SEC enforcement actions often include allegations that corporate officers affirmatively misled a company's outside auditors as part of a scheme to commit and perpetuate an accounting fraud. Such misleading actions might include, for example, signing false management representation letters or providing the auditors with fictitious documentation to support material misstatements in a company's financial statements.1 The SEC often includes such allegations as evidence that a company's officers acted recklessly or with intent to defraud, and thereby violated Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 thereunder.2 In an increasing number of recent cases, however, the SEC has also alleged that corporate officers violated Exchange Act Rule 13b2-2, which expressly prohibits officers and directors from misleading or improperly influencing a company's auditors and does not require a showing that an officer or director acted with fraudulent intent.3
A recent complaint filed by the SEC against three former senior officers at Thornburg Mortgage Inc. ("Thornburg") reflects what may be a particularly aggressive interpretation of Rule 13b2-2's requirements by the Commission's Staff.4 This memorandum reviews the allegations in Thornburg and highlights the potential risk that, in hindsight, corporate managers confronted with a financial crisis may be alleged to have failed to deal candidly with a company's outside auditors. This risk underscores the need for public companies' crisis management plans to address a company's interactions with its outside auditors, in the unfortunate event that the company is unexpectedly faced with financial or business conditions that pose a threat to its profitability or continued viability.
The Thornburg Complaint
Prior to its demise in 2009, Thornburg was a publicly traded real estate investment trust and the second largest independent mortgage company in the United States. According to the SEC's complaint, during a two-week period in early 2008 preceding the filing of the company's 2007 Form 10-K, market conditions deteriorated rapidly and Thornburg struggled to satisfy more than $300 million in a series of escalating margin calls from its lenders. Thornburg's efforts to meet those demands and stave off financial collapse ultimately were unsuccessful, and the company filed for bankruptcy in May 2009.
Earlier this year, the SEC filed charges against Thornburg's former Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer. In its complaint, the SEC did not allege that the three executives were responsible for Thornburg's collapse, or that they should have anticipated the liquidity crisis in 2008 that led to the company's bankruptcy. Instead, the SEC argued that the officers materially misrepresented the company's financial condition in the 2007 Form 10-K, and were responsible for Thornburg's failure to recognize over $425 million in unrealized losses on adjustable rate mortgage ("ARM") securities that served as collateral under the company's lending arrangements.
To support those claims, the SEC placed considerable emphasis on the executives' interactions with Thornburg's outside auditors before the 2007 Form 10-K was filed, as well as the officers' discussions with one another about what they would - and would not – communicate to the auditors about the company's efforts to meet its lenders' demands. The SEC alleged that the defendants made a number of affirmative misrepresentations to the auditors, such as providing them with a management representation letter that affirmed that Thornburg had complied with its material contractual agreements, even though Thornburg had received a notice of default from one of its primary lenders six days earlier for failing to satisfy a margin call on a timely basis. Such claims are similar to allegations in prior enforcement proceedings where the SEC has alleged or found violations of Section 10(b) and Rule 13b2-2 of the Exchange Act by corporate officers.5
However, some of the SEC's other allegations raise issues that have arisen less frequently, such as the assertions that the defendants failed to disclose material information to the outside auditors and "failed to update" the auditors about critical developments that occurred prior to the filing of the 2007 Form 10-K. For example, the SEC alleged that, while Thornburg received, and ultimately, met approximately $650 million in margin calls during the first six weeks in 2008, the defendants failed to notify the auditors that the company had been unable to satisfy, on a timely basis, over $300 million in margin calls received in late February 2008. In support of this claim, the SEC cited e-mails among the defendants, including an e-mail from the CEO to the other defendants that stated:
"We don't want to disclose our current circumstance until it is resolved. Our goal for resolution i[s] the filing of our 10-K. How we disclose this issue and what we say will depend on where we are next week when we need to file. But, our plan is to say that we had margin calls and all have been met. . . . Hopefully our disclosure will be a simple one, meaning all margin calls have been met."
