The SEC And Financial Fraud

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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