Clarification On Fair Value Accounting; Two More Financial Fraud Cases

As the market crisis continues to dominate the news, the staff at the SEC and FASB clarified certain points regarding the application of fair value accounting, which is central to the valuation mortgage backed securities. In addition, the Commission, as is customary as the government fiscal year draws to a close, filed several enforcement actions. The financial fraud cases filed are discussed below. Others will be detailed in subsequent posts.

Fair value accounting

Fair value accounting has come under scrutiny in the current market crisis in view of its impact on the mortgage backed securities which are at its center. Some have called for its suspension, claiming that it does not work where there is no market. Others disagree.

On Tuesday, the SEC’s office of Chief Accountant and the staff of the FASB issued a press release clarifying certain issues surrounding fair value measurement guidance in FASB Statement No. 157. The release today is interim guidance while the FASB and ISAB discuss issues connected to fair value accounting.

The subjects covered by the guidance issued on September 30 include:

• The use of management’s internal assumptions when the relevant market does not exist;

• How to use market quotes when assessing the mix of information available;

• Consideration of disorderly transactions in assessing fair value;

• Transactions in an inactive market being indicative of fair value; and

• Factors to consider in assessing whether an investment is other than temporarily impaired.

Previously, on September 16, 2008, the International Accounting Standards Board Expert Advisory Panel issued a draft document titled “Measuring and disclosing the fair value of financial instruments in markets that are no longer active.” The Panel has requested comments on the draft by October 3, 2008.

Financial fraud cases

In SEC v. The Penn Traffic Company, Civil Action No. 08 Civ. 01035 (N.D.N.Y Sept. 30, 2008), the Commission filed a settled financial fraud case against Penn Traffic, a New York based operator of supermarket chains and a wholesale food distribution business. The company filed for Chapter 11 protection in May 2003 from which it emerged in April 2005. The company’s stock is now traded in the pink sheets.

As with many of the Commission’s financial fraud cases, the conduct on which the complaint is based is centered on a years-old scheme which traces to fiscal year 2000, continued through fiscal year 2003 and culminated in a September 2002 restatement of the company’s financial statements.

The complaint is based on two schemes. Under the first, the company recognized promotional allowances in advance of certain key continent activities. As a result, Penn Traffic improperly reduced its cost of goods sold. This scheme was implemented by routinely submitting false information to the accounting department. The scheme resulted in the misstatement of about $10 million from the second quarter of FY 2001 through the third quarter of FY 2003.

In the second, the company used fraudulent entries and/or adjustments to the books of its wholly owned bakery subsidiary so that it would meet its earnings goals. As a result of this scheme, the company misstated more than $7 million of income over a three and one quarter year period.

To resolve this case, the company consented to the entry of a permanent injunction prohibiting future violations of the antifraud, books and records, internal controls and periodic reporting provisions of the federal securities laws. The company also agreed to certain undertakings. The Commission previously filed actions against company executives. SEC v. Lawer, 05 Civ. 1233 (N.D.N.Y. Sept. 29, 2005) (settled with a consent decree prohibiting future violations of the antifraud and reporting provisions); SEC v. Jones, 07 Civ. 957 (N.D.N.Y. Sept. 17, 2007) (pending).

The Commission also filed another is a series of actions related to BISYS Group. In SEC v. Wevodau, 08-Civ-8348 (S.D.N.Y. Filed Sept. 30, 2008), the Commission filed a settled fraud action against Steven Wevodau, former vice president of finance for the Insurance and Education Services group of the BISYS Group.

For fiscal years 2001 through 2003, BISYS Group overstated its income by approximately $180 million, largely as a result of a fraud in its Insurance Services unit. From about July 2000 through at least March 2002, Mr. Wevodau was responsible for a variety of fraudulent or improper accounting practices which included: using improper acquisition accounting by recording as revenue to BISYS the bonus commission income that was already earned but not recorded by the company BISYS had acquired; creating inflated and unsupported receivables for commissions on the sale of certain products; and improperly eliminating expense.

