[author: David Smyth]
Much ink has been spilled in recent years discussing the SEC’s and Justice Department’s focus on the Foreign Corrupt Practices Act, a law that prohibits paying bribes to foreign government officials. While the federal criminal code has provisions prohibiting bribery of domestic public officials, see 18 U.S.C. § 201, domestic bribery has rarely been a focus for the SEC. But if you’re a publicly traded company, you can’t forget the accounting provisions of the federal securities laws, because they will catch you.
FalconStor Software learned as much on June 27th when the SEC brought a settled action against it for the commercial bribery of, not public officials, but a subsidiary of J.P. Morgan Chase. FalconStor is a data storage company that sought to obtain and expand the services bought by the bank. According to the SEC’s complaint, FalconStor did not rely on the quality of its data storage solutions to win those contracts, but instead paid about $430,000 in bribes to three bank executives and their relatives. These included cash, FalconStor options and restricted stock, gift cards, golf club fees, and “lavish” entertainment, including gambling in Macau and Las Vegas casinos.
In a sense, no statutes explicitly give the SEC jurisdiction over this conduct, but public companies always have an obligation to tell investors the full story about their finances. If they’re paying bribes to maintain business with their customers, they may have to say as much. In this case, FalconStor had touted its relationship with JP Morgan in earnings calls and releases as proof of the strength of its products and its strides in moving to direct sales rather than relying on third-party distributors. They didn’t mention the bribes. In its settled complaint, the SEC charged that FalconStor should have brought those up in earnings releases filed on 8-Ks in 2008 and 2009. As it happened, “the CEO’s misleading statements inflated the price of FalconStor’s stock, which declined by over 22% following the Company’s disclosure that the CEO had been involved in improper payments and had resigned.” The omissions won FalconStor a claim under Sections 17(a)(2) and (3) of the Securities Act.
Another of the claims involved a statute that is part of the FCPA, but really has quite broad application. Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act address corporate books and records and internal controls, and were enacted along with the anti-foreign bribery provisions of the FCPA in 1977. They do not require that only foreign bribes be recorded accurately; they apply to all sorts of corporate transactions. These subsections require issuers to (1) keep books and records that reflect their transactions and dispositions of their assets (Section 13(b)(2)(A)), and (2) maintain a system of internal accounting controls sufficient to ensure that transactions: (i) are executed in accordance with management’s authorization; and (ii) are recorded in a way to allow preparation of financial statements in conformity with GAAP (Section 13(b)(2)(B)).
The FalconStor case is not unusual in the SEC’s use of Section 13(b)(2) outside the foreign bribery context, but it is a useful reminder that these disclosure provisions can catch a lot of misconduct that issuers might not consider to be part of the SEC’s jurisdiction.