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) 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.”
That 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.”