This Thursday, the United Kingdom (UK) will vote in a referendum on whether to leave the European Union (EU)—referred to as the “Brexit.” Opinion polls have shifted sharply over the past two weeks to indicate that the likelihood of Brexit has increased substantially, but Frontier Strategy Group continues to believe that the UK will vote to remain in the EU, albeit by a very small margin. Opinion polls have been extremely inaccurate in the past two UK elections and we believe some hesitant voters will choose to remain in the EU in a conservative bias that we saw in both the parliamentary elections last year and in the Scottish referendum. Markets are also interpreting the murder of pro-EU Labour MP Jo Cox as likely to damage the Leave campaign.
A narrow win for the Remain campaign—our baseline scenario—is unlikely to alleviate the grievances of those supporting Brexit and would cause deeper tensions within the UK’s Conservative Party, raising the likelihood of early elections and another referendum in the next couple of years. While the economic impact of these trends would be relatively modest, lingering uncertainty would cause investments to underperform.
Should Brexit happen, however, multinational businesses would be affected in several key ways. Besides the initial financial volatility and somewhat weaker growth in Europe, most of the broader effects of Brexit outside the UK would be slow-moving, although their long-term implications could be significant enough to reshape the European Union. Companies need to be prepared for short-term volatility—particularly of currencies—but should Brexit occur companies can expect to be gradually adapting to its effects for at least the next two to three years.
Financial-market volatility and currency depreciation
The possibility of Brexit has already rattled currency, bond, and equity markets and this volatility will increase in the immediate aftermath of the event should Brexit occur. The British pound could depreciate by as much as another 10–20% against the United States’ dollar (USD) in the aftermath of Brexit, and the euro would also likely lose value, possibly as much as 5–10% against the USD. The scale of the losses would likely be temporary, but neither currency would be likely to recover to pre-Brexit levels. Brexit would also dampen investment confidence, softening commodity prices and causing overall financial market uncertainty. Added to a backdrop of weak global growth and deep concerns about China’s slowdown, Brexit would prompt another bout of volatility that would cloud corporate expectations and complicate 2017 planning for emerging markets generally.
Growth in Europe
Brexit would cause a slowdown in UK investment and business activity. A similar, though smaller, effect would be likely in the EU as a whole. Markets strongly linked to demand from the EU—such as North Africa, Eastern Europe, and parts of Asia—would see a softening of demand for the next 12 months that would affect industrial performance but would not disrupt growth trajectories. The demand effect for other parts of the world would likely be negligible. As corporate leaders gear up for 2017 planning, they would have to dedicate more analytical energy to identifying sources of growth in Asia, the Middle East, Africa, and the Americas to compensate for weaker performance in Europe.
Brexit would raise a host of trade issues from the future of the Schengen Area to the outlook for the Transatlantic Trade and Investment Partnership, all of which would increase uncertainty over the cost and structure of supply chains that involve the EU. Any tangible effect on supply chains, however, would likely materialize over a period of several years, giving companies ample time to respond. It would, however, raise fundamental organizational issues such as where companies’ European headquarters will be located, tax rates, distribution-chain structure, and other concerns that should be factored into 2017 and longer-range planning as well as profitability targets. Making changes earlier could yield valuable competitive differentiation for cost and talent.
Brexit’s most dangerous effect could be to galvanize anti-EU sentiment and populist parties across the EU, setting into effect a series of policy disruptions in the region that could weaken the EU, slow down EU integration, or even lead to other EU members exiting the union. All of this would undermine the EU’s economic outlook, and force multinational corporations to manage political risk in this usually stable region much more closely. While that would be unlikely to have ripple effects globally, it could contribute to greater instability in the Middle East and Eastern Europe if it coincided with increasingly isolationist foreign policy from the United States.
Overall, Brexit would put greater pressure on regions outside of Europe to deliver strong results that can compensate for years of underperformance by the UK and the EU in corporate portfolios. This may be a big challenge in the current global growth environment, requiring an even greater focus on agile strategies that emphasize strong competitive positioning, careful risk management, and a reshaping of how companies plan to win in emerging markets.
In case the UK votes next week to leave the EU, boards and executive teams should ask themselves several urgent questions to effectively prepare their response:
What is our company’s exposure to short-term currency volatility of both the British pound and the euro? How would significant depreciation against the dollar affect our overall revenue and profit targets for this year?
Have we developed alternative international growth strategies that rely less on demand in Europe?
What production and distribution disruptions are we likely to face in our European operations?
How should we adjust our long-term outlook for doing business in Europe? What economic and political risks are now more likely and more significant to our company?
Joel Whitaker is Senior Vice President of Global Research at Frontier Strategy Group (FSG), an information and advisory services firm supporting senior executives in emerging markets.
In 2013, the Securities and Exchange Commission (SEC) formed the Financial Reporting and Audit Task Force to detect fraudulent or improper financial reporting, and since then has brought more than 300 issuer reporting and disclosure cases. One area of focus is a company’s restatement of financial statements and company actions connected with the restatement.
