Search for:

The U.S. Securities and Exchange Commission (“SEC”) recently filed a law enforcement action for failure to disclose loss contingencies arising out of a pending U.S. Department of Justice (“DOJ”) investigation.  This is the first SEC case that directly charges violations of the duties arising out of the requirements to disclose loss contingencies as that term is defined in the accounting literature.  The case highlights a difficult issue with which management and counsel are often confronted during ongoing law enforcement investigations:  disclosure duties arising from findings made in management’s own internal investigation into the facts, and duties concerning the disclosure of such findings to the government.

The SEC brought the enforcement action against RPM International Inc. (“RPM”) and its general counsel and Chief Compliance Officer Edward W. Moore (“Moore”).  The suit alleges that RPM failed to disclose to the SEC and its own audit committee an $11m overcharge to the government that RPM discovered and disclosed during a DOJ investigation into one of RPM’s wholly owned subsidiaries.  The DOJ investigation, which began in 2011, culminated in a $61 million False Claims Act (“FCA”) settlement with the DOJ.

According to the SEC’s complaint, RPM, an American multinational company, owns subsidiaries that manufacture and market high-performance coatings, sealants and specialty chemicals, primarily for maintenance and improvement applications.  In 2011, DOJ began investigating RPM and its wholly-owned subsidiary in response to a qui tam FCA complaint alleging that the subsidiary overcharged the federal government on certain government contracts.

The SEC alleges that RPM learned of the investigation in 2011 and that by late September 2012, RPM’s outside counsel had estimated that the subsidiary had overcharged the federal government by at least $11 million.  On October 1, 2012, RPM sent DOJ a written estimate which calculated the subsidiary overcharge at $11.4 million (a sum representing only part of the time period for only one of the relevant contracts and excluding any potential multiplier for FCA violations).

Following the company’s confirmation of the overcharge and disclosure to the DOJ, Moore failed to alert RPM’s CEO, CFO, Audit Committee, and independent auditors (the “audit firm”) of the overcharge, the disclosure to DOJ, or any loss contingencies concerning DOJ’s investigation.  Instead, on October 1, 2012, Moore signed a management representation letter stating that he had not represented RPM in connection with material loss contingencies exceeding $1.2 million.  On October 4, 2012, RPM filed a Form 10-Q, failing to disclose any information about the DOJ investigation.  For over a year, RPM did not address the DOJ investigation or related loss contingencies in any of its SEC filings or communications with the company’s audit committee.

Even after RPM disclosed the DOJ investigation and recorded a loss contingency accrual in April 2013 in its SEC filings, the SEC complaint alleges that it continued to fail to disclose material weaknesses in RPM’s internal controls concerning financial reporting and disclosures.  In August 2014, RPM filed amended restatements and SEC filings for the three quarters corresponding with the DOJ investigation, finally disclosing DOJ’s investigation and accurately reflecting related accruals.

According to the SEC’s complaint, “[a] public company facing a loss contingency, such as a lawsuit or government investigation, is required under accounting principles and securities laws to (1) disclose the loss contingency if a material loss is reasonably possible, and (2) record an accrual for the loss contingency if a material loss is probable and reasonably estimable.”  The complaint asserts that RPM faced a material loss that was both probable and reasonably estimable, but RPM failed to disclose “material facts” when required to so do.  The SEC’s complaint charges RPM with violating antifraud provisions of the federal securities laws, Sections 17(a)(2) and (a)(3) of the Securities Act of 1933; the reporting provisions of the federal securities laws, Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder; and the books and records and internal controls provisions of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act.  The complaint also charges Moore with violating Sections 17(a)(2) and (a)(3) of the Securities Act and Rules 13b2-1 and 13b2-2 under the Exchange Act.  The SEC seeks permanent injunctions, disgorgement of ill-gotten gains and interest, as well as penalties.

