This fall and winter, the Securities and Exchange Commission (SEC) can be expected to begin substantially expanding the number of accounting fraud investigations.

The SEC announced on July 2, 2013 that it is creating a Financial Reporting and Audit Task Force “dedicated to detecting fraudulent or improper financial reporting.”1 “The principal goal of the [new] Task Force,” according to the SEC, “will be fraud detection and increased prosecution of violations involving false or misleading financial statements and disclosures . . . including on-going review of financial statement restatements and revisions, analysis of performance trends by industry, and use of technology-based tools such as the [newly developed] Accounting Quality Model.”2 New Co-Enforcement Director Andrew Ceresney has indicated that the Task Force will focus on common problem areas: revenue recognition, valuation, capitalized expenses, reserves, acquisition accounting and other performance benchmarks.3

BACKGROUND

Previously, in May 2000, the SEC created a Financial Fraud Task Force to oversee and coordinate investigations of possible financial frauds and improper reporting in SEC filings. The prior year, the SEC had brought 94 financial fraud and disclosure cases; by 2007 the numbers increased to 219. The cases included some of the largest securities enforcement cases ever brought, including Enron, WorldCom and HealthSouth. In August 2009, a then new Enforcement Director, Robert Khuzami, prioritized enforcement efforts by creating five specialized units, but none of those units focused on financial fraud.4 Shortly thereafter in 2010, the Financial Fraud Task Force was abolished.

By 2013, while the Enforcement Division claimed to be instituting a record number of new cases, the number of financial fraud and improper reporting cases had again fallen to the 1999 level of 94. From 2003 to 2005, accounting fraud cases represented 25% of the SEC’s enforcement docket. By 2013, they represented only 11%. That sharp decline prompted questions and criticism from the press and others.5

The new SEC Chairman and former U.S. Attorney for the Southern District of New York, Mary Jo White, in June 2013, opined, “You’ll see more targeted resources in that [accounting fraud] area going forward.”6

STRUCTURE AND MISSION

The new Financial Reporting and Audit Task Force is dedicated to a “proactive approach to identifying fraud. By directing resources, skill and experience to high-impact areas, [the SEC expects] to increase the potential for uncovering financial statement … fraud early and [to] bring more cases aimed at deterring these types of unlawful activity.”7 Co- Enforcement Director Andrew Ceresney is troubled by the spike in companies making minor revisions to financial statements, which now account for about 65% of all restatements.8 The Task Force may use the new “Accounting Quality Model,” which analyzes “management’s discussion and analysis” section of financial statements for signs of earnings manipulation and trawl financial statements for outlining numbers that may warrant further review.9 Other risk factors, according to Co-Enforcement Director George Canellos at a recent Federal Bar Association program, include a change in auditors twice within five years; a write-down in good will; or results that consistently remain within a certain percentage of earnings estimates.

The Task Force, which will include both accountants and lawyers, expects to develop sufficient expertise to identify red flags and find cases that might not be obvious to those with less experience. Moreover, the Task Force will evaluate the many whistleblower accounting complaints received pursuant to the Dodd-Frank bounty provisions, which pay 10% to 30% of any collection exceeding $1 million. Thus far, about 18% of whistleblower complaints have concerned financial fraud and disclosure issues. As was the case with the specialized units, the best and most aggressive staff are likely to end up in the Task Force. They will feel pressure to produce more investigations and bigger cases.

REDEPLOYMENT OF ACCOUNTANTS AND TRIAL ATTORNEYS

Until now the enforcement accountants and trial attorneys have worked solely under the Chief Enforcement Accountant and Chief Litigation Counsel, respectively. This has allowed the accountants and trial counsel the independence necessary to candidly assess the merits of each proposed case. Now, there is under serious consideration the additional affiliation of these accountants and trial attorneys with specific Associate Enforcement Directors. It appears, for example, that the trial attorney evaluations, while initiated as now by the Chief Litigation Counsel, will now require not just the input of, but the concurrence of, the affiliated Associate Director, subject to a possible appeal to the Co-Directors of Enforcement.

The threat to companies is the loss of independence of the trial attorneys and accountants to just say no to ill-conceived prosecutions that an Associate Director champions after putting considerable resources into investigating. Will the trial attorneys and accountants tell the boss when her accounting is wrong? That the evidence is too skimpy? That the legal theory is weak? Will the Associate Directors listen?

GOING FORWARD

These changes promise that the SEC will subject financial statements of public companies to heightened scrutiny and more aggressive enforcement.