Speech by SEC Staff:
Remarks Before the 2009 AICPA National Conference on Current SEC and PCAOB Developments
Jason S. Flemmons
Associate Chief Accountant, Division of Enforcement
U.S. Securities and Exchange Commission
December 8, 2009
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication, or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the Staff.
Good afternoon. While I have had the opportunity to appear at a number of other industry events, this is the first time that I have had the pleasure of speaking at this renowned conference and addressing so many of you under one, very large roof.
When preparing my remarks for today, I sought to address what is typically on the forefront of everyone’s minds when someone from the Division of Enforcement takes the podium. Based on the general nature of questions that I have received at other conferences, I believe that the topics of most interest when it comes to SEC enforcement typically fall into two broad categories. The first subject is what the Division is doing to protect investors and to serve as a vital deterrent to financial fraud. The second question that is likely on your minds is one of self-preservation — how can you stay out of trouble and avoid seeing me, Rob or any other member of our Enforcement staff other than from a safe distance at industry conferences such as this one.
Rob thoroughly addressed the first topic earlier by highlighting a number of programmatic achievements and discussing some significant organizational enhancements that are underway. These efforts include the formation of specialized units, efforts to streamline and expedite various internal processes, and the creation of a new Office of Market Intelligence to name a few. I am most encouraged to hear Rob underscore his continued prioritization of financial reporting fraud and his characterization of this core area as “a main artery of our Enforcement program.” To illustrate, even with all of the attention that has been placed on ponzi schemes and insider trading this past year, the accounting and reporting arena still represented 22% of our filed caseload in fiscal year 2009, which was in line with the 23% level in the prior year. Rob highlighted a number of prominent actions that we brought this year, including charges against GE and executives of Countrywide, American Home Mortgage and New Century Financial. We also continue to vigorously enforce the anti-bribery provision of the Foreign Corrupt Practices Act. For example, during this fiscal year the SEC filed the largest FCPA case in history against Siemens. Siemens paid a total of $350 million in disgorgement to settle SEC charges. Siemens also simultaneously settled criminal actions brought by both U.S. and German prosecutors. All told, Siemens paid more than $1.6 billion to settle the combined sanctions.
The past couple of years have without question been the most difficult economic period that our capital markets have faced in decades. Revenues, earnings and stock prices have taken a beating and many companies have resorted to rather drastic, but necessary measures to remain a viable going concern. During the bull market that Wall Street enjoyed prior to the credit crisis, there was extremely heavy pressure on companies to show continued financial growth and to meet ever-increasing consensus EPS estimates. These pressures undoubtedly ignited temptations for many companies to commit financial fraud. While earnings pressures still exist today, companies may be facing a greater threat than simply missing earnings targets: a threat of survival. Recent conditions have put significant strain on core necessities such as financial solvency and access to credit. I firmly believe that these additional pressures have only increased the risk and motivation for companies to commit financial fraud. Challenging economic times are not immune to financial skullduggery. To the contrary, financial fraud is 100% recession proof.
Accordingly, I can assure you that our staff remains more committed than ever to protecting the investing public and sanctioning those who break the rules. I also believe that the initiatives that Rob and the Chairman have undertaken in their brief time at the Commission will greatly strengthen the Division and maximize our effectiveness. For example, by delegating formal order authority to the Division’s senior officers, the number of formal investigations opened this year has more than doubled.
With respect to the second topic of how you can stay out of trouble, I will attempt to address this by highlighting selected themes of misconduct that we have observed in recent enforcement actions against both financial statement preparers and outside auditors. In prior talks that I have given, I routinely walked through the wide range of specific accounting and auditing standards where we encounter violations. However, with the brief time that I have today I want to focus on the forest rather than the trees by honing in on what I believe to be the true genesis of our enforcement cases. For example, with respect to financial statement preparers, I believe that the root causes of our enforcement actions are not driven by the individual accounting issues involved, but rather by two much more basic principles: integrity and transparency. Accordingly, the themes that I will briefly address today are not esoteric accounting concepts, but are rather much more fundamental. Make no mistake, the types of accounting issues that we encounter run the gamut, ranging from novel FAS 133, multiple element arrangement and tax accounting abuses to simply making the numbers up. However, the accounting improprieties cited in our enforcement actions against preparers are the product of integrity and/or transparency defects, not the other way around. I am hopeful that these comments will serve as effective reminders and helpful advice on how to stay out of trouble as we approach the end of the calendar year and, for many registrants, 2009 fiscal year end.
