SEC Maintains Focus on Contingent Liabilities

John F. Savarese and Wayne M. Carlin are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum.

An SEC enforcement action announced today highlights a continuing focus on timely disclosure of contingent liabilities. The SEC’s order in In the Matter of Healthcare Services Group, Inc. found that HSG improperly delayed recording or disclosing anticipated losses in pending litigation. The SEC noted that the case resulted from its EPS Initiative, in which the agency deploys data analytics to search for indicators of improper earnings management. The SEC also charged HSG’s CFO, for deciding not to record the loss contingency, and the company’s controller, for a separate series of violations involving improper reductions in other expenses. The parties settled without admitting or denying the SEC’s findings, and HSG agreed to pay a $6 million civil penalty.

As the SEC Order recites, HSG was a defendant in several class action lawsuits alleging claims under various wage-and-hour labor laws. On two different occasions, HSG entered into proposed settlement agreements relating to certain of these lawsuits. Court approval was required for each settlement to become final. In several reporting periods, HSG did not accrue any loss contingency despite entry into settlement agreements, submission of those agreements for court approval, and grants of preliminary approval by the court.

The SEC found that HSG should have recorded an expense accrual in the period in which it entered into each settlement agreement, on the basis that, at that point, a loss was both probable and reasonably estimable. The SEC found that the failure to make these entries enabled HSG to report EPS that met analysts’ estimates in each of the relevant periods. In some periods, if HSG had recorded the expense, it would have missed the EPS estimates by as little as a penny.

As the SEC announcement noted, the agency continues to employ data analytics to seek out potential instances of earnings management. We also expect the SEC will continue to emphasize timely disclosure of loss contingencies, particularly involving litigation settlements. Finally, this is the latest in a very long series of enforcement actions demonstrating that the SEC will view even relatively small errors in financial reporting as material if they make the difference between meeting analysts’ earnings expectations and falling short by as little as one cent.

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