Introduction

If the public statements of the SEC Commissioners and staff are to be believed, brace yourself for the coming wave of financial reporting and accounting enforcement matters. The SEC has sent the message loud and clear in 2013: "The SEC is back and better than ever — and that certainly is the case when it comes to pursuing financial reporting and accounting fraud."1

The SEC's emphasis on financial reporting is not unique, of course; pursuing such matters has long been one of the Commission's core focus areas. Yet in recent years — after the extensive activity in the early 2000s and the Sarbanes-Oxley Act, and a brief resurgence with stock option backdating — news about financial reporting and accounting matters took a back seat to cases concerning the Financial Crisis of 2008, insider trading, FCPA-related matters, and Ponzi schemes of all types. The numbers confirm this: The SEC filed 79 financial reporting cases in 2012, compared to 219 in 2007.2 And the agency opened 124 such investigations in 2012, compared to 304 in 2006 and 228 in 2007.3 Last year, though, the SEC proclaimed that this trend was about to end.

Welcome to the inaugural edition of an annual review from Morrison & Foerster. Starting with calendar year 2013, we plan to track and analyze the SEC's renewed enforcement efforts focusing on public company financial reporting and accounting, as well as the efforts put forth by the PCAOB. Public companies, officers and directors, audit firms, auditors, and securities practitioners alike can turn here for an insightful discussion of the key cases and trends from the year.

In this edition, we first discuss developments within the SEC and its renewed vigor in the financial reporting and accounting arena. Next, we discuss areas on which the SEC has said that it will focus its financial reporting and accounting enforcement efforts. We then analyze the SEC's cases in 2013, which may best be viewed as a baseline against which future SEC priorities and efforts will be compared. Thereafter, we explore specific themes that emerged from last year's cases, as applicable to public companies and their officers and directors, as well as to audit firms and auditors. We then discuss the several cases last year that focused on Rule 102(e) bars. Finally, we close with a review of developments at the PCAOB.

We hope that you enjoy the report as much as we enjoyed putting it together. Please let us know your thoughts; we look forward to hearing from you.

Redesigning the SEC's Division of Enforcement, Again

Under the leadership of SEC Chair Mary Jo White and Division of Enforcement Co-Directors George Canellos and Andrew Ceresney, the SEC once again recast its enforcement program in 2013. In Chair White's words, the changes are designed to highlight the agency's "robust" enforcement program that is "aggressive and creative," and that "continue[s] to focus on financial statement and accounting fraud."4

Forming a New Task Force

Several years ago, in the wake of criticism concerning the SEC's enforcement efforts, the Division underwent a fundamental reorganization. In an effort to streamline its processes and conduct its investigations more efficiently, the Division flattened its management structure, obtained delegated authority to issue subpoenas, and formed five specialty units, staffed with attorneys and accountants from around the country, to focus on specific enforcement areas: market abuse, asset management, structured and new products, Foreign Corrupt Practices Act (FCPA), and municipal securities. Notably absent from the reshuffling, however, was a unit specifically focusing on financial reporting and accounting matters.

Fast-forward to 2013. Calling accurate financial reporting "the bedrock upon which our markets are based," Ceresney proclaimed that "the importance of pursuing financial fraud cannot be overstated."5 He expressed skepticism that a reduction in the number of public company restatements really meant that there was less financial fraud.6 The Division thus will "pivot away" from Financial Crisis cases and instead will dedicate resources to pursuing financial reporting and accounting fraud.7

As part of this pivot, the Division announced the creation of the Financial Reporting and Audit Task Force (here, the "Task Force").8 Building on prior efforts "to concentrate resources on high-risk areas of the market," the Task Force will be "dedicated to detecting fraudulent or improper financial reporting."9 It will identify areas susceptible to inappropriate financial reporting by, among other things, engaging in an ongoing review of financial statement restatements and revisions, analyzing performance trends by industry, and using technology-based tools.10 It will strive to serve "as an incubator to build accounting fraud cases."11 David Woodcock, Director of the Fort Worth Regional Office, serves as Chair of the Task Force, with Margaret McGuire, Senior Counsel to the Directors, serving as Vice-Chair.12 Attorneys and accountants from both the headquarters and regional offices staff the Task Force, working closely with the Commission's other Divisions and Offices.13 The success of the Task Force, according to Division leadership, "should be judged by the quality, and not the quantity, of our cases."14

Quants Rule!

