Last month, General Electric agreed to pay a $200 million penalty to settle an SEC enforcement action arising from alleged disclosure violations concerning the company's power and health insurance businesses. According to the SEC's order, between 2015 and 2017, GE did not disclose that the profits it reported for those segments were largely attributable to changes the company made to its accounting practices in order to mask significant challenges that those business lines were facing. The order further alleges that GE's belated disclosure of those difficulties in 2017 and 2018 led to a nearly 75 percent drop in the company's share price.
Notably, the SEC did not charge GE with misstating its financial results. Rather, its case was based upon the company's alleged failure to tell investors that its seemingly robust profits and cash flow were due to optimistic changes to GE's assumptions about future costs and risks - assumptions that allegedly were contradicted by the company's own internal analyses - and to GE's alteration of certain GAAP and non-GAAP measures to flatter its numbers. The case thus highlights the perils for issuers of attempting to conceal or downplay known risks or negative performance trends and of "moving the goalposts" of their financial measures without adequate disclosure.
Undisclosed Changes to Cost Estimates by GE Power
The SEC first found that GE failed to disclose that the ostensibly positive results of its power business, GE Power Services - as reported in its non-GAAP "industrial operating profit" measure - were due to the company's downward revision of its estimates of the costs of servicing the gas turbines it sold to GE Power customers. According to the SEC's order, GE did not inform investors that more than one quarter of GE Power's profits in 2016, and nearly half of reported profits in 2017, were attributable to these accounting changes.
In internal planning documents in 2014 and 2015, GE allegedly acknowledged that its power markets were "flat" and faced increasing price pressure and excess capacity. The SEC alleged that as a result, by 2016, GE Power had become heavily dependent on revenue from its turbine servicing agreements, which accounted for 83 percent of its profits and 89 percent of its operating cash flows in 2016. Internal risk assessments, however, noted that the outlook for the servicing business was itself unpromising, because the service agreements would need to be renegotiated due to lower than expected power consumption and increased competition from other servicers, and because customers would invoke termination clauses in their agreements if GE Power did not grant price and term concessions.
The SEC found that, to meet its internal operating profit targets, GE changed its profit margin assessment for the agreements by projecting cost reductions over the life of each agreement that increased the margin and resulted in an increase to revenue and earnings in the current period. These alterations allegedly increased GE Power's reported revenue by more than $1.4 billion in 2016 and more than $1.1 billion in 2017.
The SEC also found that GE's representations to investors about GE Power's results on earnings calls, investor conferences, and in its quarterly and annual reports were materially misleading because the company attributed "described changes in its service agreement portfolio as arising from items other than reductions in cost estimates in its service agreement portfolio," despite acknowledging internally that its reported earnings would not have been possible without those reductions.
Undisclosed Expansion of Inter-Company Factoring
The SEC also found that, driven by concerns about the $5 billion "deferred balance" of unbilled revenue reported in its financial statements and sluggish cash collections from customers, GE reported an increase in non-GAAP "Industrial Cash Flow" without disclosing that the increase resulted from expanding its inter-company sales of current receivables, or "factoring," by GE Power to GE Capital.
According to the order, GE had previously sold receivables of its industrial businesses that were due in one year or less, but in 2016 and 2017, it switched to an approach known as "deferred monetization," which allowed it to sell unbilled receivables with due dates up to five years out. In addition, in order to allow for deferred monetization, the company renegotiated a number of service agreements and provided pricing and other concessions to incentivize customers to agree to the changes. GE allegedly nevertheless continued to disclose in its quarterly and annual reports that it only factored "current assets."
The SEC found that GE Power executives knew that deferred monetization had the effect of pulling forward future years' cash collections, thus decreasing cash flows in later periods. The practice allegedly was described internally as a "drug" and "not sustainable," because GE had to continue deferred monetization from period to period in order to perpetuate the desired accounting effect. According to the order, this tactic increased Industrial Cash Flow by more than $1.4 billion in 2016 and more than $500 million in the first three quarters of 2017, accounting for approximately 12 percent of total reported Industrial Cash Flow at 2016 year-end, and approximately 33 percent after the first three quarters of 2017. When GE ended deferred monetization in 2017, GE Power allegedly had pulled forward $878 million in cash from 2018, $585 million from 2019, $407 million from 2020, and $400 million from subsequent years.
