On September 30, 2020, the SEC announced a settled enforcement action against HP Inc. This is another classic “known-trend” case. Almost all these actions begin with a large, surprise stock drop. Here is an excerpt from the SEC’s Accounting and Auditing Enforcement Release (or AAER):
On June 21, 2016, HP held a “Business Update Call” midway through the company’s third fiscal quarter. On the call, HP announced its change from a push to a pull model, and it explained that the company would be making a “one-time investment to reduce the level of supplies inventory across the channels.” HP disclosed that, “[a]s a result of the channel inventory reduction, the supplies net revenue is expected to be reduced by $225 million in each Q3 and Q4.”
The $450 million reduction represented 5% of HP’s reported Printing segment net revenue for the second half of 2016. Asked by an analyst about the size of the inventory reduction, HP’s CFO described it as “fairly material, because as I mentioned it’s about $450 million over a couple of quarters.” Following the announcement, HP’s stock price dropped nearly 6%, eliminating more than $1 billion of market capitalization.
One of the causal factors behind this announcement was that HP had pushed inventory into its distribution channels. Again, from the AAER:
During that period, certain regional managers at HP undertook undisclosed sales practices to increase quarterly operating profit, leading to an erosion of profit margin and an increase in channel inventory, while failing to disclose known trends and uncertainties associated with the conduct.
When distribution channels are “stuffed” there is a real risk that future revenues and profitability will suffer. This is the issue behind the known trend in this case as the SEC points out in the release:
Item 303(a)(3)(ii) of Regulation S-K, 17 C.F.R. § 229.303(a), requires such companies to describe, among other things, “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations” in its annual report on Form 10-K. Instruction 3 to Item 303(a) of Regulation S-K requires that the “discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”
In its 2015 Form 10-K, HP failed to disclose the known trend of increased quarter-end discounting leading to margin erosion and an increase in channel inventory, and the unfavorable impact that the trend would have on HP’s sales and income from continuing operations, causing HP’s reported results to not necessarily be indicative of its future operating results. The failure to disclose that material trend caused HP’s 2015 Form 10-K to be materially misleading.
If you are experiencing a deep feeling of déjà vu as you read this post (and were involved in SEC reporting 15 years ago!), you are likely remembering that HP’s case involves exactly the same issue as an enforcement action against Coca-Cola in 2005. In that case Coke had “gallon-pushed” syrup to certain bottlers. The following quotes from the Coca-Cola AAER are eerily similar to those from the HP case above:
To encourage bottlers to purchase additional concentrate, CCJC extended more favorable credit terms than usual to bottlers, typically increasing payment terms from eight to twenty-eight or thirty days. No rights of return on gallons sold pursuant to gallon pushing were offered to bottlers, and no concentrate sold pursuant to gallon pushing was returned to CCJC or Coca-Cola. All concentrate sold pursuant to gallon pushing was paid for by the bottlers.
On January 26, 2000, Coca-Cola filed a Form 8-K with the Commission which disclosed, among other things, a worldwide concentrate inventory reduction planned to occur during the first half of the year 2000. The inventory reduction was to be accomplished by Coca-Cola’s operating divisions, specifically including CCJC, ceasing to sell concentrate to bottlers until bottlers naturally reduced their inventory to purported “optimum” levels. The impact on Coca-Cola’s earnings for the first and second quarter of 2000 was estimated to be between $0.11 and $0.13 per share.
A crucial issue in both these cases is that there was no accounting misstatement. The enforcement issue is about the MD&A known-trend disclosure requirement in S-K Item 303(a)(3)(ii):
Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.
The probabilistic threshold in this disclosure, reasonably expects, requires a very complex judgment. The SEC’s 1989 MD&A Release, FR 36, provides this decision model for this judgment:
Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:
(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.
(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur
As you can see, this test creates a probability threshold that is essentially below 50%.
The HP case also focuses on disclosure controls and procedures since HP’s disclosure controls failed to detect that the known-trend information was not appropriately disclosed. More about that in the next post.
All of this brings us back to one of the “Golden Rules” of MD&A – No surprise stock drops!
As always, your thoughts and comments are welcome!