On November 12, 2024, the SEC announced yet another enforcement action focused on using sales incentives and similar strategies to achieve revenue targets without appropriate disclosure to investors about the use and impact of such strategies. This action focuses on Elanco Animal Health Inc. (Elanco), which was spun off by Eli Lilly and Company in 2018. (You can read about earlier cases in this blog post.)
As is typical of this kind of case, it began with a surprise stock drop. According to the SEC’s Order:
“On May 7, 2020, Elaco announced an expected $160 million decline in revenue for the first and second quarters of 2020 that caused its share price to drop by over 13%. The statement cited the uncertainty of the COVID-19 pandemic and a ‘strategic change’ in Elanco’s inventory management practices – including reductions in channel inventory – as the reason for the decline. Elanco publicly stated that it had not anticipated a strategic change to reduce channel inventory levels when it started the year.”
What the company did not disclose was that from the first quarter of 2019 to the first quarter of 2020 it had relied on incentives to generate sales to distributors to meet revenue targets. Internally Elanco referred to these sales as the “Quarter-End Incentivized Sales” or “Incentivized Sales.” Achieving revenue targets was particularly important for Elanco as a newly public company. As is usually the case, this practice could not go on indefinitely because inventory channels had become overstocked.
When management knows there is a potential problem on the horizon (e.g., failing to meet sales growth expectations, as in this case), the known-trend MD&A requirements of S-K Item 303 require that companies disclose:
“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.”
Again, from the SEC’s Order:
“From May 2019 through May 2020, Elanco’s public disclosures misled investors by attributing its revenue and revenue growth to strong consumer demand for its products while failing to disclose the material impact of its Quarter-End Incentivized Sales and the reasonably likely risk that such sales practices could have a negative impact on revenue in future quarters.
Elanco’s use of Quarter-End Incentivized Sales created an uncertainty or event that was known to Elanco’s senior management and reasonably expected to have a material effect on its future revenues.”
The SEC also included the failure of Elanco’s disclosure controls and procedures in the enforcement.
One important aspect of this case relates to revenue recognition accounting. There was no issue with how and when Elanco recognized revenue. No accounting issues were raised in the AAER. This enforcement is all about disclosure.
Elanco entered into a Cease-and-Desist Order and paid a $15,000,000 civil money penalty.
As always, your thoughts and comments are welcome!