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Recent signals from the SEC raise the question: Is Harvey Pitt taking a softer line on financial fraud?
Alix Stuart, CFO Magazine
December 1, 2001
As accounting frauds go, the problems at Seaboard Corp.'s Chestnut Hill Farms division amounted to garden-variety book-cooking.
Division controller Gisela de Leon-Meredith had been caught overstating deferred-farming-cost assets and understating farming expenses, inflating revenues by a total of $7 million between 1995 and the first quarter of 2000. When confronted by the internal audit staff, Meredith fessed up, and parent Seaboard, a Shawnee Mission, Kansas-based agribusiness, announced that it would restate its earnings last August. Even investors, who held Seaboard's stock price steady, were apparently nonchalant about the fraud.
The case became extraordinary, however, when the Securities and Exchange Commission thrust it into the spotlight this past October — not as a warning to other companies, but as an example of good behavior on the part of Seaboard, which willingly handed over all of the evidence it had gathered from its internal investigation.
"When businesses seek out, self-report, and rectify illegal conduct, and otherwise cooperate with commission staff, large expenditures of government and shareholder resources can be avoided," read the SEC's official statement, or so-called 21(a) report, signed by recently installed chairman Harvey Pitt and commissioners Laura Unger and Isaac Hunt. In Seaboard's case, that meant a cease-and-desist order for its Chestnut Hill Farms division was the end of the matter. No charges or penalties were levied against the company or its senior management; Meredith walked away without even a fine. Extrapolating from the case, the report set forth "some of the criteria [the SEC] will consider in determining whether, and how much, to credit self-policing, self-reporting, remediation and cooperation" in reducing the severity of enforcement actions.
What's this? Is Harvey Pitt calling off the guard dogs that his predecessor, Arthur Levitt, so carefully bred? Just last December, the associate director of the SEC's enforcement division, Paul Berger, was warning financial executives to "fasten their seat belts" as the agency ramped up its new Financial Fraud Task Force, a 14-member team charged with special accounting investigations. And while Berger outlined the very same tenets for cooperation that appear in the 21(a) report on Seaboard, the tone was more threatening than promising. Subpoenas for documents and testimony would be sent out faster than ever, with response dates that "are reasonable but less generous than you would like," he noted.
By contrast, the October report signals a friendlier direction for the agency. Moreover, it was issued one day after Pitt's genial speech to the American Institute of Certified Public Accountants, in which he invited companies to help "raise and resolve difficult issues with us, without fear that we will play 'gotcha' with you when you do." You can't blame financial executives for breathing a sigh of relief.
"We're encouraged by this," says CFO Rick Dutkiewicz, who took the reins at wireless-equipment maker Vari-L Co. after the SEC levied accounting fraud charges against the company's former CFO and controller. "I'm delighted," says one securities attorney who requested anonymity. "Before, it was tempting to adopt the bunker mentality when the SEC started investigating, because everyone was coming after you with the suspicion that you were a wrongdoer, and they were damn well going to prove it. Now they're saying, if you cooperate, you're going to be served in the process."
The factors of cooperation listed in the Seaboard case are hardly new, say attorneys, but gain new power in being cataloged and blessed by Pitt. "This statement gives companies substantially more ammunition in dealing with the division of enforcement than they may have otherwise had," says Jerry Isenberg, an SEC enforcement division official until November 2000 and now a partner at law firm LeClair Ryan, in Washington, D.C. He and others read it to mean that cooperation will more likely stem SEC action up front, rather than simply help mitigate charges.
But some people wonder whether a new era of good feeling at the SEC will translate into effective enforcement against accounting fraud. "In [Pitt's] speeches he says, 'I'm going to be really tough' — then he turns around and says, 'but I'm not going to punish you,' " says Lynn Turner, the SEC's chief accountant until this past August and now professor of accounting at Colorado State University College of Business. "I don't know how you walk that fine line, but we'll have to sit back and watch."
Less Nitpicking, More Sympathy
Some accountants also expect to find more sympathy from the commission in disputes over the gray areas of GAAP, now that former Ernst & Young senior partner Robert Herdman has replaced Turner as the commission's chief accountant.
