What Triggers a Selective SEC Filing Review?

The Securities and Exchange Commission's Division of Corporation Finance is constantly on the lookout for financial filings that aren't up to snuff. Financial statements with missing or unclear disclosures, insufficient detail, or conflicting data could attract the staff's attention. In certain circumstances, the division will launch a review of a company's filings. But just what triggers a review isn't always clear.

Former SEC employees who were once involved in the process of initiating such reviews are shedding some light on the filing review process. They say numerous red flags—some big and some small—can attract the SEC's attention and set off a formal filing review.

Corp Fin, as it is commonly called, is looking for filings that are missing critical disclosures or that conflict with SEC rules or accounting standards. It's not always a large error that triggers a review. “Just because you get a comment letter from the SEC, it doesn't mean everything is terribly wrong. It might just be a minor issue,” says Ronald Kiima, president of Kiima consulting firm and former assistant chief accountant at the SEC's Division of Corporation Finance.

Corp Fin conducts many reviews as part of the initial public offering process or at set intervals. At the minimum, companies seeking initial public registrations and initial public offerings will be subject to the review process to ensure all filings meet the accounting and disclosure requirements as prescribed by the Securities Exchange Act, says Kiima. The Sarbanes-Oxley Act further requires a minimum of one filing review every three years.

Then there are the selective reviews that the staff conducts randomly or that are initiated by problematic filings. Corp Fin's Website describing its review process states that it does not publicly disclose the preliminary review criteria in order to preserve the integrity of the selective review process.

“It's the great unknown for companies,” says David Mittelman, a partner at law firm Reed Smith and former SEC legal branch chief who oversaw the reviews on filings made by domestic and foreign registrants. He says, however, that the three most likely reasons for review are deficient accounting presentation, atypical deal structure, and other “hot topic” developing issues that may include new filing requirements that some companies are struggling with or emerging issues in particular industries.

Staff at the SEC never settle on a fixed set of criteria to determine who to review under the selective review process, says David Martin, a partner at law firm Covington & Burling and former director of the corporate finance division at the SEC. He says the selection criteria for who to target for review can change with some regularity, and that assistant directors overseeing individual industries circulate memos on what to watch out for. He adds that the selective review process has a discretionary element to it. “Staff is allowed to use common sense in selecting filings for review,” says Martin.

“Staff used to only look at underperformed companies. After the case of Enron and WorldCom, they are now taking a second look at companies that did extremely well compared to their peers.”

—Ronald Kiima,

President,

Kiima Inc.

Yet some of the criteria at a high level are fairly predictable, says Martin. In addition to first-time filers, companies with novel securities and companies going through transformative transactions or events will warrant a closer look by the staff. If questions arise in those filings it can move to a full review.  In some cases, there are large-scale reviews of several companies in the same industry that are all struggling with a particular topic or a change to the rules.

Outliers also attract attention, says Kiima. In the past the staff was more concerned with industry laggards that were more likely to have filing problems, but now those with superior results could also set off alarm bells. “Staff used to only look at underperformed companies. After the case of Enron and WorldCom, they are now taking a second look at companies that did extremely well compared to their peers,” he says.

Companies with the largest market capitalizations, industry leaders, those in emerging industries, companies with high stock price volatility, and companies with price-to-earnings disparities also come onto Corp Fin's radar, says Kiima. And companies with prior financial reporting violations are also subject to annual reviews by the SEC, at least until they have cleared up the issues. “It is a mix of a quantitative and qualitative approach,” he adds.

Outside Triggers

What can trigger a selective review isn't limited to the information contained in the statements themselves, says Martin. The Corp Fin staff considers outside information, including press reports, to hunt for inconsistencies. “The SEC staff pays more attention to press statements made by companies than companies think they do,” he says. “The staff does read the headlines,” says Martin. Corp Fin staff also read press releases made by companies and checked for discrepancies with information filed in their statements. If they found items that were inconsistent, it could trigger the staff to issue comment letters to those companies.

