On Monday, April 18, 2022, the U.S. Securities and Exchange Commission (“SEC”) announced that Rollins Inc., an Atlanta-based provider of termite and pest control services (under such brands as Orkin and Critter Control) to both residential and customers, had settled charges that it “engaged in improper accounting practices in order to boost its quarterly earnings per share… to meet research analysts’ consensus estimates.” Rollins(the “Company”) is a global business with customers in Canada, Central and South America, Europe, the Middle East, Asia, and Australia. It had revenue for the 2021 fiscal year (ended December 31) of over $600 million and was quite profitable. Nonetheless, the SEC asserted that in the first fiscal quarter of 2016 and the second quarter of 2017, the Company, at the direction of its then Chief Financial Officer (“CFO”), reduced certain reserve accounts in order to make the analysts’ consensus profit numbers – from $0.12 per share in 2016 to $0.15; and from $0.20 per share in 2017 to $0.25. The Company paid $8 million in civil penalties and agreed to cease and desist from future violations. The CFO agreed to pay a $100,000 civil penalty, as well as to cease and desist.
What were these reserves and where did they come from? Rollins, somewhat like an insurance company, apparently had fixed charges (think premiums) for a period of coverage. If inspections found no pest infestation, then Rollins’ sole cost was for the inspections. But if infestation was found, then additional efforts and costs (for both labor and materials) would be incurred. Accordingly, Rollins had established a series of reserves: the termite, medical, outside services, bad debt, and casualty reserves, to protect it from unanticipated losses. Such reserves, referred to as “cookie jar [reserves]” in footnote 3 of the SEC’s April 18 enforcement ORDER, citing the federal prosecution in U.S. v. Rand, 835 F. 3rd 451 (4th Cir., 2016), “… [can be used in] a practice by which companies manipulate earnings by overaccruing reserve accounts in good quarters, and reducing the accruals in lean quarters to meet earnings targets.” The Rollins CFO became chief financial officer in 2015; as part of his “briefing” by another executive he was advised to use the Company’s reserve accounts to avoid unpleasant surprises, “It’s part of the art of the close.”
The use of reserves to “smooth out” financial performance has a long, if somewhat tawdry, history and was a featured part most recently of both the Savings & Loan Scandal of the late 1980’s and early 1990’s and of the Great Recession of 2007-2009, when in each case lending institutions utilized loan loss reserves (estimates of future losses on outstanding loans) to improve short-term results while the diminished reserves lost their capacity to buffer the institutions from actual losses when the loans failed. Indeed, an entire area of accounting theory is devoted to the study of, and intense debates about, so-called “earnings management.” See, for example, “What Drives Earnings Management?” by Paul Rosenfeld, Journal of Accountancy, October 1, 2000, citing then SEC Chair Arthur Levitt in 1998, that earnings management “at a number of companies…[was] in danger of undermining US capital markets”; “Smooth Move – the Manipulation of Earnings” by Kurt Schacht, CFA Institute Financial Reporting, 20 May 2011; and “What is Earnings Management?” in Investopia, January 29, 2021 (which also speaks of the use of reserve accounts, “known colloquially as ‘cookie jar’ accounts”). This human failing is not new. In 1751 Tobias Smollett in “The Adventure of the Peregrine Pickle” wrote the following:
Some falsified printed accounts, artfully cooked up, on purpose to mislead and deceive.
Accordingly, the SEC seeks to identify, expose, and punish those modern-day executives who would “cook the books” using “cookie jar accounts.” In the case of Rollins, the Commission identified the violations applying advanced data analytics as part of its Earnings Per Share (“EPS”) initiative where the data analytics are, according to the Commission’s Director of Enforcement, used “to uncover hard-to-detect accounting and disclosure violations by public companies.” The SEC Enforcement Director noted that the Rollins enforcement action is the fourth EPS brought by the Commission and the highest penalty yet imposed. The enforcement action charged Rollins, and the CFO, with violating Section 17(a)(2) and (3) of the Securities Act of 1933 by making false statements in its Quarterly Reports on Form 10-Q for each quarter involved, as well as making false statements about earnings growth in its press releases and public filings. In addition, the Company was charged with violating the financial reporting, books and records, and internal control provisions of the Securities Exchange Act of 1934. Interestingly, neither the Company nor the CFO was charged with violating Section 10(b) of the Securities Exchange Act of 1934, a charge that would have required the Commission to assert that the violations were done with scienter, i.e., intent. Section 17 of the Securities Act of 1933 requires only a showing that a statement (or omission) was false – which could include a negligent misstatement or omission. That is the probable reason that no bar was sought by the Commission preventing the CFO from serving as an officer or director of a public company. The enforcement Order notes that the CFO served as CFO from 2015 until 2021.
The Rollins enforcement action is a clear warning to every public company that manipulating earnings, even by just a few pennies, will be subjected to SEC scrutiny, and when identified, bring painful economic and reputational consequences.
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