"Everyone I've spoken to is pleased [Herdman] was chosen," says Gary Illiano, a former SEC enforcement official and now regional director for Grant Thornton LLP. "We expect him to be much more willing to work with people than [Turner] was." Indeed, by way of introduction, Pitt said, "I am confident that, with Bob's leadership, the commission will make sound decisions in a respectful, affirming way, not in a demeaning, demanding, or demonizing way." Illiano says this likely means less SEC interference with the Financial Accounting Standards Board's decisions, and a move away from the hyperscrutiny of last summer, when SEC enforcement launched investigations into four companies simply for issuing press releases with pro forma numbers.
Leadership changes in the SEC's division of corporate finance may also mean less nitpicking over regular filings. Along with the departures from the division of director David Martin and deputy director Michael McAlevey, longtime accounting chief Robert Bayless quietly stepped down in October. Bayless, who was widely considered the second-most powerful person in the agency, vetted companies' regular filings with a rigor that some say led to his being asked to leave. Bayless, however, denies that Pitt asked him to step down, and says "it is premature to discuss my plans or future role, other than to say that I expect to continue to be an active member of the commission's team."
Whether the Seaboard case portends that fewer CFOs will be held individually accountable under Pitt's regime is still unclear, say most experts, as is how aggressively the agency will market such cases to criminal authorities. But a softening in such areas is certainly possible, speculates William McLucas, Richard Walker's predecessor as the SEC's head of enforcement and now a partner at Wilmer, Cutler & Pickering, in Washington, D.C. "The facts remain the same under any chairman," says McLucas. "But the judgment about what constitutes a serious violation of the law and who is responsible may change under the new administration."
Levitt's Hard Line
In theory at least, all this seems a radical shift from the heyday of Arthur Levitt, who took a consistently hard line on accounting shenanigans. "Accounting cases were always a significant part of the agency's inventory," notes McLucas, but "the enforcement division has been quite aggressive" in the past few years. Indeed, in the three years that followed Levitt's famous "numbers game" speech in September 1998 — from October 1, 1998, to September 30, 2001 — the division brought lawsuits against at least 90 companies and 54 CFOs for financial-statement fraud, including such high-profile targets as Sunbeam, McKesson HBOC, and Cendant. Meanwhile, major corporations such as Lucent, Raytheon, and Xerox are among the 250 or so cases still under SEC scrutiny, with probes widening within each firm.
The case load was an ambitious one. Frauds at larger companies tend to be more sophisticated and involve more people than the typical microcap case, which means more resources are required to crack them. Overall, about 60 percent of the companies charged in fiscal 2000 traded on major exchanges at some point.
Since many of the larger companies are multinationals, there was also a more intense focus on improprieties at foreign entities. The ongoing investigation of Xerox, for example, began with accounting problems found in its Mexico operations. Boston Scientific settled with the SEC last year on charges of channel-stuffing in its Japanese division. And several large companies, including IBM, American BankNote, and Chiquita, were hit with large fines for bribing outside parties in other countries. The cases represent a real coup for the SEC, since the amounts were often small ($30,000 in the Chiquita case, $75,000 for Baker Hughes) and hard to detect.
"It's an enormous undertaking to make sure the books and records are proper at that level of detail," notes attorney Greg Bruch, of Washington, D.C.-based Foley & Lardner. Bruch was assistant director at the division until September and worked on several of the cases. The relatively stringent responses arose from the ill intent inherent in a bribe, he says. "You wouldn't see that level of action if it was an improperly recorded invoice [for the same amount] from a real-estate venture in Kansas."
The past several years have also given rise to a growing number of CFOs being held accountable for accounting trouble. About 60 percent of the cases in the last three fiscal years named a CFO as a defendant, up from an average of 43 percent for cases brought between 1987 and 1997. And as CFO reported in September 2000 ("Jailhouse Shock"), more of those CFOs are facing criminal charges. Thanks to joint efforts between the SEC and states' attorneys general, 19 CFOs went to jail or were awaiting sentencing between 1998 and 2000, more than six times the number who did time in the previous four years.
As proof of the agency's new muscle, SEC officials point out that the number of enforcement actions for fraud, which can include multiple filings within a given company, grew from 78 in 1998 to 100 in 2000. This trend follows a rising tide of total securities law violation filings, which increased from slightly more than 400 in 1992 (the year before Levitt took over) to about 500 in 2000.
More Bark than Bite?
But while Pitt is clearly promoting a more conciliatory tone, it's worth questioning how much a change of philosophy will change the life of the average corporate issuer. While Levitt wasn't shy about using his bully pulpit to warn companies about straying from the straight and narrow of GAAP, a closer look at his overall record raises some questions about whether the agency's bite ever lived up to his bark.
