Criminal Defense Lawyers

Securities Fraud: Responding to Allegations of Inadequate Internal Controls

Dealing With Accusations of Weak Internal Controls

Companies can really get in hot water when accused of having shoddy internal controls related to financial reporting and disclosures. But even with tight policies and procedures, mistakes can happen. So how do you handle allegations that internal controls were so inadequate they enabled securities fraud? This stuff is tricky, but staying calm and knowing your options is key.

Why Internal Controls Matter

Internal controls basically mean having systems in place to prevent errors and catch issues early. This includes stuff like:

• Having enough qualified accounting personnel to handle the books properly
• Giving employees clear procedures for reporting transactions, keeping records, making disclosures etc.
• Making sure financial data gets reviewed by managers to catch mistakes
• Having auditors regularly evaluating processes

If these controls suck or get ignored, it leaves room for deceit that can cross over into illegal territory.

The Sarbanes-Oxley Act (SOX) requires public companies to have tight internal controls around financial reporting and disclosures. Failing to maintain these can technically be securities fraud if it contributes to misleading investors.

Typical Allegations

The most common accusations about internal control weaknesses enabling securities fraud include:–

Using unqualified or overworked accounting staff: This can lead to innocent mistakes or opportunities to fudge numbers.

Lacking documentation or oversight of key processes: With poor paper trails or reviews, improper transactions can slip through.

Ignoring red flags and audit findings: If management disregards warnings about control gaps, fraud may follow.

Prosecutors argue that these conditions allow material errors or deceit in financial filings that mislead investors. And if execs ignore obvious problems, it can mean scienter for fraud charges.

Responding to Allegations

If your company gets accused of having weak internal controls that facilitated misleading reporting, here’s advice on responding:

Don’t panic – Just because deficiencies get alleged doesn’t automatically equal fraud. Mistakes happen.

Review the specific claims – Determine if the issues raised are factual and truly problematic.

Gather evidence of existing controls – Show how policies, processes and personnel prevent/catch errors.

Note good faith efforts – Highlight attempts to comply with regulations and fix any gaps.

Check if misstatements are material – Small mistakes generally aren’t securities fraud.

Consider getting an expert opinion – Experienced legal and accounting advisors can assess merits of allegations.

Essentially, avoid knee-jerk admissions around controls. Instead, take a measured approach examining the nature and intent behind any problems.

Possible Defenses

If allegations of weak controls enabling securities fraud end up in court or SEC settlements, several defenses may apply:

No scienter – Defendants can argue they acted in good faith without intent to mislead. Per Ernst & Ernst v. Hochfelder, negligence alone doesn’t prove fraud.

Immateriality – Minor errors in financials usually don’t impact investment decisions enough to justify charges. See Basic Inc. v. Levinson.

Reliance on professionals – Delegating complex regulations to qualified accountants and lawyers helps demonstrate good faith.

Remedial efforts – Evidence showing defendants tried addressing control problems before violations may show no scienter.

Cooperation – Admitting errors, aiding investigations and fixing issues helps secure leniency from regulators.

So while accusations around flimsy controls enabling fraud are serious, all hope isn’t lost. An experienced legal/accounting team can help mount strong defenses.

Preventing Problems

Of course, avoiding allegations in the first place is ideal. Here are proactive measures companies can take:

Perform risk assessments – Identify vulnerable processes needing tighter controls.

Improve documentation – Ensure all key accounting procedures get detailed in policies.

Enhance reviews and audits – Have managers and external auditors closely evaluate finances for errors.

Fix gaps – If audits turn up control weaknesses, address them in timely manners.

Train personnel – Educate all employees on policies and importance of integrity with financial data.

Welcome whistleblowers – Make it easy for workers to anonymously report suspected fraud.

Monitor heavily – Watch high-risk areas like executive perks, contracts with related parties etc.

Building a culture focused on transparency, ethics and accountability makes deceit far less likely. And keeping detailed records showing good faith efforts at compliance helps fight any charges.While securities fraud allegations can seem scary, staying calm and taking a systematic approach to responding can pay off. Assessing the real merits behind claims while showcasing existing controls and remedial efforts is wise. And highlighting facts like acting in good faith, minor errors, reliance on advisors etc. can lay the groundwork for defenses.The best policy, however, is having robust systems that prevent issues in the first place. With regular risk reviews, strong documentation, frequent monitoring and a culture where employees feel safe reporting problems, companies can identify and address gaps before they become violations.So in summary, charges around inadequate controls enabling fraud aren’t necessarily a death knell. But they do warrant careful, expert review of circumstances and options. And making ongoing enhancements to identify and fix vulnerabilities before they become headline news is key.