United States: Recent SEC Enforcement Actions And Public Commentary Demonstrate The Commission's Continued Focus On Internal Control Failures

We have previously written about how, over the past few years, the SEC and other regulatory agencies have devoted substantial resources to investigations regarding allegations that public companies have inadequate internal controls and/or a system for reporting those controls. See here, here and here. That effort shows no signs of waning. As recently as March 23, 2016, the SEC announced a settlement with a multi-national company due in part to the internal controls failures at two foreign subsidiaries. On March 10, 2016, the SEC announced a settlement of claims against Magnum Hunter Resources Corporation in connection with alleged internal control failures. And, on February 17, 2016, the SEC announced a settlement of claims against a biopesticide company, Marrone Bio Innovations, based on the company having reported misstated financial results caused in part by internal control failures.[1]

These efforts coincide with related developments that, certainly when taken together, make it more likely that the SEC will become aware of allegations of internal control flaws in the first place. Specifically, in mid-2013, the SEC formed its Financial Reporting and Audit Task Force (now the "FRAud Group"), whose mandate is to detect and deter fraudulent or improper financial reporting by concentrating on issues related to the preparation of financial statements, issuer reporting and disclosure, and audit failures. According to the SEC's current Enforcement Director, the FRAud Group "is focused on identifying cases that we otherwise would not find." At around the same time, the SEC announced the adoption of a "Broken Windows" policy to police technical, non-fraud violations. In explaining the policy as applied to the securities markets, SEC Chair Mary Jo White stated, in October 2013 remarks at the Securities Enforcement Forum: "minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions." And, the Dodd-Frank whistleblowing bounty program provides more potential ammunition in the form of substantial monetary incentives to furnish information about securities law violations: in its 2015 annual report to Congress on the Dodd-Frank Whistleblower Program, the SEC indicated that nearly 4,000 tips were received, and of these, the single largest category (17.5%) related to "Corporate Disclosures and Financials."

Comments from the SEC and its leadership lend further support to the view that the Commission is highly focused on this area. In the SEC's annual financial report for fiscal year 2015, it stated that: "Enforcement will continue to prioritize financial reporting and accounting fraud with an emphasis on areas including . . . insufficient internal controls." Likewise, on March 31, 2016, in the keynote address at the SEC-Rock Center for Corporate Governance Silicon Valley Initiative, SEC Chair Mary Jo White discussed the importance of internal controls over financial reporting even for companies at the pre-IPO stage, notwithstanding that they are not subject to the applicable securities law provisions:

Another area in which pre-IPO companies, including unicorns, present risks for investors centers on financial controls and corporate governance. . . . The IPO process is not just about raising capital. A public company commits to shed light on its operations and strengthen its controls and governance in ways not required of private companies. The securities laws and relevant listing standards, for example, require a company to form an audit committee; it must establish disclosure controls and procedures and create internal controls over financial reporting; the CEO and CFO must certify to the adequacy of those controls; and the company must be audited by a PCAOB registered firm. . . . While internal controls over financial reporting, and the regulations and certifications applicable to them, do not apply to private companies, all companies should consider enhanced structures and controls for conducting their operations, especially in anticipation of going public.

Andrew Ceresney, the SEC's Enforcement Director, similarly stated in a January 25, 2016 keynote address to the Director's Forum: "[i]n addition to financial statement and disclosure issues, we have also been focused on deficient internal accounting controls, which are foundational to reliable financial reporting. On a number of occasions, we have brought charges for violations of the internal accounting controls provisions of the federal securities laws, even in the absence of fraud charges. Deficient internal accounting controls can lay the groundwork or create opportunity for future misstatement or misconduct that goes undetected."

In light of the SEC's stated focus on internal controls, coupled with the enhanced likelihood that internal control failures will come to the attention of the Commission, all public companies should consider the state of their internal control regime. This article discusses some of the recent SEC enforcement actions addressing internal control failures and offers practical steps companies can consider in assessing their internal controls.

Statutory Background

By way of background, "internal controls" are the procedures and practices instituted by a company to manage risk, conduct business, protect assets, and ensure that its practices comply with the law and company policy. A particularly important species of internal controls are "internal controls over financial reporting," or "ICFR." The statutory requirements underlying ICFR are found primarily in Section 13 of the Securities Exchange Act of 1934 (and the rules promulgated thereunder). In particular, the Foreign Corrupt Practices Act amended Section 13(b) in 1977 to generally require issuers to keep books, records and accounts that accurately reflect the company's transactions and maintain internal accounting controls to ensure that company transactions are recorded in accordance with management's authorization and in conformity with Generally Accepted Accounting Principles.

