Securities Enforcement And Fraud Risk In The Age Of President Obama

Tuesday, March 31, 2009 - 00:00

Ernst & Young

Following are excerpts from a recent webcast hosted by Ernst & Young. The discussion is moderated by Mike Herrinton, a Partner at the firm. The panel includes the former Director of the New York regional office of the SEC, Mark Schonfeld, who is now a Litigation Partner in the New York office of Gibson, Dunn & Crutcher. Mark is joined by fellow Gibson Partner John Sturc, who formerly served as Associate Director of the SEC's Division of Enforcement. Brian Loughman and Rick Sibery, both Partners in the Fraud Investigation & Dispute Services practice of Ernst & Young, round out the panel.

The full webcast is available online at http://webcast.ey.com. Search under "archived webcasts."

Herrinton: What has the SEC generally been focused on from an investigations perspective?

Sturc: There are several areas that the commission has emphasized over time and it continues to do so. These include financial fraud, insider trading, hedge funds, Foreign Corrupt Practices Act (FCPA), market manipulation and market participants. Over time economic conditions and other factors have changed the emphasis. For example, financial fraud was a big issue in the post-Enron era. Insider trading is a constant priority as is the focus on regulated market participants such as brokers, advisors and the like. In the past couple of years,there has been a major emphasis both at the SEC and the Department of Justice and worldwide on FCPA matters.

Loughman: The FCPA is enforced by both the Department of Justice and the SEC, and we've seen more enforcement cases in the last two or three years than in the previous 27 years in the life of the statute. The FCPA requires a company to maintain its books and records in an accurate and appropriate way and also maintain an appropriate internal control environment. The great value from an enforcement perspective is that there is no materiality limit in terms of transactions that fall under that purview of the statute, so the SEC has been using the FCPA as a portal into organizations to understand internal controls and books and records. It's important to note that financial fraud has always been an enforcement priority, and historically, 60 percent of financial fraud cases relate to revenue recognition issues. That isn't going away in the current environment.

Sibery: Mark,with so much happening in the markets, how is the SEC going to prioritize? Are we going to see a diminishing focus on FCPA enforcement or hedge fund regulation?

Schonfeld: I don't think so. In fact I think investigative resources and focus are going to intensify on those areas. The government has limited resources and there is a constant shifting of those resources based on the latest and highest priority. Right now it remains everything related to the financial crisis, hedge funds, market manipulation and everything related to corporate disclosures around those events. There's a heightened level of scrutiny for any company in the position of making disclosures about its current financial situation.

Herrinton: Mark, can you talk about corporate statements regarding financial health and stability?

Schonfeld: I hear from clients that they confront a recurring challenge of trying to make disclosures that are accurate but which are subject to variability as the market changes so quickly. A number of investigations discussed in the press involve executives who made a statement at a given point in time about the company's financial condition, and then something catastrophic happens within a few days or weeks. The company files for bankruptcy or is forced into a merger, and suddenly the company is under investigation. That creates a heightened risk for any company making public disclosures.

Herrinton: What types of investigations are on the horizon?

Schonfeld: The executive compensation issue has become a huge public relations and political issue. While I have yet to hear a government representative articulate any theory as to how this violates any law, if your company has received public funds under TARP, then there is a good chance that compensation at the senior executive level may be under some scrutiny.The next thing to prepare for is the Inspector General for the TARP program.It's a new position, held by Neil Barofsky, a former federal prosecutor, and he has a staff, a budget and a mandate to ensure that everything connected with the TARP program is done legally. He's already very active in working with other investigative agencies, and he will likely play an integral role in future investigations.

Sturc: My guess is that the executive compensation issue will not be confined simply to financial institutions receiving federal funds. There is a widespread perception in the country that there has been something skewed about the compensation issue and a suspicion that executives may be obtaining benefits that are not fully disclosed in proxy statements as is required by law.

Herrinton: Mark, can the SEC possibly keep up with the number of issues that it's facing in the market today?

