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By Nicolas Morgan and Jean Chow-Callam
Nicolas Morgan is a partner in the Investigations and White Collar Defense practice at Paul Hastings and based in the firm’s Los Angeles office. He focuses his practice on complex securities litigation in state and federal courts and representations involving government investigations and white-collar crime allegations levied against individuals and businesses. In the course of his practice, he routinely represents securities issuers, company officers and directors, investment funds, analysts, and brokers in connection with SEC and Financial Industry Regulatory Authority (FINRA) investigations, litigation, and arbitration. Mr. Morgan also counsels public companies, funds, and broker-dealers on securities compliance and corporate governance; conducts internal investigations; and assists in regulatory examinations initiated by the SEC’s Division of Corporate Finance and Office of Compliance Inspections and Examinations.
Jean Chow-Callam is a Senior Managing Director in the Forensic Accounting & Advisory Services practice of FTI Consulting. She is a CPA, CFE and CFF with more than 25 years of experience in forensic accounting, FCPA, compliance, governance, auditing, fraud investigations, internal controls and other financial statement related matters. Ms. Chow-Callam specializes in corporate internal investigations, securities litigation and other white-collar crime investigations resulting from U.S. GAAP and SEC reporting violations, working on behalf of companies, for counsel to companies, boards, audit committees, special committees, and for U.S. DOJ appointed monitors. She is fluent in Chinese and has conducted engagements in the United States, Europe, Latin America and Asia, as well as advising clients on cross-border issues.
More than three years ago, the Securities and Exchange Commission (SEC) announced the formation of the Financial Reporting and Audit Task Force—a group within the SEC Enforcement Division designated to identify fraudulent or improper financial reporting, using “cutting-edge technology and analytical capacity.” Fast forward to the start of 2016, when the SEC’s Director of Enforcement highlighted the importance of policing financial reporting issues with newer data-driven tools. This included the Corporate Issuer Risk Assessment program, which was designed to detect “anomalous patterns in financial statements that may warrant additional inquiry.”
Coupling the SEC’s new tools with its increasing bounties to whistle-blowers—totaling more than $100 million in 2016 alone—it should come as no surprise that SEC actions against public company related defendants hit an all-time high of 92 actions in fiscal year 2016, up from 84 actions in 2015 and prior years averaging between 40 and 50 cases annually. Closer examination of some of these cases reveals an SEC enforcement program focused on bread-and-butter issues, such as earnings management and disclosure failures. It also suggests some surprising areas that public company in-house counsel and finance teams should watch for in 2017 and beyond.
Broadly, the SEC’s trend toward stricter and more active enforcement, and the types of cases they brought forth in 2016, underscore the strategic importance of ensuring strong teams across legal and accounting. It is paramount that in-house attorneys and accountants, and their third-party advisers, understand how to deal with regulators and manage internal processes to simultaneously avoid and prepare for investigations.
In 2016, the SEC found a wide variety of shortcomings in the way public companies portrayed themselves, their operations and their financial results. These various cases can be categorized in three buckets: 1) earnings management, which may broadly include valuation/impairment issues and revenue recognition issues; 2) internal control issues; and 3) disclosure issues. Below, we outline some of the most noteworthy cases from 2016 in each of these areas, and discuss steps for mitigating risks from similar missteps going forward. Any of these types of financial reporting issues can result from unintentional conduct, or intentional fraudulent actions.
When financial reporting issues arise, determining whether they resulted from unintentional accounting management mistakes or intentional actions—fraud—is critical. The SEC reserves its harshest penalties for cases involving active concealment or intentional misrepresentation. For example, a technology company paid a $7.5 million penalty in connection with its CFO and Controller allegedly deliberately minimizing the write-down of millions of dollars of excess component parts for a product that the company had excess inventory of. An electronics company had its Executive Vice President of Operations barred from acting as an officer or director and its Controller permanently suspended from appearing and practicing as an accountant before the SEC for their roles in orchestrating a false inventory accounting scheme, allegedly making false entries in work-in-process spreadsheets to meet budgeted gross profit margins. Yet another company paid $1.75 million when its COO concealed from company finance personnel and auditors various sales concessions offered to customers, leading the company to improperly recognize revenue on sales. The U.S. Attorney’s Office brought criminal charges against the COO.
Private fraud prevention organizations such as the Treadway Commission as well as the SEC and DOJ agree that internal controls should be accompanied by mechanisms to detect violations of those controls as well as processes for reporting, investigating and correcting those violations. In addition to reducing the risk of liability from private lawsuits, the SEC offers the possibility of more lenient treatment for those companies that self-detect, investigate and remedy securities law violations. In the case of rogue employees acting fraudulently, both the SEC and the DOJ expect a company that wants lenient treatment to fully investigate and disclose the employee’s conduct and take appropriate disciplinary action.
While the promise of leniency is a strong motivator for self-reporting and fully cooperating in regulatory investigations, it is important for companies to treat the decision about self-reporting with caution. The overall approach to managing SEC concerns should be proactive and strategic, and self-reporting is no exception. This decision should be handled on a case-by-case basis and be made with the input from outside counsel and trusted advisers. Generally, companies should always be prepared to self-report, whether that is the ultimate route taken.
The implementation of robust internal controls with sufficient resources supporting them is an obvious foundation for preventing errors. However, as illustrated by the cases involving calculation or measurement errors, misapplication of accounting principles and rogue employees deliberately thwarting internal controls, even the best CFO won’t be able guarantee the elimination of all issues.
Company leadership should work diligently to ensure that the financial reporting team has integrity, strong accounting skills and a professional—not cozy—relationship with auditors. Further, to reduce future risk, repeatable processes and procedures and periodic monitoring should be put in place to remediate “red flag” issues, whether resulting from intentional or unintentional activities. The internal team must understand the unique risks its business faces, as well as how and when to bring in reliable outside advisers that may be needed to help navigate new issues and investigations.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.
Copyright © 2017 Tax Management Inc. All Rights Reserved.
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