Financial Fraud in the Era of Securities Reform

by Boris Feldman


Around the United States, a collective sigh of relief could be heard from corporate executives on December 22, 1995. As either a belated Hanukkah gift or an early stocking stuffer, the United States Congress gave public-company executives what they'd sought for years: reform of the shareholder class-action system. In overriding President Clinton's veto of the Private Securities Litigation Reform Act of 1995, Congress established strong protection for honest companies that run into hard times. But a year later companies are finding that they're still being bombarded by lawsuits. And as we go to press, the state of California is preparing to vote on Proposition 211, a proposal on the ballot that would allow a suit against a company with a single California shareholder to be considered a nationwide class-action lawsuit.

What gives? First, commentary on the new law has emphasized its safe harbor provision. The safe harbor will go far toward eliminating the classic fraud-by-hindsight suit filed when a company fails to satisfy quarterly eamings expectations. One of the carveouts from the new safe harbor, however, may lead plaintiffs to shift their attention from missed forecasts to cooked books. Proactive CFOs should take steps now to to ensure that financial-fraud lawsuits against their companies can be thrown out early.

In pre-Reform Act days, plaintiffs always preferred an accounting-fraud case to a forecasting case. Plaintiffs recognized that, to a judge or jury, forecasting is like reading a crystal ball, while financial fraud is fraud. Plaintiffs routinely alleged accounting improprieties, hoping to gain access to auditors' workpapers in search of a debatable entry. Over the years, courts caught on to the tactic and tended to dismiss accounting allegations, absent a high level of detail.

But the Reform Act will make plaintiffs even more eager to uncover a financial-fraud claim for two reasons. First, judges read newspapers. They know Congress sought to turn the class-action bar into an endangered species. Plaintiffs will face a skeptical audience when they file new cases. One way to regain credibility with the courts is by focusing on cooked-books cases -- cases so egregious a judge will view them as different from the now-disfavored forecasting claims.

Second, plaintiffs will focus on financial fraud because it's not subject to the same safe-harbor protections as are forecasts. The new safe harbor provides extremely strong protections, both substantive and procedural, for forward-looking information disclosed by a company, especially if the information is accompanied by cautionary disclosures. But the safe harbor expressly does not apply to forward-looking information contained in financial statements prepared in accordance with generally accepted accounting principles. As a result, plaintiffs will strongly prefer to file a case based on financial-statement fraud, rather than on protected forward-looking information.

Here are some suggestions to help you minimize your exposure in an accounting-based shareholder suit. Of course, you should discuss the specifics of any lawsuit against your company with your own counsel.

Forward, March
Separate protected from nonprotected disclosures. Absent unusual circumstances, the financial results contained in a company's Securities and Exchange Commission filings won't fall within the new safe harbor. Nevertheless, a variety of forward-looking information is sometimes included in the financial statements, particularly in the footnotes. Whenever possible, move such disclosures out of the financial statements and into the management's discussion and analysis section.

If SEC regulations require you to include particular information in the financial-statement footnotes, then of course you shouldn't omit it. But in that situation, consider whether forward-looking components of that item can also be included in the MD&A, accompanied by appropriate cautionary disclosures. Although plaintiffs may argue the forwardlooking information is not protected by the safe harbor even if included elsewhere in the document, a court may disagree, based on the overall circumstances of the disclosure.

In other instances, SEC regulations will not require inclusion of the forward-looking item in the footnotes, but auditors may prefer to see it there. You should probe the auditors on this issue. The fact that a particular item has historically been discussed in the footnotes doesn't necessarily mean it must remain there, instead of in the MD&A. On the other hand, the auditors may feel increased pressure from a newly effective accounting guideline, Statement of Position 94-6, which may require enhanced disclosure of forward-looking information in footnotes. You may need to explore with your accountants this tension between the guideline and the new safe harbor.

Involve the auditors in accounting decisions. In recent years, companies have won a number of class actions on pretrial motions because the challenged accounting decisions had been blessed by outside auditors. The courts reasoned that even if the accounting decision were wrong, approval by the auditors precluded plaintiffs from establishing that the company or its officers had acted with fraudulent intent. Thus, auditor involvement in nonroutine accounting determinations provides a valuable bulwark against subsequent fraud claims.

One way to enhance such protection is to have the auditors conduct timely quarterly reviews, instead of retrospective reviews during the yearend audit. Moreover, for issues on which the accounting literature contains conflicting guidance, it may be worth getting an opinion from a second accounting firm, or even from the SEC. The more detailed the disclosure to the auditors, the more likely it is their approval will defeat a fraud claim.