On balance, the average company's chances of being slapped with an SEC lawsuit for financial-statement fraud during the Levitt regime hardly increased over previous years. The SEC initiated financial fraud actions involving 29 companies in fiscal 1999, 33 in 2000, and 28 in 2001, according to CFO's analysis of the SEC's litigation releases. These statistics fit smoothly into trends revealed in the 1999 fraud report sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (known as the COSO Report), which found an average 27 companies per year facing penalties for financial-statement fraud between January 1987 and December 1997.
The types of issues that led to charges weren't particularly distinctive, either. "These cases represent good old meat-and-potatoes deception; there's nothing unusual about them or the number of people involved," says Jack Ciesielski, publisher of the newsletter Analyst's Accounting Observer. Indeed, prematurely or falsely recognized revenues were cited in an average 51 percent of the cases taken in each of the past three years, compared with 50 percent recorded in the COSO Report. Understatement of expenses or liabilities showed up in 18 percent of the COSO cases, compared with an average of 26 percent of those taken between 1998 and 2001.
And what of the ferocious Financial Fraud Task Force? Officially, the SEC has been tight-lipped about the specialized unit, which had no publicized involvement in any case for its first 18 months of existence. But at least one division insider pronounces the task force a mere "publicity ploy," noting that "at most, they can take on only one or two cases at a time," which doesn't make a dent in the total number of potential enforcement actions.
Under any chairman, in fact, tight budgets and low salaries mean the SEC is unlikely to ever take on many more cases or move faster on them. "Congress has in no way given them sufficient resources to be an active watchdog," says Turner. The enforcement division has only 20 to 25 accountants on staff, meaning it can work on only about five major cases at any given time, he says. Simply taking depositions from lower-level accounting staff to gather the ammunition necessary for CFO depositions can last several months, and when a case ultimately gets heard depends on the whims of administrative law judges. Cases can then be appealed to the commission, and beyond that, to a district court.
The Sunbeam case, which the SEC has been investigating since mid-1998, is a classic example of the sluggish process, says Turner: "My guess is they probably won't even get to court until next year."
However, Berger says the task force "has been involved in some very difficult, and what we think may be very important, investigations," declining to provide further details. And Turner notes that the task force has worked on the Sunbeam, Waste Management, and Baker Hughes cases, and is "beginning to get legs." "They've got a lot of interesting cases in the pipeline — the real question is whether Harvey will let them do their job," he says.
The Future of Enforcement
what could really change with a new chairman? There are still many unknowns, including who President Bush will name to fill the four open commissioner slots. Regardless, no one believes the agency is calling the dogs off entirely, even if the task force ultimately fades.
"Financial-fraud cases have consistently taken up about 40 percent of the enforcement division's resources, and I don't expect that to change," says attorney Bruch. Many of the enforcement division's leaders, including Berger and new director Stephen Cutler, are holdovers from the Levitt era and unlikely to switch directions dramatically. Plus, with fewer initial public offerings coming to market, the corporation finance division now has more time to look through regular filings, upping the average company's chance of being reviewed from about 8 percent in 2000 to as high as 25 percent.
And just because revenues are down doesn't mean scrutiny will decrease. Given the rash of write-offs, the SEC is now likely to focus on asset impairments, says Bruch, testing whether restructuring charges are "specific, targeted reserves, or ones that are trying to provide a cushion for earnings down the road," à la Sunbeam's cookie-jar reserves.
As for the new benefits of cooperation, skeptics point out that it will hardly offer automatic protection to anyone who comes forward. "In a typical case, investors lose money and upper management is involved in cooking the books," says Turner. "And in those cases, no matter what, most companies are still going to be afraid to go into the SEC and open the kimono." Adds David A. Zisser, a Denver attorney who has defended more than 100 companies or individuals in SEC cases since leaving the agency in 1981: "Cooperation always helps. The question is whether it helps as much as you'd like it to help." He points out that the logistical situations that make companies seem uncooperative — such as when the SEC is asking for documents a company needs to complete its own investigation, or is pressing issuers to devote more of their limited resources to the collection of evidence — are unlikely to be resolved simply by virtue of a new tone at the top.
And self-policing, after all, isn't such a new idea. Many of Levitt's measures to transform the culture by stepping up pressure on internal auditors have been particularly effective. "Now, when a company is being aggressive, that bubbles right up to the internal audit committee," says Illiano, creating a new spirit of honesty — or fear — among accounting staffs.