In the past few years, the SEC has poured increasing resources into utilizing quantitative analysis to aid enforcement efforts. The Aberrational Performance Inquiry, for example, identifies outliers in reported fund performance, which flags matters for the enforcement staff to pursue. Likewise, analysis of mass trading data obtained from broker-dealers allows the staff to identify potential insider trading and market abuse matters.

It is not surprising, therefore, that the Division created the Center for Risk and Quantitative Analytics (here, the "Analytics Group") – headed by Lori Walsh, formerly Deputy Chief of the Office of Market Intelligence – to bolster the Division's financial reporting and accounting enforcement efforts. This new Analytics Group is designed to serve as "both an analytical hub and source of information about characteristics and patterns indicative of possible fraud or other illegality."15

The staff will also build on existing analytical tools such as the SEC's Accounting Quality Model, which allows the staff to identify outlier attributes in issuer filings as compared to industry peers. Those outliers can then be further investigated for possible improprieties.16

Whistleblowers Help

The Division will not solely rely on its internal sourcing of cases. Last year, the Division continued to reap the rewards of its whistleblower program, established under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). For providing information that leads to a successful enforcement action involving sanctions of over $1 million, a whistleblower may receive an award of 10% to 30% of the amount collected by the SEC.

In fiscal year 2013, the SEC's Office of the Whistleblower received 3,238 tips concerning potential securities law violations, up from 3,001 in fiscal year 2012.17 In each of the past two fiscal years, tips about "Corporate Disclosures and Financials" were the most prevalent of those received by the SEC (aside from tips classified as "other"): 17.2% of the 2013 tips (557 tips) and 18.2% of the 2012 tips (547 tips).18 Driving the numbers home, Task Force chair Woodcock stated that whistleblowers are "hugely important" in the financial reporting and accounting fraud arena, and that the Division is currently investigating cases that it could not have uncovered through analytics alone.19

Indeed, 2013 was a banner year for the SEC whistleblower program. On September 30, the Commission announced an award of over $14 million to a whistleblower whose tip led to a successful SEC enforcement action.20 This is the largest award granted under the program to date.21 Chair White, touted the whistleblower program as "a tremendously effective force-multiplier" that the Commission expects to use with increasing frequency going forward.22 Large awards like this one, she said, will persuade others to step forward, incentivize companies to treat internal reports "seriously and fairly," and encourage companies to self-report misconduct to the SEC before whistleblowers do so.23

Settlements and Trials

Bucking years of precedent, the SEC also adjusted its settlement policy in 2013. Historically the SEC has allowed defendants to neither admit nor deny allegations of wrongdoing when settling enforcement actions. Last year, however, the SEC announced that it will seek admissions of liability under certain broadly-defined circumstances.24 Cases appropriate for potential admissions include matters involving a large number of harmed investors, conduct imposing significant risks on investors, circumstances where admissions will aid investors in future proceedings, and instances when reciting unambiguous facts will send a clear message to the market.25 The SEC already deployed this approach three times in 2013.26 Although none of these cases involved financial reporting, it is not difficult to envision a significant financial reporting and accounting matter fitting into the criteria articulated by the SEC as being appropriate for an admission. Moreover, the SEC retains its full arsenal of other remedies: disgorgement, a civil penalty, a clawback of executive compensation, a bar on serving as an officer or director of a public company, and a bar on practicing before the Commission under Rule 102(e).

