Recent SEC Enforcement Action on Internal Control Despite No Other Alleged Violations

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A recent SEC-settled administrative action is another reminder of the SEC’s focus on internal control over financial reporting (ICFR). Although prior SEC ICFR charges have been accompanied with allegations of false financial statements or violations of the Foreign Corrupt Practices Act, this SEC action only charges a former financial reporting executive with knowingly making false representations about his involvement in the design, maintenance, and operation of ICFR; his participation in the assessment of ICFR’s effectiveness; and the nonexistence of significant deficiencies in ICFR.

These misrepresentations were made in reports on Form 10-K and Form 10-Q filed by QSGI Inc., certifications filed as exhibits to those reports, and statements made to auditors orally and in management representation letters, that is, letters provided by management to QSGI’s auditors. The SEC’s order requires the former executive to cease and desist from committing or causing any violations of Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(5) and Rules 10b-5, 13a-14, 13b2-1, and 13b2-2 promulgated thereunder. In addition, the order denies the former executive the privilege of appearing or practicing before the SEC as an accountant and orders the former executive to pay a civil money penalty in the amount of $23,000. The SEC is continuing its case against the CEO of the company related to the same matters.

The SEC’s action was based on the following:

  • The former executive’s awareness of deficiencies in the design and operation of ICFR that facilitated the shipment of inventory that had not been recorded in QSGI’s books and records, the removal of inventory without recognition in the books and records that it had been removed, and the acceleration, in which he participated, of the recognition of inventory and accounts receivable for purposes of maximizing QSGI’s borrowings under its revolving credit agreement
  • The false representation in management’s report on ICFR, which was included in QSGI’s annual report on Form 10-K for its 2008 fiscal year, that the former executive and the CEO had evaluated QSGI’s ICFR in accordance with the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO’s) framework when the CEO had not participated in such an evaluation and was unfamiliar with the COSO framework
  • The false certifications, filed as exhibits to the Exchange Act reports, in which the former executive asserted that he had reported all significant deficiencies in ICFR to the auditors, when the former executive had not reported such deficiencies, including the circumvention of ICFR for purposes of maximizing QSGI’s borrowings
  • The misrepresentations and misleading statements the former executive made to the auditors when he should have disclosed the significant deficiencies in ICFR, including those that the company was unsuccessfully trying to correct
  • The former executive’s having caused, for purposes of the Exchange Act, QSGI’s violations of the books and records and internal control provisions of the Exchange Act by failing to design effective ICFR, circumventing controls that existed, and withholding information from the auditors

Other recent SEC enforcement actions including ICFR charges when financial statements are not also misstated include cases asserting violations of the Foreign Corrupt Practices Act and the failure to establish appropriate controls relating to compliance with export control and economic sanctions laws.

Topics:  COSO, Enforcement Actions, FCPA, Form 10-K, ICFR, Internal Controls, SEC, Securities Exchange Act

Published In: General Business Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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