by T. GormanPosted on Posted in SECActions

SEC recently announced the creation of a new Financial Reporting and Audit Task Force in the Division of Enforcement along with a Center for Risk and Quantitative Analysis. The new groups come as the agency refocuses its enforcement program in the post market crisis era. The implications of these actions will be explored in a series of articles beginning todayt. .

On July 2, 2013, the SEC announced the formation of a Financial Reporting and Audit Task Force (“Financial Task Force”). Its purpose is to detect “fraudulent or improper financial reporting” and “enhance the [Enforcement] Division’s ongoing enforcement efforts related to accounting and disclosure fraud.” A similar group is being formed to focus on microcap fraud, according to the announcement.

The Center for Risk and Quantitative Analysis (“Analytics Group”) is also being created as part of the new focus on financial reporting. The new Analytics Group will work in close coordination with the Division of Economic and Risk Analysis and “serve as both an analytical hub and a source of information about characteristics and patterns indicative of possible fraud or other illegality.”

The formation of a new Financial Task Force, coupled with the creation of the Analytics Group, suggests a new focus for an enforcement program that has centered on insider trading, offering fraud, Ponzi scheme and market crisis cases since the 2009 reorganization of the Division. It also suggests that the new task force will adopt at least some of the risk analysis and metric oriented approach utilized by the Division of Enforcement since its reorganization.

If the new Financial Task Force has an impact similar to that of the 2009 reorganization which spawned record numbers of cases, it is reasonable to expect that the Commission will be opening a significant number of new investigations and bringing more actions centered on financial statement fraud and related reporting issues. Indeed, there are indications that those efforts may have been underway prior to the announcement. See, e.g., SEC v. Senior, Civil Action no. 3:12cv60 (N.D. Ind. Filed January 30, 2012) (accounting fraud action against former senior officers and outside auditors of British subsidiary of issuer).

This is not the first time that the SEC has focused on financial statement fraud and reporting issues. Following a 1998 address by then Chairman Arthur Levitt titled “The Numbers Game,” which decried the manipulation of financial statements to meet Wall Street earnings expectations, the agency brought a series of high profile financial statement fraud actions. The new task force can be expected to draw from, and build on, that history.

The critical question for issuers, directors, executives, their auditors and business partners is the approach the new task force will take. Knowing that focus should permit an examination of current practices now to avoid liability tomorrow. Stated differently, understanding how the SEC Enforcement plans to proceed is good business today and tomorrow.

To analyze the likely approach of the new task force, four key points will be considered:

1. The “Numbers Game” speech – the genesis of an earlier financial statement fraud effort;

2. Financial statement fraud cases brought in the wake of the “Numbers Game” speech;

3. Market crisis financial actions; and

4. The Enforcement Division’s use of risk analysis and big data.

Analyzing these points should provide a guide to the future approach of the new task force which can be used now by issuers, their executives and auditors to conduct an analysis of current practices to avoid liability tomorrow.

Next: The “Numbers Game Speech” – Genesis of an Earlier Financial Statement Fraud Effort and the roots of current efforts

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by T. GormanPosted on Posted in SECActions

The Commission prevailed in a dispute challenging its conflict minerals rules brought by business groups, a seemingly rare event in view of recent rulings against the agency by the D.C. Circuit on such issues. The rules were those enacted under Section 1502 of the Dodd-Frank Act which became Exchange Act Section 13q. National Association of Manufacturers v. SEC, Civil Action No. 13-cv-635 (D.D.C. Filed July 23, 2013).

Section 1502 of Dodd-Frank directed the SEC to develop and issue rules requiring increased transparency regarding the use of “conflict minerals” from the Democratic Republic of the Congo or DRC and its neighboring countries. The directive is based on the notion that the “exploitation and trade of conflict minerals originating in the [DRC] is helping to finance conflict characterized by extreme levels of violence in the eastern [DRC], particularly sexual and gender-based violence, and contributing to an emergency humanitarian situation.” The provision thus requires companies to disclose annually to the SEC if the minerals in their products “originated or may have originated in Congo” to help ensure activities involving such minerals do not finance or benefit armed groups. If so, then the company must file an additional report with the SEC with a description of the products manufactured using the minerals.

The Commission developed rules which require issuers to conduct a “reasonable country of origin inquiry” regarding their conflict minerals. If, after the inquiry, the company determines that its conflict minerals did not originate in the covered countries, the issuer must disclose that conclusion to the SEC along with its predicate. If the issuer concludes that the conflict minerals did originate for a covered country – or if it cannot make that determination – a report must be prepared and filed with the agency. The rule does not require any label to be affixed to products manufactured with conflict minerals.

Plaintiffs challenged the validity of the rules, asserting two key claims. First, they challenge the rules under the Administrative Procedure Act. Second, they argue that the rules violate the First Amendment. The Court rejected both.

First, the Commission’s rules do not violate the APA, according to the court. On this issue the test is whether the action of the agency is arbitrary, capricious, and an abuse of discretion. When, however, the issue turns on an agency interpretation of the statute the two part Chevron deference test is applied.

Here, plaintiffs contend that the SEC failed to analyze properly the costs and benefits of the rules as required by the Exchange Act. Yet Sections 3(f) and 23(a)(2) of that Act do not mandate the type of analysis Plaintiff’s claim. Under those provisions the only obligation of the SEC is to consider the impact that a rule or regulation may have on various economic related factors. While the Commission may consider a variety of economic factors “there is no statutory support for Plaintiffs’ argument that the Commission was required to evaluate whether the Conflict Minerals Rule would actually achieve the social benefits Congress envisioned,” the Court concluded. This point distinguishes this case from those relied on by Plaintiffs where the SEC, in promulgating other rules, did not conduct an adequate economic analysis.

Likewise, Plaintiff’s contention that the Commission wrongly failed to implement any type of de minimis exception is incorrect. Here, the SEC is entitled to deference under Chevron since the question is one of statutory interpretation. Viewed in this context “the Court has no trouble concluding that the SEC’s interpretation – that it possessed discretion to determine whether a de minimis exception was appropriate – was permissible. Indeed, this is the very interpretation Plaintiffs themselves champion. The Court thus rejected the challenge.

The Court also rejected Plaintiffs claim that the rules were overly broad because they required due diligence and reports not just when there is reason to believe the minerals did originate in the region, but also whenever there is “reason to believe the minerals may have originated” in the region. In this provision the SEC simply exercised its interpretative authority the Court concluded to “gap-fill this silence . . .” in the statute left by Congress.

Similarly, the Court rejected a claim that the Rule was overbroad because it covered not just those who manufacture but also those who contract to manufacture. Again “the Court is convinced that the Rule’s application . . . is an amply reasonable construction of Section 1502.”

Finally, the Court concluded that Plaintiff’s constitutional claim was without merit. Here, plaintiffs clamed the rules contravene the First Amendment because they require that issuers make public disclosure of the information about their use of conflict minerals on their website. The test here is one of “intermediate scrutiny” which focuses on whether the asserted governmental interest is substantial, the regulation directly advances that interest and the fit between the ends and the means chosen to accomplish those ends is it reasonable. In this regard the Court concluded that “the conflict minerals disclosure scheme directly advances the interest of Congress “in promoting peace and security in and around the DRC.” And, in any event, the disclosure required is only that the issuer make available on its website the materials filed with the SEC.

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