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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Behind the Numbers of the SEC's Recent Financial Fraud Cases

by Richard H. Walker

Director, Division of Enforcement,
U.S. Securities & Exchange Commission

27th Annual National AICPA Conference on Current SEC Developments

December 7, 1999

As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff.


Good morning. It is a pleasure to join you again at your annual conference.

One year ago, I came before you with a pretty sobering assessment of the state of financial reporting and disclosure. I spoke of the rise in accounting fraud that we were witnessing and issued a call to arms. I was hopeful that I could join you today with a bit more holiday cheer to spread around and with the concerns I expressed last year simply a ghost of Christmas past.

In fact, over the last year I have seen real and meaningful progress by members of the accounting profession in addressing some of the concerns we have raised about weaknesses in the financial reporting process. Our message deploring the practice of earnings management has been forcefully delivered and is being embraced, I believe, by responsible practitioners and issuers. Also on the good news side of the ledger, our markets continue to experience record and sustained growth. Market performance depends on investor confidence and should not be taken for granted; it requires hard work by all of us to maintain high standards.

While we are moving in the right direction toward instilling greater care and discipline into financial reporting, and you share the credit for this, we continue to see an unacceptably high number of busted audits, and the pace of change in strengthening other important requirements – most notably, auditor independence – remains unacceptably slow. In short, there's a lot of work that still needs to be done. We are not yet at a point where I can come here and spread unqualified holiday cheer.

I announced last year that combating financial fraud was the Division of Enforcement's number one priority. It remains so today.

What I'd like to do during my time here today is to share with you my views, and they are my views and not those of anyone else, on what messages the cases we've brought over the last year teach us.

Current State of Affairs

Before I do that, though, I want to offer some observations on the current state of financial reporting. This is an area where meaningful statistics and objective evidence are scarce. The same is true as to the question of whether the quality of financial reporting is improving. Much of the evidence that informs my views in this area is impressionistic, anecdotal, and non-empirical. I'll be quick to admit I'd never make it as an accountant. Also, as Director of Enforcement, it's likely that I see a disproportionate number of audit failures. Audit successes rarely come to my attention. My friends tell me I need to improve the quality of people I do business with. In any event, let me share with you my thoughts.

First, there is some objective evidence that there have been improvements as to some of the practices that concern us. I was encouraged to read in a September 13 Wall Street Journal article that certain corporate write-offs were down 24 percent from last year. Of particular note, write-offs pertaining to in-process research and development, an area we have closely scrutinized, are down 66%. These results are the product of a constructive dialogue among the Commission, the accounting profession, and corporate America and, happily, not the Division of Enforcement.

Unfortunately, at the same time, there are indicators that financial fraud is still occurring at too great a pace. In August of this year, National Economic Research Associates (NERA) issued a report on recent trends in securities litigation. NERA found that 51 of the securities fraud cases that were brought during 1998 were based upon financial restatements; this is a 750 percent increase over the two cases of this type brought in 1992. Fifty three companies already have announced financial restatements so far this year, which means that the number of restatement cases may continue to grow even higher. Some companies have restated more than once. In at least two instances, the same auditors issued unqualified opinions on both the initial and restated financials.

In addition, NERA found that a whopping 55 percent of all securities class actions in the first half of 1999 were based on claims of fraudulent accounting. This is a material increase over the numbers from the early 1990s which ranged between 30 and 40 percent.

If you're not persuaded by class action statistics that the incidence of financial fraud is on the rise, consider what no less an authority than Warren Buffett has said on the subject of earnings management. In his most recent letter to Berkshire Hathaway shareholders, Mr. Buffett states, and I quote, "a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires."

Now Mr. Buffett is known for his plain talk. Equally direct, though perhaps less eloquent, are the statements of some of the subjects of our enforcement cases. Take for example our case against Livent, the Canadian producer of Broadway shows, that we charged with orchestrating a massive fraudulent scheme in which the company maintained two separate sets of books. In that case, Livent's General Counsel, whom we charged as a participant in the fraud, was quoted as saying: "I have to keep all the lies straight. I have to know what lies I'm telling these people. I've told so many lies to different people I have to make sure they all make sense."

Of similar import, in our earnings management case against Unison Healthcare, the company's CEO, when toying with the numbers, asked Unison's controller to leave the room, saying she did not need to see "how sausage is made." The CEO then called the controller back into the room, handed her a piece of paper and said, "here's the numbers we need to get to," and "I don't care how we get there."

Obviously, the Commission and the Enforcement Division do care how companies arrive at their numbers.

