Risk & Compliance

No More Mr. Nice Guys: SEC Sharpens Talons for 2014

Don't be complacent. The recent trough in the SEC's enforcement of financial-reporting regulations will turn around this year.
Nicolas Morgan and Jennifer FeldmanJanuary 2, 2014

A casual observer of Securities and Exchange Commission trends could be forgiven for concluding that the SEC has lost interest in pursuing enforcement of financial reporting regulations. In fact, the commission is intent on bringing record numbers of such cases and has some new tools and resources for doing so.

In 2013, the SEC brought fewer enforcement actions involving financial fraud and issuer disclosure — 68 — than during any year in the previous decade. Even including Foreign Corrupt Practices Act cases, the number was still a record-low 73, compared to 94 cases brought the previous year and far down from the high-water mark of 219 in 2007. But recent developments suggest that the downward trend will turn, perhaps dramatically, in 2014.

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Nicolas Morgan

Nicolas Morgan

Whistleblower Bounties and Tips
For one thing, the Dodd-Frank whistleblower bounty program is gaining steam. Under the program, informants who provide the SEC with original information may ultimately receive a percentage of any monetary recoveries as a result of enforcement action. For the first two full years of the program’s operation, 2012 and 2013, the single biggest category of tips received by the SEC involved corporate disclosures and financials: 547 and 557 tips, respectively, for those years. On October 1, the SEC awarded its largest bounty to date: $14 million, which may drive the number of tips still higher in 2014. As these tips work their way through the SEC, more enforcement actions will result.

Special Tools and Tactics
In July, the SEC’s Enforcement Division announced the formation of the Financial Reporting and Audit Task Force, a group of enforcement attorneys and accountants from across the country who will be tasked with identifying financial-statement, issuer-reporting and disclosure violations. The task force will work with the Enforcement Division’s Office of the Chief Accountant, the SEC’s Office of the Chief Accountant, the Division of Corporation Finance and the Division of Economic and Risk Analysis.

One weapon in the task force arsenal is the much-discussed Accounting Quality Model (AQM), colloquially known as RoboCop. The SEC describes AQM as a quantitative analytic “model that allows us to discern whether a registrant’s financial statements stick out from the pack.”

Jennifer Feldman

Jennifer Feldman

Using AQM, the SEC attempts to detect earnings management by looking at discretionary accounting choices by, for instance, examining total accruals and then estimating discretionary accruals. The AQM then classifies the estimated discretionary accruals as risk indicators (factors that are directly associated with earnings management) or risk inducers (strong incentives for earnings management). AQM produces a score for each filing and compares it with the filer’s industry peer group, assessing the likelihood that fraud is occurring.

In a recent speech, a task force official described certain flags that might result in closer scrutiny, such as when a company writes off a large amount of debt in a short period, which could suggest it’s placing the debt into an accrual “bank” to smooth its income numbers. The SEC is developing similar tools to analyze text portions of annual reports and other filings for potentially misleading disclosures.

Heightened Efforts Bearing Fruit
In December 10 comments, another task force official touted recent enforcement actions as evidence that the SEC’s stepped-up efforts in the financial-reporting area are beginning to pay off.

In one action, the SEC settled with Paccar, a Bellevue, Washington-based Fortune 200 commercial truck manufacturer. The commission had alleged various accounting deficiencies that “clouded” the company’s financial reports dating back to 2008. Three violations were alleged: (1) failure to report the operating results of Paccar’s parts business as a reportable segment; (2) failure to maintain accurate books and records regarding the company’s impaired loans and leases; and (3) overstatements in equal and offsetting amounts to loan and lease originations and collections for two foreign subsidiaries in its statement of cash flows for two quarters in 2009. The company paid $225,000 to settle the case, without admitting or denying the charges.

Under U.S. accounting rules, companies are required to report segments’ results in the way management views them, allowing investors to get the same perspective of a company’s business as its executives. The Paccar case exemplifies the SEC’s focus on this area. Segment reporting was the third-most-common area discussed in SEC comment letters in the first three quarters of 2014 (435 letters to 184 companies), following tax and goodwill accounting issues, according to an analysis by Audit Analytics. For one, Barnes & Noble recently disclosed that the SEC is investigating how the bookseller split expenses among its devices and e-book segments.

The Risk of SEC Overreach
With the new resources and tools the SEC is devoting to detecting financial-reporting violations, the commission has created an expectation that it will bring more enforcement actions. Such heightened expectations may create an incentive for the Enforcement Division to bring marginal cases not well supported by the facts or law. Compounding that troubling incentive, in June SEC Chair Mary Jo White announced that in certain cases, the SEC would not settle unless the defendants admitted wrongdoing. As a result, it’s likely that more companies, officers and directors will test the SEC’s allegations and legal positions by litigating and going to trial.

Two recent trial losses for the SEC suggest its troubling willingness to allege financial fraud in cases where the facts or the law don’t support the allegations.

In December the SEC suffered a jury trial defeat in SEC v. Kovzan, a civil fraud action alleging that the CFO of NIC Inc. failed to disclose more than $1 million in perquisites to the company’s former CEO. The SEC alleged that the CFO knew or was reckless in not knowing that the perquisites were not disclosed accurately. Not only did the Kansas jury acquit the CFO on all 12 charges, they found in his favor on every question on the jury verdict form.

That defeat was followed by another adverse ruling in December, in SEC v. Jensen. In that case, the SEC charged two former executives of Basin Water Inc. with accounting fraud for improperly recognizing revenue for six transactions, purportedly to disguise the company’s financial performance. The judge found that the SEC failed to demonstrate fraud, as there were no documents or witnesses to support the allegation that these transactions were shams. Further, the judge found there was no direct evidence of scienter or recklessness. While the SEC’s case was premised on allegations of improper accounting, the only evidence of such improprieties was unconvincing witness testimony, according to the court.

Lessons for 2014
The downward trend in SEC enforcement actions against public companies for alleged financial-reporting violations will reverse in 2014. As part of that reversal, the SEC will be making more inquiries, analyzing more periodic reports and financial statements, and ultimately filing more lawsuits. Because the SEC is likely to take an aggressive posture in bringing and litigating cases, 2014 will also see more trials involving financial reporting issues.

If recent experience is any guide, the SEC will not be successful in all of those trials, meaning that some defendants will be put to the expense, reputational damage and emotional turmoil necessary to defend against accusations not supported by the law or facts.

Nicolas Morgan is a partner at law firm DLA Piper and West Coast Chair of the firm’s Securities Enforcement Practice. Jennifer Feldman is of counsel at DLA Piper.