Two Financial Cases: More Questions about the SEC’s Enforcement Program

Two settled books and records cases filed by the SEC on Tuesday raise significant questions about the Commission’s enforcement program. Both are based on years-old conduct, an issue discussed here. One raises significant questions about prosecutorial discretion and why the case was brought at all.

SEC v. Prudential Financial, Inc., Civil Action No. 08 Civ. 3916 (D.N.J. Aug. 6, 2008) is a settled books and records case based on what is alleged to be a blatant scheme to falsify revenue. Specifically, the SEC’s complaint claims that a subsidiary of Prudential entered into round-trip transactions with reinsurance giant General Re. Under the scheme, the Prudential subsidiary entered into a series of so-called finite reinsurance contracts with General Re that had no economic substance or purpose other than to build up and then draw down off-balance sheet sums as though General Re were a “bank” for Prudential. According to a chart in the complaint, for three years Prudential understated revenue as the “bank” was funded. For three subsequent years, Prudential’s revenue was overstated as the “bank” was drawn down. The scheme is a blatant fraud that had a material impact on the financial statements of the company and filings made with the Commission.

The SEC however, did not charge Prudential with fraud. Rather, the complaint alleges only books and records charges. The complaint does not allege material impact in any current period since the scheme began in 1997 and ended in 2002. It does not allege that there was any restatement, perhaps because there is no current period impact from conduct that ended six years ago. And, there seems little if any likelihood of a reoccurrence since the subsidiary involved was sold five years ago. Nevertheless, the Commission secured a books and records injunction to settle this case. The necessity for, and purpose of, this injunction, like the reason that this years-old case is being brought now, after all these years, is at best unclear

The second case raises a different question. SEC v. Hozhabri, Civil Action No. 08-CV 1359 (D.D.C. Filed Aug. 6, 2008) presents a significant question regarding prosecutorial discretion in selecting and bringing cases. Here, Defendant Ali Hozhabri, a former project manager for ABB Network Management, fraudulently submitted $468,714 in cash and check disbursements requests to his employer between 2002 and 2004. This conduct is not alleged to have had any impact on the financial statements of the company. And, the SEC did not charge Defendant Hozhabri with fraud, only books and records violations to which it obtained a consent injunction as a settlement.

The reason the SEC decided to bring this case is puzzling. As the complaint says, Mr. Hozhabri engaged in an “embezzlement scheme.” Indeed, Mr. Hozhabri previously pled guilty to conspiracy to commit wire fraud and the SEC deferred any disgorgement to that criminal case. Embezzlement and theft is the focus of this case, not a securities transaction.

To be sure, the Commission can charge the defendant here with the violations alleged. That is not the point, however. If, for example, the theft here was tied to bribery in violation of the FCPA it would be different. But it is not. At its core this is not a securities case – it is simple theft, differing little from dozens of street crimes chargeable under state or federal criminal statutes. As the Supreme Court made clear in another context earlier this year in Stoneridge Investment Partners (discussed here), the securities laws focus on protecting investors involved in securities transactions, not ordinary business deals or, as in this case, simple theft. The SEC would do well to focus its efforts on obtaining injunctions in cases where they are needed and matter to investors and the markets and to focus its investigative efforts on policing the securities markets, not street corners.

Directors, Consultants And Auditor Independence

The SEC closed a potential loop hole in the auditor independence rules in two related administrative proceedings involving Ernst & Young and a consultant retained by the firm. In The Matter of Ernst & Young LLP, Adm. Proc. File No. 3-13114 (Aug. 5, 2008); and In The Matter Mark C. Thompson, Adm. Proc. File No. 3-13115 (Aug. 5, 2008). The Ernst & Young proceeding named as Respondents the audit firm, John Ferraro, the Vice-Chairman of E&Y, and Michael Lutze, an audit partner. The Thompson proceeding named Mark C. Thompson, who facilitates and coaches others to facilitate interviews and discussions with business, political and entertainment leaders, as the Respondent.

Mr. Thompson, according to the facts in the two Orders, entered into a business relationship with E&Y in mid-October 2002 which continued for nineteen months. That relationship entailed the creation of a series of audio CD’s of interview of corporate CEOs in particular industries or sector. Mr. Thompson appeared as a moderator on each CD, along with various E&Y partners who conducted the interview. The CDs, bearing the logos of E&Y and Mr. Thompson, were used for marketing purposes. The revenue from this project represented a significant amount of Mr. Thompson’s income.

During the entire nineteen-month period of the E&Y-Thompson relationship, Mr. Thompson was a director of Company A. For portions of that period, he was also a member of the audit committee of Company A and a member of the board of directors of Company B and Company C. At the end of each fiscal year, E&Y confirmed in writing to each company that it was independent and thus able to serve as each client’s external auditor. Each firm made filings with the SEC which contained reports from E&Y claiming they were independent. The firm did not disclose its business relationship with Mr. Thompson until after that relationship terminated in May 2004.

By April 2004, shortly before the relationship ended, E&Y’s policies required that matters potentially relating to independence be reviewed by its independence office and disclosed by the relevant coordinating audit partner to the audit client. After reviewing the relationship between Mr. Thompson and the firm, E&Y concluded that the relationship did not impair its independence because it fit within the “consumer in the ordinary course of business” exception to the independence rules general prohibitions.

The Commission rejected E&Y’s claim that its relationship came within an exception to the rule, finding that, in fact, the firm’s independence had been compromised and that Mr. Thompson was a cause. According to the Ernst & Young Order, “[b]usiness relationships with persons associated with the audit client in a decision-making capacity, such as audit client directors, officers and substantial stockholders” are prohibited by the independence rules. This conclusion is based on Rule 2-01(c)(3) which provides that “[a]n accountant is not independent if, at any point during the audit and professional engagement period, the accounting firm … has any direct or material indirect business relationship with the audit client, or with persons associated with the audit client in a decision making capacity, such as an audit client’s officers, directors or substantial stockholders.”

Here, Mr. Thompson was a member of the boards of three E&Y audit clients and on the audit committee of one. Mr. Thompson was well aware that E&Y was the auditor of the three firms since he signed filings for each and, as a member of Company A’s audit committee, participated in the retention of the audit firm.

The exception relied on by E&Y does not apply, here according to the Commission. Under Rule 2-01(c)(3) an independence compromising relationship “does not include a relationship in which the accounting firm or covered person in the firm provides professional services to an audit client or is a consumer in the ordinary course of business.” This exception however, only applies where both prongs of the test are met. Thus, the Commission concluded that “the relationship must be ‘in the normal course of business’ for both parties, and at least one of the parties must be ‘acting in the capacity of a consumer.'” (quoting the rule, emphasis original). Here, both prongs of the test were not met. This resulted in each report filed by the three companies with an E&Y report being false.

To resolve the case, E&Y and its two partners consented to the entry of an order censuring them. In addition, E&Y agreed to disgorge over $2.3 million along with prejudgment interest, while Mr. Ferraro consented to the entry of a cease and desist order. Likewise, Mr. Thompson consented to the entry of a cease and desist order.