Saturday, November 8, 2008

GM says could be out of cash; raises a going concern issue?

I noticed the following headline this week:

GM reports $2.5B 3Q loss, says running out of cash (AP)
AP - General Motors Corp. said Friday it lost $2.5 billion in the third quarter and warned that it could run out of cash in 2009 if the U.S. economic slump continues and it doesn't get government aid.

For accounting and finance professionals -- does this raise a going concern issue for GM and its auditor? And, will prospective buyers be more likely to now avoid purchasing a GM vehicle, thus further increasing going concern issues? Perhaps consideration should have been given to using different wording.

For further relevant going concern accounting literature, consider the following new (October 9, 2008) Proposed Statement of Financial Accounting Standards relating to Going Concern issues.

For your reading enjoyment, the following is additional background information from the introduction to the proposed new standard:

This proposed Statement would provide guidance on the preparation of financial statements as a going concern and on management’s responsibility to evaluate a reporting entity’s ability to continue as a going concern. It also would require certain disclosures when either financial statements are not prepared on a going concern basis or when there is substantial doubt as to an entity’s ability to continue as a going concern. Currently, AU Section 341, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, of the AICPA Codification of Statements on Auditing Standards contains the guidance about the going concern assessment. The Public Company Accounting Oversight Board (PCAOB) adopted AU Section 341 on an initial, transitional basis and has subsequently amended that interim standard.

The FASB is responsible for establishing standards that guide the overall presentation of an entity’s financial statements and related disclosures. The Board believes that accounting guidance about the going concern assumption should be directed specifically to management of a reporting entity because management is responsible for preparing an entity’s financial statements and evaluating its ability to continue as a going concern. Accordingly, the Board concluded that guidance about the going concern assumption also should reside in the accounting literature established by the FASB and decided to issue this proposed Statement.

The Board decided to carry forward the going concern guidance from AU Section 341, subject to several modifications to align the guidance with International Financial Reporting Standards (IFRSs). One of those modifications is to change the time horizon for the going concern assessment. AU Section 341 states that there is “a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited” (paragraph .02). International Accounting Standard (IAS) 1, Presentation of Financial Statements, requires that an entity consider “all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period” (paragraph 26) when assessing whether the going concern assumption is appropriate. The Board decided to use the time horizon in IAS 1 because it avoids the inherent problems that a bright-line time horizon would create for events or conditions occurring just beyond the one-year time horizon that are significant and most likely would have to be disclosed.

The other modifications to align the going concern guidance with IFRSs include (1) using the wording in IAS 1 with respect to the type of information that should be considered in making the going concern assessment (all available information about the future) and (2) requiring an entity to disclose when it does not present financial statements on a going concern basis. The Board thinks there is no substantial difference between the wording in IAS 1 and the wording previously included in AU Section 341 with respect to the type of information that should be considered in making the going concern assessment. Therefore, the Board does not expect this modification to result in a change to practice.

Dave Tate

Tuesday, October 7, 2008

Needed: mandatory CPE in (1) technical expertise, and (2) responsible decision making!

Some readers are probably aware that as I have shifted some of my focus from discussions about hard technical accounting, auditing and legal issues, to situational and governance discussions analyzing the issue: "how could this have happened?", I have come upon the belief that a significant amount of misfeasance and malfeasance is caused not only by a lack of technical understanding and expertise, but also by the failure of the person to act “responsibly” during the decision making process. To act “responsibly,” or “responsible decision making” in this context means that the person understands his or her duties and responsibilities (and to whom those duties and responsibilities are owed), and then goes about satisfying those duties and responsibilities in good faith to the best of his or her ability through diligent issue spotting, inquiry, investigation, analysis and decision making without self- or conflict of interest.

As I read the news, SEC cases and other materials, there seems to be a significant lack of “responsible” decision making. Now, I do not believe that mandatory CPE will necessarily cure that problem outright, but I do believe that it would help focus attention on the issue, and prompt or help guide many basically honest people to actively advocate for and act in a more responsible manner by using prudent decision making procedures. So . . . I do suggest that a reasonable, not overly burdensome amount of CPE should be mandatory in two broad primary areas for people in certain professions or positions. Those two broad areas are: (1) technical knowledge needed to perform the person’s job or function; and (2) responsible decision making, as discussed above, which would include in-class examples and discussions. How about 16 hours of mandatory annual CPE for officers and directors of public companies, for officers and directors of nonprofit organizations (or at least for officers and directors of nonprofits that exceed a certain threshold amount of annual revenue), and for our federal and state elected representatives in the Legislature? A minimum of 8 hours of annual in-person classroom time in each of the two above-mentioned broad topic areas (technical knowledge; and responsible decision making).

Dave Tate

Saturday, October 4, 2008

Link to a discussion about the new Form 990

The following is a link to a short discussion about the new Form 990 for nonprofit tax reporting entities.

Friday, October 3, 2008

N.Y Times article, '04 SEC rule change allowed investment banks to leverage

Here is one interesting article discussing a 2004 SEC rule change that allowed investment banks to take on considerably more investment debt, in part becoming a contributing factor in the current financial fiasco:

Sunday, September 21, 2008

How did this happen--the bailout--its not the first time--accountants weigh in please!

The current bailout isn’t the first time something like this has happened. As I understand the situation (and please correct me if I am wrong), the value of real estate has declined, and there are too many problem or uncollectible mortgages. Didn’t that happen in the 1980s with the savings and loan debacle? On the one hand, on a large or grand scale, it can be difficult to estimate or value when real estate will decline in value, and, for the most part, in general real estate as a whole does not decline in value. However, as I understand the situation, in the late 1990s or the early 2000s Congress eased the Fannie Mae and Freddie Mac loan qualifying requirements allowing for more risky loans to be made (such as with no money down, or without proof of income). That action, if true, was ill-advised. Does anyone view Congress as being prudent when it comes to issues of money or finances? I don’t. It has also been discussed for some number of years that the real estate market is over heated, and that values may drop. Of course, whether values would drop, and the amount of anticipated drop would be difficult to estimate. How should the lenders take those factors, and the amount of reserves, into consideration? How should the regulatory agencies take those factors into consideration? How should the outside auditors take those factors into consideration? I understand that the outside auditor may well be entitled to take the loan/property appraisals at face value. The point of this discussion is not to find fault. The point is to identify the weaknesses in the system, and to correct those weaknesses so as to better prevent a problem of this magnitude from happening again in the future. And, the problem is a very big problem, which will be paid for by the taxpayers. As I see it, not too long ago a similar fiasco occurred. It is way too early for a similar problem to have occurred. This time the weaknesses in the system need to be fixed. What do you think? How do we fix the problems?

Dave Tate, CPA, Esq.

Sunday, September 14, 2008

Corporate climate change disclosures: Xcel Energy settlement with Cuomo

The following is a link discussing corporate climate change disclosures relating to the Xcel Energy settlement with Cuomo.

Saturday, September 13, 2008

Auditing firm liable for allowing company to go deeper into insolvency

The following link is to the U.S. Court of Appeals, Third Circuit opinion upholding a verdict against PwC for an alleged negligent audit which allowed the insurance company which it was auditing to go deeper into insolvency.

Deloitte paper, When CFOs Debate

The following is a somewhat interesting paper published by Deloitte, When CFOs Debate. The paper discusses a few of the issues that CFOs face, and then goes one additional step by providing point and counterpoint discussion. The paper is limited in the "advice" category.

Friday, September 12, 2008

IFRS coming to an audit committee near you?

On August 27 the SEC voted to publish for public comment a proposed Roadmap that could lead to the use of International Financial Reporting Standards (IFRS) by U.S. issues beginning in 2014, or earlier. The SEC proposes to make a final decision in 2011 whether adoption of the IFRS is in the public interest and would benefit investors. The possible adoption of IFRS by U.S. issuers has been seriously discussed for at least the past couple of years. Based on this latest action by the SEC, and the volume of IFRS guidance published by the large accounting/auditing firms, adoption of the use of IFRS appears likely. What might adoption mean for audit committees? Audit committee member financial literacy would suggest a future need for some additional committee member continuing education about the differences between IFRS and GAAP. Additionally, generally IFRS tends to be less rules and more principles based, requiring the company and the audit committee to exercise (and justify) greater accounting method discretion and judgment. Some current audit committee members might not be interested in making the effort to learn the important aspects of IFRS, or in having to deal with the conversion process, or in the additional effort that may be required to exercise judgment on a greater number of accounting issues.

For your information, the following is a link to an EY paper that summarizes differences between IFRS and GAAP.$file/us_gaap_v_ifrs.pdf

Sunday, August 31, 2008

Governance lessons learned from SEC v. Con-way

Governance lessons learned from SEC v. Con-way, Inc.
Dave Tate, Esq. ;


On August 27, 2008 the SEC entered a Cease and Desist Order ("Order") against Con-way, Inc. ("Con-way") (Securities Exchange Act of 1934 Release No. 58433). Con-way consented to the entry of the Order without admitting or denying the findings, except as to the SEC’s jurisdiction over it and the subject matter of the proceedings. The findings, although not admitted and rather sparse on detail, nevertheless provide insight, lessons and missed opportunities. This discussion is organized in the following order: Summary; Comments, Lessons Learned and Missed Opportunities; and Details of the Cease and Desist Order.

In pertinent part, the Order alleges that Con-way is a public company, listed on the New York Stock Exchange. Menlo Worldwide Forwarding, Inc. was a wholly-owned U.S-based subsidiary of Con-way that Con-way purchased in 1989. During the relevant period, Menlo Forwarding had a 55% voting interest in Emery Transnational ("Emery"). As alleged by the SEC, “this matter involves Con-way’s violations of the books and records, and internal controls provisions of the Foreign Corrupt Practices Act (“FCPA”) through a Philippine-based firm, Emery Transnational. From 2000 to 2003, Emery Transnational made hundreds of small payments totaling at least $417,000 to Philippine customs officials and to officials of numerous majority foreign state-owned airlines. These payments were made with the purpose and effect of improperly influencing these foreign officials to assist Emery Transnational to obtain or retain business. In connection with these improper payments, Con-way failed to accurately record these payments on the company’s books and records, and knowingly failed to implement or maintain a system of effective internal accounting controls.”

Comments, Lessons Learned and Missed Opportunities

1. As alleged, the payments in question, although numerous, appear individually not to be material in amount. From the information provided it is not possible to determine whether the amounts would be material in total. Of course, materiality can be quantitative and qualitative in nature. An unlawful act can be material qualitatively, even if it is not material quantitatively. Quantitative materiality also may depend on whether it is viewed from the perspective of Con-way or from the perspective of Emery. In light of the disparity in size between Con-way and Emery, the transactional occurrences at Emery may have simply fallen under the radar screen.

2. Nevertheless, illegal payments are unlawful, and internal controls are required, even at subsidiaries. Thus, the SEC alleges that Con-way knowingly failed to implement or maintain a system of effective internal accounting controls. Without additional background information, such a conclusion appears harsh. “Knowing” failure to implement effective controls may imply intentional wrongdoing. The factual allegations do not support an inference of intentional wrongdoing. However, companies, officers, internal auditors, boards and audit committees should take note that lack of attention to internal controls may prompt an allegation of “knowing” failure to implement.

3. The outside auditor was required to evaluate internal controls for the purpose of performing its annual audit of Con-way‘s consolidated financial statements. Additionally, Statement on Auditing Standards (SAS) 99 required the auditor to consider the risks of fraud and related programs and controls, and Statement on Auditing Standards 54 required the communication of information pertaining to unlawful acts. Although new Auditing Standards 109, 112, and 114 had not yet been enacted during the relevant period in question, SAS 60 (communicating internal control related matters) and SAS 61 (auditor’s communications) were applicable. Additionally, Sarbanes-Oxley §404 (management’s assessment of internal controls) and §302 (chief executive and chief financial officer financial statement certification) were applicable during part of the period in question. The SEC missed an opportunity to evaluate and comment on how this situation did not come to the attention of the outside auditor. Alternatively, if the situation did come to the attention of the outside auditor, the SEC missed an opportunity to comment about how it could or should have been handled differently. The Order does not provide information from the outside auditor perspective. Even if the Order is limited to a cease and desist against Con-way, more detailed discussion about the other participants, as dicta, would help other companies, officers, outside auditors, inside auditors, boards and audit committees learn from the situation.

4. The Order does not discuss or provide information from the Con-way audit committee perspective. Such a discussion might have been helpful for other audit committees, especially with respect to governance. The audit committee is required to oversee internal controls. See, e.g., NYSE Listed Company Manual §303A.07 (audit committee composition, and additional audit committee requirements), Sarbanes-Oxley §301 (public company audit committee requirements), and Sarbanes-Oxley §407 (disclosure of audit committee financial expert). Management and the audit committee, and the outside auditor and the audit committee are also required to communicate regarding internal controls.

5. The Order also does not discuss or provide information from the internal audit perspective. New York Stock Exchange Listed Company Manual §303A.07 requires each listed company to have an internal audit function. Curiously, NASDAQ does not have such a requirement. Working with the audit committee, and with management, it may have been possible to use internal audit to evaluate and report on subsidiary internal controls and payments. A discussion in the Order about how internal audit was or was not used might have been helpful from a governance learning perspective.

These are my initial thoughts that readily come to mind. I am sure that other people will have other thoughts. What are your opinions about the events and circumstances leading to the Cease and Desist Order, and the Order itself? Please feel free to drop me an email. See below for additional detail about the Cease and Desist Order.

Dave Tate

Details of the Cease and Desist Order

The Cease and Desist Order in part alleges:

“During the relevant period, Con-way and Menlo Forwarding engaged in little supervision or oversight over Emery Transnational. Neither Con-way nor Menlo Forwarding took steps to devise or maintain internal accounting controls concerning Emery Transnational, to ensure that it acted in accordance with Con-way’s FCPA [Foreign Corrupt Practices Act] policies, or to make certain that its books and records were detailed or accurate.

During the relevant period, Con-way and Menlo Forwarding required only that Emery Transnational periodically report back to Menlo Forwarding its net profits, from which Emery Transnational then paid Menlo Forwarding a yearly 55% dividend. Menlo Forwarding incorporated the yearly 55% dividend into its financial results, which were then consolidated in Con-way’s financial statements. Neither Con-way nor Menlo Forwarding asked for or received any other financial information from Emery Transnational. Accordingly, neither Con-way nor Menlo Forwarding maintained or reviewed any of the books and records of Emery Transnational – including the records of operating expenses, which should have reflected the illicit payments made to foreign officials.

Emery Transnational made hundreds of small payments to foreign officials at the Philippines Bureau of Customs and the Philippine Economic Zone Area between 2000 and 2003 in order to obtain or retain business. These payments were made to influence the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. By these payments, foreign officials were induced to: (i) violate customs regulations by allowing Emery Transnational to store shipments longer than otherwise permitted, thus saving the company transportation costs related to its inbound shipments; and (ii) improperly settle Emery Transnational’s disputes with the Philippines Bureau of Customs, or to reduce or not enforce otherwise legitimate fines for administrative violations.

To generate funding for these payments, Emery Transnational employees submitted a Shipment Processing and Clearance Expense Report (“SPACER”) to Emery Transnational’s finance department. These SPACER reports requested cash advances to complete customs processing. The cash advances were then issued via checks made payable to Emery Transnational employees, who cashed the checks and paid the money to designated foreign officials. Unlike legitimate customs payments, the payments at issue were not supported by receipts from the Philippines Bureau of Customs and the Philippine Economic Zone Area. Emery Transnational did not identify the true nature of these payments in its books and records. During the period 2000 to 2003, these payments total at least $244,000.

Emery Transnational, in order to obtain or retain business, also made numerous payments to foreign officials at fourteen state-owned airlines that did business in the Philippines between 2000 and 2003. (Footnote omitted). These payments were made with the intent of improperly influencing the acts and decisions of these foreign officials and to secure a business advantage or economic benefit. Emery Transnational made two types of payments. The first type were known as “weight shipped” payments, which were made to induce airline officials to improperly reserve space for Emery Transnational on the airplanes. These payments were valued based on the volume of the shipments the airlines carried for Emery Transnational. The second type were known as “gain shares” payments, which were paid to induce airline officials to falsely under-weigh shipments and to consolidate multiple shipments into a single shipment, resulting in lower shipping charges. Emery Transnational paid the foreign officials 90% of the reduced shipping costs.

Both types of payments to foreign airline officials were paid in cash by members of Emery Transnational’s management team. Checks reflecting the amount of the “weight shipped” and “gain shares” payments were issued to these managers, who cashed the checks and personally distributed the cash payments to the foreign airline officials. Emery Transnational did not characterize these payments in its books and records as bribes. During the period 2000 to 2003, these payments totaled at least $173,000. Neither Con-way nor Menlo Forwarding requested or received any records of these payments, or any of Emery Transnational’s expenses, during this period.”

The Cease and Desist Order further in part alleges:

1. Con-way’s books, records, and accounts did not properly reflect the illicit payments made by Emery Transnational to Philippine customs officials and to officials of majority state-owned airlines, and that as a result, Con-way violated Exchange Act Section 13(b)(2)(A). The FCPA, enacted in 1977, added Exchange Act Section 13(b)(2)(A) to require public companies to make and keep books, records and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer, and added Exchange Act Section 13(b)(2)(B) to require such companies to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: (i) transactions are executed in accordance with management’s general or specific authorization; and (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and to maintain accountability for assets. 15 U.S.C. §§ 78m(b)(2)(A) and 78m(b)(2)(B).

2. Con-way also failed to devise or maintain sufficient internal controls to ensure that Emery Transnational complied with the FCPA and to ensure that the payments it made to foreign officials were accurately reflected on its books and records. As a result, Con-way violated Exchange Act Section 13(b)(2)(B).

3. Exchange Act Section 13(b)(5), 15 U.S.C. § 78m(b)(5), prohibits any person or company from knowingly circumventing or knowingly failing to implement a system of internal accounting controls as described in Section 13(b)(2)(B), or knowingly falsifying any book, record, or account as described in Section 13(b)(2)(A). By knowingly failing to implement a system of internal accounting controls concerning Emery Transnational, Con-way also violated Exchange Act Section 13(b)(5).

* * * * *

Saturday, August 30, 2008

Climate Change Disclosures

An interesting recent discussion about climate change disclosures from the dandodiary, What's Next: Climate Change Financial Risk Disclosure . Review my earlier blogs for additional discussions.

Thursday, August 7, 2008

IRS allows reformation of CRT in accord with trustor's intent

The IRS has issued a private ruling that allows a charitable remainder unitrust to be reformed in accordance with the trustor's intent following a court order. The ruling conforms with California law which also holds that a trust should be administered in accord with the trustor's intent.

Full Text:

Third Party Communication: NoneDate of Communication: Not ApplicablePerson To Contact: * * *, ID No. * * *Telephone Number: * * *Index Number: 664.03-02Release Date: 8/1/2008

Date: May 1, 2008

Refer Reply To: CC:PSI:B01 - PLR-100818-08LEGEND:Trust = * * *Trustee = * * *A = * * *D1 = * * *D2 = * * *State = * * *n = * * *Court = * * *Dear * * *:

This letter responds to a letter dated December 21, 2007, and subsequent correspondence, submitted on behalf of Trustee, requesting a ruling that the reformation of Trust, as described below, will not cause Trust to fail to meet the requirements of § 664(d)(2) of the Internal Revenue Code.

FACTS. The information submitted states that A created Trust on D1 under the laws of State. A created Trust with the intention that Trust qualify as a charitable remainder unitrust (CRUT) under § 664(d)(2). Trustee is the trustee and charitable remainder beneficiary of Trust. Trustee and A represent that A's intention upon establishing Trust was that the term of Trust would extend until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A, with payments during that term being made to A, then to A's spouse if surviving, then to A's issue by right of representation. The original Trust agreement provides that the unitrust amount is payable to A until A's death, and thereafter, to A's spouse until the death of A's spouse.

A and Trustee arranged the terms of Trust in a series of telephone conversations. A was assisted by certain family members, but no professional tax advisor assisted A with the creation of Trust. Trustee and A represent that several months after signing the Trust agreement, but within the same taxable year of the donation, they discovered that Trust did not accurately express A's intent as to the term of the payments and the ability of A's children to receive payments after the death of A and A's spouse.

Because of the error, and because Trust is irrevocable, Trustee sought an order from Court authorizing a reformation ab initio of Trust. No parties objected to the proposed reformation. On D2, Court issued a judgment approving the reformation of Trust, ab initio, to reflect A's intention as described above. The reformed Trust agreement provides that the term of Trust extends until the later of (i) the date of death of the survivor of A and A's spouse; or (ii) the earlier of the 20th anniversary of D1 or the date of death of the last surviving child of A. The reformed Trust agreement further provides that payments during Trust's term will be made to A, then to A's spouse if surviving, then to A's issue by right of representation. The judgment states that Court finds by clear and convincing evidence that, due to mistakes in the expression of A's intent, Trust failed to accurately implement A's intent. The judgment is contingent on receipt of a favorable private letter ruling from the Internal Revenue Service. State law permits the reformation of a trust to conform to the settlor's intent.

Trustee and A represent that they have not filed any income tax returns or other documents, taken any other action or received any payments inconsistent with Trust, including the proposed changes. A, A's spouse, Trustee, and the attorney general of State all consent to the reformation of Trust.

LAW AND ANALYSIS. Section 664(d)(2) provides that for purposes of § 664, a charitable remainder unitrust is a trust (A) for which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid not less often than annually, to one or more persons (at least one of which is not an organization described in § 170(c) and, in the case if individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals, (B) from which no amount other than the payments described in § 664(d)(2)(A) may be paid to or for the use of any person other than an organization described in § 170(c), (C) following termination of the payments described in § 664(d)(2)(A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in § 170(c) or is to be retained by the trust for such a use, and (D) with respect to each contribution of property to the trust, the value (determined under § 7520) of such remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date such property is contributed to the trust.

Section 1.664-3(a)(3)(ii) of the Income Tax Regulations provides that a trust is not a charitable remainder unitrust if any person has the power to alter the amount to be paid to any named person other than an organization described in § 170(c) if such power would cause any person to be treated as the owner of the trust, or any portion thereof, if Subpart E, Part 1, Subchapter J, Chapter 1, Subtitle A of the Code were applicable to such trust.

Section 1.664-3(a)(4) provides that a charitable remainder unitrust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in § 170(c).

CONCLUSION. Based solely on the information submitted and the representations made, we conclude that the judicial reformation of Trust, ab initio, does not violate § 664. Accordingly, we conclude that the judicial reformation, ab initio, of Trust does not adversely affect Trust's qualification as a charitable remainder unitrust under § 664(d)(2).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether Trust is or was a charitable remainder unitrust within the meaning of § 664(d)(2).

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to Trust's authorized representative.

Sincerely,Audrey EllisSenior Counsel, Branch 1(Passthroughs & SpecialIndustries)Enclosure (1)Copy of letter for § 6110 purposescc: * * *

Sunday, June 8, 2008

Audit Committee, CEO, CFO, Internal Audit, Outside Auditor Hypothetical

Audit Committee, CEO, CFO, Internal Audit, Outside Auditor Hypothetical:

The following is a hypothetical based at least in part on a real occurrence. How do you believe the various parties should handle the situation?

1. The internal auditor and the CEO disagree about whether an item should be booked currently, or left as an unadjusted error and booked over time.

2. If the item is not currently booked, the current unadjusted amount would be a material.

3. One option is to book the unadjusted error amount now.

4. Is it relevant that it is believed that competing companies will not be booking their amounts
for similar items?

5. Another option is to not currently book the amount, but to leave the current amount as an unadjusted error--although the unadjusted item is currently material, the unadjusted error will be booked over time such that by the time that a financial report is to be issued to the shareholders the remaining unadjusted error will have been reduced to an amount that is not material. This this additional information influence your belief as to how the situation should be handled?

6. What if the CEO believes that the unadjusted error should be currently booked, and internal audit believes otherwise? What if the CEO believes that the unadjusted error should not be currently booked, and the internal auditor believes otherwise?

7. What if in the hypothetical it is not internal audit, but the CFO (i.e., you exchange the CFO for internal audit)?

8. What if the outside auditor believes that the amount should be currently booked? What if the outside auditor does not believe that the amount should be currently booked? Does that change the discussion?

9. What if whether or not the amount is booked, no financial report is currently due to the shareholders but a financial report still must be currently filed with the regulators?

10. The issue is brought to the attention of the audit committee. What does the audit committee do?

11. What if internal audit or the CFO had contacted the outside auditor to discuss the issue of the adjustment, and now management is also working on adding structure including protocols for when internal audit or the CFO can access outside resources such as the outside auditor? How should protocols be determined? What if protocols are suggested for contact with the audit committee?

12. How do you handle friction that may have developed between the CEO, internal audit, the CFO, the audit committee, and the outside auditor?

* * * * *

Sunday, May 11, 2008

UTStarcom, Inc., SEC action

The following are links to the complaint, offer of settlement, consent and litigation release in the recent SEC proceeding involving UTStarcom, Inc. A copy of the Cease and Desist Order is posted below, with select noted comments to various authorities which may be relevant to the subject (preceded by the notation "DWT Comment:”). Although determinations in these proceedings often do not constitute adjudications or admissions of fact or wrongdoing, the allegations and resolutions can provide insight and interesting reading for outside and internal auditors, governance and compliance professionals, officers, directors (audit committee members), and legal counsel.


Offer of Settlement and Consent

Litigation Release



The Securities and Exchange Commission (“Commission”) deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”), against UTStarcom, Inc. (“UTSI”), Hong Liang Lu (“Lu”) and Michael J. Sophie (“Sophie”) (collectively “Respondents”).


In anticipation of the institution of these proceedings, Respondents have submitted an Offer of Settlement (the “Offer”) which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over them and the subject matter of these proceedings, which are admitted, Respondents consent to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 (“Order”), as set forth below.


On the basis of this Order and Respondents’ Offer, the Commission finds that:


1. This matter involves recurring internal control deficiencies and inaccurate financial filings by UTSI, a publicly-traded telecommunications company that has restated its financial statements three times since 2005 to correct multiple accounting irregularities. Since 2000, UTSI has improperly recognized revenue on transactions subject to undisclosed side agreements, failed to properly disclose and account for related party transactions, and failed to properly record compensation expenses related to employee stock options. Despite being put on notice of potential accounting issues by, among other things, material weakness letters sent by the company’s outside auditors, CEO Hong Liang Lu and former CFO Michael J. Sophie failed to implement and maintain adequate internal controls and falsely certified that UTSI’s financial statements and books and records were accurate.


UTSI, a Delaware corporation with headquarters in Alameda, California, is a telecommunications company that sells software and hardware products in emerging and established telecommunications markets around the world. The majority of UTSI’s operations are in Hangzhou, China and overseas. UTSI went public in 2000, and its common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and trades on the NASDAQ Global Select Market under the symbol UTSI.
Lu, 53, is a co-founder of UTSI and has served as a board member and Chief Executive Officer since 1995. Lu resides in San Ramon, California and Hangzhou, China.
Sophie, 50, was UTSI’s Chief Financial Officer from 2000 through August 2005 and UTSI’s Chief Operating Officer from June 2005 through May 2006. Sophie resides in Pleasanton, California.

DWT Comment: NASDAQ listed companies are not required to have internal audit functions. NYSE listed companies are required to have internal audit functions (Listed Company Manual §303A.07).



Historically, China has been UTSI’s largest market. Between 1995 and 2002, nearly all of UTSI’s revenue derived from sales by UTSI’s subsidiary in China (“UT-China”). By late 2002, UTSI’s business plan was expanded to include growth on an international scale. UTSI defines “international” sales as all sales outside of China, including sales in the U.S., Japan, India, and other overseas markets. In 2003 and 2004, sales in China accounted for 86% and 79% of UTSI’s revenue, respectively. By 2006, sales in China accounted for 32% of UTSI’s revenue. The finance department at UT-China handled the accounting for all transactions in China, and UTSI’s finance department in the U.S. handled the accounting for all international transactions.

6. In March 2003, UTSI received a Management Recommendation letter from its auditors detailing internal control weaknesses identified during the December 31, 2002 year-end audit. The letter was addressed to the audit committee and copied to Lu and Sophie. Among other things, the letter specifically noted that UTSI should “strengthen procedures to ensure side letters and contract amendments are communicated and accounted for in a timely manner.” In its written response to the auditor’s letter, UTSI said it had implemented the necessary controls to track and monitor side letters and non-routine transactions. UTSI sometimes used letter agreements, or side letters, to supplement or amend contractual terms. Such letters were allowed so long as the accounting for them was done properly.

7. UTSI received another Management Recommendation letter from its auditors in April 2004 detailing multiple internal control weaknesses (many classified as material) identified during the December 31, 2003 year-end audit. The letter was copied to Lu and Sophie, and again noted concerns about the use of side letters that were not forwarded to the finance department. The auditors also expressed concerns with many complex related-party transactions entered into by UTSI. The auditors informed UTSI that the company did not adequately disclose significant transactions involving joint venture arrangements between UTSI and its customers. In its written response, UTSI said it had strengthened controls to identify side letters and implemented monitoring procedures to identify significant joint venture transactions.

8. UTSI also received management recommendation letters from its auditors noting multiple material weaknesses in connection with the 2004 and 2005 year-end audits.

DWT Comment: alleged management recommendation letters for 2002, 2003, 2004 and 2005, some of which noted ongoing internal control weaknesses relating to side agreements, contract amendments and related party transactions not being communicated or recorded. Although NASDAQ listed company rules do require the audit committee to have a written charter, there are no specific duties that are enumerated with respect to internal controls. NASDAQ Marketplace Rule 4350(d)(3) in part does require the audit committee to have responsibility for complaints relating to internal accounting controls. Auditing pronouncements applicable to the outside auditor also would be relevant, including the outside auditor's evaluation of internal controls for the purpose of performing the following year audit, and evaluation to determine whether the company had in fact corrected prior year issues.

UTSI Prematurely Recognized Revenue From International Sales Subject To Undisclosed Side Agreements

9. Between 2003 and 2005, UTSI prematurely recognized nearly $50 million in net revenue from international sales, all of which occurred outside the U.S., which were subject to side agreements that had been concealed from the company’s finance personnel. Because these agreements promised future performance by UTSI, revenue should not have been recognized under Generally Accepted Accounting Principles (“GAAP”).

10. Among other contingent transactions, UTSI improperly recognized revenue from the sale of a $22 million network system to a purchaser in India. At the time of the sale, securities analysts had expressed concerns about UTSI’s ability to enter markets outside China, and Lu specifically highlighted this deal as indicative of UTSI’s success in gaining traction in India.

11. UTSI delivered the system and recognized revenue from the $22 million sale in phases over several quarters, including the second quarter of 2004 and the second quarter of 2005. Before recognizing the revenue, UTSI’s finance department required the purchaser to sign a final acceptance certificate certifying that all elements of the phase had been delivered and successfully installed.

12. During the second quarter of 2004, the purchaser sent UTSI the final acceptance certificate, but included a proposed side agreement requiring UTSI to upgrade the system after the end of the quarter. Lu and Sophie were aware of the proposed side agreement. UTSI’s revenue recognition manager, with the knowledge of Lu and Sophie, specifically admonished that approving the side agreement would prevent revenue recognition. Lu personally communicated with the customer to request that they accept the products without a side agreement.

13. Notwithstanding these directions, a UTSI sales executive signed a side agreement with the purchaser, but failed to adequately disclose the agreement to finance personnel, resulting in the improper recognition of revenue by the company. Lu and Sophie failed to take adequate steps to determine how the customer’s request for a side agreement had been resolved and whether revenue recognition was appropriate.

14. During the second quarter of 2005, UTSI recognized additional revenue from the India sale. Once again, a UTSI sales executive had signed a side letter making the customer’s acceptance contingent on future upgrades (and thus rendering revenue recognition improper under GAAP). Lu and Sophie were aware the customer had made such a request, but received a communication from finance personnel that the final acceptance certificates received from the customer were acceptable. Neither Lu nor Sophie took steps to determine how the issue was resolved and whether revenue was properly recognized.

15. In addition to the India transaction, UTSI entered into five other international sales transactions totaling $27.5 million in net revenue where side agreements had been entered into promising future products or services. These side agreements should have precluded revenue recognition. On June 26, 2006, UTSI restated its financial statements for the period between Q1 2003 through Q3 2005, reversing $49.5 million in net revenue that had been improperly recognized by the company.

UTSI Prematurely Recognized Revenue On Sales In China With Undisclosed Contract Modifications

16. Between 2000 and 2005, UTSI prematurely recognized over $350 million in revenue from 78 sales transactions in China. On some occasions, UTSI sales personnel entered into contracts that contained non-standard product upgrade provisions precluding revenue recognition. In some instances, sales personnel documented the sales on two separate contracts, and only the company’s standard contract (without the upgrade provisions) was made available to UTSI’s finance personnel. As a result, UTSI repeatedly recognized revenue for contingent sales in violation of GAAP.

17. Lu and Sophie had been on notice since at least 2003 of significant internal control weaknesses in China, including the fact that in some instances side letters and contract amendments introducing revenue contingencies were not forwarded by sales offices to the contract and finance departments. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper dual contract practices and failed to prevent certain improprieties.

18. On October 10, 2007, UTSI restated its financial statements from 2000 through the second quarter of 2006 to reverse $271 million in net revenue improperly recognized by the company.

UTSI Failed to Disclose and Properly Account for Related Party Transactions

19. In 2001, a China-based company called MDC was formed in order to provide value-added services to UTSI products. The father of UT-China’s Executive Vice President founded MDC; the UT-China executive served as the “alternate” chairman of MDC’s board of directors. Numerous officers and other employees of UT-China invested in MDC, and certain UT-China employees worked for MDC while their salaries were paid by UT-China.

20. In 2003, UT-China entered into a complex transaction involving MDC and another customer in China, whereby MDC took ownership of UTSI inventory that had decreased in value. Because UTSI failed properly to treat MDC as a consolidated entity, no impairment of the inventory value was recorded by UTSI at the time.

21. Lu and Sophie had been on notice of concerns raised by the company’s auditors about UTSI’s failure to adequately disclose related party transactions entered into by UTSI. Although Lu and Sophie took steps to improve internal controls in response to this information, neither those steps nor the resulting controls were sufficient to detect the improper transaction with MDC and failed to prevent inaccurate reporting of certain related party transactions.

22. On April 13, 2005, UTSI restated its 2003 financial statements in part to consolidate MDC, as MDC was deemed a related party controlled by UTSI. The restatement resulted in the write down of $7.5 million in UTSI inventory held by MDC.

UTSI Failed Properly to Account for Stock Compensation Expenses

23. UTSI failed properly to account for certain stock option grants because the company used incorrect grant dates for determining compensation expenses. Under GAAP, UTSI was required to record an expense on its financial statements for any stock options granted “in-the-money” – i.e. where the exercise price of the option was less than the market price for the security on the date the option was granted.

24. Certain grants to UTSI officers were backdated or accounted for with incorrect grant dates prior to the proper authorization of the grant by the company’s Compensation Committee. This resulted in an exercise price below market price on the date of the grant, yet no expense was recorded by the company.

25. UTSI failed to establish and implement adequate internal controls for the granting of employee stock options. Among other things, UTSI failed to maintain necessary documentation showing when the grants were actually authorized by the Compensation Committee.

26. On October 10, 2007, UTSI restated its financial statements from 1998 through the second quarter of 2006 to recognize an additional $27 million in compensation expenses related to employee stock options.

Respondents Lu And Sophie Signed False Certifications Under Section 302 Of The Sarbanes-Oxley Act

27. Lu and Sophie, as UTSI’s CEO and CFO, were required to sign certifications each fiscal quarter and fiscal year stating that, based on their knowledge, the company’s quarterly and annual reports did not contain any misstatements or omit material information, that the reports disclosed all significant deficiencies in the design or operation of UTSI’s internal controls, and that the reports fairly presented in all material respects UTSI’s financial condition and results of operations. Lu executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2006, and Sophie executed such certifications for the quarters and years from the first quarter of 2004 through the second quarter of 2005. For the reasons set forth above, these certifications were false.


28. As a result of the conduct described above, UTSI violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder by filing inaccurate periodic reports with the Commission, by failing to make and keep accurate books and records, and by failing to devise and maintain an adequate system of internal accounting controls. The company filed inaccurate periodic reports and failed to keep accurate books and records because the company improperly recorded revenue for transactions that involved side agreements with revenue contingencies and failed properly to account for related-party transactions and stock compensation expenses. In addition, UTSI failed to devise and maintain an effective system of internal controls relating to side agreements, related parties and stock option practices.

29. As a result of the conduct described above, Lu and Sophie caused UTSI’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder insofar as they did not take steps adequate to ensure that UTSI filed accurate financial statements, made and kept accurate books and records, and implemented and maintained adequate internal controls. Also as a result of the conduct described above, Lu and Sophie violated Exchange Act Rule 13a-14 by falsely certifying that UTSI’s periodic filings did not contain any material misstatements or omissions, disclosed all significant deficiencies in UTSI’s internal controls, and fairly presented UTSI’s financial condition and results of operations.

UTSI’s Remedial Efforts

In determining to accept the Offer, the Commission considered remedial acts undertaken by UTSI.


In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondents’ Offer.

Accordingly, it is hereby ORDERED that:

A. Respondent UTSI cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder;

B. Respondent Lu cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder; and

C. Respondent Sophie cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and from committing any violations and any future violations of Rule 13a-14 thereunder.

By the Commission.

DWT Comment: the SEC requires the company to agree to stop doing the alleged activities.

Friday, May 2, 2008

Another Court Orders Discovery of Special Committee's Materials

In Young v. Klaassan (C.A. No. 2770-VCL, Memorandum Opinion and Order April 25, 2008) the Delaware Court of Chancery ordered the defendants to produce all documents prepared in support of the special committee’s alleged findings. In support of their motion to dismiss the defendants specifically argued that the special committee found no evidence of backdating or other intentional misconduct in connection with the award of grants that were examined, including all of the grants challenged by the plaintiffs. Thus, the defendants themselves put the materials of the special committee at issue, whereupon on plaintiffs’ motion to compel production the Court ordered that the materials of the special committee be produced, citing Fleischman v. Huang, 2007 WL 2410386 (Del. Ch. Aug. 22, 2007). The defendants then offered to strike the references to the special committee in their submissions; however, the Court determined otherwise, finding that the references warrant discovery. Interestingly, the Court suggests that it ordered the production of all materials of the special committee because the committee had not prepared a report. However, report or no report, every special committee should expect that all of its activities, materials and reports may become discoverable.

Thursday, April 24, 2008

D&O Insurance: Got Protection?

D&O Insurance: Got Protection?
By David W. Tate, CPA, Esq.
April 24, 2008

As directors and officers are hit with lawsuits from shareholders, employees, clients, competitors and the government, insurance is one way to protect against the liability—whether at home or abroad.

Consider this: You’ve been a director and an audit committee member of a company for about a year when you learn that the CEO, CFO and directors are being sued by shareholders for alleged financial fraud that has been ongoing for three years.

Further, the recently fired whistle-blower employee has filed a separate lawsuit against the CEO and the audit committee (which oversees the whistle-blower reporting process) for wrongful termination and retaliation. And the SEC has begun its own investigation.

All of the plaintiffs are seeking compensatory and punitive damages, and the fired employee is also seeking attorneys’ fees.

To make matters worse, you’ve been told that the lawsuit is not covered by the directors and officers (D&O) insurance policy (coverage may be denied for the fraud claim because the company withheld information in the application for insurance, or for all the alleged intentional wrongful acts). The fees that are being paid to the defense attorneys are reducing policy limits that could be used to settle the case, and it has been mentioned that you have to pay some of the costs to defend and help settle the case.

As a director or officer, knowledge of D&O and related insurance issues is key to knowing what questions to ask and understanding whether the company’s D&O insurance coverage and application process sufficiently protect you from liability.

Standard D&O insurance covers:

• Liabilities owed by the individual directors and officers, including attorneys’ fees (sometimes referred to as Side A liability coverage); and

• Amounts paid by the company as indemnification when the company is able to indemnify the directors and officers for liability arising from alleged wrongful acts (sometimes referred to as Side B indemnity coverage). Some policies also provide coverage (sometimes referred to as Side C entity coverage) for certain claims made directly against the company. There is tremendous variation in insurance policy coverage, so each should be structured to address the specific needs of the company for which it is written.

Losses Covered

Losses typically covered under D&O insurance include amounts that the directors or officers are legally obligated to pay for claims against them for wrongful acts, including settlements, judgments, costs of litigation and investigation, attorneys’ fees and other related items. The definition of the losses covered under the company reimbursement provision typically includes amounts that the company is permitted to pay to indemnify the directors and officers. From the insurance policy’s viewpoint, a company’s indemnity payments are a loss: they are payments that the company has to make to directors or officers to pay for liability that they incur as a result of their wrongful acts. Policies are self-liquidating, meaning that the amounts paid, such as for attorneys’ fees, reduce the amount remaining for future coverage.

Generally, coverage won’t include fraud, willful or intentional wrongdoing, and criminal or highly culpable misconduct. Whether or not an act is willful or highly culpable may be the subject of disagreement, but an option may be available that makes coverage contingent upon some final judgment of wrongdoing. Losses relating to punitive damages also generally are not covered. And depending on circumstances, fines, penalties and treble damage amounts may or may not be covered.

D&O Coverage Exclusions and Other Limitations

The following are typical exclusions for which the director/officer should be aware of or on the lookout for. That said, if there is an exclusion, it may be possible to purchase an endorsement to the policy, or a separate policy, to cover the excluded area. For example, it would be possible to add an endorsement/separate policy to cover employment practices liability, or ERISA, or bodily injury and property damage.

• Other or prior insurance. Coverage is typically excluded if the company's payment for loss or indemnity is covered by other or prior insurance.

• Bodily injury or property damage.

• Losses relating to pollution or contamination.


• Libel and slander claims.

• Personal gain. Claims relating to personal profit or advantage to which the insured was not legally entitled.

• Unauthorized remuneration. Claims seeking restitution of amounts paid to directors or officers without prior shareholder approval, or that a court has held to be unlawful.

• Securities Exchange Act Sec. 16(b) Short Swing Profits. D&Os are liable to pay back profits that they obtain by buying and selling, or selling and buying stock of the company in which they are a D&O if they hold that stock for a period of less than six months. These are referred to as short swing profits. The law is intended to prevent directors and officers to benefit from the unfair use of information that they receive.

• Breach of contract.

• Insured v. Insured. Claims brought by the company against directors and officers or former directors and officers, such as with respect to shareholder derivative suits or representative class action suits.

• Regulatory exclusion. Suits brought by federal or state regulatory agencies, or on behalf of an agency by a third party.

• Activities relating to mergers and acquisitions, golden parachutes, etc.

• Public offerings of securities.

• Prior acts. Policies are written on a claims-made basis, which means a claim—an allegation of liability by a plaintiff—must be made during the policy period. However, when a company has had a difficult history, such as a prior policy cancellation or non-renewal, a lapse in coverage or a serious financial crisis, there may be an exclusion for prior acts. Thus, the policy would cover only claims made for acts that occurred after the policy period began.

• Pending or prior litigation.

• Questionable payments. This includes items such as commissions, favors, or gifts paid to government officials, agents, employees, representatives and other related people.

• Discrimination. However, some D&O policies have added employment practices liability coverage. Alternatively, there may be an option to purchase a separate EPLI policy.

• Antitrust litigation.

• Failure to maintain insurance.

The following are some additional D&O application policy issues to consider:

• Concealment or misrepresentation. The application for D&O insurance requires the company to provide information regarding its history, operations, stock ownership, directors and officers, other insurance, certain transactions and acts or omissions that might provide grounds for future claims. The application for insurance is typically signed by an officer, to the best of that officer’s knowledge and belief.

Pursuant to California Insurance Code Sec. 331, intentional or unintentional concealment entitles the insurer to rescind the policy. Fraudulent misrepresentation also allows coverage denial or policy rescission. One option may be to include language stating that fraud or inaccuracies in the application are not imputed to innocent directors and officers who were unaware of the untrue or incorrect information provided. Another option may be for the policy to provide for nonrescindable coverage.

• Retention amounts. The insurer’s duty to make payments may arise only after those insured have incurred a loss that exceeds a set amount, referred to as a ”retention,” which is in essence a deductible. The individual director or officer will want to avoid a retention provision or have the amount be as low as possible. A multiple retention issue can arise when multiple claims arguably relate to the same wrongful act. One option may be for the policy to state that a single retention will apply to claims alleging or relating to related wrongful acts.

• Co-insurance. The policy may contain a co-insurance clause, requiring those insured to pay a share of the overall liability above the retention amount. Directors and officers will want to avoid a co-insurance clause, especially with respect to Side A coverage.

• Severability of conduct exclusion. Wrongful conduct of one director or officer may impact the coverage for other innocent directors or officers. Language should be included stating that wrongful conduct by any director or officer will not be imputed to the other directors or officers.

• Bankruptcy. In bankruptcy a lawsuit may be brought by a trustee or by creditors, arguably on behalf of the company. Thus, the lawsuit could be characterized as being insured v. insured, for which coverage might be denied. An option may be for the policy to exclude coverage only for claims brought by the company, not on behalf of the company. It has also been argued in bankruptcy that the D&O policy or proceeds may be an asset of the company, thus complicating any payment under the policy. An option may be for the policy to give priority to payments made to protect the directors and officers over payments made to protect the company.

• Timing of defense cost payments. Policies vary regarding the timing of the insurer’s payment of defense costs. For example, the insurer may want to make payments semi-annually, annually or prior to final disposition. Those insured and their attorneys will want the policy to require insurer payment or reimbursement within a specific number of days.

• Duty to defend. D&O lawsuits typically involve multiple defendants and multiple claims. The policy may provide coverage for some, but not all of the defendants and claims. Issues also may exist regarding which defendants and claims are covered. Some policies attempt to address these issues with language containing preset terms, or stating that payment is not required until the issues have been resolved by agreement.

Preset policy provisions usually are not favorable to those insured and a silent policy may be preferable. Generally there is a duty to defend an insured or potentially insured against covered and potentially covered claims, although the insurer may reserve its right of reimbursement. Additionally, even if indemnity is prohibited, there may still remain an insurer duty to defend.

• Amount of coverage and the shared limits. As a result of increasing settlement and judgment amounts, and increasing coverage being offered for entity liability and new areas such as employment practices, less coverage may be available to protect the individual directors and officers. Options that may be available include purchasing increased policy limits, policy wording that gives preference to payments made for the protection of the directors and officers, or wording that allocates certain policy limits exclusively for the protection of the directors and officers.

• Separating coverage for the directors and officers. Director and officer liability coverage (Side A coverage), although separate from the indemnity and entity coverage provisions in the same policy, may still be impacted by application concealment or misrepresentation, company bankruptcy, wrongful conduct by other people and liquidating policy limits. Various options may be available for the directors and officers, including the outside directors, through the purchase of a separate policy covering just those directors or officers, or an excess umbrella policy.

• Choice of law, jurisdiction, forum and alternative dispute resolution provisions. Directors and officers should have their broker or attorney review policy provisions relating to choice of law, where and how coverage disputes must be adjudicated, and dispute resolution requirements which may be disadvantageous to the insured.

As an example, an insurer that is headquartered in Philadelphia may want a policy that covers an insured that is located in California to state that all disputes will be resolved in Philadelphia under Pennsylvania law. Philadelphia as a location would be more difficult for the insured, and Pennsylvania law might be less advantageous to the insured than the insurance laws in California.

Some Additional Concerns

Directors and officers must strategically structure their policies. Insureds may want to consider carrier financial rating, claim paying experience, and policy limits. There has been a rise in the average dollar amount paid in class action settlements. Additionally, we are seeing remaining available policy limits being further reduced by escalating defense costs and claims being made that are different than historically typical securities claims, such as derivative lawsuits; stock option, subprime, and opt-out claims; and regulatory and criminal proceedings.

International issues have also become important. A D&O insurance program should take into account foreign jurisdictional requirements where a U.S. company has major operations.

Looking Ahead

While many directors and officers are increasingly focusing on enterprise risk management, they should also focus attention to their own liability exposure and their D&O insurance coverage, understanding that it is not uncommon for D&O insurance coverage to benefit the company, insiders and outside directors differently.

Generally, people involved with D&O insurance will want to evaluate their situation (the industry, products, services and risk exposures of the company and its directors and officers to lawsuit and liability—including the dollar amount of coverage that should be purchased) and need for insurance coverage. It would also be wise for an insured director or officer (as well as the company) to ask about each area of possible exclusion or limitation to see if the policy covers the company, directors and officers for those items. If the policy does not, some manner of coverage could or should be arranged either by an additional endorsement to the policy or by purchasing a separate policy to cover those areas in which it is determined that insurance can and should be purchased.

Lawsuits are filed against directors and officers for different and sometimes surprising reasons. But they all tend to involve large dollar liability risk and are expensive to defend. While D&O insurance is an important type of insurance that every public, private and nonprofit entity must consider, policies are not standardized and are generally written to address the specific—and sometimes conflicting—needs of the insured entity and D&Os, so it’s important that directors and officers fully understand the policy they are working under to ensure proper coverage.

Dave Tate is an attorney is San Francisco (and also a CPA). You can reach him at or

Sunday, April 13, 2008

SEC uses SOX 1103 to freeze payments to officers

SEC uses Sarbanes-Oxley section 1103 to temporarily freeze proposed payments to public company officers:

The U.S. Court of Appeals for the 9th Cir. recently upheld the right of the SEC to seek a temporary freeze on certain funds that a company proposes to pay to a company officer, director or affiliate during a limited time in which the SEC is investigating possible securities fraud. See, SEC v. Yuen (9th Cir. U.S. Court of Appeals).$file/0356129.pdf?openelement

Dave Tate, CPA, Esq.

Two interesting links: governmental transparancy; FCPA

Here are two links of interest around the internet: governmental transparency; and the Foreign Corrupt Practices Act:

1. The Association of Government Accountants ( ) has a new blog, beginning April 2008. If you are an accountant, or just a person interested in governmental accounting and financial reporting transparency, you may find blog articles of interest.

2. More on the Foreign Corrupt Practices Act, and increasing prosecution, both governmental and private party. Every company that has international dealings needs to consider whether it should implement an appropriate compliance program. This topic also should be appearing or starting to appear the radar screen for public company audit committees to at least consider.

Dave Tate, CPA, Esq.

Wednesday, April 2, 2008

Comments about New Century's Examiner's Report regarding the Audit Committee and Internal Audit

Comments about New Century's Examiner's Report regarding the Audit Committee and Internal Audit

The 500+ page February 29, 2008 report of Michael J. Missal, Bankruptcy Court Examiner, in In re New Century TRS Holdings, Inc., U.S. Bankruptcy Court for the District of Delaware, offers a somewhat rare opportunity to view how a person who is knowledgeable and has experience, in this case the Court Examiner (and his legal counsel), might, after the fact, evaluate the actions of corporate officers, directors, audit committee members, internal auditors and outside auditors in a corporate bankruptcy proceeding. Although the Examiner’s report does not hold the weight of a reportable court decision, it is nevertheless truly useful as a tool, such in the manner that a mock trial might be useful. The report can be found at:

The following discussion addresses only the Examiner’s report with respect to the audit committee and internal audit.

The Examiner notes that the four independent audit committee members “were capable individuals who approached their role with a sense of responsibility.” From May 2005 to the close of 2006 the audit committee met in person or by phone 21 times. “Moreover, the Audit Committee undertook significant activities in analyzing the ramifications of strategic decisions, the structure of management, reviewing financial reports, loan quality issues, and addressing operational concerns.” “The Audit Committee also turned to others for assistance, including [the outside auditor] for financial issues and the Internal Audit Department for operational issues.”

Nevertheless, the Examiner faulted the Audit Committee in four areas:

1. The Audit Committee did not ensure that management conducted an adequate analysis of entity-wide risk;

2. The Audit Committee did not ensure that key operational risks were addressed;

3. The Audit Committee did not give sustained attention to loan quality until 2006; and

4. The Audit Committee did not adequately supervise or make effective use of internal audit.

The Examiner also notes that internal audit was led by “a well-qualified internal audit professional,” who “hired qualified staff,” and that the internal audit personnel “seemed to pursue their responsibilities diligently and professionally.” “Moreover, consistent with sound practices, Internal Audit reported to the Audit Committee, developed a risk-based ranking of issues, typically provided written audit reports to the Audit Committee and developed a procedure to monitor recommendations for improvements. Internal Audit made valuable contributions to the governance and operations of New Century by preparing a significant number of audit reports, and in the process, identified issues concerning loan quality, regulatory compliance, loan servicing and loan appraisals.”

Nevertheless, the Examiner found the following “significant deficiencies” with internal audit:

1. Internal audit did not perform a thorough assessment of entity-wide risk;

2. Internal audit did not identify and examine certain areas of operational risk; and

3. Internal audit did not address internal control over financial reporting risk.

It should be kept in mind that neither the audit committee nor internal audit is responsible for the day-to-day operations of the business; thus, neither the audit committee nor internal audit was or could be the direct cause of the problems at the business. Essentially, although both the audit committee and internal audit diligently performed their functions, when looking at the financial problems that led to New Century’s bankruptcy, it is possible in hindsight to identify audit committee and internal audit deficiencies that may have helped to allow the financial problems to remain unfixed. It is that type of scenario that can present a most difficult dilemma for both the audit committee and internal audit: despite exercising diligence, if something goes wrong often it is possible for someone to argue that greater diligence or better diligence could have prevented the wrongful situation. The Examiner essentially argues that the audit committee and internal audit should have been more diligent, that they may have missed a couple of issues, and that they dropped the ball or did not aggressively enough follow through or pursue certain issues and deficiencies with management.

A lesson can be viewed from the Examiner and his approach to the New Century situation: it can only be concluded that at the end of the day, in performing their functions, both the audit committee and internal audit must do all that they can do to ensure that they have fully resolved each and every issue that they consider important to the risk management of the entity. And that leads to what appears to be a central criticism by the Examiner, that the entity should have and was required to fully implemented and entity-wide enterprise risk management program. Keep in mind that management, the audit committee and internal audit did engage in risk management. The Examiner concluded that those activities were not sufficient.

There is little hard authority for the proposition that the audit committee is responsible for oversight of entity-wide enterprise risk management. New Century was a public company, listed on the New York Stock Exchange. The Examiner references only “best practices for corporate governance,“ and cites N.Y.S.E. Listed Company Manual §303A.07(c)(iii) and (d), and Business Roundtable, Principles of Corporate Governance 17-20 (Nov. 2005). Section 303A.07 pertains only to audit committees of N.Y.S.E. listed companies, but does require those audit committees to discuss with management policies and guidelines relating to risk assessment and risk management, and the company's major financial risk exposures. There is other statutory authority requiring audit committees of all public companies listed in the U.S. to have certain oversight of financial and accounting internal controls; however, oversight of internal controls is not necessarily the same as oversight of enterprise risk management.

With respect to internal audit responsibilities, the Examiner does cite extensively from a couple of sources including from materials published by the Institute of Internal Auditors. The functions and responsibilities of internal audit to engage in enterprise risk management are much more clear. And, of course, the audit committee does interact with and oversee the performance of internal audit.

Whether or not sufficient authority exists to establish the proposition that public company audit committees are responsible for oversight of entity-wide enterprise risk management, or that it is now a broadly established best practice for public company audit committees to perform that oversight function, it can be argued that public company audit committees should at least be considering going in that direction to help protect themselves from after the fact second guessing if something goes wrong. Audit committees also should be working on their interaction with and oversight of internal audit. Internal audit is a tremendous resource to help the audit committee satisfy its functions and responsibilities, and to help the committee evaluate and monitor risk management.

Dave Tate, Esq.

Saturday, March 22, 2008

Study evaluates the causes of restatements, with interesting conclusions.

An interesting new study evaluates the causes of financial statement restatements: If I read the report correctly, the study supports a conclusion that fraud (manipulation) is not one of the major causes of restatement. The major causes are "internal error" (basic internal company errors unrelated to the accounting standards) at 57%, and "standards" (most often due to the lack of clarity in applying the standards and/or the proliferation of the literature due to the lack of clarity in the original standard) at 37%. Restatement due to "manipulation" and "complexity" are ranked at only 3% each. Of course, "internal error" and "standards" both could be due to manipulation. The study also does not evaluate the percent of restatement caused by other factors that could be present, such as inadequate internal control.

I also found the percent of account type resulting in restatement to be interesting. The study lists the largest contributors as "expense" at 21%, "equity" at 19%, "misclassifications" at 16%, "revenue recognition" at 10%, and "acquisitions/investments" at 8%. I would have expected "revenue recognition" to be in line with "expense."

Dave Tate (click on the updated audit committee guide link)

Friday, February 29, 2008

The Foreign Corrupt Practices Act Overview (Part II), the Antibribery Provisions

The Foreign Corrupt Practices Act (15 U.S.C. §§ 78dd-1, et seq.) is a U.S. federal law that is comprised of two primary provisions: (1) the accounting record keeping and internal control provision, and (2) the antibribery provision. This overview discusses the antibribery provision.

Generally, the antibribery provision makes it unlawful for (1) U.S. firms and persons, and certain foreign issuers of securities, to make a corrupt payment (e.g., a bribe) to a foreign official for the purpose of obtaining or retaining business, and (2) foreign firms and persons to act in furtherance of a corrupt payment while in the United States.

The Department of Justice is responsible for criminal and civil enforcement with respect to domestic concerns, foreign companies and nationals. The SEC is responsible for civil enforcement of the antibribery provisions with respect to issuers.

Basic Elements to Establish a Violation of the Antibribery Provision:

Establishing a violation of the antibribery provision involves five basic elements.

1. To Whom the Act Applies.

The Act applies to any individual, firm, officer, director, employee, or agent of a firm and any stockholder acting on behalf of a firm. Individuals and firms may also be penalized if they order, authorize, or assist someone else to violate the antibribery provisions, or if they conspire to violate those provisions.

United States jurisdiction over improper payments to foreign officials depends on whether the violator is an "issuer," a "domestic concern," or a foreign national or business.

An "issuer" is a corporation that has issued securities that have been registered on a U.S. exchange, or that is required to file periodic reports with the SEC.

A "domestic concern" is any person who is a citizen, national, or resident of the United States, or any corporation, partnership, association, joint-stock company, business trust, unincorporated organization, or sole proprietorship which has its principal place of business in the United States, or which is organized under the laws of a State, territory, possession or commonwealth of the United States.

For acts that occur within the territory of the United States, issuers and domestic concerns are liable if they perform an act in furtherance of a corrupt payment to a foreign official using the U.S. mails or other means of interstate commerce, including, for example, telephone calls, faxes, wire transfers, and interstate or international travel.

Issuers and domestic concerns may also be liable for acts performed in furtherance of a corrupt payment made outside the United States. Thus, a U.S. company or national may be held liable for a payment authorized by employees or agents operating outside the United States, using money from foreign bank accounts, and without any involvement by a person located in the United States.

The FCPA was expanded in 1998 to include jurisdiction over foreign companies and people who cause, directly or through agents, an act in furtherance of the corrupt payment to take place in the territory of the United States, whether or not the act makes use of the U.S. mails for other means of interstate commerce.

U.S. parent companies also may be held liable for the acts of foreign subsidiaries, the activities of which they authorize, direct, or control, as can U.S. citizens or residents ("domestic concerns) who were employed by or acting on behalf of the foreign subsidiary.

2. Wrongful Intent or Purpose.

The person making or authorizing the payment, offer, promise or inducement must have a wrongful or corrupt intent or purpose, and the payment must be intended to induce or influence the foreign official who is receiving the payment to misuse his or her official position, to breach his or her lawful duty, to make a decision, or to otherwise act to direct business wrongfully to the payer or to any other person, or to obtain any improper advantage, or to induce the foreign official to use his or her influence improperly to affect or influence any act, event or decision.
However, the intended corrupt act does not have to actually succeed in purpose for a violation to occur. Thus, an offer or promise alone can be a violation.

3. Payment.

The Act prohibits paying, offering, promising to pay (or authorizing to pay or offer) money, or anything of value.

The Act also prohibits corrupt payments made through an “intermediary,” also referred to as third party payments. The “intermediary” is the recipient who is making the payment to the foreign official. It is unlawful to make a payment to a third party, while “knowing” that all or a portion of the payment will go directly or indirectly to a foreign official. The term "knowing" includes conscious disregard and deliberate ignorance. In other words, it is not necessary to show actual knowledge for there to be a violation. Thus, U.S. companies should exercise due diligence, investigate other entities and persons with whom they interact, react to and investigate “red flags,” and establish proper and prudent compliance staffing, procedures and processes. See also the overview of the FCPA accounting record keeping and internal control provision.

4. The Recipient.

The Act applies only with respect to corrupt payments to a foreign official, a foreign political party or party official, or any candidate for foreign political office.

A "foreign official" means any officer or employee of a foreign government, a public international organization, or any department or agency thereof, or any person acting in an official capacity, regardless of rank or position. The Act focuses on the purpose of the payment, not the duties of the recipient (see however, the “facilitating” payment exception discussed below). Whether or not a person is a “foreign official” can be difficult to determine. Consider, for example, royal family members, an official of a state-owned business, or members of a legislative body.

5. The Business Purpose Test.

The Act prohibits payments made in order to assist the firm in obtaining or retaining business for or with, or directing business to, any person. You should be aware that the term "obtaining or retaining business" is broadly interpreted for enforcement purposes. Additionally, the business to be obtained or retained does not need to be with a foreign government or foreign government instrumentality.

The Facilitation Payments for Routine Governmental Actions Exception:

The Act provides that there is no violation of the antibribery provision for payments made to facilitate or expedite performance of a "routine governmental action." The Act lists the following examples: obtaining permits, licenses, or other official documents; processing governmental papers, such as visas and work orders; providing police protection, mail pick-up and delivery; providing phone service, power and water supply, loading and unloading cargo, or protecting perishable products; and scheduling inspections associated with contract performance or transit of goods across country. Other similar actions might also be excluded. However, the “routine governmental action" exclusion does not include or apply to any decision made by a foreign official to award new business or to continue business with a particular party.

Possible Affirmative Defenses Available to a Person Charged with a Violation:

In addition to being able to prevail on one or more of the five basic elements discussed above, there are a couple of affirmative defenses that an accused defendant may be able to argue and establish for the payment or action:

-The payment was lawful under the written laws of the foreign country. Obviously, prior to making a potentially improper payment you should seek the advice of counsel regarding the “legality” of the payment under the laws of the foreign country; and

-The money was spent as part of demonstrating a product or performing a contractual obligation.

Criminal Sanctions, Penalties and Jail Time:

Criminal punishment for violation of the FCPA antibribery provisions are as follows: corporations and other business entities may be fined up to $2,000,000; and officers, directors, stockholders, employees, and agents may be fined up to $100,000 and imprisonment for up to five years. Additionally, under the Alternative Fines Act the fine may increased up to twice the benefit that the defendant sought to obtain by making the corrupt payment. Fines imposed on individuals cannot be paid by the individual’s employer or principal.

Civil Fines and Injunctive Remedies:

The Attorney General or the SEC may bring a civil action seeking a fine up to $10,000 against any firm, officer, director, employee, or agent of a firm, or any stockholder acting on behalf of the firm, for violation of the antibribery provisions. Additionally, in an action brought by the SEC, the court may impose an additional fine not to exceed the greater of the gross amount of the monetary gain to the defendant as a result of the violation, or a specified dollar limitation based on the egregiousness of the violation, ranging from $5,000 to $100,000 for a natural person and $50,000 to $500,000 for any other person.

The Attorney General or the SEC may also bring a civil action to enjoin (i.e., stop or prevent) any act or practice of a firm whenever it appears that the firm, or an officer, director, employee, agent, or stockholder acting on behalf of the firm, is in violation, or about to be, in violation of the antibribery provisions.

Private Cause of Action:

A private cause of action may also be brought against the wrongful firm or person, such as by an aggrieved business competitor, for treble damages under the Racketeer Influenced and Corrupt Organizations Act (RICO), and under various other federal or state laws.

Additional Possible Penalties and Sanctions:

A person or firm found in violation of the FCPA may be barred from doing business with the Federal government. An indictment can lead to the suspension of the right to do business with the government.

A person or firm that is guilty of violating the FCPA can be held ineligible to receive export licenses.

The SEC may suspend or bar a person or firm from the securities business and impose civil penalties on firms or persons in the securities business for violation of the FCPA.

The Commodity Futures Trading Commission and the Overseas Private Investment Corporation may suspension or debarment a person or firm from agency programs for violation of the FCPA.

And, a payment made to a foreign government official that is unlawful under the FCPA cannot be deducted for tax purposes.

Dave Tate, Esq. (and CPA)

CalCPA Financial Leadership Forum Advisory Panel member,
AICPA CPA Ambassador,
AccountingWeb Blogger,

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