United States

YOU'RE NOT SAFE YET:

The private litigation Securities Reform Act's safe harbour does not shield corporations from financial lawsuits. Read on for six ways to protect your company.

Around the United States, a collective sigh of relief could be heard from corporate executives on December 22, 1995. As either a belated Hanukkah gift or an early stocking filler, the United States Congress gave public-company executives what they'd sought for years: reform of the shareholder class action system. In overriding President Clinton's veto of the Private Securities Litigation Act Reform Act of 1995, Congress established protection for honest companies that run into hard times. But a year later, companies are finding that they're still being bombarded by lawsuits. And as we go to press, the state of California is preparing to vote on Proposition 211, a proposal on the ballot that would allow a suit against a company with a single California lawsuit to be considered a nation-wide class-action suit.

What gives? First, commentary on the new law has emphasised its safe harbour provision. The safe harbour will go far toward eliminating the classic fraud-by-hindsight suit filed when company fails to satisfy quarterly earnings expectations. One of the carve outs from the new safe harbour, however, may lead plaintiffs to shift their attention from missed forecasts to cooked books. Proactive CFOs should take steps now to ensure that financial-fraud lawsuits against their companies can be thrown out early.

In pre- Reform Act days, plaintiffs always preferred an accounting-fraud case to a forecasting case. Palaintiffs recognised that, to a judge or jury, forecasting is like reading a crystal ball, while financial fraud is fraud. Plaintiffs routinely alleged accounting improprieties, hoping to gain access to auditors' workpapers in search of a debatable entry. Over the years, courts caught on to the tactic and tended to dismiss accounting allegations, absent a high level of detail.

But the Reform Act will make Plaintiffs even more eager to uncover a financial fraud claim for two reasons. First, judges read newspapers. They know Congress sought to turn the class-action bar into an endangered species. Plaintiffs will face a sceptical audience when they file new cases. One way to regain credibility with the courts is by focusing on cooked-books cases, cases so egregious a judge will view them as different from the now-disfavoured forecasting claims.

Second, plaintiffs will focus on financial fraud because it is not subject to the same safe-harbour protections as are forecasts. The new safe harbour provides extremely strong protections, both substantive and procedural, for forward looking information is accompanied by cautionary disclosures. But the safe harbour expressly does not apply to forward looking information contained in financial statements prepared in accordance with generally accepted accounting principles. As a result, plaintiffs will strongly prefer to file a case based on financial statement fraud, rather than on protected forward looking information.

Here are some suggestions to help you minimise your exposure in an accounting based shareholder suit. O course, you should discuss the specifics of any lawsuit against your company with your own counsel.

FORWARD MARCH:

unusual circumstances, the financial, results contained in a company's Securities and Exchange Commission filings won't fall within the new safe harbour. Nevertheless, a variety of forward looking information is sometimes included in the financial statements, particularly in the footnotes. Whenever possible, move such disclosures out of the financial statements and into the management's discussion and analysis section.

SEC regulations require you to include particular information in the financial statement footnotes, then of course you shouldn't omit it. But in that situation, consider whether forward looking components of that item can also be included in the MD&A, accompanied by appropriate cautionary disclosures. Although plaintiffs may argue the forward looking information is not protected by the safe harbour even if included elsewhere in the document, a court may disagree, based on the overall circumstances of the disclosure.

In other instances, SEC regulations will not require inclusion of the forward looking item in the footnotes, but auditors may prefer to see it there. You should probe the auditors on this issue. The fact that particular item has historically been discussed in the footnotes doesn't necessarily mean it must remain there, instead of the MD&A. On the other hand, the auditors may feel increased pressure from a newly effective accounting guideline, Statement of Position 94-6, which may require enhanced disclosure of forward-looking information in footnotes. You may need to explore with your accountants this tension between the guideline and the new safe harbour.

INVOLVE THE AUDITORS IN ACCOUNTING DECISIONS:

In recent years, companies have won a number of class actions on pre-trial motions because the challenged accounting decisions had been blessed by outside auditors. The courts reasoned that even if the accounting decision was wrong, approval by the auditors precluded plaintiffs from establishing that the company or its officers had acted with fraudulent intent. Thus, auditor involvement in non routine accounting determination provides a valuable bulwark against subsequent fraud claims.

One way to enhance such protection is to have the auditors conduct timely quarterly review, instead of retrospective reviews during the year end audit. Moreover, for issues on which the accounting literature contains conflicting guidance, it may be worth getting an opinion from a second accounting firm, or even from the SEC. The more detailed the disclosure to the auditors, the more likely it is their approval will defeat a fraud claim.

