On Tuesday, the SEC announced settled charges against Baxter International Inc., its former Treasurer and Assistant Treasurer, for misconduct related to improper intra-company foreign exchange transactions that resulted in the misstatement of the company’s net income. From at least 1995 to 2019, the SEC alleged, Baxter converted foreign-currency-denominated transactions and assets and liabilities on its financial statements using its own “convention”—not in accordance with U.S. GAAP. Then, beginning around 2009, the SEC charged, Baxter leveraged the convention to devise a series of non-operating intra-company foreign exchange transactions “for the sole purpose of generating foreign exchange accounting gains or avoiding foreign exchange accounting losses.” In the order against Baxter, the SEC found that the company violated the negligence-based anti-fraud, public reporting, books and records, and internal accounting controls provisions of the federal securities laws and imposed an $18 million penalty. In this order and this order, the SEC found that the company’s Treasurer “did not take any steps to investigate how Baxter’s treasury department generated consistent gains or whether the transactions that generated the gains were permissible,” and that the Assistant Treasurer, working with others at his direction, was “primarily responsible for executing the transactions.” The Treasurer and Assistant Treasurer were determined to have violated the negligence-based anti-fraud provisions of the federal securities laws and to have caused Baxter’s public reporting and books and records violations.
As described in the orders, Baxter is a U.S.-based healthcare products company that generates the majority of its revenue outside of the U.S. Many of the company’s subsidiaries use various foreign currencies “as they manufacture and sell products globally and transact in foreign currencies.” Under the applicable GAAP Accounting Standards Codification Topics, companies are required to measure and record foreign currency transactions initially in the company’s functional currency using the exchange rate on the date of the transaction. In addition, foreign-currency-denominated assets and liabilities are required to be remeasured at the end of each reporting period using the exchange rate at that date. But, the orders alleged, Baxter did not apply these GAAP ASCs. Instead, Baxter applied its own “FX Convention,” under which “foreign currency transactions in a given month were initially measured using exchange rates from a specified date near the middle of the previous month as opposed to the exchange rate on the date of the transaction. Additionally, foreign currency denominated assets and liabilities were subsequently remeasured at the end of each month using exchange rates from a specified date near the middle of the then current month, called ‘T Day,’ and not at the end of the reporting period.” Because of the FX Convention, the orders alleged, Baxter employees knew the exchange rates that would apply to intra-company transactions from the T Day in a given month through month-end.
Around 2009, the orders alleged, Baxter sought to manage the company’s foreign exchange rate exposure more efficiently and reduce its use of third-party derivative contracts by instead managing “its foreign currency exposures on a consolidated basis through offsetting cash positions.” To better control reported foreign exchange gains and losses. Baxter’s Treasury department developed “FX Transactions”—transactions designed solely to generate non-operating foreign exchange accounting gains or avoid foreign exchange accounting losses. Initially, Treasury used “FX Transactions to avoid losses caused by foreign exchange rate fluctuations. Over time, this practice evolved to proactively generating gains from foreign exchange rate fluctuations.” FX Transactions, according to the SEC, consisted of a series of transactions involving capital distributions, currency trades and offsetting loans designed to create a foreign exchange gain or avoid a loss at Baxter subsidiaries. After month-end, the orders alleged, the Treasury group would unwind the currency trade and the loan. Because they knew the exchange rates ahead of time, the SEC charged, Treasury personnel were able to generate specific amounts of accounting gains or avoid specific amounts of accounting losses.
The SEC orders alleged that, although the Treasurer was not involved in the development of the FX Transactions, “he became aware that there were consistent gains generated by the Treasury department in the ‘other (income) expense, net’ line. He also knew that the Treasury department sometimes entered into intra-company transactions after T Day that resulted in gains.” However, he “never considered how the Treasury department was able to consistently generate gains, or whether the transactions that generated the gains were permissible.” According to the orders, because FX Transactions had been occurring prior to his tenure as Treasurer (which commenced in 2015), “he believed that the transactions had been previously vetted and approved.” Misstatements of foreign exchange gains and losses during the Treasurer’s tenure were alleged to have been at least $245 million. In addition, according to the SEC, the Assistant Treasurer, who executed the FX Transactions, believed that they had been authorized by senior Baxter officials, but he “negligently failed to realize that it was improper to utilize Baxter’s FX Convention to execute FX Transactions for the sole purpose of generating foreign exchange accounting gains or avoiding foreign exchange accounting losses.”
According to the orders, the accounting gains generated (or losses avoided) from the FX Transactions were reported on the “other (income) expense, net” line of Baxter’s financial statements and were reflected in Baxter’s net income and EPS. From 2015 through the first two quarters of 2019, the SEC alleged, Baxter reported foreign exchange gains aggregating $286 million. The SEC charged that the improper FX Transactions inflated the company’s net income and EPS, and that Baxter “should have discovered that the FX Transactions caused materially misstated financial results.” However, the SEC alleged, Baxter did not have adequate internal accounting controls over intra-company transactions to identify the improper foreign exchange gains generated by the FX Transactions.
These practices, the SEC alleged, were brought to light in 2019 when Baxter’s Tax department asked Treasury personnel about the details of the FX Transactions. According to the orders, several months thereafter, Baxter adopted a GAAP-compliant foreign exchange rate convention and announced an internal investigation, ultimately leading to a restatement of its financial statements. In the restatement, Baxter reduced its total reported foreign exchange gains and losses from 2010 through the second quarter of 2019 by $517 million. In its 10-K for 2019, Baxter disclosed that it had a material weakness in its internal control over financial reporting related to accounting for foreign exchange gains and losses: it did not have controls that would allow the company to quantify the difference between the foreign exchange gains and losses that it reported using the FX Convention and those it would have reported using GAAP exchange rates, nor did it have adequate policies and controls for “approving and monitoring intra-company transactions to prevent or detect the FX Transactions.”
Baxter was charged with fraud in violation of Securities Act Sections 17(a)(2) and 17(a)(3), periodic and current reporting violations under Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11 and 13a-13, books and records violations under Section 13(b)(2)(A) of the Exchange Act, and failure to maintain an adequate system of internal accounting controls under Section 13(b)(2)(B) of the Exchange Act. None of these violations required a finding of scienter. In addition to hiring a new Treasurer and improving its processes, Baxter also recouped bonuses paid to the CEO, CFO, the Treasurer ($192,000) and other officers pursuant to its Executive Compensation Recoupment Policy and SOX 304 clawback provisions and paid the SEC a civil penalty of $18 million.
The Treasurer and Assistant Treasurer were charged with fraud in violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act and with causing Baxter’s periodic and current reporting violations under Sections 13(a) of the Exchange Act and Rules 13a-1, 13a-11 and 13a-13, and its books and records violations under Section 13(b)(2)(A). The Treasurer was ordered to pay a civil penalty of $125,000, and the Assistant Treasurer was ordered to pay disgorgement (related to bonus payments) and interest of about $90,000 and a civil penalty of $100,000.