Financial Statement Representations in Acquisition Transactions
Barry S. Augenbraun and Ernest Ten Eyck, 47(1): 157–66 (Nov. 1991)
Most acquisition agreements contain representations with respect to the financial statements of the acquired company. The authors argue that the standard form of representations, based upon general purpose financial statements, may not effectively serve the needs of the buyer and may result in future disputes or litigation against the seller. This is because certain fundamental premises of financial reporting and the auditing process do not readily lend themselves to the economics of these transactions. They suggest ways in which buyers, sellers, and outside auditors might better approach these issues.
"Management" Reports on Internal Control: A Legal Perspective
Committee on Law and Accounting, 49(2): 889–946 (Feb. 1994)
Much attention has been devoted in the last several years to the subject of internal accounting controls, and "management" reports thereon, in Congress and elsewhere. The Committee of Sponsoring Organizations of the Treadway Commission has published an extensive report on internal controls, and the Law and Accounting Committee of the Section of Business Law has issued its own Report which explores the liability implications, and recommendations concerning terminology, of such a "management" report.
Environmental Liability Disclosure and Staff Accounting Bulletin No. 92
Richard Y. Roberts and Kurt R. Hohl, 50(1): 1–17 (Nov. 1994)
As society strives to maintain and to improve the environment, operating companies incur costs that may need to be disclosed to investors under the federal securities laws. These environmental costs have reached staggering proportions in recent years and are one of the critical issues facing businesses today. The large dollar amounts involved have produced increased pressure on the SEC to monitor the adequacy of disclosures by publicly held companies and to provide guidance to companies regarding offsetting, discounting, and other disclosure matters. This Article provides an evolution of disclosure requirements for contingent liability and analyzes the future of environmental liability disclosure in light of Staff Accounting Bulletin No. 92.
Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants
Task Force on Rule 102(e) Proceedings, 52(3): 965–89 (May 1997)
Under rule 102(e) of its Rules of Practice, the SEC may sanction accountants, lawyers, and other professionals who "practice before the Commission." If the SEC provides the professional with notice and the opportunity for a hearing, it can sanction that professional on a determination that the professional engaged in what the rule describes as "improper professional conduct." Although rule 102(e) is now in its seventh decade of existence, the criteria used by the SEC in determining what constitutes "improper professional conduct" remain far from well-defined. This Report: (i) provides a brief overview of the provisions of rule 102(e), as well as the historical bases for the imposition of sanctions under the rule; (ii) considers the limitations on the SEC's authority to impose rule 102(e) sanctions; (iii) examines the SEC's conception of what constitutes improper professional conduct by an accountant as announced in a recent opinion; (iv) discusses the standards applicable to other situations in which the SEC seeks to restrict the ability of an individual to participate in a particular business or profession; (v) surveys the other authorities that regulate the professionalism of licensed accountants; and (vi) provides a summary of the Report and sets forth the Task Force's recommendation.
Liabilities of Lawyers and Accountants Under Rule 10b-5
Lewis D. Lowenfels and Alan R. Bromberg, 53(4): 1157–80 (Aug. 1998)
Following the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994), which abolished aiding and abetting liability in private actions, accountants and lawyers remain potentially liable to nonclients under rule 10b-5 on grounds of primary liability in connection with their clients' securities fraud. The recent decisions with respect to both accountants and lawyers involve alleged misrepresentations or nondisclosures in the communications of the respective professionals or their clients with investors. Predictability, particularly in the cases involving accountants, is difficult because many of the decisions are irreconcilable and give little certainty. The cases involving lawyers are somewhat less irreconcilable but, as yet, cannot be said to have formed a clear, coherent pattern. In summary, the "certainty and predictability" that the Supreme Court had hoped to achieve in Central Bank have not yet been realized with respect to the liabilities of either accountants or lawyers to nonclients under rule 10b-5.
Clarifying and Protecting Materiality Standards in Financial Statements: A Review of SEC Staff Accounting Bulletin 99
Kenneth C. Fang and Brad Jacobs, 55(3): 1039–64 (May 2000)
Companies issuing financial statements for many years have solely used quantitative methods to determine materiality. In August 1999, the SEC released SAB 99 eliminating this practice. SAB 99 now requires companies to use a qualitative analysis to determine the materiality of misstatements or omissions. Although qualitative materiality must be used in some instances, with this almost purely subjective test, companies are now left open to liability for arguable choices in judgment. Furthermore, SAB 99 leaves open the question of issuer liability for immaterial misstatements contrary to standing statutory guidance and case law.
