Cornerstone Research has issued two reports on litigation involving accounting and auditing violations. In its annual report on accounting-related class actions, Accounting Class Action Filings and Settlements—2022 Review and Analysis, Cornerstone finds that class action filings against public companies for alleged accounting violations increased slightly last year but remain low by historical measures. On the other hand, the dollar value of accounting class action settlements rose 67 percent, compared to 2021. (For a summary of Cornerstone’s report on 2021 accounting class actions, see Cornerstone: Accounting Class Actions Fell Sharply Last Year, April-May 2022 Update.)
The findings of Cornerstone’s annual report on Securities and Exchange Commission accounting and auditing enforcement actions are almost a mirror image of those in the class action report: SEC accounting and auditing enforcement activity increased sharply in fiscal 2022, while monetary settlements dropped substantially. SEC Accounting and Auditing Enforcement Activity—Year in Review: FY 2022 found that, in 2022, the SEC announced 68t accounting and auditing enforcement actions, a 55 percent increase from fiscal 2021. However, monetary settlements in SEC accounting and auditing cases totaled $625 million, down over 60 percent from 2021. (For a summary of Cornerstone’s report on 2021 SEC accounting and auditing cases, see Accounting and Auditing Enforcement was Down in 2021, But May Now be on the Upswing, March 2022 Update.)
Accounting Class Action Filings and Settlements
Cornerstone found that, in 2022, plaintiffs filed 51 new class actions against public companies alleging accounting violations, an 11 percent increase from the 46 filings in 2021. While an uptick from 2021, the 51 cases brought in 2022 were significantly below the 2013-2021 average of 62 new filings per year. Moreover, 24 percent of 2022 federal securities law class actions involved special purpose acquisition companies (SPACs), up from 20 percent in 2021.
There were 43 accounting case settlements in 2022, inline with the average of 42 during 2013-2021. The value of these accounting-related settlements increased to $1.4 billion, up from $817 million in 2021. However, the total value of accounting-related settlements, as a percentage of the value of all securities class action settlements, declined from 42 percent in 2021 to 36 percent in 2022.
Other key take-aways from the 2022 Cornerstone report include:
Almost half of accounting class action cases settle, but it takes time. From 2013 through 2021, 40 percent of accounting case filings were settled, 43 percent were dismissed, one percent were remanded, and 16 percent are continuing. In 2022, the average time to settlement was 3.7 years, compared to 3.2 years in 2021.
Plaintiffs are bringing cases against smaller companies but settling with larger companies. The median pre-disclosure market capitalization of issuer defendants in 2022 accounting class actions was $1.1 billion, 12 percent less than the 2013 to 2021 average. This was the smallest defendant market capitalization since 2017. At the same time, the median pre-disclosure market capitalization of issuer defendants in cases that settled in 2022 increased by over 110 percent from 2021 and was nearly three times the average annual median for 2013 to 2021.
The industries that attracted the most 2022 filing were Consumer Non-Cyclicals and Consumer Cyclicals. Accounting cases against companies in the Consumer Non-Cyclical and Consumer Cyclical sectors together were almost half of total 2022 filings. The third most-sued industry was Technology, with 18 percent of cases. By comparison, in 2021 the greatest number of cases were filed against companies in the Technology, Consumer Non-Cyclical, and the Financial sectors. In 2022, case filings against companies in the Financial sector dropped to their lowest level in the last 10 years. For the first time in the last 10 years, plaintiffs filed no accounting class actions against companies in the Communications sector.
Restatements were involved in one-third of new accounting class actions. Seventeen (33 percent) of the 51 accounting cases filed in 2022 involved restatements. This was the highest percentage of restatement cases since 2014 and a sharp increase from the five restatement cases filed in 2021. (The average number of restatement cases filed per year during 2013 to 2021 was 16.) In 2022, 82 percent of the accounting case filings involving a restatement also included allegations of internal control weaknesses.
Internal control weakness allegations regained some of their popularity. The number of accounting case filings containing allegations of internal control weaknesses increased from 18 to 25 (49 percent of all cases) but was at the second-lowest level in the last 10 years. For the second consecutive year, less than half of new accounting cases alleged internal control weaknesses. Accounting cases filed in 2022 containing allegations of internal control weaknesses involved the smallest defendant firms, as measured by pre-disclosure market capitalization, since 2015.
