Governace Thoughts About SEC v. Office Depot

The following is a discussion about the SEC’s Complaint against Office Depot which is an action that was recently settled. To view the SEC’s press release about the settlement CLICK HERE. At various points in the below discussion I have inserted some of my thoughts as talking point comments—my comments begin with “DT” and are bolded and italicized.

Dave Tate, Esq. (San Francisco)
Litigation & Trials, Governance, Investigations, Mediator
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I. THE SEC’S ALLEGATIONS PER ITS COMPLAINT

A. OVERVIEW

The SEC alleged that Office Depot (1) violated Regulation FD in June 2007 by selectively communicating to analysts that it would not meet analysts’ quarterly earnings estimates without issuing a press release or other public disclosure communication, and (2) overstated its net earnings in its financial statements for the third quarter of 2006 through the second quarter of 2007 as a result of accounting violations--Office Depot prematurely recognized approximately $30 million in funds received from vendors in exchange for the company’s merchandising and marketing efforts instead of recognizing the funds over the relevant reporting periods in a manner consistent with Generally Accepted Accounting Principles (GAAP). In November 2007, the company restated the above financials and announced a material weakness in its internal controls over financial reporting, resulting from the failure of its personnel responsible for negotiating agreements with vendors to communicate all of the relevant information to accounting personnel.

Office Depot is traded on the New York Stock Exchange. Its fiscal year ends on the last Saturday in December.

B. THE ALLEGED REGULATON FD VIOLATION

In pertinent part, the SEC alleged as follows (please note that the following allegations were obtained from the SEC’s Complaint—accordingly, they are only unproven allegations):

Office Depot, as a company policy, did not offer specific quarterly earnings guidance during the relevant time period.

In late 2006 and early 2007, the CEO and the CFO believed the significant earnings per share (“EPS”) growth the company achieved in 2005 and early 2006 was not sustainable and set out to temper analysts’ expectations. DT: Just an argumentative allegation, the facts that the SEC can prove are what matter.

In February 2007, during a publicly broadcasted earnings conference call, the CEO and the CFO described Office Depot’s business model, which contemplated mid to upper teens EPS growth over the long-term.

On another public conference call in late April 2007, the company warned investors that its largest business segments were facing a softening in demand that was continuing into the second quarter.

Shortly following the analysts’ publication of EPS estimates for Office Depot in late April (when most analysts lowered their estimates for Office Depot), the company reiterated at a publicly available investor conference in early May that its business model contemplated only mid to upper teens EPS growth over the long-term and that the company faced a softening demand environment.

On May 31, 2007, the CEO alerted Office Depot’s board of directors and the executive committee that the company would not likely meet the analysts’ consensus $0.48 EPS estimate for the second quarter and that senior management was discussing a strategy for advance communication to avoid a complete surprise to the market. DT: The SEC does not discuss how the board responded to this information. It is already alleged that as a policy Office Depot did not give specific quarterly earnings guidance. Arguably this is a change from that policy. Was there additional discussion about whether to go down this path, and, if so, to have the communications reviewed by counsel and approved by the investor communication disclosure committee? Was there a disclosure committee? Additionally, as alleged, the company had already commented about the softening demand environment.

Office Depot did not have written Regulation FD policies or procedures at the time. The company had also never conducted any formal Regulation FD training prior to June 2007, although its general counsel had occasionally distributed guidance and updates on Regulation FD. DT: If true, good idea to correct this, wouldn’t you say? This might also be an area of involvement for internal audit and/or governance, risk, compliance and ethics. Did the outside auditor ever recommend improvements?

In early June 2007, in response to the CEO’s May 31, 2007 notice to the board of directors, the CFO instructed the director of investor relations and his immediate supervisor to prepare a draft press release for her review previewing certain second quarter earnings information should the company later determine to issue one. By mid June 2007, certain of the company’s preliminary internal estimates forecasted up to $0.44 EPS for the quarter. The CFO and CEO were uncomfortable with issuing a press release because the company’s internal estimates were incomplete at this point. DT: More people involved. Was anyone questioning this course of action? Where is the board, counsel, disclosure committee?