Additionally, this past year the SEC emphasized its trial acumen. Stressing the difficult and complex nature of its cases and the frequent lack of direct evidence of liability, the Commission lauded its trial group and its record.27 Chair White stated that the SEC notched an 80% success rate at trial over the past three years.28 While this statistic may be true, the outcomes have been mixed in recent high-profile cases. For example, the SEC won a verdict of liability against Fabrice Tourre, a former Goldman Sachs employee charged with Financial Crisis-related claims, but lost against Mark Cuban, a Texas businessman charged with insider trading.29

Moreover, in financial reporting and accounting cases, the SEC suffered two publicized trial losses in December. First, a jury in Kansas issued a verdict in favor of the CFO of NIC, Inc. who the SEC accused of concealing over $1 million in perquisites paid to the company's former CEO.30 Second, a court in California ruled for the former CFO and former CEO of Basin Water, Inc., finding that the SEC failed to prove that the executives entered into "sham transactions" to boost revenues.31

Nevertheless, the SEC continues to spotlight its litigation prowess and, anecdotally, indicates that its settlement posture is becoming much more aggressive. All of this signals that the Division will not shy away from taking appropriate cases to verdict.

Focus Areas: What's Next

Armed with its arsenal of enforcement tools, the Task Force and Division will focus their financial reporting and accounting efforts in several areas.32

Revenue recognition will "remain a staple of [the] financial fraud caseload."33 Other performance benchmarks used by companies likewise will be carefully scrutinized. And the staff has emphasized on multiple occasions that the effectiveness of internal corporate controls are of paramount concern.34

Additional areas highlighted in recent public comments and cases include asset valuation; recorded expenses, particularly capitalized expenses; estimated reserves and allowances; accounting in connection with acquisitions; off-balance-sheet financings; alternative tax treatments; MD&A disclosures, particularly looking at possible omissions and the use of non- GAAP measures; related-party transactions; and matters arising from foreign operations, including possible FCPA issues, cash controls, and other accounting and disclosure concerns.

Furthermore, the Task Force may seek information from multiple companies within particular industries, but Woodcock has declined to provide specifics about these potential "sweeps."35 Complex and unusual transactions, adjusting entries, and significant end of period activity are unlikely to pass unnoticed as well.

Nor will the Division solely investigate issuers. Through a companion initiative internally dubbed "Operation Broken Gate," the Division is keenly focused on identifying auditors who do not act in accordance with applicable professional standards.36 As Ceresney stated, when the staff discovers issues, "you can expect that we will scrutinize not only the CEO, CFO and Controller, but also the engagement partner, engagement quality reviewer, and the auditing firm as a whole."37

Specifically, the Division will seek to ensure appropriate audit planning, identification of risk areas, testing, follow-up on red flags, documentation, and independence. The Division also will probe the activities of other "critical gatekeepers," such as Audit Committees.38

Finally, lest anyone think that the Division and Task Force will focus solely on mega-cases, Chair White emphasized another enforcement tack that she referred to as the "broken windows" approach.39 That is, the Division will not overlook so-called smaller violations — "such as control failures, negligence-based offenses, and even violations of prophylactic rules with no intent requirement" — in order to show that the SEC cop is walking the beat and to prevent budding violators from blossoming into bigger fraudsters.40

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Footnotes

1 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

2 See id.

3 See id.

4 See, e.g., Speech 9/26/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539841202 (last visited 11/26/13).

5 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

6 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

7 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

8 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

9 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

10 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

11 See 45 Securities Regulation & Law Report 2206 (11/21/13) at http://news.bna.com/srln/SRLNWB/split_display.adp?fedfid=38332092&vname=srlrnotallissues&fcn=40&wsn=488535000&fn=38332092&split=0 (last visited 11/26/13).

12 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

13 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

14 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

15 See Release No. 2013-121 (7/2/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171624975 (last visited 11/26/13).

16 See Speech (12/13/12) at https://www.sec.gov/News/Speech/Detail/Speech/1365171491988 (last visited 11/26/13).

17 See 2013 Annual Report to Congress on the Dodd- Frank Whistleblower Program at https://www.sec.gov/about/offices/owb/annual-report-2013.pdf (last visited 11/26/13).

