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From Securities Regulation Daily, September 27, 2016

Tax accounting fraud leads to highest SEC penalty this fiscal year

By Jacquelyn Lumb

The SEC has announced the settlement of the largest penalty in a financial reporting case this fiscal year, and the third largest in the past decade, in connection with a multi-year income tax accounting fraud by Weatherford International. Enforcement Director Andrew Ceresney said the action was significant not only because it involved a major accounting fraud, but also because it brought to light Weatherford’s lack of appropriate internal accounting controls over its tax department. Ceresney added that the action also reflects the Commission’s commitment to hold executives responsible when they engage in fraud (In the Matter of Weatherford International PLC, f/k/a Weatherford International Ltd., James Hudgins, CPA, and Darryl Kitay, CPARelease No. 33-10221, September 27, 2016).

Aggressive tax strategy. Ceresney described the fraud as complex in some ways, given that tax accounting is a complex area, but straightforward in others. As part of Weatherford’s aggressive strategy to become a top-tier multinational provider of oil and natural gas equipment and services, its vice-president of tax, James Hudgins, developed an international tax avoidance structure to reduce its effective tax rate (ETR) and tax expense. The company changed its place of incorporation from the U.S. to Bermuda in what is known as an inversion as party of this strategy, and later changed its place of incorporation to Switzerland and then to Ireland.

Weatherford touted its ETR to analysts and investors, claiming that it provided the company with key competitive advantages. When the ETR was not as low as expected, Hudgins and Darryl Kitay, the tax manager, made numerous post-closing adjustments between fiscal years 2007 and 2010 to meet Weatherford’s previously disclosed effective tax rate. They reversed accounting data that was input correctly without notifying the accounting department in order to fill the gaps. These false financial statements inflated Weatherford’s earnings by over $900 million.

When the fraud was discovered, Weatherford had to restate its financial statements three times over 18 months. The March 2011 restatement reduced previously reported income by $500 million which led to an 11 percent drop in Weatherford’s stock prices.

Sanctions. Weatherford, Hudgins and Kitay consented to the SEC’s order without admitting or denying the findings. Weatherford agreed to pay a $140 million penalty. Hudgins was ordered to pay $334,067 in disgorgement, interest, and penalty, and Kitay was ordered to pay a $30,000 penalty. In addition, Hudgins was barred from serving as an officer or director of a public company for five years, and he and Kitay were suspended from appearing or practicing before the SEC as accountants, with the right to apply for reinstatement after five years.

Hudgins resigned in 2012, Kitay was terminated in 2013, and Ernst & Young, the company’s external auditor from 2001 to 2013, was not reappointed.

No clawbacks. During a press briefing, Ceresney was asked why there were no clawbacks in the enforcement action. He said that in every case the SEC assesses whether a clawback under Sarbanes-Oxley Act Section 304 is appropriate and determined that in this instance it was not warranted against the CEO and CFO. However, he noted that under certain circumstances, the SEC can order the disgorgement of bonuses and profits on stock sales.

Previous FCPA violations. Ceresney was also asked about the connection between this action and a Foreign Corrupt Practices Act case brought against the company in 2013 (SEC v. Weatherford International Ltd., 4:13-cv-3500, November 26, 2013), and whether that connection led to enhanced penalties. Ceresney acknowledged that the time period of the conduct in both cases overlapped. As part of the FCPA case, in addition to an over $65 million global settlement, Weatherford agreed to certain undertakings, including the retention of an independent compliance monitor and self-reporting to the SEC.

Reporting to SEC. In the accounting fraud case, the SEC’s order notes that Weatherford cooperated in the investigation and took a number of remedial actions, including an internal investigation, the results of which were shared with the staff. Weatherford also expended significant resources to remediate the weaknesses in its internal controls over accounting for income taxes. In addition, Weatherford agreed to report to the SEC for two years about its compliance efforts with respect to its accounting for income taxes, financial reporting, any additional remediation efforts, and the auditing and testing of its internal controls.

The SEC advised in its press release announcing the enforcement action that its investigation is continuing.

The release is No. 33-10221.

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