Schonfeld: Yes, but it needs to be smart about how it directs its resources. We have a tremendous confluence of factors here. We have the financial crisis, a new administration that came into office on a pro-regulatory platform, and an acute focus on the SEC. The new chairman, Mary Shapiro, a career regulator, will be joined by a number of senior staff (some of them from prior administrations). The agency has already said they plan to reinvigorate the enforcement division, and make it more efficient and focused. There will be a renewed emphasis on speed, and as the pressure increases on staff to bring cases, they are going to pass that pressure on to the recipients of their subpoenas.

Loughman: The SEC has a great ability to leverage the resources of the companies it regulates, along with their outside counsel and other resources. I think the SEC will probably be very focused on putting pressure on the registrants to investigate issues by using their own resources or by hiring outside counsel, forensic accountants and other appropriate resources. This will give the SEC maximum coverage with minimum resource use.

Herrinton: Mark, can you comment on the immediate future of SEC enforcement?

Schonfeld: I think the burdens and the demands on companies undergoing an investigation are going to increase. Documents and witnesses will have to be produced more quickly, and there will be a greater overall sense of urgency to getting things done and less tolerance by the SEC for delays. As to the actual outcomes of cases, I think because of the current economic environment we will see the government focus on individuals. Certainly cases against companies will continue, but in this current financial environment, how much of a sanction is the government going to extract? Normally in a pro-enforcement administration, penalties go up - and they may here as well - but given the counterbalancing effect of the economy I think the government is probably going to exercise some discretion here and not necessarily seek enormous penalties. However, this does mean that they may turn their attention more towards individuals and trying to hold individuals accountable.

Herrinton: Thinking about the FCPA, Brian, and looking at what happened in India with Satyam, what does that tell us about the future from a foreign private issuers perspective?

Loughman: In regards to the FCPA,the DOJ and SEC increased their focus on certain events within industries. If one company has a particular issue, immediately others in the same industry start to receive requests for information. I think there will continue to be thoughtful and directive activity towards particular industry issues. Regarding Satyam, nobody really knows what happened there, but it is certainly my experience that when you are dealing with a foreign private issuer, you are often dealing with a company that's been a long-established entity in its own country. It culturally views itself as a company from that jurisdiction and is used to those mores and approaches to doing business, which frankly do not always fit with the requirements in the U.S. That in itself creates a higher level of risk around compliance, which may well increase with a more empowered regulatory regime in the U.S.

Herrinton: Let's talk about some of the current financial reporting issues and their impacts on companies.

Loughman : First let me say that the classic situations that have led to fraud over the years have not gone away. Currently there is an undertow created by the current crisis: credit and liquidity issues have a kind of trickle down effect in terms of an environmental impact from an accounting perspective. When you look at judgments that were made or accounting positions that were taken that prove to be ultimately fraudulent, they were often unduly influenced by trying to make results seem better then they actually were. The credit and liquidity problem has created a situation in which many positions and assertions that are included in financial statements have been predicated on credit and liquidity situations that simply no longer exist. This is forcing companies to evaluate very closely.

Schonfeld: Today it's even more difficult because you can't necessarily rely on old assumptions, so it makes predictions about the future or estimates that you need to make very difficult.

Sibery: Absolutely. I think companies are dusting off policies and procedures that were on auto pilot. They are reevaluating what they have in terms of estimates and assumptions, and they may have fewer or different people to do that work.

Sturc : Given that, by definition, estimates are almost always wrong to some degree, how do your clients protect themselves from being second guessed?

Sibery: The first important procedure you can make sure to have is a process of documentation. If three years from now you are asked how you came up with a number, you need to show the SEC the rationale for how you made the estimate.

Sturc: In my experience in defending clients, process is critical. A claim of fraud requires three key things: 1) that the assertion of fact is false; 2) that it is material; and 3) that it was made with some kind of intent to mislead. An estimate can never be perfect; you need to demonstrate your process with contemporaneous documentation. I can't stress this enough: when I was in government, if the estimate wasn't in writing contemporaneously with support, then the government believed that it didn't happen and could have been made up after the fact.

Loughman: That's the key point because what we're talking about is a new regulatory strength or determination, which will assume that to be the case particularly if you can't demonstrate from your existing system that it wasn't documented. I think that these are systems that companies should have today. They just need to be mindful of the fact that they need to create a document and a contemporaneous record of how they're dealing with these estimates. Sibery: I would add that documentation is a good start, but a robust methodology is also important. You must show that you are really considering what's happening in the market today. Just doing what you did last year is not going to be enough, even if it is documented.

