When the Whistle Blows, What Follows?


Real estate investment trust American Realty Capital Properties (“ARCP”) recently announced the preliminary findings of an Audit Committee investigation into accounting irregularities and the resulting resignation of its Chief Financial Officer and Chief Accounting Officer. The events surrounding ARCP are a case study of how, within a matter of weeks, an internal report of concerns to the Audit Committee can lead to both internal and external scrutiny: an internal investigation and review of financial reporting controls and procedures, on the one hand; media coverage, securities fraud litigation, and an inquiry by the Securities Exchange Commission, on the other.

ARCP stated that the Audit Committee was first informed of “concerns” from an employee on September 7, 2014, which led to the engagement of independent counsel and forensic accountants to assist in an internal investigation. Within two months, the company announced that its financial statements for the fiscal year ending December 31 2013 and first two quarterly reports for 2014 should no longer be relied upon. In its October 27 release, the Company announced errors, including one related to a non-GAAP measure of income, adjusted funds from operations (“AFFO”). The Company announced that it had incorrectly included amounts related to its non-controlling interests in the calculation of AFFO for the first quarter of 2014 and, as a result, overstated AFFO by approximately $17.6 million for this period. The Audit Committee believed that this error was “identified but intentionally not corrected,” and that other AFFO and financial statement errors were intentionally made, resulting in an overstatement of AFFO and an understatement of net loss for the first three and six months of this year. In a conference call discussing the potential adjustment, ARCP CEO David Kay said in the second quarter of 2014, in preparing AFFO, “That calculation included a number that went in there in order to conceal the error from the first quarter.”

The day after ARCP’s announcement, the Wall Street Journal reported that the SEC intends to open an inquiry into “the accounting irregularities” at ARCP. That same day, plaintiffs’ lawyers filed two separate securities fraud class action lawsuits in the Southern District of New York against the Company and various executives, relying heavily on the Company’s October 29, 2014 press release. (Priever v. American Realty Capital Properties Inc. et al.; Ciraulu v. American Realty Capital Properties, Inc. et al.) One of the complaints also cited to the Journal article and the SEC’s intent to launch an inquiry into the reported fraud.

If accurately reported, the SEC’s decision to launch an inquiry into the accounting errors underlying ARCP’s announcement comes as no surprise, particularly in light of the SEC’s heightened focus on accounting fraud. As we have previously reported, the SEC has created a Financial Reporting and Audit Task Force as part of an initiative to “strengthen the agency’s efforts to identify and prosecute securities law violations related to financial reporting and audit failures.” The Task Force has announced that it intends to draw from a variety of arenas, including technology, outside experts, whistleblowers, academia, and others, to help reshape how the SEC looks at accounting cases.

As we previously reported, during the annual SEC Speaks conference held earlier this year, SEC Chair Mary Jo White predicted that The Financial Reporting and Audit Task Force would produce several significant investigations in the year ahead. While it remains to be seen, increased activity by the Task Force in the future will likely result in the filing of more enforcement actions. As in the ARCP scenario described above, this may mean that we can expect to see an increase in the number of follow-on securities suits filed as a result. The ARCP scenario also highlights a trend we might expect to see more of in the near future: whistleblowers’ revelations of accounting (or other) improprieties resulting in both SEC investigations/actions and securities class action lawsuits. This is particularly so in light of the incentives provided by the Dodd-Frank whistleblower bounty which, in one instance, granted a whistleblower a single award of roughly $30 million.