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.”

Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee. Continue reading “Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors”

SEC Levies Disgorgement and Civil Penalties for Violations of the Consumer Protection Rule and the Dodd-Frank Whistleblower Protection Rule

On June 23, 2016, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. (collectively, “Merrill Lynch”) agreed to pay $415 million and admit wrongdoing to settle charges of rules based violations, including Exchange Act Rule 15c3-3, the Consumer Protection Rule (the “Consumer Protection Rule”) and Exchange Act Rule 21F-17 (“Rule 21F-17”), which prohibits any action impeding an individual from communicating directly with Commission staff about possible securities laws violations. See Release No. 78141.

Exchange Act Rule 15c3-3, known as the Consumer Protection Rule, was enacted to “protect broker-dealer customers in the event a broker dealer becomes insolvent” by eliminating the “use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities a trading and underwriting through the separation of customer related activities from other broker-dealer operations.” To safeguard assets, the Consumer Protection Rule requires broker-dealers to “maintain a reserve of funds and/or certain qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers” and to “promptly obtain and thereafter maintain physical possession or control over customers’ fully paid and excess margin securities . . . . in one of several locations . . . held free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer.” The Consumer Protection Rule also imposes a self-reporting requirement where, in the event that a broker-dealer fails to maintain sufficient reserves, it must immediately notify the Commission and FINRA.

Signaling that the SEC may suspect that other broker-dealers may have also violated the Consumer Protection Rule, Michael J. Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, announced in a press release: “Simultaneous with today’s action, SEC staff will begin a coordinated effort across divisions to find potential violations by other firms through a targeted sweep and by encouraging firms to self-report any potential violations of the Customer Protection Rule.” Press Release No. 2016-128. In light of the significant civil penalty imposed by the SEC against Merrill Lynch, broker-dealers should take a hard look at their own compliance with the Consumer Protection Rule and seriously consider self-reporting if they find violations as required by the Consumer Protection Rule itself.

Rule 21F-17 was enacted to “evince[] a Congressional purpose to facilitate the disclosure of information to the Commission relating to possible securities law violations and to preserve the confidentiality of those who do so.” “Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934,” Release No. 34-64545, at p. 198 (Aug. 12, 2011). The SEC acknowledged that it did not discover any instance where a Merrill Lynch employee was prevented from directly communicating with the Commission regarding potential securities law violations, certain Merrill Lynch policies, procedures, and agreements with employees included language that the SEC claimed did not permit an individual to voluntarily disclose confidential information. The Order further states that Merrill Lynch promptly took “substantial remedial acts” to address any Rule 21F-17 violations, including revising its severance agreements. Notably, this is the second time the Commission has held proceedings for Rule 21F-17 violations without any evidence that any employee had been prevented from disclosing confidential information to the government. See In the Matter of KBR, Inc., Release No. 74619. Given that the Consumer Protection Rule violation seems unrelated to the Rule 21F-17 violation, it seems likely we will see the staff asking about language included in employment agreements, severance agreements and other employment policies during investigations even in the absence of specific whistleblower concerns.

While Merrill Lynch admitted to wrongdoing, the settlement involves rules based violations as opposed to fraud based violations. Merrill Lynch did not admit to any fraudulent conduct. Notably, some of the largest “admit” settlements have been grounded in rules based violations. See Press Release No. 2013-187 (JPMorgan Chase admits to wrongdoing and pays $200 million and $920 million worldwide to settle SEC charges); see also Press Release No. 2014-17 (Scotttrade admits to wrongdoing and pays $2.5 million to settle SEC charges). The Commission also announced on June 23rd, a litigated administrative proceeding against William Tirrell, Merrill Lynch’s former Head of Regulatory Reporting, related to the Consumer Protection Rule violations. See Release No. 78142. The proceeding will be scheduled for a public hearing before an administrative law judge.

Third-Party Service Provider to Private Equity Funds Pays More Than $350,000 for Gatekeeping Failures

On June 16, 2016, Apex Fund Services (US), Inc., settled charges that it ignored clear indications of fraud while keeping records and preparing financial statements and investment account statements for private funds managed by EquityStar Capital Management, LLC, and ClearPath Wealth Management, LLC, each of which has previously been charged with fraud in SEC enforcement actions. Press Release 2016-120. The settlement highlights the SEC’s focus on gatekeepers and the importance of gatekeepers monitoring red flags, especially when their role includes providing financial information to investors.

