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Bank of America Pays $20 Million for MD&A Disclosure Failures

Monday 15 September 2014

In August 2014, the Securities and Exchange Commission announced a $20 million settlement with Bank of America over disclosure failures in Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A). The disclosure failures related to two quarterly reports filed by the bank with the SEC in 2009. Although the news of this $20 million settlement was overshadowed by the bank's concurrent payment of $16.7 billion to the U.S. in a global settlement of mortgage-related issues, the MD&A case is nonetheless a timely reminder of the critical importance of MD&A for reporting companies.

Your business can take important steps to enhance its SEC reporting and compliance programme, and to identify known uncertainties, trends, demands and commitments that may impact future operating results or the company's financial condition. Learn more from the following IASeminars courses:

  • Management Discussion and Analysis (2 days)
  • SEC Reporting for International Companies (3 days)
  • SEC Form 20-F Immersion Workshop (2 days)
  • Detecting and Investigating Financial Statement Fraud (2 days)

Note:The Bank of America case is not an isolated example of disclosure failures by banks and other financial institutions in 2009 and 2010. For instance, the SEC announced on September 11, 2014 that Wilmington Trust Corporation (WTC) had agreed to pay $18.5 million to settle civil charges arising from disclosure failures in four quarters over 2009 and 2010. The disclosure failures included WTC's omission from its quarterly and annual reports filed with the SEC of over $300 million in loans that were 90 or more days past due in the last two quarters of 2009. Instead, WTC reported between $30 million and $40 million of loans overdue by 90 days or more for each of these quarters. WTC consented to the entry of an order finding it violated "the reporting, books and records, and internal controls provisions of the federal securities laws."

The Bank of America facts: From 2004 to 2008, Bank of America and a number of its affiliates sold over $1.1 trillion in mortgage loans to two government-sponsored entities: the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Bank of America also sold over $1 trillion in loans directly to institutional investors and in securitizations that included credit enhancements provided by insurers. In making these sales, Bank of America represented that the loans conformed to underwriting guidelines and with applicable laws. The sale contracts provided that if Bank of America breached a representation, the purchaser or insurer could assert a claim against Bank of America and demand that the loans be repurchased. If the purchaser/insurer and Bank of America did not agree on the claim's disposition, then the claim was considered to be at an "impasse."

As the mortgage market began encountering serious headwinds in 2008 and a conservator was appointed for Fannie Mae, Bank of America learned that Fannie Mae was adopting a more aggressive approach to making repurchase claims. The result: the number of "impasse" claims made against Bank of America by Fannie Mae increased from $41 million at the end of the 3rd quarter of 2008 to $512 million at the end of the comparable 2009 period. Similarly, "impasse" claims by insurers against Bank of America climbed from $203 million at the end of the 3rd quarter of 2008 to almost $1.7 billion at September 30, 2009.

The disclosure requirements and failures: The SEC settlement order noted that Bank of America was required by Item 303 of Regulation S-K to disclose in its MD&A, among other things, any known uncertainties that it reasonably expected to have a material impact on income from continuing operations. Instruction 3 to Item 303(a) provides that "[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition." In other words, management is not required to have a crystal ball when looking into the future, but is obligated to disclose known material uncertainties that may impact the business's future operating results or financial condition.

As the SEC noted in its 1989 MD&A Interpretive Release:

"The second sentence of Item 303(b) states that MD&A relating to interim period financial statements 'shall include a discussion of material changes in those items specifically listed in paragraph (a) of this Item, except that the impact of inflation and changing prices on operations for interim periods need not be addressed.'"

In the settlement order, the SEC emphasized that material changes to "each and every" disclosure required by Item 303(a) are required to be discussed in interim period MD&A.

The admissions: The SEC alleged - and Bank of America admitted - that the bank had failed to comply with Item 303 of Regulation S-K when it filed its 2nd and 3rd quarter Form 10-Qs in 2009. The disclosure failures related to known uncertainties about the future costs of mortgage repurchase claims, including:

  • whether Fannie Mae had changed its repurchase claim practices after being put in conservatorship;
  • the future volume of repurchase claims from Fannie Mae and the insurers; and
  • the ultimate resolution of the "impasse" claims that remained open.

The lesson: Even when preparing MD&A covering interim periods, reporting companies must carefully evaluate known uncertainties, trends, demands, commitments and events. This evaluation will focus on those items that may have a material effect on future operating results or future financial condition, and should encompass the "macro" business environment, industry conditions, and the entity's own operations. When material changes occur - as Bank of America witnessed through the enormous increase in "impasse" claims - management must respond by preparing disclosure which meets the requirements of Item 303 of Regulation S-K and considers the SEC's interpretive releases. The SEC's case against Bank of America for MD&A disclosure failures is a cautionary tale - and reminder - that interim period MD&As are just as critical to "get right" as the year-end MD&A.

A reminder: The SEC announced in 2013 that it was developing a data analysis program that would be used to analyze MD&A disclosures by public companies. The program is based on the SEC's determination that certain word choices in MD&A may reveal earnings manipulation because companies that break or bend accounting rules or policies play "a word shell game," according to SEC Chief Economist Craig Lewis. The head of the SEC's office of quantitative research, Mr. Harvey Westbrook, said in 2013 that the MD&A data analysis program "looks very promising," and that if testing supported its value, the MD&A analysis tool will be added to the SEC's Accounting Quality Model (AQM) analytic software.

Although the SEC has not publicly disclosed in 2014 the status of the MD&A data analysis program, reporting companies should assume that the SEC's AQM will continue to evolve - adding new detection and correlative analyses to the arsenal of the SEC's anti-fraud initiatives. If so, MD&A cases like the one against Bank of America may become much more common.

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