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Criminal Liabilities for Financial Statement Fraud and Elements of Such Fraud— Analysis of Criminal Judgment on CGS International Inc.'s Financial Statement Fraud
In February 2014, the Taipei District Court delivered its first-instance judgment on the case concerning CGS International Inc.'s ("CGS") entering fraudulent information in its financial statements. The judgment indicated that intending to inflate the sales figures and deflate the sums of inventory-generated bad debts in its financial reports, and obtain the needed financing, CGS conspired with other companies to conduct circular trading. CGS entered fraudulent trading information into its account book and financial statements. In fact, no goods were actually sold and no payments for goods were collected in such transactions. Produced on the basis of such financial statements, its annual financial reports and other financial and business documents, which are required to be filed with the competent authorities and published in accordance with the Securities and Exchange Act ("SEA"), contained false information. Depending on their conduct, the court charged the defendants with violation of Subparagraph 1, Paragraph 1, Article 71 of the Business Entity Accounting Act ("BEA") (entering false information), or Subparagraph 1, Paragraph 1, Article 171 of the SEA (committing financial statement fraud).
Issues in the case are often discussed in cases concerning financial statement fraud. The following discussion concerns how to differentiate violations of Subparagraph 1, Paragraph 1, Article 171 of the SEA (namely, violation of Paragraph 2, Article 20 of the Act) from violations of Subparagraph 5, Paragraph 1, Article 174 of the Act; whether a violation is material should be taken into consideration when assessing a penalty under either of the provisions; and how to determine whether a misstatement constitutes materiality.
1. Penalties on financial statement frauds in legal provisions:
Laws and regulations stipulating criminal penalties for entering fraudulent financial information include the following:
(1) Article 71 of the BEA ("deliberate preparation of accounting evidence or making of an entry in the account book based on a non-actual event, . . . and any other unlawful conduct resulting in a misstated accounting event or financial statement");
(2) Paragraph 2, Article 20 of the SEA ("The financial reports or any other relevant financial or business documents filed or publicly disclosed by an issuer in accordance with this Act shall contain no misrepresentations or nondisclosures.");
(3) Subparagraph 1, Paragraph 1, Article 171 of the SEA ("A person who has violated paragraph 2 of Article 20 of this Act shall be punished with imprisonment for not less than three years and not more than ten years."); and
(4) Subparagraph 5, Paragraph 1, Article 174 of the SEA ("making false statements on the account books, forms/statements, vouchers, financial reports or any other business documents by any issuer, public tender offeror, securities firm, securities dealers' association, stock exchange, or any other enterprises as referred to in Article 18, as required to be produced in accordance with laws or regulations, or orders of a competent authority pursuant thereto."). Basically, if a nonpublic company enters fraudulent information in its financial documents, it is subject to the penalty under Article 71 of the BEA, while a public company committing such fraud should be imposed the penalty under Subparagraph 1, Paragraph 1, Article 171 of the SEA (namely, penalty of Paragraph 2, Article 20 of the Act) or Subparagraph 5, Paragraph 1, Article 174 of the Act.
2. Differentiation between the penalty under Subparagraph 1, Paragraph 1, Article 171 of the SEA (namely, penalty of Paragraph 2, Article 20 of the SEA) and the penalty under Subparagraph 5, Paragraph 1, Article 174 of the SEA:
(1) The SEA, enacted on April 30, 1968, prescribed criminal responsibility for financial statement frauds in Subparagraph 5, Paragraph 1, Article 174 of the SEA. Twenty years later, the legislators believed that Article 174, the only provision stipulating a criminal penalty, did not provide any basis of claims to general investors who wanted to make civil claims. So they added provisions governing civil liability to Paragraph 2, Articled 20 in an amendment to the SEA on January 29, 1988. However, when amending the SEA in 2004, the legislators mistakenly thought that the liability for compensation for civil damage under the SEA applied to financial statement fraud only, overlooking the criminal penalty on such conduct in Subparagraph 5, Paragraph 1, Article 174 of the SEA. The legislators held that if the financial reports or any other relevant financial or business documents filed or published by an issuer in accordance with the SEA contain any misrepresentations or nondisclosures, the staffers concerned should be considered having committed serious violations, which also constituted a serious securities-related crime, and should be penalized. That is why financial statement fraud was added to the reasons for criminal penalties under Subparagraph 1, Paragraph 1, Article 171 of the SEA by an amendment on 28 April 2004. Thus, two articles in the same law contain different penalties on financial statement frauds.
