Materiality: No, the SEC did not write SAB No. 99

Corporate Counsel serves up a mostly excellent article, Securities Law Disclosure Checklist for Alleged (or Confirmed) Misconduct. It outlines disclosures that public companies should consider regarding alleged misconduct by employees, directors, or officers (e.g., “accounting improprieties, disclosure failures, criminal or civil actions involving the company and/or management, scandalous personal indiscretions, threatened disciplinary actions, fraud, false statements, or omissions, bribery or forgery”).

I say “mostly excellent” because, while the checklist is comprehensive and helpful to both companies and prospective whistleblowers, it unfortunately perpetuates the oddly popular myth that SEC Staff Accounting Bulletins (a.k.a. “SABs”), like SAB No. 99 dealing with materiality, are promulgated by the SEC and, therefore, are binding legal rules:

“In Staff Accounting Bulletin 99, the SEC also noted. . .” blah, blah, blah.

The SEC noted no such thing. As each and every SAB bears explicit witness, SABs are not binding partly because the SEC specifically disavows each of them with this preface:

The statements in the staff accounting bulletins are not rules or interpretations of the Commission, nor are they published as bearing the Commission’s official approval. They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws.*

Under the Fifth Amendment and the Administrative Procedure Act, so-called legislative regulations can only come into being through due process development that includes public notice and opportunity to comment. If the SEC were to so decide, it might be able to sneak by with interpretative regulations, thanks in no small part to the Supreme Court’s 2015 decision in Perez v. Mortgage Bankers Assoc. So far, however, on a number of important disclosure topics, including materiality and revenue recognition, the SEC has studiously avoided promulgating any regulations at all.

Thus, left to their own devices, SEC staff have taken the easy way out, engaging in a form of extra-legal self-help by drafting SABs, which they cook up behind closed doors with zero input from financial market constituents (investors and registrants). This is why SABs are called “Staff Accounting Bulletins.”

The distinction between legitimate SEC rules and ersatz SABs is not trivial. Rules that emerge from the crucible of notice and comment would undoubtedly differ significantly from the contents of the SABs, Wanda Wallace observed in 2007.** Investors and SEC registrants need and deserve better, legitimate regulatory guidance than the SABs. Meanwhile, the SEC should get no credit for binding regulations it has not drafted.

* See, e.g., SAB No. 99, See also Kurt S. Schulzke, Wink, Wink, Nudge Judge: Persuading U.S. Courts to Take Accountants Seriously in Federal Securities Cases with Help from the U.K. Companies Act, 16 Tenn. J. Bus. L. 231, 267 (2015) ,  (noting the disturbing appearance of this SEC mythology during Jeff Skilling’s Enron trial and in other securities cases); Kurt S. Schulzke, Gerlinde Berger-Walliser & Pier Luigi Marchini, Lexis Nexus Complexus: Comparative Contract Law and International Accounting Collide in the IASB–FASB Revenue Recognition Exposure Draft, 46 Vand. J. Trans. L. 515, 524 (2013) (similar).

** Wanda A. Wallace, Commentary: With or without due process?, ACCT. TODAY, Nov. 26, 2007, n.p. (decrying multiple SABs for their negative impact on the quality of financial information).


About that new FASB revenue recognition standard . . .

This morning, I made a short presentation on the new FASB-IASB revenue recognition standard, Revenue From Contracts With Customers, now at FASB Codification Topic 606. The slides appear below this post.

At the moment, Topic 606 will be effective for public company year ends beginning on or after January 1, 2017. We’ll see whether this effective date holds. Either way, a deeper dive on the new standard is available from three sources:

(a) Lexus Nexis Complexus: Comparative Contract Law and International Accounting Collide in the IASB-FASB Revenue Recognition Exposure Draft, co-authored by Gerlinde Berger-Walliser, Pier Luigi Marchini, and yours truly, now available online at the Vanderbilt Journal of Transnational Law;

(b) BNA’s Special Report, Navigating the New Road to Revenue Recognition by Lisa Starczewski; and

(c) FASB’s own Topic 606. It’s definitely not user-friendly — except, perhaps, to creative plaintiff’s counsel — but it’s big and it’s threatening.


