In this settled action, In the Matter of Elanco Animal Health, Inc., Elanco, a manufacturer and seller of animal health products, such as flea and tick medications, was charged with “failure to disclose material information concerning its sales practices that rendered statements it made about its revenue growth misleading.” As alleged by the SEC, “Elanco would entice distributors to make end-of-quarter purchases in excess of then-existing customer demand by offering them incentives such as rebates and extended payment terms. These incentives allowed Elanco to improve its revenue each quarter, but caused distributors to purchase products ahead of end-user demand. Without these Incentivized Sales, Elanco would have missed its internal revenue and core growth targets in each quarter in 2019.” Essentially, we’re talking here about channel stuffing. As the practice continued, it contributed over the period to “channel inventory increasing by over $100 million in gross value…during 2019, creating a build-up of excess inventory at distributors and a reasonably likely risk of a decrease in revenue and revenue growth in future periods. But, for each quarter during the Relevant Period, Elanco failed to disclose the significant impact of its Quarter-End Incentivized Sales and the reasonably likely risk that these sales practices could have a negative impact on revenue in future quarters.” The SEC charged that these disclosure failures rendered the positive statements that Elanco made about revenue materially misleading. And let’s not forget the disclosure controls violations. In settling the action, Elanco agreed to pay a civil money penalty of $15 million.
Background. As described in the Order, in 2018, Elanco was spun off from its parent company through an IPO, followed by a public exchange offer. For about 18 months beginning in January 2019, Elanco’s sales model involved selling its products to third-party distributors, which then sold them to end users, such as animal owners, veterinarians and feed lots.
Prior to the spin-off and IPO, to meet internal targets, Elanco occasionally used incentives to make quarter-end sales, but that “led to a build-up of excess inventory at distributors, as consumer demand was not strong enough for distributors to sell their excess product to end-users.” In the absence of increased consumer demand, the SEC observed, inventory build-up at distributors can result in decreases in future distributor sales. Prior to the IPO, “to more closely match channel inventory with actual consumer demand, Elanco ‘flushed’ excess channel inventory by decreasing sales to distributors until channel inventory averaged 45 days on hand.” That flushing led to a revenue decline of approximately $35 million in the quarter. By the time of its IPO, the SEC alleged, “its largest distributors targeted channel inventory of 60 days on hand.”
After the IPO, recognizing the importance of meeting financial benchmarks, Elanco personnel regularly assessed sales-to-date performance in various businesses and forecast performance necessary to meet targets. According to the SEC, by late 2018, Elanco had resumed offering to distributors incentives such as discounts, rebates and extended payment terms in an effort to meet targets, encouraging distributors to purchase products to achieve an inventory level of 90 days on hand. As alleged, that practice led distributors to reduce purchases during the first two months of the following quarter. Some employees raised concerns to management, for example, emailing “that ‘inflating inventories and kicking the can down the road will end in a reset.’”
Nevertheless, the practice continued. By the first quarter of 2019, the SEC alleged, Elanco assessed that it was not on track to meet its internal targets or external investor guidance and decided to further incentivize its distributors with extended payment terms, rebates and other incentives. Although the incentives allowed Elanco to meet its internal revenue growth targets, the company “experienced a $14 million decrease in consumer purchases from the distributors for the quarter, which together with the Incentivized Sales caused channel inventory to grow by $37 million in gross value during the first quarter of 2019.” However, in its earnings announcement and Form 10-Q for the quarter, Elanco “attributed its revenue growth in certain businesses to its sales of key products based on customer needs.” The SEC charged that these statements were “materially misleading…because Elanco failed to disclose that a significant portion of its quarterly revenue numbers were attributable to Incentivized Sales, and the reasonably likely risk that such sales practices could have a negative impact on revenue in future quarters.”
These practices continued through the subsequent quarters of 2019, with sales declines during the beginning of the quarter leading to use of increased sales incentives to meet end-of-quarter targets. But, again, there were adverse consequences. For example, the SEC alleged that, during the second quarter, “Elanco succeeded in growing end-user sales by $62 million compared to the prior quarter and $54 million year-over-year—a record level of consumer demand. Despite the record end-user demand, as a result of its continued use of Incentivized Sales, Elanco’s channel inventory levels fell by only $2 million in gross value in the quarter. If Elanco had not used Incentivized Sales, the significant increase in sales to end-users would have led to a more significant reduction in channel inventory.” However, in reporting results, the company continued to attribute the growth to “solid underlying demand for our products.”
