Blog: SEC charges HP with failure to disclose known trends and uncertainties

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Enforcement has certainly been busy at the end of the SEC’s fiscal year, with disclosure violations receiving their fair of attention.  In this action against HP Inc., the company was charged with failing to disclose known trends and uncertainties regarding the impact of sales and inventory practices, as well as failure to maintain adequate disclosure controls and procedures.  HP was ordered to pay a penalty of $6 million.

According to the order, HP had experienced declining printer and supplies sales for several years, although those sales “still delivered consistent cash flow and operating profit.” The business was operated under a “push” model, in which the company would offer incentives to promote sales of inventory to its channel partners and then use marketing and discounts to promote sales of inventory through the channel to end users. (Generally, HP recognized revenue on channel sales to distributors, which then sold to resellers; HP had no continuing obligations following sales to distributors, and the sales to distributors were not contingent on the eventual sales to resellers or end users.)

To meet revenue and profitability targets, starting in the second fiscal quarter of 2015 and undisclosed to the market, HP regional managers used higher end-of-quarter discounts to accelerate, or “pull-in,” sales, resulting in lower profit margins than if the sales had materialized in line with anticipated demand.  In some cases, the additional discounts encouraged more sales from HP’s distributors to resellers, which, in the absence of higher demand from end-users, simply held the excess products in inventory. According to the order, this “pattern led to a known trend of increasing channel inventory and lower margin sales that continued over multiple quarters.” 

In addition, to meet revenue and earnings targets, in early 2015 through June 2016, some HP managers sold printing supplies, at higher than normal discounts, to distributors known to sell HP printing supplies outside of their own territories (referred to as “A-Business”), cannibalizing sales in other regions and leading to “significant margin erosion.” The order charged that these sales were conducted in violation of HP policy and distributor agreements. Despite “increasing HP’s channel inventory and decreasing its margins worldwide,” this practice was not disclosed.

HP was also charged with providing misleading information in quarterly earnings calls by failing to disclose that its channel inventory metric included only products held by distributors (to which HP sold directly) and not to inventory held by resellers and other channel partners further down the distribution chain.  Using this metric, HP could disclose a decline in channel inventory even though distributors had sold channel inventory only to resellers and “even when overall channel inventory was increasing,” sometimes to “unhealthy levels” in the absence of additional end-user sales. The result was that HP disclosed “an incomplete picture of HP’s channel health.”  Notwithstanding the potential negative impact on HP’s future performance, HP did not disclose that these sales practices “were causing decreased margins and increased channel inventory.”

In the first half of 2016, HP decided to change its “push” model to a “pull” model, in part to address these practices, under which sales into the channels would be based on end-user demand. That change, however, required significant channel inventory reductions. According to the order, in internal presentations, the company identified significant negative effects of the change that “would decrease HP’s revenue and operating profit in the second half of fiscal year 2016. In an effort to lessen the negative impact to operating profit, HP timed the go-to-market model change to coincide with a divestiture of certain software assets.” When, in June 2016, HP announced the change to its model—resulting in a reduction of HP’s net revenue by approximately $450 million in the second half of 2016—HP’s stock price dropped nearly 6%.

According to the order, until the June announcement, “HP’s disclosures regarding channel inventory and gross margin omitted material information regarding the impact of the above-mentioned practices on these metrics, causing HP’s disclosures to be incomplete and misleading,” including in its periodic reports and on quarterly earnings calls during that period. In particular, the SEC observed, companies are required to report in MD&A, among other things, “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations,” and to focus on “material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” 

The order charged that “HP failed to disclose the known trend of increased quarter-end discounting leading to margin erosion and an increase in channel inventory, and the unfavorable impact that the trend would have on HP’s sales and income from continuing operations, causing HP’s reported results to not necessarily be indicative of its future operating results.” Although HP disclosed decreases in its operating profits resulting from declines in gross margin, according to the order, HP attributed the declines to a “competitive pricing environment” and “unfavorable currency impacts,” but failed to discuss the material impact that pull-ins and A-Business were having on HP’s gross margins. In addition, on quarterly earnings calls, HP’s disclosures regarding its channel inventory “gave the impression that the internal measurement included all of HP’s channel inventory,” but omitted to disclose that the internal channel inventory metric included only its distributors’ channel inventory, not the inventory held by resellers, giving the market a “misleading picture of HP’s channel health.” HP also failed to disclose that its sales practices were “causing channel inventory to increase above the target range.”

The order found that HP lacked sufficient disclosure controls and procedures to ensure that the negative impact of pull-ins and A-Business on margin and potential impact on future quarters “was provided to the HP executives responsible for the company’s disclosures in a timely manner as required by Rule 13a-15(a).” (Under the rules, disclosure controls
are to be “designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers,…as appropriate to allow timely decisions regarding required disclosure.”) The order concluded that

“[a]mong other things, HP lacked company-wide controls over the use of discounts by regional management. Moreover, HP’s lack of visibility into channel inventory levels below [distributors] left it without meaningful insight into its overall channel health. In addition, HP’s disclosure process lacked sufficient interaction with operational personnel who reasonably would have been expected to recognize that the known trends attributable to the pull-ins and A-Business were absent from HP’s disclosures. Instead, HP’s principal financial officers and principal executive officers who were responsible for the company’s disclosures learned of the conduct in connection with HP’s planned shift from a push to a pull model quarters after the actual conduct had taken place.”

In the order, HP was found to have violated Section 17(a)(2) and (3) of the Securities Act (in light of sales of securities under employee benefit plans), “which prohibit any person from directly or indirectly obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or engaging in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser, in the offer or sales of securities.” In addition, in connection with its periodic reports, HP was found to have violated Section 13(a) of the Exchange Act and related rules, as well as Rule 12b-20. Finally, HP was found to have violated Exchange Act Rule 13a-15(a), which requires reporting companies to maintain disclosure controls and procedures.

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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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