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Fear and Loathing on the IR Trail: Class Actions, Enforcement Proceedings and Restatements

Fear and Loathing on the IR Trail: Class Actions, Enforcement Proceedings and Restatements. Jerome F. Birn, Jr. March 18, 2005. Topics. Shareholder Class Actions SEC & U.S. Attorney Proceedings Reg. FD MD&A Safe Harbor SOX 404 and Erosion of Materiality. Shareholder Class Actions.

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Fear and Loathing on the IR Trail: Class Actions, Enforcement Proceedings and Restatements

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  1. Fear and Loathing on the IR Trail:Class Actions, Enforcement Proceedings and Restatements Jerome F. Birn, Jr. March 18, 2005

  2. Topics • Shareholder Class Actions • SEC & U.S. Attorney Proceedings • Reg. FD • MD&A • Safe Harbor • SOX 404 and Erosion of Materiality

  3. Shareholder Class Actions • Filing trends • Institutional plaintiffs • Evolving case law • Personalized exposure

  4. SEC & U.S. Attorney Proceedings • New attitude • A crime is a crime • Aiding & abetting • Explosion of chain-of-command: whistleblowers • Up and down the org chart • Enforcement as retrospective regulation • What they expect • Independent internal investigation • Discovery costs and burdens • Privilege waivers

  5. Reg. FD:Recent Enforcement Actions • Schering-Plough (Sept. 2003) • Conduct • Individual meetings with several fund managers/buy-side analysts • Non-webcast meeting with sell-side analysts • Improper disclosures • Negative tone on Q3-02 and FY 2003 – but no specific numbers • Prior disclosures said trends “could” happen; comments said “would” • “Providing guidance to a select few through a combination of spoken language, tone, emphasis, and demeanor, is precisely the kind of unfair advantage that the SEC wants to prevent.” • $1 million fine against Company; $50,000 fine against CEO

  6. Reg. FD:Recent Enforcement Actions • Allegations in Siebel Systems (June 2004) • Conduct: after CFO held one-on-one meeting with institutional investor and invitation-only dinner with investment banker, stock rose 8% the next day • Improper alleged actions • Positive comments about business activity level and deal pipeline in contrast to prior negative comments • IR Director named because he “failed to prevent selective disclosure” and “failed to cause Siebel to make public disclosure the next day” • First enforcement action for failure to maintain adequate disclosure controls and procedures

  7. Reg. FD Lessons • Current quarter guidance especially sensitive • FD applies to good news or bad news • SEC focusing on nudge and a wink • High risk • One-on-one meetings • Analyst changes projections after private meeting or call • Best Practices • Email • Don’t reaffirm guidance unless you really mean it • No follow-up calls to make sure they “get it” • Consider a press release or web-cast updates • Always check with counsel

  8. Meaningful MD&A • Caterpillar (known trends and uncertainties) • Brazilian subsidiary accounts for 23% of profits but not separately disclosed in MD&A • Notwithstanding risk disclosures in 10-K and 10-Q, Caterpillar did not go far enough to disclose uncertainties and potential adverse effects on earnings. • Company lacked "adequate procedures . . . designed to ensure compliance with the MD&A requirements."

  9. Meaningful MD&A • The key: meaningful disclosure controls • Appropriate controls can atone for a mistake • Accounting controls vs. disclosure controls • Create viable internal channel for whistleblowers and procedures for responding • Review of MD&A • Compare disclosures to internal presentations on trends and risks • Elicit views of counsel/disagreements • Non-GAAP financial measures (Reg. G and Item 10 of Reg. S-K) • Accompany and reconcile • Consistency and transparency • Need protocol to close quarter and issue results, including MD&A • Same protocol for guidance updates

  10. Effective Use of Safe Harbor • Significance and structure of Safe Harbor • Written vs. oral • Baxter case • No basis to conclude the important risks were disclosed • The risks remained the same; the problems allegedly didn’t • Companies often fail to • Identify the forward-looking information • Accompany it with risk factors • Make the cautionary disclosures meaningful

  11. SOX 404 and the Erosion of Materiality • Quick overview of Section 404 • Management design and test controls • Auditors must attest to efficacy of controls • What is a “material weakness”? • “More than remote” chance that a defective control will create a material error • You must disclose and describe a material weakness • End of the era of non-material errors? • SAB 99 and the old “5% rule” • A 1% error could be immaterial to financial statements but a “material weakness” requiring disclosure • Beginning of the era of “presumptive restatement”?

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