Internal Controls, Audit Committees Primed for SEC Scrutiny

It is an annual tradition. Every February, officials and staff at the Securities and Exchange Commission gather at the Practising Law Institute’s “Sec Speaks” confab. The late winter conference is a place where commissioners can break news and staff can dig into the details of their priorities for the coming year.

On the “news” front, two announcements were of particular note at the event, held Feb. 20-21.

Commissioner Michael Piwowar escalated his battle against what many see as the SEC’s over-reliance on in-house administrative proceedings that bypass federal district courts. He proposed that the SEC implement guidelines to determine which cases are brought in administrative proceedings and which in federal courts.

Commissioner Kara Stein urged new, more definitive guidance on when and how companies, banks in particular, are granted waivers that allow them to obtain exemptive relief despite facing an enforcement action. SEC staff confirmed that this guidance is already in the works.

The SEC allows large public companies to register as “Well-Known Seasoned Issuers” and access capital markets through shelf registration statements that don’t require SEC staff review. This status is revoked when an issuer violates federal securities laws or enters into a settlement of SEC charges, but the Division of Corporation Finance can issue waivers that allow companies to maintain their status. A similar waiver process applies to companies that would otherwise lose Regulation A and Regulation D exemptions for Rule 506 eligible private placements. Stein’s concern is that these waivers are issued too freely despite serious enforcement actions.

“Because there were fewer cases, does that mean there is less corruption? The answer is no. We have already filed as many cases this fiscal year as we did last year and it is only February. This year is going to be busy.”
Kara Brockmeyer, Chief of Enforcement Division, SEC

FCPA Remains a Priority

A constant focus for the SEC is acting upon violations of the Foreign Corrupt Practices Act, even if last year’s relatively low enforcement statistics superficially suggest otherwise.

The Division of Enforcement’s FCPA Unit brought only seven cases in fiscal 2014 (SEC fiscal years begin on Oct. 1), according to Kara Brockmeyer, its chief. The financial toll of those cases was roughly $381 million in discouragement and penalties. “Because there were fewer cases, does that mean there is less corruption? The answer is no,” she said. “We have already filed as many cases this fiscal year as we did last year and it is only February. This year is going to be busy.”

Brockmeyer added that FY2014 “included some of the largest cases ever brought.” It began with Alcoa, hit with $384 million in settlements and disgorgement penalties (fifth on the list of largest FCPA actions of all time) by the SEC and Department of Justice over activities by a Bahrain subsidiary. The calendar year ended with cosmetics giant Avon pleading guilty to concealing millions in gifts to Chinese officials, and paying more than $135 million in criminal and regulatory penalties.

Thus far in the current fiscal year, the SEC has sued both individuals and companies for FCPA violations “and you are going to see that trend continue,” Brockmeyer warned. Moving forward, expect a focus not only on big multinationals, but also small- and medium-sized companies, in particular those moving into international markets for the first time and “not thinking consistently about the types of risks they face and the changes that they need to make to their compliance programs and internal controls,” she added.

DISCLOSURE FOR THE 21ST CENTURY

The Practising Law Institute’s “SEC Speaks” conference coincided with the one-year anniversary of the appointment of Rick Fleming as the SEC’S Investor Advocate. The following are from remarks Fleming made regarding disclosure reform.
Times have changed, and so should the delivery of information to investors. If the SEC wants issuers to provide effective disclosure to the 21st Century investor, the data needs to be both layered and structured. To understand what is meant by the term “layered data,” simply picture a company website. The company does not put all the information into one long web page that requires users to scroll down endlessly. Rather, the information is split into manageable pieces that utilize appealing graphics, with tabs and hyperlinks to help users quickly find the information that is most important to them. By similarly layering the data in an S-1 or 10-K, the SEC could greatly assist the individual investor who takes it upon herself to research an investment opportunity.
In contrast, structured data could assist the analyst or intermediary who wants to search data dynamically and compare multiple companies by slicing and dicing the data. 
In 2009, the Commission began to require companies to provide their financial statements using eXtensible Business Reporting Language (XBRL), a global standard for structured financial reporting. XBRL appears today in more than 20 SEC forms, and as the Commission engages in new rulemaking, it continues to expand the required use of structured data…and the Commission is working to develop “Inline XBRL” to integrate XBRL tagging directly into HTML formatted documents.
Despite these improvements, much of the information on EDGAR is still difficult to find and use efficiently.  To be candid, I believe the SEC has been painfully slow to adapt to changing technologies that will benefit investors. 
I am even more troubled by Congressional action that may thwart the recent progress the Commission has been making.  On Jan. 14, 2015, the U.S. House of Representatives passed the “Promoting Job Creation and Reducing Small Business Burdens Act.” [It] would create an exemption from the XBRL filing requirements for Emerging Growth Companies and other small companies, which some have estimated would exclude more than 60 percent of all public companies.
If Congressional action is needed, it should be used to press the SEC to move forward in its efforts to make disclosure more accessible and useful for investors. Cost to issuers is a legitimate concern, but I think we can safely predict that smart people will quickly develop ways to bring those costs down significantly, particularly if the SEC moves forward with Inline XBRL.
Source: SEC.

