Right on the heels of the SEC’s action against Cheesecake Factory for misleading public statements regarding its financial performance (see this PubCo post) comes this settled action against General Electric Company—also for misleading public statements about its financial performance. In this action, the SEC alleged that GE failed to provide material information that would have allowed investors to understand how it was generating profits and cash flow in two key segments, power and insurance, the quality of those earnings and the underlying risks. And, as challenges in these segments were later disclosed, the company’s stock price fell almost 75%. As reported in the WSJ, the SEC and DOJ were “investigating GE’s accounting for about two years after the company disclosed large write-downs tied to its insurance business and its power business. The SEC had warned GE in September that it was preparing civil charges, and GE said it had set aside $100 million to resolve the matter.” That reserve turned out to be somewhat optimistic—a bit like some of GE’s insurance reserves—as the final civil penalty was actually $200 million. It’s worth noting here that, as stated in GE’s 8-K regarding the settlement, in its Order, the SEC “makes no allegation that prior period financial statements were misstated. This settlement does not require corrections or restatements of GE’s previously reported financial statements, and GE stands behind its financial reporting.” That is, in the end, the charges were not about funny accounting—even though some might question certain of the judgments—they were about the disclosures about the accounting, the controls over the accounting and the controls over the disclosures.
As noted above, the SEC’s Order concerns two of GE’s business segments, GE Power and the insurance segment.
GE Power. GE Power manufactures, sells and services gas turbines. In 2014 and 2015, GE described its power markets as “flat” and, to achieve operating earnings and cash targets, increasingly relied on long-term (15 to 30 years) contracts for repairs and service of customers’ power turbines, with revenue from service contracts accounting for as much as 98% of segment profits and all of its operating cash flows in 2017. However, GE was facing increased competition for its service contracts. Under GE’s accounting method, the company recognized revenue from service agreements when it incurred costs, typically earlier in time than when it actually billed under the agreements. Consequently, GE reported a “deferred balance” of unbilled revenue (roughly $5 billion) among the contract assets on its balance sheet.
In light of the flat power markets, to achieve internal operating profit targets, GE Power sought to reduce costs but, importantly, it also reduced the estimates of costs under its multi-year service agreements. These reductions in cost estimates resulted in more than $1.4 billion in revenue and earnings in 2016 and more than $1.1 billion in revenue and earnings in the first three quarters of 2017—29% of GE Power’s reported segment profit in 2016 and 45% in the first three quarters of 2017—allowing GE to achieve its forecasted non-GAAP industrial operating profit for 2016. How? Under accounting rules, GE applied a “cost to cost percentage of completion approach to estimating revenue on its service agreements,” which is explained in glorious detail in the Order, but, in essence meant that “[p]rojected cost reductions over the life of the service agreement increased the contract profit margin and resulted in an increase to revenue and earnings in the current period.”
As described by the SEC, the reductions in cost estimates “necessarily increased” GE’s deferred $5 billion balance of unbilled revenue. However, management directed the Power segment to keep a lid on the deferred balance while also increasing earnings—a difficult feat under the circumstances. So, the SEC alleged, to increase cash flow and prevent further increases to the deferred balance, GE significantly expanded its historical practice of “deferred monetization”—a type of factoring, or sales of current receivables by GE’s businesses to its GE Capital business—to include the sale of longer term receivables. This expansion had the effect of pulling forward future years’ cash collections into the present year, decreasing cash flows in later periods. However, the practice was expensive because it often involved renegotiation of service agreements and related concessions as well as interest expense on factored receivables. Internally, the practice of deferred monetization was referred to as a “drug,” because GE needed to persist in deferred monetization to continue to achieve the same favorable effect, but it was also recognized as a practice that was “not sustainable.” While the practice accounted for approximately 33% of “Industrial Cash Flow,” a non-GAAP financial measure, after the first three quarters of 2017, it also “pulled forward $878 million in cash from 2018, $585 million from 2019, $407 million from 2020, and $400 million from later years.”
However, GE did not disclose in periodic reports or other public communications its reductions in cost estimates or its reliance on its expanded deferred monetization practice—“despite recognition internally that these changes were critical to GE’s reported results”—and instead attributed the changes in profits to other causes. In the Order, the SEC characterized these omissions as materially misleading. Similarly, GE’s disclosure of its Industrial Cash Flow NGFM was characterized as misleading “in light of its failure to disclose the extent to which the reported measure relied on changes in practice expanding intercompany factoring in its GE Power business and pulling forward cash from future periods.” By failing to adequately disclose its deferred monetization practice, GE misled its investors about the quality of the company’s earnings.
It was not until a November 2017 investor conference that GE first explained the impact of the changes in service agreement cost estimates in offsetting lower transactional volume from 2014 through 2016. By the end of 2017, GE had discontinued its deferred monetization and has, since then, disclosed the impact of the practice on future cash flow.