To resolve the case, Mr. Wevodau consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records and internal controls provisions. In addition, he consented to the entry of an order requiring him to pay disgorgement, penalties and prejudgment interest totaling about $225,000 and an order barring him from serving as an officer or director for five years. See also, SEC v. BISYS Group, 07 Civ. 4010 (S.D.N.Y. May 23, 2007) (settled with consent injunction and payment of $25 million in disgorgement); In the matter of David Blain, C.P.A., Adm. Proc. File No. 3-13226 (Sept. 19, 2008) (consent to C&D re books and records provisions and 102(e) order with right to reapply after one year).

Class Action Claiming Fraud Regarding High Yield Investments Is Dismissed

In a decision which may become of increasing importance as the market crisis deepens, the court in In re: American Express Co. Sec. Litig., 02 cv 5533 (S.D.N.Y. Sept. 26, 2008) dismissed a securities class action based on allegations that the company and senior management fraudulently misrepresented and concealed the risk of the company’s high yield investments. Specifically, plaintiffs claimed that the defendants falsely misrepresented its high yield investments as conservative, concealed the extent of the company’s high yield exposure, failed to disclose the lack of risk management controls and failed to disclose the fact that the accounting was not in accord with GAAP. The suit was brought against the company and seven of its senior officers.

The court dismissed the suit, concluding that plaintiffs had failed to plead a strong inference of scienter as required by the Private Securities Litigation Reform Act. To plead a strong inference of scienter as required under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the court held that plaintiffs must plead facts which give rise to a strong inference of scienter after taking into account plausible opposing inferences. This can be established by showing that the defendants: (1) benefited in a concrete personal way; (2) engaged in deliberately illegal behavior; (3) knew or had access to facts suggesting that their public statements were not accurate; or (4) failed to check information they had a duty to monitor. This approach is based in part on the Second Circuit’s traditional “motive and opportunity” test which predates Tellabs and the Reform Act.

In reviewing plaintiffs’ allegations, the court began by rejecting claims that the defendants were motivated to commit fraud to meet aggressive income targets and because two of the individual defendants had incentive compensation. The court concluded that these claims were “not entitled to any weight,” although the allegations in the complaint must be viewed collectively under Tellabs.

The court also rejected plaintiffs’ contention that defendants were “reckless” if they did not know of the risks of the high yield investments and that the public disclosures of the company about those investments misrepresented that risk. Those allegations, the court concluded, “do no more than state in conclusory fashion what Defendants should have known, they are not entitled to any weight.”

The court also rejected as insufficient allegations from seven confidential informants. Citing the Second Circuit’s decision in Novak v. Kasaks, 216 F.3d 300 (2nd Cir. 2000), the opinion notes that these sources can be sufficient under Reform Act standards if there is an adequate basis for believing that the defendants’ statements were false and if the confidential sources are described with sufficient particularity to “support the probability that a person in the position occupied by the source would possess the information alleged.”

In this case, although the job position of each source was specified, “[n]one of the confidential sources specifically states that any Individual Defendant had information or access to information indicating that Amex was not properly valuing the High Yield Debt, that its risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company’s statements ….” Rather, the allegations from these sources were vague or general statements such as “there was pressure to conceal the impaired …” investments. These allegations did not speak directly about the individual defendants. While there were claims that two individual defendants were warned about the risks of the investments, the claims are meaningless, the court concluded, unless plaintiffs establish what the two individual defendants knew or should have known.

Similarly, allegations that two of the individual defendants had access to information regarding the investments and their risk is not sufficient to plead a strong inference of scienter. While those facts might support an inference of scienter, the more compelling inference is that defendants were not acting with an intent to deceive, since immediately after learning these risks the two men analyzed the investments and announced the results. This fact also undermines plaintiffs’ claims that there was a failure to monitor and, like the other allegations in the complaint, is insufficient to plead a strong inference of scienter as to each defendant.