United States: Whistleblowing For Accounting Fraud: Racing The SEC’s Robocop

In recent years SEC cases alleging fraudulent accounting practices have been in decline (only 11% of enforcement cases in 2012). FCPA and insider trading cases are more exciting, and generate more media attention, while financial fraud can be more time-consuming, difficult to detect and to prove. Nevertheless, when I was in the trial unit at the SEC, I enjoyed litigating these cases as they often involved complex facts, phony accounting entries, earnings management schemes, and a sort of cat-and-mouse game played against people we always thought were really bad guys taking advantage of gullible investors. We especially enjoyed catching high-level managers like CFO's, Controllers, and complicit legal or auditing gatekeepers. The SEC staff seemed to stumble into these cases in random ways, through tips, newspaper stories, and referrals from other agencies.

Fortunately, financial fraud is back in vogue at the SEC. The new SEC Chairman, former prosecutor Mary Jo White, has announced that these cases will get renewed attention. Last July, the SEC announced new programs to discover accounting fraud through the creation of a new "Financial Reporting and Audit Task Force" and a "Microcap Fraud Task Force." Most interesting perhaps will be the impact of the work of a new "Center for Risk and Quantitative Analysis" (CRQA or "RiskFin"), headed up by former Vanderbilt University Economist Craig M. Lewis.

RiskFin is, according to Mr. Lewis, "developing cutting-edge ways to integrate data analysis into risk monitoring." This SEC geek squad will mine data tagged by the new XBRL reporting system to pick out financial reports that "appear anomalous" and will automatically flag them for review by an examiner. The SEC has come a long way from the days when enforcement lawyers in DC and New York would race to get the day's Wall Street Journal to hunt for potential investigation targets and claim the case first by getting to their computer at dawn to log in a MUI ("matter under investigation").

The computer models at RiskFin will, within a day of the filing of a 10K or other report, use the new XBRL tags to identify firms that have made unusual accounting choices relative to their peer group. As Mr. Lewis described it recently to the Merrill Disclosure Solutions Blog:

If a firm was having a down year and felt that the actual numbers were lower than its peer group, it may seek ways to try and boost income, maybe by not recording as much bad debt expense....A manager may simply say: "Well, it's a bad year; let's take something out of the accrual bank." To do this, one would then say: "These credits look solid to us; we don't think we're going to lose that much." In a good year, you look at the exact same set of accounts and you say: "You know something? A lot of these credits are likely to be unable to pay us, so we want to take a little more bad debt expense." This allows you to make a deposit to the accrual bank.

Mr. Lewis noted that looking at peer group firms is logical: "If you are an oil and gas producer, there are a lot of accounting rules about how oil and gas producers have to book income, account for reserves, etc. If you are a software manufacturer, those same rules would not apply to you, so you would not want to compare a software manufacturer against an oil and gas company." The new SEC system, informally being called the SEC's Robocop, is, as Lewis described it: "[A] fully automated system that effectively takes a firm's filing the day it comes in, processes it, and then keeps it in the database so that somebody who is interested in a report on that company would be able to do so within 24 hours of the filing being posted on EDGAR."

RoboCop (officially known as the Accounting Quality Model" AQM) can model and determine how much of the total reported accruals are "discretionary." As two astute observers recently wrote: "RoboCop's objective—to identify earnings management--is not a novel one; rather, it is the model's proficiency that should worry filers... [Robocop can classify] discretionary accruals as either risk indicators or risk inducers. Risk indicators are factors that are directly associated with earnings management while risk inducers indicate situations where strong incentives for earnings management exist. Based on a comparison with the filings of companies in the filer's industry group, [RoboCop] produces a score for each filing, assessing the likelihood that fraudulent activities are occurring." Corporate Filers Beware: New "RoboCop" Is On Patrol, Jay Carney and Francesca Harker, BakerHostetler, Forbes.Com , August 9, 2013.

