COVID-19: SEC Announces Trading Suspensions and Focuses on Potential Fraud

The SEC has suspended the trading of eleven companies for issues related to the COVID-19 pandemic since February 7, 2020. Of those eleven suspensions, seven have come since April 3rd. Most of the suspensions follow the recent statement from the co-directors of the SEC’s Division of Enforcement that “the Enforcement Division is committing substantial resources to ensuring that our Main Street investors are not victims of fraud or illegal practices in these unprecedented market and economic conditions.” In addition, the SEC this week updated an investor alert about possible investor scams related to the pandemic.

The reasons for the suspensions range from possible confusion about the name of a company to suspicious statements from companies about having “FDA-approved” at-home COVID-19 test kits, supposed new technology for non-contact human temperature screening, or the ability to produce a vaccine or protective gear.

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SEC Gives Management’s Discussion and Analysis (MD&A) a Makeover

With the aim of eliminating certain duplicative disclosures, and modernizing and enhancing Management’s Discussion and Analysis (MD&A) disclosures for the benefit of investors while reducing the compliance burden on companies, the Securities and Exchange Commission (SEC) has proposed amendments to simplify and enhance certain financial disclosure requirements in Regulation S-K. The proposed amendments, released January 30, 2020, are part of an ongoing re-evaluation of the current disclosure regime per the SEC’s recommendation in the Report on Review of Disclosure Requirements in Regulation S-K, which was mandated by Section 108 of the JOBS Act, adopted in 2012.

The proposed amendments would eliminate Items 301 (Selected Financial Data), 302 (Supplementary Financial Information) and 303(a)(5) (Tabular Disclosure of Contractual Obligations in MD&A) of Regulation S-K, as well as revise a number of disclosure obligations under Item 303 (Management’s Discussion and Analysis of Financial Condition and Results of Operations).

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SEC: Here Is When Loss Contingencies Must Be Disclosed and Reserved

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.

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The SEC Files Another Litigated Disclosure Case – With More Violations

On August 29, 2019, the SEC filed a complaint against a registered investment adviser alleging failures to disclose four categories of conflicts of interest and seeking disgorgement of $10 million in undisclosed compensation. This litigated action was filed within a month of the SEC filing a litigated complaint against another firm alleging failing to disclose material conflicts of interest related to revenue sharing, despite that advisory firm having self-reported pursuant to the SEC’s Share Class Selection Disclosure Initiative (“SCSD Initiative”).

Based on these litigated actions (and despite the SCSD Initiative being over 18 months old), the SEC’s Division of Enforcement continues to focus its investigative and litigation resources on “Main Street” and to aggressively pursue registered investment advisory firms for disclosure violations involving actual or potential conflicts of interest.

In this most recent litigated action, not surprisingly, the SEC’s allegations with respect to share class selection conflicts and disclosure violations are consistent with the guidance released with the SCSD Initiative. This firm, however, did not fail to self-report its 12b-1 fee purported violative conduct. Rather, this alleged violative 12b-1 fee conduct was apparently uncovered during an examination by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”). The SEC also alleged disclosure violations related to revenue sharing, a longstanding priority for the SEC that has continued to expand since the SCSD Initiative.

The SEC’s ongoing efforts on disclosure violations about share class selection and revenue sharing have been discussed widely in the financial press and by industry groups.

The latter two alleged disclosure theories, however, have not received similar attention, but provide information and insight into other legal theories that OCIE and Enforcement may now be prioritizing in their examination and enforcement programs. Specifically, the third group of alleged disclosure violations relate to the adviser’s receipt of administrative service fees. While Enforcement has brought cases using similar fee disclosure theories in the past, the number of cases focused on the disclosures and conflicts for these types of fees, as opposed to 12b-1 fees and revenue sharing, pales by comparison. Lastly, the SEC also alleged that the adviser failed to disclose compensation that it received in the form of non-transaction-based mark-ups on charges imposed by the clearing firm. The first time that we observed the SEC charge this type of undisclosed mark-up theory was just within this past year, in December 2018.

For both of these recent SEC actions, the advisers have apparently chosen to litigate and fight the SEC’s ever expanding efforts to regulate specific disclosure language, despite the D.C. Circuit’s ruling in Robare. The D.C. Circuit’s ruling, while troublesome for the SEC as it related to “willfulness” and that aspect of the opinion, supported and favored the SEC’s disclosure theory relating to the use of general disclosure terms such as “may” when, in fact, the adviser “was” receiving compensation. Interestingly though, the SEC chose to not file these two recent matters as administrative proceedings. Doing so would have allowed for the D.C. Circuit’s Robare opinion to serve as precedent. The SEC instead chose to file these as civil complaints in U.S. District Courts outside of the D.C. Circuit. Thus, potentially opening the door for the defendants to attempt to minimize that aspect of Robare by arguing that this opinion is not precedential in those appellate circuits, but only persuasive.

We will continue to follow these litigated matters and report back on any developments likely to impact the industry.

The Final Reg BI Package: What to Know and What’s Next

To nobody’s great surprise, on June 5, the SEC approved the “Reg BI Package,” which includes a series of new standards governing the fiduciary responsibilities of broker-dealers and investment advisers. The approved items consisted of the Regulation Best Interest – Standard of Conduct for Broker-Dealers; Form CRS Relationship Summary; Standard of Conduct for Investment Advisers; and Interpretation of “Solely Incidental,” all of which seem likely to have considerable impact on the industry going forward.

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Good Disclosure of Bad Internal Controls Is Not Enough

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.

Department of Justice Announces Important Revisions to the Yates Memo

Deputy Attorney General Rod Rosenstein recently announced significant changes to the Department of Justice’s corporate enforcement policy regarding individual accountability, previously announced in the 2015 Yates Memo. The revised policy no longer requires companies who are the target of DOJ investigations to identify all parties involved in potential misconduct before they can be eligible to receive any cooperation credit. This alert examines the updated policy, which should provide companies with greater flexibility in conducting investigations and negotiating dispositions with DOJ in both criminal and civil cases.

Read the full alert.

MD&A-Related Claims against Corporate Execs Reinforce Recent SEC Enforcement Trends

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.