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.
The SEC announced settlements with an auditing firm (the “Firm”) and one of its partners relating to violations of certain auditor independence rules involving nineteen audit engagements with fifteen SEC-registrant issuers.
More specifically, the SEC found the Firm and its partner violated the Commission’s and Public Company Accounting Oversight Board’s (“PCAOB”) auditor independence rules. The alleged conduct involved performing prohibited non-audit services, including exercising decision-making authority in the design and implementation of software relating to one of its issuer client’s financial reporting as well as engaging in management functions for the company. The partner was responsible for supervising the performance of the prohibited non-audit services. Additionally, the SEC charged additional PCAOB-rule violations for failing to notify the clients’ audit committees about the non-audit services. The SEC described these failures as “mischaracterized non-audit services” despite the services involving financial software “that were planned to be implemented in a subsequent audit period and providing feedback to management on those systems—areas outside the realm of audit work.” The partner was also charged with providing material, non-public information concerning an issuer to a software company without the issuer’s consent.
In a Consent Order entered on August 15, Kraft Foods Group, Inc, and its subsidiary Mondelez Global LLC agreed to pay $16 million to settle the CFTC’s complaint alleging the firms manipulated the December 2011 wheat futures markets. The settlement was thought to have ended the litigation, begun in 2015, however, shortly after the entry of the Consent Order, the firms filed a motion seeking contempt sanctions against the CFTC and Commissioners Berkovitz and Behnam. Kraft’s emergency motion alleges the Commission’s statements, and individual Commissioner statements filed concurrently with the Consent Order violated the terms of the settlement.
The Consent Order contained two unusual aspects. First it contained no factual findings or conclusions of law. Second, it contained a clause limiting the parties’ ability to speak publicly on the litigation.
Under the Consent Agreement, both parties agreed to refrain from making any public statements, other than to refer to the terms of the settlement. The CFTC issued a press release outlining the initial claims brought against the firms, and touting the $16 million fine as “approximately three times the defendants’ alleged gain.” The CFTC simultaneously released two other statements regarding the Consent Order, one from the Commission itself, and a joint statement by Commissioners Berkovitz and Behnam.
In their release, the Commissioners stated that the “consent order only limits statements of the Commission as a collective body. Individual Commissioners, speaking in their own capacities, retain their right and ability to speak fully and truthfully about this matter.” The statement goes on to “explain to Congress and the public the basis for the sanctions obtained, as well as the rationale for entering into a settlement agreement rather than pursuing litigation.”
In their motion for contempt, filed last Friday, Kraft argued that the three statements by the CFTC were willful violations of the Consent Order. According to their memorandum in support of the motion, the three statements were released simultaneously in an orchestrated effort to violate the Consent Order, arguing that even if only the CFTC were bound by the Consent Order the Commission violated it “when it endorsed the statements of its Commissioners by identifying them in the CFTC’s official press release, linking to them, and posting them prominently on the CFTC’s webpage announcing the settlement.” Kraft further argued that not only did the violation of the Consent Order harm Kraft, but allowing Commissioners to speak publicly on issues the Commission is prohibited by the Consent Order from discussing will harm future litigants. “There will be no reason for future parties to agree to settlements if the Commissioners – the only parties with the power to bind the CFTC to an agreement in the first place – may simply disregard the agreement without consequence.”
The Commission has since voluntarily removed the press release, Commission statement, and Commissioners’ statement from its website. Judge Blakely has ordered Commissioners Behnam and Berkovitz to appear before the court in person at an evidentiary hearing scheduled for September 12, 2019.
On March 11, 2019, the SEC announced and released settlements against 79 self-reporting registered investment advisers (RIAs), touting $125 million being returned to investors. The actions stem from the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative). The SCSD Initiative incentivized RIAs to self-report violations resulting from undisclosed conflicts of interest, to promptly compensate investors, and to review and correct fee disclosures. Specifically regarding Rule 12b-1 fees, the SEC’s orders found that the RIAs failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.
