When Success Raises Suspicions: The SEC's Risk-Based Investigation Of General Electric's Accounting Practices.

On August 4, the Securities and Exchange Commission (SEC) charged General Electric Company (GE) with fraud and multiple violations of the federal securities laws (FSLs) in a civil action that GE has agreed to settle by paying a $50 million penalty and consenting to the entering of an order permanently enjoining the company from violating the antifraud, reporting, record-keeping and internal control provisions of the FSLs. GE agreed to pay the substantial financial penalty and to entry of the order without admitting or denying the allegations, thereby concluding the SEC's investigation. The suit alleged that GE misled investors by reporting materially false and misleading results in its financial statements, which were based upon improper accounting methods that increased its revenues and earnings and avoided the need to report negative financial results for certain periods. The SEC's action against GE sends a clear message to Corporate America that no public company, however large, will evade careful scrutiny of its accounting practices where there are obvious "red flags."

According to the SEC's complaint, beginning in 1995 and running through the end of 2004, GE met or exceeded analysts' final consensus expectations regarding earnings per share (EPS) every quarter. This apparently raised a red flag with the SEC, which launched an internal investigation of GE's accounting practices. The SEC uncovered the alleged accounting violations in its "risk-based investigation" of GE's accounting practices. In a risk-based investigation, the SEC first identifies a potential industry or issuer risk and then develops a plan to test whether a problem actually exists.

In the case of GE, the SEC identified the potential misuse of hedge accounting as a possible risk area for the company. Ultimately, the SEC determined that, on four separate occasions in 2002 and 2003, senior-level accounting or financial executives of GE approved improper accounting that did not comply with generally accepted accounting principles (GAAP). In one of the four instances, the improper accounting allowed the company to avoid missing analysts' final consensus EPS expectations.

The four alleged accounting violations included the following:

An improper application of GAAP standards to GE's commercial paper funding program beginning in January 2003 to avoid unfavorable disclosures and an estimated $200 million charge to pre-tax earnings;

A failure in 2003 to correct a misapplication of financial accounting standards (FASs) to certain interest rate swaps;

Reported year-end sales of locomotives in 2002-2003 that had not occurred, in order to accelerate revenue of approximately $370 million; and

An improper change in 2002 to GE's accounting for sales of commercial aircraft engine spare parts that increased 2002 net earnings by $585 million.

Although the SEC's complaint does not directly discuss the red flags that led to its investigation of these four risks, they appear to be obvious from a close reading of the complaint.

In the 2001-2006 period, GE used hedge accounting to account for interest rate swaps held for the purpose of hedging interest rate risk on its issuances of commercial paper (CP), which resulted in smoother reported earnings. In early 2003, however, GE changed its CP hedge accounting approach after spending several months trying to solve its CP hedging issues with proposals that were based upon its previously established CP hedging approach. The new approach violated GAAP, according to the SEC's complaint, but allowed GE to preserve its use of hedge accounting for its CP program and to avoid recording what GE estimated to be an approximately $200 million charge to pre-tax earnings. The red flags were the conflict between GE's new hedge accounting approach and its hedge documentation; internal emails that specifically highlighted the issues surrounding the potential problems related to the change; an email from GE's outside auditor listing its concerns with the new approach; and the failure by GE or its outside auditors to bring the new methodology to the outside auditors' national office for review.

Regarding GE's alleged improper application of FAS 133 for certain interest rate swaps, the SEC complaint specifically cites that a GE accountant learned in early 2003 that certain "shortcut swaps" included fees paid or received at inception. The existence of those fees rendered them ineligible for shortcut treatment, but GE allegedly did not correct the past accounting errors, which would have required the company to record the fluctuations in value for those swaps since their inception. Ultimately, when GE filed an amended Form 10-K for 2004 to restate its financial statements for 2002-2004, the restatement reversed the effects of incorrect hedge accounting under FAS 133.

In the case of the locomotives, the SEC found that in the fourth quarters of 2002 and 2003, GE had improperly recorded revenue of $223 million and $158 million, respectively, for the sale of locomotives to financial institutions (FIs). The SEC's complaint alleges that the six transactions were not "true sales" and did not qualify for revenue recognition under GAAP. The effect of the transactions was to improperly accelerate revenue recognition by selling the locomotives to FIs in the fourth quarters of 2002 and 2003, and having the FIs resell them to railroads in the first quarters of 2003 and 2004. In most of the transactions, the FIs received certain fees from GE rather than profits related to the sale of the locomotives. During various meetings, the transactions were sometimes referred to as "bridge financings." Internal emails, as well as documentation, related to the transactions indicate that internal audit staff were concerned that the transactions were not true sales under GAAP and that the GE business team had asked the FIs to avoid referring to "costs of storage and insurance" in their invoices.

In March 2002, GE made two changes to its method for accounting for its sale of commercial aircraft engine spare parts. After investigating the two changes, the SEC concluded that the second change did not comply with GAAP. The error in making that change resulted in GE overstating 2002 net earnings by approximately $585 million. In alleging that GE's decision to make internal pricing changes on a prospective-only basis did not comply with GAAP, the SEC cited a call on March 27, 2002, involving senior GE corporate accountants and members of the business unit.

The SEC's complaint alleges that the effect of the aforementioned record-keeping, accounting and disclosure improprieties caused GE, acting primarily through its senior corporate accountants, to engage in fraudulent activities resulting in numerous materially false and misleading statements or omissions in violation of the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the SEC's press release announcing the filing of civil charges against, and the settlement with, the company, "GE bent the accounting rules beyond the breaking point."

With this action, the SEC's Division of Enforcement has put reporting issuers on notice that they should take very seriously their responsibility under recently enacted Sarbanes-Oxley Act of 2002 requirements to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance of the accuracy of their financial statements in conformity with GAAP.

Joris Hogan, a partner with Torys LLP in New York, practices corporate and securities law. His practice focuses on advising principals, private equity firms and investment banks in domestic and cross-border M&A transactions involving public and private companies. He also represents issuers, underwriters and purchasers in public and private financings, and on corporate governance and other complex corporate matters.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

Mr Joris Hogan

Torys LLP

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