Saving Your Stock When the SEC Comes Calling
More than a decade ago, the New York Times kick-started an examination of the business practices of Computer Associates International, Inc., a global software company with a market value of $20 billion, more than Nike or Lockheed Martin. The formal investigation that followed the 2001 Times story consumed the US Attorneys’ Office, the FBI, and the Securities and Exchange Commission.
For a time, Computer Associates executives obstructed the government’s investigation. They withheld documents and made false statements. They covered up.
But what eventually unraveled was a deception that made national headlines. For more than two years, Computer Associates had inflated its quarterly earnings reports by recognizing revenue from software contracts that hadn’t been executed.
The executives accomplished the fraud partly by extending fiscal quarters to recognize additional revenue prematurely, a technique they called “the 35-day month.”
For one quarter in 2000, they opted not to apply the technique—and failed to meet earnings estimates. On the first business day after the quarter close, Computer Associates’ stock price plummeted 43 percent.
Ultimately, the company was forced to restate $2.2 billion in sales as a result of this misrepresentation. A committee later appointed by the board of directors described it as “a massive accounting fraud perpetrated by the company’s senior-most executives.”
LAW & ORDER
Given the ensuing multi-year period of concealment (and eventual disclosure) of charges filed and agreements made, a casual observer might not appreciate the lengths that regulators went to in order to enforce the law. Instead, the case may seem like one more justification for the common-place opinion that, as Associate Professor Gerald Martin has put it, “executives who cook the books end up getting just a slap on the wrist.”
Martin himself once was prone to this view. Before he started researching the data on enforcement actions against financial misrepresentation, he recalled, “I hadn’t yet really questioned this somewhat popular notion that penalties are often a bit slight relative to the conduct involved.”
But in the 1990s, shortly after becoming CEO of an aviation financial services company, Martin discovered that one of the partners to whom he reported was attempting to cheat another.
Fortunately, the harm was discovered in time to be rectified, but the experience left its mark. No longer was financial misrepresentation some- thing Martin had only heard about; now he’d actually witnessed it. Years later, he began to gather comprehensive data on the phenomenon. He has since published and presented findings on the legal penalties for financial misrepresentation and the cost to firms of cooking the books.
Now, in collaboration with Rebecca Files of the University of Texas at Dallas and Stephanie Rasmussen of the University of Texas at Arlington, Martin has written a comprehensive article on the monetary benefit of cooperation in regulatory action.
“Regulators cannot optimally enforce laws against misconduct without some element of corporate self-reporting and cooperation,” the authors wrote.
Although the general importance of cooperation has long been known, regulators haven’t always emphasized it as a tool of enforcement per se. Martin noted that the SEC first publicly acknowledged the benefits of cooperation to enforcement in an October 2001 release:
Our willingness to credit such behavior in deciding whether and how to take enforcement action benefits investors as well as our enforcement program. When businesses seek out, self-report and rectify illegal conduct, and otherwise cooperate with Commission staff, large expenditures of government and shareholder resources can be avoided and investors can benefit more promptly.
Currently, the SEC and the Department of Justice follow principles stated in pertinent manuals and sentencing guidelines to credit cooperation in enforcement actions.
However, “of necessity, they’re general guidelines,” Martin said. “Some members of chambers of commerce, for example, would love it if you could quantify for them exactly what sorts of cooperation correlate to particular credit” against the ultimate costs that otherwise might be imposed.
Of course, since no two cases are identical, such detail isn’t possible. Even if it were, “regulators wouldn’t want to specify it since that would deprive them of bargaining power.”
Although regulators do make public statements in their proceedings, Martin said, “to indicate that cooperation influenced…monetary penalties,” the lack of detailed analysis of that influence has prompted some corporate managers to question whether the benefits of providing cooperation are, in fact, worthwhile.
And so, the researchers concluded, industry professionals have been skeptical about precisely how much cooperation firms should extend to regulators.
SHOW OF MERCY
In an analysis that laid the groundwork for the study, Files sampled 127 instances wherein the SEC exercised leniency in enforcement actions involving companies that restated earnings. This more limited inquiry showed that cooperation in such cases was associated with a somewhat higher chance of being sanctioned by the SEC at all, and with a lesser monetary penalty.
Still, it remained for the professors to address the larger, more comprehensive question: What features are common to firms that cooperate, and under what sorts of circumstances do they do so? If—as the regulators’ public statements of crediting would suggest—cooperation actually reduces the ultimate financial loss to a firm, then just how much money do you save, on average?
For context, the authors noted, “[T]he average firm sanctioned by the SEC or DOJ for financial misrepresentation pays nearly $17.3 million in fines and penalties to regulators.”
