In this Order, the SEC brought settled charges against Fluor Corporation, a global engineering, procurement and construction company listed on the NYSE, in connection with alleged improper accounting on two large-scale, fixed-price construction projects. Five current and former Fluor officers and employees were also charged. (The press release includes links to the orders for the five individuals.) Fixed-price contracts mean that cost overruns are the contractor’s problem, not the customer’s, and Fluor’s bids on the two projects were based on “overly optimistic cost and timing estimates.” When Fluor experienced cost overruns, the SEC alleged, Fluor’s internal accounting controls failed, with the result that Fluor used improper accounting for these projects that did not comply with the percentage-of-completion accounting method under GAAP, leading Fluor to materially overstate its net earnings for several annual and quarterly periods. A restatement ultimately followed. Fluor agreed to pay a civil penalty of $14.5 million and the officers to pay civil penalties between $15,000 and $25,000. According to the Associate Director in the Division of Enforcement, “[d]ependable estimates and the internal accounting controls that facilitate them are the backbone of percentage of completion accounting and are critical to the accuracy of the financial statements that investors rely on….We will continue to hold companies and individuals accountable for serious controls failures and resulting recordkeeping and reporting violations.”
Background. In August 2019, Fluor announced $714 million in pre-tax charges stemming from an “operational and strategic review” of sixteen projects, including two at issue in this Order. Specifically, in 2015 and 2017, Fluor won fixed-price contracts for two large-scale projects: first, the “Radford Project,” a $245 million project that required Fluor to “validate and complete the design and to build a one-of-a-kind U.S. Army facility for manufacturing nitrocellulose, an ammunition propellant,” and second, the “Penguins Project,” a $492 million project that required Fluor to “design and build a Floating Production Storage and Offloading facility for delivery to the Penguins oil and gas field located in the North Sea.”
Fluor accounted for the Radford and Penguins Projects using the percentage-of-completion method, which, under GAAP, required Fluor “to periodically recognize a project’s costs as incurred and the revenue as a percentage of the work completed to date. Under this method, for each reporting period, a project team develops dependable estimates of expected total revenues, total costs, and total project gross margin…to arrive at a project’s financial forecast (known as the Estimate at Completion or ‘EAC’).” Notably, a project “must recognize the entire amount of an anticipated loss as soon as the loss becomes evident.” To periodically record a project’s EAC, Fluor used a Project Margin Analysis Report to “document project management’s most likely current estimate of the project’s revenue, cost, and [project gross margin] forecast.” Fluor required key personnel, including some of the officers individually charged, to certify the accuracy of these Reports quarterly.
For the Radford Project, the Order alleges, Fluor received an “incomplete and flawed” design from the prior, terminated subcontractor and, as a result, by early 2016, Fluor was experiencing significant cost overruns and delay, leading to a growing spread between the anticipated total cost over the subcontract price. According to the Order, this increasing spread over the subcontract price “should have prompted Fluor to revise the EAC to reflect all the additional anticipated costs.” Instead, Fluor personnel excluded certain costs from the cost estimate in the EAC, adding costs “only to the extent that the costs could be offset by corresponding added forecasted revenues, which were determined using overly high assumed rates of recovery.” The SEC alleges “Fluor’s forecasted cost in the EAC remained artificially low and delayed loss recognition,” reflecting, in part, Fluor’s failure to maintain adequate internal accounting controls governing the Project Margin Analysis Report process.
To address the growing gap between the subcontract price and the anticipated total cost, Fluor developed change orders for approval by the customer, and then, the Order alleges, forecast additional revenue from the change orders “using overly high rates of assumed cost recovery.” However, Fluor’s actual rates of recovery from approved change orders “remained low.” The Order identifies several other accounting issues in connection with recognition of revenue from the change orders under GAAP, including problems with inclusion of revenue from unapproved change orders without sufficient evaluation and documentation under ASC 606 of whether Fluor had an enforceable contractual right to additional revenue under the change order and whether recovery was probable.
By the end of 2016, the SEC alleges, “the Radford Project was, in reality, operating at a loss,” and Fluor’s improper exclusion of costs and improper inclusion of unapproved change-order revenue led to inaccurate books and records and material misstatements in Fluor’s net earnings reflected in periodic reports for fiscal 2016 through the first quarter of 2019. According to the Order, the accounting errors on Radford caused Fluor to overstate its net earnings from fiscal 2016 through the first quarter of fiscal 2019—by as much as 37% in one quarter. The SEC also alleges that Fluor misstated the status of negotiation (or lack thereof) of a number of change orders, omitting the potential material adverse effect of an unfavorable resolution.
