Does the SEC Still Care About Financial Reporting Cases?

Over the past few years, the Enforcement Division has focused extensively on cases involving investment advisers and companies, securities offerings, and broker-dealers, as well as high-profile matters involving bribery under the Foreign Corrupt Practices Act (FCPA), insider trading, Ponzi schemes, and the credit crisis.

Traditional financial reporting and accounting cases, including those involving revenue recognition, have seemingly become a lesser priority. For example, from 2003 through 2007, financial reporting and accounting cases generally comprised approximately 28% to 33% of the SEC's docket, with only a slight dip in 2006 to 24%; by contrast, from 2008 to 2012, these cases declined each year, representing 22.9% of the total enforcement docket in 2008, down to 21.5% in 2009, 18.5% in 2010, 12.1% in 2011, and a further decline to 10.7% in 2012. (While some of the recent decline reflects the separate break-out of FCPA cases beginning in 2011, this does not represent a significant portion of it.)

These numbers reflect the lowest levels of financial reporting-type matters since Sarbanes-Oxley went into effect approximately one decade ago. This trend is also reflected in the declining number of cases brought by the SEC: from 2003 through 2012, financial reporting-type cases declined from 199 to 79, with a significant decline evident in the past four years (from 143 to 79 cases). Interestingly, at the same time as financial reporting and disclosures cases have declined, the Enforcement Division filed record numbers of cases in 2011 and 2012.

Expect an Uptick

Despite the recent declines in enforcement actions dealing with financial reporting, one should not conclude that this trend will necessarily continue. In fact, there are plenty of reasons to expect an uptick in enforcement actions and investigations addressing financial reporting and, in particular, revenue recognition.

First, the fact that the SEC brought fewer financial reporting cases in recent years may merely reflect the natural delay in timing stemming from the Enforcement Division's often lengthy investigations of such matters. It may be that there are financial reporting cases coming down the pike that the SEC has been investigating, and yet the number remains unknown in light of the non-public nature of such investigations. We may especially see more revenue recognition cases, given that the nature of violations often reflects the state of the economy. Thus, historically, there have been more revenue recognition and other accounting frauds and schemes when companies navigate downtimes in the economy and strive to meet earnings targets and analyst expectations. This was true, of course, of a number of the big financial fraud cases announced in the early 2000s. We should expect the same in light of the struggling economy over the last several years.

Second, the last few years involved a substantial focus on credit crisis investigations and cases. Now that many of those matters have been resolved, closed, or are in the process of being litigated to a conclusion, we should expect the Enforcement Division to redeploy the resources that had been focused on those matters ' and for many to return to a focus on traditional financial reporting investigations and cases, including those addressing revenue recognition.

Third, we should expect a recent academic study regarding earnings manipulation to shape the SEC's enforcement priorities, in the same way as academic studies have done in the past. Last year, four business school professors published a study addressing earnings management, titled “Earnings Quality: Evidence from the Field,” by I. Dichev, J. Graham, C. Harvey, and S. Rajgopal (Sept. 9, 2012). Their findings were based on a survey of 169 public company CFOs and in-depth interviews of 12 CFOs. The latter responded to the following question: “From your impressions of companies in general, in any given year, what percentage of companies use discretion within GAAP to report earnings which misrepresent the economic performance of the business?” Id. at 35. The CFOs estimated that “roughly 20% of firms misrepresent their economic performance by managing earnings; for such firms, the typical misrepresentation is about 10% of reported [earnings-per-share].” Id. at 3.

According to the authors, this 20% estimate may understate the prevalence of earnings management at public companies because of a relatively conservative approach used in articulating the survey questions. Id. at 34-35. Thus, the authors note that “the answers to our questions can be thought of as a lower bound on actual earnings management encountered in practice.” Id. at 35. The responding CFOs indicated that earnings management was somewhat more likely to be income-increasing, and a “large majority” believe that misrepresenting earnings “occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives.” Id. at 4.

