly had disclosed confidential insider information that he received from a client that pertained to the pending sale of a publicly traded company. A Rule 102(e) administrative proceeding in September 2015 also permanently barred Melvin from practicing before the SEC as an accountant. Exchange Act. Rel. No. 75844.
The Department of Justice instituted a parallel criminal proceeding against Melvin that involved the same alleged wrongful activity. Melvin moved to dismiss the eventual indictment on the ground that the collective sanctions the SEC had levied upon him constitutionally precluded a criminal prosecution under the Double Jeopardy Clause. After a federal district court denied his motion to dismiss, Melvin pleaded guilty to six counts of securities fraud pursuant to a written plea agreement. He then appealed the district court’s denial of his motion to dismiss.
In United States v. Melvin, No. 16-12061 (11th Cir. Feb. 3, 2017), the Eleventh Circuit conducted two inquiries to determine whether the imposition of the civil penalty, disgorgement and professional debarment against Melvin were so punitive that they rose to the level of a criminal penalty. For the initial inquiry, the court found that Congress intended the sanctions imposed by the SEC to be a form of civil punishment because monetary penalties are expressly labeled as “civil penalties” and the legislative branch empowered the SEC to prohibit an individual from appearing or practicing before it.
As to the second inquiry, the circuit court examined seven “useful guideposts” articulated by the United States Supreme Court in Hudson v. United States, 118 S. Ct. 488, 493 (1997). These guideposts included whether:
- “the sanction involves an affirmative disability or restraint”;
- “it has historically been regarded as a punishment”;
- “it comes into play only on a finding of scienter”;
- “its operation will promote the traditional aims of punishment—retribution and deterrence”;
- “the behavior to which it applies is already a crime”;
- “an alternative purpose to which it may rationally be connected is assignable for it”; and
- “it appears excessive in relation to the alternative purpose assigned.”
Applying these guideposts, the Eleventh Circuit believed that the sanctions at issue “constitute no affirmative disability or restraint approaching imprisonment” and observed that “neither money penalties nor debarment have historically been viewed as punishment.” It also noted that “penalties for security fraud serve other important nonpunitive goals, such as encouraging investor confidence, increasing the efficiency of financial markets, and promoting the stability of the securities industry.” As such, the appellate court concluded that Melvin’s criminal prosecution did not constitute a violation of the Double Jeopardy Clause.
This ruling is the most recent cautionary reminder that, even in this era of headline-grabbing civil penalties that far exceed those the SEC sought and obtained just a few years ago, defendants should never lose sight that the resolution of SEC charges does not preclude the prospect of a parallel criminal proceeding. Indeed, any time the SEC’s prosecutorial theory is potentially fraud-based, defendants and their counsel must remain extremely cautious to the possible involvement of criminal authorities and develop their legal strategies accordingly.
The SEC’s Form 1662 underscores this point. This form, which is provided to all persons requested to supply information voluntarily to the SEC or directed to do so via subpoena, states:
It is the policy of the Commission … that the disposition of any such matter may not, expressly or impliedly, extend to any criminal charges that have been, or may be, brought against any such person or any recommendation with respect thereto. Accordingly, any person involved in an enforcement matter before the Commission who consents, or agrees to consent, to any judgment or order does so solely for the purpose of resolving the claims against him in that investigative, civil, or administrative matter and not for the purpose of resolving any criminal charges that have been, or might be, brought against him.
The disposition of an SEC proceeding also does not prevent the SEC from sharing any information it has accumulated with criminal authorities. Instead, as Form 1662 warns, the SEC “often makes its files available to other governmental agencies, particularly United States Attorneys and state prosecutors” and there is “a likelihood” that the SEC will provide this information confidentially to these agencies “where appropriate.”
In January, the SEC settled no fewer than seven enforcement proceedings with companies that involved alleged violations of generally accepted accounting principles (GAAP). While the sheer number of settlements would have been remarkable on its own, when examined individually, these proceedings reveal both emerging enforcement initiatives and recent historical trends in accounting-based actions. This article spotlights three particularly noteworthy observations from the first month of 2017.
