New Research on Undisclosed SEC Investigations

Many are called, some are chosen to be prosecuted, but very few tell investors anything while executives exploit the info for gain

Many were shocked when Under Armour Inc, the popular “performance apparel, footwear, and accessories” global manufacturer, confirmed civil and criminal probes by the Securities and Exchange Commission and the U.S. Department of Justice after they were reported by the Wall Street Journal on November 4, 2019.

The news report was based on an anonymous tip to reporters who typically cover the Justice Department.

Under Armour then did what it had not done for investors in two years— the company documented its confirmation of the active investigations immediately in a filing with the SEC.  The company disclosed it had been responding to requests for documents and information from both the SEC and DOJ for more than two years, since July of 2017, regarding “certain of the company’s accounting practices and related disclosures.”

Here at The Dig I wrote about what may be behind the Under Armour criminal investigation.

Now that the cats are out of their bags, Under Armour is keeping up, sort of, and providing some updates on the status of the investigations in its filings. 

In its most recent 10-K annual report filing, sent to the SEC on Feb. 26, 2020, Under Armour made a brief mention of the ongoing investigations by the SEC and DOJ in the “Risk Factors” section:

We are the subject of a number of ongoing legal proceedings that have resulted in significant expense, and adverse developments in our ongoing proceedings and/or future legal proceedings could have a material adverse effect on our business, reputation, financial condition, results of operations or stock price.

…For example, we are subject to an ongoing securities class action proceeding regarding our prior disclosures and derivative complaints regarding related matters, as well as past related party transactions, among other proceedings. In addition, as previously disclosed in November 2019, we have been responding to requests for documents and information from the U.S. Securities and Exchange Commission and Department of Justice regarding certain of our accounting practices and related disclosures.

Later on, in the lengthy section on “Commitments and Contingencies,” Under Armour described two class action lawsuits filed after its November disclosure of the SEC and DOJ investigations — Patel v. Under Armour, Inc. and Waronker v. Under Armour, Inc.. Both complaints claim that Under Armour’s disclosures and statements allegedly misrepresented or omitted that the company was reportedly shifting sales between quarterly periods allegedly to appear healthier and that it had been under investigation by and cooperating with the United States Department of Justice and the United States Securities and Exchange Commission since July 2017.

The Court had not consolidated these cases or appointed a lead plaintiff as of Feb. 26, but did indicate in a January 22, 2020 decision in another case filed in 2017, the In re Under Armour Securities Litigation case, that it anticipated consolidating that matter with these cases and appointing the lead plaintiff in In re Under Armour Securities Litigation as the lead plaintiff over the consolidated cases, in the event that the Fourth Circuit remands the In re Under Armour Securities Litigation case.

Under Armour is also facing a shareholder derivative lawsuit as a result of the WSJ story, filed in state court in Baltimore, Maryland on December 26, 2019, Olin v. Under Armour, Inc., et al.. The company had not yet responded to the complaint as of the filing of its annual report.

The research firm Probes Reporter tracks undisclosed SEC investigations with information also obtained via Freedom of Information Act requests. Probes Reporter had been tracking potential SEC investigative activity at Disney off-and-on since Sep 2012 and reported on October 6, 2017 that undisclosed SEC probes at Disney, another case I reported on, had been uncovered based on its FOIAs.

“Based on letters received from the SEC, at the time the SEC processed our request of 11-Dec-2015, ‘there were multiple pending law enforcement proceedings’ which formed the basis to block our access to records on Disney,” the report said.

Probes Reporter concluded that, “As a matter of law, the SEC is acknowledging some sort of investigative activity with this response.”

The Disney whistleblower, Sandy Kuba, told me at MarketWatch that, by 2016, Disney had begun to exploit errors, mistakes, duplicate revenue and revenue recorded in error based on issues with its accounting software implementation, and revenue overstatements then became deliberate. 

Kuba filed a tip with the SEC on August 2, 2017 and followed up with more information throughout the rest of 2017, before and after being terminated on Sept 21, 2017. Kuba believes the SEC’s investigation of her tips is ongoing based on subsequent phone and in person conversations with SEC officials.

Neither Disney nor the SEC have ever disclosed any investigation into the company’s accounting or other issues based on Kuba’s whistleblower tip.

“Undisclosed SEC Investigations.” is a draft research paper published by Professors Daniel Taylor of The Wharton School at the University of Pennsylvania (paper contact), Terrence Blackburne of the College of Business at Oregon State University, John D. Kepler, of the Graduate School of Business at Stanford University and Phillip J. Quinn of the Foster School of Business at the University of Washington in December 2019.

