McConville v. SEC: Widening the Net through Falsities and Scienter

McConville v. United States involved a petition for review of an order of the Securities and Exchange Commission (“SEC”) finding violations of several sections of the Securities Exchange Act of 1934 by the chief financial officer of Akorn Incorporated.[1] Akorn Incorporated manufactured and sold diagnostic and therapeutic pharmaceuticals to wholesalers and end-use consumers.[2] Akorn would process and keep track of its orders using various rates, corporate credits, and payment schedules (e.g. current, thirty to sixty days past due, etc.).[3] Akorn used a system that involved three different financing offices and used different computer programs and record-keeping mechanisms to track its orders and payments.[4] Akorn tried using a new system to improve its record keeping but the system was incapable of tracking all of Akorn’s data.[5] The company switched to another software and it did not transfer the data from the previous software system to the new one.[6]

Between February 28, 1997 and March 20, 2001, Rita McConville (“Petitioner”) worked as chief financial officer (“CFO”) of the company and was responsible for (1) supervising the finance departments, (2) working with Akorn’s auditor, and (3) filing documents with the SEC.[7] In 2000, problems with the company’s financial records came to light.[8] First, Akorn’s auditor alerted the board of problems with the company’s financial record-keeping, e.g. misapplication of credits, failure to review accounts receivables, etc.[9] Second, a dispute arose between Akorn and one of its customers as a result of billing discrepancies amounting to close to $5 million.[10]

Despite these problems, Petitioner assured the auditor that the accounts were being reconciled.[11] Petitioner also participated in the drafting of financial documents during her time as CFO, including the 2000 Form 10-K.[12] Petitioner also signed two letters essentially stating that the financial statements did not need to be adjusted because no events had occurred after December, 2000 and after February, 2001 that had a material effect on the statements.[13] In 2002, Akorn restated its financial statements for the years 2000 and 2001.[14] Akorn reported that it had some errors in their financial statements, among other concerns, that the company had in fact sustained a net loss of $2.4 million in 2000 instead of the gain of $2 million it had initially reported.[15]

In 2003, the SEC started proceedings against Petitioner and the current CFO of Akorn alleging that Petitioner’s mismanagement of the financial department caused the company to file documents that were in violation of the federal securities laws.[16] The SEC found that Petitioner’s conduct violated Sections 10(b), 13(b)(2), and 13(b)(5) of the Securities Act of 1934 (“Act”), among others.[17] After the SEC’s findings, Petitioner filed a petition for review with the United States Court of Appeals for the Seventh District.[18]

Under Section 10(b) of the Act, the Commission must show that Petitioner “(1) made a false statement or omission (2) of material fact (3) with scienter[19] (4) in connection with the purchase or sale of securities.”[20]  The issue was whether there was substantial evidence to support the Commission’s finding.[21]

Petitioner argued that the Commission did not prove the first and third elements by substantial evidence.[22] However, the appellate court found that the Commission proved the first element because Petitioner not only drafted Akorn’s financial statements, but she also reviewed and approved them, including the Form 10-K.[23] She also assured auditors that the documents were accurate and that no events had occurred that would make the documents misleading.[24] Therefore, the court concluded that Petitioner’s substantial involvement in the making of the documents and her statements to the auditors established that she made a false statement or omission.[25]

The court also found that the Commission proved the third element of scienter.[26] The court stated that “the requisite for scienter is an ‘extreme departure from the standards of ordinary care, which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.’”[27] Here, the court found that Petitioner was aware of the problems in Akorn’s financial department and that she failed to disclose them in the financial statements.[28] For example, Petitioner stated that all customer accounts would be reconciled by a specific date, but this was not accomplished.[29] Despite this, Petitioner told auditors that nothing had occurred that would have made the financial statements misleading.[30] Therefore, the court concluded that Petitioner’s conduct occurred with recklessness and that the Commission proved the third element.[31] In addition, the appellate court found that there was substantial evidence that Petitioner violated SEC rules 13(b)(2) and 13(b)(5) of the Act.[32] As a result, the appellate court denied the petition for review.[33]

McConville highlights the importance of good record keeping. Purposely submitting inaccurate or false information in documents filed with the SEC is not the only method of running afoul with the commission. Bad tracking and recordkeeping that causes inaccurate reports, even if not intentional, may also lead to violations and charges with the SEC. It is also not necessary for a person to sign a document for it to be attributed to them, it is enough that the person was substantially involved in the process of making the document, e.g. drafting, reviewing, or affirming the document’s accuracy and content.

References:

[1] McConville v. United States, 465 F.3d 780 (7th Cir. 2006). [2] Id. at 782. [3] Id. [4] Id.  at 783.  [5] Id.  [6] McConville, 465 F.3d at 783. [7] Id.  [8] Id.  [9] Id.  [10] Id.  [11] McConville, 465 F.3d at 784. [12] Id. at 785 (A 10-K Form is a document reporting a corporation’s financial health to the SEC.).  [13] Id. [14] Id. [15] Id. at 786.  [16] McConville, 465 F.3d 786 (Petitioner was the CFO during the preparation of the documents filed with the SEC but was removed shortly before the company filed its financial statements with the SEC. She continued to work gathering information for the financial statements in her new position as corporate controller.). [17] Id. [18] Id. [19] While not defined in the regulations, the United States Supreme Court has described the term “scienter” as proscribing conduct evinced by an intent to deceive, manipulate, or defraud; see, Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). [20] Id.  [21] Id. at 787. [22] McConville, 465 F.3d at 787. [23] Id.  [24] Id. at 788. [25] Id.  [26] Id.  [27] McConville, 465 F.3d at 788 (quoting Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588, 600 (7th Cir. 2006)). [28] Id.  [29] Id.  [30] Id.  [31] Id. at 789. [32] McConville, 465 F.3d at 789-90 (The opinion also explains how Petitioner violated rules 13(b)(2) and 13(b)(5) but the focus of this article was on rule 10(b)).  [33] Id. at 790.