Other Studies

Similar studies have received the Enforcement Division's attention and preceded an SEC-specific focus on the issues addressed in the studies. For example, in 1998, a study reported that 67% of public company CFOs had been asked by other executives to misrepresent financial results, and that 12% had done so. SEC officials at that time expressed serious concerns about earnings management and other potentially fraudulent accounting practices ' what then-Chairman Arthur Levitt famously called “the numbers game.” The years that followed saw a dramatic increase in public company restatements of earnings, and the uncovering of several large and widespread frauds.The SEC responded with an increased focus on financial reporting and accounting fraud, bringing 199 issuer financial reporting cases in 2003, representing nearly 30% of its entire enforcement docket at that time.

Similarly, in 2006, The Wall Street Journal reported on the SEC's commencement of investigations of stock-options backdating, which were prompted by a finance professor's 2005 academic study. The study concluded that more than 2000 companies used options backdating to reward senior executives and that in an “uncanny number of cases” they granted them right before a large share price increase. In the wake of this study, approximately 150 companies restated their financials because of errors relating to options-backdating. In addition, the SEC had a widespread focus on investigating and bringing cases in this arena, launching more than 100 investigations and bringing several significant enforcement actions. Public companies should be prepared for the same SEC response to the recent earnings management study.

Fourth, the SEC has several new tools at its disposal that should be expected to lead to new investigations focused on financial reporting. For one, the SEC opened the Office of the Whistleblower in 2011 and made its first award under the whistleblower program in 2012. This program allows a whistleblower potentially to recover 10% to 30% of monetary sanctions over $1 million. The program creates incentives for individuals with relevant information to come forward. For fiscal year 2012, the SEC reported that it received approximately 3,000 whistleblower tips, complaints, and referrals. See SEC's Annual Report on the Dodd-Frank Whistleblower Program for Fiscal Year 2012 (Nov. 2012) at 4.

The most common category reported by whistleblowers was Corporate Disclosures and Financials, comprising 18.2% of all whistleblower tips. Id. at 4-5. Significantly, many of the largest frauds uncovered during the early 2000s were reported or flagged by whistleblowers ' or whistleblowers otherwise played an important role in leading to the uncovering of such frauds. Beyond whistleblowers, the SEC has enhanced its cooperation initiatives (including deferred and non-prosecution agreements) to encourage early cooperation and, in turn, provide the Enforcement Division with more detailed information in an efficient and quick manner.

Moreover, the SEC has been developing a new quantitative analytical model ' the Accounting Quality Model ' to assist in analyzing large data sets and identifying anomalies in registrants' financial statements and potential earnings management. See “Risk Modeling at the SEC: The Accounting Quality Model,” Speech by Craig M. Lewis, Chief Economist and Director, Division of Risk, Strategy, and Financial Innovation, SEC, at the Financial Executives International Committee on Finance and Information Technology (Dec. 13, 2012). The model is expected to be fully implemented by the end of this year. The use of this model should be expected to increase the Enforcement Division's efficiency in identifying and investigating cases, and evaluating the tips and complaints reported to the SEC.

Aggressive Encorcement Activity

Finally, with a new regime at the SEC, we should expect aggressive enforcement activity and a renewed focus on more traditional financial reporting cases. The new director and two new co-heads of the Enforcement Division have each spent substantial time as federal prosecutors. Chairman White espoused her views at her confirmation hearing in March 2013 before the Senate Banking Committee, pledging that one of her highest priorities would be “to further strengthen the enforcement function of the SEC” in a manner that is “bold and unrelenting.” She further explained that, under her leadership, the SEC would aggressively pursue “all wrongdoers ' individual and institutional, of whatever position or size” to deter wrongdoing and protect the integrity of the market.

