A NEW YORK LAW JOURNAL SPECIAL SECTION White-Collar

CRIME WWW. NYLJ.COM MONDAY, APRIL 7, 2014

SEC Renews Focus on And Disclosure Fraud

also declined in this same period. Across all The most tangible sign of the SEC’s BY MARK S. COHEN, public companies, restatements fell from a renewed commitment is a new Financial SCOTT D. THOMSON peak of 1,771 in 2006 to 768 in 2012.2 Reporting and Task Force­—the “FRAud AND JONATHAN S. ABERNETHY Recent statements by SEC officials, how- Task Force.” The Task Force will use recent- ccounting fraud investigations have long ever, suggest the pendulum may swing back ly developed data analytics to assess the been a mainstay of the SEC’s enforce- to a renewed focus on accounting and dis- degree to which a company’s financial state- Ament program. In the aftermath of the closure fraud. In January 2014, SEC Chair ments appear anomalous, including through financial crisis, however, statistics show that Mary Jo White said that financial reporting comparisons of a company’s filings with fil- the SEC’s focus on accounting fraud took a fraud would be a priority going forward, ings by other companies in the same indus- back seat to cases growing out of the cri- including investigations of senior executives try.6 The SEC also has promised to target sis. In FY2012, the SEC opened 124 financial for possible misconduct.3 In a September accounting reserves, recognition, fraud/issuer disclosure investigations as com- 2013 speech to the American Law Institute, and the role of audit committees.7 pared to 304 in FY2006 and 228 in FY2007. SEC Enforcement Director Andrew Ceresney This article examines each of these three The agency filed just 79 financial fraud/issuer expressed “doubts about whether we have areas through the lens of three recent SEC disclosure actions in FY2012 compared to 219 experienced such a drop in actual fraud in enforcement actions: Capital One, ArthroCare, in FY 2007.1 Perhaps as a consequence of this financial reporting as may be indicated by and AgFeed Industries. diminished focus, accounting restatements the numbers of investigations and cases we have filed.”4 Ceresney underscored that Reserves Against Losses: Capital One incentives to manipulate financial state- Prudent reserves against losses are a criti- ments are still present, and that in 2012, the cal component of proper accounting. In his MARK S. COHEN is a partner and co-founder, SCOTT D. SEC Whistleblower Program received more THOMSON is counsel, and JONATHAN S. ABERNETHY is a September 2013 speech, Ceresney emphasized partner, of Cohen & Gresser in the white-collar defense, tips alleging financial reporting misconduct the importance of the manner in which man- regulatory enforcement, and internal investigations group. than it received in any other category.5 agement and auditors make decisions with MONDAY, APRIL 7, 2014 respect to booking reserves. Ceresney stated of up to $100 million.16 The chief risk officer, quarter of 2005 and the first quarter of 2008, that, while the SEC recognizes that manage- however, decided to include only a fraction ArthroCare materially overstated and prema- ment and auditors must use their judgment, of that projected allowance for the quarter.17 turely recognized revenue, primarily on sales the SEC “will not tolerate decisions that are As a result, the SEC found that COAF’s of SpineWands to certain distributors, includ- reached in bad faith, recklessly, or without allowance did not appropriately incorporate ing a company called DiscoCare. Most of these proper consideration of the facts and circum- information necessary to determine incurred transactions occurred at or close to the end of stances.”8 As an example, he cited an April losses under GAAP.18 Furthermore, the SEC a quarter and were intended to help Arthro- 2013 enforcement action against Capital One found, the credit risk management group Care reach aggressive internal revenue targets Financial Corporation (Capital One).9 failed to adequately document its decisions to and satisfy analysts’ revenue expectations.24 In its Order Instituting Cease-and-Desist Pro- the Capital One Allowance Committee, which The SEC found that ArthroCare repeatedly ceedings (order), the SEC found that Capital was responsible for ensuring that COAF’s turned to DiscoCare to help it overcome quar- One, a provider of commercial lending and