The SEC’s Renewed Focus on Accounting Misconduct

Faegre Drinker Biddle & Reath LLP

Two recent enforcement actions by the U.S. Securities and Exchange Commission (SEC), including a recent settled action against Kraft Heinz Co. (“Kraft”), underscore the agency’s renewed and continuing focus on accounting and financial reporting misconduct.

Two weeks ago, the SEC announced its third and latest enforcement settlement through its data-driven EPS (Earnings Per Share) Initiative. The EPS Initiative, run by the SEC’s Enforcement Division, used data analytics to detect potential reporting violations. The EPS Initiative has resulted in two prior actions. On September 28, 2020, the SEC publicly disclosed the EPS Initiative with two settlements, as discussed previously in this blog here.

Other recent enforcement actions by the SEC since Chair Gary Gensler began his tenure indicate that the EPS Initiative is part of a renewed and broader push by the SEC’s Enforcement Division to investigate accounting and financial reporting misconduct. Notably, on September 3, the SEC announced a settlement agreement it had reached with Kraft to resolve charges that it had engaged in a long-running accounting scheme which improperly reduced the company’s cost of goods sold by $208 million from the last quarter of 2015 to the end of 2018. The SEC also charged two individuals: Kraft’s former Chief Operating Officer; and its former Chief Procurement Officer for their alleged actions in connection with the accounting errors.

The SEC alleged that Kraft’s accounting scheme misrepresented the true nature of the company’s transactions with suppliers by, among other things, “recognizing unearned discounts from suppliers and maintaining false and misleading supplier contracts” in violation of GAAP. Kraft’s procurement division employees, for example, allegedly “agreed to take upfront payments subject to repayment through future price increases or volume commitments, but documented the transaction in ways which obscured the repayment obligation.” The SEC alleged that Kraft used these alleged cost savings to report inflated EBITDA.

The settlement order also detailed Kraft’s failure to “design or maintain effective controls for the procurement division, including those implemented by the finance and controller groups, in connection with the accounting for supplier contracts and related arrangements.” The SEC’s order further noted that the Chief Procurement Officer “imposed pressures on the procurement division to deliver unrealistic savings targets” and failed to take proper action when presented with numerous warning signs that supplier expenses were being mismanaged.

Kraft agreed to cease and desist from future violations and pay a civil penalty of $62 million. The individuals consented to civil penalties of $300,000 and $100,000, respectively, and one further agreed to a five-year officer/director bar. Charging and settling with these two individuals aligns with public statements from the Commission since the start of Chair Gensler’s tenure regarding an increasing focus on the culpability of individuals.

Public companies should take note of the EPS Initiative and the enhanced resources in data analytics it provides to aid the SEC in identifying potential accounting issues, which may open the door to a broader investigation into the company’s financial reporting. Accordingly, public companies must ensure their internal controls are reasonably sufficient and that accounting judgments, particularly those involving manual accrual or reserve accounts, are not applied to manage earnings or distort financial statements. Companies that are considering restating their previously issued financial statements should engage qualified outside counsel to assist with the management of SEC enforcement exposure risks.

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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