The Securities and Exchange Commission's Revised Auditor Independence Rules
William R. McLucas and Paul R. Eckert, 56(3): 877 (May 2001)
In November 2000, the Securities and Exchange Commission unanimously adopted major revisions to its auditor independence rules. These revisions focused on two principal areas of auditor independence. First, the SEC liberalized the restrictions that prohibited accountants and their family members from any investments in, or employment by, SEC audit clients. Second, the SEC identified so-called non-audit services that threaten independence when provided to SEC audit clients. This Article examines the Commission's final rule on auditor independence and compares the provisions contained in the final rule against not only the existing independence rules and the proposal first announced in June 2000, but also the existing rules of the AICPA and the work of other private standard-setting organizations such as the Independence Standards Board and the Panel on Audit Effectiveness. The Article also examines some of the events that led to the Commission's decision to engage in rulemaking in the auditor independence area and the practical consequences of certain of the compromises reflected in the final rule.
Financial Statement Fraud: The Boundaries of Liability Under the Federal Securities Laws
Richard C. Sauer, 57(3): 955 (May 2002)
Accurate information about public companies is fundamental to the operation of our capital markets. The recent spate of major accounting scandals, however, reminds us that the reported performance of public companies can be highly vulnerable to manipulation. The result is the squandering of billions in investor funds and the erosion of faith in the securities markets. This Article describes common approaches employed to misrepresent the operating results of public companies. Taking examples from recent SEC enforcement actions, it discusses a range of earnings management techniques and analyzes their status under present standards of legal liability, with particular emphasis on those areas of financial reporting in which standards are unclear or evolving.
Sharing Accounting's Burden: Business Lawyers in Enron's Dark Shadows
Lawrence A. Cunningham, 57(4): 1421–62 (Aug. 2002)
Enron-type accounting debacles illustrate that prevailing professional cultures create a crevice between law and accounting that resolute fraud artists exploit, rather than an intersection of law and accounting that should foil would-be fraudsters. The increasing significance of accounting matters in business law practice demands that competent business lawyers grasp basic accounting principles. Yet the resources devoted to teaching the subject by the legal academy have declined dramatically in recent decades. Partly to blame for law school neglect of accounting was the ascendancy of modern finance theory's efficient market hypothesis—stories that relegated accounting to the rear of the academic bus. The string of accounting debacles highlighted by Enron show the folly and fantasy of these stories. Law schools and firms must reverse the trend toward accounting neglect, for the lawyer's ethical duty of competence arguably mandates this skill set for business lawyers and, in any event, should do so.
Cautious Evolution or Perennial Irresolution: Stock Market Self-Regulation During the First Seventy Years of the Securities and Exchange Commission
Joel Seligman, 59(4): 1347–87 (Aug. 2004)
One of the most significant concepts in federal securities regulation is that of SEC supervision of industry self-regulation. As developed during the New Deal, securities industry self-regulation was based on two concepts. First, the impracticality of direct SEC regulation of several thousand broker-dealer firms and business corporations subject to SEC jurisdiction and second, a preference for business with its greater practical knowledge of its own affairs to participate in the development and application of SEC rules and reduce the likelihood of unnecessary disruption or inefficiency. Far from being a panacea, industry self-regulation subject to SEC supervision historically has repeatedly been beset by significant dysfunction beginning with the need for a reorganization of the New York Stock Exchange in 1937–1938. The enactment of the Sarbanes-Oxley of 2002 offers a new approach to the self-regulation of public accountants that includes greater separation of the industry from the self-regulator; new funding mechanisms; and a single self-regulator for an entire industry. This article analyzes the extent to which such an approach may be appropriate for stock market self-regulation.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Independent Directors as Securities Monitors
Hillary A. Sale, 61(4):1375-1412 (August 2006)
This paper considers the role of independent directors of public companies as securities monitors. Rather than engaging in the debate about whether independent directors are good or bad, important or unimportant, the paper takes their existence and basic governance role as a given, focusing instead on what recent statements from Securities and Exchange Commission officials indicating an increased focus on independent directors and their role in preventing securities fraud. The paper notes that the SEC believes that independent directors are on the board to act, at least in part, as securities monitors. This securities monitor role is another aspect of the information-forcing-substance disclosure model that the SEC has used to achieve improved corporate governance. Although directors face heightened risk when they draft or sign disclosure documents, they also have an ongoing responsibility to be informed of developments within the company, ensure good processes for accurate disclosures, and make reasonable efforts to assure that disclosures are adequate. Independent directors with expertise should be involved in reviewing and, sometimes, drafting statements. All directors, however, should be fully aware of the company's press releases, public statements, and communications with security holders and sufficiently engaged and active to question and correct inadequate disclosures. In addition to defining the role of independent directors as securities monitors, the article reviews the liability independent directors might face under private causes of action and contrasts it with the SEC's enforcement powers and remedies. The article describes some of the SEC's prior statements that emphasize the role of independent directors as securities monitors and the importance of their providing both guidance and check and balance.
