Three Restatements Conclude with SEC Enforcement Action

Following a restatement of its financial statements, many firms are investigated by the SEC and later named in an enforcement action. For Weatherford International PLC, three was the charm – following its third restatement in two years the firm was named as a respondent in an enforcement . In the Matter of Weatherford International PLC, Adm. Proc. File No. 3-17582 (Sept. 27, 2016).

Weatherford is a multinational Irish public limited company based in Switzerland. Respondents James Hudgins and Darryl Kitay were, respectively, the firm’s V.P. of Tax and Tax Director.

A key strategy of the firm was tax avoidance. At one point the firm changed its place of incorporation from the U.S. to Bermuda through an inversion. The firm refined its tax structure to minimize its effective tax rate. Its tax avoidance strategies also increased EPS and cash flow. The strategies were touted to analysts. Mr. Hudgins was their architect. Mr. Kitay reported to Mr. Hudgins. He was responsible for preparing and reviewing the firm’s consolidated income tax accounts and underlying expenses that were reported in the financial statements.

Weatherford reduced its effective tax rate nearly 10% from 2001 through 2006. That rate, however, was higher than its inverted peers. Subsequently, the firm began reporting results that suggested its strategy was outperforming that of others. In 2008 and 2009, for example, the firm reported a pre-tax effective tax rate of 17.1%.

In each year from 2007 through 2010 Messrs. Hudgins and Kitay took steps to ensure that the reported effective tax rate was commiserate with their statements to analysts and shareholders touting their tax structure. Typically at year end the two men would calculate the actual rate. If the firm had not met the metric sought, they reversed legitimate financial entries, substituted plugs, and announced the false rate and related numbers as the firm’s actual results. This gave the firm plug tax benefits of over $150 million in 2007 and just over $100 million in 2008, 2009 and 2010. The firm never questioned the drop in the effective tax rate.

In 2010 outside auditor Ernst & Young discovered certain tax accounting errors that increased Weatherford’s overall tax liability for the year. Other errors were uncovered and the internal audit group concluded that there was a material weakness in internal control surrounding accounting for income taxes. E&Y expanded its procedures and discovered the phantom income the plug entries created – the difference between what was reported as taxes and what was owed. The first restatement followed. Net income was reduced by $500 million.

Following the restatement Mr. Hudgins conducted a large-scale remediation effort. Throughout 2011 Weatherford continued to report earnings and file its financial statements, repeatedly assuring investors that as a result of its procedures the financial statements were accurate and in compliance with GAAP.

Despite those assurances, by the second quarter of 2011 Weatherford identified dozens of issues related to its internal controls for the accounting of income taxes that required review and remediation. Mr. Hudgins again lead the effort to remediate the issues. They were not handled properly. A second restatement followed, announced at the end of September 2011. This included an $84 million reduction to the firm’s previously reported net income to correct for the failure to accrue for certain withholding taxes prior to 2012. Mr. Hudgins resigned in March of the next year. Mr. Kitay was relieved of his duties.

The third restatement resulted from a material error that a firm employee identified shortly before the second restatement was filed. The email went unanswered for over a month. As a result Weatherford failed to create a timely reserve for the item. While Weatherford later claimed that the item “fell through the cracks,” another restatement was required, issued in December 2012. Net income was reduced by $186 million, driven largely by the firm’s efforts to remediate its material weakness over internal controls for accounting of income taxes. In February 2014 Weatherford announced it has successfully remediated its control weakness for accounting of income taxes.

The Order alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). The firm cooperated with the Commission’s investigation and agreed to implement a series of undertakings which include filing a report detailing its internal controls, policies and procedures over accounting for income taxes and conducting subsequent reviews.

To resolve the action Weatherford consented to the entry of a cease and desist order based on each of the Sections cited in the Order except Exchange Act Section 13(b)(5). Messrs. Hudgins and Kitay also consented to the entry of cease and desist orders but based on each of the Sections cited in the Order. The firm will pay a penalty of $140 million.

Mr. Hudgins is prohibited for a period of five years from acting as an officer or director of any issuer. Messrs. Hudgins and Kitay are each denied the privilege of appearing or practicing before the Commission as an accountant with the right to apply for reinstatement as an accountant after five year. Mr. Hudgins will pay disgorgement of $169,728, prejudgment interest and a penalty of $125,000. Mr. Kitay will pay a penalty of $30,000.

Program: The Dorsey Private Funds Symposium, September 28, 2016, New York City. Further information is available here.