- The Emergence of Non-GAAP Financial Measures
In 2016, the SEC placed growing emphasis on perceived abuses of non-GAAP financial measures under Regulation G and Item 10(e) of Regulation S-K. This included the Division of Corporation Finance’s (CorpFin) Compliance & Disclosure Interpretations in May and former Chair Mary Jo White’s speech before the International Corporate Governance Network in June. On January 18, 2007, the SEC settled its first enforcement action predicated on this alleged activity. Exchange Act Rel. No. 79823.
The SEC claimed specifically that MDC Partners, Inc., a publicly traded marketing firm, violated Item 10(e)(1)(i)(A) of Regulation S-K, which requires issuers disclosing non-GAAP financial measures to present “with equal or greater prominence” the most directly comparable GAAP-based financial measure or measures. According to the Order, MDC Partners’ quarterly earnings releases for 2013 and 2014 improperly emphasized EBITDA, EBITDA margin, and free cash flow—all non-GAAP benchmarks—without satisfying this prominence requirement. Moreover, the SEC alleged that CorpFin had raised this particular concern with the company in 2012, but, despite representations to the contrary, the violation remained uncorrected.
The SEC contended that MDC Partners also ran afoul of Item 10(e)(1)(i)(B) of Regulation S-K, which requires issuers to reconcile “by schedule or other clearly understandable method” the differences between the disclosed non-GAAP financial measures and the most directly comparable GAAP-based financial measure or measures. MDC Partners purportedly violated this provision in 2012 and 2013 when it disclosed a non-GAAP metric known as “organic revenue growth.” The SEC alleged that the company omitted reference to one of the metric’s three reconciling items, and, had it been calculated consistent with the only two reconciling items that were disclosed, the metric would have been lower. Further, the company purportedly failed to include tabular reconciliations to GAAP revenue in its periodic reports and earning releases.
The SEC found that MDC Partners’ non-GAAP disclosures violated Section 17(a)(2) of the Securities Act, Section 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act (and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder), and Rule 100(a)(2) of Regulation G. The company paid a $1.5 million civil penalty to settle these and other alleged violations.
- A Non-Reliance on Financial Statement Materiality
As in MDC Partners, there were two additional settlements last month that symbolized the SEC’s willingness to bring enforcement actions absent any quantitatively material misstatements in a company’s financial statements. A January 18, 2017 settlement with General Motors Company (GM) involved the automaker’s 2014 recall of more than 600,000 vehicles with defective ignition switches. Exchange Act Rel. No. 79825. The SEC alleged that GM engineers understood in 2012 that the ignition switches created a safety concern, but delayed more than a year in notifying those persons at the company responsible for assessing whether this concern gave rise to a loss contingency pursuant to Accounting Standards Codification (ASC) 450. ASC 450 requires issuers to evaluate whether a loss is “probable” or “reasonably possible” and, if so, sets forth when an estimated loss must be recorded or otherwise disclosed.
Interestingly, while the Order stated that GM recorded approximately $41 million for potential recall costs shortly after the internal notice was provided, it sidestepped the issue of whether GM had a probable or reasonably possible loss contingency at any time during the alleged period of delay. It also made no determination on the material accuracy of any financial statement or disclosure that may have been impacted. Instead, the SEC charged GM with possessing insufficient internal accounting controls in violation of Section 13(b)(2)(B) that stemmed from the delay in evaluating whether a loss contingency existed. GM agreed to pay a $1 million civil penalty to resolve the matter.
The SEC’s January 19, 2017 settlement with HomeStreet, Inc. provides another example. Exchange Act Rel. No. 79844. The SEC contended that the diversified-services company entered into interest rate swaps to hedge its exposure to changes in fair market value on approximately 20 fixed-rate commercial loans. The Company sought to apply hedge accounting pursuant to ASC 815, which allows qualifying issuers to record the fair value of both the hedged and hedging items, thereby alleviating potential income statement volatility from market fluctuations. The SEC contended that, between 2011 and 2014, certain HomeStreet commercial loans and interest-rate swaps periodically failed to meet the effectiveness ratio designed to test whether the necessary hedge correlation actually existed.
