March 6, 2019

Internal Controls: Who Should Worry Most About Enforcement?

In January, I blogged about the SEC’s enforcement proceedings against four companies that were unable to get their acts together when it came to ICFR. The SEC’s action was a shot across the bow of other companies that might have thought that full disclosure of a material weakness was sufficient. The SEC’s action delivered a clear message that when you’ve got an internal controls problem, you’ve got to fix it.

But at the same time, lots of companies have ICFR issues – and many material weaknesses can’t be fixed overnight.  So which companies should be concerned that SEC Enforcement might soon be knocking at their doors?  This ‘Audit Analytics’ blog may help companies assess their risk of being subject to an enforcement proceeding. It reviewed data on material weakness disclosures during the period from 2007-2017, and it concludes that the 4 companies targeted by the SEC in these proceedings all involved extreme cases of non-compliance:

When it comes to poor internal controls, these companies are some of the worst offenders, as the problems were allowed to linger for years. Looking at data from 2007 and 2018, 3.4% of registrants with any ineffective ICFR report had seven ineffective management ICFR reports, comparable to Digital Turbine.  This percentage decreases to 1.9% for registrants such as LifeWay and CytoDyn that had nine ineffective ICFR reports. Overall, less than 10% of registrants with any ineffective ICFR management ICFR report had seven or more ineffective reports.

As the biggest of the four registrants, Grupo Simec is noteworthy, being one of only 72 companies traded on NYSE that had ineffective independent auditor’s reports on internal controls in 2017 and one of only two companies that has had ten ineffective audited reports since 2007.

While companies may take some solace in the fact that these 4 targets were outliers, the blog cautions that other firms with multiple ineffective ICFR reports but only minimal remedial actions could also be at risk.

Buffett to GAAP: “Get Off My Lawn!”

Last week, Warren Buffett’s annual letter to Berkshire-Hathaway shareholders landed – and while it had its usual on-brand mix of folksy humor and provocative statements (e.g., deals are too pricy & federal debt doesn’t matter), the Oracle of Omaha led off with a jeremiad against GAAP’s new “mark-to-market” requirement for unrealized securities gains & losses:

Berkshire earned $4.0 billion in 2018 utilizing generally accepted accounting principles (commonly called “GAAP”). The components of that figure are $24.8 billion in operating earnings, a $3.0 billion non-cash loss from an impairment of intangible assets (arising almost entirely from our equity interest in Kraft Heinz), $2.8 billion in realized capital gains from the sale of investment securities and a $20.6 billion loss from a reduction in the amount of unrealized capital gains that existed in our investment holdings.

A new GAAP rule requires us to include that last item in earnings. As I emphasized in the 2017 annual report, neither Berkshire’s Vice Chairman, Charlie Munger, nor I believe that rule to be sensible. Rather, both of us have consistently thought that at Berkshire this mark-to-market change would produce what I described as “wild and capricious swings in our bottom line.”

If Warren sounds grumpy, well, you would be too if you lost $25 billion in a single quarter, like Berkshire did due to Q4 mark-to-market adjustments. But he should take some consolation in the fact that Berkshire’s by no means alone in dealing with the increased volatility resulting from the new standard.

The mark-to-market requirement was expected to have a big impact on earnings for many companies, and it appears to be living up to its advance billing. For example, this recent Reuters article notes that the new standard’s effect on publicly traded PE funds such as Blackstone, Carlyle & KKR has been so significant that they’ve opted to deemphasize the traditional “economic net income” metric – which reflects mark-to-market adjustments – in favor of “distributable earnings,” which represents the actual cash available for paying dividends.

Delaware Chancery: Choosing Venezuela’s President Since 2019?

The Delaware Chancery Court has long played an outsized role in shaping the destiny of some of the world’s largest businesses. Now, this Bloomberg story says that the court may be called upon to weigh-in on the fate of a nation – because it may have to determine who is Venezuela’s lawful president as part of a battle for control over Citgo.  Here’s an excerpt:

The leadership crisis in Venezuela could lead to an odd legal situation in the U.S. — a Delaware judge may be asked to decide who is the legitimate president of the South American country.

The issue could arise in the U.S. because of the power struggle over Citgo Petroleum Corp., the Houston-based refiner owned by Venezuela oil giant Petroleos de Venezuela SA. Last week, Juan Guaido, the U.S.-backed head of Venezuela’s National Assembly, named new directors to Citgo and PDVSA, a critical part of his strategy to seize oil assets and oust the regime headed by autocrat Nicolas Maduro, who remains in control of the military and other key parts of the government.

Venezuela’s president is the controlling shareholder of PDVSA, and the article speculates that lawyers for the U.S.-backed Guaido may set up a Chancery Court contest centering on who is Venezuela’s president by trying to remove Maduro’s directors and replacing them with his slate.

John Jenkins