As described in the Order, the contract for the Penguins Project was based in part on Fluor’s subcontracting out fabrication of the floating facility. That subcontract represented about 25% of the cost of the overall contract, for which Fluor had received a binding bid. But, oops, the bid had expired prior to submission by Fluor of its total bid to the customer. As a consequence, months of negotiations on the subcontract were required, resulting in final terms that “were significantly more expensive to Fluor than anticipated the quarter before and as had been budgeted for in the contract bid.” By the middle of the second quarter of 2018, Fluor personnel “concluded that the most likely scenario for the Penguins Project was that it ‘won’t be a break-even scenario, it will be a loss.’” Nevertheless, the Order alleges, Fluor recorded the Penguin Project’s project gross margin in the second quarter of 2018 as “essentially unchanged” from the prior quarter’s project gross margin, “despite significant changes in circumstances for the Penguins Project, most notably the subcontract price with the Fabrication Subcontractor.” As Fluor subsequently reported in its restatement, the project gross margin for the second quarter of 2018 should have been a negative $19.4 million. The same occurred for the third quarter, the Order alleged, when Fluor recorded the Penguin Project’s project gross margin as roughly breakeven, although the most likely forecast at the time showed a loss of $19.8 million.
As alleged in the Order, the exclusion of costs from the forecast for the Penguins Project led to misstated books and records and material misstatements in the Form 10-Q financial statements. Because Fluor failed to recognize the losses attributable to Penguins for the second and third quarters of 2018, notwithstanding the GAAP requirement that Fluor “recognize the full amount of the forecasted loss in its Net Earnings,” the Order alleges, Fluor overstated its net earnings by 22% in the second quarter of 2018.
The Order alleges that, “[p]rompted by the SEC staff’s investigation, Fluor undertook an internal investigation in 2020 that identified material weaknesses in its internal control over financial reporting and material errors in its financial statements, and resulted in Fluor restating its annual and quarterly financial statements for its fiscal year 2016 through the third quarter of 2019.” On both projects, the Order alleges, “Fluor failed to maintain adequate internal controls over the [Project Margin Analysis Report] process. Although Fluor’s accounting policy required the project team to determine the most likely EAC, it failed to maintain this control during the Relevant Period, as personnel failed to include all costs that were known or should have been known and, from the period ending December 31, 2017 through March 31, 2019, improperly included revenue from unapproved change orders in the accounting for Radford’s EAC.” Similarly, on the Penguins Project, “costs that were known or should have been known were excluded from the EAC in the second and third quarters of 2018.”
The SEC also charged the former Senior Vice President, Controller, and Chief Accounting Officer of Fluor and certain current and former officers and employees of the two Fluor business segments responsible for the Radford and Penguins Projects, including presidents, senior vice-presidents, CFOs and controllers. Among the types of conduct charged were accepting financial estimates for Radford and Penguins that they knew or should have known materially overstated revenue; helping to generate and review, and accepting, documents required by Fluor’s internal accounting controls, but “which reflected the incorrect revenue estimates and overstated revenue”; accepting inaccurate project forecasts that they knew or should have known failed to include all anticipated costs; and providing inaccurate best-knowledge sub-certifications representing, among other things, that “the project forecasts represent management’s best estimate, and are in compliance with the applicable GAAP and Fluor’s policies.” For example, one of the Orders alleges that a former Senior Vice President of the segment responsible for the Radford Project “participated in formulating guidance, with accounting and other [segment] personnel, indicating that generally costs should be added to the EAC only to the extent that the costs are offset by corresponding additional forecasted revenues. This guidance did not comply with GAAP.” In addition, the SEC charged that he “was a cause of Fluor personnel excluding costs from the EAC, consistent with this erroneous guidance” and with supporting “the inclusion in the EAC of forecasted additional revenue from the unapproved [change orders]…using overly high rates of assumed recovery on the order’s cost component.” As a result, Fluor’s forecast cost in the EAC remained “artificially low,” which, when combined with Fluor’s “overly high” revenue forecasts “delayed recognition of a loss on the Radford Project.” He was also alleged to have signed several misleading sub-certifications. In the end, the Orders found these individuals to be a cause of Fluor’s failure to maintain an adequate system of internal accounting controls and a cause of Fluor’s filing these materially inaccurate financial statements in its periodic reports and required to pay civil penalties ranging from $15,000 to $25,000.
Violations. The SEC charged that Fluor violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13, and 12b-20 thereunder regarding material misstatements in periodic reports; Section 13(b)(2)(A) of the Exchange Act, regarding inaccurate books and records; and Section 13(b)(2)(B) of the Exchange Act regarding internal accounting controls and Rule 13a-15(a), the requirement to maintain internal control over financial reporting. Fluor was ordered to pay a civil money penalty of $14.5 million.
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