SEC REMEDIES: DISCLOSING REMEDIAL STEPS
A key part of the SEC’s statutory mandate is to prevent a repetition of the violation after halting it. Accordingly, an important component of many settled enforcement actions is the remedial steps taken to ensure against a repetition of the wrongful conduct. Frequently however, the remedial steps instituted are only briefly mentioned, if at all. Disclosure of these steps would not only help reassure investors and the markets, but offer guidance to others.
SEC v. Cole, Civil Action No. 3:09-CV-2107 (N.D. Ohio Filed Sept. 11, 2009) and In the Matter of Dana Holding Corporation, Adm. Proc. File No. 3-13614 (Sept. 11, 2009), two related settled financial fraud cases, are good examples of the failure by the SEC to provide any real disclosure regarding the remedial steps taken by an issuer to prevent a repetition of the wrongful conduct in the future. Both cases center on a financial fraud and the inadequate internal controls at the predecessor of Dana Holdings (Dana Corporation) from 2004 through mid-2005. The civil injunctive action names as defendants Bernard Cole, William Hennessy, Douglas Hodge and Robert Steimle, all former senior executives of Dana’s Heavy Vehicle Technologies and Systems Groups, one of two main business units of the company, in a fraud and books and records action. The administrative proceeding names the company as a respondent in a books and records action.
Both actions are based on efforts to improve the operating results in the Commercial Vehicle Systems subdivision of Dana’s Heavy Vehicle business unit. At the time, Dana Corporation manufactured and supplied automotive parts and systems to vehicle manufactures worldwide. On March 3, 2006, the company filed for protection under Chapter 11 of the Bankruptcy Code. In February 2008, the company emerged from Chapter 11 as a holding company and had its shares listed on the NYSE from which it had previously been delisted.
The complaint and Order for proceedings allege that the financial statements of the company were misstated in part as a result of a scheme carried out by the individual defendants to inflate income. Key elements of the scheme included:
1) The recognition of income in transactions where assets were never transferred or the risk of ownership never passed. Specifically, in a contract with a parts supplier, the company recognized revenue, despite the fact that the agreement stipulated that Dana would retain the parts and risk of loss pending completion of the sale. On another transaction, the company recognized $5 million on the sale and lease back of a facility, despite the fact that GAAP requires that the income be amortized. The company also recognized revenue on transactions where it could not deliver the products.
2) The recognition of revenue for price increases on parts sales without agreement from the customers. In fact, the company accrued revenue for price increases while its employees were still negotiating them.
3) Improperly deferring recognition of certain surcharges. Specifically, the company used a variety of techniques, including rejecting valid invoices, to defer payment of steel surcharges.
4) Making a series of improper accounting entries that lacked proper support. In 2004 and 2005, the company improperly increased EBIT by $3.9 million by issuing improper debit memos to suppliers without their agreement which reduced outstanding payables.
In addition, from 2004 through the first two quarters of 2005, the books and records of the company contained errors amounting to $56.4 million. In part, these were related to the LIFO inventory reserve of the company.
The audit committee of the company discovered the accounting fraud in September 2005 and disclosed it the following month. In December 2005, the company restated its financial statements.
In a December 30, 2005 Form 10-K/A, the company admitted to five material weaknesses in the design and operation of its internal controls which include: 1) a failure to maintain an effective control environment; 2) having a financial and accounting organization that was not adequate to the needs of the company; 3) failing to maintain effective controls over the completeness and accuracy of certain revenue and expense accruals; 4) failing to maintain effective controls over reconciliations of certain accounts; and 5) failing to maintain effective control over the valuation of certain inventory and related costs of goods sold.
To resolve the civil injunctive action, the individual defendants each consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions of the Exchange Act. Messrs. Hennessy, Hodge and Steimle also consented to the entry of an injunction prohibiting violations of Section 17(a) of the Securities Act. The final judgments also impose a $65,000 civil penalty and a five year officer/director bar against Messrs. Cole and Hodge and a $45,000 civil penalty against Messrs. Hennessy and Steimle. Mr. Hodge also agreed to pay over $71,000 in disgorgement, along with prejudgment interest, while Mr. Hennessy agreed to pay over $44,000 in disgorgement along with prejudgment interest and Mr. Steimle agreed to pay over $21,000 in disgorgement and prejudgment interest. See also Litig. Rel. 21207 (Sept. 11, 2009).
To resolve the administrative proceeding, the company agreed to the entry of an order directing it to cease and desist from committing or causing any violations of the reporting provisions and the related rules. The Commission considered the remedial acts taken by the Respondent and its cooperation, according to the Order.
At the center of the violations detailed in the Commission’s papers is the poor financial controls and environment of the company. What steps the company took to improve its financial report processes, strengthen its internal controls and ensure that it has the proper reporting environment is not disclosed by the Commission. Accordingly, neither investors nor the market can determine how effective those steps may be.
Disclosure of the remedial steps taken by the Company would help reassure investors and the markets that the difficulties which resulted in the wrongful conduct will not be repeated. Disclosure could also offer valuable guidance to others. Unfortunately, the lack of disclosure here is typical of Commission settlements, a stark anomaly for an agency whose mission is primarily disclosure. Perhaps in the future as the Commission retools its enforcement program it will consider enhancing the disclosures made concerning the steps taken by issuers to prevent a repetition.