The SEC has just filed a complaint against Sequential Brands Group, Inc., a brand management company, for failing to take timely and appropriate goodwill impairment charges as required by GAAP and the federal securities laws, despite “clear evidence of goodwill impairment” (according to the press release).  As a result, the SEC alleges, the company “materially understated its operating expenses and net loss and materially overstated its income from operations, goodwill, and total assets” in its SEC filings, turning “a net loss into income” for financial statement purposes.

According to the complaint, Sequential acquired consumer brands through acquisitions, creating substantial goodwill on its balance sheet. As of December 31, 2016, goodwill represented $307.7 million, or 21.4%, of its total assets. During 2016 and 2017, the company’s “industry sector performed poorly,” and its stock price steadily plummeted. During just the fourth quarter of 2016, its stock price fell precipitously by over 40%.

In its 2016 Form 10-K, Sequential described its goodwill impairment process: the company first conducts a qualitative assessment.  If it concludes that it is more likely than not that its fair value is less than its carrying value, it then performs a two-step quantitative goodwill impairment test. In step one, the company compares its estimated fair value with its carrying value. If the estimated fair value exceeds its carrying amount, no
further analysis is needed. If the estimated fair value is less than its carrying amount, the company goes on to step two and calculates the implied fair value of the reporting unit goodwill to determine whether any impairment is required. Notably, in its description, the company indicated that it considered its market capitalization (adjusted for a control premium factor) to represent its fair value. Accordingly, the steep decline in its stock price should have been particularly important as an indicator of goodwill impairment. According to the SEC, management was also aware of other indications that its licensees and brands operated were struggling.

The company conducted its assessment annually on October 1. In 2016, the company engaged an external valuation consultant to conduct a quantitative assessment of fair value, and the consultant concluded that, at October 1, there was no impairment, which the company reported in its Form 10-K.  However, upon inquiry in December by the audit committee chair as to whether that assessment remained correct in December, the company undertook two more analyses using the same quantitative methodology.   The last analysis as of year-end showed that goodwill was likely impaired because fair value exceeded carrying value by a material amount, $96 million, information that was not shared with the company’s outside auditors.  Under the applicable accounting standard, ASC 350, the SEC charges, the company “could not reasonably ignore this objective, quantitative, observable evidence that goodwill was more likely than not impaired as of December 2016.”

The SEC alleges that, by failing to conduct further quantitative assessments or consider this objective evidence as part of a qualitative assessment, the company “unreasonably violated GAAP and the federal securities laws.” Instead, according to the SEC, the company conducted a qualitative assessment that ignored the evidence showing a likely impairment, prepared documentation furnished to its auditors that omitted any mention of the results of the two December market cap analyses—cherry-picking the most favorable evidence to support its case—and strained to reach a conclusion “that the market was unfairly undervaluing Sequential and that the Company’s goodwill was not impaired.”

As a result, the SEC contends, the company did not take an impairment charge in the fourth quarter of 2016, and “materially understated operating expenses and overstated income from operations by at least $100 million and understated the reported net loss by at least $42 million in its 2016 Form 10-K.” Had the impairment been timely recorded, the SEC claims, the “reported net loss for 2016 would have been 54 times larger.” Moreover, according to the SEC, the company “carried these errors forward into the first three quarters of 2017,” despite facts that should have triggered a new impairment analysis during that period. The company did not record an impairment charge until the fourth quarter of 2017, when it “belatedly impaired $304.1 million of goodwill.”

According to the SEC, there was “no reasonable basis under GAAP” for the company’s accounting treatment, which resulted in filing with the SEC of materially inaccurate financial statements and false and misleading statements and omissions in its periodic reports that “did not fairly align with the information in Sequential’s possession at the time.”

In addition, the SEC alleged that Sequential had only one internal accounting control related to goodwill impairment testing and that control “was not sufficient to provide reasonable assurance that Sequential would perform and record its interim and annual assessments of goodwill for impairment as necessary to permit preparation of financial statements in conformity with GAAP.” For example, the SEC alleged that there was “no control providing for a process to identify potential triggers, nor was there any requirement to document such assessments when no triggers were identified. Rather than engaging in systematic reviews for potential impairment indicators, Sequential instead relied heavily on senior executives’ general knowledge of the business and undocumented discussions to provide the financial and operational information that went into the Company’s testing. Further, due to the poorly designed process and controls (including the lack of adequate documentation), it is impossible to determine whether particular triggering events were considered.”  In particular, the company failed to conduct appropriate interim goodwill impairment testing where, according to the accounting standards, indicators of impairment were present, and there was “no mechanism to ensure that interim reviews were conducted properly, if at all.” Nor did the company “create any paper trail for senior management or the independent auditor to review the work (if any) that was done between annual tests.” The inadequacy of its internal controls was demonstrated by its “unreasonable failure to take into consideration the results of its market capitalization analyses” conducted in December and its “unreasonable failure to identify its declining stock price and other negative factors enumerated above as indicators of impairment.”

The complaint charges Sequential with negligence-based fraud under Section 17(a)(3) of the Securities Act, misleading statements in its periodic reports under Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11 and 13a-13 and Rule 12b-20, inaccurate books and records under Section 13(b)(2)(A) of the Exchange Act, and inadequate internal accounting controls under Section 13(b)(2)(B) of the Exchange Act. 

Posted by Cydney Posner