This article was reprinted with permission
from FCPA Professor
The SEC's administrative order (here) in the
December 2012 Allianz enforcement action cited SEC v. World-Wide Coin
Investments, 567 F.Supp. 724 (N.D. Ga. 1983) [an enhanced version of this opinion is available to lexis.com subscribers] for the following
proposition. "[The FCPA's books and records provisions do] not
require that the amounts involved be "material," nor is it necessary to prove
"scienter" under its provisions. [...] Similarly, there is no
scienter requirement for establishing a violation of [the FCPA's internal
controls provisions].
These citations are not inaccurate, but nor do they
tell the whole story of World-Wide Coin's holding.
So what does World-Wide Coin really say
about the FCPA's books and records and internal control provisions?
For starters, World-Wide Coin, amazingly
given the generic nature of the FCPA books and records and internal controls
provisions, appears to be the only judicial decision that directly
addresses the substance of these provisions. [If anyone is
familiar with another such case, please let me know]. Yes, there are
hundreds of cases if you run a search that include passing reference to the
FCPA's books and records and internal control provisions, but the decisions are
generally void of substantive analysis.
The pertinent holding of World-Wide Coin, in the
words of Judge Robert Vining, is as follows.
"The definition of accounting controls does comprehend
reasonable, but not absolute, assurances that the objectives expressed in it
will be accomplished by the system. The concept of "reasonable assurances"
contained in [internal control provisions] recognizes that the costs
of internal controls should not exceed the benefits expected to be derived. It
does not appear that either the SEC or Congress, which adopted the SEC's
recommendations, intended that the statute should require that each affected
issuer install a fail-safe accounting control system at all costs. It appears
that Congress was fully cognizant of the cost-effective considerations which
confront companies as they consider the institution of accounting controls and
of the subjective elements which may lead reasonable individuals to arrive at
different conclusions. Congress has demanded only that judgment be exercised in
applying the standard of reasonableness. [...] It is also true that
the internal accounting controls provisions contemplate the financial principle
of proportionality-what is material to a small company is not necessarily
material to a large company."
The remainder of this post summarizes the facts and holding
of World-Wide Coin.
Factually, World-Wide Coin was an egregious
case and the FCPA issues addressed were not very difficult for Judge
Vining in ruling on the SEC's request for a permanent injunction. The
case involved a wide-ranging securities fraud action involving World-Wide Coin,
a business engaged primarily in the wholesale and retail sale of rare coins,
precious metals, gold and silver coins, and bullion. Its stock was
registered with the SEC and listed on the Boston Stock Exchange. Joseph
Hale was the company's controlling shareholder, chairman of the board, chief
executive officer and president and Floyd Seibert was a member of the board and
served as the company's one-man audit committee.
In the words of Judge Vining:
"The deterioration of World-Wide's internal controls and
accounting procedures constituted the primary thrust of the SEC's
complaint. The SEC contended that the combination of late filings, lack
of internal controls, transactions unsupported by adequate documentation, and a
total disregard for proper accounting procedures resulted in the precarious
position of the company. [...] The company's accounting books were
virtually ignored. General ledgers and general journals were not kept,
and the checks written on World-Wide's five checking accounts were not
reconciled."
Judge Vining described a bookkeeper hired by the company
as follows. "[She] was not a high school graduate; her only experience
for this position consisted of five months of vocational school training and seven
years of bookkeeping for a privately held lumber company."
Judge Vinings findings of fact also
highlights how the accounting firm Kanes, Benator & Co., retained by the
company as an independent auditor, wrote a letter to the company "expressing
grave concern over certain accounting procedures and lack of internal controls
that [it] considered to be detrimental to the company. [...] This letter
[notified] World-Wide of its deficiencies in its internal accounting controls
..." Yet, "even with this official notice that improvements were needed,
Hale and Seibert did nothing to remedy the situation, and the criticisms of
[it] were virtually ignored."
With respect to a 10K report, the individuals "prepared
it themselves without the assistance of counsel and it contained" numerous
misrepresentations. "The company's problems increased [...] mostly
resulting from its chaotic bookkeeping practices and total disregard for an
adequate internal control system." The decision goes into great
detail concerning the "problems that occurred at the company with respect to
internal controls and accounting procedures" such as "(1) inventory problems,
(2) problems with separation of duties and the lack of documentation of
transactions, and (3) problems with the books, records, and accounting
procedures of the company."
As to the defendants' position, the decision states as
follows.
"With respect to the SEC's allegations of violations of
the [FCPA], the defendants presented a cost/benefit argument, contending that a
company the size of World-Wide should not be subjected to overly burdensome
internal controls systems requirements, and accounting procedures, since
compliance with such requirements would, as a practical matter, put small
companies such as World-Wide out of business."
