SEC Charges for Failure to Disclose Material Trends

Cydney S. Posner is special counsel at Cooley LLP. This post is based on a Cooley memorandum by Ms. Posner.

The SEC has just settled an action against Diageo PLC, a producer of liquor, wine and beer, for failure to disclose known trends and uncertainties. Diageo’s omission resulted in materially misleading disclosures regarding its financial results and material inflation of key performance indicators—organic net sales growth and organic operating profit growth. It’s worth noting that the SEC has not been reluctant to take enforcement action against companies that have misled investors by inflating KPIs, such as subscriber counts, revenue-per-subscriber, number of vehicles sold monthly, net new customers added, backlog and now organic net sales growth and organic operating profit growth. These types of metrics—typically outside of the financial statements—are metrics on which investors and analysts often rely to assess performance, and companies have been held to account if their presentations are materially inaccurate or misleading or the related controls are inadequate.

Faced with declining market conditions, employees of the company’s North American subsidiary (DNA) engaged in “channel stuffing,” pushing shipments of unneeded inventory to third-party distributors. These actions were part of an effort to meet performance targets and report higher growth in particular KPIs that were closely followed by analysts and investors. With distributors overstocked with excess inventory, sales were highly likely to decline in the future—a known trend that the company failed to disclose, in part because of inadequate procedures. According to the SEC, the failure to disclose the channel stuffing meant that the company’s financial results were material misleading and the KPIs materially inflated.

DNA, which sold its products through distributors, tracked distributor inventory levels by measuring Days Sales Inventory, a forward-looking metric calculated using estimates of future distributor sales of “base” products to estimate how long existing inventory would last. Newly launched “innovation” products were not included in DSI. DSI levels were reported to a Filings Assurance Committee (FAC) twice a year in connection with Diageo’s regulatory filings. Diageo set sales and profit targets for DNA, which then negotiated sales goals and purchase requirements for distributors designed to achieve those targets.

In fiscal 2014 and 2015, DNA’s business began to slow, and distributor sales declined below target. To meet targets during the period, some DNA employees pressured distributors to buy more product, especially innovation products, notwithstanding distributor pushback that more products were unnecessary. In addition, to convince distributors to take more inventory, DNA agreed to waive rights to penalty payments or rights to terminate distributors for failure to meet targets if distributors agreed to purchase more unneeded innovation products.

By early 2015, distributor inventory had reached levels that made additional purchases unsustainable. Diageo and DNA developed a plan to reduce inventory over a period of years, and DNA renegotiated its distributor contracts, reducing inventory and requiring additional payments to DNA, which mitigated the effect of the revenue lost from the inventory level reductions.

DNA’s reports to the FAC for 2014 and 2015 showed significant increases in distributor inventory, which resulted in significant additional net sales and operating profit. However, the FAC did not consider whether overshipping and inventory build-up were material trends that required disclosure because, the order alleges, “Diageo did not have adequate procedures to require such a consideration, or to specifically address how to review and evaluate a build in inventory, and particularly for innovation products.” As a result, the company’s Form 20-F “contained required statements about DNA’s financial performance, including statements of organic net sales growth and organic operating profit growth, that were rendered materially misleading by the failure to include material trends and uncertainties concerning Diageo’s revenues and profit.” For example, when the company described growth in sales, it failed to indicate that the growth was due to overshipping; when it characterized sales to distributors as “broadly in line” with sales by distributors, it failed to disclose that offsetting factors were at play: overshipping of inventory to distributors in the first half of the year followed by agreed upon inventory reduction in the second half of the year.

Likewise, information related to KPIs (organic net sales growth and organic operating profit growth) was also materially misleading in that the company failed to disclose that the data met or exceeded analyst expectations in large part because of channel stuffing; in the absence of overshipping, these KPIs would have been “materially lower.” Investors were, therefore, left with the impression that the company achieved growth in these KPIs through normal customer demand, impairing investors’ ability to evaluate the company’s future performance. In essence, “Diageo failed to disclose the trends of shipping in excess of demand and the resulting inventory builds; the positive impact those trends had on sales and profits, and the negative impact they reasonably could be expected to have on future growth; and the fact that they caused Diageo and DNA’s reported financial information to not necessarily be indicative of future operating results or financial condition.”

Diageo was found to have violated Exchange Act Section 13(a), Rule 13a-1 and Rule 12b-20 in connection with its SEC reports, as well as the antifraud provisions of Securities Act Sections 17(a)(2) and (3), in connection with employee securities issuances, and was ordered to cease and desist and pay $5 million.

Both comments and trackbacks are currently closed.