Brief Overview of the New FASB-IASB Revenue Recognition Standard


SEC loses laptops. IRS, EPA lose emails. CDC loses Ebola. What next?

SEC OIG Laptop Report

What times are these when supposedly uber-competent government agencies lose control of, well, mission-critical stuff like laptops, emails, and deadly viruses? What’s next?

The SEC OIG says hundreds of laptops are unaccounted for. The good news is that OIG has disclosed they’re missing. Bad news? While the IRS and EPA “lose” only emails, the SEC loses entire laptops. More good news: These laptops almost certainly don’t carry Ebola. More bad news: SEC laptops should contain lots of really sensitive information about ongoing investigations and the people involved, most of whom will never be accused — let alone found guilty of or liable for — any wrongdoing. Kind of like securities law Ebola. Not to mention the possibility of lots of inside information, possibly including the identity of SEC whistleblowers.

Read the entire OIG report below.

SEC OIG – Laptops Missing

Which changes in accounting principle are material?

What misstatements or omissions are “material” and which are not?  With the recent roll-out of the SEC’s new whistleblower regulations, it is a popular question among companies and prospective whistleblowers.  This brief summary offers insights into this important topic as it applies to changes in accounting principle.

First, despite recent IFRS rumblings, SEC regulations require U.S.-based registrants (known as “domestic issuers”) to follow U.S. Generally Accepted Accounting Principles (a.k.a. “U.S. GAAP”).   The SEC is currently seeking input regarding a possible future move to International Financial Reporting Standards (“IFRS”) promulgated by the International Accounting Standards Board (“IASB”).  However, for now, U.S. GAAP is still published by the U.S.-based and controlled Financial Accounting Standards Board (“FASB”) through its Accounting Standards Codification (“Codification”).

Beyond U.S. GAAP as contained in the Codification, domestic issuers are also obligated to abide by the financial statement content standards prescribed by SEC Regulation S-X.  As a practical matter, issuers and their auditors tend to follow the technically non-binding opinions of SEC staff expressed through Staff Accounting Bulletins (“SABs”).

So what about changes in accounting principle?  At what point is a change material? Under U.S. GAAP, a presumption exists that an accounting principle once adopted shall not be changed in accounting for events and transactions of a similar type.[1] A change in the method of applying an accounting principle is considered a change in accounting principle. [2] Entities must report changes in accounting principle through retrospective application of the new accounting principle to all prior periods (including interim ones), unless it is impracticable to do so.[3]

Take mortgage banking, for example, an industry on the bleeding edge of the financial markets meltdown of 2007.  Issuers involved in the mortgage industry are required to disclose the method (aggregate or individual loan basis) used in determining the lower of cost or fair value of the mortgage loans carried on their balance sheets as assets.[4] An issuer who makes a material change in its method of accounting (including accounting for mortgage loans) must indicate the date of and the reason for the change and include as an exhibit in the first Form 10-Q filed subsequent to the date of an accounting change, a letter from the issuer’s independent accountants indicating whether or not the change is to an alternative principle which in the judgment of the accountants is preferable under the circumstances.[5]

For SEC purposes, a fact is material if there is a substantial likelihood that the fact would have been viewed by a reasonable investor as having significantly altered the “total mix” of information available.[6] While some financial market players — including some auditors — might prefer to define “materiality” solely with reference to an item’s numeric magnitude (because percentages make much better bright lines), materiality must be assessed for SEC purposes with respect to quantitative and qualitative factors.   As a result, in numerous circumstances, misstatements below an arbitrary quantitative threshold — say 5%-of-basis — may be material.[7]

Potentially significant qualitative factors include whether (a) the misstatement masks a change in earnings or other trends; (b) whether the misstatement affects the registrant’s compliance with regulatory requirements; (c) whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements; (d) whether the misstatement involves concealment of an unlawful transaction.[8]

As one hypothetical illustration, a $5,000 embezzlement by the president of a Fortune 100 corporation might seem numerically insignificant in relation to the company’s balance sheet or income statement.  However, the fact that the president was involved in the embezzlement suggests serious weaknesses in the company’s governance and internal control systems and, therefore, would arguably be “material”.

