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Thomas O. Gorman,
Dorsey and Whitney LLP
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    The SEC’s New Financial Fraud Task Force: Part II, The “Numbers Game Speech”

    This is the second in a series of articles examining the creation of the new Financial Reporting and Audit Task Force along with a Center for Risk and Quantitative Analysis. Today’s article begins an examination of the roots of the new Task Force starting with the “Numbers Game” speech of former SEC Chairman Arthur Levitt which initiated a series of financial statement fraud actions.

    In 1998 then SEC Chairman Arthur Levitt delivered a speech titled the “Numbers Game.” It launched a campaign against financial statement fraud which will serve as the roots of the current efforts. Following Chairman Levitt’s speech, the Commission brought increasing numbers of financial statement fraud actions. As those efforts unfolded the Sarbanes-Oxley Act of 2002 (“SOX”) was passed, instituting certain reforms. Those included the creation of the Public Company Accounting Oversight Board (“PCAOB”) to oversee the auditing process for public companies and the requirement that the CEO and CFO of issuers execute certain certifications. See, e.g., Thomas O. Gorman & Heather J. Stewart, Is There A New Sheriff In Corporateville? The Obligations of Directors, Officers, Accountants, and Lawyers After Sarbanes-Oxley of 2002, 56 Adm. L. Rev. 135 (2004) (discussing key provisions of Sarbanes-Oxley Act).Following the passage of SOX, the Commission continued to bring a significant number of financial statement fraud actions, at least through the early years of the market crisis. See, e.g., Cornerstone Research, Securities Class Action Filings, 2012 year in Review, available at http://tinyurl.com/lppz3tf (“Cornerstone Report”).

    In his remarks the Chairman detailed his concern that the numbers in financial statements being furnished to the investing public and the markets by issuers did not reflect he substance of the enterprises’ business. The Chairman went on to state that he had “become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion.”

    Chairman Levitt identified key practices being used to alter financial results through what he called “accounting hocus-pocus.” Those included:

    • Big Bath charges: The use of restructuring charges to clean up the balance sheet;
    • Cookie jar reserves:The use of unrealistic assumptions to create pools of cash to smooth earnings; and
    • Revenue recognition:Boosting earnings through inappropriate manipulation of the recognition of revenue.

    The driver of financial statement fraud, according to Chairman Levitt, was the “pressure to make the numbers” or meet street expectations.

    In the wake of Chairman Levitt’s speech the Commission brought a series of financial statement fraud actions. Two years later Richard Walker, then the Director of the Enforcement Division, summarized those efforts to that point, noting that for fiscal 1999 the Commission brought about 90 financial statements and reporting actions, a 15% increase over 1998. Those cases “cover a broad spectrum of conduct – from multi-faceted pervasive frauds to more subtle instances of earnings management to situations involving violations of auditor independence rules,” he noted. Richard H. Walker, Director, Division of Enforcement, addressing 27th Annual national AICPA Conference on Current SEC Developments (Dec. 7, 1999).

    Following the passage of SOX the Commission continued to bring a significant number of financial statement fraud cases. Beginning in 2007, as the worst market crisis since the great depression of the 1930s was unfolding, the Commission focused a large part of its investigative resources on ascertaining its causes. See, e.g., Testimony, SEC Commissioner Elisse B. Walter before the U.S. House of Representatives Committee on Financial Services (March 20, 2009). Those efforts resulted in a significant number of market crisis actions being brought. SEC Enforcement Actions, Addressing Misconduct that Lead to or Arose From the Financial Crisis, available at http://www.sec.gov/spotlight/enf-actions-fc.shtml.

    By the end of the market crisis the number of financial statement fraud actions being brought by the Commission had dropped significantly. See Cornerstone Report. At the same time the Division of Enforcement undertook its most significant reorganization in history. That reorganization included the creation of specialty groups. SEC Press Release, SEC News, New Specialized Unit Chiefs and Head of New Office of Market Intelligence (January 13, 2010), available at http://www.sec.gov/news/press/2010/2010-5.htm. None of those groups focused on financial statement fraud. Yet the pressure that Chairman Levitt identified as the driving force causing financial statement fraud remained unabated.

    Next: The SEC brings a series of financial statement fraud actions – those concerning improper revenue enhancements

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