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In 2013, shortly after Mary Jo White became Chair of the Securities and Exchange Commission, the Commission announced a renewed focus on identifying accounting-related fraud.1 Despite declines in the number of SEC enforcement actions involving accounting issues and the number of financial statement restatements in recent years, the SEC questioned whether there had, in fact, been an overall reduction in accounting fraud. At that time, Andrew Ceresney, then Co-Director of the SEC's Division of Enforcement, expressed skepticism: “I find it hard to believe that we have so radically reduced the instances of accounting fraud simply due to reforms such as governance changes and certifications and other Sarbanes-Oxley innovations.”2 In his view, the SEC would not know whether accounting fraud had declined until it devoted additional resources to address the issue.
In the past, the SEC often relied on the market to identify financial accounting and reporting issues that would then lead to an investigation.3 The Commission's Financial Reporting and Audit Task Force, formed in July 2013, signaled a more proactive approach to identifying and pursuing potential violations using “all available means,” including whistleblower tips, quantitative analysis, and close coordination between the SEC's examination and enforcement teams.4
Consistent with the heightened focus on identifying accounting-related fraud, the number of enforcement actions initiated by the Commission involving accounting issues increased in 2014. The SEC's enforcement efforts also have consequences for private securities litigation. This article discusses the SEC's spotlight on accounting fraud and the implications of this focus on the volume of private securities litigation filed and the settlement amounts of these cases.
The SEC created its Financial Reporting and Audit Task Force to focus on identifying cases for the Division of Enforcement to pursue. The Task Force was specifically charged with using available information to develop “state-of-the-art methodologies that better uncover accounting fraud.”5
One source of available information is the Commission's Office of the Whistleblower. According to Chair White, the whistleblower program has proven to be a “game changer” that has enhanced the efficiency and effectiveness of the SEC's enforcement initiatives.6 In fiscal year 2012, the program's first full year of operation, and in each subsequent fiscal year, the highest number of tips received was in the Corporate Disclosures and Financials category.7
|FY 2012||FY 2013||FY 2014|
|Corporate Disclosures and Financials||547||557||610|
|Percent of Total Tips Received||18%||17%||17%|
|Source: U.S. Securities and Exchange Commission, 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program (Nov. 17, 2014), at 20 and Appendix A, available athttp://www.sec.gov/about/offices/owb/annual-report-2014.pdf|
In addition, the Task Force's quantitative analysis has identified numerous companies for potential investigation.8 The Task Force is working closely with the Division of Economic and Risk Analysis (DERA) to use technology to identify fraud risk factors. For example, the Commission compiles and compares public company data from SEC filings with results of other companies in the same industry to identify performance trends and patterns that may be risk indicators for financial fraud in areas such as revenue recognition, asset valuation, and accounting estimates.9
It appears that the SEC's spotlight on accounting fraud has already had an effect. SEC enforcement actions involving financial fraud and issuer disclosures increased 40 percent in fiscal year 2014, including actions involving revenue recognition, auditor independence, and allegedly false and misleading financial disclosures.10
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Company announcements of an SEC inquiry or action can be associated with significant stock price declines,11 which in turn can trigger shareholders to file a class action. However, in previous years, the announcement of an SEC inquiry or action has not often set in motion a shareholder class action filing. Instead, public SEC actions12 have typically occurred after a shareholder class action was filed. For example, based on an analysis of 231 initial complaints in accounting securities class actions13 filed from 2010 through 2013, only 31 referred to an SEC action or inquiry (approximately 13 percent). In contrast, for a sample of accounting cases that reached settlement during this same period, approximately 27 percent (slightly more than double) had corresponding SEC actions.
The SEC's spotlight on accounting fraud may be starting to reverse this trend. As shown below, in 2014 the number and percentage of accounting securities class actions that referred to an SEC inquiry or action reached their highest level in five years. Overall, in 2014, the research shows a 47 percent increase in the number of accounting securities class actions filed.14 More than one in four of 2014 filings referred to an SEC inquiry or action. Thus, this increase appears to be due, at least in part, to the filing of cases involving SEC inquiries or actions.
