Yesterday, the SEC announced settled charges against Healthcare Services Group, Inc., a provider of housekeeping and other services to healthcare facilities, its CFO and its controller, for alleged failures to properly accrue and disclose litigation loss contingencies—accounting and disclosure violations that “enabled the company to report inflated quarterly [EPS] that met research analysts’ consensus estimates for multiple quarters.”  This action is the result of SEC Enforcement’s “EPS Initiative, which uses risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices.” Gurbir Grewal, the new Director of Enforcement, warned that the SEC will continue to leverage its “in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations.” The company paid $6 million to settle the action. The SEC Order makes the matter of accruing for loss contingencies sound simple and straightforward, implying that the company’s behavior involved “big bath” accounting and other earnings management practices, and that may well be the case in this instance.  However, in many cases, deciding whether, when and what to disclose or accrue for a loss contingency is not so clear cut and can often be a challenging exercise.

HCSG, which is traded on the Nasdaq Global Select market, provides housekeeping, laundry, facility maintenance and dietary services to healthcare facilities in the U.S. According to the SEC Order, in 2013, HCSG faced at least ten labor and employment class or collective actions brought on behalf of current or former employees for alleged violations of wage-and-hour labor laws. Settlement of this type of litigation is generally subject to court approval. By the end of the year, HCSG had settled two of these cases for a total of $6 million, with the remaining cases pending at year-end.   By the first quarter of 2014, the SEC alleged, company had determined to settle the three pending California state court cases, having agreed to pay between $2.5 million and $3 million to plaintiffs, with the final amount to be determined based on the amount of claims submitted by class members. The proposed settlement agreement was submitted for court approval.

Under ASC 450, companies are required to accrue a loss contingency if it is probable—that is, likely to occur—that a liability was incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Factors to be considered in determining probability include “a) the nature of the litigation, claim, or assessment; b) the progress of the case; c) the opinions or views of legal counsel and other advisers; d) the experience of the entity in similar cases; e) the experience of other entities; and f) any decision of the entity’s management as to how the entity intends to respond to the lawsuit, claim, or assessment (for example, a decision to contest the case vigorously or to seek an out-of-court settlement).” Failure to disclose the nature of the accrual, and in some cases, the amount accrued, could make the financial statements misleading.

The SEC alleges that, although the CFO participated in the discussions, was aware of the company’s intent to  settle and the submission to the court of the proposed settlement, the company did not accrue in Q1 2014 for the loss contingency related to the settlement of the three California cases even though, in the SEC’s view, the “loss was both probable and reasonably estimable no later than Q1 2014.” According to the SEC, the CFO determined that no accrual was required because the settlement claims process was not complete and the settlement had not received final court approval at the time. The CFO did not maintain documentation regarding the company’s  ASC 450 analysis.

Nor did HCSG disclose the nature of this loss contingency or an estimate of the amount of loss in its Q1 2014 Form 10-Q. Rather, the 10-Q disclosed only that the company was “‘subject to various claims and legal actions[,]’ including ‘payroll and employee-related matters’” and described its accrual policy under ASC 450.  

The Order indicates that the CFO was aware of analysts’ consensus estimates for the quarter and, by not accruing for the contingency, HCSG was able to meet analysts’ estimates.  Had the company accrued for the settlements, the SEC alleges, the company would have missed the consensus by a penny.

Although, by the end of Q2 2014, the SEC alleges, the court had granted preliminary approval of the settlement agreement and scheduled a final approval hearing for November 2014 (Q4), the company still did not accrue for the loss contingency because there was still no final approval. Nevertheless, the company missed analysts’ estimates by two cents.  

By Q3 2014, according to the Order, as a result of a restructuring and other factors, the company reported a net loss of $22 million (a $0.31 loss per share compared with the consensus EPS of $0.22). Notably, in Q3, HCSG accrued $2.5 million for the settlement of the California state law cases, based largely on the number of claims submitted, even though there was no final court approval at the time.  According to the SEC, the company determined that the loss was “probable and reasonably estimable in this period because the deadline for making claims under or objections to the settlement had passed.”  Had the company accrued this liability when the final settlement approval was expected in Q4, the SEC alleged, HCSG likely would have missed consensus EPS estimates by a penny.

