Settlement with Large Firm Audit Partner Reaffirms SEC’s Emphasis on Related Party Disclosures

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.

(Emphasis added.)

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.

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.

D.C. Circuit Court of Appeals Issues Ruling on Conflict Minerals

On April 14, 2014, the U.S. Court of Appeals for the District of Columbia Circuit issued its opinion in the conflicts minerals case, National Association of Manufacturers, et al., v. Securities and Exchange Commission. The Court of Appeals upheld most aspects of the statute and the rule, but found that the statute and rule violate the First Amendment “to the extent that the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have not been found to be ‘DRC conflict free.’” The Court of Appeals remanded the case to the U.S. District Court for the District of Columbia for further proceedings consistent with its opinion. As of this time, there is no reprieve for issuers from the requirement to file a Form SD or conflict minerals report with the Securities and Exchange Commission (SEC) by June 2, 2014.

Background

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress required that the SEC issue regulations requiring firms using “conflict minerals” to investigate and disclose the origins of those minerals. The SEC’s rule applies to issuers that file reports with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 (the Exchange Act) and for whom conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured.

“Conflict minerals” are used in many different types of products and are defined as cassiterite, columbite-tantalite, gold, wolframite and their derivatives, tantalum, tin and tungsten. Many non-SEC reporting companies also have been impacted by the scope of the rule’s “reasonable country of origin” (RCOI) and supply chain due diligence provisions, notwithstanding the fact that the rule only applies to issuers. For more on the adoption of the conflict minerals rules and the specific requirements, see Drinker Biddle’s September 2013 Client Alert.

Court Ruling

The National Association of Manufacturers challenged the SEC’s final rule, raising Administrative Procedure Act (APA), Exchange Act and First Amendment claims. The District Court rejected all of those claims and granted summary judgment for the SEC and intervenor Amnesty International. On appeal, the Court of Appeals affirmed the District Court’s ruling on the APA and Exchange Act claims, but reversed the ruling on the First Amendment claim.

In particular, the Court of Appeals found that the requirement to disclose that products are not “DRC conflict free” violates the prohibition against compelled speech. The court explained:

The label “conflict free” is a metaphor that conveys moral responsibility for the Congo war.  It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups . . . By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.

The Court of Appeals found insufficient the SEC’s argument that issuers could explain the meaning of “conflict free,” stating that “the right to explain compelled speech is present in almost every such case and is inadequate to cure a First Amendment violation.” Also of note, the Court of Appeals found that the SEC did not act arbitrarily and capriciously by choosing not to include a de minimis exception to the conflict minerals rules. As conflict minerals are often used in limited amounts, the Court of Appeals found that a de minimis exception could leave small quantities of conflict minerals unmonitored across many issuers.

Implications

Unfortunately for many issuers who are racing to complete their specialized disclosure report on Form SD and their first conflict minerals report, due by June 2, 2014, there is no reprieve from that deadline at this time. While it is difficult to predict what action the SEC may take, it is possible that the SEC could seek further review of the rule, could stay the upcoming filing deadline in light of the ongoing proceedings, or could otherwise clarify its expectations regarding disclosure obligations, although there are no guarantees. Given that uncertainty, it would be wise for issuers to continue to work on their Form SD and conflict minerals report unless and until the SEC takes further action.

Because the Court of Appeals upheld most aspects of the conflict minerals statute and rule, the due diligence requirements remain intact, and it is possible that they could survive with modified disclosure requirements.  Therefore, notwithstanding the Court of Appeals ruling, it is advisable that SEC reporting companies continue their due diligence efforts. For those companies who are not SEC reporting companies but who are nonetheless impacted by the conflict minerals rule via the required RCOI and supply chain due diligence process, it is advisable to continue responding to RCOI and due diligence inquiries.