On Friday, the SEC announced settled charges against Kraft Heinz Company, its Chief Operating Officer and Chief Procurement Officer for "engaging in a long-running expense management scheme that resulted in the restatement of several years of financial reporting." According to the SEC's Order regarding the company and the COO, as well as the SEC's complaint against the CPO, the company employed a number of expense management strategies that "misrepresented the true nature of transactions," including recognizing unearned discounts from suppliers, maintaining false and misleading supplier contracts and engaging in other accounting misconduct, all of which resulted in accounting errors and misstatements. The misconduct, the SEC contended, was designed to allow the company to report sham cost savings consistent with the operational efficiencies it had touted would result from the 2015 merger of Kraft and Heinz, as well as to inflate EBITDA-a critical earnings measure for the market-and to achieve certain performance targets. And, once again, charges of failure to design and implement effective internal controls played a prominent role. After the SEC began its investigation, KHC restated its financials, reversing "$208 million in improperly-recognized cost savings arising out of nearly 300 transactions." According to Anita B. Bandy, Associate Director of Enforcement, "Kraft and its former executives are charged with engaging in improper expense management practices that spanned many years and involved numerous misleading transactions, millions in bogus cost savings, and a pervasive breakdown in accounting controls. The violations harmed investors who ultimately bore the costs and burdens of a restatement and delayed financial reporting..Kraft and its former executives are being held accountable for placing the pursuit of cost savings above compliance with the law." KHC agreed to pay a civil penalty of $62 million. Interestingly, this case comes on the heels of an earnings management case brought by the SEC against Healthcare Services Group, Inc. for alleged failures to properly accrue and disclose litigation loss contingencies.
The SEC Order against Healthcare Services Group, Inc., a provider of housekeeping and other services to healthcare facilities, its CFO and its controller, alleged failures to properly accrue and disclose litigation loss contingencies-accounting and disclosure violations that "enabled the company to report inflated quarterly [EPS] that met research analysts' consensus estimates for multiple quarters." Under ASC 450, companies are required to accrue a loss contingency if it is probable that a liability was incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Failure to disclose the nature of the accrual, and in some cases, the amount accrued, could make the financial statements misleading. The SEC's Associate Director of Enforcement said that "HCSG repeatedly failed to record loss contingencies related to litigation settlements despite mounting evidence that such liability was probable and reasonably estimable, while misleading investors by reporting inflated net income and consistent EPS growth..It is critical for public companies to ensure that accounting judgments, including those involving loss contingencies, are not being used to manage earnings and distort financial statements." (See this PubCo post.)
According to the Order, in connection with the 2015 merger between Kraft and Heinz, the combined company promoted its strategy to "eliminate redundancies and reduce operational costs," including achieving cost savings throughout the company, but especially in the procurement division. The cost savings strategy "was widely covered by analysts at the time." To incentivize employees to achieve this cost savings strategy, "the company set performance targets for procurement division employees tied to savings realized through negotiations with suppliers." Notably, the performance criterion for the CPO with the heaviest weight was "based on the amount of year-over-year savings the procurement division obtained from its supplier contracts." Similarly, bonus compensation for the COO was tied to success at generating operational cost savings, "which not only were a key factor in determining the company's annual budget, but were also directly impacted by the year-over-year savings achieved by the procurement division."
Initially, the company met its savings targets largely through synergies resulting from the merger, but by 2017, those synergies were fully "exhausted," and the costs of many ingredients and packaging were actually rising. To continue to achieve incremental savings improvements, the procurement division, under the direction of the CPO and the oversight of the COO, "implemented overly ambitious annual budget and division-level savings targets, based on corporate KHC targets. They, in turn, pushed procurement division employees to come up with ideas to generate additional immediate, same-year, savings, and did not adjust the internal targets."
And come up with ideas they did.
The procurement division's alleged expense management misconduct involved 59 transactions over several years that were ultimately corrected in connection with the restatement:
- "'Prebate Transactions'-KHC procurement division employees agreed to future-year commitments, like contract extensions and future-year volume purchases, in exchange for savings discounts and credits by suppliers ('Prebates'), but mischaracterized the savings in contract documentation, which stated that they were for past or same-year purchases made by KHC ('Rebates');
- "'Clawback Transactions'-KHC procurement division employees 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; and
- "'Price Phasing Transactions'-Suppliers agreed to reduce their prices during a certain period in exchange for an offsetting price increase in a future period, but the full nature of the arrangement was not communicated by KHC procurement division employees to KHC controller group employees."
