Securities Regulation & Law Report™ Reproduced with permission from Securities Regulation & Law Report, 45 SRLR 2132, 11/18/13. Copyright ஽ 2013 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com SEC ENFORCEMENT The Securities and Exchange Commission recently announced the creation of a new Financial Reporting and Audit Task Force in the Division of Enforcement along with a Center for Risk and Quantitative Analysis. The new groups are being formed as the agency refocuses its enforcement program in the post-market crisis era. The new task forces are likely to draw on the Commission’s history of bringing significant financial fraud actions and couple that approach with one tied to risk and data analysis. The SEC’s New Financial Fraud Task Force BY THOMAS O. GORMAN proper financial reporting’’ and ‘‘enhance the [Enforcement] Division’s ongoing enforcement efforts n July 2, 2013, the Securities and Exchange Com- related to accounting and disclosure fraud.’’ A similar mission announced the formation of a Financial group is being formed to focus on microcap fraud, ac- O Reporting and Audit Task Force (‘‘Financial Task cording to the announcement. Force’’). Its purpose is to detect ‘‘fraudulent or im- The Center for Risk and Quantitative Analysis (‘‘Ana- lytics Group’’) is also being created as part of the new Thomas O. Gorman is a partner with Dorsey focus on financial reporting. The new Analytics Group & Whitney LLP, resident in Washington, D.C. will work in close coordination with the Division of Eco- Mr. Gorman is a former Securities and nomic and Risk Analysis and ‘‘serve as both an analyti- Exchange Commission enforcement official cal hub and a source of information about characteris- whose practice focuses on defending govern- tics and patterns indicative of possible fraud or other il- ment enforcement actions, including SEC civil legality.’’ and Justice Department criminal securities The formation of a new Financial Task Force, actions and Foreign Corrupt Practices Act coupled with the creation of the Analytics Group, sug- matters, and conducting internal corporate gests a new focus for an enforcement program that has investigations. He is the co-chair of the firm’s centered on insider trading, offering fraud, Ponzi FCPA – anti-corruption practice group, and scheme and market crisis cases since the 2009 reorga- co-chair of the ABA White Collar Crime secu- nization of the Division. See also SEC Enforcement: Is rities subcommittee. Mr. Gorman is the author the Swagger Back?, www.secactions.com (Oct. 13, of a widely read blog which analyzes trends 2013) (discussing new SEC chair’s enforcement goals). in securities enforcement actions, www.secac- It also suggests that the new task force will adopt at tions.com. least some of the risk analysis and metric oriented ap- COPYRIGHT ஽ 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 0037-0665 2 proach utilized by the Division of Enforcement since its cial statement fraud actions, at least through the early reorganization. years of the market crisis. See, e.g., Cornerstone Re- If the new Financial Task Force has an impact simi- search, Securities Class Action Filings, 2012 year in Re- lar to that of the 2009 reorganization which spawned re- view, available at http://tinyurl.com/lppz3tf (‘‘Corner- cord numbers of cases, it is reasonable to expect that stone Report’’). the Commission will be opening a significant number of In his remarks the Chairman detailed his concern new investigations and bringing more actions centered that the numbers in financial statements being fur- on financial statement fraud and related reporting is- nished to the investing public and the markets by issu- sues. Indeed, there are indications that those efforts ers did not reflect the substance of the enterprises’ busi- may well have been underway prior to the announce- ness. The Chairman went on to state that he had: ment. See, e.g., SEC v. Senior, Civil Action no. 3:12cv60 (N.D. Ind. filed Jan, 30, 2012) (accounting fraud action become concerned that the motivation to meet Wall Street against former senior officers and outside auditors of earnings expectations may be overriding common sense business practices. Too many corporate managers, audi- British subsidiary of issuer). tors, and analysts are participants in a game of nods and This is not the first time that the SEC has focused on winks. In the zeal to satisfy consensus earnings estimates financial statement fraud and reporting issues. Follow- and project a smooth earnings path, wishful thinking may ing a 1998 address by then Chairman Arthur Levitt be winning the day over faithful representation. As a result, titled ‘‘The Numbers Game’’ which decried the manipu- I fear that we are witnessing an erosion in the quality of lation of financial statements to meet Wall Street earn- earnings, and therefore, the quality of financial reporting. ings expectations, the agency brought a series of high Managing may be giving way to manipulation; Integrity profile financial statement fraud actions. The new task may be losing out to illusion. force can be expected to draw from and build on that Chairman Levitt identified key practices being used history. to alter financial results through what he called ‘‘ac- The critical question for issuers, directors, execu- counting hocus-pocus.’’ Those included: tives, their auditors and business partners is the ap- proach the new task force will take. Knowing that focus s Big bath charges: The use of restructuring charges should permit an examination of current practices now to clean up the balance sheet; to avoid liability tomorrow. Stated differently, under- s Cookie jar reserves standing how the SEC Enforcement plans to proceed is : The use of unrealistic assump- good business today and tomorrow. tions to create pools of cash to smooth earnings; and To analyze the likely approach of the new task force s Revenue recognition: Boosting earnings through in- four key points will be considered: appropriate manipulation of the recognition of revenue. 1. The ‘‘Numbers Game’’ speech – the genesis of an The driver of financial statement fraud, according to earlier financial statement fraud effort; Chairman Levitt, was the ‘‘pressure to make the num- 2. Financial statement fraud cases brought in the bers’’ or meet street expectations. wake of the ‘‘Numbers Game’’ speech; In the wake of Chairman Levitt’s speech the Commis- 3. Market crisis financial actions; and sion brought a series of financial statement fraud ac- 4. The Enforcement Division’s use of risk analysis tions. Two years later Richard Walker, then the director and big data. of the Enforcement Division, summarized those efforts Analyzing these points should provide a guide to the to that point, noting that for fiscal 1999 the Commission future approach of the new task force which can be brought about 90 financial statements and reporting ac- used now by issuers, their executives and auditors to tions, a 15 percent increase over 1998. Those cases conduct an analysis of current practices to avoid liabil- ‘‘cover a broad spectrum of conduct – from multi- ity tomorrow. faceted pervasive frauds to more subtle instances of earnings management to situations involving violations I. The ‘Numbers Game Speech’ of auditor independence rules,’’ he noted. Richard H. Walker, Director, Division of Enforcement, addressing In 1998 then SEC Chairman Arthur Levitt delivered a 27th Annual National AICPA Conference on Current speech titled the ‘‘Numbers Game.’’ It launched a cam- SEC Developments (Dec. 7, 1999). paign against financial statement fraud which will serve Following the passage of SOX the Commission con- as the roots of the current efforts. Following Chairman tinued to bring a significant number of financial state- Levitt’s speech the Commission brought increasing ment fraud cases. Beginning in 2007, as the worst mar- numbers of financial statement fraud actions. Those ef- ket crisis since the great depression of the 1930s was forts resulted, in part, in the passage of the Sarbanes- unfolding, the Commission focused a large part of its Oxley Act of 2002 (‘‘SOX’’) which instituted certain re- investigative resources on ascertaining its causes. See, forms. Those included the creation of the Public Com- e.g., Testimony, SEC Commissioner Elisse B. Walter be- pany Accounting Oversight Board (‘‘PCAOB’’) to fore the U.S. House of Representatives Committee on oversee the auditing process for public companies and Financial Services (March 20, 2009). Those efforts re- the requirement that the chief executive officer and sulted in a significant number of market crisis actions chief financial officer of issuers execute certain certifi- being brought. SEC Enforcement Actions, Addressing cations. See, e.g., Thomas O. Gorman & Heather J. Misconduct that Lead to or Arose From the Financial Stewart, Is There A New Sheriff In Corporateville? The Crisis, available at http://www.sec.gov/spotlight/enf- Obligations of Directors, Officers, Accountants, and actions-fc.shtml. Lawyers After Sarbanes-Oxley of 2002, 56 Adm. L. Rev. By the end of the market crisis the number of finan- 135 (2004) (discussing key provisions of Sarbanes- cial statement fraud actions being brought by the Com- Oxley Act). Following the passage of SOX, the Commis- mission had dropped significantly. See Cornerstone Re- sion continued to bring a significant number of finan- port. At the same time the Division of Enforcement un- 11-18-13 COPYRIGHT ஽ 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. SRLR ISSN 0037-0665 3 dertook its most significant reorganization in history. ments at quarter end to ensure that earnings expecta- That reorganization included the creation of specialty tions were met); SEC v. Farkas, Civil Action No. 1:10 groups. SEC Press Release, SEC News, New Special- CV 667 (E.D. Va. filed June 16, 2010); U.S. v. Farkas, ized Unit Chiefs and Head of New Office of Market In- 10-cr-00206 (E.D.