by T. GormanPosted on Posted in SECActions

The SEC is very good at announcing its court cases – at least when they are filed, they win or the case settles.  Just check the web site and all those suits, settlements and victories are listed there.  Then look for the losses. They can be somewhat harder to find.  There may be good reason. 

Consider the recent court ruling in SEC v. Todd, Civil Action No. 03 CV 2230 (S.D. Cal.) on May 30, 2007.  There, the Court granted most of the post-trial motions made by two former Gateway executives charged with securities fraud and aiding and abetting filing violations.  This is not the first such ruling in this case.  Last May, the Court granted summary judgment to another former Gateway executive charged in the same case by the SEC.  Perhaps there is a reason the SEC does not want to publish these rulings. 

Consider the comments of the Court in its rulings.  Repeatedly throughout the opinion, the Court noted that either the evidence was not what the SEC claimed or there simply was no evidence.  For example, the Court notes that the SEC claimed Mr. Todd violated antifraud Section 17(a) in connection with a prospectus supplement filed with the Commission in September 2000 which incorporated a second quarter 2000 Form 10Q by reference.  In throwing out this claim, the Court noted: “In its Memorandum of Points and Authorities in Support of Motion for Partial Summary Judgment, the SEC stated that ‘there is no dispute that Todd signed a prospectus offering Gateways securities for sale,’ a statement which the Court unfortunately and mistakenly accepted as true when it denied Todd summary judgment on the Section 17(a) claim.  The evidence at trial showed that the prospectus supplement was unsigned.  The SEC presented no other evidence connecting Todd to the supplement.”  Slip opinion at 2.  

Despite the obvious flaw in its proof, the SEC persisted.  According to the Court, the SEC shifted its theory to argue that Mr. Todd signed the second quarter 2000 Form 10Q which was incorporated by reference into the prospectus supplement and that he thus “indirectly” made a false representation within the meaning of Section 17(a).  Quite aside from whether this claim is supported by the law, the Court found that: “There was no evidence presented at trial that Todd had ever seen the prospectus supplement before, let along been involved with its preparation.” 

In other portions in the opinion, the Court repeatedly noted that the SEC offered no or virtually no evidence.  On many claims, for example, the Court noted that the SEC called an expert witness.  Yet, the expert did not testify on the key point and failed to establish the claim.  

No doubt litigants have bad days in court.  No doubt there are times when the proof does not come in the way it was planned.  This is not the case here.  The SEC should be able to tell if a party signed a document.  The SEC should know if it does not have proof on a claim.  And, if the SEC’s own expert did not testify to support key points, the only thing that can be inferred is that again the agency knew it did not have the necessary evidence. 

There is no excuse for the SEC here.  The agency has vast investigative powers to assemble evidence long before it files a complaint.  If that is not enough, it can conduct discovery, although one wonders why the agency needs much if any discovery in view of its investigative powers.  This, there is no excuse for bringing claims such as those brought here.  This is particularly true in view of the harm a mere accusation of wrongdoing by the SEC can cause.  Accusations by the SEC can severely harm companies and end the careers of executives and professionals long before any court even calls on the agency to submit proof for its claims.  In view of this fact, the SEC, like any prosecutor, should exercise special care before making an accusation of wrong doing.  Indeed, the SEC, like any prosecutor, has an ethical obligation to do so if for no other reason than the harm its accusations cause can never be undone – even when those wrongly accused win in court.  

 

by T. GormanPosted on Posted in SECActions

Over the last few months news about SEC enforcement has been dominated by the on-going option backdating scandals with a sprinkling of the usual financial fraud and insider trading cases.  By now, everyone had heard that the SEC has about 140 companies under investigation for backdating options and that a total of about 200 companies are conducting internal investigations into their option backdating expenses.  It is old news that a number of enforcement actions have been brought first against individuals claimed to have been involved and more recently against companies.  The real question about the scandal at this point is the standards that will be used going forward in decisions made by the SEC as to who to include in future enforcement actions. 

Now, however, a new wrinkle to the use of options has been added.  Yesterday, the SEC filed a settled administrative action against IBM Corp. over its options practices.  Big Blue was not accused, however, of backdating its options.  Rather, the crux of the actions seems to be that the company used the issuance by the SEC of its then-new guidance on options (SAB 107) as an excuse to mislead analysts about its earnings to soften the impact of missing guidance.  According to the Order For Proceedings, IBM violated the reporting provisions of the federal securities laws by filing a Form 8-K in April 2005 that “contained materially misleading information about the amount of IBM’s stock options expense and the impact it would have on IBM’s earnings per share.  The Form 8-K created the impression that IBM’s stock options expense would be greater than what IBM actually expected it to be for 1Q05 and FYO5.”  http://www.sec.gov/news/press/2007/2007-109.htm 

A review of IBM’s April 2005 Form 8-K cited in the Order For Proceedings shows precisely what the company did.  First, in the earnings call IBM told analysts that it was implementing SAB 107.  Second, the company told analysts to reset their 2004 numbers so that they would be comparable with 2005 numbers which would include the expense.  In this context, the company told analysts to include 55 cents for 2004 and 14 cents for 1Q04.  Third, IBM told the analysts to use similar adjustments for its 2005 projections.  Finally, a chart was included which listed analysts’ projections for 2004 and 2005 and made the 2004 adjustments, but not the 2005 adjustments.  Analysts were told, however, that for 1Q05, the option expense adjustment would be comparable to 1Q04 – that is, 14 cents.  At the time the SEC’s Order For Proceedings says, IBM knew that the actual number was 10 cents, not 14 cents. 

So what is the big deal?  It’s the impact.  At the time of the conference call, earnings per share projections for 1Q05 were $1.04 per share, according to the chart given analysts at the conference call, which is reproduced in the IBM 8-K.  If the option expense for 1Q05 was actually 14 cents, then the EPS number should be adjusted down to $0.90 for the quarter.  However, if the actual option expense of 10 cents had been provided, the EPS would have been adjusted downward to $0.94.  When IBM actually reported earnings per share of $0.85 in its Form 10Q for the quarter, its share price dropped 8% the next day.  That drop resulted because the company appeared to miss its projection by $0.05.  But, actually the company missed guidance by $0.09.  Since the actual difference between street expectations and reported results was almost twice as much, one would expect a more significant drop in share price — say 15%, rather than 8%.  

This sad saga appears to just be the latest difficulty with options and meeting Wall Street expectations.  In many cases where firms strive to meet those expectations, earnings get managed with improper accounting practices such as round trip transactions, channel stuffing and the like.  Here, rather than manage income, the expectations of Wall Street were managed.  IBM resolved the matter with the SEC by consenting to a Cease-and-Desist Order.  As Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “Information regarding a company’s earnings is one of the most important factors that many investors consider in making an investment decision, and it is essential that the information companies provide be clear and accurate.” 

All of this suggests that perhaps management should move away from earnings guidance and meeting Wall Street expectations to a more long term of managing the business for shareholder value.