Accounting Fraud and SEC Investigations.

The SEC’s accounting investigations center on two primary areas: false accounting practices and misleading financial disclosures. If these violations are believed to be criminal in nature, the case will be referred to the U.S. Department of Justice. The SEC conducts civil proceedings only, but the SEC and DOJ can, and do, pursue parallel investigations. In these cases, the target faces exposure to both civil enforcement by the SEC and criminal prosecution by the DOJ. The investigation may focus on the criminal side, the civil side, or both.

A financial restatement is a common trigger for SEC accounting investigations. However, in most cases, a restatement does not establish evidence of accounting fraud or scienter, the mental state required for criminal liability. A restatement is often required due to honest accounting errors, new insights, or changes in auditing standards.

“Accounting fraud” is a term that covers many different scenarios. On the revenue side, companies may use side agreements, roundtripping, bill-and-hold, barter transactions, and other maneuvers to improperly inflate revenue figures. On the expense and loss side, companies may improperly record inventory, overvalue intangible assets, and fail to record impairments on a range of assets to hide reported expenses or losses. Another recurring focus is related-party transactions; accounting violations involving executives or owners are often deemed intentional.

These are examples of accounting fraud as applied to publicly traded companies. However, financial-reporting investigations can target IPO statements, offering materials for companies issuing stock or bonds, and disclosures for municipal bond issuers.

Which Mistakes Satisfy the SEC’s Fraud Standards?

When it uncovers accounting irregularities, the SEC often looks for evidence of fraud or deception. The Securities Exchange Act of 1934 and the Securities Act of 1933 allow the SEC to pursue civil enforcement actions against various types of missteps, and this includes:

SEC Rule 10b-5 Fraud Claims

The SEC most often pursues fraud claims under Rule 10b-5 of the Securities Exchange Act of 1934. In an SEC Rule 10b-5 enforcement action, the SEC must establish:

• Material deception in connection with a securities transaction; and
• Scienter (i.e., intent to deceive, manipulate, or defraud investors)

While a private action under Rule 10b-5 requires the plaintiff to establish reliance on the deception and resulting financial losses, these elements are not required in SEC enforcement actions under Rule 10b-5. Negligence alone cannot establish liability under SEC Rule 10b-5. For example, if an executive makes a mistaken estimate that triggers a restatement, and the executive was negligent in his or her accounting, the executive may be subject to civil penalties, but the executive will not be liable under SEC Rule 10b-5. To be liable under SEC Rule 10b-5, the executive must have made a mistaken estimate while either knowing the estimate was false or acting with reckless disregard for the truth.

Other Types of Fraud Claims

The Securities Act of 1933 authorizes the SEC to pursue claims under Sections 17(a)(2) and 17(a)(3) that can involve both negligent and fraudulent conduct. These sections broadly prohibit:

• Any transaction or acquisition or disposition of any security “by means of or by the use of any . .. untrue statement of a material fact . .. or any omission to state a material fact,” and
• Any transaction or acquisition or disposition of any security “by means of or by the use of any . .. practice which operates or which is designed to operate as a fraud or deceit upon any person.”

Sections 17(a)(2) and 17(a)(3) do not explicitly require scienter, but the SEC may pursue these claims in conjunction with fraud claims under SEC Rule 10b-5. Section 13(a) of the Securities Exchange Act of 1934 prohibits filing reporting documents that contain any untrue statement of a material fact. Section 13(a) violations do not require scienter, so a company can violate the reporting provisions even if no one acted with intent to deceive.

Other Types of Accounting Violations

Section 13(b)(2)(A) of the Securities Exchange Act of 1934 requires issuers (i.e., companies) to “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.”

Section 13(b)(5) of the Securities Exchange Act of 1934 prohibits executives, managers, and accountants from knowingly “circumventing” a company’s controls or “falsifying” a company’s books, records, or accounts. The SEC does not need to prove that a violation of Section 13(b)(5) resulted in financial or accounting fraud.

What happens after the SEC starts investigating?

When Does the SEC Issue a Subpoena?

In the context of an SEC accounting investigation, the agency’s initial evidence-gathering efforts are likely to be informal. During this stage, SEC staff may issue voluntary requests for financial records, emails, correspondence, and other relevant documents. During this time, the target of the investigation may (and should) work with the SEC. However, a formal investigation order is the stage that designates particular SEC staff to pursue subpoenas for financial records, emails, other documents, and testimony. Once issued, a formal investigation order gives the SEC the authority to seek the evidence it needs via subpoenas issued under Section 21(b) of the Exchange Act. This may include the power to compel the production of any record, book, or document in the custody or control of a person, firm, or company, and it may also include the power to compel the delivery of any other information or record.

Can IHave Counsel When I Give Testimony?

