A four-letter word was uttered early and often at a recent conference that brought together top officials from the Securities and Exchange Commission: Data.
In recent years, the SEC has made no secret of its desire to deploy sophisticated new technology capable of parsing the petabytes of data it collects to identify financial reporting red flags worthy of investigation. Yet, at the SEC Speaks confab in Washington D.C., held by the Practising Law Institute last month, SEC leadership and staffers indicated that this year the SEC will work to connect the dots of these data-based initiatives and better integrate them into examinations, investigations, and prosecutions.
“We are using powerful new data analytics and technology tools in our National Exam Program to conduct more effective and efficient risk-based examinations of our registrants.” Chairman Mary Jo White said. “This expanded data collection and analysis not only enhances our ability to identify risks more efficiently, it helps our examiners better understand the contours of a firm's business activities prior to conducting an examination.”
Among the tools in the high-tech bag of tricks: the National Examination Analytics Tool (NEAT), which can analyze years of trading in mere minutes to help guide examiners, and MIDAS (Market Information Data and Analytics System), which crunches data from the 13 national exchanges in real time, flagging potential market manipulation. Also in the works is the Accounting Quality Model, developed by the Division of Economic and Risk Analysis to sniff out outlying entries in financial statements and reveal mis-steps in discretionary accounting judgments. Once implemented, it will supplement efforts by the recently formed Financial Reporting and Audit Task Force, to detect, investigate, and prosecute financial fraud and audit failures, and assess weaknesses in internal controls.
By scouring data collected directly from registrants—as well as information collected by other regulators, self-regulatory organizations, and exchanges—the SEC will be on the hunt for aberrations that may signal wrongdoing.
“The SEC is going to look for outliers in performance, disclosures, or any kind of pattern they can discern,” says Dixie Johnson, a partner and leader of the securities enforcement and regulation practice at law firm King & Spaulding. “That will drive inspections.” The SEC will be focusing on asset valuations, revenue recognition, and management estimates, she says.
“They have these vast troves of data they are getting all the time, on a mandatory basis, on trading activity, and public company financial reporting,” says Matthew Baughman, a partner at King & Spalding and a former SEC enforcement lawyer. “They decided to capitalize on all that data to set enforcement priorities and look for areas of potential risk.”
Punishing Success?
The focus on aberrational performance as a red flag isn't sitting well with everyone. As the SEC steps up oversight of hedge funds, for example, that industry has countered that its hunt for outsized performance punishes success.
“Companies are skeptical about this,” Baughman says. “They fear they are going to be swept up in an enforcement investigation even though there has been no wrongdoing. They were identified through data mining, without whistleblower reports or any actual allegations.”
Unlike criminal prosecutions, with a burden of proof that is “beyond a reasonable doubt,” the SEC has a lower threshold when pursuing civil cases. That, too, is a concern, Baughman says.
Companies that file financial reporting figures outside the typical range, for example, could be subject to expensive investigations, even if there is no underlying wrongdoing. “It is expensive to respond to an SEC inquiry,” Johnson says. The price tag can reach hundreds of thousands of dollars, she says. Her hope is that enforcement staff will avoid the temptation to “go on a fishing expedition,” and instead build cases on narrow, targeted questioning.
“The SEC is going to look for outliers in performance, disclosures, or any kind of pattern they can discern. That will drive inspections.”
—Dixie Johnson,
Partner,
King & Spaulding
The SEC's decision to use company peer groups to assess aberrations and outliers could also be problematic, says Jose Lopez, a partner with the law firm Perkins Coie and a former SEC senior attorney. “Just because one company is doing better than the others in a peer group doesn't suggest they are violating securities laws,” he says. “Using that as a benchmark could cause problems.”
It's still unclear how transparent the SEC's data-analysis processes will be. Some worry that the SEC is going to have a significant head start on investigations and defense counsel will have to play catch up. “They'll have to figure out what the SEC's case is, and hopefully get access to the same data,” says Johnson. She advises companies to investigate financial data that falls outside the range of peers to understand why. “Then, you can put more information about why you are an outlier in your disclosures,” she says.
“Be prepared to answer the questions that, now more than ever, are likely to come, as opposed to being knocked off kilter when you get a request from SEC staff,” Baughman says. “Self-analyze and figure out what the questions could be.”