18 See 2013 Annual Report to Congress on the Dodd- Frank Whistleblower Program at https://www.sec.gov/about/offices/owb/annual-report-2013.pdf (last visited 11/26/13).

19 See Law360, "Expect Renewed SEC Emphasis on Accounting Fraud," 10/4/13 at http://www.law360.com/articles/478273/expect-renewed-sec-emphasis-on-accounting-fraud (subscription required, last visited 1/3/14).

20 See 2013 Annual Report to Congress on the Dodd- Frank Whistleblower Program at https://www.sec.gov/about/offices/owb/annual-report-2013.pdf (last visited 11/26/13).

21 See Release 2013-209 (10/1/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539854258 (last visited 10/21/13).

22 See Speech (10/9/13) at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100 (last visited 11/26/13).

23 See Speech (10/9/13) at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100 (last visited 11/26/13).

24 See Speech 9/26/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539841202 (last visited 11/26/13).

25 See Speech 9/26/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539841202 (last visited 11/26/13).

26 See Release No. 2013-159 (8/19/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539780222; Release No. 2013-187 (9/19/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539819965; Release No. 2013-266 (12/18/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540521484 (all last visited 12/20/13).

27 See, e.g., Speech 11/14/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370540374908; Speech 10/25/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370540071677 (both last visited 11/26/13).

28 See Speech 11/14/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370540374908 (last visited 12/5/13).

29 See Release 8/1/13 at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370539749266 and Release No. 22855 (10/23/13) at http://www.sec.gov/litigation/litreleases/2013/lr22855.htm (both last visited 11/26/13).

30 See "SEC's Courtroom Cred Slips as Trial Losses Mount," Law360, 12/4/13 at http://www.law360.com/articles/493461/sec-s-courtroom-cred-slips-as-trial-losses-mount (subscription required, last visited 12/5/13).

31 See SEC v. Jensen and Tekulve, C.D. Cal., Case No. CV-11-5316-R, Dec. 10, 2013 at http://articles.law360.s3.amazonaws.com/0495000/495240/SEC%20v%20Jensen.pdf and "SEC Loses Fraud Claims Against Water Purifier Co. Execs." Law360, 12/12/13 at http://www.law360.com/securities/articles/495240?nl_pk=48ae06b0-9c49-4021-aff1-c4acc84a7a33&utm_source=newsletter&utm_medium=email&utm_campaign=securities (subscription required, both last visited 12/13/13).

32 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13); 45 Securities Regulation & Law Report 1759, 9/18/13 at http://news.bna.com/srln/SRLNWB/split_display.adp?fedfid=36647326&vname=srlrnotallissues&wsn=489021000&searchid=21774354&doctypeid=1&type=date&mode=doc&split=0&scm=SRLNWB&pg=0 (last visited 9/23/13).

33 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

34 See, e.g., 45 Securities Regulation & Law Report 1759, 9/18/13 at http://news.bna.com/srln/SRLNWB/split_display.adp?fedfid=36647326&vname=srlrnotallissues&wsn=489021000&searchid=21774354&doctypeid=1&type=date&mode=doc&split=0&scm=SRLNWB&pg=0 (last visited 9/23/13).

35 See 45 Securities Regulation & Law Report 1758, 9/20/13 at http://news.bna.com/srln/SRLNWB/split_display.adp?fedfid=36647339&vname=srlrnotallissues&wsn=489020500&searchid=21774378&doctypeid=1&type=date&mode=doc&split=0&scm=SRLNWB&pg=0 (last visited 9/23/13).

36 See Release No. 2013-207 (9/30/13) at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539850572 (last visited 11/26/13).

37 See Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (last visited 11/26/13).

38 See Speech (10/9/13) at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100 and Speech 9/19/13 at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772 (both last visited 11/26/13).

39 See Speech (10/9/13) at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100 (last visited 11/26/13).

40 See Speech (10/9/13) at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100 (last visited 11/26/13).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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