In addition, in her recent testimony before the Subcommittee on Financial Services and General Government, House Committee on Appropriations, Chairman White requested a 26% increase to the SEC's budget for the next fiscal year, up to $1.674 billion. She explained that this budget increase would allow the SEC to add 676 new staff positions, including 131 in the Enforcement Division, which positions would be used to bring “increased expertise in the securities industry and new product areas, trial attorneys, and forensic accountants, as well as staff for the Office of Market Intelligence, the Office of the Whistleblower, and the SEC's collections and distributions functions.” She further testified that the additional budget would pay for significant technology additions and upgrades.

Given the anticipated renewed Enforcement Division focus on revenue recognition and other financial reporting cases, companies should be prepared in the event of an SEC inquiry or investigation.

Conclusion

It is important that companies think ahead and proactively examine their accounting policies and procedures to identify any potential earnings quality issues, including revenue recognition irregularities. Companies also must foster a corporate culture and a “tone at the top” that promotes compliance, and ensure that there are robust internal controls relating to financial reporting, business conduct, and ethics, among other areas. Moreover, companies should ensure that they have accounting departments that are focused on ensuring the proper recognition of revenue under the accounting guidance, and that there is appropriate training and oversight for accounting personnel. Finally, it is important that companies have internal reporting channels for employees who believe there may be wrongdoing or accounting irregularities within the organization, and that they educate their employees on how to report within their organizations.

Jodi E. Lopez is a partner in the Litigation group of Sidley Austin LLP's Los Angeles office. Her practice focuses on complex civil litigation with an emphasis on financial litigation in the fields of securities and professional liability, including class actions brought by shareholders, suits brought by liquidating trustees, derivative suits, and M&A litigation. She can be reached at [email protected].'

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In recent years, the U.S. Securities & Exchange Commission (SEC) has brought far fewer revenue recognition and other financial reporting cases than it had historically. That leads us naturally to wonder whether this trend will continue in the future. Not likely.

There are many reasons to expect a renewed SEC focus on financial reporting and accounting matters. We should also expect the new regime at the SEC ' including Chairman Mary Jo White and two new co-heads of the Division of Enforcement, George Canellos and Andrew Ceresney ' to rely on their extensive federal prosecutorial backgrounds in informing their approach at the the agency. Indeed, in nominating Chairman White, President Obama referred to her as “not someone to be messed with.” Given the expectation of an aggressive enforcement agenda and a return to more traditional financial reporting and accounting matters, companies should prepare now by proactively examining their policies and procedures, as well as their accounting departments.

Background

Over the past few years, the Enforcement Division has focused extensively on cases involving investment advisers and companies, securities offerings, and broker-dealers, as well as high-profile matters involving bribery under the Foreign Corrupt Practices Act (FCPA), insider trading, Ponzi schemes, and the credit crisis.

Traditional financial reporting and accounting cases, including those involving revenue recognition, have seemingly become a lesser priority. For example, from 2003 through 2007, financial reporting and accounting cases generally comprised approximately 28% to 33% of the SEC's docket, with only a slight dip in 2006 to 24%; by contrast, from 2008 to 2012, these cases declined each year, representing 22.9% of the total enforcement docket in 2008, down to 21.5% in 2009, 18.5% in 2010, 12.1% in 2011, and a further decline to 10.7% in 2012. (While some of the recent decline reflects the separate break-out of FCPA cases beginning in 2011, this does not represent a significant portion of it.)

These numbers reflect the lowest levels of financial reporting-type matters since Sarbanes-Oxley went into effect approximately one decade ago. This trend is also reflected in the declining number of cases brought by the SEC: from 2003 through 2012, financial reporting-type cases declined from 199 to 79, with a significant decline evident in the past four years (from 143 to 79 cases). Interestingly, at the same time as financial reporting and disclosures cases have declined, the Enforcement Division filed record numbers of cases in 2011 and 2012.

Expect an Uptick

Despite the recent declines in enforcement actions dealing with financial reporting, one should not conclude that this trend will necessarily continue. In fact, there are plenty of reasons to expect an uptick in enforcement actions and investigations addressing financial reporting and, in particular, revenue recognition.

