In today's heightened regulatory environment, what are common flags the SEC looks for that might indicate problems? We addressed these and other questions with Vinson & Elkins partner Rick Sauer, a former Assistant Director with the SEC's Division of Enforcement.

COMMON FLAGS

One of the weaknesses of GAAP is that, by itself, it can't necessarily differentiate between fraud and "aggressive accounting." You spent over a decade at the SEC. What were some of the most common "flags" you used to look for at the Division of Enforcement when attempting to separate legitimate (albeit subjective) accounting from fraud? And how do you think that's going to change over time?

Accounting will always have its squishy areas because no perfect system exists for measuring business performance.

All the same, some accounting treatments are flat wrong. For example, WorldCom’s propensity for tossing operating expenses into asset accounts was nakedly fraudulent.

Many of the major corporate scandals of recent years, however, began with companies that played the edge of acceptable practice and were then drawn into taking increasingly bold measures to cover up the mounting shortfalls hidden by their initial aggressive accounting or opaque disclosure.

It’s difficult to generalize about when the line is crossed because each case involves an interaction between accounting rules and the details of the company’s transactions.

But common indications that a company is cooking its books are the appearance of innovative transactions outside the company's core business or a widening gap between the company's reported earnings and operating cash flows.

Also if a company cannot explain its transactions in a way that makes sense to the average financially literate person, caution is advisable.

And, of course, it's a flag whenever a company announces that its CFO has left to “pursue other interests.”

In an article in the ABA's Business Lawyer of about two years ago, I cataloged common varieties of financial fraud. Almost all involve games against time, designed to provide temporary cover for disappointing performance metrics, customized to reflect the company’s business practices and internal control structure.

Since then, corporate disclosure has come under greater scrutiny, the FASB has tightened up a few loose areas of GAAP, and the potential costs of straying from straight accounting have been significantly raised by the Sarbanes-Oxley Act.

But given the incentives that will always exist for managers to inflate results, fraud will continue to appear in new variations on old themes.

MD&A TRENDS

In separate speeches in September, SEC Commissioner Cynthia Glassman and Under Secretary for Domestic Finance Peter Fisher each urged companies to present more useful information to investors outside the GAAP framework. "We would love to see metrics and indicators that the market deems useful," said Glassman, who referred to the SEC's study of Fortune 500 filings that found many companies simply providing boilerplate analyses. Is MD&A disclosure getting better, and will it come under greater scrutiny?

I agree with Glassman and Fisher that financial statement disclosure is not adequate by itself to provide a clear picture of a company’s results of operations. And my sense from a less-than-comprehensive knowledge of present practice is that many companies still draft their MD&A disclosure defensively, so as to give away as little as possible.

Expanded MD&A disclosure is generally a good thing, but remember that the quantity of disclosure does not necessarily correlate to its information value. Key facts can get lost in thickets of verbiage. As a rule of thumb, companies with something to hide skimp on disclosure, but some very bad ones have gone the opposite route.

Also, remember that the rules here are even more subjective than those covering financial statements. For that reason, the SEC historically has been reluctant to attack poor MD&A disclosure through enforcement actions. MD&A cases have gone in and out of fashion with the agency, with an upswing in recent years as the Commission looks more aggressively for ways to pursue forms of corporate chicanery that don't necessarily go to line item disclosure.

REVENUE RECOGNITION

According to a study released by the SEC in January, more than half of the enforcement actions related to financial reporting and disclosure violations over the past five years involved improper recognition of revenue. Are those violations — involving fraudulent reporting of fictitious sales, improper timing of sales, and improper valuation of revenue — changing over time? What new sorts of cases are you seeing at V&E?

Phony revenue transactions have always been the most common form of financial statement fraud.

Top-line revenue is itself an important measure of financial performance. Also, to the extent that revenue is simply fabricated — with no associated costs other than paper and ink — it can inflate pre-tax income on a dollar for dollar basis and improve operating margins dramatically. In addition, while the ability of a company to bury expenses is limited by even the most rudimentary internal controls, the possibilities for manufacturing revenue are potentially infinite.

Based on many delightful hours spent reading hundreds of Commission cases in this area, I would have to say that most recent bogus revenue cases have close precedents decades old.

The basic problem is always to conceal that the company either is not getting cash for its purported sales or that the “sale” proceeds are in fact a disguised loan that must be repaid.

Common dodges involved “bill-and-hold sales” and barter transactions that, by their nature, provide an excuse for the lack of short-term cash collections. These days the goods may be traded in cyberspace, but the economic substance (or lack of it) is the same.

LITIGATION TRENDS

Earlier this summer, the SEC said the number of defendants fighting (instead of settling) charges has jumped over 25 percent. This is reportedly due to stiffer penalties — specifically, disbarments and disgorgements — which executives are more likely to fight. Do you think that trend will continue? And what impact will the increased litigation have on future enforcement actions from the already-overstretched Commission?

This amount of litigation will certainly ramp up further.

A dozen years ago, Congress gave the SEC authority to seek fines against a much broader population of securities law violators than before. The number of litigated matters rose substantially and the structure and orientation of the SEC's Enforcement Division shifted accordingly.

The ante has now been upped again in several ways.

The SEC is getting more aggressive about officer and director bars. This trend preceded the Sarbanes-Oxley Act, but was further encouraged by its lowering of the legal standard for a bar. In addition, the agency is routinely seeking much larger civil penalties — particularly in financial cases — than it did, say, five years ago.

The agency’s limited litigation resources have always been a substantial factor in setting the parameters for settlements. With settlement terms increasing in severity, the other end of the equation — the willingness of defendants to litigate — will surely go up as well.

Further, given the enormous pressure on the SEC to bring cases more quickly, it is now more likely to file cases without the exhaustive investigations that were often done in the past. However understandable the goal, the result in some cases has been a less compelling investigative record and therefore a greater willingness on the part of defendants to try their luck in court.

Even with the recent increases to the Division’s manpower, something will eventually have to give. My guess is that it will be the number of cases filed, rather than the relief required to settle out individual defendants.

REGIONAL IMPACT

At a Sarbanes-Oxley Compliance Workshop we hosted last year, the SEC's Associate District Administrator in Boston, Madeleine McGrath Blake, stated that enforcement in her region was "highly-focused on the mutual fund industry." One month later, the SEC's Assistant District Administrator in San Francisco, Robert L. Mitchell, clarified that his team's recent emphasis was on high-tech companies and accounting issues. How much does a public company's physical location determine the likelihood of regulators uncovering improprieties? In your experience, are certain regions stronger than others at uncovering fraud?

SEC offices tend to pursue the types of violations common in their areas, which largely depends on the geographic distribution of businesses.

There are major mutual fund complexes in Boston and a plethora of tech firms down the peninsula from San Francisco, so it’s not surprising that those offices of the SEC would be heavy into cases involving those two sectors, respectively.

Similarly, the SEC’s New York office has emphasized cases against Wall Street firms and the Exchanges, the Miami office has done many cases against grubby South Florida brokers, and — when the SEC had a Seattle Office — it made a steady diet of penny stock cases that leaked over the border from the loosely-regulated Vancouver Exchange.

The production rates of the various offices are largely a matter of their relative staffing levels.

 

This column should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.