(2) When hearing financial statement fraud cases, Taiwan's courts usually impose penalties on the violators pursuant to Paragraph 2, Article 20 or Subparagraph 1, Paragraph 1, Article 171 of the SEA. However, courts hold divided views on the differentiation between Subparagraph 1, Paragraph 1, Article 171 (Paragraph 2, Article 20) and Subparagraph 5, Paragraph 1, Article 174 of the SEA, as they both penalize public companies committing financial statement fraud after the 28 April 2004 amendment. Sometimes, penalties were imposed by Subparagraph 1, Paragraph 1, Article 171 of the SEA with no reasons given.
(3) The first-instance judgment on CGS's case indicated that as the applicability of Paragraph 2, Article 20 of the SEA and that of Subparagraph 5, Paragraph 1, Article 174 of the SEA could not be differentiated simply by literally reading the provisions, the Taipei District Court tried to limit the applicability of Subparagraph 1, Paragraph 1, Article 171 of the SEA and that of Subparagraph 5, Paragraph 1, Article 174 of the SEA by reviewing the objectives of these provisions and by consulting the legislative purposes of the SEA, the principle of restraining the applicability of criminal laws, and the principle of the punishment fitting the crime. The court holds that the materiality should be an objective factor in determining a violation of either of Paragraph 1, Article 171 or Subparagraph 5, Paragraph 1, Article 174 of the SEA. Moreover, if a public company enters any material misstatement in its financial reports or other financial or business documents before such documents are filed with the competent authority or publicly announced, a violation of Subparagraph 5, Paragraph 1, Article 174 of the SEA should be considered committed. If material misstatement is entered and financial reports or other financial or business documents have been filed with the competent authority or publicly announced, a violation of Paragraph 2, Article 20 of the SEA should be considered committed, and the violator should be subject to the penalty under Subparagraph 1, Paragraph 1, Article 171 of the SEA. However, if the violation is not considered material, the violator should be subject to the penalty under Article 71 of the BEA. Where the violator is a nonpublic company, it should be subject to only the penalty under Article 71 of the BEA as such company is not governed by the SEA.
3. How to determine the materiality of violations:
Taiwan has not established any criteria for determining whether a financial statement fraud is material. In CGS's case, the Taipei District Court held that to assess whether a company's financial statement fraud is material, qualitative and quantitative indicators, which are significant to rational investors, should be considered. Quantitative indicators should be first considered in analysis of materiality. Having consulted Article 19 of the 51st Statement of Auditing Standard (Materiality in Planning and Performing an Audit), Article 6 of the SEA Enforcement Rules (guidelines for restating financial reports), and generally adopted U.S. accounting guidelines, the court opined that in determining whether a financial statement fraud committed by a company as a result of its dishonest circular trading is material and has reached the quantitative threshold for a crime, whether the sum involved has reached 1% of its net operating income can be taken as a criterion. Regarding the qualitative indicator, if the financial statement fraud is the result of malpractice or illegal acts committed by the management, the fraud can be considered material.
In CGS's case, the Taipei District Court held that a criminal penalty under Subparagraph 1, Paragraph 1, Article 171 of the SEA (namely, a penalty under Paragraph 2, Article 20 of the SEA) or Subparagraph 5, Paragraph 1, Article 174 of the SEA may be imposed only when the violation committed is material; that is, harsh penalties should not be indiscriminately imposed on all types of financial statement fraud, material or immaterial. Otherwise, such indiscriminately assessed penalty would cause all the issuers and their representatives to panic. Moreover, should all the trivial details be required to be entered into corporate financial reports or other relevant business documents, investors might be forced to receive too much unnecessary information. Hence, the Taipei District Court's judgment is laudable. Besides the judgment on CGS's case, several renowned scholars also analyzed how to differentiate the applicability of Subparagraph 1, Paragraph 1, Article 171 (or Paragraph 2, Article 20) from the applicability of Subparagraph 5, Paragraph 1, Article 174 of the SEA on the basis of the legislative purposes of the provisions. Some of them hold that as the violation of Subparagraph 5, Paragraph 1, Article 174 of the SEA is similar to the crime of forgery of documents under the Criminal Code, the penalty to be imposed should be increased; hence, if a financial statement fraud is serious enough to cause damage to the public or individuals, Subparagraph 5, Paragraph 1, Article 174 of the SEA is applicable. Meanwhile, a violation of Subparagraph 1, Paragraph 1, Article 171 (or Paragraph 2, Article 20) of the SEA is considered a fraud in trading securities, and a penalty under these provisions may be imposed only when the financial statement fraud committed is serious and the violator has exploited such financial statement to defraud others. This differentiation method is theory-based and can be adopted before the applicable laws are further amended.