by T. GormanPosted on Posted in SECActions

The Securities and Futures Commission of Hong Kong instituted a proceeding against Ernst & Young Hong Kong for failing to produce audit work papers. The proceeding, which is virtually identical to one brought by the SEC earlier this year, is another involving a Chinese company that entered a market requiring transparency but whose audit papers are inaccessible under PRC law.

The SFC requested that EY produce the audit work papers for Standard Water, a company which applied for listing to the Stock Exchange of Hong Kong in November 2009. In March 2010 E&Y told the Exchange that it was resigning as the reporting auditors for Standard after discovering certain inconsistencies in documentation provided by the company. Later the company withdrew its application for listing.

Subsequently, the SFC issued a formal notice to E&Y for the audit work papers. The firm failed to produce the papers since they are held by an affiliate in the Peoples Republic of China. A request to the PRC firm, Ernst & Young Hau Ming, also proved fruitless. Under an October 2009 statement by PRC authorities accounting records, including audit working papers, may be subject to claims of state secrecy. That law specifies that Hong Kong accountants are required to obtain the consent of the relevant PRC authorities before producing any accounting records to regulator even, even those in Hong Kong.

The SFC has applied to the court, seeking an order against E&Y. The court may, under the articles invoked, order the firm to comply with the request if it is satisfied that the audit firm does not have any reasonable excuse for not complying. The regulator is also continuing discussions with the mainland authorities who were consulted prior to the initiation of this its court proceeding.

The SFC proceeding is virtually identical one brought earlier this year by the SEC involving the PRC based affiliate of Deloitte. SEC v. Deloitte Touche Tohmatsu CPA, Ltd., File No. 1:11-MC-00512 (D.D.C. Filed Sept. 8, 2011). There the Commission alleged that the PCAOB registered firm served as the outside auditors for Longtop Financial Technologies Ltd., a Cayman entity based in Shanghai. In May 2011 the firm resigned from the engagement after discovering numerous improprieties during a year end audit.

The SEC issued an investigative subpoena for documents to the audit firm. To date no documents have been produced. Initially, the Commission sought to move forward with the court action, requesting an order the documents produced. In July 2012, however, the SEC asked the court to stay the proceeding for six months because of “ongoing negotiations with a foreign regulator that could impact the appropriate resolution of this case. The stay was granted. The Commission informed the court it would file a status report no later than January 18, 2013 regarding the status of the discussion.

To date the SEC’s efforts to obtain audit work held papers in the PRC have yielded the same results as those of its Hong Kong counterpart. Both regulators have sought to investigate companies that chose to enter their respective jurisdiction. Both regulators sought to review audit work papers that are supposed to be available when questions arise. Both regulators have held talks with the appropriate officials in the PRC. Neither regulator has been able to obtain the requested audit work papers.

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by T. GormanPosted on Posted in SECActions

Carter’s, Inc., the Atlanta based clothing manufacturer and its executives have been entangled with government investigations, criminal prosecutions and Commission enforcement actions since a huge financial fraud was discovered and the company self-reported to the SEC. Following that the company became the subject of the Commission’s first non-prosecution agreement, announced on December 21, 2010. Later Joseph Ellis, a sales executive at the company, was indicted on criminal securities and wire fraud charges and named in a Commission enforcement action. U.S. v. Elles, 11 CR 445 (N.D. Ga.); SEC v. Elles, Civil Action No. 1:10-CV-4118 (N.D.Ga.).

Now another executive of the company is the subject of a Commission enforcement action charging violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). SEC v. Martin, Case No. 1:12-CV-02922 (N.D. Ga. Filed Aug. 23, 2012); See also Lit. Rel. No. 22458 (Aug. 24, 2012). This time the executive is Eric M. Martin, who was employed at the company from March 2003 until he was terminated six years later in March 2009. During that period he served as Director and later Vice President of Investor Relations. He reported directly to the CFO. As part of his duties he spoke with investors and market analysts. For several years he prepared senior management for the quarterly earnings calls. He also helped the Human Relations Department develop and administer policies requiring that certain executives pre-clear their trades which was part of the insider trading procedures of the firm.