The audit committee plays an important role in navigating a restatement—from investigating errors and their origins to overseeing the restatement process. A mishandled restatement can lead to a prolonged SEC investigation, increased exposure to liability in civil litigation, loss of confidence by lenders, and potential delisting by an exchange.
To survive a restatement, audit committees should avoid the following pitfalls.
Engaging inexperienced counsel and advisors for investigation. A restatement is commonly precipitated or accompanied by an independent investigation overseen by the audit committee. Proper investigation of accounting errors is critically important, and inexperienced counsel could fumble the investigation—and restatement—from the beginning by incorrectly scoping the investigation, failing to obtain the relevant information, or losing credibility with regulators.Four qualities are essential for counsel tasked with conducting independent investigations into accounting errors.
First and foremost, counsel must be independent from management. Counsel must not have done prior work for the company or have any significant ties to the management.
Second, counsel should be experienced with conducting independent investigations for boards and board committees.
Third, counsel should understand accounting and disclosure issues, and have experience with the nuances of accounting investigations. Nonetheless, counsel should also be expected to engage experienced, outside forensic accountants to aid in the investigation.
Finally, counsel and their team must be respected by regulators and have a reputation of conducting appropriately thorough and complete investigations.
Forming a special committee when the audit committee might suffice. While a special committee might be necessary in certain rare investigative circumstances, the board should avoid forming one if its audit committee is composed of independent and disinterested directors who are suited for the task. A special committee must be disbanded at some point (usually once the investigation is completed and before the restatement process begins), and the disbanding could become a complicated news item.In contrast, if the audit committee oversees the investigation, then, once the investigation is complete, the audit committee can pivot back to its normal role, which would include overseeing the actual restatement process. Investigations overseen by the audit committee also benefit from the positive relationship that the chair usually has with the company’s outside accounting firm.
The run-away or open-ended investigation. Incorrectly scoped investigations can lead to burdensome legal fees, continued business disruptions, and inadequate investigatory results. Importantly, an independent investigation does not mean that counsel is independent of the client. The “client”—i.e., the audit committee—should discuss the scope and budget of the investigation with outside counsel and together tailor the investigation to the circumstances.
Failing to keep auditors apprised of the investigation and errors found. Keeping auditors in the dark regarding the progress and results of the investigation could delay the restatement and result in the resignation of the auditor. The audit committee’s counsel should maintain a good relationship with the company’s auditors and keep them appropriately apprised of the investigation through periodic calls or meetings. If the auditor is conducting a shadow investigation, this dialogue will aid it in confirming that appropriate remedial measures occur (e.g., a restatement) and that the company’s professional practice group, risk, or forensic functions are informed.
Indecisiveness and inability to reach conclusions. Indecisiveness can delay the investigative process, allow misconduct to persist unchecked, and create the damaging perception among investors, regulators, and the plaintiffs’ bar that the company’s problems extend beyond financial reporting. To minimize these effects and maximize potential cooperation credit, the audit committee, in conjunction with counsel, should reach conclusions concerning accounting errors as promptly as possible.
Waiting too long to deal with wrongdoers. Once an investigation has made conclusions about individual conduct, any wrongdoers should be disciplined and, when necessary, removed from their position—either by terminating their employment or forcing their resignation. When determining cooperation credit, the SEC and Department of Justice (DOJ) will focus on whether the responsible individuals are still with the company, and, if so, whether they are still in the same positions. Removing wrongdoers clears the path for the audit committee to share investigation results with management so it can correct errors and implement remedial actions.
Not self-reporting findings to the SEC. Whenever a restatement is made, the SEC will inquire whether the underlying accounting error was intentional. It also may inquire about the root cause of the error; how, when, and by whom it was discovered; the reporting periods impacted; how the error is being corrected; and the impact on the company’s financial control environment.The SEC expects a registrant to voluntarily share the results of its investigation. If the SEC learns of misconduct from a source other than the company, or if the company fails to make its investigative findings available to the SEC, the company could become ineligible for cooperation credit associated with self-reporting. The incentives in the SEC’s whistleblower bounty program provide additional motivation for companies to be proactive in promptly and thoroughly self-reporting.
Audit committee micromanagement of the restatement. Management is ultimately responsible for financial reporting, and the audit committee must maintain its supervisory role and refrain from stepping into the role of management to correct errors. Once an accounting error has been identified, it must be assessed to determine whether the affected financial statements are materially misstated. Quantifying the errors is a critical step in determining materiality, and Staff Accounting Bulletin (SAB) 108 contains guidance.The audit committee counsel should assist management, as appropriate, in understanding the nature of the errors and how to correct them. This is also a good time for the audit committee to request that management re-evaluate the enterprise-wide risk assessment process and the design and effectiveness of internal controls over financial reporting.
