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Evaluating the SEC's new 'cooperating witness' focus.

Is there a new reality for corporate crooks? The SEC's Enforcement Division thinks so. Unraveling elaborate schemes designed to conceal fraudulent activities is difficult. Establishing executive-level culpability when lower level subordinates have hands-on responsibility for carrying out a fraud can be particularly tricky. To combat intricate financial schemes, the Enforcement Division has undertaken "its most significant reorganization since its establishment in 1972" ("SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence," SEC release, January 13, 2010).

One year after being appointed SEC director of enforcement, Robert Khuzami outlined drastic new techniques to enhance investigative efforts ("SEC Announces Initiative to Encourage Individuals and Companies to Cooperate and Assist Investigations," SEC release, January 13, 2010). Key to the new SEC strategy is the "cooperating witness." Along with newly formalized guidelines for rewarding substantial assistance, the SEC has now introduced into its civil enforcement arena a controversial weapon usually associated only with criminal investigations.

Considerable Shift in Strategy

The SEC's move to make cooperating witnesses the centerpiece of its reorganized fraud enforcement strategy is a major leap forward. In the past, the SEC has acknowledged cooperation as a factor in its decision to accept a particular settlement. Nevertheless, Mark K. Schonfeld, a partner with Gibson Dunn & Crutcher LLP and former director of the SEC's New York Regional Office, stated that "these outcomes typically reflect retrospective acknowledgement of cooperation, rather than a proactive effort to obtain the cooperation of an individual in return for a particular outcome" ("Courting Cooperators: The SEC's Effort to Motivate Individual Cooperation," Corporate Counsel Weekly, December 9, 2009). If successful, this greater reliance on the cooperating witness as an enforcement weapon could have significant impact.

While the SEC is clearly optimistic about the possibilities of this strategy shift, its effectiveness is far from certain. More obvious is the SEC Enforcement Division's willingness under Chairman Mary L. Schapiro to think outside the box in experimenting with ways to prevent corporate wrongdoing from top to bottom in listed companies.

If nothing else, the Enforcement Division's announcement has gotten the attention of experts in the fraudulent financial statement community. Typical is the reaction of Russ Ryan, a partner with King & Spaulding and a former assistant director in the Enforcement Division: "Previously only companies ever got any tangible rewards for extraordinary cooperation, so individuals rarely had any incentive to come forward with information unless and until asked for it, especially if they had potential liability. This could really change the dynamic in many investigations" (Melissa Klein Aguilar, "New Cooperation Tools, an Enforcement Game Changer," Compliance Week, January 14, 2010).

Mark Hellerer and George Chikovani added, "While it may take some time for practices to develop, it can be expected that the measures will have a significant impact on the conduct of investigations and should accelerate the pace of those investigations" ("SEC Announces Significant New Initiatives to Encourage Cooperation in Investigations," Pillsbury Winthrop Shaw Pittman LLP client alert, January 15, 2010,

How It May Help

Aggressively seeking investigative assistance from cooperating witnesses could prove successful in one of two ways. First, a highly publicized policy where the SEC will routinely entice individuals to become cooperating witnesses could have a chilling effect on fraudulent activity before it occurs. The existence of an opportunity for culpable individuals to either distance themselves from their role in the fraudulent scheme or extricate themselves from liability to the SEC could increase detection risk and prosecution risk for white-collar criminals to unacceptable levels. Hence, the possibility that coconspirators will become cooperating witnesses could significantly diminish expected payoffs and, thus, discourage fraudulent behavior.

Second, the insight and testimony of cooperating witnesses could improve the Enforcement Division's effectiveness in investigating and prosecuting cases. Khuzami stated, "There is no substitute for the insiders' view into fraud and misconduct that only cooperating witnesses can provide. That type of evidence can expand our ability to conduct our investigations more swiftly, and to act quickly to file charges, freeze assets, and protect investors" (SEC, January 13, 2010). If the new SEC policy works the way Khuzami expects, the Enforcement Division should experience real improvement in processing cases.

