Corporate Financial Fraud: A Key SEC Priority
Corporate financial fraud and disclosure issues has long been a key focus of the Commission’s enforcement program. In recent years the agency has often experienced difficulties in this area, searching for ways to assess if there are issuers facing difficulty. This has been particularly true when there is no restatement of the financial statements which often has been the predicate for prior actions. Recently, however, the Commission has been successful in identifying financial fraud and disclosure issues using data analytics. Its most recent case in this area however arise the old fashioned way – a restatement of the financial statements. In the Matter of The Kraft Heinz Co., Adm. Proc. File No. 3-20523 (September 3, 2021).
The proceeding names as respondents the firm, a well-known Chicago based food and beverage firm, and Eduardo Pelleissone, then the firm’s Global Head of Operations and Chief Operating Officer. This proceeding centers on a scheme to inflate reported pre-EBITDA (earnings before interest, taxes, depreciation and amortization) beginning in the last quarter of 2014 and continuing through the end of 2018. During that period the firm negotiated upfront cash payments and discounts in exchange for future commitments to be undertaken by the company. Those payments were not properly documented, causing the firm to overstate its pre-EBITDA earnings over the period.
Under GAAP, if upfront cash and discounts are tied to future commitments, the savings must be recognized over the period the obligations are satisfied. The procurement personnel for Kraft, however, negotiated and maintained false supplier contracts which made it appear that the expense savings were provided in exchange for past or same-year events performed by the company. In reality, the payments were tied to future performance.
During the period 59 transactions were improperly documented and recorded. If the items were properly accounted for, the cost of goods sold for Kraft would have been about $50 million higher. The improper practices ultimately led to a restatement in 2019. That restatement involved the financial statements for years 2015 through 2018. It corrected a total of $208 million in cost savings from 295 transactions.
Mr. Pelleissone was presented with several warning signs indicating that expenses were being managed through the manipulation of supplier agreements. Similarly, an executive that reported to Mr. Pellewissone and who managed the procurement section, approved certain contracts and suppliers, and had sub-certification responsibilities in 2018, was confronted with several signs that should have alerted him to the issue. They did not. The Order alleges violations of Securities Act Sections 17(a)(2) and 17(a)(3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) and the related rules.
To resolve the proceedings the firm consented to the entry of a cease-and-desist order based on the Sections cited in the Order. The firm will also pay a penalty of $62 million. Mr. Pellessone consented to the entry of a cease-and-desist order based on the same Sections, and in addition, Exchange Act Section 13b-5. He also agreed to pay disgorgement in the amount of $12,500, prejudgment interest in the amount of $1,711.31 and a penalty of $300,000. See also SEC v. Hofmann, Civil Action No. 1:21-cv-07407 (S.D.N.Y. Filed September 3, 2021)(action against Klaus Hofmann, then global head of procurement and chief procurement officer of Kraft based on essentially the same allegations as above; the case is in litigation).