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In Conclusion
U.S. Securities & Exchange Commission
Division of Enforcement
The U.S. Securities and Exchange Commission, as The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any a matter of policy, disclaims responsibility for any private publication or statement by any of its private publication or statement by any of its employees. Views expressed herein are those of employees. Views expressed herein are those of the presenter and do not necessarily reflect the the presenter and do not necessarily reflect the views of the Commission or other members of the views of the Commission or other members of the staff of the Commission.staff of the Commission.
Today’s Topic
Financial Reporting and Issuer Financial Reporting and Issuer DisclosureDisclosure
Focus on Financial FraudFocus on Financial Fraud
Financial Fraud is:“… “… Intentional or reckless conduct, whether act Intentional or reckless conduct, whether act or omission, that results in materially or omission, that results in materially misleading financial statements…”misleading financial statements…”
“… “… it may entail gross and deliberate it may entail gross and deliberate distortion of corporate records, … falsified distortion of corporate records, … falsified transactions, … [or] the misapplication of transactions, … [or] the misapplication of accounting principles.”accounting principles.”
Report of the National Commission on Fraudulent Financial Reporting; Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987COSO, October 1987
Fraud is Different than Errors
““Fraudulent financial reporting differs Fraudulent financial reporting differs from other causes of materially misleading from other causes of materially misleading financial statements, such as financial statements, such as unintentional unintentional errorserrors.”.”
Report of the National Commission on Fraudulent Financial Reporting; Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987COSO, October 1987
Three Conditions are Usually Present:
Management has an Management has an incentiveincentive or is under or is under pressurepressure
The The opportunityopportunity exists for a fraud to be perpetrated exists for a fraud to be perpetrated
The fraudsters The fraudsters rationalizerationalize their fraudulent acts their fraudulent acts
Statement on Auditing Standards 99, October 2002Statement on Auditing Standards 99, October 2002
How Does it All Begin?
Answer:
Starts with “making the numbers”Starts with “making the numbers”
Then, “Managing the Numbers”Then, “Managing the Numbers”
Ends with “making up the numbers”Ends with “making up the numbers”
Rationalization includes: ““We need to make our projections…”We need to make our projections…”
““I’m getting pressure from the boss…”I’m getting pressure from the boss…”
““We need to meet Street expectations…”We need to meet Street expectations…”
““Our acquisition will fall through if we don’t…”Our acquisition will fall through if we don’t…”
And, Let’s Not Forget the Popular
““We’ll make it up next We’ll make it up next quarter…”quarter…”
But, even a simple mistake can be turned into a financial fraud
through “cover-up” efforts.
Annual Caseload by Fiscal Year
0
100
200
300
400
500
600
19951996
19971998
19992000
20012002
Fiscal Year
SEC Enforcement: FY 2002 598 total cases598 total cases Largest categories:Largest categories:
Financial fraud and issuer reporting (27%) Financial fraud and issuer reporting (27%) Offering fraud (20%) Offering fraud (20%) Broker-dealer (14%) Broker-dealer (14%) Insider trading (10%)Insider trading (10%) Market manipulation (7%)Market manipulation (7%) Investment adviser/company (8%)Investment adviser/company (8%)
Financial Reporting and Issuer Disclosure: Actions Filed
163 actions filed in FY 2002163 actions filed in FY 2002 Compared to:Compared to:
112 in FY 2001112 in FY 2001103 in FY 2000103 in FY 2000 94 in FY 199994 in FY 1999 79 in FY 199879 in FY 1998
Sources of Cases
Other AgenciesOther Agencies Self-ReportingSelf-Reporting Auditor ReportsAuditor Reports InformantsInformants
Previous Cartoon Next Cartoon
Complaint Center500-800 complaints a week500-800 complaints a weekMany concern financial Many concern financial
misconductmisconductwww.sec.govwww.sec.gov
Commission Top Priority October 17, 2001: “Financial fraud and October 17, 2001: “Financial fraud and
reporting cases are our top priority” reporting cases are our top priority” FY 2002 – 216 New financial FY 2002 – 216 New financial
fraud and reporting fraud and reporting investigationsinvestigations openedopened
69% increase over FY 200169% increase over FY 2001
Resources
970 Staff Members970 Staff Members 2500+ Open 2500+ Open
InvestigationsInvestigations Half of resources on Half of resources on
financial fraudfinancial fraud
Common Fraud Schemes
Premature revenue recognitionPremature revenue recognitionExcess reserves to smooth earningsExcess reserves to smooth earningsImproper capitalized costsImproper capitalized costsChanging estimates “to make the numbers”Changing estimates “to make the numbers”Top-Side Journal EntriesTop-Side Journal Entries““Earnings Management”Earnings Management”
Traditional Fraudulent Revenue Schemes
Backdating of Backdating of contractscontracts
Fictitious invoicesFictitious invoices Shipment of Shipment of
unfinished productunfinished product Revenue after the Revenue after the
fiscal periodfiscal period
Revenue recognized Revenue recognized on products not on products not shipped or not yet shipped or not yet manufacturedmanufactured
Hidden “side letters” Hidden “side letters” giving customers giving customers rights to return rights to return productproduct
New Types of Cases LootingLooting SPE’sSPE’s Related party transactionsRelated party transactions Undisclosed compensationUndisclosed compensation Misleading “Pro Forma” releasesMisleading “Pro Forma” releases Round-trippingRound-tripping AccommodationsAccommodations Channel stuffingChannel stuffing Acceleration of revenue in multiple-element arrangementsAcceleration of revenue in multiple-element arrangements
Growth in Enforcement Investigations