A formal investigation order is a critical step in an SEC accounting investigation, and it may be the first time that the SEC’s enforcement personnel obtain a witness’s sworn testimony. When providing testimony in an SEC accounting investigation, the SEC may require that the witness testify under oath and that the witness have a designated SEC staff member transcribe the testimony. In these cases, the witness is entitled to have an attorney present. If you are required to give a statement in a formal SEC accounting investigation, our defense lawyers can handle the process for you. We can handle all communications with the SEC, work to protect your rights, and work to prevent unnecessary exposure to further investigation.

What are the Implications of a Formal Investigation Order?

A formal investigation order is a significant development in an SEC accounting investigation. However, the SEC’s issuance of a formal investigation order is not evidence that it has found evidence of any accounting violations. In fact, many companies and their executives will find themselves the subject of an SEC investigation order before the SEC has determined that any fraud has occurred. If you or your company has been served with an SEC subpoena or other correspondence, you will need to engage experienced counsel to help you prepare a strong response.

What is a Wells Notice?

A Wells notice is an SEC enforcement division document. It is sent to targets of SEC accounting investigations to communicate the Division’s staff’s preliminary decision to recommend enforcement charges to the Commission (i.e., the SEC). When you receive a Wells notice, this provides you with the opportunity to present the factual and legal arguments that the SEC’s enforcement staff should make a different decision. Typically, a Wells notice also includes a deadline for a Wells response. You may be entitled to an extension of the deadline, but whether you get a deadline extension will remain at the SEC’s discretion.

If you are facing this situation, Spodek Law Group handles federal criminal defense matters nationwide, from offices in New York and Los Angeles.

How should we respond without worsening parallel exposure?

Q: How can the SEC’s and DOJ’s investigations run concurrently?

A SEC accounting investigation often runs concurrently with a DOJ investigation. The SEC’s investigation can be either civil or criminal, but in most cases, the SEC will open its investigation in parallel with the DOJ’s investigation. While it will be challenging to defend against two government investigations simultaneously, it is not impossible, and our attorneys can help you fight back with both civil and criminal defense expertise.

Q: Should we prepare for a potential securities class action as well?

In addition to facing parallel SEC and DOJ accounting fraud investigations, companies and their executives must be prepared to face a potential private securities class action as well. In the past, a securities class action filed in parallel with government accounting fraud investigations often signaled that the private plaintiff’s attorneys had received some level of cooperation or information from the DOJ and/or the SEC. While the private plaintiff’s counsel no longer has the same level of access to the DOJ and the SEC, a pending securities class action still adds yet another layer of complexity to an SEC accounting fraud investigation.

Q: What do we do if we are required to do our part as corporate citizens?

If you are required to respond to a government accounting fraud investigation and/or to a private securities class action, your first step should be to preserve all potentially relevant information. By that is, you may need to suspend routine destruction of financial statements, audit workpapers, and other data that may be relevant. When it is reasonably foreseeable that you or your company will need to respond to an investigation or litigate a private securities fraud claim, a duty to preserve relevant information can arise, and litigation or discovery can begin in short order. The most important way of maintaining this duty is to issue a written legal hold to all employees who may have relevant documents.

Q: What if our executives and managers’ interests are not completely aligned with the company’s interests?

If your company is facing an SEC accounting fraud investigation or a DOJ accounting fraud investigation, the legal privilege covering your company’s communications with its counsel will extend to the executives and managers whom counsel interviews during the internal investigation. In most cases, company counsel will represent the company, not the employees themselves, and the company will control whether it discloses the information obtained during interviews to the SEC or the DOJ. However, while the company’s and the executives’ and managers’ interests will generally be aligned, there will be times when a conflict of interest will be in dispute. At these times, the company may require the employee to retain separate counsel.

Q: Does the SEC expect us to share the fruits of our internal investigation?

The SEC has issued guidance recommending that companies share the fruits of their internal investigations in order to receive “cooperation credit.” If a company decides to waive its legal privilege and share privileged materials with the SEC, the company may also be voluntarily waiving its legal privilege against all other third parties. This could mean that the DOJ, the plaintiffs’ bar, or the plaintiffs’ lawyers may be entitled to copies of the company’s internal investigation records.

Q: What about parallel SEC and DOJ investigations for impairment violations?

The SEC and DOJ may open investigations into a corporate impairment statement that involves a material misstatement, whether it was an accounting violation or a securities fraud violation, and whether the misstatement was the result of an accounting or auditing error. At this point, the target of the SEC or DOJ investigation will be able to work with experienced outside counsel in order to make appropriate decisions.

Q: Should the Company Self-Report or Disclose the Investigation?

If your company independently identifies potential misconduct, you will need to determine whether it makes sense to self-report before the SEC or DOJ contacts you. This is a decision that is best made with the assistance of outside counsel who can evaluate all relevant factors on an individual case-by-case basis.

Q: Does the Company Have to Disclose the Investigation?