With respect to EquityStar, Apex settled charges that it made materially false and misleading statements to investors when it improperly accounted for undisclosed withdrawals from funds (made by EquityStar and manager Steven Zoernack) as receivables even when Apex possessed evidence that neither EquityStar nor Zoernack were willing or able to repay the withdrawals, which totaled over $1 million. After Zoernack stated his intent to repay an initial withdrawal, Zoernack continued to make withdrawals (without making repayments) that Apex repeatedly treated as “receivables,” rather than withdrawals by Zoernack, in the Net Asset Value (“NAV”) reports. Eventually, the “receivables” accounted for nearly 54% of the NAV of one fund and more than 26% of another fund. During this time, Apex learned that Zoernack had previously been convicted for wire fraud. According to the SEC, Apex repeatedly asked Zoernack to make disclosures about the withdrawals that he did not make. The SEC also found Apex ultimately determined that Zoernack would not be able to repay them. Nevertheless, Apex continued to report materially inaccurate NAVs. Release No. 4429.

ClearPath was charged with securities fraud violations relating to a misappropriation scheme last year in the District of Rhode Island. With respect to ClearPath, the SEC found Apex (i) “failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of the fund offering documents”; (ii) failed to correct prior financial reports and continued to issue “materially false reports and statements” to ClearPath and an independent auditor; and (iii) used those false reports in communication financial performance to investors. Release No. 4428.

Without admitting or denying the SEC’s findings, Apex agreed to retain an independent consultant to conduct a review of Apex’s policies and procedures and recommend corrective measures. Additionally, Apex will pay a total of $352,449, which includes (i) disgorgement of $89,050, plus $7,786 in interest and a $75,000 penalty for its actions with respect to EquityStar; and (ii) disgorgement of $96,800, plus $8,813 in interest and a $75,000 penalty for its actions with respect to ClearPath.

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.

SEC Resolves First Case Under New Municipalities Continuing Disclosure Cooperation Initiative

On July 8, 2014, the SEC announced that it had settled charges that a school district in California misled bond investors about its failure to comply with its continuing disclosure obligations under Rule 15c2-12 of the Exchange Act. Pursuant to the Municipalities Continuing Disclosure Cooperation (“MCDC”) Initiative, Kings Canyon Joint Unified School District, without admitting or denying the SEC’s findings, agreed to entry of an Order (1) finding that it was in violation of Section 17(a)(2) of the Securities Act, (2) requiring it to cease and desist from violating Section 17(a)(2), (3) requiring it to establish written policies and procedures and to conduct periodic training regarding continuing disclosure obligations, and (4) requiring it to cooperate with the Enforcement Division in any subsequent investigation and to disclose the settlement in future bond offering materials. The SEC did not order any disgorgement or civil penalty.

Rule 15c2-12 requires that an underwriter obtain a written agreement from an issuer, for the benefit of bondholders, in which the issuer promises to submit certain financial information on an annual basis. This financial information is usually submitted to appropriate national and state repositories where it is available to the investing public. Notably, a broker-dealer must consider an issuer’s failure to disclose such financial information in determining whether to recommend a security and must disclose the failure to provide such financial information to customers. Rule 15c2-12 undertakings must be described in final Official Statements.

Continue reading “SEC Resolves First Case Under New Municipalities Continuing Disclosure Cooperation Initiative”

SEC Files First Antiretaliation Enforcement Case Against Hedge Fund Advisory Firm

In a first of its kind case, the SEC last week charged an investment adviser to a hedge fund with, among other things, retaliating against an employee who reported allegedly illegal trading activity to the agency. The SEC exercised its authority under a Commission rule adopted in 2011 under the Dodd-Frank Act, which permits enforcement actions based on retaliation against whistleblowers.

Under the Exchange Act, employers may not “discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower.” 15 U.S.C. § 78u-6(h)(1)(A). The Act also provides that the Commission “shall pay an award or awards to 1 or more whistleblowers who voluntarily provided original information to the Commission that led to the successful enforcement of the covered judicial or administrative action, or related action, in an aggregate amount equal to (A) not less than 10 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions; and (B) not more than 30 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions.” Id. § 78u-6(b)(1).

The alleged retaliation at issue centered on the investment adviser’s former head trader, who reported allegedly improper principal transactions to the SEC under the SEC’s Bounty Program. According to the SEC, the investment adviser engaged in trades with an affiliated broker-dealer on behalf of one of its hedge fund clients. The SEC alleged that the investment adviser’s owner had a conflicted role as owner of the brokerage firm while subsequently advising the hedge fund client. In an attempt to satisfy written disclosure and consent requirements, the investment adviser formed a conflicts committee to review the transactions, which consisted of the investment adviser’s CFO and chief compliance officer. The SEC alleges that the conflicts committee was also conflicted because the two-person committee reported to the investment adviser’s owner and because the investment adviser’s CFO also served as CFO of the investment adviser’s affiliated broker-dealer. As a result of this conflict, the SEC contended the investment adviser did not provide effective written disclosure to its hedge fund client, and it did not obtain consent to engage in the transactions.