In 1998, we had 1733 investigationsIn 1998, we had 1733 investigations In 2002, we had 2402 investigationsIn 2002, we had 2402 investigations
39% increase in investigations39% increase in investigations
Growth in Financial Fraud Actions In 1998, we brought 79 financial In 1998, we brought 79 financial
fraud/reporting actionsfraud/reporting actions
In 2002, we brought 163 financial In 2002, we brought 163 financial fraud/reporting actionsfraud/reporting actions
106% growth in financial fraud actions106% growth in financial fraud actions
Growth in Actions Involving Fortune 500 Companies In 1998, 4 of the 79 financial fraud actions In 1998, 4 of the 79 financial fraud actions
(5%) involved Fortune 500 companies(5%) involved Fortune 500 companies
In 2002, 29 of the 163 financial fraud In 2002, 29 of the 163 financial fraud actions (18%) involved Fortune 500 actions (18%) involved Fortune 500 companiescompanies
625% growth 625% growth
Actions Brought in the Last 12 Months Michael Kopper and Andrew Fastow Michael Kopper and Andrew Fastow
(Enron)(Enron) WorldComWorldCom RiteAid and its senior managementRiteAid and its senior management Adelphia Communications and its senior Adelphia Communications and its senior
managementmanagement MicrosoftMicrosoft Senior management of Waste ManagementSenior management of Waste Management Amazon.comAmazon.com XeroxXerox
Still More PricewaterhouseCoopersPricewaterhouseCoopers Ernst & YoungErnst & Young Top officers of TycoTop officers of Tyco Homestore.com officersHomestore.com officers DynegyDynegy KPMGKPMG HealthSouthHealthSouth
FINANCIAL REPORTING AND ISSUER DISCLOSURE:
Themes and TrendsThemes and Trends
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities
Close Cooperation with ProsecutorsCorporate Fraud Task ForceCorporate Fraud Task ForceUS Attorneys want the casesUS Attorneys want the casesState authorities want the casesState authorities want the casesPlenty of cases to go aroundPlenty of cases to go around
Criminal Cases –FY 2002
17 Federal districts brought 17 Federal districts brought criminal securities fraud casescriminal securities fraud cases
More than 259 people and entities More than 259 people and entities chargedcharged
Enron Michael J. Kopper held various executive positions at Michael J. Kopper held various executive positions at
Enron, most of the time reporting directly to Andrew Enron, most of the time reporting directly to Andrew Fastow, Enron’s CFO.Fastow, Enron’s CFO.
In August 2002, the Commission filed a settled action In August 2002, the Commission filed a settled action against Kopper in which he agreed to disgorge and against Kopper in which he agreed to disgorge and forfeit $12 million, to be permanently enjoined from forfeit $12 million, to be permanently enjoined from violating the federal securities laws, and to be barred violating the federal securities laws, and to be barred from acting as an officer or director of public companies. from acting as an officer or director of public companies.
On the same day, Kopper pleaded guilty to conspiracy to On the same day, Kopper pleaded guilty to conspiracy to commit wire fraud and money laundering, agreed to commit wire fraud and money laundering, agreed to forfeit $4 million (included in the $12 million above), forfeit $4 million (included in the $12 million above), and to cooperate with the government's continuing and to cooperate with the government's continuing investigation.investigation.
Enron Commission filed enforcement action against Andrew Commission filed enforcement action against Andrew
Fastow, former CFO of Enron, alleging violations of Fastow, former CFO of Enron, alleging violations of anti-fraud, periodic reporting, books and records, and anti-fraud, periodic reporting, books and records, and internal controls provisions of federal securities laws. internal controls provisions of federal securities laws.
Commission seeks disgorgement of all ill-gotten gains, Commission seeks disgorgement of all ill-gotten gains, including all compensation received subsequent to including all compensation received subsequent to commencement of the alleged fraud, civil money commencement of the alleged fraud, civil money penalties, a permanent bar from acting as a director or penalties, a permanent bar from acting as a director or officer of a public company, and an injunction from officer of a public company, and an injunction from future violations of the federal securities laws.future violations of the federal securities laws.
Commission brought action in coordination with DOJ’s Commission brought action in coordination with DOJ’s Enron Task Force, which filed a related criminal Enron Task Force, which filed a related criminal complaint against Fastow.complaint against Fastow.
EnronCommission complaint alleges:
• Fastow involved with three transactions -- RADR, Chewco, and Southampton – that were part of an alleged scheme to hide his and Michael Kopper's interest in and control of certain entities in order to keep those entities off Enron's balance sheet.
• Fastow secretly nominated certain of the owners of these three entities, funded certain of their investments through undisclosed loans, collected undisclosed fees, and demanded and received under-the-table payments, including payments to himself and his family members disguised as yearly $10,000 non-taxable gifts.
• Purpose of scheme was self-enrichment and to mislead analysts, rating agencies, and others about Enron's true financial condition.
EnronCommission complaint further alleges:
• Fastow participated in two additional transactions that were essentially sham sales - best described as secret asset-parking arrangements.
• Fastow and others backdated documents to avoid diminution in Enron's investment in the stock of a technology company. Specifically, Fastow and others created documents that purported to lock in the value of Enron's investment in that company back in August of 2000, when that company's stock was trading at its all-time high price.
• Throughout the period of his alleged fraudulent conduct, Fastow sold millions of dollars worth of Enron securities.
