corporate compliance in the age of a re-tooled and
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Corporate Compliance in the Age of a
Re-Tooled and Aggressive SEC
Society of Corporate Compliance and EthicsJohn J. Sikora, Jr.
April 25, 2014
• The Re-tooled SEC
• The Era of Creative and Aggressive Enforcement
• Hitting and Avoiding the SEC’s Radar Screen
Agenda
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The Re-Tooled SEC
• The SEC has taken its lumps since 2008:
• Harris Poll from 2007 and 2009: Favorable ratings of the SEC dropped from 71% to 29%. The percentage of the public rating it fair or poor rose from 25% to 72%.
• The SEC has suffered recent losses in federal court trials.
• Even when taking action, the SEC was perceived as not acting tough enough with Wall Street.
• In 2011, Judge Jed Rakoff of the SDNY rejected the SEC’s $285 million settlement with Citigroup because it was too lenient.
The SEC After the 2008 Financial Crisis
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• The SEC is transitioning from reacting to the financial crisis to setting its own agenda.
• Accounting investigations, financial fraud, and issuer disclosures are areas of renewed focus.
• “The importance of pursuing financial fraud cannot be overstated. Comprehensive, accurate and reliable financial reporting is the bedrock upon which our markets are based.” Andrew Ceresney
• “The S.E.C. Is ‘Bringin’ Sexy Back’ to Accounting Investigations,” New York Times, June 13, 2013
The SEC After the 2008 Financial Crisis
• Industry Knowledge• Hiring of industry experts• Rigorous training programs
• Quantitative Capability • Hiring of experts with excellent quantitative skills
• Specialized Units, Offices and Programs• Asset Management Unit (“AMU”) • Risk and Examination Office (“REO”) • National Exam Program (“NEP”) • Financial Reporting and Audit Task Force
The Re-Tooled SEC: Increase in Staff Expertise
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• Office of the Whistleblower (OWB) established in 2011.
• In FY 2013, the OWB received 3,238 tips.
• 17.2% of FY 2013 whistleblower reports related to corporate disclosures and financials.
• “[F]raud related to the preparation of financial statements or issuer reporting and disclosure can be extremely difficult to uncover without the help of corporate insiders.”
Fin. Reporting & Audit Task Force
The SEC Whistleblower Program
• For sanctions greater than $1 million, whistleblowers may be eligible for awards of 10-30% of collections.
• Four factors that may increase award: 1. significance of information provided2. assistance provided3. law enforcement interest advanced by higher award4. participation in internal compliance systems
• Three factors that may decrease award: 1. culpability2. unreasonable reporting delay3. interference with internal compliance and reporting systems
Whistleblower Awards
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• Since the program’s inception in August 2011, the SEC has issued awards to six whistleblowers in connection with four matters.
• In August 2012, the SEC announced its first award: 30% of collections for an initial payment of $50,000.
• In October 2013, the SEC awarded over $14 million to a whistleblower who “provided original information and assistance that allowed the SEC to investigate an enforcement matter more quickly than otherwise would have been possible.”
Whistleblower Awards
Plaintiffs’ Bar for Whistleblowers
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• The SEC now has a treasure trove of data
• Data flows from all different areas regulated by the SEC
• Public companies and Industry Registrants
• Data filings are electronic
• Data tagging allows easy sorting
The Re-Tooled SEC: Big Data Analytics
• Form PF and Form ADV
• Full of data fields that can be sorted and analyzed.
• The National Exam Analytics Tool (“NEAT”) allows examiners to access and analyze massive amounts of trading data from firms.
• In a recent exam, NEAT analyzed 17 million transactions executed by one investment adviser in 36 hours.
• Examiners will use NEAT to identify signs of insider trading, front running, improper allocations of investment opportunities, and other kinds of misconduct.
• The Market Information Data Analytic System (“MIDAS”) collects one billion records of trading data every day. The system allows analysts to collect and sift through massive amounts of trading data across markets.
The Re-Tooled SEC: Access to More Data From Registrants
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• eXtensible business reporting language (XBRL)
• Accounting Quality Model (AQM)
The Re-Tooled SEC: Access to More Data from Public Companies
• The SEC has announced its intention to use public company data for lead generation
• How will this work in practice?