Judge Vining called the FCPA's provisions on
accounting controls "short and deceptively straight-forward." He
stated as follows.
"The only express congressional requirement for accuracy
is the phrase 'in reasonable detail.' Although [the books and records
provisions] expects management to see that the corporation's recordkeeping
system is adequate and effectively implemented, how the issuer goes about this
task is up to management; the FCPA provides no guidance, and this court
cannot issue any kind of advisory opinion. Just as the degree of error is
not relevant to an issuer's responsibility for any inaccuracies, the
motivations of those who erred are not relevant. There are no words
in [the books and record provisions] indicating that Congress intended to
impose a scienter requirement ...".
Judge Vining continued as follows.
"Like the recordkeeping provisions of the Act, the
internal controls provision is not limited to material transactions or to those
above a specific dollar amount. While this requirement is supportive of
accuracy and reliability in the auditor's review and financial disclosure
process, this provision should not be analyzed solely from that point of
view. The internal controls requirement is primarily designed to give
statutory content to an aspect of management stewardship responsibility, that
of providing shareholders with reasonable assurances that the business is
adequately controlled."
"Internal accounting control is, generally speaking, only
one aspect of a company's total control system; in order to maintain
accountability for the disposition of its assets, a business must attempt to
make it difficult for its assets to be misappropriated. The internal accounting
controls element of a company's control system is that which is specifically
designed to provide reasonable, cost-effective safeguards against the
unauthorized use or disposition of company assets and reasonable assurances
that financial records and accounts are sufficiently reliable for purposes of
external reporting. [...] Internal accounting controls must be
distinguished from the accounting system typically found in a company.
Accounting systems process transactions and recognize, calculate, classify,
post, summarize, and report transactions. Internal controls safeguard assets
and assure the reliability of financial records, one of their main jobs being
to prevent and detect errors and irregularities that arise in the accounting
systems of the company. Internal accounting controls are basic indicators of
the reliability of the financial statements and the accounting system and
records from which financial statements are prepared."
Among the factors that determine the internal accounting
control environment of a company are its organizational structure, including
the competence of personnel, the degree and manner of delegation and
responsibility, the quality of internal budgets and financial reports, and the
checks and balances that separate incompatible activities. The efficiency of
the internal control system of a company cannot be evaluated without
considering the company's organizational structure, the caliber of its
employees, the strength of its audit committee, the effectiveness of its
internal audit operation, and a host of other factors which, while not part of
the internal control system itself, have an impact on the function of the
system."
"Although not specifically delineated in the Act itself,
the following directives can be inferred from the internal controls provisions:
(1) Every company should have reliable personnel, which may require that some
be bonded, and all should be supervised. (2) Account functions should be
segregated and procedures designed to prevent errors or irregularities. The
major functions of recordkeeping, custodianship, authorization, and operation
should be performed by different people to avoid the temptation for abuse of
these incompatible functions. (3) Reasonable assurances should be maintained
that transactions are executed as authorized. (4) Transactions should be
properly recorded in the firm's accounting records to facilitate control, which
would also require standardized procedures for making accounting entries.
Exceptional entries should be investigated regularly. (5) Access to assets of
the company should be limited to authorized personnel. (6) At reasonable
intervals, there should be a comparison of the accounting records with the
actual inventory of assets, which would usually involve the physical taking of
inventory, the counting of cash, and the reconciliation of accounting records
with the actual physical assets. Frequency of these comparisons will usually
depend on the cost of the process and upon the materiality of the assets
involved."
Judge Vining then stated as follows.
"The main problem with the internal accounting controls
provision of the FCPA is that there are no specific standards by which to
evaluate the sufficiency of controls; any evaluation is inevitably a highly
subjective process in which knowledgable individuals can arrive at totally
different conclusions. Any ruling by a court with respect to the applicability
of both the accounting provisions and the internal accounting control
provisions should be strictly limited to the facts of each case."
Judge Vining then summarized the defendants' arguments as
follows.
"The defendants in the instant case contend that the SEC
has misconstrued the provisions of the FCPA relating to a knowledge
requirement, contending that the SEC must show scienter. The defendants further
state that the SEC does not allege a knowing attempt to circumvent for an
improper purpose an internal control system required by law and that the
complaint ignores all considerations of the costs and benefits of internal
accounting controls and seeks to require World-Wide to maintain a system of
controls that would destroy the company."
Judge Vining then stated as follows.