As is often the case, the SEC wants to encourage cooperation and is willing to reduce fines when cooperation is forthcoming. What does cooperation mean? How do you get credit? Brockmeyer detailed what was common among recent cases.

“There was real-time reporting to us of investigative findings, and that allowed us to leverage the work that the company had done to go out and talk to witnesses ourselves,” she said. “Providing English language translations of documents can speed up our review, particularly if we don’t happen to have a Russian or Mandarin speaker in-house.” Companies also brought foreign employees to the United States or other jurisdictions where the SEC could interview them. Others let investigators know if they were going to fire an employee, providing an opportunity to talk to the person while still with the company.

A piece of advice: don’t use overseas regulations as a shield. For example, when companies are faced with producing documents from overseas, they may encounter data privacy rules barring them from taking data out of the country. “The companies that get cooperation credit are the ones that think creatively about how they get the SEC the documents they are looking for,” Brockmeyer said.

Good news (from the SEC perspective, at least) is that more companies not only self-report, but do so for even minor incidents. “Those are really the success stories you may never hear about because we may never do an investigation and the company may never disclose it,” Brockmeyer said. “Companies are really starting to get serious about what it means to address their FCPA risks and put good internal controls in place. They are going to catch problems while they are still small.”

Financial Reporting Flaws

Risk areas in financial reporting that will be targeted in 2015 include revenue recognition, expense recognition, faulty valuations, supporting accounting estimates, impairment conclusions, missing or insufficient related-party disclosures, and insufficient internal controls.

“We have also been very focused on the conduct of financial reporting gatekeepers,” said Stephanie Avakian, deputy director of the Enforcement Division. “In every financial reporting investigation we evaluate the conduct of the auditors to determine if they followed audit procedures and performed their role in accordance with Generally Accepted Accounting Principles.” Auditor independence will be a high priority, and expect more actions like an auditor independence enforcement sweep last fall that sanctioned eight firms for their work with broker-dealers.

Financial fraud, disclosure inadequacies, and audit concerns are among the SEC’s continuing areas of focus, said David Woodcock, regional director of the SEC’s Fort Worth office. He noted a 40 percent increase in these cases. Recent actions included a $20 million penalty for misleading disclosures brought against CVS Caremark; a $5 million penalty for under-reported expenses and overstated income against Diamond Foods; and Saba Software’s $1.75 million penalty for improper revenue recognition practices.

Deputy Chief Accountant Daniel Murdock elaborated on issues the SEC will watch closely in 2015. Extra scrutiny will be placed on the treatment of revenue, business combinations and consolidations, and business segments.

SEC staff has “a significant number of segment reporting consultations” ongoing at the moment, Murdock said. A red flag that should encourage a consult with SEC staff: when business segments aren’t lined up with an organizational chart and their chief operating decision maker. “That’s a really good spot to think twice,” he said, “to the extent they are lined up you can probably keep moving.”

In October 2014, SEC Chair Mary Jo White announced plans to draft a concept release and explore ways to improve the work of public company audit committees. Although he made no promises for a timeline, Murdock said the project is a priority. “There are changes in financial reporting risk and we want to ensure that audit committees are continually updating the way they execute their roles and responsibilities,” he said.

The current requirements for audit committee reports haven’t been updated since the Sarbanes-Oxley Act of 2002. “Our disclosure requirements are, in some ways, outdated, and probably have not kept up with the needs of investors,” he said. A draft document is likely to be made available for public input early this year.

Expect more scrutiny on internal controls this year as well, as this may be an area where companies are slipping, Deputy Chief Accountant Brian Croteau said. “It is unusual to find disclosures of material weaknesses unless there is a restatement of the financial statements,” he said. “We have worked closely with the Division of Corporation Finance to work through the comment process with companies. In many cases, we find they had not properly identified the deficiency in their controls. They might have identified a narrow deficiency, when in fact what they really had was something much broader.”

“On top of that, in some instances companies—managers and auditors—are not adequately evaluating the severity of deficiencies,” he added. “That may mean that some of the deficiencies are being classified as significant deficiencies, when they are really material weaknesses and investors aren’t getting the disclosures that are intended.”

That’s the wrap-up for 2015. See you next year.