On Wednesday, Aug. 3, 2022, the U.S. Securities and Exchange Commission (“SEC”) sued the former CEO of RTI Surgical Holdings, Inc. (since renamed Surgalign Holdings, Inc. [“SHI”]), in the Federal Court for the District of Columbia, and instituted administrative and cease-and-desist proceedings (the “Proceedings”) against both the former SHI CFO and SHI itself. In both the judicial and the administrative proceedings, the Commission alleged that SHI and its executives had engaged in disclosure fraud in connection with periodic reports filed with the SEC and with public statements about SHI’s business and results. Further, the Commission asserted that SHI and its executives had engaged in material accounting fraud during the period running from the first quarter of 2015 through the second quarter of 2016 (the “Relevant Period”). These charges resulted in the termination of both executives and the restatement, in 2020, of SHI’s financial statements from 2014 through 2019.
The integrity of financial information about publicly traded companies is perhaps the most important focus of the SEC, as that information is the way both the investing public and other businesses assess the financial condition, the performance, and the capacity for future actions of those companies. Hence, it is predictable that the Commission has a variety of regulations and guidance requiring public companies to engage in substantial self-analysis, the results of which must be disclosed to investors in periodic reports filed with the SEC. In tandem, those regulations and guidance pieces also constrict public companies from manipulating or concealing material financial information. I have written previously about these issues in a May 9, 2022, Blog, “Penny Pest Control: Rollins, Inc., Pays $8 Million for Managing Earnings,” and again in a Blog on Sept. 2022, “Book Cooking Consequences: SEC Sanctions Corporate Executives and Outside Auditors for Accounting Fraud.”
One of the key SEC regulations relevant to these concerns is Item 303 of Regulation S-K, adopted under Section 13(a) of the Securities Exchange Act of 1934, as amended (the “34 Act”), which requires reporting companies to complete a Management Discussion and Analysis (the “MD&A”) part of each quarterly and annual report file with the SEC. A key source of SEC guidance about financial information is Staff Accounting Bulletin (“SAB”) No. 99-Materiality, issued Aug. 13, 1999, as augmented by the recent gloss on that SAB from Paul Munter, the Acting Chief Accountant of the SEC in his March 9, 2022, Statement “Assessing Materiality Focusing on the Reasonable Investor When Evaluating Errors.” Both regulation and guidance insist on consistency and accuracy.
MD&A regulations particularly applicable to this case include the following:
- disclose “any known trends and uncertainties… reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income.”
- the “discussion and analysis shall …focus on material events and uncertainties … that would cause reported financial information not…to be indicative of future …results or…financial condition.”
- Management must “reveal the underlying material causes of the matters” disclosed, including “underlying reasons…or interrelationships between constituent elements”.
The recurring use of the word “material” is not an accident; it is a watchword of disclosure regulations. Furthermore, as made clear in SAB 99, the determination of whether something is “material” requires both a quantitative AND a qualitative analysis.
SHI is a Delaware corporation headquartered in Deerfield, Illinois, whose stock is traded on NASDAQ. It manufactures surgical implants, such as orthopedic and spinal implants, and sells its products primarily to major medical product distributors for resale in connection with operations. The SEC Complaint against the SHI CEO notes SHI mostly relies “on advance orders …typically placed … three months in advance.” Customers “specified their delivery dates based on their predictions of the demand for …[SHI] products, their capacity to inspect and store the …[SHI] products, and other factors.” The relevant Section of the Accounting Standards Codification (“ASC”), which sets out the rules under Generally Accepted Accounting Principles, requires that a selling company “satisfy four elements” in order to recognize revenue – i.e., when is a sale completed: a) persuasive evidence of an arrangement to sell the product; b) reasonable assurance of payment; c) delivery to the buyer (where the buyer takes title and assumes the risk of ownership); and d) the price is fixed or determinable. If one or more element is not met, the sale has not been completed and revenue may not be recognized.
The Complaint alleges that during the Relevant Period “The CEO … masked disappointing sales numbers…by urging his subordinates to ship future orders ahead of schedule and report the revenue early. Recognizing revenue for early shipments jeopardized…[SHI’s] ability to meet its revenue guidance for future quarters and alienated its customers, who demanded discounts to accept product early and reduced their subsequent orders, putting …[SHI] further behind its aggressive revenue projections. The Complaint goes on to allege that the CEO “repeatedly misled the market, in both …[SHI’s] periodic filings and his own public statements, to conceal the truth behind…[SHI’s] seemingly robust revenues.”