According to the SEC Order, the trader subsequently informed the owner of the investment adviser that he had reported these potential securities law violations to the SEC. After the company learned of the whistleblower’s submission, it allegedly engaged in a series of retaliatory actions to strip the trader of his responsibilities. Approximately one month after doing so, the whistleblower resigned citing constructive discharge. Of note, the former trader filed a lawsuit against the investment adviser, its owner, and its affiliated broker-dealer under § 78u-6(h)(1)(B), which permits whistleblowers to bring enforcement actions, alleging unlawful retaliation, but the lawsuit was voluntarily dismissed in December 2012. It is not clear why the lawsuit was dismissed or whether the dismissal was related to a settlement.

In settling the matter with the SEC, the investment adviser neither admitted nor denied the charges. It agreed to pay $2.2 million, which includes disgorgement of $1.7 million, prejudgment interest of $181,771, and a civil penalty of $300,000. The Order expressly provides that the disgorgement relates to administrative charges relating to the principal transactions. The Order is silent, however, on whether the civil penalty of $300,000 is related to those principal transactions or has something to do with the retaliation claim. The Commission acknowledged in its order that the principal transactions were effected at the prevailing market price and the affiliated broker-dealer did not charge a markup or commission on the transactions. Significantly, the Order does not contain any finding that the funds were harmed by inadequate prices and the fact that the disgorgement relates to administrative charges strongly suggests there was a lack of monetary injury to the funds.

The SEC has authority to award the whistleblower between 10 and 30 percent of the recovery because the tip led to sanctions in excess of $1 million. According to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, a whistleblower is eligible for a whistleblower award. We have previously pointed out that the SEC intends to vigorously protect whistleblowers by using it authority under Dodd-Frank to bring retaliation claims against employers in a previous post: “Arbitration Agreements and Whistleblower Protections.” This case is proof.

District Court Confirms “Neither Admit Nor Deny” Settlements Applying Citigroup Factors

In March 2013, the SEC requested that Judge Victor Marrero of the United States District Court for the Southern District of New York approve consent judgments as to CR Intrinsic and CR Intrinsic Investments, LLC; S.A.C. Capital Advisors, LLC; S.A.C. Capital Associates, LLC; S.A.C. International Equities, LLC; and S.A.C. Select Fund, LLC (the “Relief Defendants”). Each of the proposed judgments was without admitting or denying the allegations of the SEC’s complaint. In April 2013, Judge Marrero issued an Opinion and Order in which he said, “The Court is troubled by these provisions as they permit CR Intrinsic and the Relief Defendants to resolve the serious allegations against hem involving a massive insider trading scheme ‘without admitting or denying the allegations of the Complaint.’” SEC v. CR Intrinsic Investors, LLC, 939 F. Supp. 2d 431, 436 (S.D.N.Y. 2013). Noting that the Second Circuit was then considering an appeal in SEC v. Citigroup Markets, Inc., which might clarify how much discretion the district courts might have in determining whether to approve or reject a consent judgment that contains a clause neither admitting nor denying the allegations in the SEC’s complaint, Judge Marrero conditionally approved the judgments pending resolution of Citigroup.

As explained in our June 6, 2014 post titled “Second Circuit Vacates Judge Rakoff’s Order Refusing to Approve Citigroup “Neither Admit Nor Deny” Settlement“, the Second Circuit recently clarified the proper standard for reviewing consent decrees, and the parties requested the court to approve consent decrees. Applying the standards set forth by the Second Circuit in SEC v. Citigroup Mkts., Inc., ___ F.3d ___, Docket Nos. 11-5227-cv; 11‑5375-cv; 11-5242-cv, 2014 WL 2486793 (2d Cir. June 4, 2014), Judge Marrero approved the judgments as to CR Intrinsic and the Relief Defendants. He, however, noted that the subsequent conviction of Matthew Martoma, a CR Intrinsic employee, and guilty plea by CR Intrinsic “called attention to the importance of more rigorous inquiry by the SEC in its application of ‘neither admit nor deny’ provisions in settlements embodying the exceptional circumstances presented by this action, specifically those where parallel criminal cases track an SEC complaint arising from the same facts.” SEC v. Citigroup Mkts., Inc., 2014 WL 2486793, at *5. It remains to be seen whether Judge Marrero’s “wait-and-see approach” in these situations will gain traction at the SEC, particularly because it could significantly delay settlements in cases where, like Martoma’s, the criminal conviction is appealed.