First, the fact that the SEC brought fewer financial reporting cases in recent years may merely reflect the natural delay in timing stemming from the Enforcement Division's often lengthy investigations of such matters. It may be that there are financial reporting cases coming down the pike that the SEC has been investigating, and yet the number remains unknown in light of the non-public nature of such investigations. We may especially see more revenue recognition cases, given that the nature of violations often reflects the state of the economy. Thus, historically, there have been more revenue recognition and other accounting frauds and schemes when companies navigate downtimes in the economy and strive to meet earnings targets and analyst expectations. This was true, of course, of a number of the big financial fraud cases announced in the early 2000s. We should expect the same in light of the struggling economy over the last several years.

Second, the last few years involved a substantial focus on credit crisis investigations and cases. Now that many of those matters have been resolved, closed, or are in the process of being litigated to a conclusion, we should expect the Enforcement Division to redeploy the resources that had been focused on those matters ' and for many to return to a focus on traditional financial reporting investigations and cases, including those addressing revenue recognition.

Third, we should expect a recent academic study regarding earnings manipulation to shape the SEC's enforcement priorities, in the same way as academic studies have done in the past. Last year, four business school professors published a study addressing earnings management, titled “Earnings Quality: Evidence from the Field,” by I. Dichev, J. Graham, C. Harvey, and S. Rajgopal (Sept. 9, 2012). Their findings were based on a survey of 169 public company CFOs and in-depth interviews of 12 CFOs. The latter responded to the following question: “From your impressions of companies in general, in any given year, what percentage of companies use discretion within GAAP to report earnings which misrepresent the economic performance of the business?” Id. at 35. The CFOs estimated that “roughly 20% of firms misrepresent their economic performance by managing earnings; for such firms, the typical misrepresentation is about 10% of reported [earnings-per-share].” Id. at 3.

According to the authors, this 20% estimate may understate the prevalence of earnings management at public companies because of a relatively conservative approach used in articulating the survey questions. Id. at 34-35. Thus, the authors note that “the answers to our questions can be thought of as a lower bound on actual earnings management encountered in practice.” Id. at 35. The responding CFOs indicated that earnings management was somewhat more likely to be income-increasing, and a “large majority” believe that misrepresenting earnings “occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives.” Id. at 4.

Other Studies

Similar studies have received the Enforcement Division's attention and preceded an SEC-specific focus on the issues addressed in the studies. For example, in 1998, a study reported that 67% of public company CFOs had been asked by other executives to misrepresent financial results, and that 12% had done so. SEC officials at that time expressed serious concerns about earnings management and other potentially fraudulent accounting practices ' what then-Chairman Arthur Levitt famously called “the numbers game.” The years that followed saw a dramatic increase in public company restatements of earnings, and the uncovering of several large and widespread frauds.The SEC responded with an increased focus on financial reporting and accounting fraud, bringing 199 issuer financial reporting cases in 2003, representing nearly 30% of its entire enforcement docket at that time.

Similarly, in 2006, The Wall Street Journal reported on the SEC's commencement of investigations of stock-options backdating, which were prompted by a finance professor's 2005 academic study. The study concluded that more than 2000 companies used options backdating to reward senior executives and that in an “uncanny number of cases” they granted them right before a large share price increase. In the wake of this study, approximately 150 companies restated their financials because of errors relating to options-backdating. In addition, the SEC had a widespread focus on investigating and bringing cases in this arena, launching more than 100 investigations and bringing several significant enforcement actions. Public companies should be prepared for the same SEC response to the recent earnings management study.

