Last summer, the Securities and Exchange Commission announced its new initiatives and approach to combat financial reporting and microcap fraud. Similar to the auditors’ mindset in auditing financial statements by identifying the high-risk areas of an audit through inquiry and analytics, the SEC will focus on the high-risk areas of the financial markets. The SEC has established three new initiatives that will be accomplished using cutting-edge technology and utilizing big data analytics to expose potential fraudulent financial reporting and microcap fraud.
The three initiatives as disclosed in the SEC announcement are:
- The Financial Reporting and Audit Task Force will detect improper or fraudulent financial reporting
- The Microcap Fraud Task Force will analyze trading activities that appear to be abusive and fraudulent conduct in the issuance of securities in the microcap market
- The Center for Risk and Quantitative Analytics will utilize data analytics to highlight high-risk transactions and behavior to detect potential misconduct. The goal being to prevent misconduct that harms investors.
George S. Canellos, Co-Director of the Division of Enforcement said, “The best investigative ideas usually come from the grass roots – staff in the field observing the market first-hand.” The Center for Risk and Quantitative Analytics will assist the Division of Enforcements’ staff by providing them analytical techniques, computing capacity and expertise in data mining.
The Financial Reporting and Audit Task Force will be reviewing restatements and revisions of previously issued financial statements. It will use analytics of performance trends by industry as well as the use of technology-based review tools such as the Accounting Quality Model, which contains data from over 9,000 publicly traded companies. These initiatives will focus on identifying potential SEC violations attributable to the preparation of financial statements, issuer reporting and disclosure, and potential audit failures. The SEC has claimed that in the past, financial fraud has been detected from the review of restatements. The SEC has also noted that the number of restatements have declined over the years as a result of the widespread implementation of the Sarbanes-Oxley Act of 2002.
The Microcap Fraud Task Force will investigate potential fraud in the issuance, marketing and trading of microcap securities. The goal of the Task Force is to develop and implement long-term strategies for detecting and fighting microcap securities fraud by targeting the “gatekeepers“. This could include attorneys, broker-dealers, transfer agents, stock promoters and promoters of shell companies.
The Center for Risk and Quantitative Analytics will support and coordinate the Enforcement Division’s risk identification and assessment and data analytic activities by identifying risks and threats that could harm investors. In essence, they will provide sources of information and analytics about characteristics and patterns that indicate possible fraud.
In addition, the Enforcement Division’s Task Force initiatives will continue to rely on whistleblower activity. The Enforcement Division seeks corporate insiders to provide any knowledge of wrong doing associated with potential fraudulent activities.
The SEC’s Task Force initiatives are a reflection of the complexity inherent in the current financial reporting environment that can conceal a financial fraud, combined with the opportunities electronic trading presents for abusive trading practices. Reading an SEC filing is no longer sufficient to detect, or deter, financial fraud. By implementing a comprehensive program to critically analyze large amounts of financial information and trading data, the SEC hopes to deter fraud, and detect it in a timely manner if it does exist. We all hope the SEC’s efforts are successful, and we never encounter a fraud as massive as that perpetrated by Bernie Madoff.