Disclose your accounting policies. Another way to undermine a challenge to accounting decisions is to disclose them. Plaintiffs must prove you misled investors. Even if they mount a credible challenge to a particular accounting decision, their case will be undermined if the market knew about the particular accounting treatment, especially if you disclose the financial impact of the decision or it can be determined by analysis of your financials. A judge may not know whether your accounting treatment or the treatment proposed by the plaintiffs is right, but if you spelled out for investors what you did, there's a good chance he'll dismiss the claim at the outset.

Take your accounting manual seriously. Most companies have a manual containing accounting policies and practices. Unless maintained properly, these manuals are fodder for the plaintiffs. Review your manual periodically to ensure it reflects your company's actual practices. If you're uncomfortable recording those practices in writing, then you probably should change them. Ask your outside auditors to review the manual for consistency with GAAP. Try to avoid phrasing policies in absolute terms, because circumstances may well arise in which deviation from the policy is appropriate (or occurs). Leave yourself some room.

Set your reserves consistently. Some companies use their reserve accounts (particularly bad debt and obsolete inventory) to manage earnings. In a good quarter, they can salt away extra pennies per share; in a tight quarter, they can draw down on those excess reserves. This practice is risky. Plaintiffs are very focused on reserves; indeed, they allege almost automatically that a company has maintained inadequate reserves in order to inflate earnings. The SEC, too, has heen concerned ahout companies manipulating reserves. Large reserve increases in the fourth quarter, as the company anticipates its audit, sometimes provoke SEC inquiry.

If possible in your type of business, you should articulate your reserve methodology so it doesn't rest entirely on gut decisions ahout future events. Consider disclosing the reserve methodology. For example, if you routinely book 1 percent of sales as a reserve for returns, you may benefit from disclosing that in your SEC filings. You should he able to justify quarter-to-quarter variations in reserve accounts as being legitimately grounded in the business realities of your firm. Have the auditors sign off on your reserve decisions each quarter, and consider adding a section to your SEC filings discussing changes in reserve levels.

Keep Your House Clean
Root out fraud. Few CFOs will tolerate improper accounting practices on their watches. Nevertheless, abuses can occur even in fundamentally honest companies. A salesman desperate to make quota may give a customer a secret side letter transforming the sale into a consignment; a foreign subsidiary may continue booking sales beyond the quarterly cut-off. If your company has procedures to prevent such practices, the impact on a securities suit of isolated transgressions will be greatly reduced.

One step to contemplate is invigorating your audit committee. Some committees meet sporadically and do little more than receive clean bills of health from the auditors. When a company is sued for securities fraud, defense lawyers are usually able to uncover accounting problems during the first ten interviews. Couldn't your audit committee do the same thing?

Consider having your audit committee conduct one-on-one, periodic interviews with employees at various levels of the finance department, particularly order-entry and credit and collections. You may be surprised at what you find. In any event, knowing a committee of directors will be asking such questions may make an employee think twice before booking an improper transaction.

You might also consider requiring sales executives, and even salespeople, to sign certifications that the revenue they've booked in a given quarter complies with your accounting guidelines. Make it clear that violating your revenue-recognition policies is grounds for termination. Terminate violators.

The importance of taking preventative measures is heightened by Title 111 of the Reform Act, called "Auditor Disclosure of Corporate Fraud." This portion of the bill imposes on outside auditors the duty of establishing procedures to detect illegal acts not defined within a company. If the auditors detect an illegal act, they must report it to management and ensure the audit committee or the board is adequately informed on the matter, unless it's "clearly inconsequential." If the illegal act materially affects the company's financial statements, and if management fails to take "timely and appropriate remedial action," the auditors must make a report to the board and send that report to the SEC.

Obviously, such a report would set off a fission reaction. The company's stock would be pummelled and its reputation sullied. Shareholder lawsuits would be filed within hours. The safe harbor would be unavailable.

You need to start planning today to ensure nothing like this ever happens to your company. Adopting meaningful internal fraud-detection procedures, preferably with the guidance of your outside auditors, will enable you to deal with any troublesome situations before they ferment to the level at which the new statute requires your auditors to turn you in. Don't go away discouraged. The Reform Act will be a boon to honest companies. Fewer meritless suits will be filed, especially with respect to missed forecasts. With prudent planning, you can reduce the odds of facing a post-Reform Act shareholder suit dressed up as a financial-fraud claim.

The views expressed in this article are those of the writer, and do not necessarily represent the views of his firm.