Herrinton: You mentioned revenue recognition earlier, which is of significant concern.

Loughman: Complex revenue recognition situations can occur during challenging economic environments such as this one, because usually a sales organization will go the extra mile to generate sales, and sometimes that means getting into unusual contract terms or new arrangements, leading to revenue recognition issues which are not always understood. The organization may not have caught up with this variability of terms resulting in problems down the road. Revenue recognition will continue to be challenging as businesses looks towards more complex transactions.

Sturc: Even in the simple transactions, one of the problems we're facing today is that desperate times lead people to take desperate measures. A sales person who is worried about losing her job if she doesn't meet sales goals may well say to herself that "she's got to do what she's got to do." When normally good people get pushed into circumstances where they're tempted to make false statements, those circumstances can lead to issues in the revenue recognition area. Knowing that this risk is out there, it is essential for leadership to set the appropriate tone at the top, both in terms of the demand for standards but also an understanding that times are tough and that personnel should not be held to unattainable goals.

Loughman: It is possible that the current environment holds so much bad news that many organizations will realize this is an opportunity to take whatever reserves and write-offs need to be taken. In many respects, there won't be as much criticism as there has been in the past. However, I think that the judgments that were made a year ago, before things really got this bad, could come under some scrutiny as this reporting season plays out.

Herrinton: With the current environment of companies reducing work force to maintain profitability or at least reduce losses, do you anticipate a higher level of fraud-related activity?

Sibery: There's certainly a lot of stress being created by headcount redirections and limited budgets. One of the ways companies use fraud risk assessments is to identify the areas most susceptible to fraud. Companies are asking themselves, what are our risks? What controls do we have to prevent and detect them? Hard economic times is not an excuse for an ineffective compliance program.

Herrinton: How would you recommend companies manage fraud risk?

Sibery: First, consider tone at the top. This may not be the best time for the CEO to state that the company must meet its quarter targets at all costs; instead, it might be the time to remind everyone of their ethical and moral obligations. Make sure that the sales force is educated and that finance, accounting people and sales people are all communicating. There may be new terms and sales trends; there may even be new deals that might have revenue implications. Quarter-end and year-end cutoffs should also be an area of focus. These are times to consider fraud being used to meet targets. The fraud could be on an individual basis or business line or even region.

Schonfeld: I want to emphasize the tone at the top. I think some people may have become cynical about this concept and wonder if it really has any merit.Having done this for so long on the government side, I can tell you that tone at the top does matter because it affects how the company is able to position itself before the government. If all you have are e-mails from the CEO or the CFO talking about meeting earnings at all costs and no messages about the importance of compliance and abiding by the law, you are handing the government a great record of exhibits that they will use against you. But even more important, the right tone can have an effect on the company and its employees - the way they think and how they behave.

Sibery: You can definitely see the difference at an organization where compliance and ethics are at the top. You can see it in terms of the way people act in their everyday jobs. It's really a part of what they do and it is real.

Sturc: Key to tone at the top is that the same rule has got to apply to everybody. You cannot have one set of rules for the executives and a different set for everybody else. Walking the walk is essential.

Sibery: Monitoring is also important, John. Without it, you don't know if what you have is effective or not.

Loughman: I also advise clients to keep current. If you did a risk assessment a year ago, it's clearly out of date, particularly if you had major organizational change or cutbacks. It's important to document a fact-rich and thoughtful process around why you made adjustments.

Herrinton: That ties around the issue of unusual trends and what that means for forecasting. Brian, can you talk about that?

Loughman: Forecasting is an important issue now. As John said, any forecast is going to be wrong especially now. This creates an environment where you have to demonstrate that you've taken current challenges into consideration and adapted your process accordingly. You have to be able to demonstrate that you are now doing things you never did before in terms of level of effort, your acuity around information you need, and the frequency by which you look at these things; you've really got to demonstrate that you "get it." Forecasting has very clear impact as it relates to some significant accounting and reporting issues. Financial statements being issued now are built on the premise of going concern. If that wasn't the case, you'd have a huge revision to many sets of financial statements. It's really a matter of recognizing that in most cases - and it's not true for every industry, as there are certain industries that tend to be more stable, but for most industries - companies are dealing with a sea change in terms of risk, and they've got to make sure they can adapt their process and demonstrate that it has been adapted.