Director Lewis, for example, cites as a potential "risk indicator" an "accounting policy that results in relatively high book earnings, even though the firms simultaneously select alternative tax treatments that minimize taxable income...[a]nother accounting policy risk indicator might be a high proportion of transactions structured as 'off balance sheet.'"

RoboCop will also be able to look for other potential fraud indicators such as frequent auditor changes or disagreements with auditors, and will be able to analyze the MD&A sections of annual reports to look for word and phrasing choices that are tip offs to fraud, based on similar language in past filings by known fraudsters. Lewis noted in a recent speech that "fraudsters have tended to talk a lot about things that don't really matter much and they under-report all the risks that other firms that aren't having these same issues talk quite a bit about." It is pretty scary to think that a computer at the SEC can figure all this out in a few seconds, without even taking a lunch break over at the Union Station food court.

Which brings me back to whistleblowing, a favorite subject as I represent whistleblowers and continually think I should be getting more clients (what lawyer doesn't?) given what I believe is the massive amount of accounting fraud still out there, undiscovered. If RoboCop works as planned, the SEC will be uncovering all that fraud first, although my experience with government programs is that few work out as brilliantly as predicted. "The SEC has also said it plans to use the risk scores as a means of corroborating (or invalidating) the approximately 30,000 tips, complaints, and referrals submissions it estimates will be received each year through its Electronic Data Collections Systems or completed [whistleblower] forms TCR." Carney and Harker, id.

These observers also suggest that the SEC will use the RoboCop scores to weed out whistleblower complaints: "With the SEC's new whistleblower program in place, illegitimate tips from individuals seeking a payday are sure to increase dramatically. A low score from RoboCop will make tipsters' claims less likely to be investigated." While I tend to think the SEC will not turn away a good tip simply because the company's "score" suggests lack of fraud, I am concerned that the staff will tend to rely too much on the tireless RoboCop to target investigations that may catch some offenders while still missing many others.

Rather, I suggest that would be whistleblowers become their own, less mechanized, RoboCops, and utilize the tools the SEC is using to evaluate their own company, and perhaps others in the same industry, for the same red flags the SEC's in-house robotic wizard is supposed to uncover almost instantaneously. If you are familiar with your firm's accounting policies, its books and records, and the manner in which it books accruals, for example, or makes top-side entries each quarter, you may be able on your own to sniff out earnings management or similar forms of accounting fraud. Read your company's MD&A disclosure. Contrast it with what you know to be the true facts. Compare it to your peer companies. You may also be an in-house accountant or internal or external auditor, compliance officer or in house counsel, and know the truth, or be on terms familiar enough with one of the above to ask the right questions. Certain (usually junior) members of the external audit team often know where the bodies are buried and given a conscience and a few beers may be willing to unburden themselves.

While there are complicated rules for when such insiders can become whistleblowers, the bottom line is that the SEC rules, under the right circumstances, allow almost anyone inside or outside a company to become a whistleblower. The challenge is to get the facts, find the documents, and be sure to make your internal report first (if you choose to do so) and then your submission to the SEC, in accord with its procedures.1

The encouraging news is that the SEC is once again back in the business of pursuing accounting fraud, and has geared up with new teams of lawyers, accountants, and the omni-vigilant super staffer RoboCop to ferret out the fraudsters. Happily as well, the whistleblower who beats RoboCop to the evidence will presumably receive the lion's share of the award, because as good as it is, it will never occur to RoboCop to apply for a piece of the pie.

Footnotes

1. I have tried to explain these rules and offer guidance in prior articles. See, e.g. Daniel J. Hurson, "The 'New Rules' For Becoming A Successful SEC Whistleblower", Mondaq News Service, September 2013"; Daniel J. Hurson, "When Can the Independent Auditor Become An SEC Whistleblower?", Mondaq News Service, Nov. 20, 2012.>/sup>

Daniel J. Hurson is former Assistant Chief Litigation Counsel at the SEC and former federal prosecutor. He practices securities enforcement and white collar defense law in his own firm in Washington D.C and represents SEC whistleblowers. His email is dan@hursonlaw.com. His website is http://www.hursonlaw.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.