SEC’s EPS Initiative: Duty to Report Litigation Expenses?

Earlier this week, the United States Securities & Exchange Commission (“SEC”) announced that Healthcare Services Group Inc. (“HCSG.o”) agreed to pay a $6 million dollar fine to settle claims the SEC brought against the company for failing to properly account for its legal expenses. Under this civil claim, the SEC accused the company of inaccurately reporting litigation expenses paid to settle its employees’ claims in an effort to inflate the company’s quarterly earnings.

According to the SEC, the company’s underreporting of costly litigation deliberately inflated the company’s earnings to ensure that they were consistent with Wall Street’s earnings forecasts. This intentional misrepresentation, the SEC alleged, allowed the company to avoid the SEC’s detection and disguised the company’s true financial position to investors. The SEC explained that HCSG failed to accurately capture in its quarterly financial statements loss contingencies for settlements the company knew were “probable and reasonably estimable” as a result of class and collection litigation the company underwent in 2014 and 2015. In support of its position, the SEC asserted that such a failure was inconsistent with generally accepted accounting principles.

Director of SEC Enforcement in a statement explained that “HCSG repeatedly failed to record loss contingencies related to litigation settlement despite mounting evidence that such liability was probable and reasonably estimable, while misleading investors by reporting inflated net income and consistent EPS growth.” The director further cautioned companies that “it is critical for public companies to ensure that accounting judgments, including those involving loss contingencies, are not being used to manage earnings and distort financial statements.”

This case is yet another example of the SEC pursuing actions against companies as part of its recently created earnings per share (“EPS”) initiative. Implemented by the SEC in September 2020, the EPS initiative utilizes risk-based data analytics to uncover potential accounting and disclosure violations of companies’ earnings and management practices. These analytics aim to track a company’s financial progression to identify sudden drops in EPS following consecutive positive quarterly reporting that meet or exceed that company’s estimated EPS. These sudden drops or dips alert the SEC’s enforcement branch of a company’s potential financial misreporting, which result from, among other things, failing to properly account for the company’s legal expenses. A company’s failure to accurately report its company’s financials violate Sections 17(a)(2) and (3) of the Securities Act of 1933 and may also violate the financial reporting, books and records, and internal control provisions of the Securities Exchange Act of 1934.

Litigation is costly. With the SEC’s EPS initiative, a failure to accurately capture a company’s earnings may cost the company even more money. Directors and officers alike, particularly those in a financial position, should be cognizant of the SEC’s continued watchful eye—particularly as it pertains to litigation expenses and settlements. While the SEC has not established a rule-of-thumb to determine when litigation expenses are “probable and reasonably estimable,” companies should consult financial experts and generally accepted accounting principles to determine how and when litigation expenses are disclosed on a company’s quarterly earnings.