SEC Files Settled Financial Fraud Actions

by Dorsey & Whitney LLP
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The SEC filed financial fraud actions against drug store giant CVS Caremark Corporation and its Retail Controller, Laird Daniels, CPA. CVS was charged with “intentional misconduct” based on alleged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B and each subsection of Securities Act Section 17(a). Mr. Daniels, alleged to have “orchestrated” improper accounting adjustments, is alleged to have violated Securities Act Sections 17(a)(2) and(3) while aiding and abetting the books and records violations by the firm.

Both actions settled. CVS consented to the entry of a permanent injunction prohibiting future violations of the Sections it is alleged to have violated but no ancillary relief. The firm also agreed to pay a $20 million penalty. SEC v. CVS Caremark Corp., Civil Action No. 14-177 (D.R.I. Filed April 8, 2014). See Lit. Rel. No. 22968 (April 8, 2014). Mr. Daniels, the only individual charged, consented to the entry of a cease and desist order based on Exchange Act Sections 13(a), 13(b)(2)(B) and 13(b)(2)(B) and Section 17(a). He was also denied the privilege of appearing or practicing before the Commission as an accountant with the right to reapply after one year. He will pay a penalty of $75,000. In the Matter of Laird Daniels, CPA, Adm. Proc. File No. 3-15825 (April 8, 2014).

CVS has two business segments that are approximately equal in size. One segment is the retail business which operates about 7,600 drugstores. The second segment is Caremark. That segment operates a pharmacy benefits manager or PBM which the firm acquired in March 2007.

The SEC’s claims center on key events in the fall of 2009 regarding each segment. First, CVS filed a Prospectus Supplement for a $1.5 billion senior note offering. The supplements failed to disclose material changes in its business. Those omitted facts also were not included in other filings, including the Form 10-Q for the second quarter. Specifically, in early August CVS learned that the state of New Jersey was not going to renew a PBM contract that would have been worth more than $930 million of revenue in 2010. Later that month the firm also learned that it lost several more large PBM contracts in 2010.

In mid-August 2009 the firm received more bad news as a result of the benchmarks for the Medicare Part D bidding process for 2010. CVS learned that it did poorly in that process. Internal projections at the firm indicated that CVS stood to lose 580,000 covered lives and as much as $101 million of 2010 EBIT as a result.

The second issue — the focus of the proceeding in which Mr. Daniels is named as a Respondent — centers on the accounting for acquisition of the Longs Drug Store chain. That acquisition was made in late October 2008. CVS retained an accounting firm to prepare a valuation of the Longs purchase. The firm prepared a draft report in January 2009 based on a “continued use” premise, meaning that the drug store chain would retain and continue to use the acquired property, plant and equipment except for certain stores identified that would be closed. That approach was required by the contract.

Nevertheless, in a quarterly filing by CVS in November 2009, the firm reduced the reported valuation for Longs tangible assets by $212 million with a corresponding increase in good will, compared to the January 2009 draft report. CVS made a one-time catch-up adjustment, reversing $49 million of depreciation taken from October 2008 through the end of June 2009, and did not take an additional $19 million of depreciation that would have otherwise been taken on the Longs properties for the period. The one time depreciation reversal increased third quarter 2009 EPS by about 2.4 cents. Despite the continued use premise, the drug store company completely wrote off all the personal property for about 430 of the 525 Long stores.

The adjustments did not comply with the applicable GAAP provisions regarding business combinations, according to the Commission. Those adjustments failed to reflect the expected future use of the Longs property as of the acquisition date and the information the firm had as of that date. They also did not account for the use by CVS of the assets to generate revenue after the acquisition date. For the quarter the failure to recognize those current period expenses overstated: operating profit by as much as 13.7%; income from continuing operations by as much as 12.5%; net income by as much as 12.5%; and EPA by as much as 17%. The November 5, 2009 Form 10-Q was materially false, according to the complaint, because, in part it failed to mention the one-time $49 million reversal of previously recorded depreciation expense which bolstered the EPS.

Finally, statements made by the then CVS CFO during a November 5, 2009 earnings call were materially incorrect. During that call the CEO stated that while CVS had assumed the PBM segment’s EBIT would grow 2% to 4% in 2010 it now expected the segment to decline 10% to 12%. Despite the losses, however, the CEO went on to note that the PMB segment’s retention rate—a key industry metric — for 2010 was 92%, just above the 91% for the prior year. The retention rate, however, was calculated using a methodology that differed from previous years and omitted the estimated revenue loss from its lack of success in the Medicare Part D bidding process. The CFO also informed investors that EPS was “just above” company guidance without noting the 2.4 cent increase from the adjustment and claimed that retail operating expenses had decreased as a percentage of net revenue as a result of “good spending discipline” – also without mentioning the reversal of the depreciation expense and its impact.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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