Case Studies: When the SEC Comes Knocking

It’s a narrative compliance executives hear all too often: A company becomes the center of a Securities and Exchange Commission probe. The stock price then tanks, the press goes on a feeding frenzy, and senior management is left to pick up the pieces.

And that can be the outcome when the probe just ends without charges. While innocent victims have been known to get burned in these investigations, a more common theme among companies on the hot seat is that “they seem to consistently get it wrong,” said Theodore Sonde, a partner with the law firm Patton Boggs.

Taking these lessons learned the hard way, Sonde and other litigation experts at the Association of Corporate Counsel’s annual conference in Seattle last month examined five common mistakes companies make—and how to avoid them.

1. Misleading Disclosures, Director Resignations

Rao

In a shaky economic environment, board resignations have become an almost daily occurrence. Acknowledging the timing and circumstances that give rise to a resignation is one way to avoid an SEC investigation, said Pravin Rao, a partner of law firm Perkins Coie.

Hewlett-Packard learned this the hard way, when in May 2007 the SEC charged the company with failing to disclose in its Form 8-K the reasoning behind one of its board member’s sudden departures. The resulting settlement came after an internal investigation by HP in early 2006, which revealed that a board member had been leaking confidential information to the press.

The now-notorious dispute centered on HP investigating which board members were leaking what to the press and cost numerous directors their seats when all was done. Along the way, however, HP explained away the departures as personal disagreements with the chairwoman.

Thomsen

The SEC didn’t buy it. “[I]nvestors have a right to know when a dispute among board members over operations, policies, or practices causes a director to resign, as such a dispute may have far-reaching ramifications for the company,” SEC Enforcement Director Linda Chatman-Thomsen said in a written statement.

“According to Rao at Perkins Coie, companies should ‘err on the side of caution’ and disclose the specific reasons for board resignations, regardless of whether those resignations were submitted to the board chairman or were unveiled at full board sessions.“

2. Earnings, Pre-Determined Targets

Another common blunder with earnings statements is to let outsiders make wrong assumptions and not correct them, said Daniel Jablonsky, senior corporate counsel of Flextronics International. He cited an SEC investigation into IBM after the company announced in a pre-earnings call for the first quarter of 2005 that it would report stock options as an expense in its financial statements. In that call, IBM management advised analysts to adjust their earnings models to account for the change. The company referred to an 8-K filing that showed 2004 options expense at 14 cents per share, stating that 2005 options expense would not be higher than 2004—in other words, it let analysts make wrong assumptions.

“Therein lies the problem, because that turned out not to be the case,” said Jablonsky; option expensing costs were actually higher. In June 2007, IBM consented to a cease-and-desist order by the SEC, as a result.

The takeaway of the IBM case, said Jablonsky, is not only to disclose complete and accurate financial projections at all times, but also to correct analyst misunderstandings as soon as they surface, even if the disclosure was intentional, he said.

3. Regulation FD Violations

Regulation Fair Disclosure raises similar woes for companies when it comes to SEC investigations. Jablonsky cited Schering-Plough as a prime example.

At the end of the third quarter in 2002, Schering-Plough management held several private meetings with buy-side investors. At these meetings, the CEO stated that the company would take a “hard hit” to earnings in 2003, and that it was going to be a “very, very difficult year.”

In response, analysts downgraded Schering-Plough’s stock, which prompted a sell-off of company stock. In investigating the company, the SEC said, “based on language, tone, emphasis, and demeanor” at investor meetings, the CEO selectively disclosed negative and material non-public information about company prospects.

Telling investors that the company would miss numbers is fine, Jablonsky said—but failing to disseminate this information publicly is not fine. In the end, the CEO agreed to a $50,000 fine and a cease-and-desist order.

Lessons learned from this case: that in-house counsel should advise management to use caution in scheduling analyst meetings toward the end of the quarter and also should advise management and the investor relations team to respond with “no comment” on inappropriate questions about guidance, Jablonsky said.

Sonde

Sonde added that companies should opt for the “healthier” option of annual rather than quarterly guidance. “This quarterly guidance … is the worst,” he said. “It’s an invitation for disaster.”

4. Improper Disclosures

One particular reason why quarterly guidance is so dangerous is because companies are always under the gun to make the numbers, Sonde said. “What do you think makes the numbers? You push out products,” he said.

In many instances, this practice is not always done legally. In April 2005, for example, the SEC issued an enforcement action against Coca-Cola for failure to disclose certain end-of-quarter sales practices.

“[I]nvestors have a right to know when a dispute among board members over operations, policies, or practices causes a director to resign, as such a dispute may have far-reaching ramifications for the company.”

— Linda Chatman-Thomsen,

Enforcement Director,

Securities & Exchange Commission

In its order, the Commission found that at or near the end of each reporting period from 1997 to 1999, Coca-Cola implemented an undisclosed “gallon pushing” practice for the purpose of pulling sales forward into a current period. To accomplish this, Coca-Cola offered bottlers extended credit terms to induce them to purchase quantities of beverage concentrate the bottlers otherwise would not have purchased until a following period. As bottlers’ inventory levels rose 60 percent, retail sales increased only 11 percent.

“If you’re selling and shipping products, how is that possible? It’s possible because you’ve got stuff lodged in a warehouse in inventory, and you’re not really selling products,” Sonde said. “It just looks like it.”

In another case, Bristol Myers Squibb initiated a similar channel stuffing practice by forcing distributors to buy products with the quiet promise to accept product returns later. In 2004, the SEC hit Bristol Myers Squibb with $150 million in fines and penalties. In addition, the company also reached a deferred prosecution agreement with the Justice Department for another $300 million.

Both cases highlight one of the biggest challenges for inside counsel, Sonde said: Getting management to go beyond the numbers and explain what is going on. He recommended that in-house counsel ask management the following questions:

How do you know the known trends and uncertainties affecting the company?

Are sales up or down?

Are we making or losing money per unit?

“The enforcement staff is going to be looking at this with the better of 20/20 hindsight,” Sonde said. Poll outside counsel, and try to get a sense of what you need to do to talk through the problem, he said.

5. Improper Accounting Tricks

Another common stunt is to use improper accounting tricks and shortcuts. Sonde said one example of “the worst business practices you can imagine” occurred in December 2004, when the SEC filed civil fraud charges against three former Kmart executives and several current and former employees of Eastman Kodak Company, Coca Cola, and PepsiCo’s subsidiaries, Pepsi-Cola Co. and Frito-Lay.

In this case, these vendors paid Kmart “allowances” for advertising, special displays, price protection, exclusivity, and other marketing activities. These allowances would prematurely increase earnings in the financial statements; Kmart recognized the allowances before they were earned—a practice that overstated earnings by $24 million. In the end, the SEC charged these executives $25,000 to $55,000 for improper recognition of vendor allowances.

Electing to have a volunteer monitor is one preventive best practice from falling prey to an SEC investigation. But such a preventive method can sometimes be very expensive. Siemens, for example, currently being investigated for corruption, has spent in excess of $1 billion for its ongoing monitor for accounting fees and conducting investigations in more than 50 countries, Sonde said.

But Rao stressed that it’s better to be safe than sorry. In today’s environment, you’re likely to be investigated by multiple agencies, he said. “It’s better to clean up acts before that happens.”