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Avoid Financial Restatements To Prevent Significant Legal Troubles

Merrill Disclosure Solutions | July 01, 2015

7.1.15 Featured

Abstracted from: Where Nouns And Verbs Meet Ciphers And Digits: Financial Restatements

By: Ralph Ferrara and Alexandra Skellet

Proskauer Rose, Washington DC (RF) and New York NY (AS)

Insights: Corporate & Securities Law Advisor, Vol. 29, No. 2, Pgs. 2-10

Securities lawyers must know their digits. Not just an accounting problem, a financial restatement is also a legal challenge and a corporate distraction (at best) or devastation (at worst). Attorneys Ralph Ferrara and Alexandra Skellet feel that securities lawyers, to be effective, must understand the basics of financial reporting for public companies and the pertinent accounting standards. Violations of those standards might provoke restatement of a prior period's financials, resulting in class actions, derivative suits, SEC scrutiny, and corporate liability. According to a 2014 report by researchers at Audit Analytics, the number of restatements made by US public companies dropped between 2006 and 2013, but restatements by companies with a market capitalization above $75 million have been steadily rising: from 157 in 2010 to 290 in 2013. The report differentiated a "revision" from a "reissuance" restatement. Only the second type, which includes reissuance of audit opinions, follows disclosure in Item 4.02 of Form 8-K that previously issued annual financials are no longer reliable. While the researchers found that the first type has caused the rise in large companies' restatements, the authors focus on the second type.

Look under “C” in the ASC index. Another important distinction appears in Topic 250 of the Accounting Standards Codification from the Financial Accounting Standards Board: accounting change vs. error correction. An accounting change could be a change in an accounting principle, in an accounting estimate (based on newly available facts), or in the company. An error correction addresses a mistake in calculation, a mistake in applying GAAP, or a failure to notice or properly use facts available when a financial statement was prepared. The ASC requires a restatement only for an error correction and, as Topics 250 and 105 jointly suggest, only when that error is material. The authors indicate a third differentiation, crucial in litigation and recognized by accounting scholars: the accounting error is an unintentional misstatement or omission in the financials, while an accounting irregularity is intentional, so only the latter involves fraud.

Class actions usually get a thumbs-down. It is regrettably common, the authors suggest, for securities-fraud class actions under Section 10(b) of the 1934 Act to follow when a company files a restatement. Nearly all are dismissed or settled. Defendant companies prefer dismissal over the drawn-out, expensive discovery process that leads to a possibly costly settlement. The six components of a fraud claim are a material misrepresentation or omission of facts; the existence of scienter, (i.e., intentional or reckless disregard for the truth); a link between the misrepresentation or omission and the buying or selling of securities; reliance by plaintiffs on the misrepresentation or omission; their financial loss; and loss causation. Plaintiffs must tailor their allegations to each component. For example, plaintiffs' attorneys argue that a restatement to correct an error or irregularity prevents the company from asserting it did not make a material misstatement or omission, that a restatement after an irregularity shows scienter, and that the fraud-on-the-market doctrine allows reliance to be presumed.

The SEC fingers the restater, then claws back compensation. The SEC generally responds to restatements, especially after it changed direction with its July 2013 announcement of the Financial Reporting and Audit Task Force and other new enforcement programs to fight fraud in financial reports. It had cut back on such prosecutions for several years while going after the abuses that triggered the 2008 financial disaster, but in 2014 it greatly increased enforcement actions for financial fraud and faulty disclosure. Restatements might also impel the SEC to bring an action under Sarbanes-Oxley Section 304 to claw back compensation and stock gains from a restating company's CEO and CFO. At least one court has ruled that Section 304 applies regardless of who within the company perpetrated a fraud. Under Section 954 of the Dodd-Frank Act, the SEC must order national securities exchanges to ban securities listings by companies that do not adopt a clawback policy (although the Commission has not yet issued the governing rules, the authors note).

Abstracted from Insights: Corporate & Securities Law Advisor, published by Wolters Kluwer Law & Business, 4025 W. Peterson Avenue, Chicago IL 60646. To subscribe, call (800) 638-8437.

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