Bottom line:  In assessing the materiality of a change in accounting principle (or any other aspect of an issuer’s SEC reports and disclosures), it is important to remember that easily quantified numbers and percentage thresholds are only a starting point for a thorough analysis.

[1] FASB Codification Topic 250-10-45-1.

[2] FASB Codification, Glossary.

[3] FASB Codification Topic 250-10-45-5 and 45-14.

[4] FASB Codification Topic 948-310-50-1, Financial Services, Mortgage Banking, Receivables, Disclosure.  This requirement has been in effect since the original issuance of FASB Statement No. 65 in 1982.

[5] Regulation S-X, Rule 10-01(b)(6).

[6] TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988).

[7] SEC Staff Accounting Bulletin No. 99.

[8] SEC Staff Accounting Bulletin No. 99.



Confidentiality agreements blocked by SEC Rule 21F-17

For whistleblowers and their past or present employers, one of the more important features of the SEC’s new whistleblower program regulations is Rule 21F-17,  copied in part below.  Over the years, targets of whistleblower claims have employed increasingly aggressive and sophisticated tactics — including “gag orders,” TROs, and breach of confidentiality agreement or even trade-secret-theft claims — to intimidate whistleblowers and prevent them from alerting regulators and law enforcement about wrongdoing.  Rule 21F-17 is a significant step toward ending such shenanigans and should encourage more SEC whistleblowers to come forward.

Among other things, Rule 21F-17 clearly prohibits any “person” from taking “any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce” most confidentiality agreements. (Emphasis added.)  Confidentiality agreements covering attorney-client privileged information are generally excepted from this ban under Rule 21F-4(b)(4). But even the 21F-4(b)(4) exceptions have exceptions outlined in 21F-4(b)(4)(v).

The bottom line: Attempting to silence a would-be SEC whistleblower is more dangerous now than ever before.  Employers would do well to carefully analyze the extent to which their “investigative” activities — which far too often include firing and suing the very whistleblowers who prompt such investigations — are themselves an additional violation of SEC Rule 21F-17.

§ 240.21F-17 Staff communications with individuals reporting possible securities law violations.

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement (other than agreements dealing with information covered by § 240.21F-4(b)(4)(i) and § 240.21F-4(b)(4)(ii) of this chapter related to the legal representation of a client) with respect to such communications.

(b) If you are a director, officer, member, agent, or employee of an entity that has counsel, and you have initiated communication with the Commission relating to a possible securities law violation, the staff is authorized to communicate directly with you regarding the possible securities law violation without seeking the consent of the entity’s counsel.

240.21F-4(b)(4) The Commission will not consider information to be derived from your independent knowledge or independent analysis in any of the following circumstances:

(i) If you obtained the information through a communication that was subject to the attorney-client privilege, unless disclosure of that information would otherwise be permitted by an attorney pursuant to § 205.3(d)(2) of this chapter, the applicable state attorney conduct rules, or otherwise;

(ii) If you obtained the information in connection with the legal representation of a client on whose behalf you or your employer or firm are providing services, and you seek to use the information to make a whistleblower submission for your own benefit, unless disclosure would otherwise be permitted by an attorney pursuant to § 205.3(d)(2) of this chapter, the applicable state attorney conduct rules, or otherwise; or …

(iii) In circumstances not covered by paragraphs (b)(4)(i) or (b)(4)(ii) of this section, if you obtained the information because you were:

(A) An officer, director, trustee, or partner of an entity and another person informed you of allegations of misconduct, or you learned the information in connection with the entity’s processes for identifying, reporting, and addressing possible violations of law;

(B) An employee whose principal duties involve compliance or internal audit responsibilities, or you were employed by or otherwise associated with a firm retained to perform compliance or internal audit functions for an entity;

(C) Employed by or otherwise associated with a firm retained to conduct an inquiry or investigation into possible violations of law; or

(D) An employee of, or other person associated with, a public accounting firm, if you obtained the information through the performance of an engagement required of an independent public accountant under the federal securities laws (other than an audit subject to §240.21F-8(c)(4) of this chapter), and that information related to a violation by the engagement client or the client’s directors, officers or other employees.

