United States: SEC Enforcement Of Financial Reporting & Accounting Violations

Public Company Accounting, Disclosures and Internal Controls

Financial reporting and accounting fraud reemerged as a key priority of the SEC Enforcement Division during 2015. Though the past decade saw a decline in the number of SEC cases in this area, in the past two years, the SEC has shown a renewed interest in financial reporting cases as many of the financial-crisis investigations wound down and the SEC introduced its Financial Reporting and Audit Task Force. In 2015, the SEC brought a number of notable enforcement actions and introduced a cutting-edge data analytics program, the Corporate Issuer Risk Assessment ("CIRA"), which uses over 100 different metrics to help SEC investigators detect financial reporting anomalies.

The eye-popping settlement in June with Computer Sciences Corporation ("CSC") and five of its former executives for a $190 million penalty in connection with their alleged accounting and disclosure fraud highlights the trend. According to the SEC, after CSC realized that it would lose money on its largest contract, CSC altered its accounting models to artificially increase its profits and mask what would otherwise be a substantial hit to earnings. CSC also engaged in improper accounting practices in several of its foreign subsidiaries, including overstating assets, using "cookie jar" reserves and improperly capitalizing expenses, among other things. In addition to the $190 million penalty, CSC agreed to retain a consultant to examine its compliance programs. CSC's CEO and CFO agreed to a clawback of over $4 million in incentive compensation, as well as significant monetary penalties.

In September 2015, the SEC filed another notable case against Bankrate, Inc., and three of its former executives for improper earnings management. The SEC alleged that Bankrate's executives directed various company divisions to book unsupported revenue and improperly reduce certain expenses. Without admitting or denying these allegations, Bankrate paid $15 million to settle the matter, and Bankrate's vice president was barred from practicing before the SEC and from serving as a public company officer or director for five years in addition to personally paying a $180,000 fine. Bankrate's CEO and director of accounting continue to litigate the matter.

Less than a month later, the SEC settled charges against the former CEO and former CFO of now-bankrupt OCZ Technology Group, Inc., in connection with its alleged improper revenue recognition scheme, which included "channel stuffing," mischaracterizing discounts, concealing product returns, and misclassifying expenses. The CFO agreed to an officer and director bar and to pay $130,000 to settle the matter, while the CEO continues to litigate against the SEC.

The SEC also charged Miller Energy Resources, Inc., two of its executives and its audit team leader for allegedly overstating the value of recently acquired oil and gas properties, causing Miller Energy Resources to transform from a penny-stock company to a NYSE-listed company. On January 12, Miller Energy settled the matter by agreeing to pay a $5 million penalty. Likewise, the SEC charged the former CEO and former CFO of another now-bankrupt company, KIT Digital, for allegedly falsifying financial statements and using an off-the-books slush fund to generate fraudulent payments to the company, among other improper tactics designed to make the company appear more profitable than it was. The two former KIT Digital executives now face criminal charges in a parallel proceeding as well.

In addition to these accounting fraud cases, the SEC made headlines this year for its focus on executive perk disclosures. As covered in our November 19, 2015 Newsletter ( "Baby You Can Drive My Car... Or Corporate Jet: SEC Scrutiny of Executive Compensation Perks Disclosures"), the SEC brought enforcement actions against Polycom, Inc., and MusclePharm Corporation for failing to disclose executive perks, which ranged from lavish trips to club memberships and personal tax services. Polycom agreed to settle for $750,000, while MusclePharm agreed to settle for $700,000 and to hire an independent consultant to review its disclosure policies. Notably, the SEC took the provocative step of charging MusclePharm's audit committee chair as well, claiming that he "had reason to know" the perks had not been fully disclosed.

Finally, the SEC revealed its willingness this year to prosecute companies for failing to maintain adequate internal controls, even in the absence of egregious misconduct. For example, the SEC imposed (1) a $2.75 million penalty on real estate developer The St. Joe Company for inadequate internal controls and improper accounting of its real estate developments' declining values; (2) a $1.5 million penalty on Home Loan Servicing Solutions, Ltd., for its inadequate internal controls, misleading statements regarding related-party transactions, and improper accounting method used to value its primary asset; and (3) a $800,000 penalty on discount retailer Stein Mart, Inc., for its inadequate internal controls and improper valuation of its discounted inventory, in part because it delegated decisions regarding markdowns to personnel who lacked sufficient accounting knowledge.

Taken all together, these enforcement actions signal that the SEC will continue to invest resources in identifying and prosecuting financial reporting and accounting violations throughout the coming year. And now armed with CIRA—described as the SEC's earlier fraud-detection tool "on steroids"—the SEC is positioned to command a growing presence and success rate in this enforcement area during 2016.

Auditor Enforcement Actions

Along with the SEC's renewed attention on financial reporting and accounting fraud, the SEC demonstrated that it will continue to crack down on gatekeepers, including auditors. As detailed in our September 17, 2015 Newsletter ( "A CD or not a CD, That Is the Question ... That the Auditors Should Have Answered"), SEC initiated a headline-grabbing enforcement action against national audit firm BDO USA and five of its partners for their failure to investigate a suspicious bank CD, which indeed was fraudulent. To settle the matter, BDO was forced to admit wrongdoing, pay over $2 million, and undertake remedial actions. By requiring BDO to admit wrongdoing as part of its settlement, the SEC championed a "first-of-its-kind" settlement.

But BDO was not the only audit firm required to admit wrongdoing this year. In December, the SEC brought and settled charges against Grant Thornton and two of its partners for their role in accounting violations at two publicly traded companies, Assisted Living Concepts, Inc., and Broadwind Energy, Inc. According to the SEC, the former CEO and former CFO of Assisted Living Concepts had falsified resident counts in the company's senior living residences to meet certain lease covenants, and had falsely certified that the company met those covenants. Meanwhile, Broadwind Energy and its executives had failed to timely disclose the impairment of intangible assets related to two of its customers, and allegedly had engaged in accelerated revenue recognition practices to avoid various consequences associated with the impairment. In connection with these violations, Grant Thornton and its partners became aware of repeated red flags, yet failed to take reasonable steps to investigate them, according to the SEC. As a result, Grant Thornton admitted wrongdoing, forfeited approximately $1.5 million in audit fees, and paid a $3 million penalty, signaling again the SEC's message that "audit firms need, when they see red flags, to ensure that they receive reasonable and coherent answers... before they sign off" on financial statements. Reverberations of this message will likely lead audit firms to insist on more audit committee investigations when red flags arise in the upcoming year.

Relatedly, the SEC also continued to enforce its rules requiring auditors to remain independent from their clients to ensure impartiality. The SEC settled charges against Deloitte & Touche for over $1 million in connection with a business relationship that violated the auditor independence rules. Similarly, the SEC settled charges against Grant Thornton India and Grant Thornton Audit Pty Ltd. for approximately $350,000 in connection with payments that violated these same rules.

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