Series: SEC Enforcement Program 2007, Projecting Trends and Key Issues (Part VIII)

SEC Enforcement Trends – Financial Fraud

While financial fraud cases are a traditional staple of the SEC’s Enforcement Program, issuers, directors, officers and even outside vendors and consultants to public companies should take note of the increasing aggressive posture of the Enforcement division, which at times may be over reaching.  A review of the SEC’s cases in this area last year suggests that the agency is aggressively pursing these cases in an effort to expand the contours of potential liability and that it is imposing increasingly large penalties even those who cooperate with the investigation. 

Penalties for financial fraud continue to be large.  For example:  SEC v. McAfee, Inc., (D.D. Cal. Jan 4, 2006) involved an alleged scheme to overstate revenue from 1998 to 200 by about $622 million according to the complaint.  The case settled with the defendant consenting to the entry of a statutory injunction and an order directing the payment of a $50 million penalty. 

SEC v. Tyco International Ltd., (S.D.N.Y. Apr. 17, 2006)  was based, according to the complaint, on a financial fraud centered on a scheme to overstate results by at least $1 billion.  The case settled with the entry of a consent decree which included a statutory injunction and an order requiring the payment of a $50 million penalty.  

Even in cases where the SEC acknowledged the company’s cooperation the Commission assessed large fines.  For example: 

SEC v. Federal National Mortgage, (D.D.C. May 22, 2006) was based on a complaint that alleged multiple violations of GAAP to smooth earnings over a period of years.  The case settled with the entry by consent of a statutory injunction and an order directing the payment of a $400 million penalty.  The SEC’s release acknowledged the cooperation of the company. 

SEC v. AIG, (S.D.N.Y. Feb. 9. 2006)  involved an alleged financial fraud in which the company overstated its loss reserves by $500 million to improve its balance sheet.  The actions settled with the entry of a consent degree under which the company agreed to the entry of a statutory injunction and the payment of a penalty of $100 million. Again, the SEC’s Release acknowledged the extensive cooperation of the company.  

In addition to imposing large penalties in financial fraud cases, the SEC was also aggressive in its case selection.  Consider the following examples: 

In the Matter of City of San Diego, (Nov. 14, 2006), is a settled administrative proceeding brought against the City of San Diego based on allegations of financial fraud involving bond offerings by the City.  The case alleged that the City failed to disclose difficulties with pension and retiree health care obligations in the bond offering.  The action was resolved with the entry of a cease and desist order by consent and the entry of an order, which required the retention of a consultant to review internal controls. 

SEC v. Todd, et al., Case No. 03CV2230 BEN (WMc) involved a claimed financial fraud to inflate the revenues of Gateway, Inc. by former CEO Jeffrey Weitzen, former CFO John J. Todd, and former controller Robert D. Manza.  Following a trial on the merits Todd and Manza were found liable for securities fraud on March 7, 2007.  The evidence established that both men engaged in a scheme to inflate earnings by approving credit for persons who had previously been rejected as bad credit risks and then booking sales to those individuals.  In this pre-SOX (i.e. a CEO certification was not required) case the evidence demonstrated that CEO Weitzen had not signed the filings involved and that, although Weitzen had knowledge of the accounting issues the SEC claimed were fraudulent, the SEC failed to show Weitzen acted with scienter or as a control person.  The SEC, however, sought to hold him liable as the CEO.  The court granted summary judgment in favor of Mr. Weitzen on May 30, 2006.   Both of these cases suggest the aggressive posture of the Enforcement Program.  While the City of San Diego is not the first case involving a municipal government, such cases are not an ordinary occurrence.  The case involving Mr. Weitzen suggests a very aggressive – perhaps overly aggressive – approach of trying to hold those at the top responsible. 

Finally, the SEC is pursing not only those at the company who engage in financial fraud, but others outside the company who aided and abetted the fraud – even to the point of criminal liability.  Consider for example: 

SEC v. Scientific-Atlanta, (S.D.N.Y. June 22, 2006), which is a settled enforcement action alleging that the defendant company aided and abetted Adelphia in inflating its earnings by $43 million.  The action settled with a consent to the entry of a statutory injunction and an order directing the payment of $20 million in disgorgement. 

SEC v. Ronald Ferguson, (S.D.N.Y. Feb. 2006), where the complaint charged four former senior executives of Gen Re and one senior executive of AIG with aiding and abetting AIG in improperly overstating its loss reserves by almost $500 million.  A parallel criminal case was also filed.  Both cases are pending.  

SEC v. Gary Bell, (D.D.C. Jan. 18, 2007) is an action against 13 additional employees and agents of vendors claimed to have aided and abetted a massive fraud at U.S. Food Service, Inc. by executing false audit confirmations.  Several agreed to settle for consent decrees and penalties, while others are litigating with the SEC. 

Collectively these cases suggest aggressive, and at times overly aggressive, efforts in the financial fraud area with potentially expanding contours of liability and very large penalties even when the company is fully cooperative with the SEC’s investigation.  Pushing the edge of liability, as in the action against Mr. Weitzen and others discussed earlier in this series, suggests an approach that may at times be based more on an overly aggressive posture than sound legal theory and the evidence.  All of this suggests that issuers, their directors and executives should carefully review their compliance programs to avoid becoming entangled in one of these actions.