In Q3, Elanco added a risk factor, but that apparently did not remedy the problem. Because, the SEC alleged, the risk statements were framed in the hypothetical—that is, they “described potential risks while failing to disclose the Incentivized Sales that actually occurred and the existing reasonably likely risks they created for future sales”—the SEC charged that “Elanco’s statements nevertheless remained misleading.”
In Q4, Elanco’s offer of incentives was declined by one of its largest distributors. As alleged, “a member of Elanco’s management raised a concern that Elanco’s sales practices seemed to default to loading the sales channel rather than increasing consumer demand, and that underlying demand from end users of Elanco’s products was not strong enough to reduce channel inventory.” Through incentivized sales, however, Elanco continued to meet “revenue growth targets for the quarter and achieve annual EPS within its revised annual EPS guidance range. Elanco also experienced a $36 million decrease in consumer purchases from the distributors during the quarter, which together with the Incentivized Sales caused channel inventory to grow by $44 million in gross value in the fourth quarter of 2019.” Nevertheless, during an analyst call, Elanco characterized its sales growth as “durable and resilient.” The SEC characterized those statements as “materially misleading.” By Q4, Elanco’s sales practices had “led to $100 million in gross channel inventory growth during 2019,” creating “a significant risk that Elanco would not be able to achieve future revenue growth.” As alleged, by the time of that call, Elanco “had already determined to issue lower annual revenue guidance and take steps to gradually reduce channel inventory because of the risk it posed to future revenue growth, but that material information was not disclosed.”
Finally, in Q1 of 2020, the SEC alleged, “after the onset of the COVID-19 pandemic, Elanco decided to stop offering Quarter End Incentivized Sales to its distributors and to reduce channel inventory to 60 days on hand with 60-day payment term.” Consequently, Elanco experienced a significant decrease in net sales to distributors and in revenue compared to the fourth quarter of 2019, but also a decline in channel inventory. In its Q1 reporting, Elanco announced a 10% decline in quarterly revenue. Elanco explained that most of the decline “was due to a $60 million reduction in channel inventory and that it expected an additional $80-100 million revenue decline in the second quarter of 2020.” Elanco attributed the decline to, among other things, more tight management of inventory by distributors and the impact of COVID. Elanco also reported that these issues had triggered acceleration of “an important commercial change,” including a plan to reduce channel inventory. The SEC charged that these statements were “materially misleading” because they omitted the impact on sales of the decision to stop offering Quarter-End Incentivized Sales and the impact of these incentives on channel inventory, and did not disclose that the plan to reduce channel inventory preceded the pandemic.
During the period, Elanco sold registered stock in public offerings and to employees. Elanco, the SEC charged, had acted negligently: “[f]rom May 2019 through May 2020, Elanco’s public disclosures misled investors by attributing its revenue and revenue growth to strong consumer demand for its products while failing to disclose the material impact of its Quarter-End Incentivized Sales and the reasonably likely risk that such sales practices could have a negative impact on revenue in future quarters. These failures occurred because Elanco did not act reasonably or implement disclosure controls and procedures designed to ensure that all material factors contributing to revenue and revenue growth were disclosed.”
Violations. The SEC charged that Elanco violated Sections 17(a)(2) and (3) of the Securities Act, which do not require scienter, Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11, and 13a-13 thereunder, which relate to periodic and current reports, as well as Rule 12b-20 of the Exchange Act. The SEC highlights in particular the rules for MD&A in Reg S-K Item 303, which require a discussion of known trends and uncertainties that would “cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” In the view of the SEC, Elanco’s use of Quarter-End Incentivized Sales was just such an uncertainty. The SEC also charged that Elanco violated the disclosure controls and procedures requirements of Exchange Act Rule 13a-15(a). Elanco agreed to pay a civil penalty of $15 million.
