On September 28, 2020, the U.S. Securities and Exchange Commission (the “SEC”) announced two settlements against public companies and individual charges against the former controller and chief accounting officer and the former chief financial officer of one of the companies. In its accompanying public announcement, the SEC advised that “The actions are the first arising from investigations generated by the Division of Enforcement’s EPS Initiative, which utilizes risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices.” This initiative exemplifies the harnessing of “Big Data,” i.e., large data sets that may be analyzed computationally to reveal patterns, trends, and associations.
The first settlement, against Fulton Financial Corporation, a Pennsylvania-based financial services company, involved findings that this company inaccurately presented its financial performance in late 2016 and early 2017. During two quarters of the quarters in which the company was on track to meet or beat analyst consensus EPS estimates, the order found that the company’s public filings included a valuation allowance for its mortgage servicing rights that was at odds with the valuation methodology described in the same filings. The SEC’s order found that in mid-2017, the company belatedly reversed the valuation allowance, increasing its EPS by a penny in a quarter when it otherwise would have fallen short of consensus estimates. As alleged in the order, this company’s disclosures created the misleading appearance of consistent earnings across multiple reporting periods. Despite the order’s acknowledgment of the company’s cooperation and remediation, this company was ordered to pay a $1.5 million civil monetary penalty.
The second settlement, against Interface, Inc. a Georgia-based modular carpet manufacturer, and two individuals involved findings that in multiple quarters in 2015 and 2016, the company made unsupported, manual accounting adjustments that were not compliant with GAAP. These adjustments were often made when internal forecasts indicated that the company would likely fall short of analyst consensus EPS estimates. The order found that the adjustments boosted the company’s income, making it possible for the company to consistently report earnings that met or exceeded estimates. According to the order, the former controller and chief accounting officer directed the unsupported adjustments, including those made to management bonus accruals and stock-based compensation accounts. The order also found that the company’s former chief financial officer caused the controller and chief accounting officer to direct some of the unsupported entries. For their violations, and amongst other remedies, the SEC imposed three-year and one-year suspensions on these two individuals, respectively, regarding the privilege of appearing or practicing before the SEC as accountants. Again, despite the settlement order acknowledging the company’s cooperation and remediation, this company was ordered to pay a $5 million civil monetary penalty.
Despite touting this EPS Initiative and the egregious nature of the facts alleged in both settlements, the SEC did not charge the companies or the two individuals with more serious scienter-based violations. The first company was only charged with violations of the reporting, books and records, and internal control violations of the Securities Exchange Act of 1934. The second company was charged with these technical violations and also charged with violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 (“Securities Act”). While these latter two charges are more serious, they are not scienter-based violations that require evidence of knowing misconduct. Once again, the SEC elected not to charge the more serious and scienter-based violation of Section 17(a)(1) of the Securities Act.
In terms of takeaways, this announcement and the accompanying settlements reveal that the SEC is continuing to aggressively police public companies. Further, these efforts reflect a proactive and strategic EPS Initiative that utilized risk-based data analytics to uncover potential accounting and disclosure violations. In its acknowledgments, the Division of Enforcement thanked staff in its Office of Investigative and Market Analytics. Moreover, it also exemplifies that companies that cooperate may be able to avoid fraud-based charges, but they will be given little “cooperation credit” in the context of paying civil penalties.
With the SEC’s recent history of celebrating its initiatives, we can expect more cases and investigations related to this EPS Initiative and additional initiatives being developed in coordination with the Office of Investigative and Market Analytics.