Revenue recognition is the most common GAAP allegation, although internal control weaknesses have partly displaced GAAP as a basis for litigation. In 2022, 35 percent of accounting case filings involved allegations of improper revenue recognition. Eighty-four percent of accounting case settlements involved GAAP allegations, compared to 100 percent in 2016.
SEC Accounting and Auditing Enforcement
As noted above, Cornerstone’s study of fiscal 2022 SEC enforcement found that the Commission filed 68 accounting and auditing actions, a 55 percent increase from fiscal 2021. While this level of SEC accounting enforcement reflected a 55 percent increase over 2021, it was exactly in line with the average of 68 yearly accounting and auditing filings during fiscal years 2017 through 2022 and significantly below the 93 cases brought in 2019. The SEC brought 51 of the 2022 cases as administrative proceedings and 17 as civil actions filed in federal court. Very few SEC accounting cases are litigated; settlements were announced in 66 of the 68-eight actions simultaneously with the filing of the case.
Other interesting features of Cornerstone’s SEC accounting enforcement analysis include:
Announcements of restatements or material control weaknesses are frequently the basis for SEC enforcement. Of the 68 enforcement actions, 36 referred to announced restatements of financial statements and 23 referred to announced material weaknesses in internal control over financial reporting. Five referred only to a material weaknesses announcement, 18 to only a restatement announcement, and 18 referred to both.
Revenue recognition, compensation claw backs, and auditor independence were popular topics. Twenty-five of the 36 actions that referred to restatements alleged improper revenue recognition. Nine of the 68 cases brought in 2022 were based on the Sarbanes-Oxley Act provision that authorizes the SEC to claw back executive compensation following a restatement. Five cases charged violations of the auditor independence rules.
SEC enforcement is focusing on individuals. The SEC named one or more individuals as defendants or respondents in 49 (72 percent) of the 68 cases it filed in 2022. Fifty-three percent of actions (36 cases) involved individual respondents only, a sharp increase from the FY 2017 to 2021 average of 37 percent. In total, the SEC charged 66 individuals in accounting or auditing cases in 2022, up from 38 individuals last year, but in line with the 2017-2021 average of 65 individual defendants/respondents per year.
The spotlight is on auditors. The SEC filed charges against 28 individual public company auditors and audit firms, representing 27 percent of the 103 defendants/respondents in the 68 cases brought in 2022. The number of auditor/audit firm defendants/respondents was almost double the number in 2021 and almost triple 2020.
The monetary cost of settling with the SEC declined. In fiscal 2022, 90 respondents/defendants settled with the SEC. In those settlements, 65 of the settling parties were required to make a monetary payment. These payments totaled $625 million, down from $1.627 billion in 2021. Civil penalties accounted for 67 percent of the $625 million, while the remaining 33 percent was disgorgement of illegally obtained funds (31 percent) and prejudgment interest (2 percent).
Comment: While the frequency of both class action and SEC enforcement accounting cases is somewhat low compared to historical norms, this type of litigation is increasing and remains a real possibility for many public companies. Moreover, the cost of settling class action cases, and the time required to do so, also seem to be increasing. As stated in several prior Updates, accounting issues are a significant line of attack for the plaintiff’s bar, and restatements and disclosure of internal control weaknesses are likely to attract litigation, if they coincide with a significant drop in stock price. Investing in strong internal controls, along with audit committee care and diligence in overseeing the company’s financial reporting, are a small price to pay to reduce the risk that the company will be exposed to the cost and distraction of litigation over accounting matters.
Another significant Cornerstone finding that audit committees and financial reporting management should keep in mind is the SEC’s stepped-up focus on individual culpability. As noted above, over half of 2022 accounting cases involved only individual defendants/respondents, well above the historical average. Cornerstone attributes this shift to SEC Chair Gensler's commitment to make holding individuals accountable a key priority of the enforcement program. The risk that restatements, internal control material weaknesses, and other accounting-related problems will result in SEC enforcement action against the individuals involved, along with or instead of the reporting company, is likely to remain elevated for the foreseeable future.