Just in time for the holidays—cookie jars full of…revenue adjustments! In this complaint, the SEC charged American Renal Associates Holdings, Inc., a national provider of dialysis services, and three of its finance executives with securities fraud and other misconduct. According to the SEC, the alleged fraudulent scheme involved a “series of revenue adjustments to make it appear that ARA had beat, met, or come close to meeting various predetermined financial metrics, when in fact its financial performance was materially worse.” After receiving an inquiry from the SEC, ARA conducted an internal investigation that led the company to restate its financials, which, according to the SEC, showed that the company had overstated its net income by over 30% for 2017 and by more than 200% for the first three quarters of 2018. The revenue adjustments in the cookie jar, the SEC charged, were one of the key ingredients used in this alleged effort to cook the company’s books.
ARA owned and operated dialysis clinics through joint ventures with doctors across the country, with the doctors providing patient care and ARA handling billings, collections, revenue management and patient insurance matters. Insurance reimbursement for dialysis treatments was a major component of ARA’s revenue. ARA was traded on the NYSE until it was acquired by a private equity firm in 2021. Key metrics for the industry were DSO, or days sales outstanding, and RPT, or revenue per treatment, as well as adjusted EBITDA-NCI (excluding non-controlling interests). According to the SEC, these metrics were especially important to investors and analysts, and ARA regularly touted its performance on these metrics, such as its consistently low DSO, to potential new doctors and in its SEC filings and earnings calls.
As described in the complaint, at the core of the alleged fraud was the company’s methodology for estimating and using “topside adjustments.” For companies with which ARA had a contract, ARA could simply book revenue at the pre-determined rate. However, where there was no contract or agreed-upon rate, ARA used a two-step process: First, ARA made an initial estimate of revenue that it would receive. Second, ARA would make a “revenue adjustment to true up the initial estimate to the amount actually collected,” as required by GAAP. These adjustments, which could be positive or negative, were called “topside adjustments.” Under ARA’s stated methodology as described in the company’s internal accounting controls, topside adjustments were to be based on a detailed patient-level analysis that entailed “a comparison of the actual payments received for a particular patient’s course of treatment to the prior estimates of what those payments would be.”
The SEC alleged that, after the departure of the former COO (who apparently followed a process for topside adjustments with which no one seemed familiar, but is not a subject of the complaint) at the end of 2016, the finance executives developed their own process for revenue recognition and topside adjustments, which the SEC characterized as “little more than a fraudulent scheme [to book] millions of dollars in topside adjustments that were not based on patient-level detail, but instead booked to meet predetermined financial metrics….[The executives’] decision to use this top-down approach, not based on any patient-level detail, was highly unreasonable and represented an extreme departure from the standards of ordinary care.” This decision, the SEC charged, to use a “top-down approach to book the revenue [an executive] wanted ARA to have, rather than building revenue up from actual patient-level data, was the heart of the topside scheme.” Other allegedly improper accounting practices identified by the SEC to be part of the scheme were “a) banking identified topside adjustments for use in future quarters, b) spreading out topside adjustments across multiple months, including across different quarters, and c) finding and/or creating offsetting topside adjustments between clinics in order to have a net zero effect on overall revenue and DSO.”
In particular, the executives created a “Contractual Adjustments” spreadsheet, which, the SEC alleged, functioned as a “cookie jar” that ARA used to “find topside revenue when needed. (See this PubCo post and this PubCo post for discussions of other cases involving cookie jars.) As of July 2018, ARA had identified $35.7 million in net overcollections related to services performed in Q2 2018 or earlier, but had only recorded $29.6 million by the end of Q2 2018. The remaining $6.1 million, comprised of $10.2 million in unbooked over-collections and $4.1 million in un-booked under-collections, was carried forward into future quarters by means of the cookie jar Contractual Adjustments spreadsheet.” As alleged by the SEC, the improper topside process was used to target DSO, as well as to achieve a specific target for consolidated RPT. To that end, the SEC charged, one of the executives instructed another to “find” enough revenue in topside adjustments to achieve ARA’s budgeted RPT metric, about $3 million in topside adjustments. The SEC cited in support internal emails carrying out that instruction and an employee (who was subsequently fired) questioning the propriety of the action. The SEC also alleged that the executives failed to disclose their topside adjustment practices to the company’s audit firm, created false documentation to support their adjustment methodology and signed false certifications.
The level of net topside adjustment continued to increase dramatically through the first three quarters of 2018, representing 92% of reported net income and 280% of restated net income, when an SEC inquiry led to an internal investigation and a financial restatement “showing material changes in almost every financial metric.” According to the complaint, the restatement admitted that the company had not complied with GAAP and had material weaknesses in its internal controls. The stock price dropped.
According to the complaint, the finance executives received inflated equity and cash bonuses based on financial statements that falsely reflected achievement of performance metrics. (As a result of the restatement, the company’s former CEO, who was not charged, returned almost $900,000 in compensation.)
The SEC’s complaint makes 16 claims against the defendants, including violations of the antifraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act; Section 13(a) and Rules 12b-20, 13a-1, 13a-11 and 13a-13 for reporting violations; Section 13(b)(2)(A) for failure to maintain accurate books and records; Rule 13b2-1 for falsifying books and records; and Exchange Act Sections 13(b)(2)(B) and 13(b)(5) for failure to maintain adequate, and knowingly circumventing, internal accounting controls. Most of these claims also included separate aiding and abetting claims against some or all of the finance executives. The complaint also charges some or all of the finance executives with making false statements to auditors, including signing false management representation letters, in violation of Rule 13b2-2(a) and signing false certifications in violation of Rule 13a-14. There were also charges under the clawback provisions of SOX 304(a), as a result of the restatement due to misconduct.
ARA agreed to settle by consenting to a permanent injunction and a $2 million civil penalty, all subject to court approval. The SEC is seeking permanent injunctive relief, disgorgement with prejudgment interest, civil penalties, reimbursement under SOX 304(a) and officer and director bars against the finance executives.
For more information about securities litigation, see the Cooley Securities Litigation + Enforcement blog.