America’s Top Prosecutors Used to Go After Top Executives. What Changed?
Increasingly, the prosecutors and the defense attorneys on opposite sides of the table are the same people, just at different points in their careers. Conducting a criminal investigation of an executive isn’t just risky; in addition to jeopardizing a future partnership at a prestigious law firm, perhaps most important, it incurs “social discomfort,” especially for the well-mannered overachievers who now populate the Justice Department. No one wants to be a class traitor, especially when the members of one’s class are such nice people.
In the eyes of the elite establishment, businesses are now job creators and pillars of the community. Executives who bend the rules are “good people who have done one bad thing,” in the words of one S.E.C. lawyer reluctant to bring charges against individuals. Prosecutors no longer punish lawbreakers, but instead make corporations promise to behave better in the future — in the end amounting to “at most a tollbooth on the bankster turnpike,” as the longtime S.E.C. attorney Jim Kidney lamented.
In Part 1, yesterday, I explained what’s happening regarding the SEC’s cases for financial manipulation to meet analyst estimates and other financial targets. Today, in Part 2, I explain the origins of the SEC’s approach and why I think the SEC has continued to use this approach for the last 12 years under Presidents Obama, Trump, and now Biden.
Maybe there have been fewer SEC intentional accounting fraud cases because there is less intentional accounting fraud. It would be a challenge to convince those of us who have watched the cases in the US, UK, and the rest of the world that that’s the case.
But that was the thought behind Robert Khuzami’s restructuring of the SEC’s Enforcement Division in 2009. Khuzami became SEC Director of Enforcement in February 2009, serving under Mary Shapiro, and stayed until August 2013. He described the reorganization at the AICPA National Conference on Current SEC and PCAOB Developments shortly after taking the job.
Financial statement and accounting fraud is central to our Enforcement program — routinely comprising nearly 25% of all enforcement actions we bring annually. This constitutes the single largest category of actions we file, and is a main artery of our Enforcement program. In many ways, we are already “specialized” in this area, and for that reason did not make it the subject of one of the new specialized units…financial fraud investigations are continually being pursued by large numbers of staff in every office across the country.
To underscore this point, let me now turn to some recent financial statement and accounting fraud cases. We continue to be aggressive in this area — consider GE’s recent $50 million penalty arising out of its improper derivatives accounting and the $25 million penalty against Zurich Financial Services for its role in improper finite reinsurance transactions.
But not surprisingly, we are bringing more financial disclosure cases arising out of [the post-crisis] mortgage-related businesses and activity.
Khuzami also mentioned Sarbanes-Oxley Section 304, the CEO/CFO compensation clawback rule.
Section 304 reflects Congress’ intent that high-level executives should not personally profit from misstated financial filings, and also serves as an additional incentive for CEOs and CFOs to ensure the accuracy of the company’s financials.
However, the SEC was never very aggressive in bringing clawback cases, and many of them were unable to be brought because there had been no restatement. A restatement is a required precondition for an SEC clawback. No restatement is the result, in many cases, of the SEC not bringing Section 10b and 10b-5 fraud charges that include an explicit statement that the accounting according to GAAP was wrong.
Academic research says executives are less likely to agree to fix errors in financial statements when the bulk of their pay is incentive-based. It’s all about getting paid.
Khuzami was still singing that tune for me for Forbes in November 2012, three years later, after the shock of Bernie Madoff in December 2008 and the failure of MF Global in October 2011.
Enron. Qwest. Adelphia.
Sunbeam. WorldCom. HealthSouth. A decade ago investors knew what those companies had in common: top executives who cooked the books. After their phony accounting was exposed, most went to jail--and hundreds of billions of dollars of shareholder wealth evaporated.
The Securities & Exchange Commission remains quite busy. In fiscal 2011 the agency brought a record 735 enforcement actions. But those looking to see the next Jeff Skilling or Richard Scrushy frog-marched in front of television cameras will be sorely disappointed. Only 89 of those actions targeted fraudulent or misleading accounting and disclosures by public companies, the fewest, by far, in a decade…
Is a stretched SEC neglecting accounting fraud?
In a statement to FORBES, SEC Enforcement Director Robert Khuzami argued that the task force was no longer needed because accounting expertise exists throughout the agency, and the number and severity of earnings restatements (a flag for possible accounting fraud) has declined dramatically since the mid-2000s. He added: "In a world of limited resources, we must prioritize our efforts…The reorganization helped to focus us on where the fraud is and not where the fraud isn't, while allowing us to remain fully capable of addressing cases of accounting and disclosure fraud."
I predicted in 2012 in that Forbes magazine article — one that was named a finalist for a Gerald Loeb award for business journalism — that the number of “Big R” restatements, the ones that require 8-K disclosures of non-reliance on prior financials and a full restatement of prior financial information, would be near zero in no time so that executives would not be eligible for clawbacks.