Adelphia Communications
Commission filed charges against Adelphia, its Commission filed charges against Adelphia, its founder (John J. Rigas), his three sons, and two founder (John J. Rigas), his three sons, and two other senior executives, alleging one of the other senior executives, alleging one of the most extensive financial frauds ever to take most extensive financial frauds ever to take place at a public company.place at a public company.
US Attorney for SDNY filed related criminal US Attorney for SDNY filed related criminal charges against several of the same defendants.charges against several of the same defendants.
Commission’s investigation is continuing.Commission’s investigation is continuing.
Adelphia Communications SEC complaint alleges that Adelphia, at the direction SEC complaint alleges that Adelphia, at the direction
of the individual defendants:of the individual defendants: Fraudulently excluded billions of dollars in Fraudulently excluded billions of dollars in
liabilities from its consolidated financial statements liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet by hiding them on the books of off-balance sheet affiliates; affiliates;
Falsified operations statistics and inflated earnings; Falsified operations statistics and inflated earnings; and and
Concealed rampant self-dealing by the Rigas Concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate Family, including the undisclosed use of corporate funds for Rigas Family stock purchases and the funds for Rigas Family stock purchases and the acquisition of luxury condominiums.acquisition of luxury condominiums.
Adelphia Communications The Commission is seeking:The Commission is seeking:
Officer and Director bars Officer and Director bars Disgorgement of all ill-gotten gains, including:Disgorgement of all ill-gotten gains, including:
Compensation received during the fraud Compensation received during the fraud Property unlawfully taken from Adelphia through undisclosed Property unlawfully taken from Adelphia through undisclosed
related-party transactionsrelated-party transactions Severance payments Severance payments
Permanent anti-fraud injunctions Permanent anti-fraud injunctions Civil penalties from each defendant, including Adelphia. Civil penalties from each defendant, including Adelphia.
Penalty against company sought because Adelphia failed early Penalty against company sought because Adelphia failed early on to cooperate with the Commission's investigation and on to cooperate with the Commission's investigation and actually allowed the fraud to continue until the Rigas family actually allowed the fraud to continue until the Rigas family lost control over the company's conduct. lost control over the company's conduct.
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities
2.2. Emphasis on personal accountabilityEmphasis on personal accountability Greater use of O&D barsGreater use of O&D bars Disgorgement of compensationDisgorgement of compensation
Officer and Director Bars
Officer and Director bars sought in all Officer and Director bars sought in all categories of casescategories of cases::
FY 2002: 126FY 2002: 126FY 2001: 51FY 2001: 51FY 2000: 38FY 2000: 38
Rite Aid Former CEO, CFO, Vice Chairman charged with fraud in Former CEO, CFO, Vice Chairman charged with fraud in
connection with wide-ranging accounting fraud scheme connection with wide-ranging accounting fraud scheme that enabled the company to overstate its income in every that enabled the company to overstate its income in every quarter from May 1997 to May 1999. quarter from May 1997 to May 1999. Former CEO also charged with engaging in Former CEO also charged with engaging in
undisclosed related-party transactions and fabricating undisclosed related-party transactions and fabricating Board minutes to facilitate the fraud.Board minutes to facilitate the fraud.
Commission is seeking:Commission is seeking: Fraud injunctionsFraud injunctions Officer & Director bars Officer & Director bars Disgorgement of bonusesDisgorgement of bonuses Civil penaltiesCivil penalties
Rite Aid Commission also brought settled cease and desist Commission also brought settled cease and desist
proceedings against the company for reporting and proceedings against the company for reporting and books-and-records violations, and against the former books-and-records violations, and against the former COO for fraud and causing the company’s violations.COO for fraud and causing the company’s violations. Rite Aid cooperated in the investigation, including Rite Aid cooperated in the investigation, including
declining to assert its attorney-client privilege and declining to assert its attorney-client privilege and voluntarily providing Commission staff with full voluntarily providing Commission staff with full access to an internal investigation conducted by Rite access to an internal investigation conducted by Rite Aid's counsel. Aid's counsel.
The value of this cooperation was considered in The value of this cooperation was considered in determining the appropriate resolution of this matter.determining the appropriate resolution of this matter.
Parallel criminal charges were filed against the three Parallel criminal charges were filed against the three former officers and directors. former officers and directors.
Disgorgement of Stock Options and Other Compensation
FY 2002: Sought from 28 FY 2002: Sought from 28 individualsindividuals
FY 2001: Sought from 18 FY 2001: Sought from 18 individualsindividuals55% increase in FY 200255% increase in FY 2002
Tyco International
Commission alleged that 3 former top Commission alleged that 3 former top executives of Tyco -- L. Dennis Kozlowski, executives of Tyco -- L. Dennis Kozlowski, the former chief executive officer and the former chief executive officer and chairman of Tyco's board of directors, Mark chairman of Tyco's board of directors, Mark H. Swartz, the former chief financial officer H. Swartz, the former chief financial officer and a director, and Mark A. Belnick, the and a director, and Mark A. Belnick, the former chief legal officer -- failed to disclose former chief legal officer -- failed to disclose multi-million dollar low interest and interest-multi-million dollar low interest and interest-free loans they took from the company. free loans they took from the company.
Tyco International Commission’s complaint alleges:Commission’s complaint alleges:
Kozlowski and Swartz covertly caused the company Kozlowski and Swartz covertly caused the company to forgive tens of millions of dollars of those to forgive tens of millions of dollars of those outstanding loans without disclosure to investors.outstanding loans without disclosure to investors.
Kozlowski and Swartz engaged in other undisclosed Kozlowski and Swartz engaged in other undisclosed related party transactions. related party transactions.
