Ignoring Firm Policy and Data Ends With SEC Sanctions
Many SEC enforcement actions center on violations of the company or firm policies. A series of cases involving investment advisers, for example, have been filed in recent months based at least in part on the failure of the advisory to follow the policies and procedures disclosed to clients. The same point is true in many instances where there are allegations of financial fraud. The Commission’s most recent case in that area is a prime example of a firm ignoring its own policies and data. SEC v. Conn’s Inc., Civil Action No. 4:19-cv-2534 (S.D.Tex. Filed July 15, 2019).
Conn’s Inc. is a specialty retailer of consumer goods and credit financing, focused on “credit-constrained consumers . . “ Its shares are traded on NASDAQ under the symbol CONN. Michael Pope, also a defendant, has held a series of positions in the finance area of the firm including most recently, CFO. He is a CPA, licensed in Texas where the company is based.
The company has two reportable operating segments, retail and credit. The consumer credit programs are key to the retail segment since the firm focuses on those who lack the cash to make a purchase. Indeed, about 80% of its retail sales are financed through a firm credit program. This factor coupled with the lending practices of Conn’s which concentrated on those which less desirable credit made it critically important that the firm properly identify impaired receivables and measure the amount of any impairment. GAAP requires that the company accrue for loss contingencies if it is “probable that an asset has been impaired” and disclose the loss if it can be reasonably identified.
Conn’s complied with the loss contingency requirement by accruing an allowance for doubtful accounts that had two key components: 1) Troubled debt restructuring – all accounts for which payment terms have been extended over 90 days or refinanced in bankruptcy; and 2) non- troubled debt restructuring or TDR which was calculated using a complex roll rate. Company policy required that the rate be based on historical trends.
Over a two-year period, beginning in 2013, the firm failed to comply with its policy in creating the roll rate thereby materially overstating revenue. During the period Conn’s used a role rate that was essentially a management plug. Stated differently, the “plug” was a number which ignored the firm’s own data, contrary to company policy as reflected by three points.
First, during the period Conn’s experienced increasingly large and consistent variances between “actual and projected charge-offs and between actual and projected roll rates.” If the actual firm data had been used rather than a plug number, the reserve would have been 20% to 30% larger.
Second, during the period Conn’s data established that there was an increase in “both the amount and percentage of accounts 60 plus days past due, which it admits is a leading indicator of potential charge-offs.” During the period the percentage increased from 7.1% to 9.7%.
Finally, company records demonstrate that during the two-year period the percentage of new customers in the portfolio more than doubled. Substantially increasing the number of new clients significantly increases the risk for the firm. This is particularly true here in view of the type of customers the company had and a loosing of credit standards during the period.
In the second quarter of fiscal 2015 the firm began to build its allowance for doubtful accounts properly. The role rate was retooled. By September 2014 a firm press release disclosed an operating loss for the credit segment. Guidance for fiscal 2015 was cut. The day of the announcement the stock price dropped 30%.
In the next quarter the company completed its roll rate corrections using firm data. In a December 2014 earnings press release Conn’s stated that its prior “credit operations forecasting had not been acceptably accurate . . .” A Credit Risk Compliance Committee of the Board of Directors was created. The stock price dropped 41%. During the period the company did not have internal controls adequate to address this issue. The complaint alleges violations of Securities Act Section 17(a)(3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B).
Defendants resolved the action. Conn’s consented to the entry of a permanent injunction based on the sections cited in the complaint. The firm also agreed to pay a penalty of $1.1 million. Mr. Poppe consented to the entry of a permanent injunction based on the Securities Act Section cited in the complaint. He agreed to pay a penalty of $50,000. See Lit. Rel. No. 24532 (July 15, 2019).