Undisclosed Reductions to Insurance Cost Projections
Finally, the SEC found that GE failed to disclose known risks about the costs of its legacy long-term health care insurance business, known as North American Life and Health ("NALH"), in order to avoid negatively affecting its non-GAAP "Verticals" measure for specific GE business lines. According to the order, GE's long-term policies were underpriced, and the company underestimated the number, duration, and expense of claims, causing it to pay more for nursing home and related costs than it originally forecast.
NALH used an impairment, or "loss recognition," test based on historical claims data to determine whether GE's reserves for insurance claims were adequate, resulting in a "margin" calculation. When the margin was negative, GE was required to record an income statement charge for the period in which the test was performed. Responding to pressure from GE to avoid losses, NALH management in 2015 allegedly applied significantly lower future claims cost assumptions. Although NALH actuaries raised questions about the revised assumptions in 2016, NALH decided not to alter them so as not to affect the improved margin calculation.
The SEC found that later in 2016, NALH's actuaries determined that the annual loss recognition test resulted in a negative $178 million margin, which would have required GE to take a loss to earnings in the same amount. In response, and despite concerns from internal auditors, NALH executives allegedly adopted a new approach known as the "roll-forward," which took actuarial assumptions based on data from 2015 and projected them forward nine months, changing the margin from negative $178 to a positive $86 million. According to the order, auditors allegedly warned that "[i]t is not a common practice to make such a change to a vital GAAP metric without a formalized oversight and approval process."
Meanwhile, an NALH executive warned GE Capital that long-term care performance was continuing to deteriorate and that key assumptions about claims performance had not been borne out. Ultimately, dire analyses in 2017 by NALH actuaries led GE to take a $9.5 billion pre-tax charge against earnings in January 2018, which required capital contributions of roughly $15 billion over seven years. The company began to provide detail about its claims exposure in its Form 10-Q for the third quarter of 2017.
The SEC found that GE failed to disclose "material known trends of increasing costs in its historical claims experience and uncertainties, inherent in increasingly optimistic assumptions of lower claims costs, [and] that material insurance losses were reasonably likely in the future." It also found that the omission of this information from management's discussion and analysis ("MD&A") in GE's financial statements in its Forms 10-Q and 1O-K violated Item 303 of SEC Regulation S-K, which requires the MD&A to include "information that the [company] believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations," and "any known trends or uncertainties that have had" or that the company "reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."
In addition, the SEC found that GE lacked adequate internal accounting controls, concluding that there was no formal oversight or approval for the roll-forward process, and that the company did not sufficiently document the rationale for using the roll-forward in its estimates. It also determined that the company failed to have in place adequate disclosure controls and procedures, finding a failure to inform relevant GE managers about the optimistic nature of NALH's projections despite higher than expected claims, or about the use of the roll-forward.
Issuers should take the GE action as a cautionary lesson against obscuring or concealing risks or a negative financial outlook through the undisclosed gaming of their accounting measures. This is especially relevant, as the SEC emphasized in announcing the case, to companies that have extensive inter-divisional sales and rely heavily on estimates of future costs and revenues.
This lesson, however, also applies to issuers more broadly, particularly in the current economic downturn caused by the COVID-19 pandemic. The SEC's Division of Enforcement has made clear that it believes the financial impacts of the pandemic create an increased temptation for issuers to make this type of misleading omission, and the Commission recently charged another company, The Cheesecake Factory, for allegedly failing to disclose material details about the impact of the pandemic on its operations.
In the GE action, the SEC indicated the seriousness with which it viewed the alleged violations both through the size of the penalty it imposed and by charging GE under the anti-fraud provisions of the Securities Act of 1933 (though it charged only negligent, and not scienter-based (intentional), fraud against the company). By comparison, the SEC charged The Cheesecake Factory only with making inaccurate filings under Section 13(a) of the Securities Exchange Act of 1934 and related SEC rules, a difference that may be attributable to the multiple alleged internal reports and comments that were at odds with GE's public statements to investors and analysts. In announcing the action, the SEC also noted that its investigation is ongoing, so additional charges against individuals at the company remain possible.
The SEC also required GE to provide written reports to the SEC staff for a year after the settlement on its financial reporting compliance and its remediation of its internal accounting controls and compliance program. The company may have avoided the even costlier measure of having to retain an independent monitor by virtue of its remedial efforts, which, per the order, included replacing management, revising its disclosures, and enhancing its internal controls.
In light of the GE action, public companies should confirm that their internal accounting controls specifically provide for formal approval, oversight, and documentation of any changes to their accounting measures, and that their disclosure controls expressly require that known trends and uncertainties be conveyed promptly to company management responsible for disclosure. They should also regularly review, test, and provide training to relevant personnel on these controls.
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