Regardless of the outcome, this case highlights the complexity of disclosure duties arising from ongoing disclosures to the government during an investigation.  Accepting the complaint’s allegations, once the company quantified the amount of the contractual overcharge in its ongoing investigation and reported it to the DOJ, the company was required to reassess its loss contingency disclosures.  Because the quantification of the amount of the loss to the DOJ was “reasonably estimable,” it met the accounting threshold for an accrual.  Further, the SEC highlights the risk of a FCA multiplier as material to determining the amount of any accrual.

Whether the materiality threshold is met, triggering the need for disclosure, is of course a question of fact in any given case.  The SEC position in the RPM complaint is that the threshold was met because RPM’s audit firm requested disclosure of amounts in excess of $1.2 million.  This benchmark — the threshold amount at which outside auditors request disclosure of claims – is a question for the auditors and management; it has not previously been considered by practitioners to be the equivalent of the materiality threshold for SEC filings.

By commencing an enforcement action in these alleged facts, the SEC emphasizes the importance of these disclosure responsibilities not only by issuers, but also their counsel.  More broadly, this case highlights the inherent tensions between the need for candor to government investigators and the desire to avoid unnecessary  investor uncertainty and reputational harm, as well as the potential pitfalls of nondisclosure of even small loss contingencies to audit personnel.

The full text of the SEC complaint can be found at: https://www.sec.gov/litigation/complaints/2016/comp23639.pdf.

Author

Daniel L. Goelzer has a strategic role in the Baker & McKenzie's global corporate, securities, and banking compliance practices. He has more than 35 years of securities law experience, including service in senior positions at both the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). The SEC appointed him as a founding member of the PCAOB, and he served as the Board’s Acting Chairman from 2009 to 2011. He is also a former General Counsel of the SEC and a former Vice Chair of the International Forum of Independent Audit Regulators. He writes and speaks frequently on national and international securities laws and accounting industry issues.

Author

Maurice Bellan is a Washington, DC. based partner and is Vice-Chair of the Firm's North America Litigation and Government Enforcement Practice Group. He also leads the Firm's False Claims Act practice and advises clients on a broad range of fraud and anti-corruption matters. Maurice is a former trial attorney at the US Department of Justice and has been named by Savoy magazine as one of the most influential African-American lawyers in the United States.range of concerns involving fraud and anti-corruption, focusing on the US Foreign Corrupt Practices Act and the False Claims Act. A former criminal investigator and trial lawyer at the US Department of Justice, Mr. Bellan has over 20 years of complex investigative, civil and criminal litigation experience. He was a former member of the judicial nominating committee of the Maryland bar and has served on the boards of organizations such National Senior Campuses, Inc. and the Downtown Columbia Arts & Culture Commission.

Author

Laura K. Clinton is a partner in Baker & McKenzie’s Washington, DC office. She assists clients involved in securities litigation and complex commercial disputes. She has significant court experience, having conducted civil and felony jury trials, bench trials, and a wide variety of administrative hearings and arbitrations. She represents clients before all levels of the Washington state courts and in federal courts throughout the country. Currently, Ms. Clinton represents numerous victims of the Madoff Ponzi scheme in adversary proceedings brought by the trustee for the bankruptcy estate of Bernard L. Madoff Investment Securities. Ms. Clinton focuses her pro bono work on issues affecting survivors of domestic violence, and has counseled in domestic violence cases for agencies including the Northwest Immigrant Rights Project, the King County Domestic Violence Revision Squad, and DV LEAP. In fact, she was repeatedly recognized by the Washington State Bar Association for her pro bono legal work. She argued the Washington Supreme Court case that set standards for the protection of domestic violence victims, and has authored several recent amicus briefs on legal issues affecting survivors of violence.

Author

Richard A. Kirby is a partner in the Litigation Practice Group at Baker McKenzie, Washington, DC. Mr. Kirby litigates complex corporate, securities, bankruptcy and administrative law issues. Mr. Kirby also represents clients in SEC, Justice Department, state and self-regulatory organization law enforcement investigations and in parallel private securities fraud and derivative actions. He has participated on behalf of clients in most of the major recent broker-dealer liquidations under the Securities Investor Protection Act, including Lehman Bros., and Bernard L. Madoff Investments Securities, LLC. He specializes in representing victims of Ponzi schemes.