Belnick failed to disclose the receipt of more than Belnick failed to disclose the receipt of more than $14 million of interest-free loans from the company.$14 million of interest-free loans from the company.
Kozlowski, Swartz and Belnick sold their shares of Kozlowski, Swartz and Belnick sold their shares of Tyco stock valued at millions of dollars while their Tyco stock valued at millions of dollars while their self-dealing remained undisclosed.self-dealing remained undisclosed.
Tyco International Commission is seeking disgorgement of all ill-gotten Commission is seeking disgorgement of all ill-gotten
gains, payment of civil money penalties, enjoining the gains, payment of civil money penalties, enjoining the defendants from future violations of the federal defendants from future violations of the federal securities laws, and officer and director bars. securities laws, and officer and director bars. Disgorgement sought from Kozlowski and Swartz Disgorgement sought from Kozlowski and Swartz
includes all compensation they received subsequent includes all compensation they received subsequent to their fraudulent acts and omissions, including to their fraudulent acts and omissions, including salary, bonuses, stock options and grants, and any salary, bonuses, stock options and grants, and any advances that have not been repaid.advances that have not been repaid.
Commission seeks disgorgement by all 3 defendants Commission seeks disgorgement by all 3 defendants of all loans not properly repaid to Tyco as well as of all loans not properly repaid to Tyco as well as losses avoided from sales of Tyco securities losses avoided from sales of Tyco securities subsequent to their fraudulent acts and omissions.subsequent to their fraudulent acts and omissions.
Disgorgement of Stock Options and Other Compensation
Waste Management (BuntrockWaste Management (Buntrock)): Injunctive action : Injunctive action charging founder, Buntrock, and five other former top charging founder, Buntrock, and five other former top officers with fraud in systematic scheme to misrepresent officers with fraud in systematic scheme to misrepresent financial results. Company acknowledged that it had financial results. Company acknowledged that it had misstated its pre-tax earnings by $1.7 billion over a five-misstated its pre-tax earnings by $1.7 billion over a five-year period. year period. Commission is seeking O&D bars, Commission is seeking O&D bars,
disgorgement of options, bonuses, performance-disgorgement of options, bonuses, performance-based compensation and proceeds from stock based compensation and proceeds from stock sales, and civil penalties.sales, and civil penalties.
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Cooperate and coordinate with criminal Cooperate and coordinate with criminal authoritiesauthorities
2.2. Emphasis on personal accountabilityEmphasis on personal accountability
3.3. Effort to speed up our investigationsEffort to speed up our investigations
“Real Time” Enforcement
Take actions to stop fraud and other Take actions to stop fraud and other investor harm expeditiously;investor harm expeditiously;
Trading suspensionsTrading suspensionsTROs and orders freezing assetsTROs and orders freezing assets
Bring cases in pieces (e.g., issuer, then Bring cases in pieces (e.g., issuer, then officers, then auditors)officers, then auditors)
WorldCom 6/25/02 Co. admits it capitalized 6/25/02 Co. admits it capitalized
$3.8 billion of expenses to meet $3.8 billion of expenses to meet estimates during last five quartersestimates during last five quarters
2001 reported earnings of $2.3 2001 reported earnings of $2.3 billion billion
Actually lost $662 millionActually lost $662 million SEC files case in less than 24 hoursSEC files case in less than 24 hours
WorldCom
Within 48 hours, Commission obtained a Within 48 hours, Commission obtained a court order preventing destruction of court order preventing destruction of documents, prohibiting extraordinary documents, prohibiting extraordinary payments to current and former officers, payments to current and former officers, directors and other employees, and appointing directors and other employees, and appointing a corporate monitor.a corporate monitor.
WorldCom
Nov. 26, 2002–partial settlementNov. 26, 2002–partial settlement Full injunctive reliefFull injunctive relief Extensive review of governance Extensive review of governance
and internal controlsand internal controls Employee trainingEmployee training Penalty reservedPenalty reserved
WorldCom
SEC has charged four WorldCom SEC has charged four WorldCom employees and officersemployees and officers
Criminal charges also filedCriminal charges also filed Restatement to exceed $9 billion Restatement to exceed $9 billion Commission’s investigation is continuing, Commission’s investigation is continuing,
along with investigation of U.S. Attorney’s along with investigation of U.S. Attorney’s Office for S.D.N.Y. Office for S.D.N.Y.
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations
4.4. Hold companies accountable for non-Hold companies accountable for non-cooperationcooperation
Xerox Commission alleged undisclosed accounting Commission alleged undisclosed accounting
actions that accelerated revenue recognition actions that accelerated revenue recognition of equipment by over $3 billion and of equipment by over $3 billion and increased pre-tax earnings by $1.5 billion increased pre-tax earnings by $1.5 billion over a four-year period. over a four-year period.
Company settled to a fraud injunction and Company settled to a fraud injunction and other relief.other relief.
The Commission’s investigation is The Commission’s investigation is continuing. continuing.
Xerox Goal: show growth in the face of competitive Goal: show growth in the face of competitive
challengeschallenges Commission alleged scheme was orchestrated by Commission alleged scheme was orchestrated by
senior managementsenior management Accelerated recognition of revenue into current Accelerated recognition of revenue into current
periods at the expense of futureperiods at the expense of future 1997-2000 accelerated revenue by over $3 billion and 1997-2000 accelerated revenue by over $3 billion and
increased earnings by $1.5 billionincreased earnings by $1.5 billion One-offsOne-offs Cushion reservesCushion reserves
Xerox Settled for $10 million penalty, Settled for $10 million penalty,
restatement and special review of restatement and special review of accounting controlsaccounting controls
Penalty reflects, in part, sanction Penalty reflects, in part, sanction for lack of “full” cooperation in for lack of “full” cooperation in the investigationthe investigation
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations
4.4. Hold companies accountable for non-Hold companies accountable for non-cooperationcooperation – but credit meaningful – but credit meaningful cooperation.cooperation.