Insurance. GE has long been involved in reinsurance, but divested much of the business between 2004 and 2007. However, it retained billions in reinsurance of long-term care policies that it could not sell without substantial losses, perhaps because they were severely underpriced, i.e., the premiums were not high enough to pay the originally projected costs of long-term care to be covered by the policies, a problem that, by the 2010s, was recognized to plague the long-term care insurance industry generally. Although, during 2015 and 2016, it was acknowledged internally that these legacy policies would be the source of “continuing and expected losses” and “posed a growing risk to GE’s financial statements,” according to the Order, GE did not publicly disclose this risk.
Executives considered how to minimize the losses. One potential answer surfaced in connection with impairment testing conducted annually to evaluate the adequacy of GE’s insurance reserves. As part of testing, NALH (the GE entity holding the policies) evaluated claims data, and actuaries used this data to propose a revised set of assumptions for the year. In 2015, when NALH experienced higher claims than anticipated, NALH leadership, under pressure to avoid losses, changed the testing process and reduced the assumptions about the projected cost of future claims, for example, by increasing the morbidity improvement assumption as a result of unspecified future medical improvements. By projecting lower claims costs over time, GE simultaneously concluded that it did not have insurance losses.
However, in 2016, actual claims experience continued to deteriorate, raising the possibility of substantial losses and leading one of the actuaries to question whether the assumptions about future claims were supportable. (According to the Order, NALH did not follow up.) When the results of the August 2016 impairment test would have meant a $178 million charge, “NALH executives employed a new approach, referred to as the ‘rollforward,’ which eliminated the loss recognition testing deficiency. The rollforward, which changed the ‘valuation date’ for certain assumptions used in the loss recognition testing,” changed the “negative $178 million to a positive $86 million, avoiding any losses on GE’s financial statements.” The rollforward was justified as “a means to provide a ‘more current’ estimate for loss recognition testing”; however, the rollforward did not use claims cost data received during 2016, but rather relied on actuarial assumptions and claims data from the end of 2015 and projected them forward nine months. The change in methodology was questioned by Internal Audit. In 2017, an actuarial analysis “indicated that NALH might need to substantially increase its insurance reserves. In July 2017, GE publicly disclosed a review of its insurance portfolio, which ultimately led to GE’s $9.5 billion pre-tax charge against earnings in January 2018 and required capital contributions of approximately $15 billion over seven years. In GE’s quarterly report on Form 10-Q for the third quarter of 2017, the company began to provide detailed information regarding its long-term care insurance exposure and, later, additional detail about the assumptions used in its loss recognition testing process.”
The Order indicates GE failed to disclose in MD&As contained in multiple periodic reports the “material known trends of increasing costs in its historical claims experience and uncertainties, inherent in increasingly optimistic assumptions of lower future claims costs, that material insurance losses were reasonably likely in the future.” Although GE knew that uncertainties in its estimates were “reasonably likely to come to fruition and had the potential for material insurance losses in the future,” nevertheless, “NALH offset increasing historical claims experience by assuming projected claims costs would significantly decrease in the distant future.”
The SEC concluded that GE’s failure to disclose these known trends and uncertainties rendered GE’s periodic reports for the period “materially misleading.” In addition, the SEC charged, GE’s internal accounting controls were deficient and its books and records inadequate. According to GE’s own Internal Audit report, the Order indicates, the company’s “rollforward process lacked formal oversight and approval, and the company failed to adequately document the rationale for the rollforward process it employed in its estimate.” What’s more, by failing to ensure that known trends and uncertainties regarding insurance liabilities were accumulated and timely communicated to the GE executives responsible for disclosure, the SEC alleged, GE lacked sufficient disclosure controls and procedures. In particular, the Order highlights that GE executives were not informed of the use of the rollforward in 2016 and were not advised “until the second quarter of 2017 of NALH’s increasingly optimistic projections of future liabilities despite higher than expected claims.”
The Order also points out that there were a number of securities transactions during the period, including an 8.7 billion Euro bond offering in May 2017, tender offers involving GE preferred and common stock and employees stock option exercises.
Here’s the list of violations compiled by the SEC: Section 17(a)(2) and (3) of the Securities Act, for misleading statements in connection with offers and sales of securities; Section 13(a) of the Exchange Act and Rules 13a-1, 13a11, and 13a-13 thereunder, and Rule 12b-20, for inaccurate and misleading periodic reports; Exchange Act Rule 13a-15(a), for inadequate disclosure controls and procedures; Exchange Act Section 13(b)(2)(A), for inadequate books and records; Exchange Act Section 13(b)(2)(B), for insufficient internal accounting controls; and Rule 100(b) of Reg G, for making public use of a misleading NGFM.
In addition to a civil penalty of $200 million and an order to cease and desist, GE is undertaking, for one year, to periodically report to the SEC staff its compliance with SEC “regulations and GAAP regarding its financial reporting and the status of any remediation, implementation, auditing and testing of its internal accounting controls and compliance measures related to its insurance and Power businesses.” GE is also undertaking to fully cooperate with the staff on any related actions, and the SEC’s press release indicates that there is an “ongoing investigation.”