SEC Chairman Jay Clayton commented: “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed. This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure. Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”
While the SEC and its Division of Enforcement may be pleased, the various industry reactions during the course of the SCSD Initiative included frustration–and at times reasonably so. Tempering that frustration, is that the SEC’s focus on RIA conflicts of interest and disclosures continues. First, there is an expectation that the SEC will announce more settlements in the future for additional SCSD Initiative participants and that this may involve a grouping of a “second wave” of settlements. Second, Enforcement’s Asset Management Unit has already opened investigations into RIAs who did not self-report. Lastly, these investigations included requests for documents and information regarding revenue sharing practices and disclosures.
In conclusion, it is expected that the SEC’s aggressive enforcement efforts regarding RIA conflicts of interest and disclosures to Main Street investors will continue and has already expanded to include revenue sharing.
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.
On July 26, 2017, the U.S. Commodity Futures Trading Commission (“CFTC”) issued an order finding that Simon Posen engaged in the “disruptive practice of ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” The CFTC’s findings, which spanned more than three years, beginning at least in December of 2011, indicated that Posen, based in New York City, had traded from his home, using his own account, in violation of Section 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 6c(a)(5)(C)), which explicitly outlaws spoofing.
The CFTC found Posen placed thousands of orders in gold, silver, copper, and crude oil futures contracts with the intent to cancel them before execution. These orders were placed so as to move the market prices so that smaller orders, which he would also place on the other side of the market, would be filled.
The CFTC permanently banned Posen from trading in any market regulated by the CFTC and from applying for registration or claiming exemption from registration with the CFTC, ordered him to cease and desist from spoofing, and penalized him $635,000. Posen settled without admitting or denying any of the CFTC’s findings or conclusions. James McDonald, Director of the CFTC’s Division of Enforcement, made clear that spoofing prosecutions remain a priority for the CFTC and people, like Posen, “will face severe consequences.”
Under the new leadership at the CFTC — the future marches on —with a continuing aggressive emphasis on the investigation and civil prosecution of manipulative trading and in particular spoofing. The CME Group had initially investigated aspects of Posen’s trading on two occasions and ordered a $75,000 fine and five-week trading bar and subsequently, for other activity, ordered a $90,000 fine and four-week trading bar. Drinker Biddle will continue to monitor the CFTC’s and CME’s actions so as to provide continuing analysis and counseling for our clients.
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.
Last week, Louis Capital Markets, L.P. (“LCM”) agreed to disgorge $2.5 million in settlement of charges that it charged false execution prices to its customers in order to generate secret commissions.
LCM executed orders to purchase and sell securities for its clients, without holding any securities in its own account and thus bore no market risk, i.e., riskless principal trades. It purported to generate profits by charging customers small commissions, typically between $0.01 and $0.03 per share. LCM, however, unbeknownst to customers, inflated those commissions, by embedding undisclosed markups and markdowns into reported execution prices. LCM provided those false execution prices—either lower sales prices or higher purchase prices than LCM actually obtained in the market—to its customers. Critically, LCM did not engage in this deceptive behavior for every trade, rather “LCM opportunistically added markups/markdowns to trades at times when customers were unlikely to detect them, for example, during periods of market volatility.” (Order ¶ 13.) By engaging in these acts, LCM “unlawfully obtained millions of dollars from its customers.” (Order at 2.)
Without admitting or denying the findings, LCM agreed disgorge $2.5 million and to cease-and-desist violating Section 15(c)(1), which prohibits fraudulent conduct by broker-dealers. The SEC noted that while the conduct would support a civil penalty, it considered LCM’s financial status and accepted LCM’s offer that did not include one. Interestingly, LCM’s customers were “primarily large foreign institutions and foreign banks,” demonstrating the SEC’s commitment to eradicate fraud regardless of sophistication of investors.