Under GAAP, the Order charges, the company should have recognized the savings that were in exchange for future commitments over the period of time that the company performed the commitments. That is, "if the upfront cash and discounts are tied to future commitments, then the expense savings must be recognized over the period the future obligations are satisfied." As a result, the savings from prebates given for a contract extension or future volume commitment "should have been recognized over the life of the extension or the future period in which KHC purchased the goods from the supplier. Conversely, rebate savings from past or same-year commitments should have been recognized ratably over the period in which they were earned. Finally, clawback transactions should have been recognized ratably over the clawback period-when it was reasonably estimable that KHC would satisfy its repayment obligation."
The Order provides numerous alleged instances of these types of misconduct, including some that predated the merger. For example, when the procurement division of Heinz faced a $10 million gap on its cost savings goal, creating pressure to find ways to close the gap, the CPO, who worked at Heinz at the time, was alleged to have improperly recognized additional cost savings from a previously negotiated agreement. The prior agreement called for a $3.5 million prebate in exchange for the parties' signing a new three-year contract in 2015. Following the merger, the company renegotiated that provision to state that the payment was a "non-refundable" payment for 2015 purchases, mischaracterizing "the true nature of the supplier payment," which "remained linked to a three-year contract." However, the company recognized the cost savings in 2015, which the SEC alleges was improper. The COO received monthly performance reports of these negotiations, and various "planning documents" presented by the CPO to the COO "acknowledged that Heinz was in the process of negotiating a new supplier contract for the purpose of generating 'improved, backdated impact for CY15' in the form of a 'rebate'"; without these changes, "the company could 'book only 1/3 of benefit' in 2015." They just needed to get the "wording" right.
In addition, the Order alleges that the CPO and COO restructured a $2 million retention bonus that the supplier had awarded to legacy Kraft before the merger into a "supposed purchase volume rebate," which "enabled KHC to improperly recognize the full $2 million in 2015." The SEC charged that, as a result of these rebate transactions, as well as an alleged history of unsuccessful efforts by procurement employees to mischaracterize transactions, the COO and CPO should have been on notice of "the appropriate accounting treatment for these types of transactions, that procurement division employees misrepresented the true economic nature of rebate transactions, and the importance placed on not linking payments from suppliers to future contract obligations in order to achieve premature costs savings."
Beginning in 2017, as a result of inflation, unfavorable foreign exchange rates and other factors, the SEC alleged, the company's ability to achieve incremental costs savings ran into more "headwinds." Nevertheless, the COO "failed to adjust expense reduction expectations for the procurement division, creating a high-pressure environment focused on obtaining same-year cost savings." In 2017 and 2018, the SEC alleged, this pressure, at least in part, led members of the procurement division to manipulate 54 supplier transactions "to improperly obtain premature recognition of cost savings." Based on past experience, the SEC charged, the COO and CPO should have known of the possibility that contracts submitted by procurement employees "did not reflect the true nature of the underlying agreements and would result in improper accounting treatment."
For example, in 2017, the Order charged, one agreement with a sugar supplier provided for a $2 million prebate to KHC "in exchange for a three-year contract extension and future sugar purchases. In addition, the agreement called for KHC to return the $2 million back to the supplier, in the form of paying higher prices for sugar over the three-year period. Thus, the agreement did not produce any actual cost savings." Although the CPO and COO should have recognized the "the true structure of the transaction," the SEC charged, the company recognized the full cost savings in August 2017. What's more, the COO, a member of the company's disclosure committee, "affirmed the accuracy and completeness of KHC's quarterly filings spanning the recognition of this transaction." Accordingly, the SEC charged, he "failed to implement the internal accounting control of disclosure committee review of SEC filings."
In 2018, the SEC alleged, the sugar supply agreement was extended, giving the company an immediate sugar price reduction, with inflated prices resuming later in the year and continuing over an extended time period. However, the company immediately recognized new cost savings of $500,000.
Through 2017 and 2018, the company continued to enter into other agreements with suppliers providing for "upfront payments that were recognized prematurely, even though they were tied to future commitments and allowed the suppliers to 'clawback' an agreed-upon percentage of the upfront prebate." In addition, the CPO was alleged to have "approved 'price phasing' transactions, which created the illusion of immediate cost savings through price decreases from suppliers, but, in reality, were structured to include an offsetting price increase later in time. These 'price phasing' transactions violated GAAP because they purported to generate cost savings that did not exist."
During these periods, the COO "failed to review the quarterly and annual SEC filings provided to him as part of his disclosure committee responsibilities, yet he still certified that he was unaware of inaccuracies or omissions in those filings," and both the COO and CPO signed sub-certifications as to the accuracy and completeness of the financial statements.