A renewed vigilance also seems present among external auditors, which themselves were subject to some unusual enforcement actions recently. In the past year, the SEC has taken action against Big Five auditors in at least three cases and named Andersen specifically for allegedly being complicit in fraud at Waste Management. In fact, the SEC's actions against Andersen resulted in a sizable civil settlement — $7 million — and marked the first time in more than 20 years that the agency had brought such action against a major accounting firm. Only 10 of the 300 SEC financial fraud cases between 1987 and 1997 named auditors at big national firms, and none of them sought action against the firm itself, according to the COSO Report. Curiously enough, the biggest spate of actions against accounting firms, in the late 1970s, occurred during Pitt's tenure as the SEC's general counsel.
Andersen, now facing public criticism for its work at Enron as well, has stepped up its efforts to "place fraud consideration at the heart of every audit, rather than make it a side issue," says Toby J.F. Bishop, the firm's partner in charge of fraud research and development. In this position, created about two years ago, Bishop is spearheading efforts toward more "professional skepticism." On the technology side, this means using the firm's ample database of fraudulent filings to "train" a new software product that will be able to analyze clients' financial statements for these features. The real focus, though, is on so-called tone at the top, or subjective assessments of executives' attitude toward fraud.
"We know that managers can override most internal controls, so we try to avoid excessive dependence on red flags," says Bishop. Starting this year, audit teams for Andersen's largest clients regularly brainstorm on "how someone could best cook the books and conceal it from auditors if they wanted to," he says, adding that "if it works well, we'll roll it out to all our clients."
And to be sure, investors themselves are more attuned to accounting shenanigans. The recent uproar at Enron is a perfect example, with that company's shares falling 19 percent on the news that the SEC was moving its previously disclosed investigation from a local office to its Washington, D.C., headquarters. Further proof is seen in the rising number of shareholder suits involving accounting allegations — topping 50 percent of the 200 securities class-action suits filed in 2000, compared with 40 percent in 1995, according to PricewaterhouseCoopers LLP's 2000 Securities Litigation Study.
Whether or not the SEC itself can more effectively combat accounting fraud, though, will be one of the more tantalizing questions of the next year. Pitt's new strategy seems entirely in character for someone who, as a prominent attorney in the private sector, represented such clients as Ivan Boesky, major brokerages, and the Big Five accounting firms. But before that, there was the Harvey Pitt who was the aggressive SEC general counsel.
"The question I've always had is: Which Harvey are we dealing with?" says Turner. "Until we see some big cases, I have no idea."
Alix Nyberg is a staff writer at CFO.
For the SEC's fraud cops, the fiscal year-end is crunch time. Financial-statement fraud charges filed by the Securities and Exchange Commission, September 2001.
Source: SEC, December 2001
|Filed||Company||Financial Officers Charged||Allegations||When||Consequences|
|9/28/01||TransEnergy||CFO/VP William Woodburn||Failed to disclose over $1 million in material lawsuits in filings, overvalued oil reserves in press release,misled investors with information on Web site||1998-|
|No resolution yet|
|9/28/01||TELnetgo2000||CEO Wayne E. Mullins||Made unreasonable revenue projections in filings, failed to disclose lack of necessary business licenses||2000||No resolution yet|
|9/27/01||Sabratek||CFO Stephen Holden; VP Fin/CAO Scott Skooglund; former CFO Paul Jurewicz||Created fictitious sales, parked inventory at third-party warehouses, recognized revenue on sales with right-of-return provisions, filed an incomplete MD&A||1998-|
|Jurewicz ordered to pay $17,556;|
no resolution yet for others
|9/27/01||Vari-L||CFO Jon Clark, controller Sarah Hume||Improperly recognized bill-and-hold sales; held books open at end of quarter; improperly capitalized labor and overhead costs as assets; overstated inventory||1996-|
|Clark ordered to pay $216,632|
|9/19/01||Madera Int'l||CFO Daniel Lezak||Recorded and overvalued assets the company didn't own; created fictitious sales; made false or incomplete disclosures in filings, press release, and to auditors||1994-|
|No resolution yet|
|9/12/01||Baker Hughes||CFO Eric Mattson||Authorized bribes to Indonesian tax officials, violating Foreign Corrupt Practices Act; created false invoices so that bribes could be recorded as consulting services||1995, 1998, 1999||Mattson agreed to settle without admitting or denying guilt; no|
monetary penalties mentioned
|9/10/01||Swisher Int'l||Founder/CEO Patrick Swisher||Several cases of fraud related to 1996 sale of franchise to another entity owned by Swisher||Q2 1996||Swisher ordered to pay $391,627|
in fines and restitution
|9/6/01||M&A West Int'l||CFO Salvatore Censoprano||Helped set up publicly traded shell companies with sham revenues, created fictitious sales to cover up "revenues" from unregistered stock sales||1999-|
|Criminal charges against CEO;|
civil case ongoing
|9/5/01||Indus Int'l||CAO Robert Pocsik||Lied about contingencies on certain sales to CFO, accountants, and auditors, leading to premature revenue recognition.||Q3 1999||Pocsik pled guilty to one count of securities fraud; faces up to five years in prison and $250,000 fine|
Some big names among the 250 cases in the SEC's enforcement pipeline.