The order claimed that the company’s balance sheets and income statements were misstated during this period, because hedge accounting was applied to certain loans when the hedge associated with those loans failed to qualify. Notably, the order did not allege any of these misstatements were material; to the contrary, it acknowledged that the company and its outside auditors had concluded that the accounting errors were not material in any reporting period and no restatements were necessary. The SEC charged HomeStreet with books and records and internal control violations under Sections 13(b)(2)(A) and 13(b)(2)(B) for these GAAP-based deficiencies and imposed a $500,000 civil penalty for these and other violations.
- An Absence of Fraud Allegations
The SEC has pursued fraud-based claims in accounting matters with less regularity in recent years and, in turn, has increased its reliance on the less-imposing strict-liability provisions under Section 13 and negligence-based antifraud provisions under Section 17. January was no exception. None of the accounting settlements during the month included alleged fraudulent conduct, even though, in several instances, the tenor of the settlement language arguably signaled a more culpable state of mind than the violations required. In HomeStreet, the SEC also settled claims against the company’s chief investment officer, Darrell van Amen, who allegedly instructed a subordinate to make “unsupported adjustments” to the effectiveness ratio “for the purpose of making the testing results ‘effective.’” The Order also stated that the company made these adjustments to achieve effectiveness 64 times during the relevant period. The SEC charged van Amen under Sections 13(b)(2)(A) and 13(b)(2)(B). He agreed to pay a $20,000 civil penalty.
The HomeStreet settlement was not alone in this regard. The SEC instituted proceedings against L3 Technologies, Inc., an aerospace contractor, and Orthofix International, a medical device company, on January 11 and January 18, respectively. Exchange Act Rel. Nos. 79772, 79815. Both of these enforcement actions centered on allegations of improper revenue recognition in violation of ASC 605 and the recording of sales revenues before collectability was reasonably assured. In L3 Technologies, the order attributed this prohibitive conduct to “pressure from certain supervisors” to satisfy an annual operating plan, while the Orthofix order cited “a culture of aggressively setting internal sales targets and imposing pressure upon its sales personnel to meet those targets.” Both orders recounted material overstatements in revenue and attributed subsequent restatements to these improper deviations from GAAP.
Until recent years, these types of allegations routinely served as a blueprint for fraud-based claims. Then, the ensuing legal battle concentrated frequently on whether the SEC could establish the requisite state of mind. Now, under the current enforcement landscape, the absence of non-fraud claims renders the basic defense argument ineffective and, accordingly, often incentivizes cooperation and settlement. These two revenue recognition settlements in January are reflective of this trend. The SEC imposed a $1.6 million penalty on L3 Technologies for alleged Section 13(b)(2)(A) and 13(b)(2)(B) violations. Orthofix paid $8.25 million for its purported violations under Sections 17(a)(2) and 17(a)(3); Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B); and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder. In each instance, the SEC recognized the company’s cooperation with its investigation.
January 2017 offered several prime examples of the current state of SEC enforcement in accounting-based actions. Of course, it also ushered in a new presidential administration and the prospect of substantial changes in policy and focus as SEC leadership readies to change. The coming months will offer an initial indication whether these emerging initiatives and recent trends continue to remain at the forefront of the SEC’s enforcement approach.