Internal Investigations and the Defense of Corporations in the Sarbanes-Oxley Era
Robert S. Bennett, Alan Kriegel, Carl S. Rauh, and Charles F. Walker, 62(1): 55–88 (Nov. 2006)
Internal investigations long have been an integral part of the successful defense of corporations against charges of misconduct, as well as an important board and management tool for assessing questionable practices. With the heightened standards of conduct and increased exposure created by Sarbanes-Oxley, this essential instrument for safeguarding corporate interests has become even more crucial in identifying and managing risk in the enforcement arena. This article examines from a practitioner's standpoint when and how internal investigations should be conducted in order to protect the corporation in criminal, civil and administrative proceedings. Particular attention is paid to the issues created by a concurrent government investigation and in dealing with employees and former employees in the course of an investigation. The article also addresses the role of the Audit Committee under Sarbanes-Oxley, and the important issue of reporting the findings of the investigation to appropriate corporate officials. The subject of self-reporting by the Company to enforcement authorities is considered as well. In this context, the article explores the SEC's position on crediting self-reporting and cooperation as set forth in the Seaboard report; Department of Justice policy as embodied in the Thompson Memorandum; and the impact of the Federal Sentencing Guidelines for Organizations.
Jeffrey L. Kwall and Stuart Duhl, 63(4): 1153–1186(August 2008)
Backdating is a much misunderstood and largely unexplored subject. It involves a wide range of conduct, some of which is an integral part of everyday law practice. To the layperson, backdating connotes wrongdoing. The propriety of backdating, however, depends upon its purpose and effect. Every lawyer should be capable of distinguishing legitimate backdating from improper backdating. Unfortunately, the dividing line is often far from clear. Little guidance exists on backdating, notwithstanding its pervasiveness, the complexity of determining its propriety, and the serious consequences of a misjudgment. An in-depth examination of the day-to-day backdating issues that most business lawyers face cannot be found in the literature. This Article begins to fill that void.
This Article explains the different meanings of backdating, explores the reasons why it is difficult to distinguish legitimate backdating from improper backdating, examines the impact of disclosure on the propriety of backdating, and develops an analytical approach to assist business lawyers in wrestling with the difficult situations most will confront in their daily practices. By illuminating the subject, it is hoped that this Article will begin a much-needed dialogue about backdating.
The Clawback Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean
Rachael E. Schwartz, 64(1): 1-36 (November 2008)
The Sarbanes-Oxley Act of 2002, passed in the wake of corporate scandals involving misstated financial reports, included a provision for certain compensation and profits from the sale of company stock to be "clawed back" from chief executive officers and chief financial officers of companies that are required to restate their financials, due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct. Courts have determined that only the Securities and Exchange Commission may sue to enforce this clawback provision. In the six years following passage of the law, there have been Sarbanes-Oxley clawbacks in only a small number of cases, each one an options backdating case involving allegations that the officer affected personally committed fraud. This Article takes the position that the clawback provision has no scienter requirement and its application should not be limited to officers who have personally engaged in misconduct. Rather, the wording of Sarbanes-Oxley, its legislative history, and the policies it serves call for the clawback to be applied to the chief executive officers and chief financial officers of companies that are required to restate their financials due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct, regardless of whether those officers actively participated in the wrongdoing, knew of and failed to correct the wrongdoing, or were oblivious to wrongdoing by employees subject to their control. This general rule can be made subject to an exemption for circumstances involving certain misconduct by non-management employees.
