SEC Issues Cease-and-Desist Order for KPI Disclosure Issues

Wilson Sonsini Goodrich & Rosati

In the wake of the recent guidance issued by the U.S. Securities and Exchange Commission (SEC) on key performance indicators (KPIs) and metrics, which we discussed in this previous Client Alert, the SEC issued a cease-and-desist order against DIAGEO plc (Diageo) as a result of Diageo's failure "to disclose significant known trends and uncertainties in its 2014 and 2015 Forms 20-F[,]" in particular, relating to its reporting of two of its KPIs—organic net sales growth and organic operating profit growth.

According to the SEC order, during fiscal years 2014 and 2015, employees at Diageo's largest and most profitable subsidiary—Diageo North America, Inc. (DNA)—1) "pressured distributors to purchase additional products" in excess of demand (a practice known as "channel stuffing" and referenced in the SEC order as "overshipping") and 2) engaged in what the SEC referred to as "extraordinary sales practices," including waiving contractual termination clauses and penalties for distributors that agreed to purchase unneeded products, all in an effort to meet DNA's performance targets. As levels of inventory became unsustainable for certain distributors, Diageo approved DNA's plan to reduce inventory through "destocking," a plan that "would reduce distributor inventory over a period of years in an amount that would have been material if it occurred in a single reporting period."

Diageo is a foreign private issuer and thus files Form 20-Fs with the SEC. Item 5 of Form 20-F has requirements similar to those set forth in Item 303(a) of Regulation S-K, Management's discussion and analysis of financial condition and results of operations, and requires companies, among other things, 1) to identify the most significant recent trends in sales and inventory since the last fiscal year and 2) to discuss, for at least the current financial year, any known trends, uncertainties, demands, commitments, or events that are reasonably likely to have a material effect on the company's net sales, revenues, or profitability, or that would cause reported financial information not necessarily to be indicative of future operating results or financial condition.

The SEC's order cited numerous concerns with the disclosures in Diageo's Form 20-Fs, including, among others, that 1) the failure to disclose DNA's overshipping made the KPIs materially misleading because, without the overshipping, the KPIs "would have been materially lower" and 2) Diageo's failure "to disclose the trends of shipping in excess of demand and the resulting inventory builds; the positive impact those trends had on sales and profits, and the negative impact they reasonably could be expected to have on future growth," in effect, "caused Diageo and DNA's reported financial condition to not necessarily be indicative of future operating results or financial condition." Notably, the SEC's order also cited issues with Diageo's internal disclosure process that "failed to ensure that [Diageo] adequately considered its disclosure obligations surrounding DNA's trend of overshipping and the resulting inventory build at the U.S. distributors and subsequent inventory reductions."

The order required Diageo to cease and desist from any further violations and required Diageo to pay a civil money penalty of $5 million.

What to Do Now?

While the emails with distributors and internal documents cited in the SEC order appear to support both a claim of channel-stuffing and a claim of "destocking" that rendered Diageo's disclosures in respect of known trends and uncertainties about both itself and DNA misleading, this order serves as an important reminder of the recently issued guidance on KPIs including: 1) ensuring that the disclosures associated with the KPIs are not materially misleading; 2) ensuring that consideration is given to what disclosures may be required regarding known trends and uncertainties, including with respect to KPIs and metrics, and 3) the importance of strong disclosure controls and procedures. In addition, companies should be mindful of the SEC's KPI guidance, as discussed in our previous Client Alert as they prepare their annual disclosures this year.

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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