Bad Controls Put Company On SEC Hot Seat

In what is believed to be the first case of its kind, an Indiana manufacturer settled charges with the Securities and Exchange Commission earlier this month that poor internal controls led to five years of sloppy accounting and a restatement that nicked company financial reports by $16 million.

The Feb. 9 settlement with Cummins Inc., a $4.6 billion maker of power equipment, appears to be the first time the SEC has specifically targeted lax internal controls as the subject of an enforcement action, says Blase Dillingham, a partner with the Los Angeles office of the law firm Manatt, Phelps & Phillips.

Dillingham

“Violations of internal control problems have been pretty much ancillary to some other major substantive issue: Foreign Corrupt Practices Act violations, or a massive fraud, or failure to comply with GAAP in general,” Dillingham says (see related cases at right). “Here, the SEC is saying, ‘Internal control violations in and of themselves are serious to us. We’re taking it seriously and making an issue of internal controls’ ” regardless of other issues.

The SEC imposed no fines or other penalties, but Cummins did agree to a cease-and-desist order imposed by the agency.

An SEC spokesman said the agency does not track the causes behind its investigations, and could not confirm that Cummins is the first enforcemnt action premised on internal controls. But the spokesman also did not dispute several securities lawyers who follow SEC enforcements closely and say that is indeed the case.

Van Dorn

Walter Van Dorn, a partner with Thacher Proffitt & Wood in New York, says the SEC “presumably is doing this to set something of an example” for other companies. “They’re trying to draw a bit of a line in the sand.” Van Dorn also notes that the thresholds for such cases are also relatively new. “I wouldn’t be surprised to see more,” he says.

Dillingham, meanwhile, says that because chief executives and chief financial officers are now required to certify to the effectiveness of internal controls, he expects to see more cases of enforcement actions citing individuals “and the failure of their own responsibilities, in addition to just citing the companies.”

Balance Rolled Forward

Cummins Inc. is a $4.6 billion company that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and other engine-related products. According to the SEC settlement order, the company failed to reconcile key accounts at its manufacturing locations in Minnesota and the United Kingdom from 1997 to 2002. The two locations accounted for upwards of 20 percent of the company’s total revenues.

The Minnesota facility was the primary cause of the accounting errors, according to the SEC. Staff at that location, contrary to company policy, failed to reconcile its account payable subsidiary ledger beginning in 1997. Instead they simply rolled forward the accounts payable balance reflected in the general ledger account each month, without investigating or reconciling the differences between the ledgers.

In 1998 and 1999, the company “took actions to address unrelated matters that had the unintended effect of exacerbating the accounts payable problem at the [Minnesota] facility,” the SEC said. One actions involved a new software system implemented partly to address Y2K concerns. Employees were not adequately trained on the new system and created “work around” procedures that further weakened the accounts payable system. Because of the failure to reconcile accounts payable accounts, the problem wasn’t identified or corrected.

EXCERPT

The excerpt below is from the Legal Analysis section of the SEC's Order Instituting Cease-And-Desist Proceedings in the matter of Cummins Inc. Please note that footnotes have been removed from the excerpt; view the link below for the original version.

...Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers with securities registered under Section 12 of the Exchange Act to file annual and quarterly reports with the Commission. The obligation to file such reports embodies the requirement that they be true and correct. See, e.g., SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Section 13(b)(2)(A) of the Exchange Act requires issuers to make and keep books, records, and accounts that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer. Section 13(b)(2)(B) requires issuers to devise and maintain systems of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain accountability of assets.

A fundamental concept underlying accurate financial reporting is that all accounting entries that are required to be recorded must, in fact, be recorded. During the relevant period, two Cummins manufacturing facilities failed to properly record transactions and the disposition of assets on their books and ledgers. Cummins’ failure to properly record these transactions resulted in material discrepancies between the general ledger accounts on Cummins’ books and the supporting subsidiary ledgers for the accounts payable accounts. If Cummins had properly and timely performed reconciliations for these key balance sheet accounts, it would have detected and corrected the errors years earlier.

Cummins also failed to maintain sufficient internal accounting controls to provide reasonable assurances that its transactions were recorded as necessary to permit the preparation of its financial statements in conformity with generally accepted accounting principles. Among other things, Cummins failed to employ and train qualified personnel in its Fridley and Darlington finance departments and failed to have an internal control system adequate to monitor the accounts reconciliation process.

As a result of the conduct described above, Respondent violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-1, and 13a-13 thereunder...

Source

SEC Order Instituting Cease-And-Desist Proceedings In The Matter Of Cummins Inc. (Feb. 7, 2006)

Cummins took some corrective action in 1999 when it became aware of its Minnesota problems, but only one employee and one consultant were charged with doing the work and it was still incomplete when the Sarbanes-Oxley Act was enacted in 2002. Passage of SOX led to a stepped-up effort to address the matter.

Cummins experienced a similar but smaller issue in its U.K. facility, where the accounting staff did not appear to understand how to reconcile accounts properly, according to the SEC. The effort to reconcile the accounts after the problem was identified took more than two years.

The accounting errors ultimately led to a restatement in 2003, when Cummins cut its previously reporting net earnings for 2000 by 43 percent and for 2002 by 12 percent.

Cummins spokesman Mark Land says the company has now corrected its problems, and is “pleased that this is behind us... We’ve taken a hard look at our controls. We’re committed to being transparent and this has helped to make us better along those lines. We have strengthened our reporting process as a result of this."

‘Low-Hanging Fruit’

Carter

Peter Carter, a partner in the Minneapolis office of Dorsey & Whitney, says that while the SEC’s approach in the Cummins case “is certainly not uncommon,” it is notable that the agency didn’t turn the controls violations into a fraud claim. He speculates that “some very good negotiations between the Commission and Cummins’ lawyers” may have helped the company elude a more serious charge.

Carter also wonders whether the SEC will pursue internal control weaknesses in situations that do not generate restatements. Cummins, he says, “was low-hanging fruit. As soon as you issue a restatement, you in essence announce to the world that your internal controls are insufficient.”

The real question, he says, is how the SEC will handle companies that disclose weak internal controls that don’t lead to restatements. “If a company discloses a material weakness as part of a SOX 404 assessment, the SEC may use those material weaknesses as the markers of the places to look for books-and-records violations,” he says, “generating more books and records violations even without restatements.”

Kaplan

Mitchell Kaplan, a partner with Choate, Hall & Stewart in Boston, notes that deficient accounting—which took place in Cummins largely before the enactment of SOX—could still occur despite the tightening of corporate oversight.

“There’s no question that what the accounting firms are requiring before they will give you your Section 404 attestation is enormous, so a lot of the sloppiness will be gone,” Kaplan says. “But you still need adequate personnel. We’re still going to see instances where restatements occur not because someone was trying to mislead the investing public, but because they had people who weren’t up to the task.”