On June 20, 2007, ten days prior to the close of Office Depot’s second quarter for 2007, the CEO and the CFO, both of whom had investor relations experience, discussed how to encourage analysts to revisit their analysis of the company. The CEO, in an attempt to get analysts to lower their estimates, proposed to the CFO that the company talk to the analysts and refer them to recent earnings announcements by two comparable companies that had recently publicly announced results which were impacted by the slowing economy. The CEO further suggested that Office Depot point out on the calls what the company had said to the market in April and May 2007. The CEO and the CFO jointly decided to adopt this approach. The CEO believed that if the analysts looked at Office Depot again in that light, they would come to the point of view that their estimates were too high and likely would lower them. DT: Again, as alleged, a departure from policy.

The CFO, the director of investor relations, and the director’s immediate supervisor, drafted talking points based in part on the CEO’s suggestions for use as a guide for the calls with analysts. The CEO was not asked to review the talking points and did not do so. DT: Is there oversight or involvement by anyone else? Although the allegations in this SEC Complaint were somewhat detailed, I am of the viewpoint that to the reasonable extent possible the SEC has a responsibility to investigate an alleged situation of wrongdoing to a high degree prior to bringing an action, and to then include in the Complaint all of the significant factual allegations. The SEC is an advocate, but it also has a responsibility to objectively evaluate an alleged situation of wrongdoing before bringing an action and to only bring actions that are reasonably warranted. For clarification, it would be relevant to allege that no other people were involved or exercised oversight, if that was in fact the case.

The alleged agreed upon talking points were as follows:

-Haven’t spoken in a while, just want to touch base.

-At the beginning of the quarter we’ve talked about a number of head winds that we were facing this quarter including a softening economy, especially at small end.

-I think the earnings release we have seen from the likes of [Company A], [Company B], and [Company C] have been interesting. On a sequential basis, [Company A] and [Company B] domestic comps were down substantially over prior quarters. [Company C] mentioned economic conditions as a reason for their slowed growth.

-Some have pointed to better conditions in the second half of the year – however who knows?

-Remind you that economic model contemplates stable economic conditions – that is midteens growth

On Friday, June 22, 2007, and the following Monday, June 25, 2007, the director of investor relations spoke individually with all eighteen analysts covering Office Depot and conveyed to them the information contained in the talking points. Office Depot did not regularly initiate calls of this type to all 18 analysts covering the company. Word of these calls quickly spread among analysts, some of whom believed that Office Depot was “talking down” analysts’ earnings estimates. DT: Who at the company was reviewing disclosures that were being made? Did the outside auditor become aware of the disclosures at some point?The CFO and the CEO were in communication with the director of investor relations during and after the calls. On Saturday, June 23, 2007, the CFO emailed the analysts’ revised estimates to the CEO and advised that the director of investor relations had spoken to most of the company’s analysts and that two had reduced their estimates. The CEO responded positively and encouraged the calls to continue so that additional analysts would lower their estimates.

On Monday, June 25, 2007, the CFO asked the director of investor relations’ immediate supervisor whether the director of investor relations had contacted a particular analyst whose EPS estimate was the highest and had not yet been revised. Also on Monday, the CEO requested and received an update, which showed that the analysts’ consensus estimate was still $0.46. With the CFO’s knowledge, the CEO then commented to the director of investor relations that they still needed conversations with a few more analysts.

Office Depot’s calls influenced many analysts to revise and lower their second quarter 2007 forecasts. By the end of the second day of the calls, fifteen of the eighteen analysts lowered their estimates, bringing the consensus estimate down from $0.48 to $0.45.

During a call on Friday, June 22, 2007, one analyst expressed concern to the director of investor relations about the lack of a press release. That same day, the director of investor relations conveyed to the CFO this concern and that one other analyst was informing his customers that he expected Office Depot’s earnings to be down based on his call. DT: If true, this appears to be a wakeup call to consider actions.

