December 12, 2019

SEC Calls Foul on “Earnings Management”

You likely saw this WSJ article last month, detailing an SEC investigation into one company’s end-of-quarter “earnings management” practices – e.g. leaning on customers to take early deliveries and rerouting products to book sales. The company says “everyone’s doing it” – and according to a McKinsey survey described in this Cleary blog, that’s not too much of an exaggeration:

Lest anyone think the SEC’s focus on “pulling in” revenues is an issue of limited relevance, note that approximately 27% of US public companies provide quarterly guidance, and evidence of widespread earnings management is not merely anecdotal. A broad survey by McKinsey reveals that, when facing a quarterly earnings miss, 61% of companies without a self-identified “long-term culture” would take some action to close the gap between guided and actual earnings, with 47% opting to “pull-in” sales. 71% of those companies would decrease discretionary spending (e.g., spending on R&D or advertising), 55% would delay starting a new project, even if some value would be sacrificed, and 34% would delay taking an accounting charge.

But the widespread nature of these practices doesn’t make the SEC more amenable to them – e.g. they imposed a $5.5 million fine and a cease-and-desist order in a recent enforcement action involving similar maneuvers. The blog notes:

The use of any of these techniques, if resulting in the obfuscation of a “known trend or uncertainty . . . that may have an unfavorable impact on net sales or revenues or income from continuing operations,” would presumably be equally objectionable to the SEC.

Accordingly, for those companies that are still providing earnings guidance, it would be prudent to make sure that your disclosure committee is having frank and frequent discussions with management about exactly what, if any, earnings management tools are being used, whether these tools fit squarely within the company’s revenue recognition policies, whether the company’s auditors are aware of the scope and persistence of these practices, and, most importantly, whether the use of the tools is, intentionally or not, masking a trend of declining sales, a declining market share, declining margins, or other significant uncertainties.

“Climate Accounting”: Exxon Prevails in Martin Act Suit

A couple months back, I blogged that Exxon Mobil was defending itself in New York state court against allegations that it had misled investors by saying publicly that it estimated higher future costs of climate change regulations when it evaluated potential oil & gas projects – when it was actually basing those decisions on current costs, and assumptions that the regulatory environment wouldn’t change.

Among other things, the complaint by the New York Attorney General alleged violations of the state’s Martin Act, which turns on whether there’s a misrepresentation or omission of material facts. The alleged misrepresentations were made by Exxon in reports that were published back in 2014 in exchange for the withdrawal of two shareholder proposals – and were then repeated in other reports such as the company’s “Corporate Citizenship Report.”

Earlier this week, the judge on the case issued this 55-page opinion in Exxon’s favor. Basically, the decision came down to a finding that investors didn’t care about the info – there was no market impact and the info wasn’t “material” when considered with the total mix available in the company’s 10-K and other disclosures. The judge also accepted Exxon’s argument that the company’s internal practices didn’t impact its financials.

This was a big victory, but it’s pretty fact-specific (as detailed in this “D&O Diary” blog) – and you’ve gotta wonder whether the outcome would be the same if the allegations were based on more recent disclosures, since current-day investors keep claiming they care about this stuff. Exxon continues to face other “climate change” lawsuits – including a consumer protection case in Massachusetts. And they aren’t alone. This Davis Polk blog notes that at least one D&O insurer is observing a growing number of climate-related claims – and that it will consider that risk during underwriting. Here’s an excerpt:

Among 28 countries, 75% of climate-related cases brought to date were in the United States alone. The firm anticipates that the failure to disclose climate change risks may drive claims in upcoming years. Moreover, a company’s lack of responsiveness to overall environmental, social and governance (ESG) issues, including ethical topics, can cause brand values to plummet. The insurer warns that, when gauging a company’s reputation, underwriters of D&O insurance will consider the nature and tone of comments made on social media relating to the company.

November-December Issue of “The Corporate Counsel”

We recently mailed the November-December issue of “The Corporate Counsel” print newsletter (try a no-risk trial). The topics include:

1. Hedging Disclosure Is Here—Are You Ready?

– Background of Hedging Disclosure Requirement
– What Item 407(i) of Regulation S-K Requires
– Applicability & Effective Dates
– Interpreting the New Hedging Disclosure Requirement
– Rule Applies to Broad Categories of Transactions
– Elaborate Policy Not Required
– Drafting Proxy Disclosure

2. Non-GAAP: Staff Scrutinizes “Individually Tailored Accounting Principles”

– Evolution of the Staff’s Non-GAAP Comments
– What is “Tailored Accounting?”
– Where is the Staff Raising “Tailored Accounting” Comments?
– Comments On Acquisition-Related Adjustments
– Five Key Takeaways on Tailored Accounting

Liz Dunshee