Enforcement 1999

This brings me to our enforcement program and a discussion of our recent cases. Our 1999 fiscal year ended on September 30, and we recently finished tallying our enforcement statistics for the year. We brought approximately 90 financial statement and reporting actions, a 15 percent increase over the 79 actions we brought in 1998. The cases cover a broad spectrum of conduct – from multi-faceted pervasive frauds to more subtle instances of earnings management to situations involving violations of auditor independence rules.

We also brought our first financial fraud sweep this past September. On the one-year anniversary of Chairman Levitt's "Numbers Game" speech, we announced the filing of 30 enforcement actions against 68 individuals and companies for engaging in financial fraud. The conduct of those charged resulted in the fraudulent financial reporting by 15 public companies.

Of course, the raw numbers tell only a limited story. What's more instructive is to go behind the numbers to extract the important messages from the cases. Last year's cases reveal at least ten important messages.


First, and perhaps most important, we will give closest scrutiny to intentional misstatements by senior management, even if small in amount, and particularly if designed to manage earnings. We brought 18 actions last year specifically alleging that the purpose of the fraud was to engage in earnings management for the purpose of meeting projections and compensation benchmarks. Many, if not most, of the remaining actions involved schemes to manipulate earnings for similar purposes. These actions shared a common blueprint: companies either recorded non-GAAP or fictitious sales, or, as we alleged in the case of W.R. Grace, created cookie-jar reserves.

The cases also confirm the conclusion of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission that in a very high percentage of cases – 83 percent in the COSO Study – the frauds occurred at the direction, or with the active participation, of senior management. In our recent financial fraud sweep, we charged CEO's in 11 of the 15 actions. I join Walter Schuetze in urging the auditor community to stand tall, resist the pressures to bend or stretch the rules and help put an end to improper earnings management.

The topic of earnings management brings me to the second message of the recent cases which is that items less than 5 percent in amount may have a significance to a company's operations that is disproportionate to the size of the number alone. In other words, materiality requires more than a slavish adherence to a 5 percent test. Our cases against W.R. Grace and ABS Industries, and our recently issued Staff Accounting Bulletin 99, make clear that you must consider qualitative factors in addition to quantitative factors when assessing materiality. Lynn Turner has told you about the importance of SAB 99 and Walter Schuetze will describe for you our ABS case. Both of these should help you understand our current thinking on materiality.

The third message is that you should pay particularly close attention to receivables and other revenue recognition items. Borrowing a phrase from Walter Schuetze, revenue recognition remains the recipe of choice for cooking the books. This was also one of the findings of the COSO Study. It should come as no surprise to anyone given that many of today's frauds are driven by efforts to engage in improper earnings management.

About one-third of the actions we brought – 32 of the 90 – involve improper revenue recognition. These actions primarily involve side letters, rights of return, consignment sales, and shipping unfinished product. Another 12 cases involve the booking of fictitious sales. You should pay close attention to SAB 101, issued this past Friday, for guidance in the area of revenue recognition.

The other most common income statement fraud is the failure properly to record expenses. Here, we brought 13 cases.

On the balance sheet side, overvaluation of assets is the common denominator of financial fraud. Seventeen of our cases last year involve fraudulent asset valuations. Next in number were cases involving improper capitalization of expenses, of which we brought 12 actions.

In addition to these time-honored methods of inflating results, companies are also using novel and creative methods to cook the books. For example, we are beginning to see an increase in the use of "barter" transactions, especially among high-technology companies, where the assets received in exchange for goods and services provided are greatly overvalued. We brought 4 "barter" cases last year.

Message number four is that we will bring charges not just against companies whose financial statements are false or misleading, but against the individuals responsible for doctoring the books as well. While issuers bear the ultimate responsibility for the accuracy of their financial statements, and thus must bear the ultimate consequences for misstatements, their culpability derives entirely from the individuals who engage in fraud. Sanctions against issuers are necessary to achieve deterrence, but may have the unfortunate consequence of indirectly affecting innocent shareholders as well. Sanctions against individual wrongdoers hit the bulls-eye. They should be fair but should reflect the seriousness of the harm to investors and the egregiousness of the conduct in question. It is no secret that neither I nor the Commission favor enforcement actions that only charge the company and not any individuals. Last year, only three cases named issuers without naming individuals. All told, our actions of the past year charged 120 corporate officers and employees with participating in financial frauds.

And we don't limit our sights to just senior officers. In many cases, there are multiple participants in fraudulent activity. We look up and down the ladder to assess culpability of all involved and rationally apportion sanctions. For example, in our recent action against Knowledge Ware, we charged eleven individuals, ranging from the CEO down to three district sales managers. For other examples, I'd direct you to Livent, where we charged eight officers, and W.R. Grace, where we charged seven.

Fifth, in addition to examining the conduct of those within a company, we also review the conduct of those without the company who have responsibilities for financial reporting. This includes the auditors and others as well. We brought actions against 12 auditors last year for violating GAAS.

