On July 2, 2013, the Securities and Exchange Commission (SEC) announced three new enforcement initiatives: the Financial Reporting and Audit Task Force, the Microcap Fraud Task Force, and the Center for Risk and Quantitative Analytics.1 According to the SEC’s announcement, these initiatives are an effort to “build on its Division of Enforcement’s ongoing efforts to concentrate resources on high-risk areas of the market and bring cutting-edge technology and analytical capacity to bear in its investigations.”
These new initiatives, along with recent press reports that the Enforcement Division would no longer settle certain cases without obtaining admissions of wrongdoing (for example, where misconduct harmed a large number of investors), are among the first steps taken by the SEC under the leadership of new Chairman Mary Jo White, who has pledged “to further strengthen the enforcement function of the SEC” in a way that is “bold and unrelenting.”2
Financial Reporting and Audit Task Force
It has been reported in the press that the financial crisis that emerged in 2008, along with the widely publicized Ponzi schemes that came to light around the same time, shifted the SEC’s primary focus away from financial reporting fraud such as the high-profile investigations of WorldCom, Adelphia, and Enron that had taken place in the early 2000s.3 Notably, at the beginning of the Obama Administration, the Enforcement Division established five specialized units focusing on particular enforcement priorities but none with a particular emphasis on accounting fraud and financial reporting issues.4 Now, as financial crisis and other fraud litigation wanes, the SEC is establishing a task force specifically focused on financial reporting and auditing.
The Financial Reporting and Audit Task Force will concentrate on the preparation of financial statements, issuer reporting and disclosure, and audit failures with the goal of detecting fraud and increasing the prosecution of violations involving false or misleading financial statements and disclosures. The Task Force will identify issues for potential investigation by reviewing restatements, looking at industry trends, and using technology-based tools such as the SEC’s proprietary Accounting Quality Model (AQM). The AQM is a model that compares registrants’ filings and seeks to identify filings that are anomalous, with a particular aim at identifying instances of earnings management.5 The SEC has employed a similar tool, the Aberrational Performance Inquiry (API), in overseeing hedge funds.6
Although the Financial Reporting and Audit Task Force formalizes the SEC’s renewed focus in this area, there already has been an increase in SEC administrative proceedings against auditors in recent months, primarily under SEC Rule of Practice 102(e).7 While many of these cases arose from audits of companies that were impacted by the financial crisis, it is likely that the Task Force will continue to make use of Rule 102(e) proceedings in enforcement actions against accounting firms and auditors.
The Financial Reporting and Audit Task Force will be led by David Woodcock, Director of the Fort Worth Regional Office. The Task Force will include Enforcement Division attorneys and accountants from across the country who will work with the 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.
Microcap Fraud Task Force
The Microcap Fraud Task Force builds on the Microcap Fraud Working Group, which was created in 2010, and will investigate fraud in the issuance, marketing, and trading of “microcap” securities – low-priced stocks issued by small companies with sometimes limited financial reporting. According to the SEC, these stocks pose a high risk for fraud because there is limited reliable public information about the companies, they often are traded on over-the-counter markets with no minimum listing standards, and the issuers are often inherently risky companies with few assets, little or no operations, and low trading volume.8 In addition, according to the SEC, fraudulent activity in the microcap market often includes “serial violators and organized syndicates” that use social media to promote their fraudulent schemes to less sophisticated investors.
The Microcap Fraud Task Force will develop and implement long-term strategies for detecting and combating fraud in the microcap market and will focus on market gatekeepers such as attorneys, auditors, broker-dealers, transfer agents, stock promoters, and purveyors of shell companies. It will be led by Elisha Frank, Assistant Regional Director of the Miami Regional Office, and Michael Paley, Assistant Regional Director in the New York Regional Office.
Center for Risk and Quantitative Analytics
The third enforcement initiative is the Center for Risk and Quantitative Analytics (CRQA). The principal role for the CRQA will be identifying and assessing risks and threats that could harm investors, as well as assisting the SEC Staff in conducting risk-based investigations.
The CRQA will work closely with other SEC offices and divisions with the goal of providing guidance to the Enforcement Division’s leadership on how to allocate resources strategically in light of the risks it is able to identify. The CRQA will be led by Lori Walsh, former Deputy Chief of the SEC’s Office of Market Intelligence.
Expanded Admissions of Wrongdoing in Settling Cases
In addition to the newly announced enforcement initiatives, Chairman White announced on June 18, 2013 that the SEC will modify its longstanding policy of allowing certain defendants to settle charges without admitting or denying allegations of wrongdoing in a civil injunctive complaint or administrative order.
The SEC had long allowed defendants to settle using “neither admit nor deny” language even where they had made admissions of wrongdoing in parallel criminal or civil proceedings.9 That policy, however, has received substantial criticism in recent years. Most notably, Judge Jed Rakoff of the Southern District of New York has questioned settlements where defendants neither admit nor deny the underlying allegations and rejected a significant settlement with Citigroup arising out of the financial crisis.10 While the Citigroup decision is currently on appeal and it is far from clear whether Judge Rakoff will be affirmed, these criticisms have been echoed by at least five other federal judges.11
Since the Citigroup decision in 2011, the SEC has revisited its policy. On January 6, 2012, Robert Khuzami, the Director of the Enforcement Division at the time, announced that SEC settlements would no longer include “neither admit nor deny” language where defendants have been subject to parallel criminal convictions or have signed Non-Prosecution Agreements (NPAs) or Deferred Prosecution Agreements (DPAs) that contain admissions or acknowledgments of criminal conduct. As we noted in a prior advisory, although the SEC’s changed policy represented an additional consideration a party must take into account when entering into a settlement, the practical impact of the policy change was likely to be modest.12
The latest changes contemplated by the Enforcement Division would go further and apply to settlements regardless of whether there are parallel criminal convictions or NPAs or DPAs with admissions or acknowledgments of criminal conduct. According to press reports, a June 17, 2013 internal email was sent to the SEC Staff stating that the Enforcement Division is considering requiring admissions of wrongdoing in cases where those admissions are in the “public interest,” including (i) where there was “misconduct that harmed large numbers of investors or placed investors or the market at risk of potentially serious harm,” (ii) “where admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct,” or (iii) “when the defendant engaged in unlawful obstruction of the commission’s investigative processes.”13
While the precise contours of these reported changes need to be finalized and their practical impact remains to be seen, they will represent an additional factor that settling parties will need to consider. Notably, the Enforcement Division has emphasized that it will continue to use the “neither admit nor deny” settlement model, which Chairman White indicated will remain a “major, major tool in the arsenal.” Accordingly, it remains uncertain how often, and under what circumstances, the SEC will seek admissions of wrongdoing from settling defendants.