Statement on Effect of FIN 48 on Audit Response Letters
Committee on Audit Responses, ABA Section of Business Law, 64(2): 389-394 (February 2009)
Disclosure Obligations Under the Federal Securities Laws in Government Investigations
David M. Stuart and David A. Wilson, 64(4): 973-998 (August 2009)
With the prevalence of government investigations into corporate conduct, public companies frequently face decisions about whether, when, how, and where to disclose to investors the existence of such investigations and the facts learned in the course of, or as a result of, those investigations. While the federal securities laws (and the rules and regulations promulgated thereunder) require disclosure of specific events that may arise during an investigation, neither those laws nor the courts that have interpreted them provide clear guidance for many of the disclosure decisions that must be made over the course of an investigation. As a result, counsel must carefully analyze numerous facts and circumstances, understand the company's previous disclosures, make "materiality" assessments, and determine whether to make disclosure in a current report or wait until the next periodic filing. This Article seeks to present, through an analysis of precedent disclosures, caselaw, rules, and practical ramifications, the considerations counsel must take into account in evaluating disclosure decisions in the context of an investigation. These considerations can help counsel avoid having a disclosure decision worsen the already difficult circumstances posed by the investigation itself.
SEC Cybersecurity Guidelines: Insights into the Utility Risk Factor Disclosures for Investors
Edward A. Morse, Vasant Raval, and John R. Wingender, Jr., 73(1): 1-34 (Winter 2017/2018)
In October 2011, the SEC issued new guidelines for disclosure of cybersecurity risks. Some firms responded to these guidelines by issuing new risk factor disclosures. This article examines the guidelines and cybersecurity disclosures in the context of existing laws governing securities regulation. It then examines empirical results from firm disclosures following the new guidelines. Evidence shows a relatively small proportion of firms chose to modify their risk factor disclosures, with most firms choosing not to disclose any specific cybersecurity risk. Moreover, disclosing firms generally experienced significant negative stock market price effects on account of making new disclosures. Rather than viewing disclosure as a positive signal of management attentiveness, investors apparently viewed it as a cautionary sign.
Dilution, Disclosure, Equity Compensation, and Buybacks
Bruce Dravis, 74(3) 631-658 (Summer 2019)
Equity compensation and company share buybacks are complementary: Equity compensation share issuances increase outstanding shares; buybacks decrease outstanding shares. Yet the two types of transactions require very different approval processes and securities and financial disclosures, and generate different financial and tax results, all of which are described in this article, and illustrated by data collected from fifty-nine of America’s largest public companies. This article encourages critics of buybacks to consider the complexity and interrelationship of buybacks and equity compensation.
Simple Insolvency Detection for Publicly Traded Firms
J.B. Heaton, 74(3) 723-734 (Summer 2019)
This article addresses current limitations of financial-market-based solvency tests by proposing a simple balance-sheet solvency test for publicly traded firms. This test is derived from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation. The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The solvency test is a generated upper bound on the total amount of debt the firm can have and still be solvent or, alternatively, the minimum amount of stock-market capitalization the firm must have if it is solvent at current debt prices. The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. The method proposed here can identify insolvent firms that should be retaining assets and not paying them out to shareholders as dividends or repurchases, identify stocks that brokers and investment advisers should treat as out-of-the-money call options that may be unsuitable investments, and can help auditors identify publicly traded firms that are candidates for going-concern qualifications and other disclosures.
The ABA Statement on Audit Responses: A Framework that Has Stood the Test of Time
Alan J. Wilson, Stanley Keller, Randall D. McClanahan, Noël J. Para, James J. Rosenhauer, and Thomas W. White, Audit Responses Committee, ABA Business Law Section, 75(3): 2085-2102 (Summer 2020)
This article summarizes key developments in the preparation of audit response letters concerning loss contingencies since the American Bar Association Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information was published in 1976. These developments illustrate both the utility of the framework set forth in the ABA Statement and the responsiveness of the American Bar Association through the Business Law Section Audit Responses Committee (and predecessor committees) to issues arising under the ABA Statement and changes in accounting and auditing standards and practice.
The Evolution and 2020 Status of Cooperation in SEC Enforcement Investigations
Dixie L. Johnson, Carmen J. Lawrence, and Jamie Stinson 75(4): 2427-2466 (Fall 2020)
When facing potential enforcement action from the Securities and Exchange Commission (“SEC”), companies often seek to mitigate the consequences by cooperating with the SEC in one or more of the following ways: self-policing, self-reporting, remediation, and cooperation. While a 2001 SEC report of investigation known as the Seaboard Report provides a roadmap for what steps to take in order to earn cooperation credit and describes generally the potential benefits to be received, no such report or guidance exists that details exactly what tangible benefits a company will receive in return for the earned credit and how it will be determined. In addition, outside of narrow exceptions where the SEC engages in self-reporting initiatives, companies looking for publicly available guidance on how best to cooperate face a lack of consistency in the SEC’s settlement documentation describing cooperation factors and what benefits may be earned.