A study by two University of Connecticut accounting professors found auditors have waved the weakness flag in advance of a small and declining share of earnings restatements--just 25% in 2008 and 14% in 2009, the last year studied. There was no auditor warning before Lehman Brothers' 2008 collapse, even though a bankruptcy examiner later concluded it used improper accounting gimmicks to dress up its balance sheet. And no warning before Citigroup lowballed its subprime mortgage exposure in 2007. (It paid a $75 million SEC fine.)
Instead, companies and auditors flag material weaknesses as they're restating earnings--that's what JPMorgan did in August when it revised first-quarter earnings to show $459 million more in losses from "the London Whale's" trading bets than it first reported.
Yet another Sarbox provision, absent vigorous SEC enforcement, may even be leading, perversely, to less disclosure of accounting problems. It provides that a year of performance-based pay can be "clawed back" from a CEO or CFO who signed off on earnings that have to be restated. Thus executives have a financial incentive to handle problems they discover quietly--either internally or with an "earnings revision" instead of a restatement. Last year revisions (as opposed to formal restatements) accounted for 57% of 727 earnings fixes, up from 33% of 1,384 fixes in 2005, Audit Analytics reports.
Never heard of a "revision"? Companies and auditors like it that way. With a formal restatement, a company must file a special form, 8-K, calling attention to its corrections. With a revision it can fix flawed accounting without filing an 8-K or formally restating old earnings, since the change supposedly isn't "material." With a revision executives' prior pay isn't at risk, auditors don't have to retract their approval of earlier statements, and there's usually little impact on the stock and so no investor lawsuits.
Olga Usvyatsky, former Vice President of Research for Audit Analytics, noted in a 2014 blog post that “Big R” restatements were headed down, but not because errors and misstatements had disappeared. Instead errors and misstatements were being classified by companies with their auditors approval as non-material and therefore not "restatements" anymore. Companies started "revising" and "adjusting" on a go-forward basis.
Even material errors and misstatements, such as at Keurig/Green Mountain Coffee, were being addressed on a go-forward basis and not subject to a “Big R” restatement, until the SEC called them out and the auditor changed its tune.
Khuzami took credit in the December 2009 speech for an enforcement action in August 2009 against GE that was in play for seven years before he got there. GE had been doing derivatives without competent accounting personnel. GE paid a $50 million penalty to settle the SEC's charges alleging 10b and 10b-5 intentional fraud violations amongst others. The SEC said that the company had misled investors by reporting materially false and misleading results in its financial statements. On four separate occasions in 2002 and 2003, the SEC said high-level GE accounting executives or other finance personnel approved accounting that was not in compliance with GAAP. In one instance, the improper accounting allowed GE to avoid missing analysts' final consensus EPS expectations.
I wrote in September 2015 for MarketWatch about how the SEC had missed many opportunities to come down harder on companies and executives and, in particular, enforce the Sarbanes-Oxley clawback law:
Some of the opportunities the government might have considered were high-profile cases involving financial restatements as a result of misconduct at well-known companies, including J.P. Morgan Chase, General Electric, and Dell Computer.
The SEC fined General Electric $50 million for transactions that were intentionally designed to defraud investors and resulted in two restatements. CEO Jeff Immelt earned approximately $27 million in bonuses between 2001 and 2007, the periods that were restated, but none was clawed back. GETTY IMAGES
It’s not surprising we see recidivist companies like GE, ones that are not deterred from future frauds by the SEC’s repetitive rapping of their knuckles with a wet noodle. The fines are no more than a cost of doing business and individuals are rarely prosecuted fully.
In another example, Navistar’s former CEO Dan Ustian was a rare clawback target when his company was the subject of an enforcement action in August of 2010.
This is a financial fraud, reporting, and internal controls case against Navistar, a Fortune 200 manufacturer of commercial trucks and engines, and certain current and former employees.
From 2001 to 2005, Schultz, the Waukesha plant controller, engaged in various fraudulent accounting practices that collectively caused income during that period to be overstated by a total of approximately $38 million. At times from 2001 through 2005. Schultz engaged in the aforementioned conduct in an attempt to improve Waukesha’s financial results. The aggregate monetary impact of Schultz’s accounting misconduct was material to Navistar’s financial statements. Schultz knew or recklessly failed to know that the actions described above were not in compliance with GAAP. Navistar overstated its pre-tax income by a total of approximately $137 million as the result of various instances of misconduct. Fraud at a Wisconsin foundry and in connection with certain vendor rebates and vendor tooling transactions accounted for approximately $58 million of that total. The remaining approximately $79 million resulted from improper accounting for certain warranty reserves and deferred expenses.
The SEC’s Navistar enforcement action did not cite 10b and 10b-5 violations against the company, Ustian, or his CFO Bob Lannert. The SEC did charge several lower level executives with intentional fraud.
Both Ustian and Lannert had their incentive compensation clawed back per Sarbanes-Oxley Section 304 because there had been multiple restatements and plenty of misconduct to go around. Navistar was also a company that had the rare experience of having to actually admit a “tone at the top” material weakness in its internal controls over financial reporting.
