SEC Focus on Accounting Fraud
This year's conference, held against the backdrop of the trial of former executives of failed energy giant Enron, included a panel examining the commission's work to identify accounting irregularities and how companies were "cooking the books."
SEC Division of Enforcement Chief Accountant Susan Markel described numerous instances of accounting violations the SEC found in 2005. She noted that frauds typically were committed at companies where management had financial incentives to do so, or was under pressure to produce results.
Markel also said it was common for management involved in frauds to rationalize the conduct. Typical reasons cited were the need to make projections; pressure from a superior; potential for a pending acquisition to fall through; and reliance that the company would make up next quarter fictitious revenue that had been booked.

Markel noted the SEC took actions with respect to 185 cases of accounting violations in 2005. She said 44 of those action actions, or 24 percent, involved Fortune 300 companies. Typically, the SEC discovered the violations through news reports, self-reporting by the company, auditor reports, or from the Public Company Accounting Oversight Board, she noted.

Markel also indicated that there were several common methods used in such cases. One such method was improper revenue recognition, whereby a company books revenue in a chosen accounting period rather than in the period in which the revenue was actually earned. This, she noted, occurred at companies such as Peregrine Systems, SafeScript, eFunds, and Cutter & Buck. While revenue recognition issues may be hard to detect, Markel commented that a common problem for companies improperly recognizing revenue is that companies never collect the fictitious cash they claim to have earned. Thus, accountants may note items such as the companies' accounts receivable growing at a suspicious rate.

Frequently, the SEC found that, when companies engaged in accounting fraud, companies looked to use further improper accounting to cover up the initial deception, Markel said. Two strategies include the use of restructuring charges and merger accounting. When a company incurs restructuring charges, such as the cost of a plant closing or employee severance, such charges may be inflated to cover past overstatements of earnings.

In merger accounting, where the "purchase method" of accounting is used, the merged company adjusts the value of assets carried on its balance sheet. By deliberately adjusting the value of assets to a value other than true market value, companies may be able to cover up improper accounting from earlier periods.

Internet Posting of Proxy Statements to Improve Shareholder Access
Many panelists at this year's conference spoke about the commission's ongoing efforts to allow for Internet posting of proxy statements. SEC Commissioner Roel Campos argued that permitting shareholders to play a greater role in the governance of companies is one benefit of the ""Internet proxy" rule, the public comment period for which closed on Feb. 13. The proposed rule would permit companies to post their proxy statement on the Internet rather than to require companies to mail the proxy statement to shareholders.

Campos indicated that the proposal would reduce costs both for companies and for dissident shareholders seeking to wage a proxy contest. He noted that currently the combination of prohibitively expensive proxy fights and state law default rules providing for director election by a plurality of votes effectively give shareholders no alternative in most cases other than to vote for management nominees.

Currently, SEC interpretive guidance permits electronic delivery of proxy statements to shareholders consenting to such delivery. Thus, for shareholders who have already "opted-in," the process is already completely electronic and mailing costs are not incurred with respect to those shareholders. The number of shareholders opting-in, however, is estimated to be low at many companies.

The new proposal would require shareholders to "opt-out" in order to continue to receive paper proxy statements. When shareholders do not opt-out, mailing costs still would not be completely eliminated unless shareholders also opted to receive a post-card type meeting notice in electronic form.

Where shareholders do not opt-in to receive electronic notices, the cost savings produced by the proposed rule would be the difference between the mailing cost of the postcard type notice (potentially accompanied by the proxy card) and the mailing cost of weightier proxy statements. Also, the company may incur fees imposed by intermediaries, such as Automatic Data Processing (ADP), to whom brokers have contracted out responsibility to forward proxy materials to beneficial owners (who hold shares in "street name" rather than as record owners).

Betsy Murphy, chief of the Division of Corporation Finance's Office of Rulemaking, outlined key elements of the complex proposal.

Companies would post their proxy statement on an Internet site other than the SEC's EDGAR site and would send a meeting notice to shareholders 30 days before a shareholder meeting, she noted. The meeting notice could be used to satisfy state law shareholder meeting notice requirements, said Murphy, and the notice would state where the proxy materials are located on the Internet. She also noted that other soliciting materials could not accompany the notice and that the company's proxy card would be sent either with the notice or with the proxy statement.

According to Murphy, shareholders may request a paper proxy statement, and companies have two days to respond to requests received under the proposed rule. Delivery of proxy statements to beneficial owners of shares will occur by intermediaries forwarding the notice to beneficial owners. Proxy statements proposing that shareholders approve business combinations are excluded from the rule.

Commissioner Campos noted that, despite the cost-efficiencies the rule would create, he has concerns over two potential adverse consequences of the proposal. First, he indicated that separating the proxy card from the proxy statement might encourage retail shareholders to vote blindly without reading proxy materials. Second, Campos said the rule could disproportionately affect elderly people who may not have Internet access.

However, it is not clear whether the proposed rule would permit a shareholder to conduct a completely online proxy contest that is effective. Shareholders at Alaska Airlines in 2005 experienced frustration in their efforts to do this. In that contest, the Alaska Airlines dissidents relied on existing exceptions to the proxy rules that permit communication with other shareholders and conducted an Internet campaign.

But because the dissidents had not mailed materials to a sufficient number of shareholders, the New York Stock Exchange ruled that the matter did not constitute a contested election under its rules. Thus, brokers retained discretionary authority to vote the shares of beneficial owners holding in "street name" for management's slate, making success more difficult for the dissidents.

Nevertheless, the dissidents were successful in obtaining support for their proposals that the company had included on its proxy statement and card. They did this by gaining the support of the company's largest shareholders by contacting them directly.

The dissidents were frustrated, however, in their solicitation in favor of other proposals that did not appear on the company ballot. For these proposals, the dissidents did not mail their own proxy cards but posted their card on the Internet. Alternatively, they suggested shareholders scratch out the company's proxy card and write in votes in favor of the dissidents. Regarding the proposals not on the company proxy card, the dissidents ran into problems, however, because ADP (as voting agent) refused to vote the proxy card of the dissidents, and the dissidents balked at paying fees to ADP to forward the proxy card to street name holders.

It is not clear whether these issues of broker discretionary votes and acceptance of proxy cards by intermediaries such as ADP that arise when dissidents are required to do a mailing of any sort would be solved by the Internet proxy rule. The SEC may ultimately decide that, in the case of an annual meeting, dissidents are not required to mail a notice, because, presumably, the company would have mailed its own notice to shareholders already informing them of the upcoming event.

If dissidents are required to mail a notice, however, and if a significant number of shareholders did not consent to electronic delivery, dissidents reluctant to incur even the mailing costs of the postcard-type notice might continue to face obstacles to conducting an effective solicitation.