The researchers obtained data, via the Freedom of Information Act, on the targets of all formal SEC investigations closed between 2000 and 2017 (regardless of outcome of the investigation and regardless of whether the company disclosed the investigation.) The researchers find that undisclosed investigations are red flags for “economically meaningful declines in firm performance.”

Even though some companies may voluntarily disclose active investigations, “they are not required to do so––even in the extreme case when an enforcement action is likely,” the authors write.

I spoke to Professor Daniel Taylor, who summed it up this way:

“SEC investigations are not required to be disclosed and only 19% of targeted firms initially disclose the investigation.  However, the non-public information is often material information––in the sense that it is relevant for valuation––and executives appear to be trading on it. In some firms, the data suggest insiders are neither disclosing nor abstaining from trading.”

The researchers remind readers that one of the distinguishing features of the SEC’s investigative process is that it is “shrouded in secrecy.  The SEC explicitly seeks to protect the identity of those under investigation.”

Generally only SEC staff, senior managers of the company being investigated, and outside counsel are aware of active investigations.”

I get the question all the time: When does a company have to disclose that the SEC, or the Department of Justice, is investigating it or has issued a Wells Notice to the company?

A Wells Notice is a letter from the securities regulator notifying a potential defendant that the regulator intends to bring charges against them, describing them and giving the potential defendant a chance to  respond to them first.

A recent court case says you may never see this disclosure unless or until the SEC brings a formal complaint against the company or individual.

In re Lions Gate Entertainment is a case from 2016 where the federal court in the Southern District of New York ruled that corporations are under no obligation to disclose SEC investigations or the receipt of a Wells Notice.

The court held, “the defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities laws do not impose an obligation on a company to predict the outcome of investigations. There is no duty to disclose litigation that is not ‘substantially certain to occur.”

Taylor and his research colleagues obtained data for all formal investigations closed between 2000 and the end of 2017. Based on an analysis of the data, they estimate at least 10% of publicly-listed firms are targets of an investigation in the average year. The average investigation lasts three years, and the SEC’s headquarters in Washington D.C. opens the most investigations (23%), followed by New York (14%) and Los Angeles (10%).

Taylor told me in an interview that the data they received from the SEC includes records for more than 12,800 investigations, including several records about investigations at Disney that were closed between 2000 and 2017.

I searched every Disney annual report from 2002 through 2017 for the terms “Securities and Exchange Commission” and “investigation” and found no disclosures of an open SEC investigation in any of them. For good measure I also searched 2018 and 2019 annual reports to see if there was any mention of an open investigation at the SEC regarding Sandy Kuba’s whistleblower allegations. There is none, but now we know that is not the final answer on whether the SEC or any other law enforcement agency is actively investigating Disney.

A spokesperson for the Walt Disney Company did not respond to a request for comment on the substance and status of the investigation revealed by the SEC in its FOIA response to the academics.

Undisclosed investigations, if investors knew about them, could help explain the subsequent economically meaningful declines in firm performance and increased share price volatility the researchers say occurs. Because the investigations are secret, the performance declines are slow and gradual, and are not quickly reflected in share prices. That suggests, the researchers write, that insiders who know the details of the investigation have a substantial information edge.

For example, the median market-adjusted return one-year (two years) after the opening of an investigation is –5.73% (–9.35%). Despite substantial declines in performance, only 19% of targeted firms disclose the investigation at the outset, and 44% disclose the investigation by its conclusion.

The SEC, FINRA, and the exchanges have beefed up monitoring of unusual trading around publicly disclosed corporate actions like mergers and acquisitions. That means anyone who has a connection to material non-public information and starts trading, for the first time, in a big way around a publicly disclosed corporate event and wins big will be spotted right away. But those monitoring processes at exchanges and FINRA, in particular, only work for material non-public information from corporate events that they know about.

One party that does know when company executives are aware of secret SEC investigations is the SEC.  Taylor told me the regulator could be doing much more to monitor abnormal trading activity after they open an investigation.

Finally, the researchers saw a significant spike in insider trading at the beginning of severe investigations by corporate officers. The officers’ abnormal trading activity at the outset of the investigation appears “highly opportunistic,” that is, not easily explained by any other news or corporate activity. These opportunistic trades earn substantial abnormal returns, enable loss avoidance in many cases, and are larger than those of industry-peers and larger than would be suggested by the officers’ own trading history.

The researchers saw no evidence of abnormal trading by independent directors, and no evidence of a capital market reaction around the investigation open, given that it was a secret.

The absence of mandatory disclosure of SEC investigations provides insiders with an information advantage, the researchers say, and insiders take full advantage to time their trades to exploit this information edge.

Next, for paid subscribers only, more very specific disclosures by the SEC of undisclosed now closed investigations by the SEC at actively traded companies. © Francine McKenna, The Digging Company LLC, 2020

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