SEC Enforcement – More Internal Controls

Internal accounting controls is emerging as a continuing theme with SEC enforcement. In recent weeks, for example, the agency has issued a report of investigation on internal accounting controls relating to cyber security and resolved an FCPA investigation, centered on internal accounting controls. Now the Commission has settled a corporate internal control action where self-reporting and cooperation earned the firm no penalty despite an admission of weak controls. In the Matter of The Hain Celestial Group, Inc., Adm. Proc. File No. 3-18921 (Dec. 11, 2018).

Hain is a leading marketer, manufacturer and seller of organic and natural food and personal care products. The firm’s customer base is primarily specialty and natural food distributors, supermarkets, natural food stores, mass-market and e-commerce retailers and food service channels. The firm’s shares are listed on NASDAQ.

Over the past five years net sales in the U.S. business segment have declined from about 65% of world-wide sales in FY 2013 to about 46% in FY 2016. During the two year period beginning with FY 2014 the firm’s net sales for the U.S. business segment were derived in part from two Distributors – No. 1 and No. 2. During the two-year period Hain’s U.S. business segment sales team responsible for the two distributors rolled out an “end of the quarter” or EOQ sales incentive program. It included a number of incentives including cash, extended payment terms, discounts, spoils coverage and similar incentives. While none of the incentives are improper they can have financial reporting implications.

The financial reporting implications of EOQs are illustrated by the impact with Distributor No. 1. Hain and the Distributor executed annual sales contracts, stipulating to quarterly inventory sales growth targets. Distributor No. 1 earned financial incentives by meeting the targets. A number of incentives were employed. One critical incentive involved spoils coverage because it was based largely on oral understandings. That resulted in periodic disputes regarding whether the products were eligible. During the period Distributor No. 1 purchase 52 to 64% of it its inventory in or around the last month of the quarter. That made about half of Distributor No. 1’s inventory purchases eligible for the EOQ spoils protection.

Hain did not have sufficient policies and procedures to provide reasonable assurances that the EOQ sales were accounted for properly. Sales personnel were not appropriately trained or knowledgeable regarding the accounting impact of the sales practices. The policies and procedures were also inadequate to monitor incentives made in sales transactions. This created potential revenue recognition implications. In addition, the arrangements were not fully communicated outside the sales department. Similar, although slightly different issues, arose with respect to Distributor No. 2 and the EOQ program.

In May 2016 the finance department became aware of the arrangements. An internal investigation began. By August the firm self-reported to the SEC. The firm also announced that its fiscal year end 2016 results would be delayed. About 10 months later the firm determined that a restatement was not required, although certain adjustments were made. Subsequently the two Distributors reduced their inventories.

The Order alleges that Hain violated Exchange Act sections 13(b)(2)(A) and 13(b)(2)(B). Following its self-report, the firm fully investigated the issues, cooperated with the staff investigation and undertook certain remedial steps. Those included revisions to the firm’s revenue recognition policies and procedures, standardization of its contract documentation, revisions to its monitoring controls and changes in its communication function. A training program was implemented. To resolve the proceedings the firm consented to the entry of a cease and desist order based on the sections cited in the Order. No penalty was imposed in view of the self-report, cooperation and remediation.

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