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Here Comes the JOBS Act

As Fei-Lu Qian reports in the current issue of The Pomerantz Monitor, on April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (“JOBS Act”), with the purpose of spurring job creation by improving access to the public capital markets for “emerging growth companies” (“EGCs”). The JOBS Act classifies start-up companies as EGCs until, for example, they generate $1 billion in annual gross revenues, or the fifth anniversary of their initial public offering (‘IPO’).”

The main goal of the JOBS Act is to make it easier for start-up companies to go public. IPO registration statements will now need to include only two years of financial statements, and only selected financial data will have to be provided for any previous period.  Prior to an offering, an EGC will be able to expand communications and file with the SEC a draft IPO registration statement and amendments on a confidential basis, for its review and comment, and the EGC would not need to release those confidential filings to the investing public until just 21 days before the company’s IPO “road show.” Moreover, before filing a registration statement, an EGC will not be restricted to communicating only with qualified institutional buyers or institutional accredited investors. Perhaps most significantly, the EGC’s auditor will not have to certify the efficacy of internal controls and procedures under Section 404(b) of Sarbanes-Oxley.

Critics contend that the JOBS Act will lead to increased financial problems and fraud, and make it more difficult for shareholders to detect those problems.  For example, an EGC will be able to resolve issues with the SEC without investors finding out about them until only 3 weeks prior to an IPO.  Case in point: if the JOBS Act had been in effect prior to Groupon’s IPO, that company probably would have been able to resolve its accounting problems with the SEC without ever disclosing them to the public. Recently, Groupon disclosed that its executives failed to reserve enough money for customer refunds on expensive offers.

According to a survey conducted by the CFA Institute, a global association of investment professionals, only 29% of its members wanted the legislation to pass, and 63% believed that the bill “would create additional gaps in investor protection and transparency.” The Institute believes that the Act’s permission to allow brokerage firm analysts whose firms are underwriting an IPO to write and distribute research on companies “is a return to the kind of conflicted research that decimated investor confidence after the burst of the dot-com bubble.”

PCAOB Continues to Find Audit Deficiencies Among Big Four Accounting Firms

Nearly a decade after the accounting world was turned on its ear by the Enron and Worldcom scandals, it appears there are still worrisome issues with audits conducted by the industry’s biggest firms.  The Public Company Accounting Oversight Board (“PCAOB”)—the body created in the wake of the earlier scandals to oversee the accounting agency—issued recent reports detailing its study of audits performed by Big Four firms PriceWaterhouseCoopers (“PWC”) and KPMG.  Those reports found a troubling rate of audit deficiencies at both firms; detailing flaws in 28 of 75 audits by PWC and 12 of 54 audits by KPMG.  In some cases, the flaws went to the heart of the audit.  The reports note that PWC, in some cases, “failed to obtain sufficient appropriate audit evidence to support its audit opinion,” and that KPMG sometimes failed “to identify, or to address appropriately, financial statement misstatements, including failures to comply with disclosure requirements.”  The PCAOB study, which examined audits from 2010, also found that the deficiency rates for both firms were higher than in previous years. 

The PCAOB’s findings are good reminder that even audits conducted by the largest accounting firms are susceptible to significant error.  It is clear that the auditing industry still has a way to go before investors can rely on any accounting firm’s stamp of approval.

What Comes of Free Enterprise Fund v. PCAOB?

Yesterday’s Supreme Court decision concerning the constitutionality of the Public Company Accounting Oversight Board (“PCAOB”) is perhaps most important for what it didn’t hold.  Many have noted that the decision—striking down a provision of the Sarbanes-Oxley Act (“SOX”) that provided PCAOB members could only be removed for cause—will have little practical effect in the business world (the Wall Street Journal quotes Office Max’s CFO going so far as to say “[w]hat happens as a consequence of the rulings today is frankly not important”).  In a nutshell, the majority held that, because PCAOB members can only be removed by the SEC for cause, and SEC members can themselves only be removed by the President for cause, the “dual for-cause limitations” withdraw from the President the power to determine whether good cause for such removals exists.  This, the Court held, “contradicts Article II’s vesting of the executive power in the President.”  Thus, as the New York Times puts it, the PCAOB “survived a constitutional challenge on Monday, emerging only with its members having a little less job security.”  The decision is significant, however, in that it did not question the overall constitutionality of SOX and, in particular, held that it could sever the unconstitutional PCAOB tenure positions without having to throw out the entire Act.  This means not only that SOX has survived a significant constitutional challenge, but also that in the event other vulnerable provisions of the Act are held unconstitutional, SOX can potentially shed those offending provisions as well without dissolving completely.

