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SEC Pursuing Fraud in Financial Reports With New Aggressive Tactics

Merrill Disclosure Solutions | January 07, 2014


Abstracted from: Public Companies: Back In The SEC Hot Seat?
By: Marc Fagel and Leslie Wulff, Gibson Dunn & Crutcher, San Fran, CA
Wall Street Lawyer Vol. 17, No. 9, Pgs. 1, 4-8

Financial fraud in the crosshairs again. Reversing a trend, the SEC has recently publicized new programs for identifying fraud in public companies' financial reports. Enforcement cases alleging financial fraud had historically comprised 25% or more of the SEC's cases annually, peaking at 33% in 2007. Yet for several reasons, explain attorneys Marc Fagel and Leslie Wulff, the figure has steadily dropped since then, reaching less than 11% in 2012. The Sarbanes-Oxley Act of 2002 - passed in response to accounting scandals at Enron, WorldCom, and other companies - enhanced corporate governance and curtailed dishonest accounting, while scrutiny of those scandals by the public, the SEC, and the Justice Department encouraged auditors and directors to monitor financial reporting more strictly. The financial crisis removed much of the inducement to falsify revenue-growth reports and discouraged IPOs (which report financial results before developing proper internal controls). Lastly, the SEC redirected its investigatory resources away from fraudsters and toward financial institutions,
investment advisors, and investment companies.

Despite taking aim, it might find few targets. Change is afoot, the authors indicate. The SEC's new leadership is using more aggressive enforcement tactics. In a breach of tradition, those named in enforcement actions might not be allowed to settle without confessing to misconduct. The SEC's recently established Financial Reporting and Audit Task Force will detect - and boost prosecutions for - deceitful or misleading financials and disclosures. The new Center for Risk and Quantitative Analytics and the already operating Division of Economic and Risk Analysis will help by providing software to examine suspect wording in annual reports' MD&A sections and an analytical tool, the Accounting Quality Model, to scour financial statements for statistical abnormalities. These efforts might fail, however. Very few important cases have ever sprung from industry-wide searches that relied on quantitative analyses. Furthermore, no evidence exists of vast, undetected financial fraud. In fact, the steady drop in financial-fraud cases strongly suggests great improvements in internal controls and reporting. Still, the SEC staff increasingly makes companies perform onerous self-examinations and pass on the results.

Stay out of its sights. Given the SEC's aggressive stance, the authors advise executives, directors, and lawyers for public companies to take steps now to head off investigations. First, and most obviously, avoid accounting irregularities. Make your internal controls efficient, and enforce corporate-governance policies. Scrutinize off-shore operations and the integration of recently purchased businesses, both of which can present accounting difficulties. Look for anomalies in your corporate disclosures by comparing them to that of peer companies. In conjunction with those efforts, both senior and middle managers, who oversee sales and accounting on a daily basis, should create a culture that makes company-wide ethical behavior mandatory.

Rifle through, but preserve, your documents. Next, if the SEC begins an investigation, conduct a thorough search of electronic records right away - regardless of the cost - to find and save potentially relevant documents. Stop any customary deletion of centrally stored electronic data, counsel the authors. A company could receive a harsher punishment for destroying emails or other documents after hearing about an investigation than for doing whatever triggered the investigation in the first place. Encourage employees to report possible securities-law violations internally, assess their reports transparently and fully, and resolve their concerns. Doing so will minimize the danger of their becoming external whistleblowers and will count in the company's favor, should the SEC file an enforcement action. Lastly, remember not only the SEC's frequent assertions that cooperation with inquiries will strongly influence its decisions on sanctions, but also its frequent impositions of harsh sanctions for serious allegations against even cooperative targets.

Abstracted from Wall Street Lawyer, published by West Group, 610 Opperman Drive, Eagan MN 55123. To subscribe, call (800) 344-5008 or (800) 328-9352; or visit

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