Securities Fraud: When Do Disclosures to Auditors Reduce Criminal Risks?
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Securities Fraud: When Do Disclosures to Auditors Reduce Criminal Risks?
Securities fraud refers to deceptive practices in connection with the offer, purchase, or sale of securities. This type of fraud can take many forms, but generally involves misrepresenting or omitting material information to investors. Securities fraud is prohibited under federal laws like the Securities Act of 1933 and the Securities Exchange Act of 1934.One issue that sometimes arises in securities fraud cases is whether a company’s disclosures to its auditors can reduce the risk of criminal liability. This article examines when disclosures to auditors may help mitigate criminal risks associated with securities fraud.
Duty to Disclose Material Information
Publicly traded companies have a duty under securities laws to disclose all material information to investors. Information is considered “material” if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy, sell or hold a security. This includes information about a company’s financial condition, operations, management, products, and risks or uncertainties facing the business.If a company intentionally fails to disclose material information or provides misleading disclosures, it can face civil and criminal liability under securities fraud laws like Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. The government must prove the company acted with scienter, meaning an intent to deceive, manipulate or defraud investors.
Role of Auditors
Public companies are required to have their financial statements audited annually by an independent external auditor. The auditor examines the company’s books, records and internal controls to assess the accuracy and completeness of its financial statements and related disclosures.Auditors do not have a duty to detect fraud. However, auditing standards require that auditors conduct procedures to identify risks of material misstatement due to fraud. Auditors must also assess programs and controls the company has implemented to mitigate fraud risks.Part of an audit involves inquiries of management about fraud risks, including asking whether management is aware of any actual, suspected or alleged fraud. Management representations about fraud risks are an important source of audit evidence.
Disclosure of Fraud to Auditors
If a company is aware of misconduct that could materially impact its financial statements, it is expected to disclose this information to its auditors. Concealing fraud from the auditors can indicate an intent to deceive and heighten risks of criminal liability.In some cases, companies under investigation for securities fraud have cited their disclosures to auditors as evidence that they lacked any intent to mislead investors. However, these disclosures only help demonstrate good faith if they are timely, complete and accurate.
Timing of Disclosures
For a company’s disclosures to auditors to be exculpatory, they must be made before any public misstatements occur. If a company discloses fraud to auditors only after false statements have been made to investors, that does not eliminate liability for the earlier misrepresentations.In SEC v. Jensen, for example, the SEC brought charges against a corporate officer who backdated stock options to enrich himself while deceiving shareholders about company expenses. The executive claimed he had disclosed the backdating to auditors. However, the SEC presented evidence these disclosures occurred years after the scheme began and false financials were reported. Because the disclosure was not timely, it did not shield the executive from fraud charges.
Accuracy and Completeness
Any disclosures to auditors must also be complete and accurate in all material respects. In SEC v. Diebold Inc., the company disclosed to its auditor that it had prematurely recognized revenue on certain contracts. However, the company misled the auditor about the amount of premature revenue recognized. The incomplete disclosure did not absolve the company because it still concealed the full extent of the misconduct.If a company reveals only part of the fraud to auditors while omitting key details, that selective disclosure may still evince an intent to deceive.
Good Faith Reliance
For a disclosure to auditors to reduce criminal risks, the company must show it made the disclosure in good faith reliance that the auditor would take appropriate action. In U.S. v. Hatfield, the court found a CEO criminally liable for fraud even though he told the company’s auditor about improper accounting practices.The court concluded the CEO only made the disclosure to the auditor after it became clear the fraud would likely be uncovered by regulators. There was no evidence the CEO ever intended for the auditor to put a stop to the improper accounting. His belated disclosure appeared aimed at creating a defense rather than remedying the misconduct.
When Disclosure to Auditors is Exculpatory
While disclosures to auditors do not provide an automatic defense against securities fraud charges, they can help demonstrate good faith in certain circumstances.If a company voluntarily discloses misconduct to its auditor before any public misstatements are made, fully reveals all relevant details, and relies on the auditor to take appropriate remedial action, that can be exculpatory evidence. It negates an intent to deceive investors and indicates the company tried to address the problem properly.This was the case in SEC v. Jensen, where the SEC charged a different executive of backdating stock options but declined to impose fraud penalties. During the audit, the executive informed the auditors about the backdating and tried to convince the company’s CFO to correct the related accounting issues. The SEC concluded the executive acted in good faith reliance on the audit process before any false financials were filed.
Practical Implications
- Companies should carefully evaluate any potential disclosure issues each year during the audit process and err on the side of fully informing auditors about all potential compliance problems or fraud risks.
- Disclosures should be made as early as possible, before any misleading statements reach investors. Waiting until after false disclosures could eliminate the benefit of voluntary disclosure.
- Descriptions of any fraud or misconduct to auditors must be complete and accurate in all material respects. Half-truths or omitting key facts could still evidence an intent to deceive.
- Companies should only disclose potential fraud to auditors if they are prepared to have the auditors fully investigate the issues and implement any necessary remedial measures. Disclosures as a shield after-the-fact appear less credible.
- While auditors do not have a duty to detect fraud, disclosures may prompt them to expand audit testing in affected areas. This could uncover problems sooner and lead to corrective actions and revised financial reporting.
- If companies ignore or conceal fraud from auditors, that eliminates any argument they tried in good faith to comply with securities laws and relied on the audit process to address the issues.
In summary, timely and complete disclosures to auditors, coupled with reliance on remedial action, can provide compelling evidence of good faith and lack of intent to deceive investors. While not a silver bullet defense, such disclosures may persuade regulators or prosecutors to decline fraud charges in appropriate circumstances.