Failure to Disclose as Fraud Under the Securities and Exchange Act

photo - expanded SOX liability by Gwan KhoCorporate officers face an ever expanding and deepening pool of potential legal liability when it comes to running their business and making (or not making) disclosures about it. A recent case involving the federal Securities and Exchange Commission (SEC) and a Florida computer equipment company is an example, according to an SEC press release.

The SEC’s approach in this case may increase practical exposure to liability for corporate officers who sign financial statements and certifications required under Section 302 of the Sarbanes-Oxley Act (“SOX”).

  • The SEC used a new theory of fraud against the former CEO (Marc Sherman) and CFO (Edward Cummings) of Quality Services Group, Inc. (QSGI), a business that filed for bankruptcy in 2009.
  • The SEC claims that Sherman misrepresented the extent of his involvement in evaluating internal controls and that he and Cummings were aware of significant internal controls issues with the company’s inventory practices that they failed to disclose to investors and internal auditors.
  • The case doesn’t involve a restatement of financial statements or claims of accounting fraud, just disclosure issues concerning internal controls and involvement in a review of the same by senior management.

To show an actionable misstatement, the SEC claims that Sherman and Cummings signed,

  • Form 10-Ks with false management reports on internal controls, and
  • SOX certifications in which they falsely represented that they had evaluated the management report on internal controls and disclosed all significant deficiencies to auditors.

The SEC says the Form 10-K SOX management reports were false because,

  • They contained assertions that management, with the participation of Sherman and Cummings, evaluated internal controls using a specified framework, but Sherman didn’t participate and was unfamiliar with the framework, and
  • Two internal controls problems that Sherman and Cummings were aware were not reported to the company’s external auditors.

The charges against Sherman and Cummings include violations of the Securities Exchange Act of 1934,

  • Section 10(b): prohibiting the “use of any device, scheme, or artifice to defraud” in connection with the purchase or sale of a security, and
  • Section 13(b)(5): forbidding knowing falsification of a public company’s books and records or knowing circumvention of a public company’s internal controls.

The SEC contends this caused QSGI to violate of Section 13(b)(2) of the statute, which requires public companies to make and keep accurate books and to devise and maintain effective internal accounting controls .

Cummings settled the case without admitting or denying the claims, resulting in a $23,000 civil penalty and minimum five-year bars from appearing in front of the SEC as an accountant and as acting as an officer or director of a public company. Sherman has not settled the claims against him.

The SEC stated that corporate executives have “an obligation to take the Sarbanes-Oxley disclosure and certification requirements very seriously” in its press release. The case appears to be an instance of SEC’s “Broken Windows” strategy (to pursue small infractions on the theory that minor violations lead to larger ones) to public company disclosure and accounting.

Securities Exchange Act and SOX laws can be complex and compliance can be challenging. Failure to comply, both because of actions and failures to act, can result in lawsuits and enforcement actions by the SEC. If you have questions about these areas of law, or your company is subject to legal action under these laws, contact my office so we can talk about your situation and your legal options.