22 May 2020
Introduction
The COVID-19 pandemic has given rise to a "perfect storm" of uncertainty, financial pressure and social disruption, creating fertile conditions for fraud against companies and individuals. In this week's enforcement update, we examine some of the key areas of fraud risk for businesses. |
Misleading investors
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In the last week, the US Securities & Exchange Commission (SEC) has launched enforcement actions against two US companies, Applied BioSciences Corp.(APPB) and Turbo Global Partners, Inc. (TRBO), in both cases alleging fraudulent misconduct relating directly to COVID-19.
The SEC's complaint against APPB relates to two company press releases issued in late March announcing, respectively, that APPB was shifting manufacturing operations to focus on production of COVID-19 related goods (including hand sanitiser); and that APPB had begun shipping a line of COVID-19 home testing kits. The SEC alleges that these announcements, which immediately preceded to a sharp increase in APPB's share price and trading volume, were "false and misleading" and constituted an attempt by APPB to "exploit the COVID-19 pandemic for profit".
The complaint against TRBO, a digital marketing company, also relates to company press releases, in this case announcing a strategic alliance with another company, BeMotion, Inc., to sell equipment that could be used to scan large crowds to detect individuals with elevated body temperatures, and that the equipment was available to be shipped immediately. The SEC alleges that these claims were false and designed to defraud investors.
One notable aspect of both cases is the speed with which the complaints have been brought by the SEC. This, along with the fact that both complaints prominently and very directly accuse the defendants of having sought to profit from COVID-19, reinforce the SEC's previously declared intention to act decisively to deal with misconduct aimed at exploiting the global pandemic. Asian and other global enforcement agencies have made similarly strong statements of intent and we would expect them to act with similar expediency when faced with instances of COVID-19 related fraud.
For companies that are diversifying manufacturing or other operations in response to COVID-19, timing of market announcements is crucial. Given market conditions, there may be considerable pressure to fast-track an announcement which will have a positive impact on investor sentiment but companies and their financial or communications advisors must avoid pre-empting events or overstating operational readiness. In the TRBO complaint, while the SEC concedes that TRBO had, in fact, entered into a written agreement with BeMotion (and that BeMotion, in turn, had signed a contract with a Chinese manufacturer of thermal scanning equipment), their strategic alliance did not specifically regard thermal scanning equipment and the parties never reached agreement on the terms of any distribution agreement for such equipment. Company announcements must also accurately reflect the status of all relevant regulatory approvals. A key allegation in the APPB complaint is that the company failed to disclose that it had not received Food & Drug Administration approval for the sale of COVID-19 testing kits. Companies that directly or indirectly mislead as to the status of a regulatory approval process, or even simply omit to mention that they have not received relevant approvals, put themselves at significant risk of enforcement action. |
Revenue recognition
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More generally, companies need to consider carefully how they report COVID-19 related impacts, both positive and negative, on the financial position of their business. Legal and compliance teams should also watch out for potential misconduct by individuals or groups that may impact on financial reporting at the corporate level. We have regularly assisted clients in instances where relatively low-level misconduct within an organisation has had an impact on the accuracy of financial reporting to the extent that companies have been required to issue restatements and, in some cases, submit themselves to considerable scrutiny by market regulators.
Financial pressure within an organisation may also induce business unit leaders, concerned with meeting expectations and with the security of their own position, to mislead management as to the financial performance of their department. A sharp decline in demand for certain products may also lead to a risk of fraudulent revenue recognition practices, such as channel stuffing, a practice where vendors deliberately send distributors products in excess of demand in the short term (often with an agreement that orders can be reduced in future and/or the distributor can return unsold stock to the vendor) in order to meet internal sales target. This means a drop in demand which would have had a material impact on financial position in a given reporting period can be spread over a longer timeframe and thereby mitigated. A number of recent high-profile enforcement actions and significant penalties imposed by the SEC, the UK Serious Fraud Office and other authorities against multinational corporations show the potentially serious consequences for companies whose reporting does not accurately reflect known trends in demand. Accounting and compliance teams should be particularly alert to situations where reported earnings/sales are markedly better than expected, or where financial results appear to be at odds with "real world" market conditions. |
Employee-level fraud
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Remote working situations may create opportunities for fraud, as employees seek to take advantage of an actual or perceived lack of oversight of their activities. Such misconduct may include fraudulent expense claims, or ordering goods and/or payments for their own use (or to benefit their own personal contacts). Teams responsible for approving expenses and procurement requests should remain particularly vigilant and ensure they have approval processes in place that function in a remote working context.
Companies forced to make difficult decisions about resourcing and cost base may also inadvertently increase the motivation for fraud. Employees facing reduced salaries, for example, may resort to misconduct as a way of "topping up" their pay, while some may be motivated to misappropriate from their employer as a result of being disgruntled about a change in their working conditions or the loss of colleagues.
In light of market volatility, compliance teams in financial institutions should also be particularly alert to unauthorised trading committed by individuals to enable them to continue trading in the hope that things will turn around. |
For further information, please contact:
Kyle Wombolt, Partner, Herbert Smith Freehills
kyle.wombolt@hsf.com