by T. GormanPosted on Posted in SECActions

Financial fraud was a staple of SEC enforcement for years. Complex financial fraud cases in which the “books were cooked” to make earnings guidance, increase bonuses or for other reasons were the daily grist of SEC enforcement up to the time of the market crisis. The Commission has tried to revive its financial fraud program since the market crisis. For example, two years ago the agency announced a financial fraud task force and a related data analytics group quickly labeled “Robocop.” While financial fraud actions have been brought, the initiatives have not generated the kind of complex fraud actions or the remedial efforts that were once the mainstay of SEC enforcement.

Last week, however, SEC Enforcement Director Andrew Ceresney stated that “financial reporting has been a consistent area of focus for the Division” of Enforcement, noting that new tools have been developed to ferret out possible violations. Andrew Ceresney, Director’s Forum Keynote Address, San Diego, California (January 25, 2016)(here). The Director began with a bit of history, recounting the initiatives of the late 1990’s and the well known speech by then SEC Chairman Arthur Levitt titled the “Numbers Game.” In his remarks Chairman Levitt warned against the erosion of financial reporting standards by games issuers and their executives played with their financial reports such as the use of “cookie jar” reserves and other improper techniques which resulted in false reporting. What followed, of course, was an unprecedented series of Commission financial fraud actions against many of the largest companies in U.S. and their executives.

In the wake of the Commission’s actions Congress crafted the reforms incorporated into the Sarbanes-Oxley Act of 2002. Since that time restatements by issuers have remained relatively flat, the Director noted. Nevertheless, issuers and their executives still face significant pressures today which, like those at the time of Chairman Levitt’s “Numbers Game” speech, can result in financial reporting issues. Those include, according to the Director,

  • Pressure to meet earnings and other performance expectations;
  • Excessive focus on short term performance;
  • Poor oversight in units and subsidiaries;
  • Growth outpacing the reporting and accounting infrastructure; and
  • Management’s over-reliance on processes and poor “tone at the top.”

The list differs some what from that of Chairman Levitt but the bottom line is the same: Short-term pressures to meet certain metrics or goals can drive earnings fraud, particularly if the control environment is inadequate.

The Director then listed a series of recent financial fraud action, at least suggesting that the program is returning to its roots although the remedies focused on penalties and the resulting headlines. Those included:

Revenue recognition: In the Matter of Computer Sciences Corporation, Adm. Proc. File No. 3-16575 (June 15, 2015)(and related court actions against certain executives); an action that centered on a fraud to conceal difficulties with the firm’s largest contract in which a $190 million penalty was paid;

Valuation and impairment issues: In the Matter of Deutsche Bank AG, Adm. Proc. File No. 3-16557 (May 26, 2015); an action centered on failing to incorporate the risk of potentially billions in losses in connection with the valuation of a portfolio of derivatives in which a $55 million penalty was paid;

Earnings management: In the Matter of Bankrate, Inc., Adm. Proc. File No. 3-16786 (September 18, 2015); an action centered on earnings management in which a $15 million penalty was paid.

The Director went on to stress an recurrent theme in SEC enforcement: Gatekeepers and their importance to halting fraud. There can be no doubt that the audit committee, external auditors and other professionals are critical to halting financial fraud. At the same time, as the court stated years ago in SEC v. Arthur Young & Co. 590 F. 2d 785, 788 (9th Cir. 1979), while this is a salutary idea, Congress has not yet conscripted these professionals as the advance guard of SEC enforcement.

Perhaps the most significant portion of the Director’s remarks was the concluding section which focused on efforts by the agency to act as its own kind of gatekeeper, or at least get to the scene of a financial fraud at an earlier point. Here the Director highlighted two initiatives by the agency, one called CIRA and the second FRAud Group. The former is the Corporate Issuer Risk Assessment program developed by the Division of Economic and Risk Analysis. This program is the successor to the earlier effort to create a computer driven analytics model which the SEC called the Accounting Quality Model and the press called Robocop. Its focus is to “detect abnormal, relative results, focus on particular financial reporting anomalies, and generate lists of companies that meet the criteria for further analysis,” according to the Director.

The latter is the Financial Reporting and Audit Group, again a successor to the earlier initiative on financial reporting launched two years ago. This group is “focused on identifying cases that we otherwise would not find, finding new ways to utilize our resources and developing new resources, and building out a methodology for proactive identification of financial reporting and audit issues . . .” It is one of several similar initiatives in the Division of Enforcement.

While CIRA and FRAud Group are clearly focused on detecting financial fraud at an earlier point than the agency has traditionally been able to do, and both work in conjunction with the whistleblower program, it is unclear how this goal might be accomplished. Using computers to analyze corporate filings may in identify some issues such as changes in accounting principles, metrics or trends that are outliers from company or industry trends and similar items. The approach is also likely to suffer from the same kinds of difficulties experienced by Robocop – numerous false positives. Just how FRAud Group will add to this effort, other than perhaps sorting through the false positives, is also unclear. What is clear is that the agency is redirecting its focus on financial statement fraud and related disclosures which should serve as a caution to issuers who would do well to carefully examine their compliance programs.