The SEC also alleged a similar storyline for a federal court action brought against the company by a group of employees under the Federal Fair Labor Standards Act. After contesting the case vigorously, and following court-ordered mediation, in Q2 2015, the company ultimately agreed to pay a maximum of $8 million in settlement, including $4 million in fees to plaintiffs’ attorneys.   The parties advised the court of the resolution and received a stay of proceedings to finalize a settlement agreement. However, the SEC alleged, the company did not accrue any amount for the settlement in Q2 2015, nor did it disclose the nature or an estimate of this loss contingency in its filings. Rather, the SEC contends, the CFO believed that “the loss was neither probable nor reasonably estimable because it was unclear whether the court would grant any approval of the settlement due to the amount of plaintiffs’ attorneys’ fees, and the payment of those fees in HCSG stock.” As a result, the SEC charged, the company reported record EPS for the quarter, which met analysts’ estimates;  had it taken a charge, it would have missed the estimate by 25%.  The company also made some adjustments to its expense amounts, reducing the amount recorded for the quarter for legal expenses “without adequate documentation.” Notably, according to the Order, on the day of the mediation, the CFO advised a company officer that meeting the consensus EPS estimate “is going to be a stretch based on current [cost of services].” The SEC contends that “[b]ased on the information available at the time, the loss contingency for the [federal] action was probable and reasonably estimable by Q2 2015 regardless of whether the court had granted any approval of the settlement, and despite any uncertainty posed by the amount of the attorneys’ fees or their payment in HCSG stock.”

The Order also charges that, notwithstanding execution of a settlement agreement in the federal case and preliminary court approval of the settlement in September 2015, the company did not accrue for the loss contingency in Q3 2015 and reported EPS that set another record and met the consensus—achievements that would not have occurred if the company had taken a charge.  The SEC alleges that the company again reduced the amounts recorded for legal and accounting expenses without adequate documentation.  The company did not take a charge for this loss contingency until Q4 2015, when the court granted final approval of the $8 million settlement. The company reported Q4 2015 EPS of $0.13, missing the consensus estimate of $0.26.  The SEC also identified a number of additional accounting charges and expenses without adequate documentation taken during the two loss quarters.

The SEC’s Associate Director of Enforcement said that “HCSG repeatedly failed to record loss contingencies related to litigation settlements despite mounting evidence that such liability was probable and reasonably estimable, while misleading investors by reporting inflated net income and consistent EPS growth….It is critical for public companies to ensure that accounting judgments, including those involving loss contingencies, are not being used to manage earnings and distort financial statements.”

The SEC charged that HCSG had inadequate “internal accounting controls over (a) accruals for litigation loss contingencies, (b) manual journal entries, and (c) period-end adjustments made during the closing process. Although HCSG had policies and procedures requiring accounting entries to have adequate supporting documentation, its finance staff regularly recorded manual journal entries with no or inadequate supporting documentation.”  In addition, the procedures of  the company’s Disclosure Control Committee “were insufficient in identifying and addressing material inaccuracies in HCSG’s financial statements, especially relating to the accounting for and disclosure of litigation loss contingencies. Moreover, HCSG’s accounting system did not have an audit trail or time stamp function that enabled the finance staff to identify when certain manual journal entries or adjustments were made during the closing process.” Accordingly, the company’s “internal accounting controls were not designed or maintained to provide reasonable assurance that HCSG’s financial statements would be presented in conformity with GAAP, and it further failed to maintain internal control over financial reporting. HCSG’s books, records, and accounts also did not accurately and fairly reflect, in reasonable detail, HCSG’s transactions and disposition of assets.”

The SEC charged the company (which had sold shares to employees on an S-8 during the period) with fraud in the offer and sale of securities under Section 17(a)(2) and (3) of the Securities Act, which are negligence-based prohibitions and do not require a showing of scienter; filing misleading periodic reports under Exchange Act Section 13(a), which does not require scienter; violation of the books-and-records and internal accounting controls provisions of Section 13(b)(2)(A) and (B) of the Exchange Act, including Rule 13b2-1, which likewise do not require scienter. The company was ordered to pay a civil penalty of $6 million.

The CFO  was charged with willful violations of Securities Act Sections 17(a)(2) and 17(a)(3), and Exchange Act Rule 13b2-1, as well as with causing the company’s various violations.  In support of the charge of “willfulness,” the SEC noted that a “willful violation of the securities laws means merely ‘that the person charged with the duty knows what he is doing.’” He was required to pay a $50,000 penalty and suspended from appearing or practicing before the SEC as an accountant for at least two years. The controller was charged with causing the company’s books-and-records and internal accounting controls violations and required to pay a penalty of $10,000.

For more information about securities litigation, see the Cooley Securities Litigation + Enforcement blog.

Posted by Cydney Posner