(iv) If you obtained the information by a means or in a manner that is determined by a United States court to violate applicable federal or state criminal law;

(v) Exceptions. Paragraph (b)(4)(iii) of this section shall not apply if:

(A) You have a reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or property of the entity or investors;

(B) You have a reasonable basis to believe that the relevant entity is engaging in conduct that will impede an investigation of the misconduct; or

(C) At least 120 days have elapsed since you provided the information to the relevant entity’s audit committee, chief legal officer, chief compliance officer (or their equivalents), or your supervisor, or since you received the information, if you received it under circumstances indicating that the entity’s audit committee, chief legal officer, chief compliance officer (or their equivalents), or your supervisor was already aware of the information.

SEC settles Dell fraud case: Execs pay millions

Is the SEC on a roll or just looking over its shoulder at salivating securities whistleblowers? On the heels of settling with Goldman Sachs last week for $550 million, the SEC yesterday announced its $111+ million take from settling accounting fraud charges against Dell Computer and several current and former Dell executives including Michael Dell, Kevin Rollins and James Schneider.  The three will pay the SEC $4M, $4M and $3M, respectively, to settle.  Assuming the facts are as stated by the SEC, they’re fortunate. And wasn’t the Sarbanes-Oxley Act supposed to prevent this kind of thing? Continue reading

Dodd-Frank H.R. 4173 now before the Senate

The leviathan Dodd-Frank bill, newly renamed the “Restoring American Financial Stability Act of 2010,” has been taken up by the Senate.  On CSPAN-2, Hawaii Senator Daniel Akaka is now droning on about how “too many investors don’t know the difference between a broker and investment advisor.”  Note well:  Both “Wall Street Reform” and “Consumer Protection” have disappeared from the bill’s title.  My brief analysis of the securities whistleblower provisions, in Act Section 922, tells me that once the bill is signed by the President the SEC should brace for a deluge of securities fraud claims.  These claims will take years to process but the process holds out some hope that securities whistleblowers may receive some compensation for their efforts to bring fraud to light.

Dodd-Frank: SEC Whistleblower Facelift

Thinking of blowing the whistle on securities fraud?  Thanks to the  Dodd-Frank Restoring American Financial Stability Act of 2010 (H.R. 4173), it now makes financial sense to consider it.

Securities whistleblowers may not have much company in cheering H.R. 4173 but Section 922 is a major improvement over the largely non-functional anti-retaliation provisions of the old Sarbanes-Oxley § 806.

For readers familiar with the somewhat comparable False Claims Act (a.k.a. “FCA”), in some respects Section 922 is nearly identical.  In others, it differs significantly.  In theory at least, both statutes offer whistleblowers potentially handsome financial rewards for bringing forward “original information” about fraud.  The awards generally range between 15 and 30 percent under the FCA (10-30 percent under § 922)  of what the government collects as a result of the whistleblower’s disclosures.  The FCA seeks to protect government funds from unscrupulous contractors and tax cheats.  In contrast, Section 922 purports to shield investors from securities fraud.  Other major points of comparison and divergence follow.

Size Matters

Section 922 makes awards only in cases where the “monetary sanctions” collected from the defendant exceed $1,000,000.  In contrast, there is no statutory floor on FCA claims although practically speaking each U.S. attorney’s office has its own threshold.  There are just too many FCA cases and too few assistant U.S. attorneys to follow them all.  Some won’t consider a case alleging less than $1,000,000 in “single damages”.  Others will jump at $500K.  Local context can loom large.

Section 922 excludes more whistleblowers

Oddly enough, if you gain the case information through the performance of an audit of financial statements required under the securities laws and, for you in your position, submission of the information to the SEC would be contrary to the requirements of section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), forget about it.*  You can’t be an SEC whistleblower.  In this, you’re not alone.  The same exclusion applies to to “any whistleblower who is, or was at the time the whistleblower acquired the original information submitted to the Commission, a member, officer, or employee of (i) an appropriate regulatory agency; (ii) the Department of Justice; (iii) a self-regulatory organization; (iv) the Public Company Accounting Oversight Board; or (v) a law enforcement organization.”