Throughout the period, the SEC charged, the company did not design or maintain effective controls for the procurement division. Notably, the SEC charged, the controller group, under pressure and without adequate documentation, allowed the company "to recognize fully in 2017 a rebate that it had previously determined correctly to spread over a future-year period." Similarly, finance personnel in gatekeeping roles were alleged to have overlooked indications of improper accounting-including acknowledged efforts "to 'jam [a] rebate in to help [KHC's] results in 2017'"-without reporting the conduct to legal or compliance. The procurement legal staff was also under-staffed and under-resourced and subject to internal performance metrics and compensation tied to assisting the procurement division's efforts to reduce costs. The SEC charged that the COO "should have known that, in not properly addressing several indicia that supplier contracts were being used to manage expenses, he caused KHC's internal accounting controls failures."
Similarly, the complaint against the CPO also alleged that "[d]espite numerous warning signs that should have alerted [the CPO] that KHC procurement division employees were circumventing KHC's internal controls in order to achieve artificial cost savings targets in supplier contracts, [the CPO] negligently approved and failed to prevent supplier contracts that masked the true nature of the transactions. [The CPO] also should have known that the false and misleading contract documentation that he negligently approved and failed to prevent was provided to KHC's finance and controller groups responsible for preparing KHC's financial statements., thus causing KHC to prematurely recognize cost savings in its financial statements."
The Order found that Kraft violated the negligence-based anti-fraud provisions of the Securities Act (Sections 17(a)(2) and (3) in connection with the issuance of debt securities and employee securities), the periodic and current reporting requirements of the Exchange Act (Section 13(a)), and the books and records and internal accounting controls provisions of the Exchange Act (Sections 13(b)(2)(A) and (B)). KHC agreed to pay a civil penalty of $62 million. The Order also found that the COO violated the negligence-based anti-fraud, books and records, and internal accounting controls provisions of the federal securities laws and, additionally, failed to provide KHC's accountants with accurate information and caused KHC's reporting, books and records, and internal accounting controls violations (Section 13(b)(5) of the Exchange Act, Rule 13b2-1 and Rule 13b2- 2(a)). He agreed to pay disgorgement and prejudgment interest of just over $14,000, and a civil penalty of $300,000. The SEC's complaint against the CPO alleged that he violated the negligence-based anti-fraud provisions, failed to provide accurate information to accountants, and violated the books and records and internal accounting controls provisions of the federal securities laws. Under the settlement with the CPO, which is subject to court approval, he agreed to pay a civil penalty of $100,000, and will be barred from serving as an officer or director of a public company for five years.
In March, in a speech to the Council of Institutional Investors, SEC Commissioner Caroline Crenshaw advocated that the SEC revisit its approach to assessing financial penalties. The SEC, she argued, has taken a "myopic approach" when assessing penalties by looking at "whether a corporation's shareholders benefited from misconduct, or whether they will be harmed by the assessment of a penalty because the costs may be passed on to shareholders." In her view, the SEC should not be reluctant to impose appropriately tailored penalties that effectively deter misconduct, irrespective of the impact on the wrongdoer's shareholders. (See this PubCo post.) In a statement posted on Friday, she used the penalties imposed on KHC to make her point. Once again, she criticized as "flawed" an approach that "posits that any penalty that exceeds the easily quantifiable benefits resulting directly from a securities law violation unfairly burdens the corporation's shareholders." Corporate benefits, she argued, are "notoriously difficult to quantify," not just because of complexity, but because, she believed, corporate defendants may "strategically release bad news in ways that dampen or obscure the market's reaction. The resulting change in stock price therefore may not be an effective way to measure corporate benefits." She observed, for example, that KHC's announcement of the SEC investigation was released contemporaneously with other negative news, which, in her view, "obfuscated what portion of the stock drop resulted from news related to its potential SEC violations versus the other significant issues." In addition, KFH had initially announced "only a $25 million increase in cost of products sold in connection with its response to the SEC's investigation," but later reported "errors totaling $208 million, not just $25 million," and, notwithstanding the SEC settlement with the COO, "reiterated that it did not identify any misconduct by any members of senior management..Corporate claims of lack of senior management involvement or materiality could also dampen the stock price reaction to negative news and affect a corporate benefit analysis." But if benefits are undercounted, she maintained, that leaves "the corporation in a potentially better economic position for having committed the violation." To the extent that companies use information bundling to "make it more difficult to measure corporate benefit, that merely reinforces [her] inclination in setting penalties to focus more heavily on other factors, such as punishing misconduct and effectively deterring future violations."
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