"The definition of accounting controls does comprehend
reasonable, but not absolute, assurances that the objectives expressed in it
will be accomplished by the system. The concept of "reasonable assurances"
contained in section 13(b)(2)(B) recognizes that the costs of internal controls
should not exceed the benefits expected to be derived. It does not appear that
either the SEC or Congress, which adopted the SEC's recommendations, intended that
the statute should require that each affected issuer install a fail-safe
accounting control system at all costs. It appears that Congress was fully
cognizant of the cost-effective considerations which confront companies as they
consider the institution of accounting controls and of the subjective elements
which may lead reasonable individuals to arrive at different conclusions.
Congress has demanded only that judgment be exercised in applying the standard
of reasonableness. The size of the business, diversity of operations, degree of
centralization of financial and operating management, amount of contact by top
management with day-to-day operations, and numerous other circumstances are
factors which management must consider in establishing and maintaining an
internal accounting controls system. However, an issuer would probably not be
successful in arguing a cost-benefit defense in circumstances where the
management, despite warnings by its auditors or significant weaknesses of its
accounting control system, had decided, after a cost benefit analysis, not to
strengthen them, and then the internal accounting controls proved to be so
inadequate that the company was virtually destroyed. It is also true that
the internal accounting controls provisions contemplate the financial principle
or proportionality-what is material to a small company is not necessarily
material to a large company."
Judge Vining concluded his decision as follows.
"This court has already declined to adopt the defense
offered by the defendants that the accounting controls provisions of the
FCPA require a scienter requirement. The remainder of World-Wide's
defense appears to be that such a small operation should not be required to
maintain an elaborate and sophisticated internal control system, since the
costs of implementing and maintaining it would financially destroy the company.
It is true that a cost/benefit analysis is particularly relevant here, but it
remains undisputed that it was the lack of any control over the inventory and
inadequate accounting procedures that primarily contributed to World-Wide's
demise. No organization, no matter how small, should ignore the provisions of
the FCPA completely, as World-Wide did. Furthermore, common sense dictates the
need for such internal controls and procedures in a business with an inventory
as liquid as coins, medals, and bullion."
"The evidence in this case reveals that World-Wide, aided
and abetted by Hale and Seibert, violated the provisions of section 13(b)(2)(B)
of the FCPA. As set forth in the factual background portion of this
order, the internal recordkeeping and accounting controls of World-Wide
has been sheer chaos since Hale took over control of the company. For example,
there has been no procedure implemented with respect to writing checks:
employees have had access to presigned checks; source documents were not
required to be prepared when a check was drawn; employees have not been
required to obtain approval before writing a check; and, even when a check was
drawn to cash, supporting documentation was usually not prepared to explain the
purpose for which the check was drawn. In addition to extremely lax security
measures such as leaving the vault unguarded, there has been no separation of
duties in the areas of purchase and sales transactions, and valuation
procedures for ending inventory. Furthermore, no promissory notes or other
supporting documentation has been prepared to evidence purported loans to
World-Wide by Hale or by his affiliate companies."
"Since Hale obtained control of World-Wide, employees
have not been required to write source documents relating to the purchase and
sale of coins, bullion, or other inventory. Because of this total lack of an
audit trail with respect to these transactions and the disposition of World-Wide's
assets, it has been virtually impossible to determine if an item has been sold
at a profit or at a loss. Furthermore, there are more than $1,700,000 worth of
checks drawn to Hale or to Hale's affiliates, or to cash, for which no adequate
source documentation exists. Furthermore, Hale and Seibert knew that the
medallions that were sold to World-Wide by Hale in 1979 were overvalued and
unmarketable. Even so, they allowed the incorrect value of the medallions to be
entered on the books of World-Wide. They also knew that the company's books and
records were neither accurate nor complete. Pursuant to their directives,
source documents were not prepared with respect to the transfer of funds;
additionally, no audit trail was maintained for the acquisition and disposition
of inventory. Furthermore, it appears that there were numerous false and
misleading statements and omissions in the company's numerous reports to the
SEC, many of which were filed late or not at all."
"Individually, the acts of these defendants do not appear
so egregious as to warrant the full panoply of relief requested by the SEC nor
to impose complete liability under the FCPA. However, the court cannot ignore
the all-pervasive effect of the combined failure to act, failure to keep accurate
records, failure to maintain any type of inventory control, material omissions
and misrepresentations, and other activities which caused World-Wide to
decrease from a company of 40 employees and assets over $2,000,000 to a company
of only three employees and assets of less than $500,000. It is evident that
World-Wide, Hale, and Seibert violated all provisions contained in section
13(b)(2)(A) and (B) and the SEC's rules promulgated thereunder."
Read more articles on the FCPA by Mike
Koehler at FCPA
Professor.
For more information about LexisNexis
products and solutions connect with us through our corporate site.