In this Order, the SEC brought settled charges against Rollins, Inc., a termite and pest control company—think “Orkin”—and its former CFO for earnings management. In essence, the SEC alleged that the company adjusted the amounts in several of its corporate reserves, without support or documentation, to bump up its EPS so that its EPS would meet analysts’ consensus EPS estimates for two quarters. The company would otherwise have missed those consensus estimates by a penny in each quarter. The SEC charged the company with securities fraud under the Securities Act, financial reporting violations under the Exchange Act and failure to maintain adequate internal accounting controls and imposed a civil penalty of $8 million. The CFO was also charged with similar violations and ordered to pay a civil penalty of $100,000. According to Gurbir Grewal, Director of Enforcement, “[t]his is the fourth action and the highest penalty to date against an issuer in connection with the Division of Enforcement’s highly successful and continuing EPS Initiative, which uses data analytics to uncover hard-to-detect accounting and disclosure violations by public companies….The SEC staff’s ever-increasing sophistication with data made today’s action possible and underscores that we will continue to pursue public companies that lack adequate accounting controls and engage in improper earnings management practices.”
According to the Order, the company had historically promoted the consistency of its earnings growth, touting in a 2017 earnings release that it was reporting its “45th consecutive quarter of improved revenue and earnings.” Like many companies, the company and its management also regularly tracked its earnings performance against analyst estimates. The company maintained several reserve accounts—such as its termite reserve, for claims related to termite control services—which were reassessed each quarter to determine the appropriate reserve amounts. As alleged by the SEC, “[i]n practice, the CFO had the final and ultimate authority to determine the appropriate amount of the corporate-level reserves.”
Typically, on the fifth day after the end of each quarter, the company would receive a “flash report” showing preliminary financial results, including EPS, and, on the next day, finance personnel, including the CFO, would meet to finalize the corporate reserves. The SEC alleged that, at these meetings, the CFO “discussed the impact that proposed adjustments to the corporate-level reserves would have on the company’s reported EPS. Moreover, in quarters where the fifth day flash report reflected that the company’s preliminary EPS calculation was short of consensus EPS estimates, [the CFO] and other finance personnel discussed whether any corporate-level reserves could be reduced in order to increase net income, and by extension the company’s reported EPS.” And that, according to the SEC, was consistent with how the CFO was schooled on the quarterly close process at the company when he first took over as CFO in 2015: a then-executive “advised that, for a particular reserve account, ‘[y]ou give up positive adjustments at qtr end that offset negative surprises’ and ‘[s]ome quarters you need flexibility and it is good to know a place where you might have it. It’s part of the art of the close.’ In other communications with [the CFO] in 2019, the executive wrote that Rollins ‘need[ed] to keep something in that cookie jar for quarters like this.’” The CFO used a spreadsheet, given to him by the executive “to avoid ‘surprises’ at the end of the quarter,” which “included an embedded calculation on how to impact EPS ‘[by 1 cent]’ by adjusting various corporate-level reserves during the quarterly close process.”
As alleged in the Order, the flash reports for the first quarter of 2016 and the second quarter of 2017 showed preliminary EPS below consensus estimates. In discussions regarding the unexpected lower income for Q1 2016, a finance employee observed that the termite reserve, which was causing higher expenses, was the “biggest driver.” The CFO “responded that he had ‘room to look’ in the termite reserve for additional income,” and later “directed a $1.3 million reduction of the termite reserve account,” as well as reductions in other reserves. The SEC charged that the CFO directed these reductions to reserves “without adequately documenting the basis for their reductions and without consideration of any accounting criteria or guidance.” EPS reported for that quarter rounded up to $0.15, which just met consensus estimates; without the reserve adjustments, the company would have reported EPS of $0.14, which would have missed consensus EPS estimates by one penny.
Similarly, the SEC charged, adjustments to various reserves were made to boost EPS for Q2 2017. According to the Order, when the initial reserve adjustments did not quite cut it, the CFO asked what he was missing. A finance employee advised that if he was “trying to get to [$].25 [consensus EPS] for the qtr it will take about [another] $1.2 million,” and asked whether the CFO wanted to make additional reserve reductions in that amount. The CFO directed that additional reductions to reserves be made, until finally the target EPS was reached. These adjustments were also made “without adequately documenting the basis for their reductions and without consideration of any accounting criteria or guidance.” In one instance regarding a proposed $1 million reduction in the casualty reserve account, the SEC alleged, company risk personnel had initially advised against any adjustment to that account for Q2, but later in the day reversed that objection. Following these adjustments, the company reported EPS that rounded up to $0.25, consistent with the consensus estimates; in the absence of the adjustments, the company would have reported EPS of $0.24, which would have missed consensus estimates by one cent.
According to the Order, the “inadequately supported reserve adjustments” caused the company to misstate its net income and EPS in its Forms 10-Q for the Q1 2016 and Q2 2017 and in its earnings releases for these quarters. The CFO also signed and certified these Forms 10-Q.
The SEC alleged that the company did not adequately document or memorialize sufficient bases for the reserve adjustments. While the company had policies and procedures that required adequate supporting documentation, the finance staff—some of whom, the SEC said, did not have the requisite level of accounting knowledge, experience and training—failed to follow them and recorded manual journal entries with no or inadequate supporting documentation, according to the Order. The SEC also alleged that the company “lacked procedures to ensure that the accounting personnel received necessary information to properly record and document quarter-end reserve adjustments.” Accordingly, the SEC charged, the company failed to maintain adequate internal accounting controls over its reserves, manual journal entries and period-end adjustments, with the result that its “internal accounting controls were not designed or maintained to provide reasonable assurance that Rollins’ financial statements would be presented in conformity with GAAP, and it further failed to maintain internal control over financial reporting.” Similarly, the SEC alleged, the company’s books, records and accounts were inaccurate and failed to “fairly reflect, in reasonable detail, Rollins’ transactions and disposition of assets.”
The SEC charged that the company committed securities fraud in violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act, and also violated the reporting provisions of Section 13(a) of the Exchange Act and related rules, which do not require scienter. In addition, the SEC charged the company with books and records violations under Section 13(b)(2)(A) of the Exchange Act and internal accounting controls violations under Section 13(b)(2)(B) of the Exchange Act. The SEC also charged the CFO with securities fraud under Sections 17(a)(2) and 17(a)(3) of the Securities Act and with internal controls and books and records violations under Section 13(b)(5) of the Exchange Act and Rule 13b2-1, as well as with causing the company to commit the violations above. The company agreed to pay a civil penalty of $8 million and the CFO agreed to pay $100,000.
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