A recent Securities and Exchange Commission (SEC) internal controls enforcement action drew my attention. It was not a Foreign Corrupt Practices Act (FCPA) enforcement action but it certainly does have implications for a Chief Compliance Officer (CCO), compliance practitioner and corporate compliance function. It involves General Motors (GM). In the SEC Press Release it noted the company agreed, in a Cease and Desist Order (Order), “to pay a $1 million penalty to settle charges that deficient internal accounting controls prevented the company from properly assessing the potential impact on its financial statements of a defective ignition switch found in some vehicles.”
In the Press Release, Andrew M. Calamari, Director of the SEC’s New York Regional Office, stated, “Internal accounting controls at General Motors failed to consider relevant accounting guidance when it came to considering disclosure of potential vehicle recalls. Proper consideration of loss contingencies and assessment of the need for disclosure are vital to the preparation of financial statements that conform with Generally Accepted Accounting Principles [GAAP].” All of this revolved around the manner in which the company handled loss contingencies such as a potential vehicle those when a vehicle recall might arise.
GAAP, whose principal source is the Accounting Standards Codification (“ASC”), requires automobile manufacturers to assess the likelihood of whether a potential vehicle recall will occur, then “provide an estimate of the associated loss or range of loss or otherwise provide a statement that such an estimate cannot be made.”
ASC 450 provides guidance for the recognition and disclosure of a loss contingency. The ASC defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. The term loss, as used in ASC 450, includes many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses.” The standard goes on to require companies to “assess the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability is remote, reasonably possible or probable. “Probable” means the future event or events is likely to occur. A loss is considered “reasonably possible” when the chance of the future event or events occurring is more than remote but less than likely. A loss is considered “remote” when the chance of the future event or events occurring is slight.”
The Order found “the company’s internal investigation involving the defective ignition switch was not brought to the attention of its accountants until November 2013 even though other General Motors personnel understood as early as the spring of 2012 that there was a safety issue involving the ignition switches in certain car models. This meant that during at least an 18-month period, GM accountants did not properly evaluate the likelihood of a recall occurring or the potential losses resulting from a recall of cars with the defective ignition switch.”
GM had what can only be charitably termed as a Byzantine procedure for making such an assessment. There was a “Field Performance Evaluation, or “FPE,” process. The FPE process included an investigation and, when merited, a recall decision-making process that relied on three committees.” The first committee was the investigative team which gathered information and passed their gathered information up to the “Field Performance Review Committee (“FPERC”), which made a preliminary determination about whether an issue qualified as a safety defect and made a recommendation regarding recall decisions” up to the next level; which was the “Executive Field Action Decision Committee (“EFADC”), which made a final recall decision.”
Unfortunately, this process did not end with the EFADC. If the issue was accepted as a recall by this committee it was placed on something called the “Emerging Issues List” and under ASC 450, the issue was “probable and estimable” for accounting purposes and it was reported to another group called the “Warranty Group”, which was “responsible for the accounting treatment of possible losses related to potential” issues. But it only made it to this financial reporting group if and when the EFACD made a final determination. If the investigation determined much earlier that a recall was warranted this earlier information never made it to the Warranty Group.
When it came to the ignition switch issue, GM was aware of the issue some two years before it began to accrue for the recall. It was made aware of the issue when a GM engineer discovered the existence in a deposition from an unrelated civil action. Not reporting it was a violation of ASC 450. The Order stated, “by not devising and maintaining a system of internal accounting controls sufficient to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles.”
The implications from this case in FCPA enforcement actions involving the SEC are clear cut. Recall the standard requires a company to “assess the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability is remote, reasonably possible or probable. “Probable” means the future event or events is likely to occur. A loss is considered “reasonably possible” when the chance of the future event or events occurring is more than remote but less than likely. A loss is considered “remote” when the chance of the future event or events occurring is slight.”
If the SEC looked at the filings of issuers around their FCPA disclosures how many would meet this standard? My suspicion is not many. This SEC enforcement puts additional pressure on an organization in several different areas. Obviously the first around the decision to self-disclose (or not) which is already fraught with many different trap-doors. Now overlay this accounting requirement to accurately record and then forecast.
Looking at it from the opposite perspective what if the accounting side of the house makes a disclosure under this requirement without consulting compliance or legal. How do you think the SEC might feel about a company if they read such a disclosure in a K or Q filing? Finally, what about the internal controls that GM set by way of its investigative committee structure? What if information is turned up clearly showing a FCPA violation yet the investigator cannot make that determination and is even hamstrung in getting up the line to the proper committee for further review and reporting?
This case emphasizes not only the need for robust, functioning and effective internal controls but also demonstrates how an aggressive posture by the SEC can bring a routine corporate action into an enforcement action.
How ineffective internal controls can lead to failures in accounting provisions leading to a SEC enforcement action.Click to tweet
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© Thomas R. Fox, 2017