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by T. GormanPosted on Posted in SECActions

Washington spent much of this week digging out from a monster snow storm which left the government closed for two full days and reporting for work on a delayed based for two others.

Two recent reports from Cornerstone Research chart trends in securities litigation. One analyzes trends in SEC actions, detailing the shift to administrative proceedings and its impact on actions against public companies. Another records an increase in securities class action filings.

Despite the snow storm and closed offices, the SEC filed four new actions this week. Those centered on an investment adviser incurring large losses while failing to follow its announced investment strategy, charges based on acting as an unregistered broker, and offering fraud and an action for selling unregistered securities.

SEC

Remarks: Andrew Ceresney, Director, Division of Enforcement delivered the key note address at the Directors Forum 2016, San Diego, California (January 25, 2016). His remarks reviewed past initiatives of the Division regarding financial reporting, discussed current issues of concern in that area, the obligation of gatekeepers and concluded with a discussion of current data analysis efforts in the area (here).

CFTC

Remarks: Chairman Timothy Massad addressed the P.R.I.M.E. Finance Annual Conference (January 25, 2016). His remarks focused on central clearing issues and CCP issues (here).

Trends in securities litigation

SEC enforcement trends: SEC enforcement is bringing more actions and more administrative proceedings but obtaining lower amounts of penalties and disgorgement, according to a recent report by Cornerstone Research. titled SEC Enforcement Activity Against Public Company Defendants, Fiscal Years 2010 — 2015. The number of SEC enforcement actions is increasing, focused on disclosure and FCPA violations as to public companies, according to the Report. In fiscal 2010 there were 681 actions filed, while there were 735 brought the next year. By 2014 there were 755 actions filed followed by 807 last year. During the same period the number of enforcement actions brought against public company defendants remained roughly constant, with 33 such actions brought in 2010 and 2015.

The Report charts a shift in venue selection. For the period 2010 through 2013 over 65% of the actions against public companies were brought in federal court. Thus, in fiscal year 2010 only 21% of the actions were brought as administrative proceeding while in fiscal year 2011 it was 34%, 2012 24% and 2013 35%. Fiscal years 2014 and 2015 represent a dramatic shift. In 2014 74% of the actions against public companies were bought as administrative proceedings while only 26% were filed in federal court. The shift continued the next year with 76% of those actions being brought as administrative proceedings and 24% as federal court actions.

Last year 82% of the actions brought against public companies were settled at the time of filing. That is consistent with the fact that 85% of such actions were settled on filing in 2014 and 81% in 2013. The trend of filed at the time of settlement seems to shift with venue however. In 2015 96% of the actions filed against public companies as administrative proceedings were settled at the time the action was instituted. That is higher than the 88% in 2014 but less than the 100% recorded in 2013 and 2012. In contract, in 2015 only 38% of the enforcement actions filed by the SEC against public companies in federal court were settled at the time of filing. The prior year it was 78% and in 2013 71%.

Securities class actions: Last year there were more class action suits filed compared to the prior year. The actions were brought largely against companies traded on the two major exchanges in the biotech and healthcare sectors, according to a recent report by Cornerstone Research titled Securities Class Action Filings: 2015 Year in Review. In 2015 there were 189 securities class actions suits filed, an increase of about 11% compared to the year before when 170 suits were brought. Indeed, the number of suits filed last year is the largest since 2008 when a total of 223 cases were filed. The number of filings last year is up slightly over the average of 188 filed from 1997 to 2014.

Suits against firms in the S&P 500 continued to remain at historical lows. Last year about 2.6% of the firms listed on the S&P 500 were named in a suit, compared to 2.2% in 2014 and 3.4% in 2013. The average from 2001 through 2014, however, is 5.5%. At the same time 84 suits were brought against NYSE firms while 96 named those listed on NASDAQ as defendants. That compares to 75 and 84, respectively, in 2014 and 76 and 96 in 2013. Finally, the chance of being named in a class action suit for an exchange listed firm increased last year to 4% compared to 3.6% in 2014 and 3.1% in 2013. Those statistics must be considered against the fact that in 2013 the number of exchange listed firms decreased by 2.61% but increased in 2014 by 0.11% and in 2015 by 3.67%.

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive case and 2 administrative proceeding, excluding 12j and tag-along proceedings.

Insider trading: SEC v. Spivak, Civil Action No. 1;15-cv-13704 (D. Mass.) is a previously filed action which named as defendants Vlad Spivak and his girlfriend, Shirmila Doddi. The complaint alleged that Ms. Doddi obtained inside information regarding a pending acquisition of a firm through her employment as a financial analyst at a commercial bank. She furnished that information to Mr. Spivak who traded, realizing profits of about $222,000. The court entered a final judgment by consent as to Ms. Doddi, prohibiting future violations of Exchange Act Section 10(b). There will be further proceedings to determine financial remedies. See Lit. Rel. No. 23455 (January 27, 2016).

