SEC Probe Into Foamex Internal Controls Won't Be Last

Foamex International disclosed last week that it is the subject of an informal inquiry by the Securities and Exchange Commission relating to the company’s internal controls—marking what appears to the first time that a Commission investigation specifically targeting internal controls under The Sarbanes-Oxley Act of 2002 has been made public.

In announcing its fourth quarter and full-year 2004 financials, the Linwood, Pa.-based maker of foam products said it is attempting to negotiate a settlement of the matter with the SEC.

Meisner

Informal inquiries—which is how SEC investigations usually begin—are not made public by the Commission, noted Derek Meisner, a former branch chief in the SEC’s Division of Enforcement.

Such informal investigations are usually only disclosed if the company itself does so, as was the case with Foamex, said Meisner, now a securities lawyer at Kirkpatrick & Lockhart Nicholson Graham in Boston.

“In the age of heightened disclosure, many companies routinely disclose the existence of any SEC investigation, assuming that they have a reasonable basis to conclude that they are more than tangentially involved in the investigation,” he said, noting that an informal inquiry would often fall within the duty to disclose material information to investors.

Although this may be the first post-SOX internal control investigation to be revealed to the public, it almost certainly won’t be the last, Meisner told Compliance Week.

“I wouldn’t be surprised if [the Commission] has many investigations that are occurring right now. Companies have been routinely disclosing problems [under Section 404 of SOX]. If a company comes out and says that its auditor refuses to certify, that’s generally something the SEC may look at,” added Meisner. “I think you’ll see the SEC judiciously use their enforcement resources to determine which type of 404-related actions they’re going to bring. You’ll probably see a number of settlements over the coming months.”

Two Material Weaknesses Identified

In its April 4 statement, Foamex revealed that, to date, it has “identified two material weaknesses in its internal control over financial reporting and may identify others as it concludes its assessment.”

The first identified material weakness concerned a required restatement of the company’s third-quarter results. That restatement corrected an error in recording the valuation allowance established in last year’s third quarter against its deferred income tax assets.

The other material weakness related to Foamex’s accounting for labor and overhead variances to its standard costs, which should have been included in its work in process and finished goods inventories. “Management is addressing the material weakness by revising the Company’s process to account for labor and overhead variances,” Foamex said.

The Commission itself does not comment on informal inquiries—which in this case was triggered when Foamex disclosed certain reportable conditions regarding its internal controls in April 2004, the company said.

While making the SEC informal inquiry public, Foamex also reported year-end results. Net sales came in at $1.27 billion, down 3 percent from $1.30 billion in 2003. The decline was blamed on a $96 million fall in net sales in the company’s automotive products segment. Net loss for the year was $150.9 million, or $6.17 per diluted share, compared to a net loss of $21.5 million, or 88 cents a share, in 2003. The loss for the year included a $128.6 million income tax charge for the establishment of a valuation allowance for the company’s deferred income tax assets.

The announcement of the SEC inquiry and the less-than-rosy year-end numbers caused Foamex’s stock price to take an immediate hit. The price tumbled 17.9 percent on April 4, the day of the announcement, to $1.51.

Most Investigations Settled

According to Meisner at Kirkpatrick & Lockhart, Foamex may have reason to be optimistic about a settlement.

“The vast majority of SEC investigations result in settlements," he says, "One benefit of settling is that a party is not required to admit the underlying conduct—and that allows parties to avoid the consequences of admitting wrongful conduct, such as criminal exposure and the increased risk of private litigation,” he said.

Meisner said it’s impossible to speculate on what type of penalty might be part of a settlement with Foamex or any company—but the possibilities include cease and desist orders, censures and monetary penalties. He said that he expects to see “a number of settlements” in the near future involving books and records, internal controls and accounting provisions.

The Commission may also be eying cases that will resonate more broadly. “The SEC is always looking to send a message,” he said. “It will look to make certain entities an example—to show through an enforcement action what entities are not supposed to do.”