In his January 25 keynote address, SEC Enforcement Director Andrew Ceresney told attendees at the 2016 Directors Forum in San Diego that, since 2013, the agency has significantly increased the quality and number of its financial reporting cases. Moreover, the emphasis on financial reporting will continue because “significant violations still occur, accounting frauds are still perpetrated, and gatekeepers still fail to comply with their legal and professional obligations.” Therefore, he warned, “audit committee members who fail to reasonably carry out their responsibilities, and auditors who unreasonably fail to comply with relevant auditing standards in their audit work, can expect to be in our focus.”
Mr. Ceresney stated that, with respect to financial reporting enforcement generally, “the Commission has more than doubled its actions in the issuer reporting and disclosure area – from 53 in fiscal year 2013 to 114 in fiscal year 2015.” In most of these actions, individuals, often senior executives have been charged, along with the reporting company. “During the past two fiscal years, excluding follow-ons, the Commission has charged over 175 individuals in issuer reporting and disclosure matters.”
Mr. Ceresney listed five specific aspects of financial reporting that have triggered SEC enforcement:
- Revenue Recognition. “Improper revenue recognition continues to be an area in which [we] see manipulation and wrongdoing, largely because revenues are such a critical measure of performance.”
- Valuation and Impairment Issues. “In the last several years, valuation and impairment issues also have been a prominent theme in many of the Commission’s financial reporting enforcement actions, in some cases relating to actions arising during the financial crisis which produced unusual impacts on assets. * * * Particularly in times of economic turmoil, when valuation adjustments and management discretion may be the last avenues for improperly enhancing performance, we look closely at these issues.”
- Earnings Management. “Managing earnings and other financial targets was obviously a hallmark of some of the major accounting cases in the early 2000s. And this is an area where the Commission has continued to see issues.”
- Missing or Insufficient Disclosures. “[M]issing or insufficient material disclosures hinder investors’ ability to make informed investment decisions. These deficient disclosures have ranged from executive perks to related party disclosures.”
- Internal Accounting Controls. “In addition to financial statement and disclosure issues, we have also been focused on deficient internal accounting controls, which are foundational to reliable financial reporting. On a number of occasions, we have brought charges for violations of the internal accounting controls provisions of the federal securities laws, even in the absence of fraud charges. Deficient internal accounting controls can lay the groundwork or create opportunity for future misstatement or misconduct that goes undetected.”
He also noted that the Commission has “aggressively” used its authority under the Sarbanes-Oxley Act to “claw back” compensation from executives of companies that have engaged in financial reporting violations that resulted in restatements.
Mr. Ceresney emphasized, as has SEC Chair Mary Jo White (see July 2014 Update), that audit committee members, along with external auditors, are gatekeepers whose role is “critical to helping ensure that issuers make timely, comprehensive, and accurate disclosure” and who have “a responsibility to foster high-quality, reliable financial reporting.” However, as to audit committee members in particular, Mr. Ceresney suggested that their inclusion in financial reporting enforcement actions was the exception, not the rule:
“We have not frequently brought cases against audit committee members. That is because in my experience, audit committee members in most cases carry out their duties with appropriate rigor. But in the last couple of years, we have brought three cases against audit committee chairs that provide helpful guidance on the type of failures that will attract our attention. In each case, the audit committee member approved public filings that they knew, were reckless in not knowing, or should have known were false because of other information available to them.”
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“The takeaway from these cases is straightforward: when an audit committee member learns of information suggesting that company filings are materially inaccurate, it is critical that he or she take concrete steps to learn all relevant facts and cease annual and quarterly filings until he or she is satisfied with the accuracy of future filings.”
The three audit committee member cases to which Mr. Ceresney referred are –
- AgFeed Industries (see April 2014 Update) (audit committee chair allegedly learned facts suggesting that sales were inflated and was advised by a former director that there was “not just smoke but fire” and that an internal investigation was warranted; the audit committee chair allegedly ignored these warnings and signed off on the filing of the financial statements).
- L&L Energy (see April 2014 Update) (in a settled case, former audit committee chair was found to have signed an annual report that she knew or should have known contained a certification purportedly signed by the company’s acting CFO when, in fact, the person identified as acting CFO had declined to serve in that position).
- MusclePharm (see September 2015 SEC order) (in a settled case, former audit committee chair was found to have signed several SEC filings that did not disclose the full extent of executive perquisite compensation; although audit committee chair learned of the nondisclosure of the perks, according to the order, he substituted his interpretation of the disclosure requirements for the views of the company’s compensation consultant, resulting in additional filings with incomplete perks disclosure).
Comment: Director Ceresney’s comments make clear that the SEC’s focus on financial reporting and its “Operation Broken Gate” (see October 2013 Update), under which auditors and directors may be held responsible for financial reporting failures, will continue in full swing, at least through the end of SEC Chair White’s term. Audit committee members can take some comfort from his assertions that enforcement cases alleging that directors bear responsibility for these violations are rare and will only be initiated when the director knew or should have known that the company was filing inaccurate information with the SEC. However, while the cases that have been brought during the last several years seem fairly clear-cut, it is easy to imagine situations in which it may be more debatable whether audit committee members “should have known” of the company’s reporting violation.