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On a Friday afternoon in a relatively placid week, the chief financial officer asks to drop by to see her company’s chief counsel for a few moments. She says she has just received a report on a spot internal audit, occasioned by an anonymous suggestion some weeks earlier. As a result of the spot audit, the CFO nervously states that she believes “we have a significant problem.” She goes on to explain that, apparently, the company, which sells specialized software, has recognized revenue for software that was not really sold, and is significantly overvalued. She explains further that software revenue is generally recognized upon shipment of the product. It appears, however, that the marketing department had engaged in a sort of pyramid scheme: Orders were solicited for a new software product, and the products were shipped — but under a tacit agreement with the buyer that the invoice would never be paid and the product never actually delivered. Instead, in six or nine months, the customer would place an order for, and receive, a second generation of the software and pay a total price significantly discounted from the invoice amount for the first-generation software. The CFO reports that the basic information came from an administrative employee in the marketing department who had become uncomfortable with this practice. The CFO reports that the audited financial statements of the company for at least the last year, or perhaps longer, are significantly in error because they greatly overstate revenue. ACCOUNTING IRREGULARITIES DRAW INCREASED ATTENTION Improper revenue recognition is but one of many “creative accounting” situations that raise the specter of significant exposure to legal liability, both civil and criminal, due to erroneous or false financial statements. Other examples include “accruals of future losses and general ‘reserves’ or ‘cushions,’ use of unsupportable depreciable lives, and misapplication of the concept of materiality.” Lynn E. Turner, chief accountant, Securities and Exchange Commission, Speech to the 39th Annual Corporate Counsel Institute(Oct. 12, 2000). The SEC has issued Staff Accounting Bulletins (SABs) that address many of these issues and are available on the SEC Web site, www.sec.gov. In particular, SABs 99 (materiality), 100 (accounting for one-time events) and 101 (revenue recognition) should be considered required reading. These issues have gained increased attention as a result of several recent cases. Last year, for example, a major telecommunications company consented to pay $3.5 million in civil penalties for improperly reporting advertising expenses — incurred from mailing free computer disks — as an asset on its balance sheet. Currently, the SEC is investigating several well-recognized corporate names for accounting improprieties. In one, an established manufacturer of telecommunications equipment is alleged to have engaged in a combination of sales-practice abuses and false revenue recognition specifically for the purpose of inflating numbers to meet revenue projections. These cases portend increased attention and action by the appropriate enforcement authorities. Tellingly, the SEC has launched the Financial Fraud Task Force as a separate unit within the Division of Enforcement to focus solely on misstated financials. The task force is the result of “an alarming increase in financial reporting improprieties by public companies.” Paul R. Berger, associate director, SEC Division of Enforcement, Speech to American Institute of Certified Public Accountants(Dec. 5, 2000). According to Mr. Berger, 362 companies have restated their financials since 1997, and shareholder suits over restatements increased by 750 percent from 1992 to 1998. Indeed, Mr. Berger stated, “Every week, one or more companies announce that they will be restating earnings or revenues in a way that is tied to revenue recognition problems or other potential accounting violations.” As a result of these increased irregularities in financial reporting, the SEC plans to review one out of every four annual reports filed last year. See Robert A. Bayless, chief accountant, SEC Division of Corporate Finance, Speech to The Practising Law Institute(March 2, 2001). Notably, prosecutors last year obtained convictions in 62 of the 64 cases in which indictments were returned due to referrals by the SEC. In Mr. Berger’s words, “if you become involved in an investigation that is being conducted by the Task Force, fasten your seatbelts.” Other principal catalysts for enforcement actions are civil suits by shareholders, creditors and others alleging damages as a result of reliance on erroneous or falsified statements. For example, the equipment manufacturer mentioned above was sued by a class of shareholders for materially overstating revenue. Similarly, a class of shareholders is suing another well-known company alleging that a financial statement improperly recognized uncollectible receivables. The allegations in these suits become fodder for enforcement authorities, often prompting investigations and, in selected cases, prosecutions. The legal implications of these cases can be quite serious. On the civil side, there is potential liability to shareholders, other investors and creditors who relied on audited financial statements and related data to make investment and business decisions. Typically, claims of material misstatements concerning revenue can be brought under � 10(b) of the Securities Exchange Act of 1934 (and SEC Rule 10b-5) as well as � 20(a) of the Exchange Act. Other types of financial reporting improprieties can lead to liability under more specific provisions. SEVERAL STATUTES PROVIDE BASES FOR PROSECUTION On the criminal side, the potential liability is equally broad. Any false information provided to the SEC runs afoul of federal criminal statutes, including the broad proscription against making any false material statement to a federal agency. 18 U.S.C. 1001. When false financial statements are provided to investors, there is the potential for mail- and wire-fraud allegations (18 U.S.C. 1341 and 1343, respectively), which, in turn, can support both money-laundering and RICO allegations. 