SEC Chief Accountant Shines Spotlight on Audit Committees

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.

(Emphasis added.)

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.

(Emphasis added.)

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.

SEC Freezes $27 Million Related to a Blockchain/Cryptocurrency Acquisition

On April 6, 2018, the Securities and Exchange Commission (SEC) obtained a court order freezing more than $27 million in proceeds from alleged illegal distributions and sales of restricted shares of a public company, and charged the company, its CEO, and three other affiliated individuals. That same day, the Nasdaq Stock Market said it halted trading in the company’s stock. The SEC’s complaint alleges that shortly after the company began trading on the Nasdaq Stock Market and announced the acquisition of a purported blockchain-empowered cryptocurrency business that its stock price rose dramatically until its market capitalization exceeded $3 billion. The SEC further alleges that the CEO and the three other individual defendants then illegally sold large blocks of their restricted shares to the public while the stock price was excessively elevated and that they collectively reaped more than $27 million in profits.

By way of background, and as alleged by the SEC, the company went public under a scaled-down version of a traditional initial public offering known as Reg A+ late last year. In December 2017, the company’s Class A shares began trading on the Nasdaq Stock Market. Two days later, the company announced that it had acquired the purported blockchain-empowered cryptocurrency business from another entity. The SEC alleges that one of the individual defendants held at least a 92% stake in this entity. The SEC further alleges that — notwithstanding that this acquired business had no ascertainable value — the company’s stock price rose excessively and quickly after said acquisition. Specifically, by December 18, 2017, the company’s stock price rose to a high of $142.82 per share; an increase of nearly 550% from the prior day’s closing price and about 2,670% above the company’s closing price on its first day of trading just several days earlier.

This action serves as yet another example of the SEC’s heightened and aggressive focus in this area. As we discussed previously on this blog, one of the focus areas for the SEC’s Cyber Unit that was created just last September is “Violations involving distributed ledger technology and initial coin offerings.” More recently, the financial press reported that the SEC had launched a “sweep” in this area by serving subpoenas and information requests on technology companies and investment management firms and brokers doing business in the virtual currency markets.

Returning to the SEC’s $27 million freeze action here, the SEC alleged only registration offering violations against the defendants. This may not be the last of the charges, however, as the SEC described this as a “continuing investigation” in its press release.

11th Circuit Nixes CPA’s Claim That SEC Sanctions Preclude Criminal Prosecution

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:

  1. “the sanction involves an affirmative disability or restraint”;
  2. “it has historically been regarded as a punishment”;
  3. “it comes into play only on a finding of scienter”;
  4. “its operation will promote the traditional aims of punishment—retribution and deterrence”;
  5. “the behavior to which it applies is already a crime”;
  6. “an alternative purpose to which it may rationally be connected is assignable for it”; and
  7. “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.”

A GAAP-Happy Month in SEC Enforcement

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.

  1. 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.

  1. 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.

  1. 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.

Conclusion

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.

Latest Auditor Suspensions Illustrate Key SEC Enforcement Focal Points

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.”

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.