The SEC continues to bring cases that illustrate its renewed commitment to financial reporting enforcement, including actions that charge erroneous accounting and inadequate internal controls, but are not alleged to involve fraud. The most recent example is the SEC’s December 5, 2014 order charging Hampton Roads Bankshares, a bank holding company, with violations of the books-and-records, internal control, and periodic reporting requirements of the Securities Exchange Act of 1934. The SEC also issued a separate order charging the bank holding company’s former CFO with being a cause of these violations. The gravamen of these cases is that the company relied on erroneous projections concerning the likelihood of future profitability in determining the value of a deferred tax asset (DTA) carried on the company’s books. Both the company and the former CFO consented, without admitting or denying the SEC allegations, to orders requiring them to cease and desist from further violations of accounting and periodic reporting requirements. The company also agreed to pay a civil money penalty of $200,000.
A DTA represents the right to offset a future tax obligation (e.g., prior losses can be used to reduce or eliminate taxes on future income). A DTA may only be carried on the balance sheet if it is more likely than not that it will be realized in a future period – that is, that the company will generate taxable income which the DTA can be used to offset. Hampton Roads recorded a DTA based on losses during 2009 and the first quarter of 2010. In connection with the preparation of the 2009 financial statements, the former CFO’s office prepared a memorandum forecasting that the company would work through existing non- performing loans and would earn $33.6 million annually. Accordingly, the company concluded that it was more likely than not that the DTA would be realizable and that no allowance was needed to reduce the DTA valuation.
The SEC’s order states that these conclusions “were not reasonable.” The SEC points to the fact that projections underlying the CFO’s analysis assumed that the company’s loan loss reserve would drop from over $33 million in the 2009 third quarter to $2.35 million by the end of 2010. However, internal company reports reflected that, as of November 2009, the company’s total delinquent and non-accruing loans had actually increased during each of the first three quarters of 2009 and that non- performing assets rose an additional 11 percent from September to October 2009.
In August 2010, the company amended its 2009 Form 10-K and 2010 first quarter Form 10-Q to restate the financial statements by reflecting a valuation allowance against the DTA. As a result, the company stated that it was “undercapitalized” as of December 31, 2009, as opposed to “adequately capitalized,” as originally reported, and “significantly undercapitalized” at the end of the 2010 first quarter, rather than merely “undercapitalized.”
Comment: As noted above, this case, like several others described in recent Updates, illustrates the SEC’s enforcement focus on financial reporting and internal controls, including situations that are not alleged to involve fraud or intentional misstatements. The separate action against the CFO also demonstrates the emphasis the enforcement program is placing on identifying and charging the individuals that the SEC staff views as responsible for corporate accounting violations.