Securities Fraud: When Do Disclosures to the Board Reduce Liability Risks?
Companies and their executives can face serious consequences if they are accused of securities fraud related to public disclosures. However, having a strong internal disclosure review process can help mitigate these risks. This article explores best practices around corporate disclosures and how the “disclosure process defense” can reduce liability for securities fraud allegations.
The Disclosure Process Defense
The disclosure process defense argues that company executives and directors reasonably relied on an appropriate, documented procedure for drafting and approving public disclosures. Instead of accusing executives of intentionally committing fraud, this defense claims they depended in good faith on internal controls and sign-offs.
To utilize this defense, companies need to demonstrate they had a rigorous disclosure workflow in place. Hallmarks include:
- Documented policies and procedures around financial reporting
- Robust controls, review, and approval mechanisms for public filings
- Cross-functional participation from legal, compliance, accounting, and business units
- Avenues for open discussion and addressing concerns or discrepancies
Simply having a process isn’t enough. Companies need to prove it was comprehensive and executed consistently in practice.
When properly implemented, though, this defense can undermine accusations that executives knowingly published false or misleading information. Plaintiffs must then prove intent to defraud despite available controls.
Real-World Examples
Recent SEC enforcements showcase the importance of disclosure procedures and where breakdowns can lead to fraud charges.
GTT Communications faced allegations after unsupported adjustments increased reported income in several quarters. According to the SEC, GTT struggled reconciling data across systems acquired during rapid expansion. The order cited disclosure control failures for permitting unsupported adjustments without further review.
The SEC ultimately only charged GTT under the Securities Act’s antifraud provisions. It credited the company’s self-reporting, cooperation, and remediation efforts in its settlement.
Bloomberg also settled SEC charges in 2023 that it failed to properly disclose limitations in its fixed income valuation product, BVAL. According to the SEC, BVAL derived some security prices from a single input like a broker quote. This methodology wasn’t aligned with prior service descriptions. The SEC said this was misleading for clients assessing asset valuations.
Bloomberg paid $5 million to settle without confirming or denying the findings. This showcases the importance of transparency around valuation methodologies.
Ongoing Legal Considerations
The Supreme Court is also currently set to hear a case about whether inadequate internal controls can directly support Exchange Act fraud claims. Defendants argue that control weaknesses alone shouldn’t satisfy intent requirements for private shareholder litigation.
This case could set further precedent around disclosures and liability risks. It exemplifies the complexity organizations still face balancing transparency, controls, and legal obligations.
Best Practices for Mitigating Liability
Given this landscape, what steps can companies take to design disclosure procedures that better withstand scrutiny? Consider these leading practices:
Document detailed protocols covering the end-to-end financial reporting process, with clearly defined roles and responsibilities. Keep comprehensive records of each disclosure cycle.
Mandate cross-functional participation, including from legal, accounting, finance and relevant business leaders. Seek broad alignment to avoid perception of rubber-stamp approvals.
Facilitate open evaluation of disclosures so issues get surfaced early, even if uncomfortable. Foster a culture where constructive challenges are encouraged, not discouraged.
Confirm figures directly with data owners and obtain sign-offs from process participants. Don’t assume information passing through business cycles is accurate without validation.
Review previous filings when events could necessitate amendments or restatements. Evaluate recent swings in performance as possible indicators of undetected errors.
Disclose limitations in data inputs, calculations, and methodologies alongside published metrics so users understand precision levels.
Standardize controls across acquired businesses to maintain consistency even during times of rapid change. Prioritize integration of financial reporting.
Promptly investigate, self-report and remediate any identified gaps or unsupported figures. Cooperate fully with regulatory inquiries and settlement proceedings.
Continuously improve by analyzing past filing cycles for enhancement opportunities in governance, data inputs, reviews and system reconciliations.
Conclusion
Robust disclosure policies, controls, and board oversight can limit liability risks even as reporting regulations and shareholder litigation evolve. While mistakes still occur, companies perceived as ignoring or circumventing protocols face harsher consequences.
Reliance on established disclosure procedures with cross-functional participation demonstrates good faith efforts to produce accurate filings. Seeking input, documenting decisions, and requiring sign-offs provide a trail of evidence if questions later arise.
Ongoing assessments, validations, and transparency around limitations also help safeguard credibility with regulators and shareholders alike. When gaps surface, swift action further mitigates risks.
While complex regulations will continue posing disclosure challenges, sound governance and diligent controls can pay dividends if allegations of impropriety one day arise.