Hurdles to Enforcement

Not everyone is as optimistic. Schonfeld feels there are significant barriers to this strategy working as planned. He wrote that a major hurdle for the SEC is its "inability to provide sufficient incentives to cooperate." He further stated, "The SEC lacks the substantial leverage that comes from the threat of prison posed by criminal prosecutors. Put simply, the threat of prison is a far greater motivator than the threat of financial sanctions" (Schonfeld 2009).

Equally disturbing is that cooperating with the SEC may preclude individuals from settling their individual misconduct charges on the usual "neither admit nor deny" basis. Thus, individuals cooperating with the SEC may encounter more legal exposure than if they had chosen not to be cooperating witnesses in the first place (Schonfeld 2009). For anyone contemplating the SEC's offer to become a cooperating witness, these are not trivial considerations.

The successful reliance upon cooperating witnesses in the fight against fraudulent financial reporting may prove to be as elusive as the whistleblower protection provisions of the Sarbanes-Oxley Act of 2002 (SOX) have been in exposing corporate fraud. Conventional wisdom espoused by many supporters of SOX suggested that more financial fraud would be exposed if whistleblowers were provided with greater protection. Based on the available evidence, SOX's greater protection of whistleblowers has not resulted in increased exposure of financial statement fraud. There may be other benefits attributable to SOX, but exposure of financial statement fraud does not appear to be one them.

Whistleblowing as a Model

Indicative of the rough road that may be ahead for the Enforcement Division's cooperating witness strategy in combating financial statement fraud is a study of 1,000 whistleblower cases by lawyers from Orrick, Herrington & Sutcliffe LLP. "The report states that 665 of the almost 1,000 cases examined were dismissed as having no merit; 126 complaints were withdrawn by the whistleblower; and 138 complaints were settled before a Department of Labor ruling. Only 17 cases were deemed to have merit and allowed to proceed" (Tracy Coenen, "The Failure of Whistleblower Protection Under Sarbanes-Oxley," AllBusiness,, November 28, 2007). The implication is clear. In over-whelming numbers, employers have had little to fear from whistleblowers in combating financial statement fraud.

Whenever there are highly publicized financial frauds such as at Enron and in the Bernard L. Madoff case, there is understandable public outrage and concern with preventing future occurrences. In their study of 200 financial statement fraud cases for the years 1987-1997, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) noted that while top senior executives (chief executive officers and chief financial officers) were involved in 83% of the fraud cases, the companies committing financial statement fraud were relatively small compared to public registrants. "Most companies (78% of the sample) were not listed on the New York or American Stock Exchanges" ("Fraudulent Financial Reporting: 1987-1997: An Analysis of U. S. Public Companies," Committee on Sponsoring Organizations of the Treadway Commission, March 1999). Aside from admitted failures in not preventing the Enron and Madoff fraudulent schemes from succeeding for as long as they did, the SEC already has a good idea of where to find most executive criminals. At issue is how best to protect the investing public from these individuals.

While there are important differences between whistleblowers and cooperating witnesses, both fraud prevention strategies rely upon individual insiders revealing information about their employers. So far, whistleblower protections in SOX have not resulted in noticeable success in combating financial statement fraud. To the contrary, less than 2% of 1,000 cases examined by Orrick, Herrington & Sutcliffe LLP were deemed to have merit (Coenen 2007). There is no compelling reason to believe the Enforcement Division's cooperating witness program will be any more successful. In the final analysis, the best hope for real progress in prosecuting crooked executives may not be new strategies. It may simply be the commitment of legislators to finance enforcement efforts and insist on the recruitment, training, and retention programs for experienced enforcement personnel needed to effectively combat fraudulent financial reporting.

Alexander L. Gabbin, PhD, MBA, CPA, is the KPMG LLP Professor in the School of Accounting, James Madison University, Harrisonburg, Va.
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Title Annotation:fraud
Author:Gabbin, Alexander L.
Publication:The CPA Journal
Date:Sep 1, 2010
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