Last week, the SEC announced settled charges against Gentex Corporation, a manufacturer of digital vision, connected car, dimmable glass and fire protection products, and its former Chief Accounting Officer and current CFO, Kevin Nash, related to financial reporting, books-and-records and internal accounting controls violations. Allegedly, these violations were the consequence of deficiencies in the company's accounting practices for its bonus programs, which practices allowed the company to manage its earnings by adjusting its accruals for bonuses to ensure that publicly reported EPS was in line with consensus EPS estimates—without the required accounting analysis or adequate supporting documentation. According to the SEC, had the company not reduced the accrual for bonuses, it "would have missed consensus EPS estimates by one penny." Gentex was ordered to pay a civil money penalty of $4 million and Nash to pay $75,000. These charges represent yet another case resulting from SEC Enforcement's "Earnings-Per-Share Initiative," which applies risk-based data analytics to detect potential violations from earnings management, among other things.
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Enforcement seems to be all over earnings management cases of late. In April 2022, SEC brought settled charges against Rollins, Inc., a termite and pest control company—think "Orkin"—for earnings management, a case also arising out of SEC Enforcement's EPS Initiative. In essence, the SEC alleged that the company adjusted the amounts in several of its corporate reserves, without support or documentation, to bump up its EPS to meet analysts' consensus EPS estimates for two quarters. The company would otherwise have missed those consensus estimates by a penny in each quarter. In December 2021, the SEC charged American Renal Associates Holdings, Inc., a national provider of dialysis services, with conducting a fraudulent scheme to raid the cookie jar—a "series of revenue adjustments to make it appear that ARA had beat, met, or come close to meeting various predetermined financial metrics, when in fact its financial performance was materially worse." The revenue adjustments in the cookie jar, the SEC charged, were one of the key ingredients used in this alleged effort to cook the company's books. (See this PubCo post.) In August 2021, in another case resulting from the EPS Initiative, the SEC announced settled charges against Healthcare Services Group, Inc., a provider of housekeeping and other services to healthcare facilities, for 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." (See this PubCo post.) Then, in September 2022, there were settled charges against VMware for inadequate disclosure about its "backlog management" practices, which were allegedly used to control the timing of revenue recognition "to more closely match guidance and analyst estimates for its total and license revenue." (See this PubCo post.) And just a year before, there were settled charges against Kraft Heinz Company 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 and related complaint, 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 inflate EBITDA and to allow the company to report sham cost savings consistent with the operational efficiencies it had previously touted. (See this PubCo post.)
Background. According to the Order, Gentex had a discretionary profit-sharing bonus program for employees and made monthly accruals for the expected quarterly bonus expense based on the company's adjusted pre-tax, pre-bonus income. As part of the quarterly close, Nash typically examined whether the prior accruals reflected the company's expected bonus payouts for the quarter and, if not, directed the staff to make adjustments. The closing process required reconciliations of all material balance sheet accounts, including the bonus account, accompanied by supporting and backup documentation.
During the summer of 2015, a new executive pay-for-performance bonus plan was approved, and Nash was instructed to reserve funds for the plan. In October 2015, Nash directed the accrual of $300,000 for the new plan, without any supporting documentation—not even documentation of any analysis that was required by the accounting rules for loss contingencies. The very next day, after "realiz[ing] that the initial accrual of $300,000 would cause Gentex to miss the consensus EPS estimate of $0.27 for the third quarter of 2015," Nash directed that the accrual be reduced to $100,000—once again without any supporting documentation or any required analysis.
A revealing email thread allegedly explained the underlying rationale for the revision. The Order recounts that, in "an October 9, 2015 email exchange with the CFO, the CFO asked Nash if he had reserved some money for the PB Bonus Plan. Nash responded, '100K. had [sic] 300K, but had to reduce in order to keep .27 per share.' The CFO replied, '[g]ood call. That puts in line with consensus, right?' to which Nash replied, '[y]es.'" The SEC concluded that if Nash had "not directed the partial reduction of the $300,000 accrual for the PB Bonus Plan expense, Gentex would have missed the third quarter 2015 EPS consensus estimate by a penny."
During the ensuing quarters through July 2018, Nash made a number of bonus accruals and adjustments, again without proper documentation. Some of the accruals exceeded the expected payout amounts, but no corresponding reductions were made, building a little "cushion" in the bonus account, which, Nash emailed the CFO, "would not be bad to have for the third quarter and fourth quarter of 2017."
According to the Order, Gentex did not maintain adequate books and records or internal accounting controls: "Gentex did not keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflected the transactions and disposition of assets by Gentex in connection with its bonus programs. In addition, Gentex failed to devise and maintain internal accounting controls that were sufficient to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with GAAP. In particular, ... Gentex's internal accounting controls also did not provide for sufficient documentation and review of accounting entries associated with the bonus compensation programs."
Violations. Gentex was charged with violation of the reporting requirements of Section 13(a) of the Exchange Act (as well as Rule 12b-20), the books-and-records requirements of Section 13(b)(2)(A) and internal accounting controls requirements of Section 13(b)(2)(B) (none of which require a showing of scienter), Exchange Act Section 13(b)(5) (which "prohibits any person from knowingly circumventing or knowingly failing to implement a system of internal accounting controls or knowingly falsifying any book, record, or account subject to Section 13(b)(2)(A)") and Rule 13b2-1 (which "prohibits any person from directly or indirectly falsifying or causing to be falsified, any book, record, or account subject to Section 13(b)(2)(A)" and does not require scienter). Nash was charged with violation of Section 13(b)(5) of the Exchange Act and to have caused Gentex's violations of Exchange Act and related rules above.
Notably, both Nash and the CFO were promoted during the period to their current positions; the CFO was elected CEO in January 2018, and Nash was appointed CFO in February 2018.
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