by T. GormanPosted on Posted in SECActions

This week the SEC announced more enforcement actions and settlements in its action involving Royal Ahold (Koninklijke Ahold N.V.) and its subsidiary, U.S. Foodservice. http://sec.gov/litigation/litreleases/2007/lr19975.htm.  Thirteen additional individuals were charged in the massive financial fraud and several agreed to settle for consent decrees and fines, while others are litigating with the SEC.  These actions bring the total number of individuals charged by the SEC in this fraud to 30 along with the company.   The complaints in these actions all focus on a massive financial fraud at U.S. Foodservice to ensure that the reported earnings were equal to or greater than targeted regardless of the company’s true performance.  In essence, the scheme involved U.S. Foodservice personnel contacting vendors and securing false audit confirmation letters.  In some instances the vendors were simply urged to falsify confirmations while in others they were coerced.  The confirmation letters provided that they were for the outside auditors.  Defendants in the various actions included the senior management of the company, including the CEO, CFO, and an executive vice president, and several others.  In some instances, the vendors who participated in the scheme engaged in insider trading.  Generally, individuals who settled agreed to the entry of a consent decree enjoining them from future violations of the antifraud provisions.  Officers agreed to an officer director bar and, in many instances, fines.  

What is interesting about the case is not the claims themselves, but the settlement with the company and the statements of the SEC about cooperation.  These recent settlements make clear that this case involved a massive fraud which pervaded senior management of the company and implicated many others.  The company settled in October 2004 by agreeing to the entry of a consent decree and statutory injunctions prohibiting future violations of the antifraud and books and records provisions of the securities laws.  http://sec.gov/litigation/litreleases/lr18929.htm.  The SEC did not seek a fine for several reasons, including that criminal prosecutors investigating the case in The Netherlands requested them not to seek fines to avoid potential double jeopardy issues.  In September 2006, the DOJ entered into a non-prosecution agreement with the company.  http://www.corporatecrimereporter.com/documents/ahold.pdf 

At the time of settlement, the SEC cited Ahold’s extensive cooperation.  That cooperation included:  1) self-reporting; 2) an extensive internal investigation; 3) voluntarily expanding the investigation to cover a number of other areas; 4) promptly providing the staff with the internal investigation reports and the supporting information; 5) waiving the attorney-client privilege and work product protection with respect to the internal investigations; 6) making its current personnel available for interviews or testimony; 7) significantly assisting the staff in arranging interviews or testimony from former personnel in the U.S. and abroad; and 8) promptly taking remedial steps, including revising internal controls and terminating employees responsible for the wrongdoing.  According to the Release it is clear that Ahold took every imaginable step to be cooperative.
 

Contrast this case with the example of cooperation in the Seaboard Release.  There, a relatively isolated fraud took place in a subsidiary.  The SEC cited the cooperation of the company as the basis for its decision not to prosecute the organization and pointed to the actions of the company as an example of cooperation in the Release.  That cooperation consisted of 1) self-reporting; 2) promptly notifying the SEC; 3) conducting a complete internal investigation; 4) making the investigation report available to the staff; 5) not asserting privilege; and 6) terminating those responsible. 
 

Comparing the facts and the results in the two cases is instructive in assessing the definition of cooperation under Seaboard and its impact on the SEC’s prosecutorial judgment.  Ahold is, by all accounts, a massive fraud.  With thirty individuals named, the SEC’s investigation is still on-going.  The fraud involved the entire top of the company and included a former audit committee member.  Nevertheless, once discovered by the company, every possible action was taken to cooperate with the SEC beginning with self-reporting and including privilege waivers.  Ahold, however, was required to settle for a full statutory injunction that included fraud claims.  Penalties were not imposed because of the requests of Dutch prosecutors, although the SEC also noted that it considered the cooperation of the company in reaching that decision.  In contrast, Seaboard was an isolated fraud where cooperation yielded no prosecution based on essentially the same steps taken by Ahold.  In both cases, the companies waived the attorney client privilege.  The difference seems to be that pervasive fraud equals at least an enforcement action and maybe penalties (absent a request from the criminal prosecutors) while an isolated fraud does not.  In either case, however, privilege waivers seem necessary.

by T. GormanPosted on Posted in SECActions

A new study by finance professors suggests that the backdating of stock options may be a much more wide-spread practice than once thought.  Initially, many believed that stock option backdating might have been concentrated in the high tech area.  Later, many thought that the practice occurred predominately during the period before the passage of the Sarbanes-Oxley Act in 2001.  Now, however, a new study by Professor John Bizjak of Portland State University and Michael Lemmon and Ryan Whitby of the University of Utah entitled “Option Backdating and Board Interlocks” suggests that as many as fifty percent of the companies that issued options during the 1990’s engaged in backdating.  This conclusion would clearly make the practice much more wide-spread than anyone had initially thought. 
 

The study also suggests that the practice may have proliferated as a result of directors who held positions on more than one board.  Overlapping board memberships may have facilitated the transmission of the practice from one company to another through the small and exclusive club of corporate directors.  This suggestion is also contrary to the current wisdom that the practice was management driven – at least that is the inference from the two cases the SEC and DOJ have filed.  This finding also undermines the theory that outside directors will serve as a watchdog on improper management practices.  If correct, it means the watchdog is the source of what may –backdating is not illegal in and of itself – be an improper practice. 
 

The study should clearly cause everyone to rethink the issues surrounding option backdating.  It also significantly changes the stakes for corporate boards and officers.  Previously, companies understandably could have thought that questions about backdating were limited to a handful of companies and, thus, no action was required.  Now the stakes are different.  The new study suggests that the problem is so prolific that it cannot be ignored, particularly in view of the stakes. 
 

If a company discovers a problem it has the opportunity to take control of the situation and expeditiously resolve it.  If, however, the SEC, another regulator, or even a whistleblower discovers a problem the company will loose the opportunity to control the situation and guide it to a chosen resolution.  Prudence dictates that companies take a proactive approach, conducting an internal investigation into its past option granting practices followed by taking any necessary corrective steps.  The alternative is to gamble that the company is in the fifty percent of companies that did not backdate any option grants.  In view of the high stakes and the impact of being wrong, that would be a bad gamble.
 

Bizjak , John M., Lemmon, Michael L. and Whitby, Ryan J., “Option Backdating and Board Interlocks” (November 2006). Available at SSRN: http://ssrn.com/abstract=946787.  A discussion of the report is contained in the New York Times, January 21, 2007 at BU-5.