There is a common misconception that companies have an obligation to publicly disclose all SEC investigations. In most cases, the opposite is true. While federal securities law mandates certain types of disclosures, the mere receipt of a subpoena or other documentation signaling the start of an SEC investigation does not necessarily trigger a mandatory disclosure. Instead, companies generally only need to make a disclosure when silence would render any previously issued public statements materially misleading.

This basic rule has two primary exceptions, and both require companies and issuers of municipal bonds to notify the public about specific financial and accounting reporting issues:

• Form 8-K Item 4.02, A public company must generally notify the public within four business days of deciding that a previously issued financial statement needs correction.
• Regulation S-K Item 308, Regulation S-K Item 308 requires reporting companies to disclose annually any identified material weakness in their internal control over financial reporting.

Q: How Does the SEC Determine Whether to Grant a Company Cooperation Credit?

When it comes to evaluating a company’s cooperation during an accounting fraud investigation, the SEC follows what is known as the “Seaboard” framework. This framework sets out several key factors that will be used to determine whether to grant a company “cooperation credit”:

• Self-policing, Did the company proactively seek to uncover misconduct, or did it wait until the misconduct was identified externally?
• Self-reporting, Did the company promptly disclose the misconduct to the SEC upon learning of it?
• Remediation, What steps did the company take to address the misconduct and prevent future violations?
• Cooperation, How did the company cooperate with the SEC’s investigation?

These factors, among others, determine the degree to which the SEC can reduce sanctions or decline to bring enforcement actions against the company.

In many cases, the answer to the question of whether to self-report under the Seaboard framework depends on whether there is a risk of the government learning of the misconduct through other means. If the company’s exposure to a whistleblower, former employee, or other third party is high, self-reporting may be advisable. Even if a company self-reports, this does not guarantee it will avoid civil or criminal liability; however, it can open the door for a declination or reduced sanctions if the company can secure cooperation credit under the Seaboard framework.

Q: Does a Company Have to Waive its Attorney-Client Privilege to Secure Cooperation Credit?

While there is a common misconception that companies must waive their attorney-client privilege to secure “cooperation credit” from the SEC, the SEC’s policy explicitly declines to make waiver a required condition for cooperation credit.

Q: How Long Does the SEC Have to Pursue Civil Penalties?

There is debate regarding how long the SEC can pursue civil penalties after an alleged violation. The debate centers on the interpretation of 28 U.S.C. §2462, which has historically been thought to impose a five-year statute of limitations on monetary penalties and other financial liability. However, a 2013 Supreme Court decision, Gabelli v. SEC, 568 U.S. 442, determined that the statute of limitations triggers when the alleged fraud actually occurred, not when the fraud was discovered. This means that the SEC’s statute of limitations to pursue civil penalties for any GAAP violations and other accounting violations may begin to expire long before the SEC begins investigating.

Q: How Long Does the SEC Have to Pursue Disgorgement?

Under Section 21(d)(8) of the Exchange Act, the SEC has ten years to seek disgorgement when scienter can be shown, and five years in all other cases.

The statute of limitations in SEC investigations can also be extended through a “tolling agreement,” which is a mutual agreement to suspend the limitations period for a set period. If you are willing to sign a tolling agreement, you should ensure that you have counsel to assist in negotiations, and that the agreement is only signed if it is in your best interest.

Q: What are the Potential Civil Penalties for SEC Accounting Fraud?

The Exchange Act provides for three statutory tiers of civil penalties for securities law violations under Section 21(d)(3):

• First Tier Penalties, An SEC violation of the Exchange Act allows the SEC to impose penalties that are either: (i) up to $100,000 per violation, or (ii) up to the amount of the “pecuniary gain” resulting from the violation.
• Second Tier Penalties, An SEC violation that involves “fraud, deceit, manipulation, or deliberate or reckless disregard of a statutory provision, rule, regulation, or order” can lead to penalties up to $500,000 per violation, or the greater of up to three times the pecuniary gain.
• Third Tier Penalties, An SEC violation that involves “fraud, deceit, manipulation, or deliberate or reckless disregard of a statutory provision, rule, regulation, or order and which results in substantial losses or substantial pecuniary gain to the issuer or others,” can lead to penalties up to $1 million per violation, or the greater of up to three times the pecuniary gain.

Q: What Other Enforcement Measures Does the SEC Use?

In addition to civil penalties, the SEC may pursue civil injunctions against corporate officers and other defendants. To secure a civil injunction, the SEC may be required to show that there is a reasonable likelihood that future violations will occur.

The SEC may also pursue officer-and-director bars under Section 21(d)(2) of the Exchange Act, with statutory bars being issued upon finding “unfitness” or scienter. Finally, as an alternative to monetary sanctions, settlement agreements may include “undertakings.” Undertakings involve affirmative obligations to take corrective action on certain disclosures and corrective measures to prevent any future violations.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.