On Monday, June 25, 2007, the director of investor relations notified the CFO that another analyst told him that he was surprised at the lack of a press release and indicated that several of his clients were also surprised. Also, late Monday evening, the CFO instructed the director of investor relations to call the company’s top twenty institutional investors and relay the same talking points to them, which he did the following day.

After the close of the market on Thursday, June 28, 2007, six days after the calls to analysts began, Office Depot filed a Form 8-K publicly disclosing, among other things, that its earnings would be “negatively impacted due to continued soft economic conditions.” DT: So, here is a good thing, arguably the company did quickly take action to address the situation.

Between Friday, June 22, 2007 (the day Office Depot began calling analysts) and June 28, 2007 (the last market close before Office Depot filed its 8-K), the company’s stock dropped 7.7%. On the first day of the calls, Office Depot’s stock closed at $33.49 per share. This was a decrease of 2.8% from the previous close, on trading volume of almost 7.5 million shares, which was two and half times the average volume for the remainder of that week. On the second day of calls, the stock dropped another 3.5% to $32.32 per share on trading volume of 7 million shares.

C. THE ALLEGED GAAP AND INTERNAL CONTROLS VIOLATIONS

In pertinent part, the SEC alleged as follows (please note that the following allegations were obtained from the SEC’s Complaint—accordingly, they are only unproven allegations):

Office Depot often arranges with its vendors to receive funding for its various marketing and promotional activities relating to the vendors’ products, such as advertising, store displays, and product exclusivity. For example, vendors frequently pay Office Depot to place their products in prominent store locations.

Under GAAP, the funds from these agreements are recognizable during the reporting period in which Office Depot provides the marketing and promotional activities called for in the agreements. When the activities cover multiple reporting periods, the funds are to be recognized over the relevant reporting periods in a manner consistent with GAAP.

Between the third quarter of 2006 and the second quarter of 2007, Office Depot prematurely recognized funds from approximately 100 vendor agreements. Many of the transactions involved an email arrangement between Office Depot personnel and the vendors that were separate from, but in addition to, the original documented agreement. These supplemental agreements often included terms that bound Office Depot to some kind of future performance and thus, would have caused the recognition of these funds to be deferred into future periods. DT: In other words, the SEC argued that Generally Accepted Accounting Principles require the company to defer recognizing portions of the income and to variously recognize those deferred portions during the period of time covered by the company's merchandising and marketing efforts that were required by the company's agreements with vendors. The SEC's allegations relating to this claim are incomplete. It would really be helpful to know, for example, if some process was different in these transactions which then resulted on the details of the transactions falling through the cracks, or if prior email arrangements were common but in this case they were not reported up the line, and why not. As indicated in the following paragraph, if true, the situation had an impact.

The premature recognition of vendor funds inflated Office Depot’s operating profit from the third quarter of 2006 through the second quarter of 2007 by a total of approximately $30 million. Office Depot’s quarterly and annual financial statements during this period overstated net earnings by 1.3% to 6.7%.

In November 2007, Office Depot announced that it would be restating its financial statements for the third quarter of 2006 through the second quarter of 2007 due to material errors in the accounting recognition of vendor funds that should have been deferred into later periods. The company also announced having a material weakness in its internal controls over financial reporting based on the failure to ensure that complete and accurate documentation was provided to individuals responsible for the proper recognition of vendor funds. DT: Again, I cannot determine from the information alleged by the SEC, but it seems like it might have taken a while to spot the issue or problem.

The accounting errors leading to Office Depot’s restatements resulted from a communication breakdown between the Office Depot personnel responsible for negotiating and executing vendor agreements (internally referred to at Office Depot as “Merchants”) and the personnel responsible for accounting for the funds. During either the negotiation or execution of vendor agreements, the Merchants often had email or other communications with the vendors that modified the terms of existing agreements. However, the Merchants often failed to provide all of the documentation to the accounting department for consideration. DT: Some good things here, the SEC does not allege or provide facts evidencing any intentional wrongdoing, and these situations are correctible with proper education or instruction, internal controls, and oversight by the CFO, internal audit, the audit committee, and the outside auditor.

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