1. Control Environment: As of October 31, 2005, management was unsuccessful in establishing an adequately strong consciousness regarding the consistent application of ethics across all areas of the company and the importance of internal controls over financial reporting, including adherence to GAAP. This weakness in the overall control environment likely contributed to many of the other material weaknesses disclosed herein. As identified by the Board of Directors’ independent investigation, certain members of management and other employees, in place at that time, were involved in instances of intentional misconduct that resulted in some of the company’s smaller, but material, restatement adjustments. With respect to these instances, most of these individuals are no longer employed by the company.
Lannert left the company in 2006 but Ustian stayed on the job!
The SEC, therefore, had to make make convoluted excuses for why the CEO and CFO were not charged with intentional fraud, and why Navistar, as a company, was not fined.1
These findings do not reflect a coordinated scheme by senior management to manipulate the Company’s reported results or conduct committed with the intent of personal gain. Instead, these findings reflect misconduct that resulted in large part from a deficient system of internal controls, evidenced in part by insufficient numbers of employees with accounting training, a lack of written accounting policies and procedures, and flaws in the Company’s organizational structure.
The internal control deficiencies, in turn, resulted from senior management’s failure to dedicate sufficient resources and attention to the adequacy of Navistar’s accounting and reporting functions. The deficient internal controls failed to provide adequate checks on certain employees’ efforts to meet the Company’s financial targets.
Ustian stayed on the job as CEO of Navistar until his company stubbornly stuck to a losing strategy to try to meet diesel truck emission standards that resulted in chronic fines from the EPA. Ustian finally retired.
Former SEC enforcement chief lands a $5 million a year gig
If you really wanted truth and justice and all that from your SEC, you probably wouldn’t go for someone who “worked with lawyers (at Deutsche Bank) who advised on the CDOs issued by the German bank and how details about them should be disclosed to investors,” as The Wall Street Journal noted three years ago. Okay, it worked with Joe Kennedy, but that was a different era.
You know the results of Khuzami’s tenure: A splashy half-billion-dollar deal with Goldman Sachs, a bunch of “neither admits nor denies the charges” settlements, banks sued for fraud with no bankers sued for fraud, and embarrassingly low settlements with the likes of Citigroup and Bank of America for slam-dunk frauds. Oh, and who could forget: soliciting promises from banks to not break a specific law again, even though they’d already promised the SEC repeatedly not to break that law again in previous settlements.
Now, the payoff: The New York Times reports that Kirkland & Ellis will give Khuzami a whopping $5 million a year to <continue serving> represent their corporate clients.
Andrew Ceresney, served as Director of Enforcement under Mary Jo White gave a speech in 2013 and sought to explain, sort of, what happened to accounting fraud cases.
In the wake of the financial crisis, the SEC was very focused on financial crisis cases – cases involving CDOs, RMBS, Ponzi schemes, and other transactions that resulted in massive losses to investors. Consequently, we devoted fewer resources to accounting fraud. During this period, we have had fewer accounting fraud investigations. So for example, in FY2012, we opened 124 financial fraud/issuer disclosure investigations compared to 304 in FY2006 and 228 in FY2007. As for accounting fraud cases, we saw a reduction here as well: we filed 79 financial fraud/issuer disclosure actions in FY2012 compared to 219 in FY2007.
Ceresney actually cast doubt on the “fewer restatements because there is less corporate fraud” narrative.
Another trend we have seen over the last few years is a reduction in restatements. So for example, across all public companies, restatements fell from a peak of 1,771 in 2006 to 768 in 2012. Although I should also note that the number of large companies (market capitalization over $75 million) restating their financials actually jumped from 153 in 2009 to 245 last year. Some have suggested that these reductions resulted from Sarbanes-Oxley and the improvement in financial reporting caused by related reforms…
But I have my doubts about whether we have experienced such a drop in actual fraud in financial reporting as may be indicated by the numbers of investigations and cases we have filed. It may be that we do not have the same large-scale accounting frauds like Enron and Worldcom. But 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 incentives are still there to manipulate financial statements, and the methods for doing so are still available. We have additional controls, but controls are not always effective at finding fraud.
In the end, our view is that we will not know whether there has been an overall reduction in accounting fraud until we devote the resources to find out, which is what we are doing.
What happened next? Well, the recent cases at GE and Under Armour, and almost every other big company since, tell the story. More disclosure violations, less accounting fraud.
Andrew Ceresney agreed that not much had changed in terms of the fraud triangle — opportunity, need, and rationalization. So why didn’t he prosecute more financial accounting manipulation as intentional fraud?
Ripple’s response to the SEC’s charges, filed late last week, shows they plan to go down fighting, just like Telegram and its Ton token. The company has brought in the big guns — former SEC Chair Mary Jo White and her protégé, former SEC Director of Enforcement under White Andrew Ceresney who are now at law firm Debevoise — to argue that XRP is a currency.
Disclosure: I worked as a consultant to Navistar’s Internal Audit Department in 2007 and early 2008 supporting their Sarbanes-Oxley effort during the restatement process and the complete revamp of its internal audit function. My former client, the Chief Audit Executive who replaced one that didn’t stand up to the executives who wanted to keep doing what they were doing, later sued the company in a Sarbanes-Oxley whistleblower suit.
Excellent post!