We are pleased to offer our clients and friends this update on
financial reporting and issuer disclosure enforcement activity in
2015. It will focus principally on the Securities and Exchange
Commission ("SEC") but will include other developments
outside the SEC where we deem relevant. We will also discuss where
things might be headed in the future and actions that companies,
directors, and officers can take to minimize the likelihood of
becoming embroiled in an investigation.
The last year has demonstrated that the SEC is as focused on
financial reporting and issuer disclosure violations as it has been
in many years. The agency is filing more cases in the area, and
while the subject areas for those cases are largely unchanged from
historical patterns, the SEC is alleging more technical and some
might say less egregious (non-fraud) violations than we have seen
in the past. The cases also involve individuals more often than
not, so the critique lodged against other government departments
for not targeting individuals would not be fairly applied to the
SEC. And there is little reason to believe this aggressive approach
will abate anytime soon because the agency is using data, tools,
and new techniques to find more cases, and the whistleblower
program is attracting more financial reporting and disclosure tips
every year. Overall, it is fair to characterize the SEC's
approach to this area as aggressive and proactive, in a way that
should cause companies, management, and boards to reexamine the
internal controls and processes around financial reporting and
disclosures.
EXECUTIVE SUMMARY
Financial reporting and issuer disclosure violations are among
the most costly types of securities violations. While prosecuting
them has always been an important part of the SEC's agenda, the
internal reshuffling of resources following the financial crisis
and the extensive rulemaking required by the Dodd-Frank Act caused
the agency to prioritize other areas. Now that its agenda is no
longer driven by those same factors, financial reporting and
disclosure have returned to the top of the SEC's enforcement
agenda. And there is every reason to believe the SEC will continue
to focus on this area in the near term.1
The first notable development in the last year is that, no matter
how you count them, there has been a sharp increase in the number
of actions filed over the past three years. The number of financial
reporting and disclosure actions filed in fiscal year 2015
increased to 134 cases, a dramatic increase from the 98 in 2014 and
68 in 2013.2 Many of the actions are less severe in
terms of the misconduct and smaller in terms of penalties and
disgorgement relative to the massive restatement cases filed in the
mid-2000s, but the increase in activity in this area is nonetheless
notable. We might expect this trend of more relatively smaller
actions to continue in part because the number and average size of
restatements themselves are down sharply.3
Another clear trend is the very public focus on bringing cases
against individuals. This includes individual officers, directors,
auditors, and accountants—those who are in a position to
ensure that financial statements and disclosures are accurate and
that company compliance programs are operating effectively. Another
trend is the continued effort to hold gatekeepers accountable for
fraud and negligence in financial reporting and
disclosures.4 In a somewhat related development, the
Department of Justice ("DOJ") issued an internal
memorandum to prosecutors that reemphasizes the DOJ's desire to
criminally prosecute individuals and requires corporations to
identify individual wrongdoers and provide evidence against them to
the government in order to obtain cooperation credit.5
The dual focus by the SEC and DOJ on pursuing actions against
individuals is a trend that may significantly affect the conduct of
government and internal investigations, as well as the defense of
issuers, officers, and directors.
Another sign of the SEC's aggressive and proactive approach in
this area is its conversion of the Financial Reporting and Audit
("FRAud") Task Force to a permanent group within
Enforcement, signifying the SEC's long-term interest in this
area. First created in 2013, the slightly reconstituted FRAud Group
will continue focusing on developing and refining methods to
identify potential new investigations, working with data to better
detect fraud and investigate cases, and serving as thought leaders
in the area of financial reporting, issuer disclosures, and auditor
liability. Related indications of proactive enforcement in this
area include the increasing use of data analytics to identify
potential wrongdoing and the burgeoning importance of
whistleblowers.