The CEO came to SHI in 2001 when he was 42, after a 20-year career managing corporate businesses, including serving as Controller, Vice President of Finance, Division President, and Chief Operating Officer of a “large medical technology company.” The fact that he served as both the Controller and, notionally, later Vice President of Finance, for a large company indicates that he had experience and skills in finance, and would be especially knowledgeable about the requirements of the ASC, SAB 99, and MD&A. Why, one might ask, did he at age 56 decide to cause the performance of SHI to LOOK so much better (running to the $100’s of millions) than it really was? This type of “pull forward” accounting abuse was euphemistically termed “order book management” by the CEO. The Complaint does not assert misconduct by him before the Relevant Period, but the fact that SHI eventually had to restate its financial statements beginning with 2014 suggests that the CEO was not complying with the securities laws by then. Indeed, the order issued in the Proceedings recites that SHI was engaged in “order book management” from 2014 through 2019. The Complaint asserts that the CEO “knew that he would receive bonus compensation in the form of cash and stock awards if …[SHI] hit its revenue targets.” He did receive a bonus in March of 2016 of $208,622 cash and over 275,000 shares of SHI stock. He sold some of that stock during the Relevant Period, and after leaving SHI in December 2016, he sold over $6 million of SHI stock. The Complaint notes that those sales occurred before SHI restated its financial.
The CEO was charged by the Commission with a veritable encyclopedia of securities law violations including the following:
- Section 10(b) of the Securities Exchange Act of 1934, as amended (the”34 Act”) and Rule 10b-5 thereunder;
- Section 17(a) of the Securities Act of 1933, as amended (the “33 Act”);
- 34 Act Rule 13b2-1 falsifying records;
- 34 Act Rule 13b2-2 lying to the outside auditor;
- Section 13(b)(5) of the 34 Act violating the record-keeping requirements;
- Rule 13a-14 of the 34 Act falsely certifying (as required by Sarbanes-Oxley) that there were no false statements in SHI’s periodic reports;
- Section 304 of Sarbanes-Oxley requiring reimbursement of an issuer for any bonuses received when the issuer’s financial statements are in material non-compliance with any reporting requirements;
- Sections 17(a)(2) and (a)(3) of the 33 Act materially aiding and abetting SHI’s securities law violations;
- Section 13(a) of the 34 Act and Rules 12b-20, 13a-1, 13a-11, 13a-13 thereunder by materially aiding and abetting SHI’s violations of accounting standards; and
- Sections 13(b)(2)(A) and 13(b)(2)(B) of the 34 Act by materially aiding and abetting SHI’s failure to maintain required records.
Based on the foregoing, the Commission requested that: the Court find the CEO liable; permanently enjoin him from future violations of the securities laws; order him to pay a civil penalty as provided under the 34 Act; order him to disgorge all ill-gotten gains plus prejudgment interest; order him to reimburse all bonuses received with respect to the Relevant Period; and permanently bar him from serving as an officer or director of a public company.
The Proceedings led to the entry of the Aug. 3, 2022, SEC order (the “Order”) that asserts SHI was using pull forward sales reporting techniques from 2014 through 2019. The former SHI CFO, who resigned in September 2017, is a 58-year-old former CPA (the Order notes his license lapsed in 1989). He is charged in the Order with being part of SHI senior management who overrode employee concerns about the use of “order book management” to manipulate the reported revenue and earnings of the company. More generally, he is charged with helping the CEO materially misstate SHI results and with failing to disclose both the falsified information and the adverse impact on SHI customer relations. The Order lays out in detail the timing and amounts of the misreported “sales.” The Order notes that SHI sold stock during the period before the rested financials were issued, including under an employee stock purchase plan, and issuing share compensation under employee incentive plans. Similar and extensive record-keeping violations are identified, akin to those outlined in the Complaint.
The Order finds that the CFO and SHI engaged in securities law violations essentially duplicative of those cited in the Complaint. The SEC notes that SHI provided “substantial cooperation” to the Commission during the SEC investigation of this matter, “including by disclosing information about conduct that the [SEC] staff had not yet uncovered” and “conducting an internal investigation regarding…[that] conduct.” Nonetheless the Commission imposed sanctions on both the former CFO and on SHI, to which they consented.
The CFO is ordered: to cease and desist from future violations of the cited securities law provisions; barred from practicing as an accountant before the Commission with a right to apply for readmission after five years; reimburse SHI $206,831 for stock-based compensation received from SHI (as required by Sarbanes-Oxley Section 304); and pay a civil penalty of $75,000. SHI is ordered to cease and desist from future violations of the cited securities law provisions and to pay a civil penalty of $2 million. In addition, the SEC’s Aug. 3, 2022, Press Release reports that three other “former” SHI executives “returned” $361,000 of incentive-based compensation.
If one were to ponder the motivation of all the SHI senior management, one would necessarily focus on their willingness to sacrifice accuracy in the interest of personal financial rewards. One hopes their fixation on the profit motive did not affect the design and manufacture of the SHI products – no surgical patient would want to receive an inaccurately made implant. Cutting corners “For a Few Dollars More” (with apologies to Sergio Leone) invites judgment AND punishment.
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