The charge against Mr. Martin: Insider trading in advance of earnings announcements. What is perhaps unusual about the case is that while most insider traders are very successful, Mr. Martin was not despite holding a position which required him to have a detailed knowledge of the earnings information he supposedly was in possession of at the time of his trades. Stated differently, what does it mean when an insider trader is largely unsuccessful?

The Commission’s complaint is divided into two sections centered. The first centers on successful trades through which he is alleged to have made profits or avoided losses totaling about $170,000. The second involves trades in which he was not successful.

Trades listed as profitable in the complaint are:

  • 2Q07: The data Mr. Martin received showed that EPS was down compared to the same quarter one year earlier. Mr. Martin sold 21,484 shares. Following an earnings announcement the share price dropped 8.52%, resulting in Mr. Martin avoiding a loss of $45,546.
  • 4Q07: Mr. Martin learned the company expected to have higher losses than planned but would meet the market consensus EPS of $0.50, although the company had a history of beating street expectations. Two days later Mr. Martin sold 5,000 shares of Carter’s stock and, subsequently, another 2,000 shares. After the announcement that EPS was actually $0.45 the stock fell 24%. Mr. Martin avoided losses of $37,000.
  • 2Q08: Mr. Martin learned revenues would exceeded estimates. Three days later he bought 25,000 shares. After an earnings announcement that EPS for the period exceeded street expectations the stock price rose 4.33%. Mr. Martin had a profit of $16,500.
  • 3Q08: Initially the information Mr. Martin received was negative with revenue down for the quarter compared to the same period a year earlier. He made three sales the same day he learned this information, totaling 22,847 shares. Later the information changed and showed the company would beat expectations. Mr. Martin made three purchases totaling 8,800 shares. Following the announcement the share price increased 13.71%. He had profits of over $70,000 on the purchases.

The unprofitable trades listed in the complaint are:

  • 4Q06: Mr. Martin received information that sales were down and gross margin had decreased for the quarter. Several days later Mr. Martin sold 3,700 shares. In the announcement, however, the company stated EPS was down one cent based on the cost of closing a major distribution center and the expense of the stock repurchase program. The share price increased 3.47%.
  • 3Q07: Mr. Martin would be aware of a planned write down in one division. He sold 15,000 shares. In its earnings announcement the news was mixed with EPS beating consensus by 2 cents but there was a nine-month loss from various adjustments. The share price closed up 8.47%.
  • 4Q08: Mr. Martin learned initially that sales and revenue were up significantly. He bought 24,000 shares. Later he learned that EPS was down two cents compared to the same period one year earlier but would beat consensus by one cent. He sold 27,000 shares and then purchased 3,000 shares. Following the earnings announcement the share price was up 10.54%. Mr. Martin did not make a profit or loss since his buys and sells netted to zero for the period.
  • 1Q09: Mr. Martin repeatedly received positive information. He bought 6,000 shares. In the earnings announcement Carter’s stated that EPS beat consensus but disclosed its restructuring initiative and employment related cutbacks. The stock price closed down 9.18%.

In the end the complaint lists four transaction in which Mr. Martin made a profit and four in which he did not.

A closer analysis suggests a some what different picture. To be sure, in 2Q07, 4Q07 and 2Q08 Mr. Martin either avoided losses or made profits. In 3Q08 however, he sold 22,847 shares while buying and making a profit on only 8,800 shares. Net for the period he probably had a loss give the number of shares sold, although the complaint does not contain sufficient data to tabulate his exact position. Likewise, for 4Q06, 3Q07 and 1Q09 Mr. Martin was on the wrong side of the trades. For 4Q08, however, his dalliance resulted in a net zero position for the period, meaning he did not profit or lose.

Overall this means that of the eight periods in which he traded, Mr. Martin either profited or avoided losses successfully in only three. Three out of ten is a good average, if you are a major league baseball player hitting for average. For an insider trader with what appears to be extraordinary access to inside information it raises significant questions about the timing of the trades, the materiality of the information and the evaluation made of the overall financial picture and its potential impact on the market. At the same time, there is noting in the insider trading laws that requires the trader be successful or properly assess the market impact of the company information in his possession at the time of the trades – that is, the trader does not have to be good or successful.

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