Probes Reporter Perspective reports identify and summarize those SEC-related risk factors that we believe hold the potential to destabilize a company, distract its management, and/or interfere with underlying fundamentals. Our reports otherwise take no view on a public company’s fundamental outlook or whether you should buy, sell, or hold its securities. They are typically based on a combination of public company disclosures and/or documents we acquired from the SEC under the Freedom of Information Act (FOIA).

As a reminder, at present, this report is posted in real-time for free.  In the future, and by necessity, we expect Probes Reporter will likely become a paid subscription service.  If we move toward a paid service, you should expect both timing and access to our content that you enjoy today for free will gradually change.

International Business Machines Corporation (IBM) 
Probes Reporter Perspective

PR’s Perspective:  IBM’s recent earnings disappointment may have been influenced by a massive SEC investigation that ended only this year combined with a festering FCPA probe that remains ongoing. Management may still be adjusting to potential changes triggered by both recent and on-going SEC scrutiny.  If so, earnings visibility for the company could easily be a challenge until this gets further along.  

The Facts:  On 18-Sep-2014 we received notice of a staggering volume of records (approximately 1,181 boxes) on a closed but unspecified SEC investigation of IBM that ended sometime after June-2013, the date of our previous request on IBM.  The following is an excerpt from the SEC letter to us --

We rarely see this volume of SEC records related to a closed investigation; in our experience it’s definitely an outlier. 

To put it into context, a brand new box of paper holds 10 reams, 500 sheets each, or a total of 5,000 sheets.  If we assume each box of investigative records only hold 3,000 pages (which is the estimate the SEC gives us), 1,181 boxes of records equates to more than 3.5 million pages of investigative records.

Disclosures made by IBM in just the past 18 months point to SEC pressure in two areas:  A festering FCPA probe that appears ongoing and investigation in May 2013 into how IBM reports cloud revenue, which was concluded in May-2014.  The company reports the cloud revenue investigation was concluded without the SEC taking enforcement action.

In that same letter dated 18-Sep-2014, the SEC also cited the "law enforcement exemption" of the FOIA as basis to deny the public access to the detailed records we sought on this company.  As a matter of law, the SEC is acknowledging some sort of investigative activity with this response.  (See below for more on how this works).  This is consistent with company disclosures of an ongoing FCPA matter. 

An earlier FOIA response we received, dated 06-Jun-2013, found no SEC activity at the time.  This suggests the 1,181 boxes of records are from a probe that ended sometime after Jun-2013.  The only disclosed probe that fits this profile is the cloud revenue matter which the company said ended in May-2014.

We filed an administrative appeal to challenge this denial.  In our experience, about two-thirds of these SEC responses are confirmed on appeal. With a disclosed FCPA probe, we expect this one will be confirmed.   We also filed a request to try and figure out what’s in those 1,181 boxes.  

Analyst Observations:  We can't be certain the "cloud revenue" investigation that ended in May-2014 is the source of the estimated 3.5 million pages of records.  It's possible there was a different SEC probe never disclosed by the company.  We are trying to find out. 

Is 3.5 million pages of investigative records literally 3.5 million reasons for an earnings miss?  Of course not.  But, again, we rarely see this volume of SEC records related to a closed investigation.  It's simply huge, or what kids on the playground might call "Ginormously Huge!".  

Even when the SEC closes investigations without taking enforcement action, as happened here, there still can be consequences for investors later.  Just as the instinct is to pull your foot off the gas when seeing a police car on the highway, SEC pressure can trigger similar reflexes inside public companies.

For example, SEC scrutiny of a public company can bring about internal changes in practices, accounting, internal controls, and/or even additional auditor scrutiny. Any of these could result in negative surprises to investors later.  Companies once seen as high fliers can inexplicably start missing earnings as transactions that might previously have been booked without question are now subjected to new standards.  Companies can also lose the ability to forecast as well as was perceived in the past.

Regarding the FCPA matter, ask yourself this simple question:  What's the proper accounting treatment for a bribe?  The answer implies accounting and internal controls problems.  Then ask, what happens to a company's operations when bribery is no longer available as a tool of business?  We believe both apply to IBM right now.

Those with an interest in IBM should definitely try to find out what changes, if any, have been triggered by SEC scrutiny.   They probably won't tell you.  They may not even fully comprehend the impact themselves.  They still should be asked.

Background on the Law Enforcement Exemption

When we report on risk of undisclosed SEC investigative activity for a company, it is based upon a response from the United States Securities and Exchange Commission (SEC) to one of the approximately 2,500 Freedom of Information Act (FOIA) requests we file with the agency each year seek.  Our requests seek information concerning the conduct, transactions, and/or disclosures of public companies.

There are many legitimate reasons for the government to deny a FOIA request.  One reason often cited by the SEC is the so-called “law enforcement exemption” of the FOIA.   As a matter of law, the SEC is acknowledging some sort of investigative activity when it asserts this exemption. To learn more about FOIA exemptions, go to FOIA.gov (link is external).  To learn more about the law enforcement exemption specifically, see also Department of Justice Guide to the Freedom of Information Act, Exemption 7(A) (link is external). 

We know from experience there can be many reasons for the FOIA office of the SEC to assert the law enforcement exemption.  Some would be of little to no consequence to investors.  Others would be of great concern, and can have meaningful negative consequences for investors.

If the SEC cited the law enforcement exemption to deny the public access to records on a public company, and if no disclosures of SEC investigative activity were found in the past two years of this same company’s SEC filings, we then add the company to our Watch List as a company with a "Possible Undisclosed SEC Investigation". 

Again, to say a company has a possible SEC probe is not the same as when we say it has a "Confirmed Undisclosed SEC Investigation".  As we say in our reports, a confirmed investigation is the highest standard we can achieve regarding undisclosed SEC activity at a public company.  Here's why -- 

When the SEC asserts a law enforcement exemption, if warranted, we then file an administrative appeal with the SEC’s Office of General Counsel. The appeal process allows a different set of eyes within the SEC to manually review our request and the initial denial.  In response to our administrative appeal, the SEC typically does one of the following –

• The SEC can deny our appeal by saying, "We have confirmed with staff that the responsive matter remains open and that releasing the withheld information could reasonably be expected to interfere with the on-going enforcement proceedings." 
  
  This is why we say this is the  highest standard of affirmation we can achieve regarding undisclosed SEC activity at a public company.  We interpret this appeal response to mean the company is involved in an SEC investigation that somehow involves its conduct, transactions, and/or disclosures.   Companies on which we receive this response are maintained on our Watch List.
   
• The SEC may deny our appeal on grounds there are no records responsive to our request.  This may be because the Company was incidentally named or tangentially listed in an SEC investigation of some other person or entity; or, there was an investigation that concluded in the past but the SEC’s computerized records were not current at the time of our request.   Companies on which we receive this appeal response are removed from our Watch List.
   
• We may be informed the law enforcement exemption no longer applies and our request has been remanded back to the FOIA office for further processing.  We interpret this response to mean there was an investigation that is now over and records from that investigation may now be provided to us.  Companies on which we receive this appeal response are removed from our Watch List.
   
• Finally, the SEC could inform us the law enforcement exemption was cited in error.  We rarely see this but it does happen.  Companies on which we receive this appeal response are removed from our Watch List.

Notes: The SEC did not disclose the details on investigations referenced above. The SEC reminds us that its assertion of the law enforcement exemption should not be construed as an indication by the Commission or its staff that any violations of law have occurred with respect to any person, entity, or security.  New SEC investigative activity could theoretically begin or end after the date covered by this latest information which would not be reflected here.

To learn more on our process and what our findings mean, click here.