Section 922 offers no private cause of action

Unlike the FCA which authorizes plaintiffs called “relators” to sue even if the government decides not to, under § 922 only the government can pursue a securities fraud claim.  If the SEC chooses not to pursue a whistleblower case, the whistleblower is pretty much out of options.  To place this in practical context, not even Harry Markopolos — with all of his data and analysis — could force his Bernie Madoff case into court if the SEC didn’t want to go.

“Original information” is broader under Section 922

While the term “original information” is not used in the FCA, the FCA also makes awards only for the provision of new information.  That said, Section 922’s formulation of “original information” appears to be more expansive than that of the FCA.

Unlike the FCA, Section 922 includes within its domain of “original information” not only bare “knowledge” but also “analysis” provided by a whistleblower.  This should be seen as significantly expanding the “original information” perimeter to include private analysis of publicly available data like that which enabled Harry Markopolos to detect the Madoff fraud long before the SEC did.  While it is possible that an FCA whistleblower may have won a settlement on the basis of such analysis alone, I am not currently aware of any such case.

On the flip side, Section 922 excludes from permissible “original information” information “exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report (as opposed to federal government, in the FCA), hearing, audit, or investigation, or from the news media, unless the whistleblower is a source of the information.  The phrases “exclusively derived” and “a source” are exclusive to Section 922 — they do not appear in the FCA.

Arguably, the net impact of “government,” “exclusively derived,” and “a source” — together with the addition of the word “analysis” — is to expand the pool of “original information” for SEC whistleblowers beyond than that available to FCA relators.

Section 922 will be administered by a dedicated SEC office

FCA relators should be so lucky.  FCA claims are typically administered and enforced by Main Justice DOJ Civil Division attorneys or by local Assistant US Attorneys who have lots of responsibilities in addition to FCA cases.  The focus offered by a special SEC whistleblower office should give SEC whistleblowers a leg up assuming that it is properly staffed and managed.

SEC determines Section 922 awards

Unlike the FCA where the district courts have authority to approve FCA settlements and associated whistleblower awards, Section 922 grants the SEC complete discretion to identify award recipients and set largely unappealable award amounts.

Act § 21F(c)(1)(B) directs the SEC to “take into consideration” a specific list of four factors in making awards.**  However, the House-Senate Conference Committee’s softening of the Senate version language of § 21F(c)(1)(B) from “shall account for” to “shall take in consideration” signals that the SEC can weight and apply these factors almost at will.  Act § 21F(f) deprives district courts of any supervisory role, sending award appeals directly to the circuit courts which must review SEC decisions in accordance with Section 706 of the federal Administrative Procedure Act.  As a practical matter, SEC decisions on awards will be very difficult to overturn on appeal.

Readers may judge for themselves what awards whistleblowers should expect in light of the fact that awards will be paid out of the same SEC Investor Protection Fund from which the SEC’s OIG will fund its activities.

Bottom line: Dodd-Frank offers pros and cons for SEC whistleblowers.  While it isn’t nearly as robust as the FCA, Dodd-Frank is a major improvement over Sarbanes-Oxley.  If you’re thinking of blowing the SEC whistle and can’t wait to get started, give us a call.  We can help you blow with greater velocity and focus.

# # #

* The emphasis on “and” is mine.  The contextual meaning of the phrase “contrary to the requirements of section 10A” is anybody’s guess at this point.  This kind of legislative loose end keeps litigators employed and drives auditors — who crave definition and bright lines — to distraction.

** The § 21F(c)(1)(B) award-amount factors are as follows:

1. the significance of the information provided by the whistleblower to the success of the action;

2. the degree of assistance provided by the whistleblower and any legal representative of the whistleblower in a covered judicial or adrninistrative action;

3. the SEC’s programmatic interest in deterring violations of the securities law by making awards to WBs; and

4. such additional relevant factors as the Commission may establish by rule or regulation.

*Cross-posted at Whistleblower Central.

SCOTUS to SEC on PCAOB: “Fire at will!”

With today’s SCOTUS decision in Free Enterprise Fund v. PCAOB, the Public Accounting Oversight Board (“PCAOB”) survives but with less swagger and self-importance than before.  This decision holding unconstitutional the “dual for-cause limitation” on the President’s ability to fire PCAOB members leaves the PCAOB’s form intact but downgrades its political independence. Continue reading