Private Companies Not Immune to the SEC

Under the 'Lying to the Auditors' provision, companies can be hit with costly, damaging investigations
By: Jason A. Copling
Dallas Business Journal
December 23, 2005

Since the passage of Sarbanes-Oxley in 2002, the Securities and Exchange Commission has made it very clear that publicly traded companies will be held accountable for any misstatements in their financial statements.

While privately held companies have been largely unaffected by this legislation, it is important to keep in mind that private companies are not immune from the SEC. Recently, many private companies have been prosecuted for participating in a public company's securities fraud — specifically, for providing false information to a public company's independent auditors.

The SEC, using the "Lying to the Auditors" provision of the federal securities laws, has brought numerous civil and criminal actions in the last few years against both private and public companies and their executives for "aiding and abetting" the securities law violations of public companies. Fines in these actions regularly exceed $50,000 per incident and have surpassed $10 million in one of the most egregious cases.

There are four typical fact patterns that the SEC has focused on. Brief descriptions of the two most common categories follow:

Consignment sales: A consignment sale case involves a public company selling a product to a distributor who, in turn, resells the product to a third party. The distributor typically has an agreement with the public company, either orally or in writing, that payment is not due from the distributor until the product is resold to the third party. The public company, however, recognizes all of the revenue from the transaction immediately upon sale to the distributor, as if the transaction were a true sale rather than a consignment. Upon questioning from the public company's independent auditors, the distributor fails to note the true terms of the transaction.

Revenue pull-forward: A revenue pull-forward case usually involves a public company that acts as a wholesaler or retail seller of a manufacturer's goods. Within this kind of relationship, a manufacturer will often grant the seller credits for selling certain volumes of goods or promoting the manufacturer's product in the seller's advertisements. The seller will use those credits to offset expenses in their financial statements. In a revenue pull-forward case, the seller leans on the manufacturer to allow the seller to recognize the credit before it is actually due, which causes the credit to be offset against expenses which have not yet occurred and gives the impression that the seller earned more profit on the same revenue than it actually did. When the seller's independent auditors seek confirmation of the reason for and amount of the credit, the manufacturer fails to disclose its true terms.

The SEC has taken the position that, in addition to prosecuting the public companies for securities fraud, it is also entitled to prosecute the companies on the other side of the transactions. As noted earlier, the SEC uses the "Lying to the Auditors" provision of the federal securities laws to prosecute companies who mislead independent auditors by signing incorrect audit confirmation letters, and many times even prosecutes the actual individuals involved.

An SEC investigation into a company's practices can be very damaging and expensive. The most important step in preventing this type of conduct is to educate employees about the importance of being completely honest with the independent auditors of a public company. If a transaction seems even a little suspicious, the company should investigate thoroughly before responding to an audit confirmation request. A quick primer on potential personal exposure and a reminder of the substantial cost of an SEC investigation and fine should drive the point home nicely.