Fourth, the SEC has several new tools at its disposal that should be expected to lead to new investigations focused on financial reporting. For one, the SEC opened the Office of the Whistleblower in 2011 and made its first award under the whistleblower program in 2012. This program allows a whistleblower potentially to recover 10% to 30% of monetary sanctions over $1 million. The program creates incentives for individuals with relevant information to come forward. For fiscal year 2012, the SEC reported that it received approximately 3,000 whistleblower tips, complaints, and referrals. See SEC's Annual Report on the Dodd-Frank Whistleblower Program for Fiscal Year 2012 (Nov. 2012) at 4.

The most common category reported by whistleblowers was Corporate Disclosures and Financials, comprising 18.2% of all whistleblower tips. Id. at 4-5. Significantly, many of the largest frauds uncovered during the early 2000s were reported or flagged by whistleblowers ' or whistleblowers otherwise played an important role in leading to the uncovering of such frauds. Beyond whistleblowers, the SEC has enhanced its cooperation initiatives (including deferred and non-prosecution agreements) to encourage early cooperation and, in turn, provide the Enforcement Division with more detailed information in an efficient and quick manner.

Moreover, the SEC has been developing a new quantitative analytical model ' the Accounting Quality Model ' to assist in analyzing large data sets and identifying anomalies in registrants' financial statements and potential earnings management. See “Risk Modeling at the SEC: The Accounting Quality Model,” Speech by Craig M. Lewis, Chief Economist and Director, Division of Risk, Strategy, and Financial Innovation, SEC, at the Financial Executives International Committee on Finance and Information Technology (Dec. 13, 2012). The model is expected to be fully implemented by the end of this year. The use of this model should be expected to increase the Enforcement Division's efficiency in identifying and investigating cases, and evaluating the tips and complaints reported to the SEC.

Aggressive Encorcement Activity

Finally, with a new regime at the SEC, we should expect aggressive enforcement activity and a renewed focus on more traditional financial reporting cases. The new director and two new co-heads of the Enforcement Division have each spent substantial time as federal prosecutors. Chairman White espoused her views at her confirmation hearing in March 2013 before the Senate Banking Committee, pledging that one of her highest priorities would be “to further strengthen the enforcement function of the SEC” in a manner that is “bold and unrelenting.” She further explained that, under her leadership, the SEC would aggressively pursue “all wrongdoers ' individual and institutional, of whatever position or size” to deter wrongdoing and protect the integrity of the market.

In addition, in her recent testimony before the Subcommittee on Financial Services and General Government, House Committee on Appropriations, Chairman White requested a 26% increase to the SEC's budget for the next fiscal year, up to $1.674 billion. She explained that this budget increase would allow the SEC to add 676 new staff positions, including 131 in the Enforcement Division, which positions would be used to bring “increased expertise in the securities industry and new product areas, trial attorneys, and forensic accountants, as well as staff for the Office of Market Intelligence, the Office of the Whistleblower, and the SEC's collections and distributions functions.” She further testified that the additional budget would pay for significant technology additions and upgrades.

Given the anticipated renewed Enforcement Division focus on revenue recognition and other financial reporting cases, companies should be prepared in the event of an SEC inquiry or investigation.

Conclusion

It is important that companies think ahead and proactively examine their accounting policies and procedures to identify any potential earnings quality issues, including revenue recognition irregularities. Companies also must foster a corporate culture and a “tone at the top” that promotes compliance, and ensure that there are robust internal controls relating to financial reporting, business conduct, and ethics, among other areas. Moreover, companies should ensure that they have accounting departments that are focused on ensuring the proper recognition of revenue under the accounting guidance, and that there is appropriate training and oversight for accounting personnel. Finally, it is important that companies have internal reporting channels for employees who believe there may be wrongdoing or accounting irregularities within the organization, and that they educate their employees on how to report within their organizations.

Jodi E. Lopez is a partner in the Litigation group of Sidley Austin LLP's Los Angeles office. Her practice focuses on complex civil litigation with an emphasis on financial litigation in the fields of securities and professional liability, including class actions brought by shareholders, suits brought by liquidating trustees, derivative suits, and M&A litigation. She can be reached at [email protected].'

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