To obtain a thorough enough sampling, the authors analyzed SEC- and DOJ-initiated enforcement actions for financial misrepresentation from 1978 through 2011. So that their valuation of “monetary benefit” would include measurements relating to common stock prices, they limited their sample to the 1,059 enforcement actions involving firms with common equity securities.
THANK YOU FOR YOUR COOPERATION?
It’s clear that regulators heed published guides in deciding on an enforcement action against a particular firm. In the authors’ analysis of actions over the 33-year period they studied, they controlled for those criteria—including the nature and extent of the violation, firm characteristics, and the regulatory environment.
Consistent with prior studies, the research found that cooperating with regulators increases the likelihood—by more than 11 percent—that a firm will be named as a respondent in an enforcement action. Since the likelihood of such an action is already high—nearly 78 percent, regardless of cooperation—this increase is relatively minor.
There also are significant monetary benefits for firms that cooperate with regulators: “Being cited for cooperation by regulators in a[n]… action reduces the firm’s monetary penalty by 34.7 percent.” Conversely, being uncooperative increases the penalty by 53.1 percent. Assuming an average penalty, cooperation translates into a $6 million benefit.
And for companies that conduct independent internal investigations and provide the results to regulators “unconditionally,” monetary penalties to drop by 47.1 percent—an average “savings” of $8.2 million.
“We find that monetary penalties are highly systematic and significantly associated with many criteria considered by regulators, including the direct benefit to the firm, shareholder harm, characteristics of the misconduct, and remedial efforts,” the authors wrote.
Their analysis also produced ancillary findings. For example, firms that are more likely to cooperate tend to have certain things in common, such as a lower relative market valuation (as measured by the market-to-book ratio). The financial misrepresentation of these firms usually centers on foreign bribery charges, is associated with inadequate internal controls, or is motivated by internal or external sales or earnings expectations. More- over, the misconduct does not involve fraud, and the firm responds quickly once leaders become aware of it.
Firms were generally also penalized more when the violation period was longer—thus creating more chance for shareholders to be harmed.
In fact, where underlying violations caused harm to shareholders, the typical investor loss was substantially lower for cooperative firms—55.8 percent—contrasted with approximately 70 percent for uncooperative firms.
The authors also found an impressive overall trend: enforcement actions and cooperation both have increased markedly.
The number of annual enforcement actions for financial misrepresentation has grown, from an average of 13.5 per year during the period 1978–1989, to 30 per year during 1990–1999, to 49.8 per year during 2000–2011.
The proportion of enforcement actions citing firm cooperation also grew—from just 3.1 percent in 1978–1989 to 42 percent in 2000–2011.
“The dramatic rise in credit given in the last decade,” the researchers observed, “may be due to either an increase in cooperation, an increase in regulators’ willingness to credit, or both.”
A NEW PERSPECTIVE
“This research turned me 180 degrees from the idea that the penalties were lenient,” Martin recalled. “Clearly, the SEC and the other agencies are finding ways to proportionately reward cooperation.”
Mere observation without in-depth analysis, he pointed out, would likely miss this fact because these enforcement actions take a long time to complete.
“The average length of time from when a violation begins—when illegal activity first started to occur—to the very end, the last regulatory action, is eight years.”
Studying the data, he said, “you can see how firms that cooperate want to ferret out the harm. They get just as mad as shareholders do when a rogue executive or staffer has been violating the law, and they want to do the right thing.
“But you’re talking about a long, long time frame.”
The enforcement action against Computer Associates, he said, pointedly illustrates both sides of this dynamic.
The company’s initial failure to cooperate constituted, as the US Attorneys’ Office put it, “the most brazen and most comprehensive obstruction that we’ve witnessed in recent history.”
But about two and a half years after federal investigations began, in mid-2004, the company accepted responsibility for its conduct, according to the SEC.
Acknowledging that, as a result of the conduct of certain executives and other employees, it had made false statements and obstructed investigations, Computer Associates reached a settlement agreement with the government in September 2004. The company agreed to pay $225 million in restitution, fire the offending officers and employees, change its management, and accept independent monitoring to ensure future compliance.
The US Attorneys’ Office agreed to defer prosecution, citing the company’s “continued cooperation.” By the time enforcement actions concluded in 2007, eight executives had pleaded guilty to charges of federal securities fraud and/or obstruction of justice. For seven of them, the penalties amounted altogether to about $80 million; four were sentenced to prison terms. But of these seven executives, the SEC said in a public announcement, five also agreed “to cooperate with the prosecution.”
“The Monetary Benefit of Cooperation in Regulatory Enforcement Actions for Financial Misrepresentation,” Rebecca Files, Gerald S. Martin, and Stephanie J. Rasmussen, was published in 2012.