allowance complied with FAS 5.19 The SEC terly revenue shortfalls by recording revenue diversified banking services, materially under- sanctioned Capital One, the chief risk officer, from large orders shipped to DiscoCare at stated its loan loss reserves for its auto finance and the divisional credit officer for violations or near quarter-end. The orders were initi- business, known as Capital One Auto Finance of §§13(a), 13(b)(2)(A), and 13(b)(2)(B) of ated by ArthroCare employees. DiscoCare (COAF), and failed to maintain effective internal the Securities Exchange Act, based on their had no need for the excessive controls to ensure the appropriate and accu- failure to file accurate reports, keep accurate and no reasonable likelihood of selling the rate recording and reporting of its loan loss books and records, and maintain adequate products within a reasonable timeframe. .10 The SEC fined Capital One $3.5 mil- internal controls.20 ArthroCare provided DiscoCare with signifi- lion and also imposed civil penalties of $85,000 cantly extended payment terms, while also and $50,000, respectively, against its chief risk agreeing that DiscoCare did not have to pay officer and COAF’s divisional credit officer.11 Recent statements by SEC for the products until it had sufficient funds By way of background, a company’s best to do so.25 Accordingly, the SEC contended, estimate of losses incurred in its loan portfo- officials suggest the pen- it was improper under FAS 48 (which governs lio as of any given reporting date is reflected where a right of return in the allowance for loan and lease losses dulum may swing back exists) for ArthroCare to recognize revenue (allowance). The company’s for loan to a renewed focus on from these sales.26 losses, in turn, is the per quarter or per In addition, shortly after the close of the year of maintaining an adequate allowance. An accounting and disclo- second quarter of 2006, ArthroCare employ- increase to the allowance, or “allowance build,” ees arranged for DiscoCare to return products is recorded as an on the company’s sure fraud. shipped just before quarter-end, while con- ; it decreases cealing from ArthroCare’s accounting staff the for the period.12 Under There are at least two lessons from the Capi- reason for the return of the products: that the Standards (FAS) 5, in accounting for a loan loss tal One enforcement action. First, companies shipments had caused ArthroCare to exceed expense, a company is obligated to record should have clear methodologies for estimat- analysts’ revenue targets, and employees were losses if they are both probable and capable ing necessary reserves and, if they depart from concerned that this would cause analysts to of being reasonably estimated. those methodologies, they should adequately set the following quarter’s estimates too high. Beginning in October 2006, Capital One began document the reasons for the departure. Sec- The SEC found that recognizing revenue from experiencing higher, unexplained loan charge- ond, the SEC will not shy away from targeting these sales violated GAAP.27 offs and delinquencies in virtually all of its con- individuals in cases involving reserves when As with Capital One, the SEC found that sumer lines of business. Given the breadth and they “ignore inconvenient truths about losses ArthroCare violated §§13(a), 13(b)(2)(A), magnitude of the losses, Capital One became and the need to increase reserves.”21 and 13(b)(2)(B).28 The company, which concerned that it was facing a “credit turn,” a provided “substantial” cooperation to the Revenue Recognition: ArthroCare phenomenon where there is a general worsen- SEC and instituted remedial actions, was not ing of the credit environment causing losses in As Ceresney underscored in his September required to pay a fine.29 consumer lending businesses.13 2013 speech, revenue recognition fraud, long a The remedial actions that ArthroCare Conditions continued to worsen to the “staple” of the SEC’s caseload, can take many implemented may be useful for other com- point that the company’s credit risk man- forms, including sham transactions, premature panies, particularly start-ups and early stage agement group estimated in 2007 that the recognition of revenue, schemes to inflate sales companies, to help guard against revenue allowance build would increase by $72 million numbers, and