In Rare Move, the SEC Assesses No Penalty for Significant Corporate Accounting Control Failures
Last week, the Securities and Exchange Commission (the “SEC”) settled charges against a manufacturer and seller of food and personal care products (the “Manufacturer”), alleging that the Manufacturer, a public company, had inadequate internal controls and failed to maintain accurate books and records in connection with certain sales incentives that the Manufacturer offered to two of its largest domestic customers in an effort to increase sales at quarter end. Among other things, the SEC alleged that the Manufacturer’s conduct violated Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act because the incentives were not appropriately documented and the Manufacturer lacked policies, procedures, and internal controls to account for these sales activities. However, in a rare departure from typical practice, the SEC did not impose any monetary penalty on the Manufacturer, acknowledging that the Manufacturer (1) promptly conducted an internal investigation, (2) ultimately determined that it did not need to restate prior financial statements, (3) self-reported promptly to the SEC, and (4) engaged in remedial measures.
Similarly situated companies should certainly consider this result in deciding whether to conduct an internal inquiry into potential accounting and sales issues, and ultimately whether to self-report to the SEC.
Background: The SEC’s Position on Self Reporting
When evaluating whether, and to what extent, to take enforcement action against a company, the SEC often considers four factors:
Self-policing prior to discovery of the misconduct, including the existence of robust compliance procedures;
Self-reporting of misconduct when discovered, including conducting a thorough internal investigation and prompt, complete, and effective disclosure to the public and to regulators;
Remediation, including dismissing or disciplining wrongdoers, improving internal controls, and appropriately compensating those adversely affected; and
Cooperation with regulators, including providing all relevant information concerning the misconduct and remedial efforts.
The level of cooperation credit given to companies may range from taking no enforcement action at all to reduced charges or sanctions. At times, the SEC has even agreed not to prosecute entities or to defer its prosecution through the use of Non-Prosecution Agreements or Deferred Prosecution Agreements. As seen in the Manufacturer’s settlement, the SEC may also choose to forego sanctions and penalties.
The Circumstances of the Manufacturer Settlement
According to the SEC, from 2014 to 2016, approximately 30% of the Manufacturer’s net sales for its U.S. operations were attributable to two customers, both of which were distributors that ultimately resold goods to retailers. The Manufacturer allegedly offered sales incentives, including cash, discounts, and extended payment terms, to the distributors in exchange for increased purchases at quarter end. Although the SEC clarified that the incentives were not inherently improper, the Manufacturer purportedly (1) provided the incentives without appropriate documentation because the incentives were only communicated orally or via e-mail rather than in formal contracts; (2) lacked sufficient policies and procedures to provide reasonable assurances that the incentives and the resulting sales were properly accounted for and monitored, or that personnel were properly trained on the accounting implications; and (3) did not communicate the end of quarter sales incentives with personnel in the accounting and finance departments.
In May 2016, the Manufacturer’s finance department learned about the quarter-end sales incentives, and the audit committee of the Manufacturer’s board of directors conducted an internal investigation with the assistance of independent counsel to determine, among other things, whether there were revenue recognition issues and whether the sales were accounted for in the correct periods. Three months later, the Manufacturer self-reported to the SEC that it was investigating these practices and announced in a Form 8-K that its fiscal year-end results would be delayed. The Manufacturer delayed filing its Form 10-K for fiscal year 2016 and disclosed material weaknesses in its controls over financial reporting. Ultimately, the Manufacturer determined that financial restatements were not necessary, but corrected immaterial errors in prior statements.
The SEC noted that the Manufacturer undertook additional steps, such as regularly updating the SEC on its internal investigation, hiring compliance personnel, implementing changes to its monitoring of customer sales contracts, and changing its revenue recognition practices. Based on these factors, the SEC determined that a civil penalty was not warranted.
The SEC’s settlement with the Manufacturer highlights the importance of a prompt and thorough response to suspected misconduct, and it is a clear reminder of the benefits of self-reporting, cooperating and implementing remedial measures. However, the Manufacturer’s settlement is only one data point among many that a company should consider when confronted with similar circumstances. The SEC’s views of corporate misconduct, cooperation, and remedial efforts are fact‐specific, and the facts presented in the Manufacturer’s settlement were somewhat unique. For example, there was no knowledge of the sales practice by the finance department, and there was no need for a financial restatement. Without those facts, the result likely would have been different. Thus, it is critical to seek specific advice from experienced counsel familiar with the SEC’s process and mindset before undertaking any corporate actions in response to potential misconduct.
It should also be noted that an SEC settlement does not necessarily eliminate the risk of civil or class litigation. For instance, the Manufacturer currently faces a shareholder suit alleging internal controls deficiencies relating to its sales and financial reporting practices. Accordingly, when cooperating with the SEC, corporate counsel should be mindful of the potential risk that additional discovery or evidentiary admissions might arise in the context of a related civil action.