Recent SEC Financial Reporting Settlement Reflects the Growing Value of Early Self-Reporting and Cooperation

5 minute read | February.26.2024

Among the worst nightmares of public company executives may be reports of possible accounting errors in earlier periodic filings or alleged employee manipulation of numbers. What to do?  The historical playbook is well known. Report the issue to the Audit Committee of the Board of Directors and auditors, begin an internal investigation and take remedial measures as warranted, including terminating wrongdoers’ employment. In addition, claw back executive bonuses, file the Form 8-K and restatements of prior financials and cooperate with the inevitable SEC investigation.

Wrestling with whether and when to self-report potential financial reporting errors and related problems to the SEC’s Division of Enforcement has long been a thorny strategic consideration.  Reporting early may involve the SEC in a matter that proves to be unsubstantiated, leading to regulatory inquiry and costs the issuer may not otherwise have incurred.  Reporting too late may trigger increased regulatory scrutiny, especially if the SEC perceives a desire on the part of the issuer to sweep the allegations under the rug.  

A recent SEC financial reporting settlement may alter the calculus. In that case, early self-reporting and meaningful cooperation garnered a settlement with no civil penalty, an unlikely outcome in the absence of the early self-report and cooperation.

Issuer Self-Reported the Errors Before Performing its Own Investigation

On February 6, 2024, the Commission announced a settlement with Cloopen Group Holding Limited, a provider of cloud communications products. The company is based in China, but its American depositary shares traded on the NYSE.  

In early 2022, Cloopen’s auditor discovered irregularities with certain customer transactions in the prior year, as well as numerous internal control shortcomings.  The company announced the auditor’s resignation and said it would investigate.  Notably, within a few days of hiring counsel to conduct the independent internal investigation, and before any significant steps had been taken as part of that investigation, Cloopen self-reported the accounting errors to the SEC.  

The internal investigation determined that two senior managers schemed to prematurely recognize revenue for work not yet completed and, in some instances, not even started. They acted to meet internal sales goals and avoid losing salary and bonuses for failing to meet sales targets.  As a result of the misconduct, Cloopen’s revenue for the second and third quarters of 2021 was overstated by 4% and 6%, respectively, and its guidance for the fourth quarter of 2021 was significantly overstated.  The investigation also identified deficient internal accounting controls and policies and practices.

The SEC Highlighted Early Self-Reporting

The order accepting Cloopen’s settlement offer and imposing sanctions highlighted Cloopen’s early self-report as among the reasons the SEC accepted the company’s offer.  The order further noted the substantial assistance the company provided to SEC staff through timely reporting of detailed findings and supporting documentation, steps that conserved SEC resources. The Commission also noted remedial measures Cloopen took, including strengthening internal controls and policies, terminating wrongdoers and clawing back executive bonuses.  Most of these measures are now routine, but the early self-reporting – before any significant steps or conclusions from the independent investigation – stands out as unusual.

Cloopen’s reward was the standard permanent injunction against future violations of Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, and 13a-16 and, notably, no civil penalty.  The lack of a civil penalty in a case involving fraud allegations is unusual in the absence of a demonstrated inability to pay, which does not appear to be the case here.

Key Takeaways and Considerations

The SEC’s settlement with Cloopen offers several considerations for issuers and their counsel facing allegations of accounting and financial reporting errors or misconduct. Here are some things they should take into account when weighing early self-reporting:

1. Assess the seriousness of the reported errors and/or misconduct, if possible.

The more serious a problem is, the more likely it is to receive regulatory scrutiny.  In the case of Cloopen, the auditor’s findings were serious enough to trigger the auditor to resign, and that likely tipped the scales toward early self-reporting.

2. Determine who knows.

How widespread is knowledge of the errors and/or misconduct, both internally and externally? Analyze the risk of whistleblower actions in the decision of whether to self-report. Cloopen’s Form 8-K announcing its auditor’s resignation reported the company already knew the conduct involved “several” employees “fabricating” financial documents.  Including such detail is likely to get the issuer in front of any potential whistleblower, who must satisfy the requirements of Section 21F including the “original information” and “independent analysis” requirements.

3. Weigh long-term benefits against short-term costs in deciding when to self-report.

Self-reporting offers long-term benefits to the issuer but also comes with short-term costs in time, resources and the likely loss of some control over the public narrative about the issues, the speed and course of the independent investigation and over characterization of the ultimate findings and conclusions.  This is because the SEC staff would likely request timely, rolling production of information and documents as discovered in the independent investigation, leaving less time and ability to curate the conclusions.

4. Decide what to share. 

Once a company decides to self-report and cooperate, it must align on  what to share with SEC staff. That choice is fraught with difficult decisions implicating the attorney-client privilege and attorney work product doctrine, as well as considerations relating to overseas data privacy protections for foreign-domiciled or multinational issuers, among other things.  SEC staff sometimes offer to receive information that may arguably be covered by the attorney-client privilege and/or work product doctrine under a Confidentiality Agreement that includes an express non-waiver provision. Obviously, the more you share, the better your chance of obtaining maximum credit.  In the case of Cloopen, the company shared generously, including summaries of interviews of witnesses that likely waived any attorney-client privilege or work product protections that may have attached.  That said, SEC Confidentiality Agreements are unlikely to withstand challenge in court and should be entered only with a full understanding of the parallel litigation landscape, among other considerations. 

Ultimately, the decision whether to early self-report to the SEC is one that must be made with caution and a clear-eyed understanding of the potential costs and benefits.  In the case of Cloopen, it appears the company’s decision to early self-report likely earned a settlement with no civil penalty, potentially saving the company millions of dollars.  Given this potential benefit, issuers and their counsel should consider following a similar path if confronted with comparable circumstances.

If you have questions about this insight, reach out to our authors, Stephen Cazares and Paul Rugani