Our focus on company outsiders does not stop with the auditors. For example, in our case against Computone, we charged the president of a Computone customer with causing Computone's financial fraud. We allege that he issued a confirmation to Computone's auditors falsely stating that his company owed Computone money for products held on consignment and not yet sold.

Sixth, we will use the full range of remedies available to us. Against those affiliated with issuers, we regularly seek injunctions and significant money penalties. In addition, we brought 23 proceedings under Rule 102(e) against officers of issuers who were CPAs. Eighteen of these persons have settled with us, and the sanctions were stiff – 6 took permanent bars and another 6 took 5-year bars. We also sought officer and director bars, a sanction reserved for particularly egregious conduct, against 21 persons.

Auditors who violated the law while performing audits faced, for the most part, Rule 102(e) proceedings. As I previously mentioned, we brought 12 102(e) actions against auditors. Six of the twelve individuals have settled, all but one to permanent bars.

Seventh, where possible, we will proceed quickly, and, in the most serious cases, in tandem with criminal prosecutors. There are many reasons why financial fraud investigations are the most difficult, most time-consuming and most labor intensive of the investigations we do. Nevertheless, we are prioritizing and accelerating these investigations by using new techniques such as the SWAT team approach we successfully used in Livent to complete an investigation of fraudulent misconduct over an eight year period in just four months. Admittedly, most financial fraud cases cannot be brought this quickly, but we will pursue these cases aggressively.

And I'm sure that it has not escaped anyone's attention that increasing numbers of our cases are also accompanied by criminal charges. For example, in Livent, the U.S. Attorney's Office for the Southern District of New York indicted Livent's Chairman, Garth Drabinsky, and its CEO, Myron Gottlieb. With the active assistance of our partners in the U.S. Attorney's Offices, we are moving towards turning the "Numbers Game" into a game of Monopoly – that is, cook the books, and you will go directly to jail without passing go.

The eighth message of our cases, as already shared with you today by Commissioner Hunt, is that we will look particularly closely at companies' internal controls. The Securities Exchange Act of 1934 requires issuers to have in place internal controls designed to provide reasonable assurance that financial statements are prepared in conformity with GAAP. We have long stressed the importance of internal controls, and we will continue to be vigilant in policing against deficient controls. We brought 51 actions last year charging issuers with having deficient internal controls, individuals for causing the issuer's violation, or individuals for overriding controls.

Message number nine is that we will not tolerate clients misleading their auditors. Eighteen of our cases last year included charges under Exchange Act Rule 13b2-2. This rule prohibits officers and directors from either lying to or concealing material information from auditors. The inclusion of these charges in our cases should underscore the importance of truthful and accurate reporting.

The last message of the cases is that we view auditor independence as critically important to the integrity of the financial reporting system. We brought 4 cases last year charging violations of the auditor independence rules. Several of these cases involved violations of one of the most fundamental tenets of auditor independence – ownership of audit client securities. In some of the cases the violations were knowing and intentional; in others, they were the product of careless, perhaps reckless, inattention and inadequate internal controls. I hope the cases serve as a wake-up call for everyone in the profession. It is imperative that the profession take steps to rapidly and aggressively ensure that auditor independence is maintained, both in fact and appearance. We have a number of matters under investigation involving potential independence violations ranging from stock ownership of audit clients, to the provision of both auditing and consulting services to the same client. In an era of expanding services provided by large accounting firms, it is imperative that the audit function be safeguarded and protected from real or potential conflicts of interest.

One message that you will not glean from our cases of last year, but which I hope will become apparent shortly, is that we take auditor responsibilities under Exchange Act Section 10A very seriously. This section, principally drafted by Senator Ron Wyden and Representative John Dingell, requires auditors to bring illegal acts to the attention of senior management and the audit committee, and if remedial action is not taken, to report those acts to the SEC.

Although Section 10A did not become effective until after January 1, 1996 for larger companies and January 1, 1997 for smaller companies, I'm concerned that we've only received less than a dozen reports to date. There are several explanations for the low number of reports. One is that issuers may be swiftly taking remedial action to the satisfaction of their auditors when confronted with reports of illegal acts. Another is that auditors are not fulfilling their responsibilities. While I know it is no easy task to be charged with ferreting out fraud – and under certain circumstances – reporting it to the SEC, both the law and the integrity of our markets requires that this task be performed competently and diligently.


I've covered a lot of ground today and can only hope that the messages I've shared both educate and guide you as we continue our joint efforts to combat financial fraud. I leave you secure in the notion that the progress the profession has made this past year in responding to our concerns will continue in the future and the dialogue among us will remain open as we address unfinished business. Thank you.