Here’s another earnings management case from SEC Enforcement, this time against Roadrunner Transportation Systems, Inc., a shipping and logistics company formerly traded on the NYSE, involving a veritable pu pu platter of alleged financial manipulations. As charged in the SEC’s Order, from July 2013 through January 2017, the company engaged in an “accounting fraud scheme by manipulating its financial reports to hit prior earnings guidance and analyst projections.” Among other things, Roadrunner was alleged to have improperly deferred and stretched out expenses over multiple quarters to minimize their impact on earnings, failed to write down worthless assets and uncollectable receivables, and manipulated earnout liabilities related to its numerous acquisitions. The company agreed to pay disgorgement of just over $7 million, with prejudgment interest of approximately $2.5 million—except that the company paid nothing additional: the penalties were deemed satisfied by the settlement payment the company made in connection with prior private securities litigation.
Background. As described in the Order, between 2010 and 2017, Roadrunner acquired, operated and consolidated over 20 transportation companies. However, by the second quarter of 2013, Roadrunner faced a number of financial challenges: several of its recent acquisitions were “underperforming,” and the company “faced mounting expenses that weighed on net earnings,” jeopardizing the company’s ability to meet consensus EPS estimates and earnings guidance. The SEC alleged that Roadrunner sought to disguise its underperformance by engaging in a “fraudulent scheme to (a) hide major expenses, (b) hide the poor performance of some of its recently acquired Operating Companies, and (c) avoid the write off of significantly overstated or impaired assets and accounts.” To that end, the company used “several fraudulent accounting techniques,” including “(a) improperly deferr[ing] recognition of known expenses to future quarters, (b) fail[ing] to write down assets and accounts that it knew were worthless (or overvalued), and (c) manipulat[ing] contingent earnout liabilities related to Roadrunner’s purchase of Operating Companies.”
When the company negotiated an acquisition, it typically included as part of the consideration an “earnout” provision—payments based on that target’s future performance—recorded as “contingent purchase obligations.” Under GAAP, the earnouts were to be recorded as liabilities in the amount of the earnout’s fair value at the acquisition date, which, in this instance, the company estimated based on the target’s EBITDA, to be adjusted at each reporting date. When an acquired company’s EBITDA declined, the SEC charged, Roadrunner should have reduced the liability, which would have both boosted EPS but also signaled that all was not well at the acquired company. However, instead of reducing the liability, the SEC alleged, Roadrunner hid the acquired company’s underperformance and created a “cushion” for future use, “fraudulently inflat[ing]” the targets’ EBITDA projections “to support overstated earnout valuations that would help Roadrunner meet analysts’ consensus EPS estimates in future periods.”
To meet EPS estimates and guidance, the SEC charged, Roadrunner also improperly deferred the recognition of known expenses, contrary to GAAP, which requires that expense liabilities be recognized when “it is probable that the liability has been incurred and the amount of the liability can be reasonably estimated.” In its Form 10-Q for the second quarter of 2013, the company’s operating expenses were “materially understated by $2.375 million, and its disclosed contingent earnout liabilities were materially overstated by approximately $2.689 million, and the adjustments to the earnout liabilities were understated by a corresponding amount,” which allowed the company to achieve its target EPS and create an earnout cushion for future quarters. On August 13, 2013, based in part on these numbers, Roadrunner sold common stock registered on a Form S-3 shelf registration statement. With regard to Roadrunner’s fourth quarter 2013 financial statements, the SEC alleged that Roadrunner engaged in similar manipulations, with the result that its Form 10-K was also materially misleading.
The SEC also charged that Roadrunner failed to properly account for known probable and reasonably estimable claims from customers for damaged shipments. The failure to properly disclose these expenses in the financials “improperly reduced Roadrunner’s historical losses used to estimate for future claims” and allegedly led to understated claims reserves and material misstatements.
In addition, Roadrunner allegedly failed to write down (and deduct from income) assets of its acquisitions that were either significantly overstated or worthless, as required by GAAP. Instead of write-offs, the SEC charged, the company developed a plan “to delay and spread the write-offs over several quarters,” but ultimately failed to do even that in some instances. In one case described in the Order, for example, Roadrunner discovered that one of its acquired companies had on its balance sheet uncollectible receivables and other worthless assets, aggregating over $7.5 million. Rather than correcting the problem, the company determined “to arbitrarily write off $2 million of the overvalued accounts by booking a $166,666 expense every month in 2015. Performance concerns led Roadrunner to delay and then abandon the plan.” One of the purposes of this plan, the SEC charged, was to conceal the write-offs from Roadrunner’s independent auditor, including through the use of allegedly false and misleading documents. These accounts were not actually written off until Roadrunner issued a restatement in January 2018. The absence of expenses recorded for customer claims and the failure to write down accounts and assets resulted in material misstatements in the company’s Form 10-Q for the second quarter of 2014, including overstatements of operating income by over $4.5 million, net earnings by at least $2.8 million and EPS by at least $0.07 per share. The same problems recurred in the third quarter, and the amount of those overstatements just about doubled.
Roadrunner also allegedly failed to write off an almost $1 million uncollectable receivable from a former large customer of an acquired company and did not properly reduce that company’s earnout reserve to reflect the loss of the customer, leaving the remainder as cushion for the future. Roadrunner also “hid the loss of this customer from its independent auditor.” As a result, the SEC charged, Roadrunner’s 2015 Form 10-K was materially misleading. According to the SEC, the combination of the improper deferral of expenses (above) and the earnout manipulation enabled Roadrunner “to hit its EPS target while hiding material expenses and concealing the underperformance of the Operating Company from the investing public.”
And another thing—the SEC also alleged that a company executive altered bonus accruals to ensure that the company did not breach the cash flow leverage ratio in its debt covenants. To avoid a projected violation, the executive instructed the acquired companies to “increase their earnings calculations by reversing annual bonus accruals in Q3 and reestablishing the entire annual bonus accrual the following quarter. This reversal, in addition to others, was sufficient to bring Roadrunner in compliance with its debt covenants in Q3 2016” and contributed to an overstatement of operating income, earnings and EPS for the quarter.
Finally, in January 2017, the company filed an 8-K announcing that it had begun an investigation “concerning potential accounting discrepancies and that its audit committee determined that certain previous financial reports had been misstated.” A year later, Roadrunner restated its financials, reporting an overstatement of net income “by more than $66 million from 2011 to Q3 2016, and a revaluation of Roadrunner’s goodwill and other intangibles resulting in non-cash impairment charges of $373.7 million.”
The company advised the SEC of the results of its investigation and did some significant remedial work. It also settled related securities litigation for $20 million.
Violations. The SEC charged Roadrunner with securities fraud under Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and related Rule 10b-5, violation of Exchange Act Section 13(a) and related rules in connection with its materially misleading periodic and current reports, books-and-records violations under Exchange Act Section 13(b)(2)(A) and violations of the internal accounting control requirements under Exchange Act Section 13(b)(2)(B). The company was ordered to pay disgorgement of $7,096,092 and prejudgment interest of $2,539,819.71; however, these amounts were deemed satisfied by the company’s payment in the litigation settlement.