In addition, Sarbanes-Oxley added new requirements for management and auditors related to internal controls. Sarbanes-Oxley Section 302 requires management to certify to, among other items, their responsibility for maintaining internal controls; disclosing significant deficiencies and material weaknesses in internal controls to auditors and audit committees; and disclosing any significant changes in internal controls. And Sarbanes-Oxley Section 404 (as amended by the Dodd-Frank Act) requires, among other things, that: (i) company management assess and report on the effectiveness of the company's internal control over its financial reporting, and (ii) the company's independent auditors verify management's disclosures. Sarbanes-Oxley also created the Public Company Accounting Oversight Board ("PCAOB") to oversee public company audits, including the audits of internal control reporting. The PCAOB, in turn, conducts regular inspections to ensure compliance with laws, rules and professional standards.

Recent SEC Enforcement Actions

Magnum Hunter Resources

On March 10, 2016, the SEC announced a settlement with Magnum Hunter Resources, which filed for bankruptcy protection in December 2015, related to the company's ICFR failures. Magnum is a Texas-based oil and gas company that, as a result of several acquisitions, experienced substantial growth between 2009 and 2011. While Magnum only had $6 million in revenues in 2009, it acquired four entities (for more than $700 million) in the course of two years, bringing its revenues to over $100 million by 2011. This growth put a significant strain on the company's accounting department. In February 2011, Magnum's external auditor advised the company that its accounting department was experiencing "manpower issues" and lacked sufficient personnel to complete required tasks on a timely basis. As discussed below, these problems were not adequately addressed. In June 2013, Magnum belatedly filed its 2012 Form 10-K, which disclosed fourteen "material weaknesses" in ICFR as of December 31, 2012 and admitted that Magnum "did not have sufficient personnel with an appropriate level of knowledge, experience and training commensurate with the growth of the company's corporate structure and financial reporting requirements."

Upon investigation, the SEC determined that Magnum had misrepresented the severity of its ICFR problems in previous disclosures. Item 308(a)(3) of Regulation S-K requires public companies annually to disclose any "material weaknesses" in ICFR. Rule 1-02(a)(4) of Regulation S-X defines a material weakness as an ICFR deficiency that creates a "reasonable possibility" that a material misstatement of the company's financial statements will be made or not detected on a timely basis. Magnum's auditors identified in a written report numerous ICFR deficiencies, including inadequate staffing, significant delays in preparing financial statements, incomplete testing activities, and unprepared reconciliations. The report stated that "the potential for error in such a compressed work environment presents substantial risk. With complex financial and reporting structures there are few individuals within the team with the capacity to perform many tasks and there is little time for senior reporting personnel to review, analyze, and evaluate because they are performing transaction level reporting tasks."

Nonetheless, the report concluded that these failures were only "significant deficiencies," a less severe metric of ICFR failures as defined in Regulation S-X (a conclusion that led the SEC to query "how a deficiency that created a substantial risk" of a financial statement error did not rise to the level of a material weakness). The company's CFO and Chief Accounting Officer accepted the audit firm's conclusion, including because there had been no "actual identified material error" in its financial statements.

Because Magnum (incorrectly, in the view of the SEC) categorized these issues as significant deficiencies, the company was able to omit them from public disclosures and instead state that ICFR was effective. The SEC investigation determined that Magnum's auditors had "misapplied" the applicable standard when determining the severity of the deficiencies, but also noted that company management retained ultimate responsibility for the company's evaluation. Among the SEC's criticisms were that the standard for determining whether an ICFR problem rises to the level of a material weakness does not depend on whether "an error actually occurred."

The SEC also determined that Magnum had failed to adequately document its ICFR assessment. Under Regulation S-K, company management is required to maintain documentation to provide reasonable support for its ICFR assessment. Magnum, however, did not adequately document its basis for determining that there were "significant deficiencies" rather than "material weaknesses."

As a result of this conduct, the SEC ordered Magnum to pay a $250,000 civil penalty and cease and desist from future violations of Section 13. In related settlements, Magnum's CFO and external auditor agreed to penalties of $25,000 and $15,000, respectively, and two other company accountants agreed to be suspended from appearing and practicing before the SEC.