Three days later, the CAO allegedly reported that "[w]e have purposely not told [the auditors] about the margin calls so that we don't escalate an issue which we believe will be put to rest by the time they have to issue their opinion." The SEC's complaint makes clear that the SEC did not consider such decisions reasonable efforts to avoid a premature and potentially unnecessary discussion with the auditors: instead, the SEC characterized the non-disclosure of the margin calls as an act of "concealment." In the SEC's view, had the auditors been advised of the margin calls, they would have discovered the liquidity crisis confronting Thornburg and made further inquiries about the GAAP consequences of the steps Thornburg was taking to satisfy the margin calls.6
The SEC also alleged that the executives failed to update the outside auditors about other developments that had significant accounting implications for Thornburg. Specifically, the SEC alleged that, shortly before Thornburg filed its 2007 Form 10-K, the CFO had advised the outside auditors of his view that prices for mortgage-backed securities ("MBS") were stabilizing. This assessment, if accurate, would have reduced the likelihood that Thornburg would be subject to future collateral calls. According to the SEC, however, the CEO and CFO also learned around this time that a large European hedge fund with substantial MBS holdings was on the verge of collapse, a development that could have been expected to depress the price of Thornburg's ARM securities and trigger additional margin calls. The SEC alleged that the CFO thus "improperly failed to update what had become a misleading statement" about the MBS market to Thornburg's outside auditors.
Potential Litigation Hurdles Under Rule 13b2-2
The SEC's action against the Thornburg executives highlights the risk that the SEC may allege that a lack of candor by corporate officers with a company's outside auditors during a financial crisis provides evidence of Section 10(b) violations or, in the alternative, violates Exchange Act Rule 13b2-2. It is not entirely clear from the complaint whether the SEC alleged that the officers failed to disclose material information to the auditors, and then failed to update them, in order to support the SEC's Section 10(b) allegations, the Rule 13b2-2 claims, or both. These distinctions are significant, because the SEC must show that a defendant acted recklessly, or with intent to defraud, in order to establish a violation of Section 10(b) and Rule 10b-5, whereas the SEC need only establish negligence to prove a Rule 13b2-2 violation. The ambiguity in the pleading thus gives the SEC "two bites at the apple" in alleging misconduct by the Thornburg executives.7
If the SEC does intend to argue that failures by the Thornburg executives to disclose certain facts to the company's outside auditors, and subsequently to update the auditors, violated Rule 13b2-2, the SEC may face several hurdles. In particular, the SEC would need to establish that the information that the defendants allegedly failed to disclose to the outside auditors was necessary in order to make other statements that were made to the auditors not misleading, or that Rule 13b2-2 imposes a duty on management to update the auditors when prior representations are no longer accurate.
Omissions Under Rule 13b2-2: As to the defendants' alleged omissions, the precise timing of the communications at issue is likely to be a critical factor. Rule 13b2-2 prohibits the omission of material facts that are necessary in order to make statements that were made to an accountant not misleading "in light of the circumstances under which such statements were made."8 Thus, a key issue in the Thornburgh case may be whether information that the defendants allegedly failed to disclose to the auditors was, in fact, known by them when they made other, affirmative statements to the auditors. On its face, Rule 13b2-2 calls for an objective assessment of an officer's or director's conduct as of a particular point in time, and does not permit a hindsight review undertaken with the benefit of information that he or she may not have understood when communicating with the auditors.
"Duty to Update" Under Rule 13b2-2: Nothing in Rule 13b2-2 creates an express duty on the part of corporate officers or directors to update the auditors when information that previously may have been provided to the auditors no longer is accurate. Notably, in one of the few cases prior to Thornburg where the SEC expressly alleged that a corporate officer violated Rule 13b2-2 by failing to update the outside auditors after receiving additional, material information, that charge was dropped when the case ultimately settled.9
Despite the absence of an explicit "duty to update" in Rule 13b2-2, however, auditors regularly request updates from corporate managers during an audit, and may lose confidence rapidly in officers whom they suspect have withheld material information about significant financial developments. Thus, as a practical matter, corporate officers may regularly update the outside auditors as a matter of "best practices," and not simply to mitigate the potential risk of being charged by the SEC with securities law violations.
The Relevance to Crisis Management Plans
The Thornburg complaint demonstrates that the SEC Staff believes that management communications with both outside auditors and investors are particularly critical when a company is threatened with severe financial difficulties or business challenges.10 Many companies have now adopted crisis management plans that seek to address how management will respond to an unanticipated financial or operating crisis. The SEC's complaint underscores that a company's communications with the outside auditors, among other stakeholders, should be an important element of such plans.