From the Pages of The Pomerantz Monitor: SEC Brings First Clawback Action

The September/October issue of The Pomerantz Monitor reports on the first “clawback” action brought by the SEC for violation of Section 304 of the Sarbanes-Oxley Act. Section 304 of SOX provides that if a company is required to restate its financial results because of “misconduct,” the CEO and the CFO “shall reimburse” the company for any bonus or other incentive-based compensation received during the year following the issuance of the erroneous financial statement. This provision was obviously designed to deprive the two principal officers of any benefit they derived from reporting inflated financial results, such as achieving a certain level of earnings or revenues. If those benchmarks were not really achieved, the two chief officers should not keep benefits that they received under false pretenses. 

Frustratingly, courts have held that there is no private right of action for shareholders to “claw back” these overpayments. Because companies are typically loath to invoke this remedy and the SEC has done nothing to enforce it, Section 304 has been a right without a remedy. Making matters worse, without any caselaw, no one really knows whether the misconduct that must occur in order to trigger the clawback has to be committed personally by the CEO or CFO.

This issue may soon be clarified. On July 22, 2009 the SEC brought the first action under SOX’s clawback provision to recover compensation, and it does not even accuse the defendant of committing any misconduct. The SEC enforcement action charges Maynard L. Jenkins, the former CEO of CSK Auto, with receiving over $4 million in bonuses and profits on the sale of stock within one year of CSK’s issuance of false and misleading financial results for 2002-04. The SEC concedes that the actual accounting fraud was committed by other CSK officials, who were sued earlier. 

There is no requirement in Section 304 that the CEO or the CFO from whom the reimbursement is sought have any involvement in the events that necessitated the restatement. Indeed, the statute doesn’t require any showing of wrongdoing or fault at all by these individuals. 

On September 15, 2009, Jenkins filed a motion to dismiss the SEC’s high-profile case against him, stating that the SEC “is attempting to impose a Draconian penalty on an admittedly innocent person.”

To be continued . . .

From the Pages of The Pomerantz Monitor: Should SEC "Fair Funds" Supplant Private Securities Fraud Litigation?

As Pomerantz Partner Marc I. Gross advised readers in the July issue of The Pomerantz Monitor, the SEC has set up an $800 million fund to be paid to investors in American International Group ("AIG") securities during a four year period. This fund will distribute to injured investors $700 million in "disgorgement" and $100 million in civil penalties that AIG paid to the SEC, in settlement of the SEC's securities fraud claims.

The AIG fund is one of several "Fair Funds" that the SEC has created under Section 308 of the Sarbanes Oxley Act ("SOX"). SOX, enacted in 2002, gave the SEC for the first time the authority to distribute to injured investors any "disgorgements" and penalties recovered by the agency. Fair Funds have also been created in proceedings against Fannie Mae ($350 million), Tyco ($50 million), and from mutual fund companies and third party institutions that engaged in "market timing" of those funds' shares (over $1 billion). Such a compensatory role is a departure from the historic mission of the SEC. Prior to adoption of SOX, the SEC had principally focused on deterring future violations, looking to the securities class action bar, the "private attorneys general," to recover compensation for injured investors.

But now, in the wake of the advent of Fair Funds, business leaders have started arguing that private securities litigation is no longer necessary to achieve compensation for injured investors.

Restatements Decline with the Assistance of the SEC

According to a new study from Glass, Lewis & Co., there was a significant drop in the number of financial restatements filed by companies to correct accounting errors. Specifically, in 2007 there was a 17% decline in restatements, compared to the previous year. Moreover, for the first three months of 2008, there was a 21% decline in restatements from the comparable period in 2007. Click here for story.

One innocent explanation for the decline is that companies are used to the compliance requirements of the Sarbanes-Oxley Act which includes internal control tests and independent audits. An alternative explanation for the decline is the SEC advisory committee’s new guidelines which are “designed not to reduce the number of errors, but the number of corrections.” In other words, the SEC is telling public companies not to restate when it is not necessary and only correct their financials when they are significant to “investors making current investment decisions.” Glass Lewis sees the SEC’s approach as flawed because the “goal should be to ensure accurate financial statements that are comparable across multiple periods and companies.”

The report also noted that the most common errors were related to expense recognition, misclassifications, and improper accounting for equity items. Interestingly, Deloitte & Touche was associated with the highest auditor restatement rate and KPMG had the lowest rate.

A lesson on the importance of internal controls from across the pond

Ever since Sarbanes-Oxley was enacted, corporate lobbyists have derided its internal control provisions as unnecessary red tape that threatens American competitiveness.  According to these critics, implementing strong financial controls, and having auditors review their efficacy, was simply not worth the expense.

The French might disagree.  Last week, it was reported that Jerome Kerviel, a lone trader at French bank Societe Generale, lost $7.2 billion of the bank's money in unauthorized trades betting on European equity index futures.  The unwinding of these trades has imperiled the future of Societe Generale, which only weeks earlier was named Risk Magazine's "Equity Derivative House of the Year." 