Big Data Analytics: Public Company Illustration
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Data Analytics: XBRL
• Computer markup language that uses standard definitions, or taxonomies, to allow computers to recognize data for sophisticated viewing and analysis.
• Voluntary program for filing XBRL-tagged financial statements started in March 2005.
• Office of Interactive Disclosure (OID) established in 2007.
• In January 2009, the SEC issued final rules to phase in requirements that companies file with XBRL-tagged financial statements.
• Limited liability for first 2 years of interactive filings, terminating for all categories of filers on October 31, 2014.
http://xbrl.us/research/Pages/data.htm
XBRL Example Analysis
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http://xbrl.us/research/Pages/data.htm
XBRL Example Analysis
• Data analytics program to cull XBRL data from financial reports for identifying earnings management
• Allows comparison of filings against industry competitors to identify anomalies
• Output is an automated risk score
• Designed for exam teams to prioritize exam selections and targeting exam priorities
• Also recognized use by Enforcement or Office of Compliance, Inspections, and Examinations (OCIE)
Data Analytics: Accounting Quality Model
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• Accounting income – cash flows = total accruals
• Non-discretionary accruals: objective, strictly GAAP-based
• Discretionary accruals: subjective, require judgment
• Basic premise: outlier discretionary accruals are accurate indicators of earnings management
• Using regression, the model estimates discretionary accruals from factors that are proxies for discretionary and non-discretionary components.
Data Analytics: Accounting Quality Model
• Discretionary factors further broken into:
• Risk inducers: factors that induce earnings management
• Loss of market share • Transient performance problems
• Risk indicators: factors that indicate earnings management
• Ratio of book to taxable income• Off-balance sheet transactions• Changes in auditor or delayed financial statements• Multiple revisions over a short period of time
Data Analytics: Accounting Quality Model
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Data Analytics: Accounting Quality Model
“I find it hard to believe that we have so radically reduced the instances of accounting fraud simply due to reforms such as governance changes and certifications and other Sarbanes-Oxley innovations. The incentivesare still there to manipulate financial statements, and the methods for doing so are still available.”
Andrew Ceresney, September 2013
• The SEC is expanding the model to analysis of MD&A, press releases, and other investor communications.
• Lists of words and phrasing common among fraudulent filers
• “[F]raudsters have tended to talk a lot about things that really don’t matter much and they under-report all the risks that all the other firms that aren’t having these same issues talk quite a bit about.” Craig Lewis, June 2013
Expanding the Accounting Quality Model
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• High priority accounting issues:
• Reserves—bad faith, reckless
• Revenue recognition—inflating sales
• Auditor independence
• Audit committee—red flags
• Cross-Border—U.S. public companies with substantial foreign operations
Financial Reporting and Audit Task Force
Center for Risk and Quantitative Analytics
• Announced in July 2013
• Focus is risk identification and assessment
• Use of quantitative data to identify characteristics and patterns indicative of fraud
• The Center will “provide guidance to the Enforcement Division’s leadership on how to allocate resources strategically in light of identified risks”
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• Alleged Violations of Section 13(a), books & records, internal controls
• PACCAR failed to report operating results of aftermarket parts business separately from truck sales business.
• PACCAR and subsidiary failed to provide complete information about loan and lease portfolios.
• PACCAR overstated equal and offsetting amounts in two lines with its statement of cash flows, which PACCAR later identified and corrected.
• Outcome
• PACCAR agreed to a permanent injunction and to pay $225,000 to settle the case.
• The company neither admitted nor denied the charges.
SEC v. PACCAR Inc. (2013)
• Alleged Violations of Sections 17(a), 13(a), books & records, internal controls
• When walnut prices increased, Diamond improperly excluded portions of payments to walnut farmers from its financials by delaying recording of payments into future fiscal periods.
• The company’s EPS was overstated by over 65% for 2010 and by over 89% for 2011.
• The complaint and SEC release cite to Diamond’s touting of its EPS as consistently beating analysts’ forecasted expectations.
• After media reports raised questions, Diamond conducted an investigation and restated its financials.
• Outcome• Diamond agreed to pay $5 million to settle the case.• A separate action against the CFO is pending in district court.
