A recent Securities and Exchange Commission (the “SEC” or “Commission”) order illustrates the SEC’s continued focus both on companies’ earnings management practices and also their litigation-related disclosures—a topic that Baker Botts previously discussed here. Healthcare Services Group, Inc. (“HCSG”) agreed to pay $6 million to settle charges in connection with the SEC’s findings that it failed to accrue and disclose material loss contingencies related to several litigation settlements. According to the SEC’s order,¹ HCSG held off from accruing probable and reasonably estimable litigation contingencies in certain quarters to avoid missing research analysts’ consensus earnings per share (“EPS”) estimates. In some quarters, accruing the loss contingencies would have caused the company to miss EPS estimates by as little as a penny. By not accruing those litigation loss contingencies, the SEC found that HCSG was able to consistently meet analyst estimates during this time period as well as show EPS growth and even report a record-high EPS for several quarters. This settled enforcement action represents the third settlement to result from the SEC’s ongoing EPS initiative. The EPS initiative uses “risk-based data analytics” to uncover, among other things, potential improper earnings management practices. As announced here last fall, the SEC brought settled enforcement actions against two public companies and their former executives. As with the HCSG action, the SEC found those companies made similarly small quarterly adjustments to meet or exceed analyst consensus EPS estimates. This alert reviews the factual findings and charges in the HCSG settlement and highlights the key takeaways.

In 2013, HCSG faced at least ten labor and employment class or collective actions for alleged violations of wage-and-hour labor laws. Five of the actions had been filed in California state court while the other five had been filed in various federal courts. By the end of 2013, HCSG had settled two of the five California state court actions.

California State Court Lawsuits

In Q1 2014, HCSG decided to settle the remaining California state actions. In the proposed settlement submitted for court approval, HCSG agreed to pay between $2.5 million and $3 million to plaintiffs. However, because the court had not given final settlement, the company’s CFO determined no loss contingency amount was probable or reasonably estimable and directed the company not to accrue for the loss. If HCSG had accrued for the settlement in Q1 2014, the company would have missed the analyst consensus EPS estimates by $0.01.

By the end of Q2 2014, the court had granted preliminary approval of the settlement. The company again did not accrue or disclose the settlement loss contingency. By not accruing for the settlement amount, HCSG reported an EPS of $0.20. If HCSG had accrued for the settlement loss contingency, its Q2 2014 EPS would have been $0.19, missing consensus estimates by $0.03 rather than by $0.02.

In Q3 2014, the company accrued $2.5 million for the settlement of the remaining California lawsuits. While the settlement still had not received final court approval, the deadline for making claims under or objections to the settlement had passed. The company’s decision to report the litigation contingency loss in Q3 2014, however, occurred during a quarter where HCSG reported a net loss of $22.2 million (or -$0.31 EPS) the bulk of which related to the creation of an insurance subsidiary and a corporate restructuring. In other words, the company recorded the litigation contingency liability in a quarter with an already substantial net loss and loss per share.

Federal Lawsuit

In Q2 2015, HCSG agreed to settle one of the federal actions pending against the company. Per the proposed settlement agreement, HCSG agreed to pay a maximum amount of $8 million, including nearly $4 million in plaintiffs’ attorneys’ fees. The company’s CFO did not direct accrual, however, because court approval of the settlement remained pending. By not accruing for the loss contingency, HCSG reported a new company record EPS of $0.23, which also met the consensus estimate for that quarter. If HCSG had accrued the loss liability, it would have reported an EPS of $0.17 and missed the consensus estimate by nearly 25%.

HCSG again did not accrue for the settlement loss in Q3 2015 despite receiving preliminary court approval. By not accruing any amount of the settlement, HCSG reported another company record EPS of $0.24, which met the consensus estimate. Had HCSG accrued for the settlement loss, it would have reported an EPS of $0.18, missing the consensus estimate by 25%.

In Q4 2015, the federal court granted final approval of the $8 million settlement and HCSG recorded loses related to the settlement. This caused HCSG to report a Q4 2015 EPS of $0.13, missing the consensus estimate of $0.26.

The SEC’s Order

In its order instituting proceedings, the SEC announced that HCSG failed to properly record the financial impact of the litigation loss contingencies as soon as they were probable and reasonably estimable, reasoning that the loss contingencies were probable and reasonably estimable as soon as HCSG reached a preliminary settlement agreement with the plaintiffs.

Though the SEC made no findings that HCSG acted with scienter, the Commission concluded HCSG’s failure to timely accrue the litigation loss contingencies—as required by GAAP and ASC 450—caused it to file “materially misleading” financial statements. By not accruing the loss contingencies, according to the SEC, HCSG was able to “report multiple quarters of EPS growth, including then-record-high EPS,” which were then followed by quarters where the company—due to its accrual of the loss contingencies—missed the consensus EPS by wide margins.

The SEC further found that HCSG’s failure to properly account for litigation loss contingencies was due in part to HCSG’s lack of “sufficient internal controls.” For example, while HCSG had a Disclosure Control Committee that met each quarter, the SEC found that the committee’s procedures were insufficient in “identifying and addressing material inaccuracies in HCSG’s financial statements,” especially as it related to “accounting for and disclosure of litigation loss contingencies.” Based on HCSG’s failure to promptly accrue these settlement losses, as well as several other accounting entries, the SEC found that HCSG violated Sections 17(a)(2)-(a)(3) of the Securities Act and Sections 13(a), 13(b)(2)(A), and 13(b)(2)(b) of the Exchange Act. It also found the company’s CFO and controller in violation of the same or similar sections. None of these violations required the SEC to prove scienter.

HCSG agreed to pay $6 million to settle the enforcement action. The CFO and Controller agreed to pay $50,000 and $10,000, respectively, to settle the action. Additionally, the CFO agreed to be suspended from appearing and practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies.

Takeaways

• The SEC Staff continues to employ data analytics to uncover improper earnings management practices. The settlement with HCSG shows that the SEC will continue to use that analytics-based approach to uncover violations even when they result in EPS adjustments as little as one penny.
• The new Director of the SEC’s Division of Enforcement, Gurbir Grewal, specifically highlighted in the press release announcing the HCSG settlement that the Commission will use its EPS-focused technology to “identify improper accounting and disclosure practices that mask volatility in financial performance.” Companies that consistently meet or exceed EPS consensus estimates for multiple quarters but then miss the consensus estimate by a wide margin may trigger SEC review under its EPS initiative.
• As the recent HCSG settlement demonstrates, the SEC remains focused on the timely disclosure of loss contingencies, including litigation loss contingencies. Litigation loss contingencies must be accrued when they are probable and reasonably estimable. The lack of final court approval of a settlement, by itself, does not excuse a Company’s obligation to disclose a litigation loss contingency.

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