billing for uncompleted prod- recognition problems. Among other things, by year-end based on the company’s inter- ucts.22 The recent enforcement action against ArthroCare expanded its nal loss forecasting methodology.14 Never- ArthroCare Corporation provides an example. function, implemented a sub-certifications theless, the chief risk officer and divisional ArthroCare is a medical device company process as part of its quarterly and annual credit officer decided not to include any of that develops and markets surgical products, reporting, enhanced its internal controls the $72 million in the allowance for the sec- including products with the name “Spine- related to revenue recognition, and provided ond quarter of 2007.15 In the third quarter, Wands” that were used by surgeons to treat regular training to employees on revenue COAF again suffered higher than expected spinal injuries.23 In its order against the com- recognition and appropriate procedures for loan losses and was facing an allowance build pany, the SEC found that between the fourth handling sales contracts.30 MONDAY, APRIL 7, 2014

and delay disclosure to investors.42 According 10. Id. ¶ 1. Audit Committee Responsibilities: AgFeed 11. Id. ¶¶ 78C, 78D, 78E. Capital One neither admitted nor to the SEC, the chair and CFO, among other denied the findings. In his September 2013 speech, Ceresney 12. Id. ¶ 9. things, failed to disclose to the company’s out- 13. Id. ¶ 20. emphasized the importance of focusing on side auditors that an in-house attorney ear- 14. Id. ¶ 28. 15. Id. ¶ 32. audit committees of boards of directors, lier that year had circulated a memorandum 16. Id. ¶ 34. “which serve as a gatekeeper for quality detailing how had been falsified.43 17. Id. ¶ 41. 18. Id. financial reporting” and play a “critical role In addition, the SEC alleges that the chair and 19. Id. ¶¶ 63-64. by overseeing and monitoring the … reporting 20. Id. ¶¶ 71-78. Section 13(a) requires issuers to file with CFO assisted in drafting public statements that the SEC such information, documents, and periodic reports process.”31 He warned the SEC would crack they knew or were reckless in not knowing as the Commission may require and, pursuant to Rule 12b-20, 32 mandates that periodic reports contain such further material down on audit committees that fell short. It contained false financial figures.44 As a result, information as may be necessary to make the required state- was not long before Ceresney’s warning came ments not misleading. Section 13(b)(2)(A) of the Exchange Act the SEC charged them with fraud and aiding requires issuers to keep books, records, and accounts that ful- to pass. In March 2014, the SEC charged the and abetting AgFeed’s fraud in connection with ly and fairly reflect their transactions and dispositions of their . Section 13(b)(2)(B) requires all reporting companies to chair of the audit committee of AgFeed Indus- an offering of securities under §§10(b) and devise and maintain a series of internal accounting controls tries (the chair) and AgFeed’s former CFO sufficient to provide reasonable assurances that transactions 20(a) of the Exchange Act and 17(a) of the are recorded as necessary to permit preparation of financial with failing to disclose a massive accounting Securities Act.45 The SEC also charged them statements in accordance with GAAP. 21. Ceresney at 5. fraud in AgFeed’s China operations while the with, among other things, knowingly failing to 22. Id. company was trying to raise capital in 2011.33 implement a system of accounting controls 23. See Order Instituting Cease-and-Desist Proceedings, In the Matter of ArthroCare, File No. 3-14249, Rel. No. 3232 (S.E.C. Interestingly, the SEC’s complaint does not to assure that AgFeed’s financial statements Feb. 9, 2011) ¶ 1. The company neither admitted nor denied allege that the chair or CFO had any role in the findings. were prepared in conformity with GAAP or 24. Id. ¶ 3. the fraud itself. Instead, it charges that they knowingly falsifying books and records; deceit 25. Id. ¶ 4. 26. Id. ¶ 4 n.2. failed to aggressively investigate the fraud and of auditors; and aiding and abetting AgFeed’s 27. Id. ¶ 5. disclose what they knew in filings accompany- 46 28. Id. ¶¶ 8-10. violations of §§13(a) and 13(b)(2). 29. Id. at 4. 