SEC v. Diamond Foods (2014)
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• Fund Managers also now under the microscope
• SEC has greater supervisory controls over investment advisers than public companies
• SEC allows registration and can pull an adviser’s ticket if there is misconduct
Big Data Analytics: Investment Advisers
• Created in January 2010 to focus specifically on investigations involving investment advisors, investment companies, hedge funds, and private equity funds.
• Comprised of more than 75 attorneys, industry experts, and other professionals, including former employees of hedge funds, mutual funds, and due diligence firms.
• AMU private equity specialist was a deal professional executing transactions and a LP performing manager selection at a large institution.
• Other AMU industry experts with expertise in hedge funds, RIC’s, due diligence and operations.
• AMU has launched a Private Equity Initiative, which aims to detect problematic conduct through the use of data and quantitative methods.
The Asset Management Unit (“AMU”)
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• The AMU and its experts confer with the Office of Compliance Investigations and Examinations (“OCIE”) and the Division of Investment Management (“IM”).
• Bruce Karpati:
• “AMU personnel have helped train [OCIE] examiners and have accompanied them on exams of private equity managers. In return, the National Exam Program has enhanced our understanding of the private equity industry with observations and insights from examinations.”
• “[The AMU] also frequently engage[s] with our Division of Investment Management colleagues on the legal aspects of private equity. IM staff assists us in addressing complex legal and contractual issues that crop up in our investigations. They also consult with us when they are writing rules that impact the private equity industry.”
The Re-Tooled SEC: Increase in Integration
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• The SEC has emphasized hiring senior specialized examiners who have prior experience in the private fund industry.
• Building out exam modules informed by internal expertise
• Using a Risk-Based Exam Approach
• Thematic exams—sweeps
• Never Before Examined
The Office of Compliance Investigations and Examinations (“OCIE”)
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• Aberrational Performance Inquiry (“API”)
• The API uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmark forms a basis for further scrutiny.
• Robert Kaplan and Bruce Karpati: “We are applying analytics across the investment adviser space—beyond performance and beyond hedge funds.”
The Re-Tooled SEC: Risk Analytic Initiatives
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• In December 2011, the SEC brought enforcement actions against three separate advisory firms and six individuals under the API.
• The SEC alleged that the firms and managers violated Sections 206(1)-(2), Section 17(a), Section 10(b), and 10(b)(5) through:
• Fraudulent valuation of portfolio holdings• Misuse of fund assets • Misrepresentations to investors about performance, assets, liquidity,
investment strategy, valuation procedures, and conflicts of interests
• Robert Kaplan and Bruce Karpati: “The extraordinary returns reported by these advisers and portfolio managers were, in most cases, too good to be true. In other cases, outlier returns were a telltale sign that something else was amiss.”
API Hedge Fund Enforcement Actions
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• SEC’s search for aberrational performance reaches money market funds.
• Allegations: In violation of Rules 2a-7 and 38a-1 of the Investment Company Act, a money market fund firm repeatedly made false statements to the trustees of Ambassador Money Market Fund about the credit risk in the securities it purchased for the portfolio, the fund’s exposure to the Eurozone credit crisis of 2011 and the diversification of the fund’s portfolio.
• “The enforcement action stems from an ongoing analysis of money market fund data by the SEC’s Division of Investment Management, in this case a review of the gross yield of funds as a marker of risk. The performance of the Ambassador Money Market Fund was identified as consistently different from the rest of the market.”
• Norm Champ: “This is an excellent example of how our investment in data analysis leads directly to investor protection.”
In the Matter of Ambassador Capital Management, LLC, et. al. (2013)
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The Era of Creative and Aggressive Enforcement
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• Andrew Ceresney: “My goal was to bring the SEC’s swagger back. I think we’re doing that.”
• Mary Jo White: “One of our goals is to see that the SEC enforcement program is – and is perceived to be – everywhere, pursuing all types of violations of our federal securities laws, big and small.”
A New Tone at the SEC
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• When a window is broken and it is not fixed, it “is a signal that no one cares, and so breaking more windows costs nothing.”
• Former NYC Mayor Rudy Giuliani and Police Commissioner Bill Bratton applied this theory to the city’s policing strategy.
