SEC enforcement cases to increase in 2014: 4 things public companies need to know

Securities Enforcement Alert

A casual observer of SEC trends could be forgiven for concluding that the SEC has lost interest in pursuing enforcement actions involving public company financial reporting violations. 

But the casual observer would be mistaken.  This year, the SEC is intent on bringing record numbers of financial reporting cases and has some new tools and resources to enable it to do so.


In 2013, the SEC brought fewer enforcement actions involving financial fraud and issuer disclosure than at any time in the previous decade:  68.  Even when we add in Foreign Corrupt Practices Act cases, the number was still a record low 73, fewer than the 94 cases brought the previous year, and far fewer than the high-water mark of 219 financial fraud cases the agency brought in 2007.  But recent developments suggest that the downward trend will turn, perhaps dramatically, in 2014.


1.  Whistleblower bounties and tips are on the rise


The first development to note is that the Dodd-Frank whistleblower bounty program is gaining steam.  Under this program, informants who provide the SEC with original information may ultimately receive a percentage of any monetary recoveries obtained by the SEC as a result of an enforcement action.  For the first two full years of its operation, 2012 and 2013, the single biggest category of tips received by the SEC involved corporate disclosures and financials: 547 and 557 tips for each year, respectively.  On October 1, the SEC awarded its largest bounty to date:  US$14 million, which may drive the number of tips still higher in 2014.  As these tips work their way through the SEC, more enforcement actions in this area will result.


2.  SEC is now deploying new financial reporting tools and tactics


In July, the SEC’s Enforcement Division announced the formation of the Financial Reporting and Audit Task Force, a group of Enforcement Attorneys and Accountants from across the country, who will be tasked with identifying financial statement, issuer reporting and disclosure violations.  The Task Force will work with the Enforcement Division's Office of the Chief Accountant, the SEC's Office of the Chief Accountant, the Division of Corporation Finance and the Division of Economic and Risk Analysis.


One weapon in the Task Force arsenal is the much-discussed Accounting Quality Model (AQM), colloquially known as RoboCop.  The SEC describes AQM as a quantitative analytic “model that allows us to discern whether a registrant’s financial statements stick out from the pack.”


Using AQM, the SEC attempts to detect earnings management by looking at discretionary accounting choices such as by examining total accruals and then estimating discretionary accruals.  The AQM then classifies the estimated discretionary accruals as risk indicators (factors that are directly associated with earnings management) or risk inducers (strong incentives for earnings management).  AQM produces a score for each filing and compares it with the filer’s industry peer group, assessing the likelihood that fraud is occurring.  In a recent speech, a Task Force official described certain flags that might result in closer scrutiny, such as a company that writes off a large amount of debt in a short period, which could suggest that the company is placing the debt into an accrual “bank” to smooth its income numbers.  The SEC is developing similar tools to analyze text portions of annual reports and other filings for potentially misleading disclosures.


3.  The latest enforcement actions are bearing fruit for the SEC


In December 10 comments, another Task Force official touted recent enforcement actions as evidence that the SEC’s heightened efforts in this area are beginning to bear fruit.


In one action, the SEC settled with a Bellevue, Washington-based Fortune 200 commercial truck manufacturer in a case where the agency alleged various accounting deficiencies that “clouded” the company’s financial reports, dating back to 2008.  The SEC alleged three issues: (1) failure to report the operating results of its parts business as a reportable segment; (2) failure to maintain accurate books and records regarding the company’s impaired loans and leases; and (3) overstatements in equal and offsetting amounts to loan and lease originations and collections for two foreign subsidiaries in its statement of cash flows for two quarters in 2009.  The company paid US$225,000 to settle the case, without admitting or denying the charges. 


Under US accounting rules, companies are required to report results from segments in the way that management views them; thus, segment reporting allows investors to get the same perspective of a company’s business as its executives.  This case exemplifies the SEC’s focus on this area.  Segment reporting was the third most common area discussed in SEC comment letters in the first three quarters of this year, following tax and goodwill accounting issues, according to one third-party firm’s analysis.  In its regular review process, the SEC addressed segment reporting issues in some 435 letters to 184 companies this year through September 30, according to this analysis, and a nationwide book retailer recently disclosed that the SEC is investigating how the bookseller split expenses among its devices and e-book segments.


4.  Great expectations create risk of SEC overreach


With the amount of new resources and tools the SEC is openly devoting to detecting financial reporting violations, the SEC has created an expectation that it will bring a greater number of enforcement actions in this area.  Such heightened expectations may create an incentive for the Enforcement Division to bring marginal cases not well supported by the facts or law


Compounding that troubling incentive, in June, SEC Chair Mary Jo White announced that in certain cases, the SEC would not settle unless the defendants admitted wrongdoing.  As a result, more companies, officers and directors, will test the SEC’s allegations and legal positions by litigating and going to trial.


Two recent trial losses by the SEC suggest a troubling willingness of the SEC to allege financial fraud in cases where the facts or the law don’t support the allegations.


In December 2013, the SEC suffered a jury trial defeat in SEC v. Kovzan, a civil fraud action against the chief financial officer of a Kansas-based website management company alleging that the CFO failed to disclose US$1.8 million in perquisites to its former CEO.  The SEC charged that the CFO knew or was reckless in not knowing that more than US$1.8 million in perquisites were not disclosed accurately.  The Kansas jury not only acquitted the CFO on all 12 charges, but found in his favor on every question on the jury verdict form.


The defeat in Kovzan was followed by another adverse ruling in December in SEC v. Jensen.  In that case, the SEC charged two former executives of a water purifying company with accounting fraud for improperly recognizing revenue for six transactions purportedly to disguise the company’s financial performance.  Because there were no documents or witnesses to support the allegation that these transactions were a sham, the judge found that the SEC failed to demonstrate fraud.  Further, the judge found that there was no direct evidence of scienter or recklessness.  The SEC’s case was premised on allegations of improper accounting – however, the only evidence of such improprieties was unconvincing witness testimony, according to the court.


Takeaway for 2014: a time to be wary


The downward trend in SEC enforcement actions alleging public company financial reporting violations will reverse in 2014.  As part of that reversal, the SEC will be making more inquiries, analyzing more periodic reports and financial statements and, ultimately, filing more lawsuits. 


Because the SEC is likely to take an aggressive posture in bringing and litigating cases, 2014 will see more trials involving financial reporting issues.  If recent experience is any guide, the SEC will not be successful in all of those trials, meaning that some defendants will be put to the expense, reputational damage and emotional turmoil necessary to defend against accusations not supported by the law or facts.


For more information about the SEC’s pursuit of financial reporting cases, please contact:


Nicolas Morgan

Jennifer Feldman



Courts confirm: Dodd-Frank whistleblowers must report to the SEC, Dodd-Frank whistleblower protections do not extend to conduct outside the US

SEC continues to focus on “fair value” practices of investment advisers