The SEC settled charges with an organic foods company on Tuesday over internal control failures that led to several years of revenue manipulation, in a case with multiple lessons for the internal control community. We don’t see an internal controls case this large come along every day, so let’s digest.
First, the background. The accused company is Hain Celestial Group, a $2.5 billion maker of foods such as Bearitos, Earth’s Best, and Ella’s Kitchen, among others. According to the SEC’s complaint, Hain abused incentives in the mid-2010s to get several large distributors to buy up lots of inventory near the end of each quarter, so Hain could meet quarterly internal sales targets.
The incentives offered by Hain included right of return for products that spoiled or expired before they were sold to retailers; plus cash incentives of up to $500,000, substantial discounts, and extended payment terms. Some of the incentives were documented only in email exchanges with the distributors, while others were only agreed upon verbally and not documented at all.
From 2014 into 2016, Hain sales executives were feeling a squeeze: overall U.S. sales were growing, but for a variety of reasons, the rate of net sales growth in the United States was declining — from 17 percent in 2014, to only 6.6 percent in 2015, into negative territory in 2016. Uh-oh.
To get out of that jam, Hain executives asked the company’s top two distributors, responsible for about 30 percent of Hain’s U.S. sales at the time, to purchase specific dollar values of inventory by quarter-end, in exchange for additional incentives.
Spoiler alert: as each quarter progressed, the distributors made noises about not being able to fulfill their previously agreed purchase volumes. Hain then promised “extra-contractual incentives” such as cash payments ranging from $75,000 to $500,000 per quarter, or spoils coverage, or extended payment terms.
Documentation of these arrangements was slim; policies and procedures to account properly for all these end-of-quarter transactions was even slimmer. For example, the Hain sales department repeatedly gave one distributor 90-day extended payment terms, but neglected to disclose those terms to Hain’s accounting and finance departments, or to corporate management.
Compliance to the Rescue!
Hain’s finance department discovered the scheme in May 2016. We can’t be sure exactly why, but that coincides with the arrival of a new chief accounting officer, Michael McGuiness, whose LinkedIn profile says he started working at Hain in March of that year.
Hain self-reported its problems to the SEC that summer, and announced that it would delay filing new financial statements while it investigated. Ten months later Hain confirmed that it would not need to restate prior financials, but did report a material weakness in its internal control over financial reporting.
By mid-2017, Hain’s two distributors also cut their inventory levels with Hain dramatically. Those reductions, the SEC said, “can be attributed to factors other than the distributors’ desire to realign their inventories to lower levels, including lowered demand at the retail level.” (Stone-cold language as always, SEC. This is why I never want to be on your bad side.)
Translation: fewer people buy Hain’s stuff. These days annual sales are just under $2.5 billion, well off the $2.88 billion in sales when Hain executives started these shenanigans in 2014.
The SEC praised Hain’s remedial action after discovering the funny numbers, including an expansion of compliance and audit staff.
The SEC did praise Hain’s remedial action after discovering the funny numbers, including beefing up its compliance and audit staff: “In particular, Hain made a number of organizational changes, such as hiring staff in compliance positions and establishing an internal audit function.” James Presser, the company’s head of internal audit, joined Hain in January 2017.
Lastly, Hain implemented a suite of revenue recognition reforms, including:
- standardization of its contract documentation and revenue analyses;
- revisions to its review process and monitoring controls over contracts with customers, customer payments, and incentives; and
- changes in its communication function related to contractual modifications, between those involved in the sales process and those in Corporate Finance.
Hain also developed a revenue recognition and contract review training program.
The Bottom Line
Yes, Hain Celestial had problems with its revenue recognition practices and the accounting controls to keep those practices on the straight and narrow. Once Hain discovered those problems, however, it disclosed the misconduct, cooperated with investigators, and took extensive steps to correct the problem.
Hence the SEC decided to impose no monetary penalties against the company. That’s very much in step with SEC chairman Jay Clayton’s view that monetary penalties harm shareholders, and should only be imposed when the misconduct is egregious and the company in question is dawdling its way to resolution.
That’s not what happened here. Hain took its problem seriously and hit the three criteria regulators in the Trump Administration want to see companies hit.
Here’s hoping Hain can now put some weight back onto its income statement. For the rest of us in compliance and audit — it’s food for thought.