Corporate governance roles and financial reporting stress

The Securities and Exchange Commission recently settled an action through a cease and desist order against Calumet Specialty Products Partners, related to reporting misleading financial results in a quarterly press release.

Calumet is a producer of specialty hydrocarbon products, headquartered in Indianapolis. The facts for the action are described in the SEC’s Accounting and Auditing Enforcement Release No. 4102.

What’s most notable about the case is that Calumet seemed far from ready to issue its financial results when it released misstated financial results for the year ending Dec. 31, 2017, in its March 2018 earnings release. Yet no one stopped the release.

Per the AAER, Calumet issued the results in response to significant pressure from investors.

Needless to say, Calumet’s corporate governance system and disclosure controls failed to stop the company from releasing the flawed results, raising questions about the responsibilities of those involved, including management, the board and the audit committee.

Of significance, the release highlights the pressures on ordinary governance roles when a public registrant is dealing with financial reporting stress.

Overview of reporting failure

Calumet’s reporting failure followed systems problems, turnover of key people, a prior filing delay, and known internal control weaknesses. Any one of those situations would present material challenges for a public registrant’s financial reporting function, while the combination creates a recipe for failure unless the situation is tightly managed.

Calumet systems problems were disclosed in its financial statements for the quarter ended Sept. 30, 2017. In the filing, the company described problems with its implementation of a new enterprise resource planning — or ERP — system that resulted in various “operating and reporting disruptions, including limitations on [Calumet’s] ability to ship product and bill customers, project [its] inventory requirements, manage [its] supply chain, maintain current and complete books and records, maintain an effective internal control environment and meet external reporting deadlines.”

Adding to Calumet’s systems problems, three senior finance and accounting managers, including the company’s interim controller, resigned during the fourth quarter of 2017.

The combination of the systems problems and the turnover likely also caused the third quarter filing to be seven weeks late, a filing that reported internal control weaknesses for the failure to exercise sufficient corporate governance and oversight, as well as the failure to design effective controls over the ERP implementation.

Per the AAER, Calumet investors, concerned that Calumet would not be able to disclose its year end 2017 financial results on time, began pressuring the company to issue its earnings release in early March, consistent with the timeframe Calumet achieved in prior years.

Complicating matters, Calumet’s auditors advised the company on March 1 that its problems with closing of the books and records warranted another internal control weakness disclosure.

Yet, despite the stresses on its financial reporting function, Calumet acquiesced to the investors’ pressures and issued an earnings release on March 8, 2018, announcing the company’s 2017 financial results. However, on March 19, 2018, Calumet disclosed that its earnings release from March 8 was wrong. Calumet’s shares declined over 8 percent that day.

Subsequently, on April 2, 2018, Calumet filed its 2017 Annual Report on Form 10-K, reporting materially different results from what had been reported in the March 8 earnings release. In its corrected results, Calumet reported 2017 earnings before interest, taxes, depreciation and amortization (EBITDA) that was $18.7 million lower (approximately 7.6 percent), and a net loss that was $18.7 million greater (approximately 18 percent) than what it reported on March 8.

According to the AAER, Calumet’s errors directly related to problems with the company’s ERP implementation and other internal control weaknesses.

To assess who bore the greatest responsibilities to stop the flawed earnings release from being issued involves assessing both traditional roles and responsibilities, as well as how those roles may shift when under the stresses described above.

Management

Importantly, management carries the primary responsibility to prepare a company’s financial statements and present the company’s financial condition and results of operations along with presenting proper disclosures. This responsibility includes establishing and maintaining the company’s internal controls over financial reporting and the company’s disclosure controls and procedures.

The SEC’s release reveals numerous problems at the company that would have put the board and audit committee on high alert to exercise their oversight functions in the most cautious manner.

From simply reading this definition, one may quickly conclude that management bears the greatest responsibility for the issuance of the flawed earnings release.

However, the SEC’s release reveals numerous problems at the company that would have put the board and audit committee on high alert to exercise their oversight functions in the most cautious manner.

Board of directors

The board of directors oversees the company’s management and business strategies. While boards delegate the responsibility for operating the company’s business to senior management, boards are responsible for oversight of a company’s activities.

Importantly, boards need to be adequately informed in order to fulfill their oversight role related to the company’s financial statements, a critical consideration when boards are dealing with company crises. Of significance, the distinction between oversight and assisting in management can be blurred during such crises and when boards engage more actively in major decisions.

In defense of the Calumet board, in the ordinary course it would be justified in fulfilling its oversight role by inquiring of management if the earnings release was fairly stated and ready for issuance. However, when reading the extent of the company’s reporting problems, and knowing the audit was still underway, it does appear there were sufficient grounds for the board to challenge management’s judgements and stop the issuance of the earnings release.

The board’s assessment in this situation would be led by the audit committee, which is the subset of the board that provides expertise on financial reporting matters and is comprised of board members who meet financial literacy standards, including one or more committee members who qualify as audit committee financial experts.

Presumably, Calumet’s full board relied on its audit committee in forming its judgements, so let’s consider the role of the audit committee for the faulty earnings release.

Audit committee

On behalf of the board, the audit committee should be aware of significant issues relating to the company’s financial statements, discuss the issues with management, and be in control of the outside auditor relationship. Audit committees should review earnings press releases before they are issued.

The audit committee should be satisfied that the financial statements and other disclosures prepared by management fairly present the company’s financial condition and results of operations.

The audit committee also oversees the company’s system of internal controls over financial reporting and should be knowledgeable of any significant deficiencies or material weaknesses in internal controls and apprised of action plans for corrections and improvements.

Overall assessment

Unfortunately, we have only the facts presented in the SEC’s release, and additional facts may change our assessment, including the advice and/or consultation with the independent auditor. That said, even recognizing management’s primary responsibility for the financial statements, the audit committee, as the board’s financial and accounting experts, seems to bear the greatest responsibility to have stopped the flawed results from being issued.

The combination of the finance function turnover, internal control weaknesses, and ERP systems problems, plus the apparent unfinished audit procedures as of the issuance date, would present such significant risks that the audit committee should have advised the board that a delay would be necessary.

Even though this assessment is made with the benefit of hindsight and knowledge of the flawed results, one should not deliver financial results to the market at anything less than a full confidence level.

Suggestions for legal counsel

The SEC’s enforcement action doesn’t mention the role of legal counsel for the company, board or audit committee, even though one would expect each had legal representation. Suggestions for legal counsel to pursue under similar circumstances include:

• Interview staff personnel in the financial reporting function as to the completeness of their efforts, major open items, and their comfort level in the financial information presented as of the earnings release date.
• Inquire whether company officers sign the equivalent of Section 302 of the Sarbanes-Oxley Act of 2002 certifications, which require that the information presented in the earnings release is accurate and complete and that management has established and maintained adequate internal controls for public disclosures.
• Assist the audit committee in discussions with the independent auditors regarding the status of their audit, open issues, ongoing internal review processes, and, importantly, estimated date for completion.
• Inquire of public relation and communication specialists regarding comparable delayed messaging.
• Formally report to the company on the legal, regulatory and financial consequences of the earnings release delay, versus the risks of prematurely issuing an earnings release that may be erroneous.
• Finally, engage financial reporting experts who can assist and advise on the readiness of the financial information and risks created by the control failures.

Joseph J. Floyd, a CPA and attorney, is a partner and co-founder of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise.