It's been more than a decadesince a series of scandals involving companies like WorldCom andEnron made headlines, exposing levels of financial fraud thatstartled most Americans and put federal regulators into a state ofhigh alert. In the years since those scandals, the Securities andExchange Commission (SEC) has put a tighter focus on financialdisclosure statements in an attempt to root out “soft information”and uncover true financial fraud.

The fact of the matter is, financial disclosure documents havealways represented a bit of a minefield for public companies, butnowadays, SEC scrutiny is even greater. The Commission looksclosely at financial statements, down to the smallest footnote,putting more pressure on true financial metrics, but also on theexplanations for matters ranging from revenue to risk.

Increased focus
By putting more emphasison these financial disclosure documents, the SEC has shone thespotlight on the information contained within, digging deep whenpossible.

“When the SEC reviews the information, assumptions are notdisclosed in a lot of detail, so it's hard for the SEC to reviewcertain areas. Often, they will note that a company has impaired anasset and ask what was the company's basis for not having done soearlier,” says Linda L. Griggs, partner at Morgan Lewis LLP andformer chief counsel to the chief accountant at the SEC. “In thearea of fair value judgments, it can be hard for the SEC to providereal-time, meaningful comments, internal estimates andjudgments.”

In the past, companies would rely on third parties to preparemuch of their disclosures, but now, businesses must do enough ofthis work internally to ensure they are comfortable with everydetail.

It's not just internal, year-to-year consistency of a certaincompany's reports that the SEC looks at. The Commision is alsocomparing a company to its competitors. “The SEC compares acompany's disclosures to others in the same industry,” explains KitAddleman, partner at Haynes & Boone LLP, and former regionaldirector of the Atlanta office of the SEC.

The SEC Division of Corporation Finance is divided into a dozendifferent industry groups for reviews. In her role in the WhiteCollar Defense and Investment Funds Practice Group at Haynes &Boone, Addleman consults with a number of companies. “We adviseclients to learn the industry standards, to focus on whether yourcompetitors are providing more or less information. You as insidecounsel want to provide similar disclosure and look at similarrisks for the SEC and for analysts.”

An ounce of preparation
Because of thisincreased scrutiny, the impetus falls on companies to ensure thattheir preparation is essentially flawless. With so much detail anddata going into disclosures, it can be overwhelming for insidecounsel. Often, law departments will seek outside counsel likeGriggs or Addleman as advisers.

“When I counsel companies, I try to get them to focus on thearea of management discussion and analysis, looking at trends anduncertainties,” says Griggs. “Trends and uncertainties indisclosures are difficult, and when there is a lawsuit after thefact, it's easy to ask 'why didn't we identify these?' But in realtime, looking at what is happening, you don't know what the resultwill be.” Griggs also recommends a focus on internal control overfinancial reporting and input from executives and the board.

Addleman sees risk reporting as one of the most important areasof focus for all companies making these disclosures. “The companyhas to identify the biggest risks and make them known to investorsand shareholders,” she says. “Underselling or overselling datasecurity, for example,” puts companies in the position of walkingalong the side of a mountain, trying to get the right informationwithout falling over.

Out for justice
Ofcourse, when companies perpetrate fraud through their financialdisclosures, they run the risk of coming into the crosshairs of notjust the SEC, but also the Department of Justice (DOJ). Accordingto Mythili Raman, partner at Covington & Burling and formerActing Assistant Attorney General of the Criminal Division of theDOJ, the Justice Department is focused on fraud.

“The Justice Department looks at these cases through the lens oftraditional fraud statutes—whether wire or mail or securitiesfraud,” she explains. “These statutes are intended to hold entitiesand individuals accountable in the event that they make materialmisrepresentations to, or withhold material facts from, the marketand the investing public”

The crux of any DOJ inquiry, then, is determining if companieshad intent to defraud investors. Negligent misstatements are, ofcourse, not very good, but errors might not rise to the level of acrime. Therefore, prosecutors must be sure that there was intent todefraud. The burden of proof is quite high, Raman points out, asthese are criminal charges, and therefore must be proven beyond areasonable doubt.

According to Raman, the DOJ looks at matters such as inflationof earnings, misrepresentations about the health of the businessand accounting fraud. “The financial fraud environment is at an alltime high in terms of the vigor with which prosecutors and agentsare investigating and bringing cases against both entities andindividuals,” she explains.

The number of individual white-collar defendants charged in thelast several years is at a 20-year high, and the prosecution ofindividuals is the “bread and butter” of the DOJ's investigativework. “There is a desire to ensure that the public knows that DOJ'senforcement efforts are focused on both individuals and entities,”she says. “Prosecutions of culpable individuals send the messagethat it is not just entities paying fines, but individuals who arecharged, prosecuted, convicted and sentenced.”

Advice for GCs
Often, financial disclosureduties can be shuffled off to the accounting department, but withthe increased importance of these documents – and stiffer penaltiesfor problems related to them – general counsel need to take anactive role in the process.

“GCs should be involved in financial disclosures,” says Griggs.“The GC attends board meetings and knows what the board is focusedon, what management is telling the board. The GC should evaluatefinancial disclosures, and can play a role in asking good questionsabout judgments and assumptions in financial statements.”

In order to be useful in the preparation of these disclosures,though, GCs need to follow one specific piece of advice: “Know thebusiness,” advises Addleman. “If the GC understands the business,they can have a better understanding of potential risks, thinkmatters through with businesspeople and know what points areimportant for inclusion in financial disclosures.”

In the end, inside counsel should know that they have aresponsibility both to shareholders and to the marketplace. “Insidecounsel know better than anyone that the entity they're working formust accurately represent the health of its business to themarketplace,” says Raman. “Real care is needed, and a respect forthe marketplace has to come through in these disclosures, lettinginvestors know what they are getting into when they invest in acompany.” After all, WorldCom and Enron investors didn't have aclue what they were getting into, and look at what happened tothem—and the entire marketplace.