Homestore Commission filed charges against John Commission filed charges against John
Giesecke Jr., Homestore's former chief Giesecke Jr., Homestore's former chief operating officer; Joseph J. Shew, its former operating officer; Joseph J. Shew, its former chief financial officer; and John DeSimone, chief financial officer; and John DeSimone, its former vice president of transactions, for its former vice president of transactions, for fraudulently inflating Homestore’s revenues fraudulently inflating Homestore’s revenues by causing the company to overstate its by causing the company to overstate its advertising revenues by $46 million (64%) advertising revenues by $46 million (64%) for the first three quarters of 2001. for the first three quarters of 2001.
Homestore Commission announced that it would not bring Commission announced that it would not bring
enforcement action against Homestore because of its enforcement action against Homestore because of its swift, extensive and extraordinary cooperation. swift, extensive and extraordinary cooperation.
Cooperation included reporting discovery of possible Cooperation included reporting discovery of possible misconduct to the Commission immediately upon the misconduct to the Commission immediately upon the audit committee's learning of it, conducting thorough audit committee's learning of it, conducting thorough and independent internal investigation, sharing and independent internal investigation, sharing results of that investigation with the government, results of that investigation with the government, terminating responsible wrongdoers, and terminating responsible wrongdoers, and implementing remedial actions designed to prevent implementing remedial actions designed to prevent the recurrence of fraudulent conduct. the recurrence of fraudulent conduct.
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations4.4. Hold companies accountable for non-Hold companies accountable for non-
cooperationcooperation
5.5. Conduct of gatekeepers scrutinizedConduct of gatekeepers scrutinized
Frank E. Walsh, Jr. (Tyco) Commission filed a settled civil action alleging that Frank E. Commission filed a settled civil action alleging that Frank E.
Walsh Jr., a former Tyco director, violated the federal securities Walsh Jr., a former Tyco director, violated the federal securities laws by signing a Tyco registration statement that he knew laws by signing a Tyco registration statement that he knew contained material misrepresentations.contained material misrepresentations.
According to the complaint, the registration statement filed in According to the complaint, the registration statement filed in connection with Tyco's acquisition of The CIT Group Inc. connection with Tyco's acquisition of The CIT Group Inc. incorporated and attached an Agreement and Plan of Merger incorporated and attached an Agreement and Plan of Merger stating that no one other that Lehman Brothers and Goldman, stating that no one other that Lehman Brothers and Goldman, Sachs was entitled to an investment banking or finder's fee for Sachs was entitled to an investment banking or finder's fee for representing Tyco in the transaction. representing Tyco in the transaction.
At the time that he signed the registration statement, Walsh At the time that he signed the registration statement, Walsh knew that he had been promised a $ 20 million finder's fee for knew that he had been promised a $ 20 million finder's fee for having arranged a meeting of the companies' CEO's to discuss a having arranged a meeting of the companies' CEO's to discuss a possible merger.possible merger.
James A. Fitzhenry Fitzhenry was a Senior Vice President, General Fitzhenry was a Senior Vice President, General
Counsel and Secretary for FLIR Systems, IncCounsel and Secretary for FLIR Systems, Inc Commission found that in connection with FLIR’s Commission found that in connection with FLIR’s
1998 year-end audit, Fitzhenry signed management 1998 year-end audit, Fitzhenry signed management representation letters to FLIR’s auditors that he representation letters to FLIR’s auditors that he understood contained material misrepresentations understood contained material misrepresentations regarding $4.1 million in sales.regarding $4.1 million in sales.
In settlement, Fitzhenry agreed to:In settlement, Fitzhenry agreed to: Cease and desist from violating the lying-to-the-Cease and desist from violating the lying-to-the-
auditors rule of the Exchange Act, andauditors rule of the Exchange Act, and 5-year prohibition on appearing or practicing 5-year prohibition on appearing or practicing
before the Commission under Rule 102(e).before the Commission under Rule 102(e).
KPMG LLP Commission sued KPMG LLP and four KPMG Commission sued KPMG LLP and four KPMG
partners – including the head of the firm’s department partners – including the head of the firm’s department of professional practice – in connection with the audits of professional practice – in connection with the audits of Xerox Corp. from 1997 through 2000. of Xerox Corp. from 1997 through 2000. The Commission's complaint alleges that the The Commission's complaint alleges that the
defendants' fraudulent conduct allowed Xerox to defendants' fraudulent conduct allowed Xerox to inflate equipment revenues by approximately $3 inflate equipment revenues by approximately $3 billion and inflate pre-tax earnings by approximately billion and inflate pre-tax earnings by approximately $1.2 billion in the company's financial results for the $1.2 billion in the company's financial results for the relevant yearsrelevant years..
Commission’s action charges the firm and four partners Commission’s action charges the firm and four partners with fraud, and seeks injunctions, disgorgement of all with fraud, and seeks injunctions, disgorgement of all fees and civil money penalties. fees and civil money penalties.