Such communications often require careful thought. When a company faces a challenge that may have material implications for its financial statements, management may assume that it is confronted with a dilemma: (1) disclosing the developments to the auditors and potentially incurring additional audit fees and possible delays in the company's ability to obtain audited financials, which could exacerbate a crisis; or (2) not making or postponing such disclosures and incurring the risk that, in hindsight, the auditors may lose confidence in senior management or the SEC Staff may allege that the officers acted with an improper intent. Without an appropriate communications plan in place, the odds that some officers may persuade themselves, in the heat of the moment, that they can "manage their way out" of a financial crisis without alerting the auditors may be higher.
In addressing communications with the auditors as part of a crisis management plan, one question that a company should consider is: "How might a situation be perceived in hindsight by the SEC, other regulators, and the auditors, assuming that management is not successful in its attempts to address the financial challenge?" Obviously, not every challenge that confronts a business need be raised with the auditors, but the answer to the foregoing question may often lead a company to conclude that it is appropriate to alert the outside auditors promptly, when matters are identified that clearly have potentially significant implications for the company's financial statements. Management teams and boards of directors that have developed a constructive relationship with the outside auditors well before any such crisis develops will be in the best position to speak openly with the auditors, and thereby avoid potential misunderstandings later with either the auditors or the SEC.
1 See, e.g., Complaint, SEC v. Retail Pro, Inc., No. 08-cv-1620 (S.D. Cal. Sept. 4, 2008); Complaint, SEC v. Delphi Corporation, et al., No. 2:06-cv-14891 (E.D. Mich. Oct. 30, 2006).
2 15 U.S.C. § 78j(b), 17 C.F.R. § 240.10b-5.
3 17 C.F.R. § 240.13b2-2. Rule 13b2-2 originally dates back to 1979 and was amended in 2003 following the adoption of the Sarbanes-Oxley Act. See Exchange Act Release No. 34-15570, 44 Fed. Reg. 10,968 (Feb. 15, 1979); Exchange Act Release No. 34-47890, 68 Fed. Reg. 31,820 (May 28, 2003).
4 SEC v. Goldstone, et al., No. 1:12-cv-00257 (D.N.M. Mar. 13, 2012).
5 See, e.g., Complaint, SEC v. Delphi Corporation, et al., No. 2:06-cv-14891 (E.D. Mich. Oct. 30, 2006) (including allegations that the company's CEO, CAO and Controller each signed multiple management representation letters containing materially false statements and/or omitted material facts).
6 The SEC made similar claims in SEC v. Dauplaise, et al., 6:05-cv-1391 (M.D. Fla. Sept. 22, 2005), where the SEC alleged that corporate officers had signed forbearance agreements relating to a defaulted $15 million note and then both failed to publicly disclose these facts in SEC filings and concealed the existence of the default and related forbearance agreements from the outside auditors.
7 Federal Rule of Civil Procedure 8(d) permits a party to "set out 2 or more statements of a claim or defense alternatively or hypothetically . . . regardless of consistency." Such "alternative pleading" is common in complaints filed by the SEC. See, e.g., Complaint, SEC v. Life Partners Holdings, Inc., et al., No. 6:12-cv-00002 (W.D. Tex. Jan. 4, 2012) (including allegations of Rule 13b2-2 violations, together with other scienter-based charges, that corporate officers failed to disclose material facts to the outside auditors when consulting with the auditors about a hypothetical scenario, thereby rendering the hypothetical incomplete and misleading).
8 Rule 13b2-2(a)(2) (emphasis added).
9 Compare SEC v. Kamber, et al., No. 1:07-cv-01867 (D.D.C. Oct. 17, 2007) (including charge against a corporate officer under Rule 13b2-2) with SEC Litigation Release No. 21636 (Aug. 31, 2010) (omitting the alleged Rule 13b2-2 allegation from the final settlement).
10 See SEC Press Rel. No. 2012-42, SEC Charges Three Mortgage Executives With Fraudulent Accounting Maneuvers in Midst of Financial Crisis (Mar. 13, 2012) (statement by Enforcement Director Robert Khuzami that "[t]he truest test of corporate executives' commitment to full and accurate shareholder disclosure comes not during times of soaring profits and double-digit growth, but when companies are under financial stress and shareholders have the greatest need for accurate information.").
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