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United States: General Counsels beware: Loss contingencies as securities fraud

Recent Securities and Exchange Commission (SEC) action suggests a requirement to disclose government and regulatory investigations far earlier than previously thought.

Failure to disclose matters relating to DOJ investigation

The SEC recently filed securities fraud charges against RPM International Inc. (RPM) and Edward Moore, RPM's general counsel and Chief Compliance Officer. RPM is a NYSE-listed manufacturer of protective coatings and sealants.

The SEC's complaint alleges that both RPM and Moore violated the antifraud and other provisions of the securities laws by failing to timely disclose and account for material loss contingencies and accruals relating to an investigation being conducted by the Department of Justice (DOJ). The investigation focused on allegations that RPM potentially overcharged the federal government on certain sales of its products. The SEC also alleges that Moore failed to inform RPM's CEO, CFO, internal audit committee, and independent auditor of the progress of the DOJ investigation.

The facts alleged by the SEC in the RPM case are enough to give pause to any general counsel of a publicly traded company.

Loss contingency should have been disclosed much earlier

The origin of this case dates back to July 2010 when a former RPM employee filed a qui tam action on behalf of the federal government under the False Claims Act (FCA) for allegedly fraudulently overcharging the federal government. In FCA cases, the complaint is filed under seal, reviewed by the DOJ and the district court in camera, and not initially served on the defendant. RPM first received a copy of the FCA complaint from the DOJ in August 2012. Negotiations with the DOJ began in September 2012, when RPM met with the DOJ and disclosed that it had overcharged the government by at least USD 11 million. When a final settlement was reached in August 2013, that figure increased to USD 28.3 million.

On April 4, 2013, RPM filed a Form 8-K with the SEC publicly disclosing for the first time the DOJ investigation and an accrual recorded in the amount of USD 68.8 million, likely reflecting both disgorgement and a penalty. At this time, the FCA complaint remained sealed. In August 2014, RPM also filed amended Form 10-Q, restating its income for the relevant quarters (June 2012 – February 2013).

The SEC alleges that from at least the time of RPM's first meeting with the DOJ in September 2012, RPM knew of an impending material loss that was probable and reasonably estimable but failed for three quarters to disclose and accrue for the loss. Between September 2012 and August 2013, RPM and the DOJ were still actively negotiating a resolution, and RPM was still investigating the matter.

Materiality – a moving target

The SEC's Enforcement Division appears to take an aggressive position on materiality in at least two respects. First, instead of looking to RPM's USD 109.9 million in annual net income for the fiscal year ending May 31, 2013, the SEC alleges that RPM's failure to disclose the potential for a one-time expense associated with the USD 11.4 million overcharge estimate is material relative to its USD 33.9 million quarterly net income, and specifically material to investors participating in RPM's investment grade bond offering.  

Secondly, the SEC appears to take the position that restated SEC filings may constitute admissions that the original filings were materially inaccurate. Here, the Enforcement Division appears to put companies and in-house counsel in the position of either "admitting" to having made a material misstatement by restating an immaterial error, or not restating and running the risk of the SEC second guessing their determination of materiality.  

A tough call for in-house counsel

The SEC appears to have taken an aggressive position on in-house counsel's management of government investigations and of disclosure obligations. Mishandling the disclosure of an ongoing investigation can itself lead to an investigation and exposure for both the company and counsel. This suggests a troubling dilemma for in-house counsel: disclose your negotiating position and risk the government using it against you or withhold the information and risk the SEC charging your company with securities fraud for the omission.

Further information

This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication.  For more information please contact Karen Birch karen.birch@allenovery.com, or tel +44 20 3088 3710.

Legal and Regulatory Risk Note
United States