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SEC Issues Guidelines for Registrant Self-Reporting
of Material Misstatements and Omissions
By Marcus Williams
[Dec. 2001]
In times of economic uncertainty, publicly traded companies find
themselves dealing increasingly with the question whether to report
- and how to report - unpleasant operational and financial issues.
Among these difficult disclosures are corrections to previous reports
filed under the Securities Exchange Act of 1934 due to recent discoveries
of previously unknown circumstances and facts that make inaccurate
one or more matters disclosed in the earlier reports. Not uncommonly,
companies find themselves in this situation because they were misled
by their own employees' misstatements. In the past, one's diligence
in making timely, accurate disclosure of newly discovered problems
often was rewarded with SEC investigations and enforcement actions.
However, a recent SEC release provides guidance for public companies
to avoid or minimize sanctions for Exchange Act violations that
result from employee misconduct.
Public Company Liability for False or Misleading
Reports Caused by Employee Misconduct
The Private Securities Litigation Reform Act of 1995 protects public
companies from civil litigation where unforeseen developments vary
from management's previously expressed expectations where the statements
were made with a reasonable basis in fact and were clearly identified
as expectations rather than assurances. That statute does not, however,
provide a shield from liability for misstatements of past performance,
whether or not made in good faith.
In this time of economic unrest, which follows closely on the heels
of unprecedented technological and economic expansion, public companies
may discover that they have over-reported revenues, understated
expenses, or misstated a description of material contracts, pending
litigation, or various other matters.
This misreporting may have resulted from facts and circumstances
that were previously unknown and perhaps even intentionally concealed
by employees. For example, a number of registrants have encountered
problems where sales employees overstated their sales commitments
which resulted in the registrant having "booked" orders that did
not exist, or that were recognized in the wrong reporting period.
Employees who have deliberately falsified revenue and expense items
or who have concealed significant mistakes may well have caused
their employers to make inadvertent but material misstatements in
their SEC filings and exposed their employers to both civil liability
and enforcement actions.
The SEC generally will pursue enforcement actions - and in some
cases, criminal prosecutions - against employees whose misconduct
perpetrates a fraud or serves as a "manipulative or deceptive device
or contrivance" in connection with securities registration or reporting.
The enforcement staff also may sanction the public company based
on the notion that the employer should be held responsible for employees'
misconduct that results in the company's filing false or misleading
Exchange Act reports. Many registrants facing this situation have
thus found themselves in a quandary because voluntarily reporting
newly discovered problems might trigger an inquiry from the SEC
enforcement staff and in many cases can result in enforcement actions.
However, a recent SEC release may relieve registrant's of some of
the tension in facing this conundrum.
New Enforcement Staff Guidelines Afford Registrants
an Opportunity to Avoid or Minimize Enforcement Action and Sanctions
In October 2001 the SEC's Division of Enforcement clarified the
criteria it uses to evaluate whether to take enforcement action
against a reporting company for violations resulting from employee
misconduct. The SEC decided not to take action against Seaboard
Corporation where an employee of one of Seaboard's subsidiaries
had booked improper revenue and expense entries and had concealed
the errors from Seaboard and the subsidiary. Seaboard discovered
the concealment in 2000 and promptly began an internal investigation
into the matter, which involved more than $7,000,000 in misstatements
over a five-year period. These misstatements had been included in
Seaboard's Securities Exchange Act filings covering that same period,
and caused Seaboard to fail to comply with its Exchange Act record
keeping and ~~reporting obligations.
After concluding an internal investigation of the matter, Seaboard
contacted the SEC, issued a press release, filed a Current Report
Form 8-K describing and quantifying the problem, and restated its
earnings to account for the discrepancies. Stephen M. Cutler, the
SEC's Acting Director for Enforcement, issued a press release approving
Seaboard's response, stating that "crediting those who seek out,
self-report and rectify illegal conduct is critical to achieving
the Commission's goal of 'real-time enforcement.' We hope that,
by setting forth a framework for exercising its prosecutorial discretion,
the Commission will encourage companies to address unlawful conduct
swiftly and meaningfully and to cooperate with law enforcement authorities.
The result will be more efficient and effective enforcement of the
securities laws."
The SEC went on to identify four factors that will play an important
role in the staff's decision to pursue criminal or administrative
sanctions against the issuer:
- Self-policing. Registrants that have established effective
compliance and internal audit programs, including setting the
"appropriate tone" from the top down, are less likely to encounter
problems from employee misconduct and more likely to discover
surreptitious actions that might otherwise go undiscovered.
- Self-reporting. When a reporting company discovers misreporting,
it should conduct a thorough review of the nature, extent, origins
and consequences of the problem and act affirmatively to disclose
the problems "promptly, completely and effectively" to the SEC,
the listing stock market, and the investing public.
- Remediation. The issuer must take corrective action to discipline
or dismiss wrongdoers, and should modify and improve internal
controls and procedures to prevent recurrences of similar problems.
The company also should "appropriately compensate" those adversely
affected by the erroneous reports.
- Cooperation. The reporting company must provide the SEC and
other law enforcement authorities with all information relevant
to the underlying violations and must describe thoroughly its
remedial efforts.
Where the registrant acts with these goals in mind, the SEC has
indicated that it will give "credit for cooperative behavior," which
may include bringing reduced charges, seeking lighter sanctions
or, in exemplary cases, "the extraordinary step of taking no action
at all." By following these guidelines aggressively, including establishing
appropriate procedures before problems are discovered, public companies
may thus discover problems early - in some cases before a misstatement
or omission occurs - or may minimize the damage that otherwise might
occur.
This Corporate Finance Advisory Bulletin is a publication of
Davis Wright Tremaine LLP and is prepared by its Corporate Finance
Department, chaired by David C. Baca and Keith G. Baldwin. It is
not intended to serve as legal advice, nor is it a substitute for
consistent consultation with qualified corporate finance counsel
and accounting professionals. Instead, we have provided this information
to our clients and friends to help them consider whether they should
design and implement various protective and remedial measures.
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