Failing to remediate. If accounting errors lead to a restatement, then the company may have deficiencies in internal controls. In addition, inadequate or ineffective internal controls often raise issues that should be investigated by the audit committee relating to the certifications by the CEO, CFO, and outside auditor. Failure to remediate gaps in internal controls and to address certification issues provides the opportunity for additional misconduct and could damage the company’s credibility with regulators. The SEC in particular will focus on what steps the company took upon learning of the misconduct or control weaknesses, whether the company took immediate corrective action, and what new and more effective internal controls or procedures the company plans to adopt to prevent a recurrence. When documenting remedial actions, the company should avoid characterizing them as other than what they are—improvements in internal control procedures. This neutral approach might help to mitigate potentially harmful collateral impacts in civil litigation.
Creating an unnecessarily detailed SAB-99 materiality analysis. Shareholder class actions inevitably follow restatements. The audit committee should resist the impulse to create an unnecessarily detailed SAB-99 materiality analysis that will be discoverable in litigation against the company and could provide a roadmap for private plaintiffs. To the extent additional details regarding the materiality analysis are necessary, oral discussions with auditors are often sufficient.
Bradley J. Bondi is a partner with Cahill Gordon & Reindel LLP. He advises financial institutions and global corporations, boards of directors, audit committees, and officers and directors of publicly-held companies in significant corporate and securities matters, with particular emphasis on internal investigations and enforcement challenges, including those related to restatements. Michael D. Wheatley, a litigation associate at Cahill, assisted with this article.
Jonathan T. Marks, CPA, CFE, a managing director with Navigant Consulting, Inc. in its global disputes and investigations practice, and Michael Pesce, an associate director with Navigant, contributed to this article.
The U.S. False Claims Act (FCA) is an anti-fraud statute used to police the conduct of companies that accept federal funds or have payment obligations to the federal government. The government has been hugely successful in pursuing FCA cases, collecting $26.4 billion from 2009-2015, with $5.5 billion and $3.5 billion in 2014 and 2015, respectively. In light of these staggering figures, every company potentially subject to the FCA must be aware of and take steps to minimize its FCA compliance risk.
The FCA imposes liability on companies and individuals that submit “false claims” for payment to the government. Originally termed “Lincoln’s Law,” the FCA was enacted during the Civil War to bring to justice suppliers who sold fraudulent goods to the Union Army. Its modern incarnation has expanded beyond its defense contracting roots to become a leviathan statute with the ability to reach a vast number of companies and organizations.
The FCA imposes a broad spectrum of liability. “Claims” may be direct or indirect. In addition to a classic “claim”—i.e., an invoice for services rendered—the FCA also applies to, for example, pharmaceutical companies receiving funds through research grants and oil companies paying royalties. Indeed, any entity participating in a government program that provides funding, including Medicare, the Small Business Administration, or even the Federal Emergency Management Association, is subject to the FCA.
While a violation occurs only if the claim is “false,” falsity is a concept given wide latitudes under the FCA. A claim could be “false” if it incorrectly states the amount owed, mischaracterizes services rendered, or in at least some jurisdictions—even if the claim is entirely accurate on its face—the submitter was not in perfect compliance with an applicable contract term, statute, or regulation, and a plaintiff convinces a court that this lack of compliance could have affected the government’s decision to pay that claim.
Penalties for violating the FCA are severe, including triple damages and up to $11,000 penalties per false claim. These high penalties push this civil statute into the quasi-criminal realm. This means that in an industry where invoicing occurs based on discrete transactions, the penalties alone could be harsh even if the actual “false claim” is relatively small. FCA cases are also expensive to defend, and carry additional risks of reputational impact and even suspension or debarment from doing business with the government. Companies often choose to settle these cases for high amounts rather than risk an unfavorable verdict. In 2014, Countrywide Financial Corp. and Bank of America paid $1 billion to settle an FCA case, rather than litigate to measured damages and penalties.
The FCA is a bounty statute, allowing private citizens to bring suit on behalf of the government in exchange for a “bounty” for bringing the case to the government. The potential rewards for turning in a whistleblower create a strong incentive for current and former employees to run to the government with any perceived violations rather than reporting the concern to management. In 2015 alone, FCA whistleblowers received over $590 million.
There are some affirmative steps that a board can take to protect against FCA liability:
Review the company’s business operations with management to identify “claims” subject to potential FCA enforcement and ensure that these actions are periodically reviewed to prevent and detect potential FCA violations;
Maintain a publicized, anonymous and confidential fraud reporting hotline for employees and third parties;
Investigate reports of fraud-related conduct through counsel to establish and maintain attorney-client privilege over the investigation;
Ensure hotline reporters are informed about the company’s attention to their concerns, validating their efforts while only sharing non-privileged information so as to protect the privilege;
Be aware of whistleblower protection laws, especially the FCA’s prohibition of retaliating against employees;
Upon learning of potential FCA liability, consider whether the company has any obligation to report this to any government agency;
Ensure that the company has a compliance professional and/or experienced FCA counsel who periodically assesses the company’s potential liability and advises the Board about this complex and evolving statute.
Tirzah Lollar is a partner and Kathleen Neace is an associate in the Washington, D.C. office of Vinson & Elkins LLP.