Sources: Securities and Exchange Commission, news reports
|ConAgra Foods||The fictitious sales and "irregular practices" at a subsidiary led to restating three years' worth of earnings.|
|Critical Path||Back-dated sales contracts and side-letter deals raised eyebrows as well as revenues.|
|GenesisIntermedia||The investigation relates to "trading in its securities," according to the company.|
|Informix||The company settled, but the SEC is continuing its investigation of former officers|
after suing a former VP in May.
|Lucent||The beleaguered telecom company used channel-stuffing and excessive credits to energize sales in 2000, according to published reports and lawsuits.|
|Raytheon||Possible accounting irregularities at its former engineering and construction unit, sold to Washington Group International in July 2000, have brought both companies into the probe.|
|Rite Aid||The SEC alleges it used cookie-jar reserves and faked bank documents to meet loan repayments, restated 1997-99 earnings; now negotiating with local criminal authorities to avoid charges in exchange for a civil penalty.|
|Warnaco||The company disclosed in its April 10-K that the SEC had begun an investigation into its accounting practices, then announced an earnings restatement in August with no further details.|
|Xerox||Accounting irregularities, including a $100 million cookie-jar reserve at Xerox's Mexican subsidiary, have led to an expanded probe of practices and three years' worth of restated earnings.|
The first known accountants were pairs of scribes who independently recorded daily transactions for the pharaohs of ancient Egypt. If their numbers didn't match at the end of the day, explains Joseph T. Wells, chairman of the Association of Certified Fraud Examiners (ACFE), both were put to death. "One of the first internal controls, if you will," he says.
Today, that historical emphasis on fraud detection is making a comeback (albeit with less dire consequences) after decades of neglect. Thanks to the globalization of business in the early 1900s, and especially after the stock market crash of 1929, explains Wells, auditors shifted their focus from fraud detection to public reporting. "That created an expectation gap between auditors and the reading public," who still viewed auditors as the first line of defense against fraud, says Lawrence Redler, who runs the Forensics and Investigative practice for accounting firm Grant Thornton LLP.
Now that gap is being filled. The ranks of specialized forensic accountants and fraud examiners who sniff out financial shenanigans by practicing a mix of accounting, law, technology, ethics, and criminology are growing. Since its founding in 1988, the ACFE has swelled to 25,000 members in 105 countries. And all of the Big Five accounting firms have recently formed forensic- accounting and fraud-detection units.
Forensic accounting is "one of the busiest areas of our financial consulting practice," says Harvey Kelly, a partner in PricewaterhouseCooper's Corporate Investigation practice. That's due in part, he says, to the SEC's increased vigilance in recent years. That's something PwC is painfully aware of — it's audit division is under investigation for possible negligence in failing to detect fraud at MicroStrategy and Allegheny Health Education and Research Foundation.
In fact, despite their new antifraud speciality divisions, the Big Five are also making sure that regular auditors are more alert to fraud. For example, this year, all KPMG LLP auditors received training by forensic investigators, says Richard Girgenti, principal of the firm's Forensic and Litigation Services practice. That's in line with the Public Oversight Board's O'Malley report, released in September 2000, which recommended that "auditors should perform some 'forensic-type' procedures on every audit to enhance the prospects of detecting material financial statement fraud." Says Girgenti: "It's a trend that goes back to the origins of the accounting profession."
Except these days, auditors aren't put to death for missing numbers — they just get sued. Jokes Wells, "Which is worse?"