SEC Ramping Up Technology to Uncover Accounting Fraud

In August 2021, the Securities and Exchange Commission announced a $6 million settlement with Healthcare Services Group, Inc. for accounting and disclosure violations related to inflating the company’s quarterly earnings per share (EPS).

This is the third enforcement action of its kind resulting from the SEC’s Division of Enforcement “EPS Initiative,” which the SEC describes as using “risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices.”

Details of the enforcement action from the SEC:

The SEC's order finds that in 2014 and 2015, HCSG, a provider of housekeeping, dining, and other services to healthcare facilities, failed to timely accrue for and disclose material loss contingencies related to the settlement of private litigation against the company, as required by US Generally Accepted Accounting Principles. By failing to properly record the loss contingencies in the appropriate quarters, which would have had the effect of reducing the company's income, HCSG reported EPS that met to the penny or came close to meeting research analyst consensus EPS estimates and reported multiple quarters of EPS growth, including then-record-high EPS. According to the order, HCSG's former CFO John C. Shea failed to direct the recording or disclosure of the loss contingencies on a timely basis. The order also finds that HCSG's Controller, Derya D. Warner, made other accounting entries that were not supported by adequate documentation as required by company policies.

Healthcare Services Group, Inc. and its former CFO John Shea and controller Derya Warner share in the costs of the settlement, agreeing to pay civil penalties of $6 million, $50,000, and $10,000, respectively.

The SEC reported that “Shea also has agreed to be suspended from appearing and practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies.”

The SEC’s Approach to Accounting Fraud Is Evolving

The agency’s EPS Initiative showcases how the agency is using data analytics to uncover accounting issues at public companies.

Gurbir Grewal, director of the SEC's Division of Enforcement, said of the latest enforcement action that “we will continue to leverage our in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations."

When these anomalies are discovered, public companies can expect that the next step is an investigation.

The SEC started to discuss its EPS initiative after the program’s first two enforcement actions in 2020. This initiative is yet another step in the agency’s plans to improve the way in which it can conduct surveillance on fraud.

The SEC’s use of technology to detect potential corporate fraud is not new. Recall that back in 2013, the SEC was talking about its use of big data analytics as part of its “Accounting Quality Model,” a project that took advantage of the SEC’s ability to mine its own data.

Another example of the SEC using data analytics to uncover fraud is based on a popular academic research paper on earnings per share data. The research found that of 951,612 quarterly earnings reports, there was a striking absence of the number 4 in the tenth of a cent decimal when it came to accounting practices leading to EPS disclosures (dubbed “Quadrophobia” by the researchers).

The absence of “4” in quarterly earnings reports piqued the interest of the SEC, which led to the agency probing select companies about it.

D&O Insurance Coverage and SEC Investigations

A reminder, if your public company is targeted due to accounting fraud, D&O insurance coverage for SEC investigations is tricky.

It’s true that D&O insurance policies typically cover individual officers and directors in an investigation, but not corporate entities (unless otherwise negotiated.) Unfortunately, investigations usually start with the entity.

Adding to the complexity of the situation is that SEC investigations tend to be “informal” for a long period of time. In an informal investigation, a company is cooperating voluntarily with the SEC. This is problematic in the insurance world because voluntary cooperation is not the type of action that the policy is designed to cover.

It is worth noting that in the current D&O insurance environment, carriers are looking for ways to contract, not expand, the scope of coverage. In other words, attempting to obtain corporate coverage for a potential SEC investigation is likely to be prohibitively expensive if it is available at all.

I discuss this issue at length and share some solutions in the article, SEC Investigations: Protecting the Company’s Balance Sheet.

As for lessons learned from this latest SEC enforcement action against Healthcare Services Group, Inc., this article by law firm Bradley Arant Boult Cummings LLP does a good job of summarizing areas of special concern for directors and officers. This includes the following admonition:

To the extent an accounting practice of adjustment makes the difference between exceeding EPS consensus or disappointing the market, these practices should be fully and robustly disclosed in the Issuer’s filings ….

This sound advice is all the more important if, as noted by Bradley Arant, a company has “consecutive periods of meeting or exceeding consensus estimates.” If these periods are followed by a precipitous decline in EPS, the company is likely to be flagged for review by the SEC’s software.

If that happens, directors and officers will be especially glad that they were extra cautious and thorough in how they handled their disclosures.