by T. GormanPosted on Posted in SECActions

Financial reporting cases are a key focus of SEC enforcement. In some instances the actions result from fraudulent schemes such as those where executives falsify the numbers to obtain a bonus. In other instances the actions center on accounting errors. Both can result in incorrect financial statements. The recently filed action involving The Phoenix Companies, Inc. falls in the latter category. In the Matter of The Phoenix Companies, Inc., Adm. Proc. File No. 3-17345 (July 15, 2016).

Phoenix was a holding company for three insurance subsidiaries. One focused on life insurance, a second on annuities and a third on life and annuity products. On November 8, 2012 the firm announced that its previously issued audited financial statements, including those in its Forms 10K for the years ended December 31, 2011, 2010 and 2009 could no longer be relied on and would have to be restated. That included the unaudited financial statements for quarterly periods in Forms 10-Q going back to March 31, 2011.

As the firm and its auditors worked through the restatement issues, a number of additional errors were discovered which delayed the process. The Commission filed settled administrative proceedings which required the firm to become current by a specified date. A cease and desist order was entered and penalties imposed. Subsequently, the Commission extended the filing deadlines and imposed additional sanctions.

On April 1, 2014 the firm filed a Form 10-K for the year ended December 31, 2012. In the filing Phoenix restated and amended its consolidated financial statements for the years ended December 31, 2011 and 2010. The filing identified several errors as well as material weaknesses in internal controls. Overall income before taxes decreased by 92% for fiscal 2011 and 20% for fiscal 2010.

Certain errors discovered involved the firm’s universal life insurance products. In those instances Phoenix improperly applied accounting guidance intended to take into account potential future losses on certain products. For 2011 those errors increased liabilities and decreased stockholder’s equity and net income. For 2010 the errors also decreased net income.

Other errors involved the fixed indexed annuity product of Phoenix. In the third quarter of 2011 the firm established an internal valuation system for its annuity contracts. When the transition was made to the new system Phoenix erroneously included fees it earned from purchases of a certain rider while excluding its cost. That resulted in an overstatement of income. The firm also concluded that the internal valuation system could not accurately value the annuities. Once restated these errors caused a significant decrease in pretax income for 2011and resulted in a net loss for 2010.

Phoenix also found errors in its accounting for reinsurance contracts. In 2008 and 2009 the firm purchased reinsurance contracts for certain term life policies. That reduced the risks of its term life business. Phoenix did not perform a premium deficiency analysis on the underlying block of term life policies involved as required. Accordingly, Phoenix had to establish a liability which decreased net income. The firm also discovered errors in the way the modeling had been done by its valuation system. The restatement of these errors resulted in a decrease in net income for 2011 and an increase for 2010.

Finally, Phoenix made errors regarding the accounting for certain derivatives. Those derivatives were purchased to hedge certain risks. The instruments were valued without taking a credit valuation risk adjustment as required. That accounts for the default risk of the counterparty. Restatement of this error resulted in a decrease of pretax income for 2011 and 2010. The Order alleges violations of Exchange Act Section 13(a), 13(b)(2)(A) and 13(b)(2)(B).

To resolve the proceeding Phoenix consented to the entry of a cease and desist order based on the Sections cited in the Order. The firm will also pay a civil penalty of $600,000. Previously, the firm had paid $1.1 million in civil penalties as a result of the delays in preparing the restatement. The Commission took into account the firm’s remedial efforts in determining to accept its settlement offer.

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by T. GormanPosted on Posted in SECActions

The Commission filed another offering fraud action in what has become virtually a continuous stream of these cases. Its latest action centers on the sale of interests in a payday lending business operated in partnership with a federally recognized Native American tribe. In marketing those interests the defendant failed, according to the complaint, to disclose information regarding arrangements and payments made by the issuer since there was a “substantial likelihood” a reasonable investor would have found the facts material. SEC v. Roberts, Civil Action No. 2:16-cv-1664 (D. Nev. Filed July 14 2016).

Defendant Zachary Roberts is an inactive member of the bar of California. He controlled Encore Acceptance I, LLC, a Nevada limited liability company. In 2010 Mr. Roberts was introduced to the Chippewa Cree Tribe of the Rocky Boy’s Reservation, Montana. Eventually an agreement was stuck between Encore Service Corporation LLC, another Encore entity ostensibly operated by a Roberts associate, and an entity controlled by the Tribe. Under the terms of that agreement Encore would advise and mange the Tribe’s then nascent entry into the online payday lending business through a wholly owned subsidiary.

The management agreement contained a number of provisions precluding interference with the business of the Tribe. Those included making payments to members of the Tribe and restricting Tribe members’ ability to have financial interests in certain controlled entities related to the on-line business.

Subsequently, the Tribe entered into an agreement with Think Finance, Inc., a large Texas-based lender. The lender controlled a significant loan portfolio. Think sought to have the Tribe become a business partner. Following the execution of this arrangement Encore, through another affiliate, sought to, and did, expand its management agreement to increase its business with the Tribe and the fees paid to it. The new agreement was initially rejected by the Tribe but later approved after arrangements were made to make payments to certain members of and officials of the Tribe (collectively “Tribe Affiliate”).

Between December 2011 and July 2012 Encore offered and sold about $1.72 million of notes with an interest rate of 24% to 18 persons using a private placement memorandum. That memorandum contained certain information about Encore and the planned use of investor funds with the Tribe entity. It did not disclose that from September 2011 to July 2013 over $1.1 million was paid by the Encore affiliate to Tribe Affiliate; the agreements under which the payments were made; and the fact that under the terms of the management agreement those arrangements and payments could be deemed an act which might result in the termination of the agreement and thus jeopardize the value of the investors’ interests.

Those arrangements and payments should have been disclosed because there is a “substantial likelihood that a reasonable investor would have considered the omitted information material . . . in deciding on the investment, according to the complaint. Indeed, Encore was under a duty to disclose the omitted information not just in view of its materiality but also because of its “fiduciary or agency relationship, course of prior dealings, and attendant circumstances such that investors had placed trust and confidence . . .” in the firm the complaint claims. Alternatively, the omission of the facts regarding the agreements and payments to Tribe Affiliate made the statements to investors materially incomplete and thus false.

The Tribe eventually discovered the undisclosed agreements. The relationship with Defendant was terminated. Mr. Roberts tried to convince investors that the interruption resulted from a change in Tribe leadership. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation. See Lit. Rel. No. 23595 (July 15, 2016).

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