Marrone Bio Innovations

About one month before it announced the Magnum Hunter settlement, the SEC announced that it had charged Marrone Bio Innovations, Inc. and its Chief Operating Officer "with inflating financial results to meet projections it would double revenues in its first year as a public company." The matter arose out of a fraud perpetrated by the COO, who is also the subject of criminal charges by federal prosecutors in the Eastern District of California. According to the SEC's complaint against the COO, he directed the company to offer "its distributors various sales concessions, primarily the right to return any unsold product, in order to ensure Marrone met its projection that it would double its revenue in 2013. [The COO] concealed these concessions from Marrone's finance and accounting personnel, leading the Company to recognize revenue on these transactions contrary to applicable accounting principles and the Company's stated revenue recognition policies." The SEC also alleges that the COO falsified contemporaneous sales records to support his revenue recognition scheme and, on one occasion, "when Marrone did not have enough of the correct product to fulfill a sale, he instructed his subordinates to intentionally ship the wrong product, so that Marrone could record revenue in the current quarter."

It is clear that the SEC views the case as, in substantial part, implicating a failure of internal controls. As explained by SEC Chair White during her keynote speech at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative: "just last month, the Commission brought charges against a company and a former executive for inflating financial results to meet projections that it would double revenues in its first year as a public company. Because, in part, of insufficient internal controls, the executive was able to direct his subordinates to obtain false sales and shipping documents and intentionally ship the wrong product to book sales."

Indeed, the allegations in the complaint suggest any number of such issues that might have been uncovered with adequate internal controls, including:

  • The COO was able to lie repeatedly to the company's controller when asked at regular meetings whether "there were any arrangements with distributors that would affect revenue recognition, including any side deals or concessions."
  • The COO lied to a company sales director, who the COO instructed to offer "inventory protection" to distributors in order to sell as much product as possible by year end, that the CEO had authorized the concession.
  • The COO instructed a customer services manager to take a term sheet containing a provision on "inventory protection" and "put it in [a distributor's] office desk drawer and not to show it to anyone."
  • A distributor who agreed to purchase more product with "inventory protection" sent a purchase order referencing that aspect of the transaction. After the controller noticed the reference and asked the COO about it, the COO lied, stating that there was no inventory protection. The COO then requested that the distributor create and send a revised purchase order omitting that provision and provided that revised order to the company's finance department for its review.
  • The COO "ghost wrote" and then successfully persuaded one of the company's distributors to send an email making it appear as if the company had shipped product to the distributor before a quarter end, in order to support the company's recognition of revenue in that quarter, even though the product actually shipped after the quarter ended.
  • The COO arranged to backdate shipping labels for a similar purpose – to make it appear as if product was shipped before a quarter end in order to recognize revenue in that quarter.

Marrone agreed to pay $1.75 million to settle the SEC's charges.

Guidance on ICFR Regimes

In light of the sustained regulatory focus in this area, companies and their counsel should ensure that procedures are in place to evaluate on an ongoing basis the sufficiency and effectiveness of internal controls. In particular, management and audit committees, working with outside auditors, are advised to:

  • administer a full assessment of financial reporting risks and ICFR systems;
  • evaluate whether existing controls are designed to address those risks;
  • document and communicate internally the company's control systems on a regular basis;
  • ensure that the audit committee is actively involved in assessing and asking questions about internal controls and the proper application of various ICFR rules;
  • maintain regular substantive interaction with outside auditors on the subject of internal controls;
  • evaluate whether company growth, changes in the regulatory or competitive environment, or other factors warrant an increase in accounting and compliance personnel;
  • assess whether additional resources are needed in order to effectively monitor internal controls;
  • Recognize that the existence of a financial statement error is not determinative of whether there is a material weakness in internal controls under the definition provided in Regulation S-X;
  • make sure that senior personnel are kept informed and are actively involved in internal control compliance, particularly those managers that are required to publicly certify the efficacy of the company's ICFR; and
  • establish a "tone at the top" that demonstrates management and the board's commitment to a rigorous ICFR regime, including by taking appropriate remedial action in the event misconduct is uncovered and devoting sufficient monetary and personnel resources to ICFR functions.


[1] Likewise, on September 22, 2015, the SEC settled claims against Stein Mart, Inc. for materially misstating its pre-tax income due to improper valuation of inventory subject to price discounts and for having inadequate internal accounting controls. For example, for a period of time, the decision to characterize a markdown of merchandise in inventory as permanent (which should have led to an immediate corresponding reduction of inventory value on financial statements) resided solely with Stein Mart's merchandising department, which did not understand the impact that Stein Mart's markdowns could have on inventory valuation accounting. Likewise, Steinmart's CFO did not learn that the company was waiting to reduce inventory value until the item was sold for two years after assuming that role. The company agreed to pay $800,000 to settle the matter.

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.

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