• No infraction was too small to be uncovered and punished.
• NYPD pursued infractions of law at every level, from turnstile jumpers to the biggest crimes in the city.
• Created an environment of law and order that discouraged serious crime.
The “Broken Windows” Strategy
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“The [Broken Windows theory] can be applied to our securities markets – minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions. Retail investors, in particular, need to be protected from unscrupulous advisers and brokers, whatever their size and the size of the violation that victimizes the investor.”
Mary Jo White, October 2013
“Broken Windows” and SEC Enforcement
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• In 2012, the SEC changed the no-admit-no-deny language as it applied to settlements with parties that have pled guilty in a related criminal action.
• Now, the SEC explicitly references those admissions in the settlement.
• The SEC even seeks admissions of guilt in certain cases not involving any parallel criminal case:
• Cases where a large number of investors have been harmed or the conduct was otherwise egregious.
• Cases where the conduct posed a significant risk to the market or investors.
• Cases where the admission would aid investors deciding whether to deal with a particular party in the future.
• Cases where reciting unambiguous facts would send an important message to the markets about a particular case.
Tougher Sanctions, Tougher Approach: Requiring More Admissions of Guilt in SEC Settlements
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• “Individuals tempted to commit wrongdoing must understand that they risk it all if they do not play by the rules. When people fear for their own reputations, careers or pocketbooks, they tend to stay in line.”
Mary Jo White, September 2013
• The SEC can ask for a court order imposing a bar on an individual from working in the securities industry or serving on the board of a public company.
• Barring individuals not only punishes past actions, but can reduce the likelihood that the individual can commit any further wrongdoings on the public.
Tougher Sanctions, Tougher Approach: Suing Individuals and Firms
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• “[W]e must make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties – whether against companies or individuals – play a very important role in a strong enforcement program.”
Mary Jo White, September 2013
• Factors that guide the consideration of penalties include:
• The egregiousness of the misconduct• The pervasiveness of the misconduct• Whether the company or individual had a strong compliance
program
Tougher Sanctions, Tougher Approach:Higher Monetary Penalties
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• “If, in fact, a result of our change in settlement policy results in more trials, one clear winner will be the administration of justice, which will always fare best in the open for the public to see and to take stock of what a defendant did and what its government is doing.”
Mary Jo White, November 2013
• “But the possibility of more litigation does not deter us from implementing [the change in settlement policy] – perhaps that’s just the former prosecutor in me. If we end up litigating more frequently, we will shift around resources as necessary. I have great confidence in our trial team and I am more than willing to try more cases.”
Andrew Ceresney, September 2013
Tougher Sanctions, Tougher Approach:Willingness to Try Cases
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• “Bad Actor” Rule 506(d): An issuer cannot rely on the Rule 506 exemption from registration if the issuer or any other person covered by the rule is disqualified by a “triggering event”:
• Court injunctions—in connection with the purchase or sale of any security; or arising out of the conduct of an investment adviser
• SEC cease and desist orders for scienter-based violations
• SEC suspensions or bars
Collateral Consequences of Amped Up Enforcement: “Bad Actor” Rule
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Hitting and Avoiding the SEC’s Radar Screen
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• The SEC is looking for aberrations and outliers• Accounting Positions• Returns• Leverage• Liquidity• Counter-Parties
• How the SEC finds the aberrations and outliers• XRBL analysis
• Form ADV and Form PF analysis• Analyzing published benchmarks• Comparing notes from exams and enforcement
Hitting and Avoiding the SEC’s Radar Screen
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See Yourself As Your Regulator Sees You
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• Know where you stand relative to your peer group
• Industry standard for accounting treatment/approach
• Industry standard for disclosures
• Examine your own YoY—what changed materially and why did it change?
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Public Company
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• If there is a published benchmark, know it and be sure you know if you are beating it.
• Double check all performance calculations in marketing materials and quarterly reports.
Investment Adviser: Performance
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• Be sure you are on top of how principals, traders and other personnel communicate with each other.
• The exam staff will ask for emails and any instant messaging/texting/chats.
• Be aware of the content before the exam staff starts asking tough questions.
Books and Records
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