18 U.S.C. 981 et seq. (forfeiture provisions), 1956-57 (money-laundering offenses) and 1961 et seq. (RICO). If there is concerted activity among management or business units, or between a company and its outside audit personnel, the possibilities for a prosecution for conspiracy to defraud the United States by impeding and impairing the functions of a regulatory agency (such as the SEC), increase markedly. 18 U.S.C. 371. As a practical matter, one of the principal methods prosecutors use to select cases is to assess corporate culture and intent. One legal doctrine of significance plays into that analysis. Established federal case law permits a substitution of “conscious avoidance” for actual knowledge in establishing criminal intent. Prosecutors are permitted to prove knowledge by the production of evidence that shows that management officials turned a blind eye toward an obvious illegality. A conscious-avoidance jury instruction “permits a finding of knowledge even when there is no evidence that the defendant possessed actual knowledge.” U.S. v. Ferrarini, 219 F.3d 145, 154 (2d Cir. 2000). The exercise of prosecutorial discretion is another factor that plays an important role in whether a case will be treated criminally. Criminal prosecution is usually reserved for the most egregious cases. In cases involving financial reporting improprieties, factors such as evidence of high-level management involvement in an affirmative effort to mislead auditors, and thus investors, about a company’s finances will weigh significantly in the decision whether to prosecute. Other factors that play a significant role in this determination include affirmative efforts after discovery of a potential problem to continue to mislead regulators, investors or other interested parties so as to obstruct or impair investigations or inquiries. This “obstruction factor” suggests very strongly that the way a corporation addresses a potential problem of this nature can have a great effect on whether it becomes a criminal issue. The level of media and other public attention to this issue is likely to result in increased attention by regulators, plaintiffs’ counsel and others in a position to seek liability for fraud or other falsehoods in financial statements. Accordingly, corporate counsel have a responsibility to anticipate these problems, seek to prevent them and be prepared to address them should they arise. COUNSEL CAN TAKE SEVERAL STEPS TO REDUCE RISKS On the prevention front, there are a few common-sense steps that corporate counsel can take to assess the risk for potential problems. First, counsel can work with the CFO and others to examine internal accounting practices and interactions with outside auditors with an eye towards spotting any irregularities. Second, counsel can talk with the CFO regarding the legal implications of accounting and reporting irregularities, thereby raising consciousness regarding these issues and highlighting counsel’s availability to assist in assessing potential problems. Third, it would seem advisable to establish, in conjunction with the CFO and the internal audit department, contact with auditors during the annual financial audit process. The purpose of this communication would be to put up an early-warning radar array for potential issues or problems. In addition, counsel can assist by making sure that auditors are provided with all necessary information and access to personnel in order to produce the most accurate and reliable financial statements. In this regard, it is worth noting that reference to (or refuge in) accepted accounting standards and auditing practices may protect the auditors but may not be sufficient for the corporation to avoid liability. Lastly, particularly for smaller companies where both counsel and the CFO may need the assistance of outside experts to undertake such a process, all of this should be done as a legal project, affording the protection of privilege to the resulting work. When prevention has failed and a problem of this nature arises, clearly it is appropriate to obtain the assistance and expertise of outside counsel, given the potential civil and criminal liability that may result. There are also several initial steps in assessing the situation that may assist corporate counsel in reaching preliminary conclusions about the nature and extent of any problems. First, facts are critical. When there is a sign of a problem, an effort to investigate the issue and determine reliable facts upon which further judgments and recommendations can be made is essential. Second, financial managers should be cautious about initiating any discussions with the accounting firm that performed the financial audit. Plaintiffs’ counsel and/or prosecutors may well see such contact, particularly if it results in no action, as some effort or conspiracy to obstruct justice and otherwise confederate on factual defenses to potential allegations. Next, senior management should be informed at the earliest appropriate moment, and its imprimatur is to be sought for aggressive remedial action. This can be critically important to a prosecutor’s assessment of corporate culture and intent should the matter become the subject of enforcement proceedings. CAREFUL THINKING GOES INTO CORRECTING STATEMENTS Of course, one of the most difficult issues that a company can face is correcting financial statements. The provisions that require registrants to make accurate financial reports also compel restatement of financials when there is a material change in circumstances. Such restatement of financials, however, should be undertaken in a manner designed to be as low-key and as non-provocative toward enforcement authorities as circumstances permit. In some situations, it may be appropriate to affirmatively contact regulatory authorities to provide advance information of a restatement and seek to allay any concerns they may have about the underlying circumstances. As put by Associate Director Berger, any “cooperation must be early, meaningful, and complete.” Such candor can also be part of a good public relations strategy to deal with these difficult circumstances. Having a good public relations strategy, of course, goes hand-in-hand with a positive legal strategy that can help prevent these circumstances from turning into a full-blown corporate crisis. George J. Terwilliger III is a partner in the Washington, D.C., office of New York’s White & Case.

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