Investment strategy: In the Matter of Peter Kuperman, Adm. Proc. File No. 3-17075 (January 28, 2016) is a proceeding which names as Respondents, Mr. Kuperman and QED Benchmark Management, LLC, an investment adviser. Respondents marketed a fund managed by QED by telling investors about a scientific stock selection strategy. In practice that strategy was not followed. Significant losses followed. Mr. Kuperman took steps to conceal those losses and made misrepresentations to investors. The Order alleges violations of Exchange Act Section 10(b), Securities Act Section 17(a) and Advisers Act Sections 206(1), 206(2) and 206(4). To resolve the proceeding Mr. Kuperman undertook to reimburse investors $2,877,000. In addition, Respondents consented to the entry of a cease and desist order based on the Sections cited in the Order. Mr. Kuperman is barred from the securities business and will pay a penalty of $75,000.

Unregistered broker: In the Matter of 3C Advisors & Associates, Inc., Adm. Proc. File No. 3-17070 (January 27, 2016) is a proceeding which names as Respondents the firm, Stephen Jones, a founder and managing director of the firm, and David Prolman who is also a managing director of the firm. The firm solicited small and medium size businesses by marketing capital advisory services. In this regard it assisted with arranging private placements of debt and equity securities and capital raises. Customers paid performance fees calculated as a percentage of the capital raised. As such it was acting as an unregistered broker and the two individuals aided and abetted those actions, all in violation of Exchange Act Section 15(a). The proceeding will be set for hearing.

Perks: SEC v. Miller, Civil Action No. 3:15-cv-1461 (N.D. Cal.) is a previously filed action against Andrew Miller, former CEO of Polycom Inc. The complaint centered on claims that Mr. Miller used about $190,000 in corporate funds for personal perks that were not disclosed and for which he created false expense reports and took other deceptive actions. The Court entered a final judgment by consent this week, enjoining Mr. Miller from future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(b)(5) and 14(a) and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A). The order also bars Mr. Miller from acting as an officer or director of a public company for 5 years and directs him to pay $450,000 in disgorgement, prejudgment interest and a penalty. See Lit. Rel. No. 23454 (January 27, 2016).

Unregistered securities: SEC v. OTC Capital Partners, LLC, Civil Action No. 1:16-cv-20270 (S.D. Fla. Filed January 22, 2016). The action centers on a scheme to convert corporate debt to securities which are sold into the market, raising millions of dollars.

The defendants are OTC Capital, which describes its business as providing financing for companies through aged debt and other transactions; Adi Elfenbein who once held Series 7 and 63 licenses, worked as a registered representative and is the sole owner of OTC Capital; and attorney Joseph L. Pittera, a sole practitioner from California. The scheme is straight forward and was repeatedly implemented through a series of step: 1) OTC entered into a Debt Purchase Agreement with MusclePharm Corporation vendors who held aged invoices that MucclePharm had failed to pay; 2) The agreement authorized OTC Capital to amend the terms of the debt and covert the debt invoices into common stock of MusclePharm priced at a substantial discount; 3) MusclePharm’s board of directors approved the issuance of the necessary stock and directed the transfer agent to issue unrestricted shares; 4) Attorney Pittera was retained by Mr. Elfenbein to write opinion letters for ten deals between the two companies; and 5) Rule 144 letters were authored, claiming that the holding period had been met because it began to run not from when the stock was issued but the date of the invoice despite the fact that the invoices were not securities. About 23.9 million unregistered shares were sold into the open market raising $1.19 million, although there was no registration statement in effect or exemption available. The complaint alleges violations of Securities Act Sections 5(a) and 5(c). The case is pending. See Lit. Rel. No. 23452 (January 22, 2016).

Offering fraud: SEC v. Crumbley, Civil Action No. 3;16-cv-00172 (N.D. Tex. Filed January 21, 2016) is an action which names as defendants Kenneth Crumbly and Sedona Oil and Gas Corporation for which he serves as President. The complaint alleges that since June 2013 about 55 investors have spent about $3.3 million to acquire the securities of the firm based on misrepresentations. Those included claims that: Returns ranging from 37% to 276% would be paid; all of the offering proceeds would be used to develop certain properties; and did not inform potential investors that funds would be used for the personal expenses of the promoters. Defendants are also alleged to have engaged in the destruction of evidence. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 20(a) and (b). The court entered a temporary freeze order at filing. The case is pending. See Lit. Rel. No. 23453 (January 27, 2016).

Australia

Disclosure: ZhongHauanYun Holdings Group was penalized $33,000 following an Australian Securities and Investment Commission investigation which determined the firm failed to comply with its continuous disclosure obligations. The firm announced its half year financial report on March 17, 2017 — an after tax profit of $82,539. That was a decrease of 92% from the prior half year. Although the firm was aware by February 14, 2015 that the operating profit would be materially less than for the prior period it failed to make the requisite disclosure.

U.K.

Privilege: The High Court ruled in favor of the Serious Frauds Office, sustaining the manner in which it handles privileged materials. The challenge arose in the context of a seizure of a cell phone and related computers at the time a director of a construction company was arrested. The phone and computers contained privileged material. The SFO had in-house technicians handle the privileged material rather than outside contractors as claimed by the petitioner.

Bid rigging: The SFO announced that five individuals had been found not guilty of conspiracy to defraud in connection with the on-going investigation into the manipulation of LIBOR.

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