Herrinton: What are the most significant early warning signs of stress?

Loughman: You want to look for deterioration in some of your activities and your status around your debt covenants, lender relationships and/or cash flow. You should consider if there is unpredictability around the more stable business processes. In other words, do you see severe order drop off or changes in your underlying activity? These can all be early warning signs of stress. In the current economy, results are not likely to be as good as they've usually been, but you still have tremendous pressure to achieve those results, you may have a sign of stress. Certain industries are going through major upheaval. You need to be aware of how that might impact your business. If you start to see stable performance and solid results against this backdrop, you may need to step back and ask how you are getting those results.

Sibery: That's exactly right. Maybe the fact that nothing has changed in that metric is the problem. Maybe you should be expecting change, and if you don't see change, start asking questions.

Herrinton: So let's say the SEC has just arrived, should you cooperate?

Schonfeld: The first rule is that you never want to be deemed uncooperative. You always want the government to feel as though you are being cooperative. The question of just what exactly that means in practice is going to depend a lot on the specific situation that you are in. As a first order of business, you need to get your arms around the facts. You need to know what the status of the evidence is on a given situation. That will enable you at least to make a judgment about what the appropriate posture for the company is, whether there is an appropriate defense, whether this is an issue about which reasonable minds could differ, or if you have a reasonable argument with the government. If you have a serious enough problem maybe it is time to clean house and move on. But you can't do that until you know the facts. As I said, you never want to be perceived by the government as delaying or in any way obstructing the investigation.

Herrinton: Can you each provide one last comment to wrap things up?

Schonfeld : I think that we have talked about how bad things are. I want to leave on a hopeful note. My message is that from adversity comes opportunity. With all the difficulties that companies are confronting in the financial sector and the economy, coupled with the heightened scrutiny from the government, you actually have the opportunity now to position your company in a better light - to make sure that compliance and internal controls are in place, processes are documented, and questionable compliance issues are addressed. That way if the government comes knocking, you have the opportunity to get ahead of the problem and show the government that you did things right or at least you did the best that you could and there was no intent to do anything wrong. That is the opportunity that you have.

Sturc: I want to follow up on that comment. It is inevitable that, from time to time, a crisis will arise, issues will arise, and a company will need to deal with that crisis.Sometimes there will be government investigations. The key from a manager's point of view is: manage the business. Find a way to manage the investigation, or the parallel litigation, in order to keep the business going, because it is imperative that management keep the business going rather than have the investigation or litigation take all attention away from keeping the business moving forward.Employing some of the ideas that we have talked about in the financial reporting process and risk assessment is key. Planning how to deal with an inquiry should it arise is also important so that one can segregate the management of the problem. The ability to put it aside and keep business going is important to an optimal outcome.

Loughman: We have talked about a lot of processes that are already in place in many organizations. Entities generally have internal control processes in place. They stay on top of the challenges that they face in their business everyday. I think that the recurring theme for me in this sort of discussion is that there are challenges out there, but if you really sort of boil down the advice, it is to be cognizant of the challenge and recognize that you need to upgrade your process accordingly because process is king. That is what is going to be your savior if you get into some problems. As long as you can demonstrate a sound consistent process that is unbiased and you are gathering the information that you should gather and processing it accordingly, that is what is going to help you through these situations.

Sibery: Obviously the current environment is tough. There is a lot of pressure to meet not only the street's expectations but there is pressure for reasons of debt covenants or credit problems. Forget some of what I would call the classic fraud risks, such as revenue recognition, as well as (given these added pressures) cookie jar reserves and expense deferrals. These are the types of fraudulent activities that over the years have surfaced again and again. While we haven't necessarily seen financial restatements coming out of the current problems in the economy, I think it is only a matter of time.

The views expressed in this article are those of the authors and don't necessarily reflect the views of Ernst & Young LLP.