SEC Brings Charges Against Director and Former Executive Officers for Allegedly Lying to Auditors About Loss Contingencies Concerning a Government Investigation

SEC Brings Charges Against Director and Former Executive Officers for Allegedly Lying to Auditors About Loss Contingencies Concerning a Government Investigation

Blog Keeping Current: Disclosure and Governance Developments

Last week, the Securities and Exchange Commission (SEC) filed a complaint in U.S. District Court against a company’s director, former CEO and former CFO for allegedly making false and misleading statements to the company’s auditors, in violation of Rule 13b2-2 of the Securities Exchange Act of 1934, as amended (Exchange Act).  

This latest enforcement action underscores the SEC’s continued focus on loss contingencies and serves as a reminder to directors and officers of the need to carefully assess company disclosures and the statements made to auditors about loss contingencies, including in management representation letters. 

This enforcement action also highlights the challenges often associated with government investigations when making disclosure and/or accrual determinations under Accounting Standards Codification 450-20 (Contingencies—Loss Contingencies). The loss contingency at issue in this latest matter involved an SEC investigation into the company’s investment in a separate biotechnology company. A chronology of relevant events is as follows:

  • 2014. SEC commences an investigation into the company’s investment in a certain biotechnology company.
  • November 2014. The then CFO forwards a letter to the company’s auditor from the company’s outside counsel regarding the SEC’s investigation. Thereafter, nothing was updated or disclosed to that auditor (or the successor auditor).
  • March 2015 – November 2017. SEC Division of Enforcement sends multiple subpoenas to the company and its officers and directors seeking documents and testimony related to the investigation.
  • April 2017. SEC Division of Enforcement sends a Wells Notice to the company’s counsel, which indicated that the SEC intended to recommend to the Commission that it charge someone with violating the federal securities laws. 
  • May 2017. Company responds to the Wells Notice.
  • June 2017 – December 2017. Company receives additional subpoenas from the SEC Division of Enforcement and holds meetings with senior SEC staff about the recommended charges and potential settlement options.
  • January 24, 2018. Counsel for the company and its board chair sends a settlement offer to the SEC’s Division of Enforcement. An SEC attorney responded and indicated (i) that any settlement offer must include an injunction prohibiting further violations of Section 7(a) of the Investment Company Act and a civil penalty and (ii) that the SEC’s process was moving forward.
  • January 26, 2018. Counsel for the company and its board chair responds to the SEC attorney, indicating that if the company and its board chair could come up with a counter offer, they would present it. No counter offer is presented. 
  • March 5, 2018. A text string among the company’s board chair and the then CEO and then CFO notes “with the SEC complaint only days/weeks away from being served … we really need to get this 10-K filed ASAP.”
  • April 2, 2018. Company files its Form 10-K for its fiscal year ended December 31, 2017. That Form 10-K does not include any mention of the pending SEC investigation.

Generally speaking, ASC 450-20 requires disclosure of a loss contingency when “there is at least a reasonable possibility that a loss or an additional loss may have been incurred . . . .” In its complaint, the SEC asserts that by April 2, 2018, when the company filed its Form 10-K for the fiscal year ended December 31, 2017, it was reasonably possible that the company would incur a material loss in connection with the SEC investigation because: 

  1. the SEC staff [had advised the company that it] intended to recommend charges and a civil penalty against [the company]; 
  2. settlement discussions with the SEC’s staff had broken down; 
  3. any penalty would be material; and 
  4. an SEC action was likely coming, and coming soon.

Consideration of the above elements frequently involves highly fact-specific inquiries, and depending on the stage and nature of the investigation, information may be known only to the government agency. Accordingly, when making disclosure and/or accrual determinations, it is incumbent upon the company’s officers, accountants and legal advisors to consider all relevant facts and circumstances associated with a pending government investigation. For instance, in this enforcement action, among other points, the SEC alleges that it had communicated potential penalty ranges to the company and that the company acknowledged to the SEC staff that any monetary relief against the company would “effectively kill” the company.

For officers signing management representation letters, and others making verbal representations to auditors more generally, care should be taken when aware of a pending government investigation. In this enforcement action, management received audit inquiries on January 31, 2018 with several questions, including: “Does management have knowledge of any violations or possible violations of federal, state, or other regulatory body, laws and regulations?” Management allegedly responded “no,” despite being aware of the pending government investigation. Similarly, the board chair allegedly responded on February 1, 2018, to an audit inquiry that he had no knowledge of “any situations where the company may not be in compliance with any federal or state laws or government or other regulatory body regulations,” or “of violations or possible violations of laws and regulations.” The SEC claims that management’s and the board chair’s responses were materially false and misleading because each respondent knew of the SEC’s investigation into the company’s violation of the federal securities laws and plan to recommend bringing charges. The SEC’s complaint stated, “A reasonable auditor would have wanted to consider the SEC’s investigation and the SEC staff’s plan to recommend charging [the company] in order to plan and carry out an audit to determine if [the company’s] financial statements were presented in conformity with GAAP.”

This latest enforcement action follows some notable developments this year involving loss contingencies, including the Second Circuit’s ruling in Noto v. 22nd Century Group, 35 F.4th 95 (2d Cir. 2022) that plaintiffs had succeeded in stating a claim that failure to disclose an SEC investigation violated Rule 10b-5, thus, potentially intensifying the pressure to err on the side of earlier reporting of government investigations in SEC reports. These and other developments are worth monitoring as companies conduct good faith assessments as to whether a possible pending enforcement action should be disclosed.


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