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Cady Bar the Door Insight & Commentary on SEC Enforcement Actions and Related Issues

Financial Fraud Specialists at the SEC

Posted in Accounting Fraud, Financial Fraud

We live in a world where people do not always do what I wish they would do.  I imagine you’re probably okay with that; I’m coming to terms with it.  But here is an example of something I think should happen that probably won’t:  The SEC should create a sixth specialized unit in the Enforcement Division devoted to financial fraud.  FTI Consulting’s Marty Wilczynski recently made this case in greater detail than I’m going to do here.  More recently, though, SEC Chair Mary Jo White and her Co-Enforcement Director George Canellos said they don’t think that’s a necessary step for the Commission to take.

Still, the SEC did bring a case in early June that I think reinforces Wilczynski’s point.

PACCAR, Inc.

On June 3rd, the Commission sued commercial truck manufacturer PACCAR, Inc. in the Western District of Washington for accounting deficiencies stemming from three separate issues.  First, for five years PACCAR failed to report the operating results for its parts business as a reportable segment, as required by GAAP.  Accordingly readers of its reports may not have been able to understand PACCAR’s business as seen by the Company’s executives.  Second, during 2009 PACCAR failed to maintain accurate books and records regarding its impaired loans and leases. As a result, the company’s disclosures of impaired receivables were understated.  Third, PACCAR made overstatements in equal and offsetting amounts to loan and lease originations and collections for two foreign subsidiaries in its statement of cash flows for two quarters in 2009.

I want to focus on the first issue.  As the SEC’s complaint says, in its 2009 10-K, PACCAR’s Truck segment reported nearly $7 billion in net sales and revenues, with income before income taxes of $25.9 million. Though PACCAR separately reported gross margins for its truck business and its parts business, PACCAR allegedly did not separately report income before income taxes from truck sales and aftermarket parts sales.

But . . . GAAP and Commission rules require an issuer to report specified information about reportable segments that meet certain criteria. A component of an enterprise is a reportable segment if it: (1) engages in business activities from which it may earn revenues and incur expenses; (2) has operating results that are regularly reviewed by the company’s “chief operating decision maker” to make decisions about resources to be allocated to the segment and assess its performance; and (3) has discrete financial information available.  Since at least 2008, the SEC alleged, PACCAR’s aftermarket parts operations met the segment reporting criteria and should have been reported as a separate segment.

First, PACCAR allegedly conducted its parts business through PACCAR Parts, a separate division from PACCAR’s truck divisions with a separate headquarters building and separate management team. PACCAR Parts maintained its own set of internal financial statements and reporting documents, which reflected that the company’s parts business earned revenues and incurred expenses.

Second, PACCAR’s “chief operating decision maker” regularly (and allegedly!) reviewed parts operating results to make resource-allocation decisions and assess performance.  He reviewed parts operating results, including a profit contribution by region, on a monthly basis.  He also worked with PACCAR’s board and executive operating committee on allocating resources throughout the Company and its various divisions, including approving PACCAR Parts’ annual capital budget and approving the establishment of PACCAR’s parts distribution centers, some of which were independent of the Company’s truck factories.

Finally, though PACCAR did not allocate many shared costs to its aftermarket parts operations, PACCAR allegedly maintained discrete financial information for its aftermarket parts activities such as internal parts financial statements, a parts profit contribution measure contained in a profit and loss statement, and other financial information.

In reporting its truck and parts results as a single segment, PACCAR allegedly did not enable investors to see it “through the eyes of management,” as GAAP requires.  The SEC brought claims under Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, as well as Rules 12b-20, 13a-1, and 13a-13.

Specialize It

Now, raise your hand if you think the SEC’s enforcement staff intuitively understands the facts or the law involved here.  Some of them, especially the accountants, surely do.  But most are generalist lawyers who do not automatically know that “GAAP and Commission rules require an issuer to report specified information about reportable segments that meet certain criteria.”  They just don’t.  And that’s not even a criticism!

The breadth of rules that any SEC enforcement staff member potentially has to cover is truly staggering.  The arcana of the Investment Management Division are quite different from the arcana of the Trading & Markets and Corporation Finance Divisions, but at different times the enforcement staff have to be conversant in all of it.  A specialized unit devoted to financial fraud would become skilled at these cases.  It would also create a base of lawyers who could take calls from other staff and with a fair degree of confidence be able to say, “Yes, I’ve seen this before.  Here’s what you need to think about and do to make your case.”  As it stands, it can be hard to know who to call to get those answers, and many SEC staff take fact patterns that are new to them and struggle alone to figure them out.  I suspect a specialized unit for financial fraud would add a lot of efficiency to what can be tough cases to solve.