DISCLOSE YOUR ACCOUNTING POLICIES:

Another way to undermine a challenge to accounting decisions is to disclose them. Plaintiffs must prove you mislead investors. Even if they mount a credible challenge to a particular accounting decision, their case will be undermined if the market knew about the particular accounting treatment, especially if you disclose the financial impact of the decision or it can be determined by analysis of your financials. A judge may not know whether your accounting treatment or the treatment proposed by the plaintiffs is right, but if you spelled out for re investors what you did, there is a good chance he will dismiss the claim at the outset.

TAKE YOUR ACCOUNTING MANUAL SERIUOSLY:

Most companies have a manual containing accounting policies and practices. Unless maintained properly, these manuals are fodder for the plaintiffs. Review you manual periodically to ensure it reflects your company's actual practices. If you're uncomfortable recording those practices in writing, then you probably should change them. Ask your outside auditors to review the manual consistency with GAAP. Try to avoid phrasing policies in absolute terms, because circumstances may well arise in which deviation from the policy is appropriate (or occurs). Leave yourself some room.

SET YOUR RESERVES CONSISTENTY:

Some companies use their accounts (particularly bad debt and obsolete inventory) to manage earnings. In a good quarter, they can salt away extra pennies per share; in a tight quarter, they can draw down on those excess reserves. This practice is risky. Plaintiffs are very focused on reserves. This practice is risky. Plaintiffs are very focused on reserves: indeed, they allege that a company has maintained inadequate reserves in order to inflate earnings. The SEC, too has been concerned about companies manipulating reserves. Large reserve increases in the fourth quarter, as the company anticipates its audit, sometimes provoke SEC inquiry. If possible in your type of business, you should articulate your reserve methodology, so it doesn't rest entirely on gut decisions about the reserve methodology. For example, if you routinely book 1 percent of sales as a reserve for returns, you may benefit from disclosing that in your SEC filings. You should be able to justify quarter to quarter variations in eserve accounts as being legitimately grounded in the business realities of your firm. Have the auditors sign off on your reserve decisions each quarter, and consider adding a section to your SEC filings discussing changes in reserve levels.

KEEP YOUR HOUSE CLEAN:

ROOT OUT RRAUD:

Few CFOs will tolerate improper accounting practices on their watches. Nevertheless, abuses can occur, even in fundamentally honest companies. A salesman desperate to make quota may give a customer a secret side letter transforming the sale into a consignment; a foreign subsidiary may continue booking sales beyond the quarterly cut off. If your company has procedures to prevent such procedures, the impact on a securities suit of isolated transgressions will be greatly reduced.

One step to contemplate is invigorating your audit committee. Some committees meet sporadically and do little more than receive clean bills of health from the auditors. When a company is sued for securities fraud, defence lawyers are usually able to uncover accounting problems during the first few interviews. Couldn't your audit committee do the same thing?

Consider having your audit committee conduct one-on-one, periodic interviews with employees at various levels of the finance department, particularly order-entry and credit control and collections. You may be surprised by what you find. In any event, knowing a committee of directors will be asking such questions may make an employee think twice before booking an improper transaction.

You might also consider requiring sales executives, and even salespeople, to sign certifications that the revenue they've booked in a given quarter complies with your accounting guidelines. Make it clear that violating your revenue-recognition policies is grounds for termination. Terminate violators.

The importance of taking preventive measures is heightened by Title III of the Reform Act, called "Auditor Disclosure of Corporate Fraud." This portion of the bill imposes on outside auditors the duty of establishing procedures to detect an illegal act, they must report it to management and ensure the audit committee or the board is adequately informed on the matter, unless it's "clearly inconsequential." If the legal act materially affects the company's financial statements, and fails to take "timely and appropriate remedial action," the auditors must make a report to the SEC.

Obviously, such a report would set off a fission reaction. The company's stock would be pummelled and its reputation sullied. Shareholder lawsuits would be filed within hours. The safe harbour would be unavailable.

You need to start planning today to ensure nothing like this ever happens to your company. Adopting meaningful internal fraud detection procedures, preferably with the guidance of your outside auditor, will enable you to deal with any troublesome situations before they ferment to the level at which the new state requires your auditors to turn you in.

Don't go away discouraged. The Reform Act will be a boom to honest companies. Fewer meritless suits will be filed, especially wit respect to missed forecasts. With prudent planning, you can reduce the odds of facing a post Reform Ac shareholder suit dressed up as a financial fraud claim.

For further information contact

Tim Scott
Wilson, Sonsini, Goodrich & Rosati, 
650 Page Mill Road,
Palo Alto,
CA, 94304,
650 493 9300

We operate a free-to-view policy, asking only that you register in order to read all of our content. Please login or register to view the rest of this article.

You're Not Safe Yet

Contributor

Contributor

Contributor