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations4.4. Hold companies accountable for non-Hold companies accountable for non-
cooperationcooperation5.5. Conduct of gatekeepers scrutinizedConduct of gatekeepers scrutinized
6.6. Compliance with GAAP not always Compliance with GAAP not always enoughenough
Edison Schools Only three months after initiating inquiry, Only three months after initiating inquiry,
Commission instituted settled cease-and-desist Commission instituted settled cease-and-desist proceeding against Edison Schools.proceeding against Edison Schools.
Commission found that Edison, despite technical Commission found that Edison, despite technical compliance with GAAP, inaccurately described compliance with GAAP, inaccurately described aspects of its business in its SEC filings, in violation aspects of its business in its SEC filings, in violation of the securities laws.of the securities laws. Specifically, Edison failed to disclose that a Specifically, Edison failed to disclose that a
substantial portion of its reported revenues consist substantial portion of its reported revenues consist of payments that never reach Edison. Funds are of payments that never reach Edison. Funds are instead expended by school districts to cover costs instead expended by school districts to cover costs of operating schools managed by Edison. of operating schools managed by Edison.
Edison Schools In settling the action, Edison agreed to:In settling the action, Edison agreed to:
Cease and desist from committing violationsCease and desist from committing violations Add to its management a Director of Internal Audit Add to its management a Director of Internal Audit
to report to the Audit Committee to report to the Audit Committee Create an Internal Audit Department appropriate Create an Internal Audit Department appropriate
for the company's size and business. for the company's size and business. PrinciplePrinciple: If a company makes filings with the : If a company makes filings with the
Commission that mischaracterize its business, or omit Commission that mischaracterize its business, or omit significant information, technical compliance with significant information, technical compliance with GAAP will not insulate it from enforcement action.GAAP will not insulate it from enforcement action.
PNC Financial Services
Accounting or alchemyAccounting or alchemy
SPEs:PNC Financial Services
Get weak loans and investments Get weak loans and investments off booksoff books
Avoid recognizing further lossesAvoid recognizing further losses Keep possibility of gainKeep possibility of gain Use SPE’s Use SPE’s
PNC Financial Services
Insurance company puts in 3% of equity for Insurance company puts in 3% of equity for all common stockall common stock
Looks like IC controls businessLooks like IC controls business PNC gets preferred for weak loans PNC gets preferred for weak loans SPE buys 30 year zero bond Treasury = SPE buys 30 year zero bond Treasury =
preferred after 30 yearspreferred after 30 years
PNC Financial Services
Not GAAPNot GAAP IC did not really put in 3%IC did not really put in 3% PNC really has the risk and rewardsPNC really has the risk and rewards Fed and SEC blow whistleFed and SEC blow whistle EPS – before restatement $1.91EPS – before restatement $1.91 Restated: $1.38Restated: $1.38 SEC charges fraudSEC charges fraud
PNC Financial Services
GAAP is not alchemyGAAP is not alchemy Even if GAAP, must evaluate material Even if GAAP, must evaluate material
accuracy and completeness of presentation accuracy and completeness of presentation of financial statementsof financial statements
Must disclose risksMust disclose risks
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations4.4. Hold companies accountable for non-Hold companies accountable for non-
cooperationcooperation5.5. Conduct of gatekeepers scrutinizedConduct of gatekeepers scrutinized6.6. Compliance with GAAP not always enoughCompliance with GAAP not always enough7.7. Facilitating another company’s reporting Facilitating another company’s reporting
violations may create liabilityviolations may create liability
Accommodations:Ashford -- Amazon Resolve disputeResolve dispute Amazon will pay $600,000 to AshfordAmazon will pay $600,000 to Ashford Ashford will credit Amazon with providing Ashford will credit Amazon with providing
11,500 customers11,500 customers Ashford asks Amazon to split the deal into Ashford asks Amazon to split the deal into
two letters, one referring to 3000 customers two letters, one referring to 3000 customers and another for the balanceand another for the balance
Ashford -- Amazon Ashford charged with fraudAshford charged with fraud Amazon charged with being a cause of Amazon charged with being a cause of
Ashford’s reporting violation because Ashford’s reporting violation because Amazon knew or should have known that Amazon knew or should have known that the reason Ashford wanted to split the deal the reason Ashford wanted to split the deal was to allow Ashford to improperly defer was to allow Ashford to improperly defer expensesexpenses
Moral – do not be an accompliceMoral – do not be an accomplice
Financial Reporting & Issuer Disclosure: Themes and Trends
1.1. Coordination with criminal authoritiesCoordination with criminal authorities2.2. Emphasis on personal accountabilityEmphasis on personal accountability3.3. Effort to speed up our investigationsEffort to speed up our investigations4.4. Hold companies accountable for non-cooperationHold companies accountable for non-cooperation5.5. Conduct of gatekeepers scrutinizedConduct of gatekeepers scrutinized6.6. Compliance with GAAP not always enoughCompliance with GAAP not always enough7.7. Facilitating another company’s reporting violations Facilitating another company’s reporting violations
may create liabilitymay create liability8.8. Auditor independence remains a critical Auditor independence remains a critical
element of sound financial reportingelement of sound financial reporting
Ernst & Young and Moret Ernst & Young Accountants
Moret affiliate has business Moret affiliate has business arrangement with Baanarrangement with Baan
Moret audits Baan Moret audits Baan Moret relies on US E&Y which also Moret relies on US E&Y which also
had business arrangement with Baanhad business arrangement with Baan
Ernst & Young and Moret Ernst & Young Accountants
E&Y case involved joint E&Y case involved joint business arrangement between business arrangement between E&Y and audit client E&Y and audit client PeopleSoft. PeopleSoft.