The amped-up focus on data analysis also feeds into the SEC's desire, as directed by White, to enter fewer arrangements that allow companies to settle without admitting to wrongdoing. Building a case using data from the registrant itself is going to strengthen the SEC's cases and make individual culpability easier to prove, Johnson says.
FCPA Cases, Too
FOCUS ON FINANCIAL FRAUD
The following are from remarks made by Securities and Exchange Commission Chairman Mary Jo White at the recent “SEC Speaks” event in Washington D.C. The two-day gathering of SEC officials was held by the Practising Law Institute.
Admissions
Last year, we modified the SEC's longstanding no admit/no deny settlement protocol to require admissions in a broader range of cases. As I have said before, admissions are important because they achieve a greater measure of public accountability, which, in turn, can bolster the public's confidence in the strength and credibility of law enforcement, and the safety of our markets.
When we first announced this change, we said that we would consider requiring admissions in certain types of cases, including those involving particularly egregious conduct, where a large numbers of investors were harmed, where the markets or investors were placed at significant risk, where the conduct undermines or obstructs our investigative processes, where an admission can send a particularly important message to the markets or where the wrongdoer poses a particular future threat to investors or the markets. And now that we have resolved a number of cases with admissions, you have specific examples of where we think it is appropriate to require admissions as a condition of settlement. My expectation is that there will be more such cases in 2014 as the new protocol continues to evolve and be applied.
Financial Fraud Task Force
Last year, the Enforcement Division also increased its focus on accounting fraud through the creation of a new task force. The Division formed the Financial Reporting and Audit Task Force to look at trends or patterns of conduct that are risk indicators for financial fraud, including in areas like revenue recognition, asset valuations, and management estimates. The task force draws on resources across the agency, including accountants in the Division of Corporation Finance and the Office of the Chief Accountant and our very talented economists in the Division of Economic Risk and Analysis. The task force is focused on more quickly identifying potential material misstatements in financial statements and disclosures. The program has already generated several significant investigations and more are expected to follow.
In addition to the new admissions protocol and the Financial Fraud Task Force, the Enforcement Division also has other exciting new initiatives including a new Microcap Task Force and a renewed focus on those who serve as gatekeepers in our financial system, just to name a few.
Source: SEC.
It is not just financial reporting mis-steps and fraud that will come under greater scrutiny. At SEC Speaks, Kara Brockmeyer, chief of the Foreign Corrupt Practices Act Unit, said she has planned a very active year ahead.
While the SEC brought fewer FCPA cases in fiscal year 2013 than in prior years, the trend has reversed and the SEC has already filed as many enforcement actions in fiscal year 2014 as all of last year. Her unit's focus, she said, is on companies that have inadequate compliance programs and don't have necessary internal controls to detect and prevent violations.
The SEC will focus on vetting travel and entertainment expenses for foreign officials, scrutinizing charitable donations, and investigating payments to foreign officials in return for value-added tax refunds. Her unit will also place greater scrutiny on the use of third-party intermediaries.
Administrative Proceedings
For enforcement actions related to FCPA violations, or related to data mined from financial reports, the SEC will increasingly turn to administrative proceedings rather than district court cases, officials said at the event. The Dodd-Frank Act expanded the SEC's ability to pursue administrative proceedings, conducted by the SEC itself rather than by a court, against both companies and individuals. These proceedings allow for an expedited process without a jury, place limitations on discovery, and provide less time for defense to prepare.
“There is expedited discovery in an administrative proceeding process, and the speed of the process is certainly a challenge for both sides,” says Junaid Zubairi, chair of the law firm Vedder Price's government enforcement and special investigations group.
The SEC, as detailed at the event, will also be on the lookout for seldom, if ever, used sections of the Securities Exchange Act that could assist enforcement efforts. For example, Section 20(b) of the Exchange Act can be used to hold individuals and firms liable for violating securities laws through the actions of another person or entity. This could be particularly useful in “false statement cases” and pursuing those who put false information in the hands of another party that then distributes it, knowingly or not, to investors through public statements or disclosures.
“Some of these secondary liability tools may not have been in vogue historically, but now the SEC is trying to identify ways to use them as possible enforcement tools,” Zubairi says.
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