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Accounting securities cases involving SEC actions have often been associated with financial statement restatements. For example, over the five-year period ending in 2014, nearly two-thirds of the accounting cases that involved accompanying SEC actions at the time of settlement also involved restatements. The Commission's more proactive approach to identifying accounting fraud may ultimately result in even more SEC inquiries or actions involving restatements that are accompanied by securities class actions.15
Separately, recent trends in restatement activity may also increase the number of cases that involve both a restatement and an SEC inquiry or action. The number of restatements reported by accelerated filers has increased four years in a row.16 Accelerated filers are relatively large firms (with a market value for common equity of $700 million or more).17 These firms may be targeted by the SEC18 and also by plaintiffs in securities class actions. Importantly, large stock price declines often trigger securities class actions. As shown below, recent research finds that the average stock price drop surrounding announcements of restatements in 2014 was the most severe in the last 10 years.19
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In recent years, both the SEC and securities class action plaintiffs have had a similar focus on internal controls.20 As observed by Mr. Ceresney, internal control problems have been prominent in recent enforcement actions, even when such actions did not involve fraud charges. Mr. Ceresney observed that this trend “reflects [the SEC's] view that adequate internal controls are the building blocks for accurate financial reporting and can prevent fraudulent activity.”21
On the securities class action front, the majority of accounting case filings in recent years have included allegations of internal control weaknesses. Since 2013, the number of accounting case filings involving these allegations has increased, reaching 60 percent of all accounting case filings in 2014.22
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The increase in accounting class action filings accompanied by SEC actions has important implications for settlements of these cases. Securities class actions with corresponding SEC actions are associated with significantly higher settlement amounts and higher settlements as a percentage of investor losses. Median settlement amounts for accounting securities class actions with an SEC action tend to be more than twice the amount for cases without a corresponding SEC action.
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In 2014, SEC enforcement activity related to financial fraud and disclosure issues increased, consistent with the SEC's stated renewed focus on identifying accounting fraud. Other trends such as an increase in financial statement restatements, as well as recent commentary by SEC representatives regarding the Commission's strong pipeline of cases,23 suggest that this increased enforcement activity is likely to continue.
SEC enforcement activity has significant consequences for private securities litigation. In fact, one question arising from the SEC's increasingly proactive approach to identifying accounting fraud is whether SEC actions will become a more significant driver of private securities litigation and potentially impact aggregate settlement values in these cases.
Elaine M. Harwood is a vice president in the Los Angeles office of Cornerstone Research and head of the firm's accounting practice. Dr. Harwood is a certified public accountant and is certified in financial forensics. She specializes in economic and financial consulting in complex litigation, regulatory proceedings, and corporate investigations. Many of the cases she has worked on involve financial accounting, financial reporting, and auditing issues.
Laura E. Simmons is a senior advisor in Cornerstone Research's Washington, DC office and a certified public accountant. Dr. Simmons focuses on damage and liability issues in securities and ERISA litigation, as well as on accounting and other issues arising in complex commercial litigation matters. She has more than 20 years of experience in accounting practice and economic and financial consulting and has served as a testifying expert on a variety of topics.
The views expressed in this article are solely those of the authors, who are responsible for the content, and do not necessarily represent the views of Cornerstone Research.
1 See Press Release, U.S. Securities and Exchange Commission, SEC Announces Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis, 2013-121 (July 2, 2013), available athttp://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975.
2 Andrew Ceresney, Co-Director, Division of Enforcement, U.S. Securities and Exchange Commission, Financial Reporting and Accounting Fraud, speech at the American Law Institute Continuing Legal Education Conference (Sept. 19, 2013), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370539845772.
3 Peter J. Henning, The S.E.C. Is 'Bringin’ Sexy Back’ to Accounting Investigations, N.Y. TIMES DEALBOOK, June 3, 2013, available athttp://dealbook.nytimes.com/2013/06/03/the-s-e-c-is-bringin-sexy-back-to-accounting-investigations/.
4 Mary Jo White, Chair, U.S. Securities and Exchange Commission, Deploying the Full Enforcement Arsenal, speech at the Council of Institutional Investors fall conference (Sept. 26, 2013), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370539841202.
5 Andrew Ceresney, Co-Director, Division of Enforcement, U.S. Securities and Exchange Commission, Financial Reporting and Accounting Fraud, speech at the American Law Institute Continuing Legal Education Conference (Sept. 19, 2013), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370539845772.