Financial Statement Preparers
Corporate integrity is without question the nucleus of reliable financial reporting. Investor confidence begins and ends with registrants doing the right thing even in the face of opportunity or pressure to do the opposite. Our numerous financial fraud cases have revealed integrity lapses by employees at various levels of corporate structure, including not only CEO’s, CFO’s and controllers, but also purchasing, sales and marketing personnel. Necessity being the mother of all inventions, including financial frauds, the temptation to make unsupported closing journal entries or pull forward revenue to meet budget or street expectations can be extraordinary. It is from this perceived need, opportunity and pressure that accounting can become too much of an art and less of a science. I urge everyone to resist making even the smallest of ethical compromises as this is where the slippery slope of a financial fraud typically begins and how you can quickly wind up being the subject of an SEC investigation. In his famous 1998 speech entitled “The ‘Numbers Game’”, former Chairman Levitt emphasized such core concepts when addressing what he referred to as “accounting hocus-pocus” by stating “That’s why the highest standards of objectivity, integrity and judgment can’t be the exception. They must be the rule.”
One area that remains particularly vulnerable to integrity lapses is with the reporting of accounting estimates. The more dependent that an estimate is on human subjectivity, the more susceptible it is to both unintentional bias and intentional manipulation. Whether an estimate involves the valuation of “category 3” instruments, an effective tax rate or any one of the numerous types of reserves, reliable accounting judgments are most dependent on good faith. When developing accounting estimates, registrants are best served by employing sincere efforts to get to the right answer and supporting their positions with documented analyses or independent valuations. Many of our enforcement actions in this area have involved a troubling dearth of documentation to support material estimates, which further corroborated other evidence that these figures were merely a means to plug earnings shortfalls. Other enforcement actions where documentation was produced were the result of certain inputs or assumptions being fraudulently developed, such as through reverse engineering to meet earnings targets.
Corporate integrity also extends beyond the active deterrence of financial fraud. It also applies to a company’s response when errors or irregularities are discovered. It is imperative that such issues are addressed head on and not ignored or swept under the rug.
Transparent financial reporting involves much more than just getting the numbers right but also providing accurate, meaningful disclosures. Transparency is particularly important when preparing your company’s MD&A as this is widely considered the “Rosetta stone” of a company’s operations and financial performance. Investors rely heavily on MD&A in order to understand a company’s performance through the eyes of management. Providing misleading MD&A information to investors concerning financial statement components or trends exposes you and your company to enforcement action. For example, one required component of registrants’ MD&A disclosures is to identify material trends or changes in liquidity. This year the Commission won a significant trial against the former CEO of Kmart, which involved Kmart intentionally delaying the payment of accounts payable to suppliers in order to create a synthetic liquidity mirage. The company’s MD&A disclosures intentionally omitted this material information and left investors with a distorted picture of the company’s financial health in the months preceding its bankruptcy.
Transparency is also essential when reporting non-GAAP financial measures. Analysts and other financial statement users rely on pro forma reporting as an important measure of a company’s future profitability. By fiddling these financial metrics, investors can be tricked into believing that a downturn in GAAP earnings is temporary and not attributable to a company’s core operations. In these circumstances, non-GAAP measures are used as a mechanism to obscure financial results rather than as a means to expound upon them. Last month the Commission filed fraud actions against SafeNet and five senior employees alleging that they manipulated the company’s reported pro forma earnings. We alleged that the company intentionally excluded ordinary, recurring operating expenses from its reported non-GAAP earnings under the guise that these costs were unusual or non-recurring. While we have brought other enforcement actions involving misleading pro forma reporting, this was the first case that the Commission has brought pursuant to Regulation G, which became effective in 2003. To the extent that your company utilizes non-GAAP financial measures, hopefully this will serve as a caution to ensure that the legitimacy of pro forma earnings is maximized.
The significance of both integrity and transparency also extends to your interactions with outside auditors. Misleading an outside auditor is in itself a violation of Commission rules. We have charged more than 500 individuals with lying to auditors since Sarbanes Oxley was enacted, including dozens this past year.
So as you can see, for preparers, avoiding SEC enforcement action is rather simple. The recipe is no secret and the bread and butter ingredients are quite easy to come by. Upholding the fundamental concepts of integrity and transparency will significantly reduce your exposure to charges by the SEC.