PricewaterhouseCoopers and PricewaterhouseCoopers Securities Settled enforcement action against PricewaterhouseCoopers Settled enforcement action against PricewaterhouseCoopers
(PwC) and its broker-dealer affiliate, (PwC) and its broker-dealer affiliate, PricewaterhouseCoopers Securities (PwCS), for violations PricewaterhouseCoopers Securities (PwCS), for violations of the auditor independence rules. of the auditor independence rules.
The auditor independence violations arise from:The auditor independence violations arise from: PwC's use of prohibited contingent fee arrangements PwC's use of prohibited contingent fee arrangements
with 14 different audit clients for which PwCS provided with 14 different audit clients for which PwCS provided investment banking services, and investment banking services, and
PwC's participation with two other audit clients, Pinnacle PwC's participation with two other audit clients, Pinnacle Holdings Inc. and Avon Products Inc., in the improper Holdings Inc. and Avon Products Inc., in the improper accounting of costs that included PwC's own consulting accounting of costs that included PwC's own consulting feesfees
PWC and PWCS
PWC contingent fee arrangement with PWC contingent fee arrangement with 14 audit clients for which PWCS 14 audit clients for which PWCS provided investment banking servicesprovided investment banking services
For two clients, Pinnacle and Avon, For two clients, Pinnacle and Avon, PWC was also a cause of company’s PWC was also a cause of company’s GAAP violationsGAAP violations
PWC and PWCS Remedies
$5 million civil penalty$5 million civil penaltyC&D from violating the C&D from violating the
auditor independence rulesauditor independence rulesCensured for engaging in Censured for engaging in
improper professional improper professional conduct.conduct.
Section 10A -- Solucorp Company recognizes licensing revenue Company recognizes licensing revenue
before final dealbefore final deal Auditor finds backdated licensing Auditor finds backdated licensing
agreement agreement Auditor fails to determine whether act Auditor fails to determine whether act
illegal and fails to inform audit illegal and fails to inform audit committeecommittee
Andersen --Enron October 17, 2001 Enron announces October 17, 2001 Enron announces
problemsproblems Andersen destroys documentsAndersen destroys documents Andersen indictedAndersen indicted Clients fleeClients flee Engagement partner pleads guiltyEngagement partner pleads guilty Firm convictedFirm convicted
Andersen – WMI The Underlying Fraud
From 1992 to 1996, Waste From 1992 to 1996, Waste Management overstates earnings Management overstates earnings by $1.43 billion and understates by $1.43 billion and understates taxes by $178 milliontaxes by $178 million
Andersen Enjoined
Andersen and 3 partners Andersen and 3 partners enjoined from future fraudenjoined from future fraud
Andersen fined $7 millionAndersen fined $7 million
3 partners fined $30,000 to 3 partners fined $30,000 to $50,000 each$50,000 each
102(e) SanctionsAndersen and 4 partners Andersen and 4 partners
charged with improper charged with improper professional conduct professional conduct
Andersen censured Andersen censured
4 partners barred 4 partners barred
SEC Action First fraud injunction against a First fraud injunction against a
Big 5 firm in 20 yearsBig 5 firm in 20 years Record penalty against a Big 5 Record penalty against a Big 5
firm of $7 millionfirm of $7 million First case against Big 5 firm First case against Big 5 firm
Practice Director in 20 yearsPractice Director in 20 years
Andersen Indicted
Two months laterTwo months later SEC begins Enron inquirySEC begins Enron inquiry In October, Enron problems In October, Enron problems
surfacesurface Andersen starts destroying Andersen starts destroying
Enron documentsEnron documents
Special Study Pursuant to Sarbanes-Oxley Act Section 704 summarizes financial reporting Section 704 summarizes financial reporting
enforcement actions over the past five yearsenforcement actions over the past five years
Available on SEC website – www.Sec.GovAvailable on SEC website – www.Sec.Gov
What Preventive Measures can Management Take?
Preventive Measures for Mgmt.
First:First:
Full disclosure with your auditorsFull disclosure with your auditors Don’t wait for auditors to find problemsDon’t wait for auditors to find problems Vet novel or complex issues with Vet novel or complex issues with
national office technical expertsnational office technical experts
Preventive Measures
Keep audit committee informed at all timesKeep audit committee informed at all times Discuss significant accounting policies, Discuss significant accounting policies,
judgments and estimatesjudgments and estimates
Preventive Measures
Open discussions with Corp. Fin./OCAOpen discussions with Corp. Fin./OCA Pre-clearance program for novel and Pre-clearance program for novel and
unusual accounting questionsunusual accounting questions See SECPS Practice Alert No. 2002-1See SECPS Practice Alert No. 2002-1
Preventive Measures And, last but not leastAnd, last but not least
Assess the “tone at the top”Assess the “tone at the top” Aka – the “pressure from the top”Aka – the “pressure from the top”
Take a “fresh” look at your code of ethicsTake a “fresh” look at your code of ethics Ensure it is up-to-date and covers all lines of Ensure it is up-to-date and covers all lines of
businessesbusinesses Reminder: S-O to require disclosure of any change Reminder: S-O to require disclosure of any change
to or waiver of codeto or waiver of code
Earnings Releases
Perhaps the better approach is to issue Perhaps the better approach is to issue earnings in close proximity to the filing of earnings in close proximity to the filing of the financial statementsthe financial statements Accelerated filersAccelerated filers Caution: Pro forma earningsCaution: Pro forma earnings
Pro Formas: Trump Hotels
SEC’s first SEC’s first pro formapro forma financial reporting financial reporting case.case.
