SEC Issues Guidelines For Registrant Self-Reporting Of Material Misstatements & Omissions

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.

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.

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.