SEC Sanctions Firm, Founder For Undisclosed Alteration of Financial Metric

An old saying states “Be careful what you wish for . . .” If that statement were recast into financial reporting it might go something like “Be careful what you define as a key measurement of financial success . . . and be consistent . . .” This is exactly the issue in one of the Commission’s most recent financial reporting cases, In the Matter of Heartland Payment Systems, LLC, Adm. Proc. File No 3-18819 (Sept. 21, 2018).

Heartland Payment Systems, founded by Robert Carr, also a Respondent, sells credit card processing services to retail merchants. An internal sales force conducts sales. Those sales persons are compensated with bonuses for newly signed merchants. They also receive residual payments based on actual merchant profitability on a monthly basis. The signing bonuses are based on a metric Heartland calls “new gross margin installed.” The firm defines this metric as “the expected annual gross profit from a merchant contract after deducting processing and servicing costs associated with that revenue.”

The aggregate of the new gross margin installed metrics paid to sales persons was referred to by the company and Mr. Carr as NMI. That metric was viewed as being a forward looking growth indicator because of its composition – new business and new sales. It was frequently cited in quarterly earnings calls by the firm for that reason. For example, NMI was cited in the earnings releases and/or calls for the third quarter of 2013, the fourth quarter of 2014 and the second quarter of 2015. Analysts such as Wells Fargo Securities cited the metric when discussing trends at the firm and others when assessing investment strategies.

Beginning in 2013 however, the firm altered the metric without disclosing that fact. First, in that year the firm included changes in ownership accounts which provided no net revenue growth. Indeed, Heartland and Mr. Car generally recognized that COOs as this information is called were not revenue generating new business. Yet these metrics became a material, but undisclosed, part of NMI.

Second, in March of 2013 the firm began adding margin from signing American Express and Discover card processing products to NMI numbers. While these numbers had previously been available for sales, and the revenue from the sale of them had been included in the firm’s net revenues, they had been excluded from sales person bonus calculations. Finally, the firm began including margin installed for three additional product types into NMI under a plan approved by Mr. Carr. These additions to NMI made it appear that the forward looking growth of the firm was materially accelerating at a more rapid rate that the original metric would have reflected. The order alleges violations of Securities Act sections 17(a)(2) and 17(a)(3).

To resolve the matter the firm consented to the entry of a cease and desist order based on Securities Act sections 17(a)(2) and 17(a)(3) while Mr. Car consented to a similar order based only on subsection 17(a)(2). The firm will pay a penalty of $2.16 million while Mr. Car will pay a penalty of $120,000. In determining to accept the offer of settlement the Commission considered the fact that Heartland merged with Global Payments in 2016 and that firm meaningfully cooperated with the staff during the investigation.

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Commission Charges Issuer With Internal Control Violations

Internal controls are essential to proper financial reporting. It is thus critical that firms maintain the proper controls and foster the appropriate environment. When deficiencies appear the firm must promptly assess the situation. Failing to conduct a full assessment – particularly if there is evidence not just of deficiencies but also perhaps improper practices – can result in further errors and deficiencies as occurred in In the Matter of Primoris Services Corporation, Adm. Proc. File No. 3-18816 (Sept. 21, 2018).

Primoris is a holding company that furnishes a wide range of construction, fabrication, maintenance and engineering services to utilities, municipalities and other firms. Much of its work is done on a percentage-of-completion basis. Under this method the firm projected the revenues earned using estimates for the value of its contracts and the total costs expected for the agreement. In making these estimates Primoris often included a contingency for the risks inherent in the projects. Those included unanticipated costs caused by delays, design errors, subcontractor performance, supplier delays and similar items As the project went forward, and the risk of these errors reduced, the contingency would be adjusted and typically reduced. That resulted in an increase in the percent completed and the revenue for the project. These calculations thus had a material impact on revenue recognition.

The firm identified this method of accounting as a significant accounting policy in its Form 10-K. Nevertheless, the company did not have written policies or procedures describing how contingencies should be estimated at the beginning of a project. It also did not have written policies directing how the in-progress adjustments should be made or specifying how the estimates should be adjusted as the project continued.

Equally problematic was the firm’s failure to sufficiently document its process for evaluating risks contained in the initial estimate. The firm’s processes suffered from the same deficiency for in-progress adjustments – they were not adequately documented.

These deficiencies resulted in difficulties. In March 2015 the firm learned that it had three accounting errors related to contingencies in one segment of its business. Those errors resulted in a failure to reduce contingent cost expectations and recognize revenue and profits in the appropriated quarter. Accordingly, the firm’s ability to make and keep accurate books and records regarding contingencies was impaired.

Primoris conducted an internal investigation of its contingency accounting practices in 2014. A number of emails were discovered involving division executives, project controls managers and others. Those emails referenced “cushion,” “cookie jars,” and “sandbagging” in reference to contingencies regarding projects in the division.

In assessing these issues the firm evaluated the specific errors but did not consider the potential for error or the overall environment. At the time the firm had over 1,100 construction projects using the percentage-of-completion method of accounting. In most instances those involved contingent cost estimates that were exposed to the control deficiencies. Yet the firm concluded that while it had a significant control deficiency related to contingency accounting that there was no material weakness because of certain compensating controls. Those controls, however, were not tested despite the fact that the knew that several of the individuals who were tied to the emails referencing “cookie jar” and similar items were involved.

Section 13(b)(2) of the Exchange Act and the related rules requires public companies to make and keep accurate books and records. The section also requires that a firm device and maintain a system of internal accounting controls sufficient to provide reasonable assurance that transactions are properly recorded. In addition, those controls must permit the preparation of financial statements in accord with GAAP. Management and the principal executive and principal financial officers are required to evaluate the effectiveness of those controls at the conclusion of each fiscal year. Management is also required to provide an annual report that contains an assessment of the effectiveness of the internal controls and any material weakness. Documentation that will support the conclusions must be maintained.

In assessing internal controls, a “material weakness” is defined in terms of one where there is a reasonable possibility of a material misstatement. A “significant deficiency” is defined in as one which is less severe than a material weakness but important enough to merit attention by those charged with oversight of the firm’s financial reporting.

Here Primoris failed to comply with section 13(b)(2) and to maintain adequate documentation. The firm failed to properly address the question of material weakness and the prospect of a reasonable possibility of a material misstatement. The firm also failed to maintain the proper documentation. The Order alleges violations of Exchange Act sections 13(b)(2)(A) and 13(b)(2)(B).

To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the sections cited in the Order. The firm will pay a penalty of $200,000.

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