Another trend worth watching is the increasing focus on internal
controls and other technical violations. Whether this is properly
included in the SEC's "broken windows" approach is
unclear, but the SEC continues to initiate enforcement actions
focused on internal controls and books-and-records violations. The
SEC filed some notable internal controls-only enforcement actions
this past year that did not involve any accusations of fraud. How
far the SEC will go in the space remains to be seen, but at some
point the Commission may need to address its long-standing policy
not to use the books-and-records and internal controls provisions
to expose companies and individuals to enforcement action "as
a result of technical and insignificant errors in corporate records
or weaknesses in corporate internal accounting
controls."6
Some other developments outside enforcement are also worth
mentioning for 2015. The most notable is the United States Supreme
Court's decision in Omnicare, Inc. v. Laborers District
Council Construction Industry Pension Fund, which set out
rules for determining whether a statement of opinion constitutes a
material misstatement or omission under §11 of the Securities
Act of 1933. The SEC also continued its flurry of Dodd-Frank
rulemaking with several of its efforts touching on issuer
disclosure and financial reporting. The most impactful of these may
be the new Rule 10D-1, under which companies will be required to
develop their own policies and procedures for clawing back certain
executive compensation in the event of a restatement without regard
to the involvement or fault of the executive.
We should expect to see continued focus on financial reporting and
issuer disclosure matters. First, the leadership has signaled a
strong interest in this area, so until that leadership changes, we
should expect continued strong interest. Second, the creation of
the FRAud Group has reenergized the area, as attorneys and
accountants are motivated by internal competition to find the next
big financial reporting or disclosure fraud case before the FRAud
Group identifies it first. Third, the current downturn in the
energy sector and depressed growth in some key foreign countries
are creating deterioration in business fundamentals that companies
may be tempted to delay recognizing and disclosing. As a result, we
should expect to see continued focus on financial reporting and
disclosures.
In view of all this, some suggestions for how companies,
management, and directors can respond include:
- Create the right tone at the top. From the top down, consistently communicate that ethical behavior and compliance are paramount values of the company.
- Reexamine your ethics and compliance program. This includes structural evaluations, regular audits and testing, and training. Every employee must believe he or she is part of the compliance function, regardless of title or level.
- Encourage a "speak up" culture. Employees at every level need to know senior management and the board expect them to speak up when they see a problem and will reward them when they do, even if the news is bad.
- Synchronize internal and external communications. Continually consider how an investor or an SEC enforcement attorney reading the company's disclosures would view internal discussion of the company's condition because a wide variance between internal communications and external disclosures will be Exhibit A in an enforcement action.
- Focus on internal controls. Management and the board must continue to focus on internal controls because the SEC is focused on them.
- Embrace would-be whistleblowers. Ensure you have (i) strong procedures for promptly escalating and addressing whistleblower complaints internally and (ii) good controls for preventing retaliation against whistleblowers.
While there is no one answer to how to deal with the SEC's
focus on financial reporting and disclosures, it never hurts to be
reminded of the importance of ethics and compliance.
Footnotes
1 See Andrew Ceresney, Director, SEC Div. of Enforcement, "Directors Forum 2016 Keynote Address" (Jan. 25, 2016).
2 Emily Chasan, "SEC Doubles Number of Financial Reporting and Audit Cases in Two Years," Wall St. J.: CFO J. (Oct. 22, 2015).
3 See Tammy Whitehouse, "Parsing the Data on Financial Restatements," Compliance Week (May 5, 2015).
4 SEC. AND EXCH. COMM'N, "SEC Announces Enforcement Results For FY 2015" (Oct. 22, 2015).
5 Sally Q. Yates, "Memorandum re: Individual Accountability for Corporate Wrongdoing" (Sept. 9, 2015) [hereinafter Yates Memorandum]; Jones Day, "U.S. Department of Justice Announces Updated Guidelines on Individual Accountability for Corporate Wrongdoing: Implications for Internal and Government Investigations" (Sept. 2015).
6 Harold M. Williams, Chair, SEC, "The Accounting Provisions of the Foreign Corrupt Practices Act: An Analysis," at 6, SEC Developments Conference, AICPA (1981).
Download - SEC Enforcement in Financial Reporting and Disclosures - 2015 Update
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