It's been more than a decade since a series of scandals involving companies like WorldCom and Enron made headlines, exposing levels of financial fraud that startled most Americans and put federal regulators into a state of high alert. In the years since those scandals, the Securities and Exchange Commission (SEC) has put a tighter focus on financial disclosure statements in an attempt to root out “soft information” and uncover true financial fraud.
The fact of the matter is, financial disclosure documents have always represented a bit of a minefield for public companies, but nowadays, SEC scrutiny is even greater. The Commission looks closely at financial statements, down to the smallest footnote, putting more pressure on true financial metrics, but also on the explanations for matters ranging from revenue to risk.
By putting more emphasis on these financial disclosure documents, the SEC has shone the spotlight on the information contained within, digging deep when possible.
“When the SEC reviews the information, assumptions are not disclosed in a lot of detail, so it's hard for the SEC to review certain areas. Often, they will note that a company has impaired an asset and ask what was the company's basis for not having done so earlier,” says Linda L. Griggs, partner at Morgan Lewis LLP and former chief counsel to the chief accountant at the SEC. “In the area of fair value judgments, it can be hard for the SEC to provide real-time, meaningful comments, internal estimates and judgments.”
In the past, companies would rely on third parties to prepare much of their disclosures, but now, businesses must do enough of this work internally to ensure they are comfortable with every detail.
It's not just internal, year-to-year consistency of a certain company's reports that the SEC looks at. The Commision is also comparing a company to its competitors. “The SEC compares a company's disclosures to others in the same industry,” explains Kit Addleman, partner at Haynes & Boone LLP, and former regional director of the Atlanta office of the SEC.
The SEC Division of Corporation Finance is divided into a dozen different industry groups for reviews. In her role in the White Collar Defense and Investment Funds Practice Group at Haynes & Boone, Addleman consults with a number of companies. “We advise clients to learn the industry standards, to focus on whether your competitors are providing more or less information. You as inside counsel want to provide similar disclosure and look at similar risks for the SEC and for analysts.”
An ounce of preparation
Because of this increased scrutiny, the impetus falls on companies to ensure that their preparation is essentially flawless. With so much detail and data going into disclosures, it can be overwhelming for inside counsel. Often, law departments will seek outside counsel like Griggs or Addleman as advisers.
“When I counsel companies, I try to get them to focus on the area of management discussion and analysis, looking at trends and uncertainties,” says Griggs. “Trends and uncertainties in disclosures are difficult, and when there is a lawsuit after the fact, it's easy to ask ‘why didn't we identify these?’ But in real time, looking at what is happening, you don't know what the result will be.” Griggs also recommends a focus on internal control over financial reporting and input from executives and the board.
Addleman sees risk reporting as one of the most important areas of focus for all companies making these disclosures. “The company has to identify the biggest risks and make them known to investors and shareholders,” she says. “Underselling or overselling data security, for example,” puts companies in the position of walking along the side of a mountain, trying to get the right information without falling over.
Out for justice
Of course, when companies perpetrate fraud through their financial disclosures, they run the risk of coming into the crosshairs of not just the SEC, but also the Department of Justice (DOJ). According to Mythili Raman, partner at Covington & Burling and former Acting Assistant Attorney General of the Criminal Division of the DOJ, the Justice Department is focused on fraud.
“The Justice Department looks at these cases through the lens of traditional fraud statutes—whether wire or mail or securities fraud,” she explains. “These statutes are intended to hold entities and individuals accountable in the event that they make material misrepresentations to, or withhold material facts from, the market and the investing public”
The crux of any DOJ inquiry, then, is determining if companies had intent to defraud investors. Negligent misstatements are, of course, not very good, but errors might not rise to the level of a crime. Therefore, prosecutors must be sure that there was intent to defraud. The burden of proof is quite high, Raman points out, as these are criminal charges, and therefore must be proven beyond a reasonable doubt.
According to Raman, the DOJ looks at matters such as inflation of earnings, misrepresentations about the health of the business and accounting fraud. “The financial fraud environment is at an all time high in terms of the vigor with which prosecutors and agents are investigating and bringing cases against both entities and individuals,” she explains.
The number of individual white-collar defendants charged in the last several years is at a 20-year high, and the prosecution of individuals is the “bread and butter” of the DOJ's investigative work. “There is a desire to ensure that the public knows that DOJ's enforcement efforts are focused on both individuals and entities,” she says. “Prosecutions of culpable individuals send the message that it is not just entities paying fines, but individuals who are charged, prosecuted, convicted and sentenced.”
Advice for GCs
Often, financial disclosure duties can be shuffled off to the accounting department, but with the increased importance of these documents – and stiffer penalties for problems related to them – general counsel need to take an active role in the process.
“GCs should be involved in financial disclosures,” says Griggs. “The GC attends board meetings and knows what the board is focused on, what management is telling the board. The GC should evaluate financial disclosures, and can play a role in asking good questions about judgments and assumptions in financial statements.”
In order to be useful in the preparation of these disclosures, though, GCs need to follow one specific piece of advice: “Know the business,” advises Addleman. “If the GC understands the business, they can have a better understanding of potential risks, think matters through with businesspeople and know what points are important for inclusion in financial disclosures.”
In the end, inside counsel should know that they have a responsibility both to shareholders and to the marketplace. “Inside counsel know better than anyone that the entity they’re working for must accurately represent the health of its business to the marketplace,” says Raman. “Real care is needed, and a respect for the marketplace has to come through in these disclosures, letting investors know what they are getting into when they invest in a company.” After all, WorldCom and Enron investors didn't have a clue what they were getting into, and look at what happened to them—and the entire marketplace.