On July 22, 2016, the SEC suspended an accounting firm and permanently suspended one of its former partners for conducting a defective audit for a publicly-traded company allegedly engaged in a fraud scheme that resulted in numerous material misstatements on its financial statements. Exchange Act Rel. No. 78393 (July 22, 2016). These suspensions derived from the SEC’s settlement with New York-based EFP Rotenberg, LLP and engagement partner Nicholas Bottini, CPA, for audit services performed on behalf of ContinuityX Solutions, Inc., which claimed to sell Internet services to businesses. The SEC found that EFP Rotenberg violated and Bottini aided and abetted and caused EFP Rotenberg’s violations of Sections 10A(a)(1) and 10A(a)(2) of the Securities Exchange Act of 1934 and Rule 2-02(b)(1) of Regulation S-X. It also concluded that the accounting firm and its former audit partner engaged in improper professional conduct pursuant to Section 4C(a)(2) of the Exchange Act and Rule 102(e)(1)(ii) and (iii) of the SEC’s Rules of Practice.
According to the Order, ContinuityX’s financial misstatements included impermissibly recognizing commission revenue from fraudulent sales transactions, recording assets belonging to third parties as its own and failing to disclose related party transactions. The SEC alleged that when auditing ContinuityX’s fiscal year 2012 financial statements, EFP Rotenberg and Bottini failed to perform sufficient audit procedures and repeatedly engaged in improper professional conduct that resulted in violations of PCAOB standards and demonstrated a lack of competence. Specifically, the SEC found that the respondents failed to: “(1) appropriately respond to risks of material misstatement; (2) identify related party transactions; (3) obtain sufficient audit evidence; (4) perform procedures to resolve and properly document inconsistencies; (5) investigate management representations that contradicted other audit evidence; and (6) exercise due professional care.” Notwithstanding these shortfalls, the audit firm provided an unqualified opinion on the company’s annual financial statements.
The SEC supported its factual findings with numerous alleged instances in which EFP Rotenberg and Bottini either capitulated to the will of ContinuityX’s management or seemingly concluded their audit procedures prior to obtaining reasonable assurances. These alleged instances included:
- Acquiescence to a scope limitation resulting from the company’s refusal to permit the auditors to obtain accounts receivable confirmations from third parties;
- A failure of the engagement team to perform procedures sufficient to detect whether revenue was earned legitimately despite obtaining adequate documentation to do so;
- An absence of audit workpaper documentation explaining the resolution of material inconsistencies between audit evidence and representations from management; and
- A failure to insist that the company respond to an auditor inquiry regarding whether its chief financial officer had a related party relationship with a particular customer.
Without either respondent admitting or denying the SEC’s findings, EFP Rotenberg agreed to pay a $100,000 penalty and accept a one-year suspension from public company audits, conditioned upon the certification of an independent consultant that it has remedied the various causes behind its failure to detect ContinuityX’s fraud. Bottini agreed to a $25,000 penalty and a permanent suspension from appearing and practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies. In imposing these penalties, the Order stated that these were not the respondents’ first SEC violations. Both EFP Rotenberg and Bottini each had settled an unrelated 2014 SEC proceeding involving an audit for a separate client that occurred during 2011. In that earlier proceeding, which also included violations of Section 4C(a)(2) and Rule 102(e)(1)(ii), EFP Rotenberg consented to a $50,000 penalty while Bottini agreed to pay $25,000 and accept a minimum two-year suspension. Exchange Act Rel. No. 72503 (July 1, 2014).
Given the presence of repeat offenders and numerous audit deficiencies, it is tempting to discount the overall significance in these particular proceedings, especially when compared to recent enforcement actions brought against more recognizable accounting firms. This would be a mistake, however, as this case serves as a cautionary tale concerning both the particularized financial reporting issues that are receiving heightened regulatory attention and the actions (or inactions) that potentially trigger “gatekeeper” culpability. As Andrew Ceresney, Director of the SEC’s Division of Enforcement, confirmed in a speech earlier this year, two of the central accounting issues in these proceedings – revenue recognition and related party transactions – remain high enforcement priorities. At the same time, Director Ceresney also signaled to the auditing profession that it “must be the bulwark against client pressure” and “demand objective evidence and investigation when they come across situations which suggest inaccuracies in the company filings.” Otherwise, as these proceedings reveal, the SEC intends to make examples of auditors who are found to have shirked these responsibilities and “fail[ed] to heed numerous warnings and red flags concerning alleged frauds.”