34 ing securities offerings. In the SEC’s press The case is at a very early stage, the chair 30. Id. 47 31. Ceresney at 6. release announcing the charges, Ceresney and CFO appear poised to fight the charges, 32. Id. cited the case as “a cautionary tale of what and it will be interesting to see whether the 33. See SEC Charges Animal Feed Company and Top Ex- ecutives in China and U.S. With Accounting Fraud, Press Rel. happens when an audit committee chair fails SEC’s vow to go after audit committees proves No 2014-47, March 11, 2014 at 1 (Press Release), available to perform his gatekeeper function in the face at http://www.sec.gov/News/PressRelease/Detail/PressRe- successful in this instance. However the case lease/1370541102314. of massive red flags.”35 is resolved, it serves as an important reminder 34. See Complaint, S.E.C. v. AgFeed Industries, et al. (M.D. Tenn. March 11, 2014) (Complaint), available at http://www. According to the complaint, filed in the that audit committees may increasingly be in sec.gov/litigation/complaints/2014/comp-pr2014-47.pdf. The Middle District of Tennessee, AgFeed execu- Complaint charges a number of former executives and the the SEC’s cross-hairs if, in the SEC’s view, they company itself. tives began inflating reported revenues in ignore clear indicia of fraud. To guard against 35. Press Release at 1. 36. Id. ¶ 17. 2008 after AgFeed acquired 29 Chinese farms this, committees should consider hiring out- 37. Id. ¶ 18. for its new hog production division.36 The 38. Id. ¶ 19. side counsel and conducting thorough investi- 39. Id. ¶ 21. inflated numbers included sales of non- gations whenever allegations of potential fraud 40. Id. ¶ 20. 41. Id. ¶ 44. existent hogs and exaggerated weights for come to light. 42. Id. ¶ 63. real hogs.37 The company also recorded ficti- 43. Id. ¶ 67. Conclusion 44. Id. ¶ 70. tious to partially offset its exaggerated 45. Id. ¶¶ 88-104. revenues.38 The SEC charges that AgFeed With financial crisis cases winding down, 46. Id. ¶¶ 106-07, 112-13, 118-120, 129-131. 47. See “SEC Charges AgFeed Audit Committee Chair in maintained two sets of books, an “outside” accounting and disclosure fraud investigations Accounting Fraud Case,” Reuters, March 11, 2014, available at http://www.reuters.com/article/2014/03/11/usa-sec-agfeed- set provided to auditors and an “inside” set and cases will take on new prominence, as idUSL2N0M81KK20140311. that contained accurate, lower numbers that illustrated by SEC officials’ statements and 39 were hidden from auditors. recent enforcement actions. Companies would Reprinted with permission from the April 7, 2014 edition of the NEW YORK be wise to review and, if necessary, strengthen LAW JOURNAL © 2014 ALM Media Properties, LLC. All rights reserved. Further Relative to the size of the company, the duplication without permission is prohibited. For information, contact 877-257-3382 alleged fraud was epic. The SEC contends their internal controls in this area. or [email protected]. # 070-04-14-08 that AgFeed’s revenue was overstated by $239 •••••••••••••• •••••••••••••• million over a 3.5 year period. On an annual • 1. Andrew Ceresney, Financial Reporting and - basis, between 2008 and 2010 the company’s ing Fraud speech, American Law Institute Continuing Le- gal Education, Washington, D.C. Sept. 19, 2013 (Ceresney), revenue was bloated by between 71 percent available at http://www.sec.gov/News/Speech/Detail/ and 103 percent per year and gross profit Speech/1370539845772. 40 2. See id. at 2. inflated between 98 percent and 153 percent. 3. Mary Jo White, Keynote Address, 41st Annual Secu- According to the complaint, the fraud came rities Regulation Institute, Coronado, California, Jan. 27, 2014, available at http://www.sec.gov/News/Speech/Detail/ to light within the company in 2011, and the Speech/1370540677500. 4. Ceresney at 3. chair and CFO then learned of the two sets 5. Id. at 3-4; see also U.S. Securities and Exchange Com- of books and of executives’ involvement in mission, 2013 to Congress on the Dodd-Frank Whistleblower Program at 8. the fraud.41 The SEC charges that instead of 6. Id. at 5. 7. Id. at 5-6. retaining outside counsel or commencing an 8. Id.at 5. investigation, the chair, along with the CFO, 9. Id. at 5; see Order Instituting Cease-and-Desist Proceed- ings, In the Matter of Capital One Financial, File No. 3-15299, engaged in a scheme to minimize the fraud Rel. No. 694442 (S.E.C. April 24, 2013).