Commission found that Trump Hotels & Commission found that Trump Hotels & Casino Resorts violated Section 10(b) and Casino Resorts violated Section 10(b) and Rule 10b-5.Rule 10b-5.
Company was ordered to cease and desist Company was ordered to cease and desist from violating those provisions. from violating those provisions.
Trump Hotel – Pro Forma Financial data that is not GAAPFinancial data that is not GAAP
3Q ’99 Company trumpets results: 3Q ’99 Company trumpets results: “better than estimates;” result of “better than estimates;” result of improved operationsimproved operations
Disclose not counting $83 mil. one time Disclose not counting $83 mil. one time expenseexpense
Trump Hotel Do not disclose $17 million one time gain is Do not disclose $17 million one time gain is
included included Stock up 7.8%Stock up 7.8% Would not exceed estimates and would Would not exceed estimates and would
show revenue decline if excluded one time show revenue decline if excluded one time gaingain
Truth comes out: stock drops 6%Truth comes out: stock drops 6% Settled 10(b), 10b-5 C&DSettled 10(b), 10b-5 C&D
21(a) REPORT ON 21(a) REPORT ON COOPERATION:COOPERATION:
The “Seaboard Report”The “Seaboard Report”
21(a) Report on Cooperation
Framework for evaluating a proposed Framework for evaluating a proposed defendant’s cooperationdefendant’s cooperation
The carrot: Credit for extraordinary The carrot: Credit for extraordinary cooperationcooperation
The stick: Harsher remedies for lack The stick: Harsher remedies for lack of “full cooperation”of “full cooperation”
No promises -- Not an amnesty No promises -- Not an amnesty programprogram
21(a) Report on Cooperation
Wider range of outcomesWider range of outcomes Finer distinctions between wrongdoersFiner distinctions between wrongdoers Seaboard – No action against companySeaboard – No action against company Xerox -- $10 million penaltyXerox -- $10 million penalty Dynegy -- $3 million penaltyDynegy -- $3 million penalty
Four Principles
Self-policingSelf-policingSelf-reportingSelf-reportingRemediationRemediationCooperationCooperation
The Meaning of Cooperation Self-policingSelf-policing prior to discovery of misconduct prior to discovery of misconduct
Effective compliance proceduresEffective compliance proceduresAppropriate “tone at the top”Appropriate “tone at the top”
Self-reportingSelf-reporting misconduct upon discovery misconduct upon discoveryThorough review of nature, extent, Thorough review of nature, extent,
origins & consequencesorigins & consequencesDisclosure to public and regulatorsDisclosure to public and regulators
The Meaning of Cooperation
RemediationRemediationDismissing or appropriately Dismissing or appropriately
disciplining wrongdoersdisciplining wrongdoersInternal controls and procedures to Internal controls and procedures to
prevent recurrenceprevent recurrenceCompensating those adversely Compensating those adversely
affectedaffected Cooperation with law enforcement Cooperation with law enforcement
authoritiesauthorities
The Meaning of Cooperation:Internal Investigation
Independent counselIndependent counsel Forensic auditorsForensic auditors Share results with staffShare results with staff Waive work product, privileges Waive work product, privileges Secure cooperationSecure cooperation
Independent AccountantsEvery case raises the question:Every case raises the question:
Let’s Get Back to the Basics
Back to the Basics…Know your audit clientKnow your audit client Understand the key reports used by managementUnderstand the key reports used by management
Understand the budget processUnderstand the budget process
Understand the source of growthUnderstand the source of growth
Know your client’s industryKnow your client’s industry
Back to the Basics…
Don’t over rely on management’s Don’t over rely on management’s representationsrepresentations
Don’t get too comfortable with the clientDon’t get too comfortable with the client
Don’t engage in “Conversational Auditing”Don’t engage in “Conversational Auditing”
Back to the Basics…
““Professional skepticism is an attitude that Professional skepticism is an attitude that includes a questioning mind and a critical includes a questioning mind and a critical assessment of audit evidence.”assessment of audit evidence.”
Statement on Auditing Standards 99, October 2002Statement on Auditing Standards 99, October 2002
Professional Skepticism
Should be displayed by all members of the Should be displayed by all members of the team throughout the audit and review team throughout the audit and review engagementsengagements
Back to the Basics…
Vary the audit testing performedVary the audit testing performed
Prepare a detailed audit programPrepare a detailed audit program
Understand the client’s closing processUnderstand the client’s closing process
Don’t forget the general ledgerDon’t forget the general ledger
The Closing Process
Follow-up on all questionable items during Follow-up on all questionable items during the final analytical reviewthe final analytical review
Examine all consolidating financial Examine all consolidating financial statementsstatements Including, all post closing and top-side Including, all post closing and top-side
entriesentries
Back to the Basics… Open dialogue with audit committeeOpen dialogue with audit committee
Both proposed and passed audit adjustments as Both proposed and passed audit adjustments as a result of audit and the reviewsa result of audit and the reviews
Troubles encountered during audit or reviewsTroubles encountered during audit or reviews
Ongoing dialogue with “financial experts” on Ongoing dialogue with “financial experts” on committee may be necessarycommittee may be necessary
Back to the Basics…Issues encountered during the audit ---Issues encountered during the audit ---
Deal with the issue at handDeal with the issue at hand
Don’t try to “paper over” the problemDon’t try to “paper over” the problem
Management letter comment is not enoughManagement letter comment is not enough
Don’t make the client’s problem your ownDon’t make the client’s problem your own