REVIEWING THE REVIEW

The following excerpt from the SEC's Website on the Filing Review Process explains the level of review, staff comments, and company response to comments:

Levels of Review

If the Division selects a filing for further review, the extent of that further review will depend on many factors, including the results of the preliminary review. The level of further review may be:

a full cover-to-cover review in which the staff will examine the entire filing for compliance with the applicable requirements of the federal securities laws and regulations;

a financial statement review in which the staff will examine the financial statements and related disclosure, such as Management's Discussion and Analysis of Financial Condition and Results of Operations, for compliance with the applicable accounting standards and the disclosure requirements of the federal securities laws and regulations; or

a targeted issue review in which the staff will examine the filing for one or more specific items of disclosure for compliance with the applicable accounting standards and/or the disclosure requirements of the federal securities laws and regulations.

Much of the Division's review involves reviewing the disclosure from a potential investor's perspective and asking questions that an investor might ask when reading the document. When the staff notes instances where it believes a company can enhance its disclosure or improve its compliance with the applicable disclosure requirements, it provides the company with comments. The range of possible comments is broad and depends on the issues that arise in a particular filing review. The staff completes many filing reviews without issuing any comments.

In addition to a first level examiner, in nearly all cases a second person reviews a filing and proposed comments to help achieve consistency in comments across filing reviews. We refer to this person as the reviewer.

Staff Comments

The Division views the comment process as a dialogue with a company about its disclosure. The Division's comments are in response to a company's disclosure and other public information and are based on the staff's understanding of that company's facts and circumstances. In issuing comments to a company, the staff may request that a company provide additional supplemental information so the staff can better understand the company's disclosure, revise disclosure in a document on file with the SEC, provide additional disclosure in a document on file with the SEC, or provide additional or different disclosure in a future filing with the SEC.

Company Response to Comments

A company generally responds to each comment in a letter to the staff and, if appropriate, by amending its filings. A company's explanation or analysis of an issue will often satisfactorily resolve a comment. Depending on the nature of the issue, the staff's concern, and the company's response, the staff may issue additional comments following its review of the company's response to its prior comments. This comment and response process continues until the Division and the company resolve the comments.

While the staff and the company may ultimately disagree with the final outcome of a staff comment, a company should, in any instance it wishes to, seek reconsideration of a staff comment by other Division staff members. Depending on the nature of a pending issue, the Division's Office of Chief Accountant may decide to involve the Commission's Office of the Chief Accountant during the comment and response process on matters relating to accounting and financial disclosure matters.

Source: SEC Filing Review Process Information.

Whether a company will be subjected to a full or limited review depends on the issues at hand. According to Kiima, a full review is generally conducted on registration and proxy statements and annual and quarterly reports, while limited-scope reviews are done on executive compensation disclosures, 8-Ks, and other filings.

An initial comment letter from the Corp Fin staff generally signals a review process. Some issue questions for companies to answer. The most effective strategy companies can adopt when replying to an SEC comment letter is answering the question in a straightforward manner, says Martin. “Answer the question! You see a lot of companies not answering the issue at hand,” he says. When preparing to reply to the comment letter, read the comment and make sure you understand it, says Martin. A common mistake committed by some companies, he says, is answering a comment that they themselves do not fully understand. Martin adds companies should seek clarification from a staff member if they don't understand the question.

Another error committed by companies when preparing to draft a response to a comment letter is getting too many people or the wrong personnel involved in the process. “Look at the information, find out the problem. If it is an issue with executive compensation, get the HR personnel and not the auditor,” says Kiima.

He said although most comment letters have a relatively short timeline for companies to submit their responses, usually within eight to ten business days, companies should still craft their correspondences carefully. “Hold a roundtable meeting with all interested parties, discuss the area of comment to be addressed and form a working group to draft the response,” he says.

Kiima adds that companies should be aware that they can request an extension if the issue cannot be addressed within the limited time period. “If you need more time, send in your request to the SEC,” he says.

Even after the company has submitted their response to the initial letter, SEC staff may issue additional comments if they find the company's reply does not resolve the issue at hand. The process continues until the division and the company resolves the issues. Martin said companies should not hesitate to seek outside expert help when responding to SEC comment letters from a filing review. “Get the right assistance both internally and externally in reviewing the proposed response,” he said.

The best practice a company can adopt to avoid the problem entirely is to invest time to ensure its filings contain clear disclosure, meet the technical rule requirements, and comply with SEC staff interpretations, says Mittleman. “Simply reviewing staff compliance and disclosure interpretations and other recent pronouncements can provide dividends because they are areas that staff comments upon,” he says.