The SEC’s Division of Enforcement has made a concerted effort in recent months to warn auditors and other corporate “gatekeepers” that it intends to scrutinize the adequacy of related party disclosures in financial filings. This emerging trend continued on April 29, 2015, when the SEC announced the settlement of an enforcement proceeding against McGladrey LLP partner Simon Lesser. See Exchange Act Rel. 74827 (Apr. 29, 2015). Lesser, who served as lead engagement partner during McGladrey’s financial statement audits of investment advisory firm Alpha Titans LLC and several related private funds over a four-year fiscal span, settled claims that he engaged in improper professional conduct within the meaning of Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(iv)(B)(2) of the SEC’s Rules of Practice. The SEC also alleged that Lesser willfully aided and abetted and caused his audit client to violate Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 thereunder.
Lesser’s settlement derived from assertions that Alpha Titans failed to adequately disclose related party relationships and material related party transactions in accordance with generally accepted accounting principles (GAAP). Specifically, Alpha Titans’s chief executive officer and general counsel were alleged to have transferred more than $3.4 million in client assets among the various funds to pay for adviser-related operating expenses during fiscal years 2009 through 2012. These payments purportedly were not agreed to by fund clients or authorized under the various operating documents. As asserted, Lesser knew about these related party relationships and the underlying transactions, which should have been disclosed under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 850, but, nonetheless, “gave his final approval for McGladrey to issue audit reports containing unqualified opinions.”
The SEC also claimed in the settlement that Lesser failed to ensure that McGladrey’s audits for each fiscal year were conducted in conformity with generally accepted auditing standards (GAAS). Lesser allegedly did not exhibit the requisite level of due professional care in that he “should have … place[d] greater emphasis on the related party relationships and transactions, and the adequacy of the related party disclosures.” The SEC further contended that Lesser did not obtain sufficient audit evidence or prepare audit documentation explaining adequately why he considered the financial statements GAAP compliant absent such related party disclosures. Without admitting or denying the SEC’s findings, Lesser agreed to a $75,000 civil penalty and a minimum three-year suspension from appearing or practicing before the SEC as an accountant.
Although the circumstances surrounding this particular proceeding were announced only last week, high-ranking SEC representatives began eluding to the likelihood of related party-based enforcement actions earlier this year. In late February, Julie M. Riewe, Co-Chief of the Division of Enforcement’s Asset Management Unit (AMU)—the same unit that conducted the investigation against Lesser—provided a revealing glimpse into AMU’s 2015 priorities during her presentation at the IA Watch 17th Annual IA Compliance Conference. Ms. Riewe cautioned:
For private funds—meaning hedge funds and private equity funds—the AMU’s 2015 priorities include conflicts of interest, valuation, and compliance and controls. On the horizon, on the hedge fund side, we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks.
Stephanie Avakian, Deputy Director of the Division Enforcement, provided parallel commentary in the context of auditors and other corporate “gatekeepers” during SEC Speaks 2015 in February. Ms. Avakian emphasized that accounting and financial reporting violations are considered an ongoing enforcement priority with particularized attention to related party disclosures.
Indeed, another recent enforcement proceeding further underscores that last week’s settlement with Lesser should not be construed as an isolated occurrence. The SEC announced a similar settlement with a Hong-Kong based auditing firm and two of its auditors in December 2014, involving an alleged “fail[ure] to uphold U.S. auditing standards and exercise appropriate professional care and skepticism with regard to numerous related-party transactions” not adequately disclosed by a Chinese-based oil company. See Press Rel. 2014-284, SEC Imposes Sanctions Against Hong Kong-Based Firm and Two Accountants for Audit Failures. The firm in that instance agreed to pay a $75,000 civil penalty with the two professionals agreeing to pay penalties of $20,000 and $10,000, respectively, and to accept three-year minimum suspensions. Accordingly, the enforcement action against Lesser is not the first recent settlement involving related party disclosures and, given the SEC’s pointed remarks earlier this year, it almost certainly will not be the last.