Could all this have been avoided if the bank had effective controls enforcing the bank's position limits, requiring risk managers to sign off on large positions, or requiring that hedged trades be stress-tested for counterparty risk?   It sure seems so.  As European Central Bank President Jean-Claude Trichet told  television reporters last Friday, "the lesson to be drawn, as in the case of previous frauds of this magnitude (is the) ... absolute necessity of substantially reinforcing internal controls and internal risk controls in all establishments."  We couldn't agree more.

69 Unregistered Audit Firms and Partners Busted

Under Sarbanes-Oxley Act (“SOX”), auditors and accounting firms that prepare and issue audited reports for public companies are required to register with the Public Company Accounting Oversight Board (“PCAOB”), the nongovernmental body created after SOX to oversee auditors. However, last week, the SEC charged 37 unregistered small size audit firms and 32 audit partners with violating the SOX registration requirement. Specifically, between November 2003 and October 2005, the auditing firms issued 60 audit reports for 53 public companies that were mostly listed on the over-the-counter Bulletin Board or the Pink Sheets.

Out of the 69 audit firms and partners, 28 firms and 22 partners have agreed to cease and desist from violating the registration requirement. Additionally, in the course of the SEC’s investigation, most of the settling firms returned the audit fees to their issuers, which ranged between $100 and $32,000. Only two firms were forced to disgorge the audit fees. For the remaining nine audit firms and ten partners that decided not to settle, the SEC has instituted proceedings against them where “an administrative law judge will determine whether the SEC’s allegations are true and whether the auditors’ right to practice as accountants should be revoked."

Bush Sides With Those Who Commit Fraud

A few months ago, we reported that the Bush Administration decided not to file a brief in support of shareholders in the Stoneridge case, a Supreme Court case that will decide whether the federal securities laws create a private cause of action against those who participate in fraudulent schemes through deceptive acts, but do not themselves deliver false statements to the market.  Then, just last week, the Administration went even further and affirmatively argued that such non-speakers should be immunized from liability.

Although we at PomTalk have an admittedly special interest in the Stoneridge case, because we are the lead attorneys representing shareholders, our outrage over the Administration’s position is more substantive than tactical.  In supporting the defendants in Stoneridge, the Administration overruled the recommendations of the SEC and a variety of congressional legislators who drafted the Private Securities Litigation Reform Act and the Sarbanes-Oxley Act.  Moreover, the Administration disregarded the pleas of virtually every major shareholder-rights organization and advocate in the country. 

While this issue is not likely to attract the attention of the electorate in the upcoming presidential race, in the way that abortion or other hot-button social issues will, it is important.  Indeed, the Supreme Court’s decision in Stoneridge will directly affect the nearly 150 million Americans who invest in the markets, whether through an insurance policy, a 401-K plan, or a pension plan – probably more than are directly affected by many of the social issues that will dominate the presidential debates.  By siding with accountant, lawyers and bankers who commit fraudulent acts, over the interests of such Americans, the Administration has made it clear whose interests they care most about.  We just hope that the majority of Americans who are shareholders are paying attention. 

SEC Playing Parent with the FASB

While Sarbanes-Oxley gave the SEC the authority to oversee the Financial Accounting Standards Board, the FASB has been pretty much independent, until now. In last December, the SEC was presented with a final list of individuals for appointments and reappointments to the FASB and was not pleased. Now, the SEC wants to formalize its oversight role in the FASB appointment process.

Recently, in a letter to SEC Chairman Cox, the Financial Accounting Standards Board has agreed to give the SEC more say in the process of appointing members to the FASB and its own board. Specifically, the SEC will now be notified when candidates are up for appointments to the FASB. This will give the SEC the opportunity to interview those candidates and even nominate their own candidates.

According to a recent Wall Street Journal article entitled, “SEC Is to Get More Sway Over FASB,” the fear among accounting experts and FASB members is that the FASB will be less independent and there will be more “political meddling in the way accounting standards are set.” Edward Trott, a current FASB board member who is about to retire believes this change “is a big step on a slippery slope toward the SEC becoming the parent of the FASB.”

Further, Trott calls the agreement “disturbing” and it is another way for Congress “to influence the selection of politically expedient candidates.” Even Arthur Levitt, the former SEC chairman believes the reconfiguration raises the “risk of political interference.” Also, we don’t need to look very far in the past to see what happens when Congress interferes with the FASB’s business. Indeed, in the mid-90s, after Congress interjected itself, the FASB did not implement a rule that would have required companies to expense stock options. Accounting experts now looking back and believe this “laid the groundwork for the [current] backdating scandal.”