This week the Securities and Exchange Commission settled its first enforcement actions under its EPS Initiative, which it describes as using risk-based data analytics to uncover potential accounting and disclosure violations by public companies caused by, among other things, earnings management practices. Interface, Inc., a Georgia-based modular carpet manufacturer, agreed to pay a civil penalty of $5 million.1 Fulton Financial Corporation, a Pennsylvania-based financial services company, will pay a civil penalty of $1.5 million. Hilton Worldwide Holdings, Inc., the Virginia-based holding company of Hilton Hotels, will pay a civil penalty of $600,000. These actions highlight the need for issuers to pay close attention to accounting and disclosure controls around earnings, earnings per share (EPS), and executive perquisites.
The SEC found that Interface made unsupported and inappropriate manual accounting adjustments in 2015 and 2016 to boost the company’s earnings and meet analysts’ EPS estimates.2 According to the order, Interface closed expected earnings shortfalls by, among other things, manually reducing accruals for nondiscretionary bonuses despite forecasts that the accrued amounts were highly likely to be paid. The SEC also found that Interface misstated expenses related to an insurance arrangement with, and a bonus paid to, a key independent consultant. But for these misstatements, “Interface’s reported earnings would have been more volatile than reported, and in two quarters in which it reported meets of analyst consensus EPS, Interface would have in fact missed the consensus estimates.”
In Fulton, the SEC found that the company had manipulated a valuation allowance relating to certain mortgage servicing rights (MSRs) retained by Fulton after the underlying loans had been sold.3 According to the order, Fulton maintained a portfolio of MSRs and assessed, on a quarterly basis, whether the assets were impaired. Fulton beat consensus earnings estimates in each of the first three quarters of 2016 by a penny despite booking MSR valuation allowances in two of those quarters. By Q4 2016, the value of Fulton’s MSRs had risen, which would have ordinarily supported reversal of the prior allowances. According to the order, Fulton, whose financial performance was then in line with analysts’ EPS estimates, temporarily changed valuation methods in late 2016 to avoid reversing the allowances and overshooting analysts’ expectations. The order found that Fulton did not reverse the allowances until Q2 2017, when the reversal allowed it to avoid falling short of consensus EPS estimates. According to the order, Fulton thus “created the appearance of consistent earnings trends across reporting periods and deprived investors of the ability to understand management’s involvement in fair value calculations.”
In Hilton, the SEC found that the company’s system for identifying, tracking, and calculating perquisites failed to catch $1.7 million worth of travel-related benefits provided to its CEO and other executive officers between 2015 and 2017.4 Items that Hilton incorrectly classified as business expenses included use of corporate aircraft and certain hotel stays. According to the order, these control weaknesses caused Hilton’s definitive proxy statements to understate the “All Other Compensation” portion of officers’ compensation by an annual average of approximately $425,000.
The SEC’s EPS initiative to systematically analyze earnings-related and other information will likely lead to additional enforcement investigations focused on what Enforcement Director Stephanie Avakian described as “evidence of earnings management and other accounting or disclosure improprieties.” This dovetails with remarks by Avakian in a speech two weeks ago in which she noted the division’s proactive use of internal and external tools along with routinely looking at all public information available for an issuer in order to develop a “deep understanding” of an issuer.5Although the SEC did not disclose why it launched these investigations, Interface’s and Fulton’s patterns of consistently and precisely meeting analysts’ EPS estimates (or beating them by one penny) likely were red flags. The relatively large civil monetary penalties imposed in the first two of these actions against smaller companies is also a signal that the SEC is aggressively pursuing suspected earnings management. And the Hilton matter highlights executive compensation as an additional area of focus. These initiatives are consistent with the focus by the Division of Corporation Finance on non-generally accepted accounting principles metrics, disclosure controls, and MD&A disclosures and speaks to an overarching SEC emphasis on accounting and disclosure issues
Accordingly, public companies should routinely assess not only their internal controls over financial reporting but also their disclosure control processes and procedures to ensure that their financial disclosures, including those relating to EPS and executive compensation, are carefully and consistently applied and accurately described in their public filings.
1 Interface’s former CFO and former controller agreed to pay civil monetary penalties of $70,000 and $45,000, respectively, and be suspended from appearing and practicing before the commission as accountants. Unlike in Fulton, the settlement with Interface and its former CFO included certain antifraud charges.
2 In re Interface, Inc., et. al., Exchange Act Rel. No. 10854 (Sept. 28, 2020).
3 In re Fulton Fin. Corp., Exchange Act Rel. No. 90017 (Sept. 28, 2020).
4 In re Hilton Worldwide Holdings, Inc., Exchange Act Rel. No. 90052 (Sept. 30, 2020).
5 Stephanie Avakian, Remarks at the Institute for Law and Economics, University of Pennsylvania Carey Law School Virtual Program, Protecting Everyday Inv’rs and Preserving Mkt. Integrity: The SEC’s Div. of Enf’t (Sept. 17, 2020), https://www.sec.gov/news/speech/avakian-protecting-everyday-investors-091720. See also Stephen Cohen, Nader Salehi & Paul Bello, Framing the Legacy of the SEC Under Clayton, LAW 360 (Sept. 23, 2020, 5:20 pm), https://www.law360.com/articles/1312799/framing-the-legacy-of-the-sec-under-clayton.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers.
Attorney Advertising—Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. +1 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships, as explained at www.sidley.com/disclaimer.
© Sidley Austin LLP