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Inside the SEC’s Focus on Financial Reporting Fraud

Robert Herz | August 26, 2014

Just over a year ago the Securities and Exchange Commission announced the formation of a Financial Reporting and Audit Task Force to focus on strengthening and expanding the SEC’s abilities to identify and to prosecute instances of fraudulent, false, or misleading financial reporting by issuers and audit failures by independent auditors.

The Task Force includes enforcement attorneys and accountants from the SEC’s headquarters and regional offices, bringing together capabilities across a number of the SEC’s divisions and offices, and it includes on-going review of restatements of financial statements, analysis of industry trends, and use of data analytic tools such as the SEC’s Accounting Quality Model.

So a year into this initiative, it would seem appropriate and interesting to review some of the primary enforcement themes and types of enforcement actions undertaken by the SEC relating to accounting and auditing.

A number of key themes emerge: These include a continuation of enforcement actions against particular banks and investment managers relating to improper financial reporting and inadequate internal controls, fraudulent reporting and conduct by China-based registrants, numerous cases involving false or improper revenue and expense recognition, and false or misleading disclosures by registrants. It also includes breaches of the Foreign Corrupt Practices Act by companies, and various instances of auditor independence violations and improper professional conduct by auditors.

In addition to the emphasis on these areas, there has also been a continuation of the trend in recent years for the SEC to name individuals, not just companies, in enforcement actions. In the 68 accounting and auditing enforcement actions in 2013, for example, the SEC named 49 CEOs and 31 chief financial officers, vice presidents of finance, or chief accounting officers, as well as number of CPAs of external audit firms.

While it may be too early to precisely determine the impact of the SEC’s Financial Reporting and Audit Task Force on its enforcement activities, it seems likely that this effort will strengthen and broaden the Commission’s abilities to identify and prosecute instances of fraudulent and improper accounting and auditing in the coming years.

One of the more notable recent SEC enforcement actions relating to banks is the one against JPMorgan Chase relating to trading losses and breakdowns of controls in the highly publicized “London Whale” case. When settling the enforcement action in September 2013, JPMorgan admitted wrongdoing and agreed to pay a $200 million penalty. The SEC has also charged two former JPMorgan traders in connection with this matter. Other recent SEC enforcement actions against banks, such as those against Fifth Third Bancorp and Anchor Bancorp Wisconsin, involve improper accounting to avoid reporting losses on loans during the 2008-09 financial crisis. In both cases the SEC charged the former CFOs, as well as the banks.

The China Syndrome

Accounting and auditing enforcement actions relating to registrants based in China continue to be an area of focus for the SEC. A number of these cases involve multiple allegations against the companies and senior officers relating to fraudulent accounting, diversion of funds, lying to auditors, and other improper actions. For example, in its July 2013 action against China Intelligent Lighting and Electronics, NIVS Intellimedia Technology Group, and the sibling CEOs of the two companies, the SEC alleged that the companies and their CEOs engaged in fraudulent schemes to raise and divert the proceeds of two offerings and tried to mask these by falsifying bank and accounting records and lying to auditors. In its recent actions against China Media Express Holdings and its Chairman and CEO involving defrauding investors, filing fraudulent financial statements, and attempting to bribe an independent investigator, the SEC was able to obtain disgorgements and penalties totaling over $68 million.

Fraudulent and improper inflation of reported revenues continues to be one of the core “oldy but goody” areas of focus by the SEC in its accounting enforcement activities. For example, in its enforcement action against Imperial Petroleum and several executives, the SEC has accused the company and these individuals of creating an illegal scheme to generate falsely reported revenues and illicit profits and is seeking disgorgement of ill-gotten gains, financial penalties, along with permanent injunctions and bars against the named individuals from acting as officers or directors of public companies.

In its enforcement action against two former sales executives of Hansen Medical, the SEC alleged that these individuals provided false information relating to improper sales transactions to the company’s finance department. The February 2014 settlement of this case required the two executives to pay penalties and prohibits one of them from serving as an officer or director of a public company for five years.

Called to Account

Over the past year there have been a number of SEC enforcement actions in which senior corporate officers allegedly undertook multiple actions to mislead investors through fraudulent and improper accounting practices. One of the more significant and pervasive of these relates to the collapse and bankruptcy of the law firm Dewey Leboeuf in 2010. In March of this year, the SEC charged five former executives of Dewey & Leboeuf with widespread use of accounting tricks and gimmicks and false disclosures in connection with a 2010 bond offering.

According to the SEC complaint, starting in 2008, these executives deliberately undertook various actions to falsify the law firm’s reported financial performance and condition including creating fictitious revenues, reclassifying compensation as equity distributions, mischaracterizing uncollectible client balances and credit card debts owed by the firm, and improper lease accounting. While the SEC’s enforcement action seeks various civil remedies including disgorgement, financial penalties, permanent injunctions, officer and director bars against three of the defendants, and bars against two of them from practicing law, four of the executives have also been indicted by the Manhattan District Attorney on various criminal charges.

Corruption Focus

The SEC also continues to prosecute cases involving asserted breaches of the anti-bribery, books and records, and internal control provisions of the Foreign Corrupt Practices Act. Not surprisingly, these often relate to major international companies and settlements involving significant disgorgements and fines . For example, in January of this year Alcoa agreed to settle an SEC investigation and parallel criminal case by the Department of Justice relating to corrupt payments to Bahraini officials by paying a total of $384 million in disgorgements and fines.

Auditors are also on the SEC’s radar screen. The agency continues to undertake numerous enforcement actions against auditors for independence violations and improper professional conduct. Most of these relate to partners at smaller accounting firms that audit microcap and small SEC registrants, broker-dealers, and investment advisers. One of the higher profile SEC enforcement actions in this area over the past year, however, involved a KPMG partner, Scott London who headed KPMG’s Southwest audit practice, whom the SEC charged with insider trading for providing a friend, Bryan Shaw, with non-public information about five KPMG audit clients.

According to the September 2013 SEC complaint, Shaw made over $1.2 million in illicit profits from the inside information and rewarded London by paying him at least $50,000 and giving him an expensive Rolex watch and other jewelry and paying for meals and entertainment events. In a parallel action London was also criminally charged by the U.S. Attorney for the Central District of California. London pleaded guilty to the charges and in April was sentenced to 14 months in federal prison and ordered to pay a $100,000 fine.

In all, these cases are sobering reminders of the potential consequences of engaging in fraudulent, illegal, and improper accounting and auditing. While it may be too early to precisely determine the impact of the SEC’s Financial Reporting and Audit Task Force on its enforcement activities, it seems likely that this effort will strengthen and broaden the Commission’s abilities to identify and prosecute instances of fraudulent and improper accounting and auditing in the coming years.