by T. GormanPosted on Posted in SECActions

Financial fraud actions have long been a staple of SEC Enforcement. Following Arthur Levitt’s famous “Numbers Game” speech in 1997 for example, the Commission brought a series of blockbuster financial fraud actions that spurred the passage of The Sarbanes-Oxley Act in 2002. Since that time, and particularly following the market crisis, the agency has tried to rekindle its earlier successes, formed a task force to focus on financial fraud a few years back while making efforts to create what many called “RoboCop” – a computer to fret out financial fraud. Cases have been brought. But not a series of actions like those that spawned SOX.

One explanation is that following SOX the number of restatements has dwindled. To be sure that is true. There are, however, still restatements with a significant number issuers restating and revising their financial statements, according to a report prepared by Audit Analytics titled “2015 Financial Statements: A Fifteen Year Comparison” (here).

Restatements come in two types. One is where the issuer has to disclose in a Form 8-K that the past financial statements can no longer be relied on but will be reissued at some point in the future, according to the Report. A second does not require disclosure in a Form 8-K or the reissuance of the firm’s historical financial statements because it is a revision.

The high water mark for restatements in recent years was 2006 when there were 1851. Since that date the number of restatements has declined to 737 in 2015. That is more than in the year prior to the passage of SOX when there were 625 restatements and the 700 in the year the Act was passed but below the 788 in 2003. From that year forward the number increased until the high point in 2006 after which there has generally been a decline.

The numbers and the trends differ, however, if they are broken out to show the trend in reissuances vs. revisions. For the former the numbers generally decline over the period 2008 to 2015. In 2008 there were 433 reissuances – that is, situations where disclosure that the historical financial statements could no longer be relied on was required. By 2015 that number had dropped to 161. The trend for revisions is the opposite. In 2008 there were 448 revisions (just over half of the total number of restatements). By 2015 the number had increased to 516 (over three quarters of the restatements). The numbers between 2008 and 2015 generally increases overall but not each year while the percentage of revisions as a function of the total number of restatements increased every year, according to tables in the Report.

While restatements can involve a variety of issues, the average income adjustment for companies listed on the three U.S. exchanges has ranged from a low of about $3.1 million in 2014 to a high of just under $13 million in 2011 and about $5.2 million in 2015. At the same time a significant number of restatements do not have an impact on the income statement. In 2007, for example, over 39.4% of the restatements had no impact on the income statement. In 2014 that percentage reached a high for the period of 60% before dropping to just over 55% the next year.

Other restatements have involved significant dollar amounts for particular issuers. For example, in 2002 the restatement for Tyco International, Ltd, had a negative impact on net income of $4,512,700,000. Two years later the restatement for Federal National Mortgage Association Fannie Mae had a negative impact of $6,335,000,000. In 2005 the restatement for AIG had a negative impact of $5,193,000,00, in 2011 for China Unicom Ltd. it was $1,556,743, in 2013 for Quicksilver Reserves, Inc., it was $1,419,888,000 and in 2015 for Alphabet (parent of Google) it was $711,000,000.

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by T. GormanPosted on Posted in SECActions

The SEC has become “Sky Pilot” (borrowed from the rock song sung by Eric Burden and The Animals) in an effort to fret out financial fraud. In the past evidence of financial fraud may have come from a whistleblower. Staff accountants might have combed through financial statements and company filings, digging for possible clues that could unravel a financial fraud. Then there was RoboCop, the computer program that was supposed to discover evidence of financial wrong-doing.

But now the Enforcement staff has discovered a new technique – aerial surveillance. Not drones, but surveillance (although possibly by drones – or more likely, Google). That technique was used by the staff to help establish financial fraud by a large Mexican home builder. SEC v. Desarrolladora Homeex S.A.B. de C.V., Civil Action. No. 3:17-00432 (S.D. Cal. Filed March 3, 2017).

Homex, based in Culiacan, Sinaloa, Mexico, was at one time known as Mexico’s largest home builder. The firm specialized in constructing affordable, middle-class homes in Mexico. Its ADRs were listed for trading on the NYSE from 2004 through 2014. Its shares were also listed on the Mexican Stock Exchange or BMV. During that period the firm’s shares were controlled by the De Nicolas family. Gerardo de Nicolas served as CEO until his resignation in May 2016 in the wake of an announcement regarding the Commission staff’s investigation. The firm’s CFO also resigned at that time.

The company prepared its financial statements during the period applicable here in accord with Mexican Financial Reporting Standards or MFRS. For 2012 the firm used International Financial Reporting Standards or IFRS. In its annual report on Form 20-F for 2010 and 2011 the company prepared a reconciliation.

Revenue recognition policies at the firm – the central issue here – specified that Homex recognize revenue from a home sale only if specific criteria were met. Essentially “control” of the home had to be transferred to the buyer and it had to be probable that Homex would recieive the economic benefits associated with the transaction.

During the period here the firm maintained an internal system called Sistema Integral de Administration or SIA where accounting entries were recorded. The firm’s CEO strictly limited employee access to the system.

Beginning in 2010 manual entries for home sales and the related revenues and expenses were entered into the system. This materially inflated the financial results of the firm. For example, in 2010 the firm reported revenue of $18,465 million on the sale of 44,347 unites. In fact revenue was only $6,456 million for 16,077. The numbers for 2011 and 2012 were inflated in a similar manner.

The fraudulent entries were tracked on manually prepared spreadsheets. The fraudulent nature of the entries was also readily apparent from an inspection of sites were the homes supposedly were built. For example, satellite images taken in March 2012 of one project for which revenue was recorded shows that hundreds of the units had yet to be built. A photo of the satellite image is attached to the complaint and the related press release.

In addition to fraudulent revenue the firm also reported fictitious receivables. When Homex built and sold a home the purchase price was typically financed by a mortgage from one of two large Mexican Government-backed lending institutions. Homex usually received the loan proceeds from the lender within weeks. During the waiting period the company carried the expected payment from the lender on its books as an account receivable. Most of those receivables were fictitious since the sales were fictitious.

The fraud also resulted in fraudulent agreements with a group of thirteen Mexican banks. To monetize its receivables, the firm factored the expected payments from lenders with the group of banks. Since the sales were largely false, the factoring agreements were also false, although they were certified by the CEO and CFO of the company. Indeed, all of the false financial information was reflected in filings made with the Commission and certified by the CEO and CFO.

By no later than June 2012 Homex was aware of the staff’s investigation. Nevertheless, the conduct continued. Eventually the firm tumbled into the Mexican equivalent of bankruptcy. Its CEO and CFO resigned; its shares were delisted but continue to be quoted on OTC Link. Shareholder value was essentially wiped out.

To date the firm has not corrected, restated or made any disclosures regarding the reliability of its financial statements. There is no indication that any employees have been terminated, although the CEO and CFO did resign. No charges have been brought against the CEO, CFO or any individual. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).

To resolve the action the company consented to the entry of an injunction based on the Sections cited in the complaint. It did not agree to pay disgorgement, prejudgment interest or a penalty. The Commission considered the cooperation of the new management of the firm and the fact that what the press release calls “critical information” was furnished to the staff during its investigation as well as the continuing cooperation of the company. The Commission suspended trading in Homex shares.

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