6 Mary Jo White, Chair, Securities and Exchange Commission, The SEC as the Whistleblower's Advocate, speech at the Ray Garrett Jr. Corporate and Securities Law Institute-Northwestern University School of Law; Chicago, Illinois (Apr. 30, 2015), available athttp://www.sec.gov/news/speech/chair-white-remarks-at-garrett-institute.html.
7 Excluding tips in the “Other” category. In the first quarter of 2015, the SEC saw an increase of more than 20 percent in the number of tips received as compared to the same quarter last year. The SEC has received “higher quality” tips as the program has grown. See Mary Jo White, Chair, U.S. Securities and Exchange Commission,The SEC as the Whistleblower's Advocate, speech at the Ray Garrett Jr. Corporate and Securities Law Institute-Northwestern University School of Law; Chicago, Illinois (Apr. 30, 2015), available at http://www.sec.gov/news/speech/chair-white-remarks-at-garrett-institute.html.
8 David Woodcock & Margaret McGuire, Presentation on Enforcement at the SEC Speaks in 2015 (Feb. 2015), available at https://www.pli.edu/Content/OnDemand/Economic_and_Risk_Analysis/_/N-4nZ1z129yu?ID=251823.
9 See Mary Jo White, Chair, U.S. Securities and Exchange Commission, Chairman's Address at SEC Speaks 2014 (Feb. 21, 2014), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370540822127, and Andrew Ceresney, Director, Division of Enforcement, U.S. Securities and Exchange Commission, Remarks to the American Bar Association's Business Law Section Fall Meeting (Nov. 21, 2014), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370543515297.
10 See Mary Jo White, Chair, U.S. Securities and Exchange Commission, Chairman’s Address at SEC Speaks 2015 (Feb. 20, 2015), available athttp://www.sec.gov/news/speech/2015-spch022015mjw.html.
11 See, e.g., Ehsan H. Feroz, Kyungjoo Park & Victor S. Pastena, The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases, 29 J. ACCT. RES. (1991).
12 Public SEC actions refer to SEC enforcement activity that has been publicly announced, as opposed to informal investigations that may not have been announced publicly by the company or the SEC.
13 Accounting securities class actions are securities class action cases that include allegations related to Generally Accepted Accounting Principles (GAAP) violations, auditing violations, or weaknesses in internal control over financial reporting.
14 See CORNERSTONE RESEARCH,ACCOUNTING CLASS ACTION FILINGS AND SETTLEMENTS--2014 REVIEW AND ANALYSIS (2015).
15 Academic research has found that the presence of a restatement doubles the likelihood of an SEC investigation resulting in a formal enforcement action. See Rebecca Files, SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter? 53 J. ACCT. ECON. (2012).
16 See AUDIT ANALYTICS,FINANCIAL RESTATEMENTS 2014--A FOURTEEN YEAR COMPARISON (April 2015).
17 U.S. Securities and Exchange Commission, 17 C.F.R. Parts 210, 229, 240 & 249.
18 See Rebecca Files, SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter? 53 J. ACCT. ECON. (2012).
19 Analysis is based on the percentage change in stock price net of overall market returns calculated over a two-day window including the announcement day and the following date, as identified by data provided by Audit Analytics. Price changes during this two-day window may include movements in response to events unrelated to the restatement announcement.
20 Questions about the adequacy of internal controls have also been raised in connection with the Task Force's review of revision restatements (i.e., restatements that do not involve material misstatements of the financial statements). Specifically, the Task Force identified multiple revision restatements by the same issuer as signifying a potential indication of internal control weaknesses. See David Woodcock, Presentation at the ALI/CLE Accountants' Liability Conference (Sept. 12, 2014).
21 Andrew Ceresney, Director, Division of Enforcement, U.S. Securities and Exchange Commission, FCPA, Disclosure, and Internal Controls Issues Arising in the Pharmaceutical Industry, remarks at CBI's Pharmaceutical Compliance Congress (Mar. 3, 2015), available athttp://www.sec.gov/news/speech/2015-spch030315ajc.html.
22 CORNERSTONE RESEARCH,ACCOUNTING CLASS ACTION FILINGS AND SETTLEMENTS--2014 REVIEW AND ANALYSIS (2015).
23 See, e.g., Andrew Ceresney, Director, Division of Enforcement, U.S. Securities and Exchange Commission,Remarks to the American Bar Association's Business Law Section Fall Meeting (Nov. 21, 2014), available athttp://www.sec.gov/News/Speech/Detail/Speech/1370543515297.
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