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The SEC’s AgFeed Complaint: No Restatement Means No Sarbanes-Oxley Clawback

 The Securities and Exchange Commission says it’s stepping up scrutiny of corporate accounting and disclosure fraud. That means going after gatekeepers like auditors, lawyers, and directors under an aptly named initiative Operation Broken Gate. The AgFeed case is the mother lode for an SEC that says it’s ready to rack up some accounting fraud enforcement points and, perhaps, pursue a more aggressive enforcement approach to sparsely utilized Sarbanes-Oxley provisions like Section 304, compensation clawbacks.

AgFeed has everything a reinvigorated corporate fraud fighting and broken gate fixing SEC could want. My recent three part series on this Chinese reverse merger gone bad and bankrupt was published before the SEC recently filed a complaint against AgFeed and six executives. The SEC complaint includes fifteen allegations that cover a wide range of federal securities laws including Sarbanes-Oxley law.

I previously wrote about the Audit Committee member, Milton Webster, who was a whistleblower. The complaint alleges another guy, an Audit Committee Chairman, “engaged in a scheme to avoid or delay disclosure of the fraud.”

I previously wrote about the two audit firms that missed the fraud, Goldman Parks Kurland Mohidin LLP and McGladrey & Pullen LLP, defendants in private shareholder class action litigation alleging malpractice. The SEC’s complaint says AgFeed executives deceived the auditors, a violation of Rule 13b2-2 or Section 303(a) of the Sarbanes-Oxley Act. (The SEC has, in the interest of strengthening its own case against the executives, given the audit firms a big SEC-supported leg up in defending themselves against private litigation for malpractice.)

The SEC’s complaint “anonymizes” two trusted advisors, a firm and an individual, and credits them with trying to do the right thing and warning executives about the potential for fraud. I wrote about Fred Rittereiser, an advisor to the board that Milton Webster referred to in his deposition as a “consiglieri”, and not the upstanding, law abiding kind. I also wrote about Protiviti, a consulting firm with close ties to the Audit Committee Chairman and, later, AgFeed CEO and Chairman Van Gothner. Protiviti helped AgFeed management prepare its Sarbanes-Oxley internal controls assessments starting in 2008, respond in March of 2012 to initial SEC investigative inquiries and then doubled down in early 2013, after the fraud was well-known, to be the company’s internal audit service provider.

The SEC complaint does not even mention law firm Latham & Watkins, since the agency chose to focus only on the fraud in the Chinese operations of AgFeed that allegedly occurred from 2008 until the end of June 2011. I wrote about Latham & Watkins, the firm that began representing AgFeed and its officers and directors shortly they disclosed the Chinese fraud and shareholders sued them. Latham continues to represent the company and some executives. Latham & Watkins was hired as counsel to a special investigative committee at the end of 2011 and the law firm hired consulting firm FTI to act as forensic accountants under its direction. A derivative suit was eliminated by the bankruptcy in July of 2013. Latham also now serves as special counsel to the company in bankruptcy.

The SEC complaint includes a claim against the former Chinese CEO and CFO and the subsequent US CFO for “failure to reimburse”, a violation of Section 304(a) of the Sarbanes-Oxley Act of 2002. The Section 304 claim hits all the highlights of the law:

“As a result of the misconduct described above, AgFeed filed reports that were in material non-compliance with its financial reporting requirements under the federal securities laws. AgFeed’s material non-compliance with its financial reporting requirements resulting from the misconduct required the company to prepare accounting restatements.”  But the SEC admits “the company prepared a draft restatement but never completed it because on July 15, 2013, the company filed for protection under the United States Bankruptcy Code.”

The SEC then makes a calculation of the impact of the restatement that should have been, if only the AgFeed executives had completed and filed it.

“Based on the company’s draft restatement work, the fraud caused AgFeed’s publicly-reported revenues to be overstated by approximately $239 million over a three-and-a-half year period. On an annual basis, for 2008, 2009, and 2010, the fraud caused revenue inflation ranging from approximately 71% to approximately 103% and gross profit inflation ranging from approximately 98% to approximately 153%.”

On March 7, 2014 AgFeed filed an 8-K to, among other things, announce “the Company has not completed, and is not working on, its financial statements for the years ended 2013, 2012 or 2011, or its restated financial statements for the year ended December 31, 2010.” The company’s auditor, McGladrey LLP, also resigned on March 7.

(The company had previously disclosed that, based on the completion of the special committee investigation into certain accounting issues in the Company’s animal nutrition and legacy farm hog operations in China, “investors and others should not rely on the Company’s (1) audited financial statements for the year ended December 31, 2010, which were audited by McGladrey, (2) audited financial statements for the years ended December 31, 2009, 2008 and 2007, which were audited by another registered accounting firm and not McGladrey, and (3) unaudited financial statements for all quarters within those years and the first two quarters of 2011.”)

The SEC’s fifteenth and final claim against AgFeed and its executives, “Failure to Reimburse – Violation of Section 304(a) of the Sarbanes-Oxley Act of 2002 [15 U.S.C. § 7243(a)]” is a huge prosecutorial stretch given the law and the agency’s track record, if you can call it that, for enforcing Section 304.

Here’s why…

 Read  the rest of the article at the re: The Auditors, a blog by Francine McKenna.

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