Unlike a lawyer’s advocacy obligations, an external auditor’s ultimate allegiance is to investors, not to the client. This is an incredibly important distinction and one that warrants a reminder as many of you head into the audit busy season. We continue to see numerous situations where auditors abdicate their core responsibility to investors by signing off on audits that fall seriously short of professional standards and by certifying financial statements that materially depart from GAAP. Most of our enforcement actions against outside auditors have been due to parties engaging in improper professional conduct as defined under Rule 102(e). This SEC Rule of Practice defines several prongs of professional misconduct for which an auditor may be barred from appearing or practicing before the Commission. These provisions consist of reckless or intentional conduct resulting in a violation of professional standards, as well as two types of negligent conduct. Our enforcement actions in this area have resulted in bars against numerous auditors from practicing before the Commission, including engagement partners, concurring partners, relationship partners and even national office partners. The Commission has also instituted 102(e) bars against a number of audit managers and audit seniors for violations of professional standards. In addition, the Commission has sued dozens of external auditors for fraud or other violations of the securities laws when warranted.
Management Fraud Is Not An Exemption
An important topic that I want to emphasize today is that the existence of management fraud does not provide an automatic exemption to auditors from SEC enforcement action. In fact, many, if not most, of our cases against outside auditors have arisen from financial frauds by client management who went to great lengths to mislead auditors.
The Commission’s position in this regard is well chronicled and has remained virtually unchanged since the SEC’s inception. In December of 1938, the Commission opened an investigation into McKesson & Robbins, which was the first major accounting scandal that surfaced following the creation of the SEC in 1934. This case involved fake purchases and sales, materially overstated inventory and revenues, and fictitious purchase orders and shipping records. As part of its investigation, the Commission held four months of hearings to examine the conduct of its auditor, Price Waterhouse & Co., and to assess the adequacy of standard auditing practices at the time. In December of 1940, the Commission issued its findings in Accounting Series Release No. 19. In this report, the Commission stated that “Accountants can be expected to detect gross overstatements of assets and profits whether resulting from collusive fraud or otherwise.” The Commission also found that the auditors’ failure to discover misstatements was due to their failure to employ the necessary degree of “vigilance, inquisitiveness, and analysis of the evidence.” Given the non-existence of formal auditing standards at that time, this case sparked the development of the first auditing standards by the American Institute of Accountants.
Notwithstanding the paucity of formal auditing standards prior to the McKesson scandal, the overarching message sent by the Commission in its 1940 report is still very applicable today: management fraud does not exempt an auditor from carrying out his or her professional responsibilities to investors. Due care and professional skepticism are not abstract or arcane concepts that are retained just long enough to pass the CPA exam. To the contrary, these are bedrock principles that must be exercised in everything that an auditor does. Due care and professional skepticism must be vigorously employed whether you are planning, performing or supervising an audit or review. So while the nature of a client’s misrepresentations is certainly relevant in evaluating whether the auditor complied with professional standards, the mere fact that an auditor was lied to is not the end of our analysis. One of the threshold questions that we assess is whether the lies were hollow and exposable had the requisite level of diligence required by professional standards been employed.
A common thread in many of our enforcement actions against outside auditors is the failure to demonstrate professional skepticism by obtaining persuasive audit evidence. It is not enough to obtain suggestive, but opaque, evidence. The documentation must constitute persuasive audit evidence that corroborates the assertions being tested. It is also not enough to appropriately identify the various risks, develop a well designed audit plan, ask the right questions and seek the right evidence. It is at this point where the rubber meets the road and the most critical phase of an audit begins — actually obtaining the requisite audit support and not rationalizing evidence received as being more persuasive than it actually is. In numerous cases we have seen corporate frauds that are allowed to continue because the audits did not go beyond conversational auditing or merely asking for essential audit evidence. The Commission has also brought many actions that involved very well designed audits that would have exposed financial frauds had the fundamental principles of due care, professional skepticism and audit evidence been properly applied. In these instances the auditors had the equivalent of first down and goal on the one yard line and elected to punt. Such professional misconduct runs counter to the basic tenets of auditing and the degree of “vigilance, inquisitiveness, and analysis of the evidence” that the Commission referred to almost 70 years ago.
I would like to close with a reminder that everyone in this room is a gatekeeper. From the accounting clerk of a public company to the CFO, or from a first year audit staff to a national office partner at a public accounting firm, each and every one of you plays a crucial role in maintaining a capital market system of the highest caliber and integrity. I urge all of you to take your gatekeeping responsibilities seriously and with utmost alacrity. By working together, we will continue to promote and protect the most prestigious and influential securities markets in the world.