Risk & Compliance

The SEC Has a Few Questions for You

Receiving a comment letter is no cause for panic, particularly if you know what to expect.
Sarah JohnsonMay 1, 2010

It was a letter that Tom Cawley, CFO of Peet’s Coffee & Tea, couldn’t ignore.

Seven months after the company filed its 2008 annual report, there it was: a missive from the Securities and Exchange Commission seeking certain clarifications about the company’s assumptions and business relationships.

Some day there may be an app for that, but today it’s the envelope no CFO looks forward to opening, even if the inquiry proves to be fairly routine.

That was the case for Cawley, who had to supply answers to 11 questions, including two minor points in the management discussion and analysis (MD&A) section of the company’s 10-K. In his written response, Cawley disclosed the source for Peet’s claim of a 12% uptick in grocery specialty-coffee spending and clarified his company’s relationship with a coffee distributor.

That the SEC zeroed in on that facet of the 10-K did not surprise Cawley in the least. “The MD&A is the part that changes every year,” he says. “It’s talking about where the business is going, and where you’ve been, and what’s driving the [underlying] economics.” Indeed, the MD&A was the topic cited most frequently in 2009 by the SEC in its reviews of U.S. publicly traded companies’ annual and quarterly filings, according to a CFO analysis of data compiled by Audit Analytics.

After the MD&A, the SEC has been focusing on two of the most controversial issues of the day: executive compensation and fair-value accounting. While most of the agency’s concerns cluster around what might be considered a top 10 list of trouble spots (see “The SEC’s Top 10 Concerns” at the end of this article), it also sends comment letters simply to ask for missing data that a company believes isn’t material or doesn’t apply to it (such as, in Peet’s case, whether it has any off-balance-sheet arrangements), or to address current topics of concern. Today, for example, it may probe a firm’s ties to business partners that operate in countries deemed state sponsors of terrorism.

The good news for companies is that when it comes to SEC comment letters, history does, in fact, repeat itself. “The top-10 list has been fairly consistent for at least the last five years,” says Bridgette Hodges, partner in charge of SEC regulatory matters at Grant Thornton, who has been tracking SEC comment letters since 2004.

Three Is the Magic Number

Ever since the SEC began making the letters public on the Edgar database six years ago, outside advisers, including accounting and law firms, have been helping companies stave off probing SEC queries by spotting trends and suggesting their clients add preventive disclosures.

The assistance is welcome because a company’s likelihood of getting reviewed has increased in recent years. More than 2,200 companies received a letter last year on their quarterly and annual filings, a 73% increase over 2005, according to CFO’s analysis. Under the Sarbanes-Oxley Act, the SEC must look at one filing from each public company at least once every three years. (The commission may also pay particular attention to certain types of companies at any given time, as well as to firms with the largest market caps or the most volatile stock prices.)

Although the commission may review a company’s financials without offering its two cents, some CFOs say they expect to get an SEC letter addressed to them or their CEO every third year. If that letter contains only minor questions, finance executives take that as an indication that the lawyers, accountants, and controllers have “done a pretty good job of protecting us,” Cawley says.

Still, the preemptive work doesn’t always make a difference. “The scope of SEC comments depends on the SEC reviewers, what they’re focusing on, how much time they have to focus on your company, and the latest hot-button issues at the time,” says Gian-Michele a Marca, a partner at law firm Cooley Godward Kronish.

CFOs also measure the success of their correspondence with the SEC based on minimizing the amount of follow-up correspondence required. In a worst-case scenario, a review can lead to an amended filing or restatement. More often, it results in the company providing additional data and promising to give more detail in future filings.

Even if the process goes smoothly, the letters become an instant priority, distracting CFOs from other work and costing a sizable sum to boot.

“For something we were not planning to address, 5 to 10 days of work and $15,000 to $20,000 of unbudgeted expenses is not necessarily insignificant,” says Mark Haidet, CFO of restaurant and hospitality technology provider Radiant Systems, who recently went through the comment-letter process. He says Radiant’s costs were probably minor compared with other firms’, since the latest round did not involve substantial questions.

Qualms for 2010

For its part, the SEC usually hints at the areas its examiners will home in on shortly before the calendar fiscal year begins. Based on such hints, many of their 2010 questions should concern MD&A disclosures, non-GAAP financial measures, goodwill impairments, and risk disclosures tied to climate change.

Moreover, the SEC will continue to pry for more data on how companies pay their top people. Three years after issuing new guidance on pay, the regulator has promised to hold companies to a higher standard of disclosure. The SEC wants more information about incentive-pay performance targets, such as earnings per share, and companies’ choice of peer businesses. “Companies were not saying enough about the group of peer companies they’re judging themselves against,” says a Marca.

The increased scrutiny of the compensation discussion and analysis sections doesn’t sit well with executives who feel they are unduly subject to the same regulations as financial institutions whose pay packages have been pilloried by the general public. “Most companies don’t have compensation plans that are as complex or rich as AIG’s or Lehman Brothers’s,” laments R. Don Elsey, CFO of Emergent BioSolutions, who was recently asked by the SEC to explain why the company adjusted its most highly paid executives’ base salaries.

To be sure, CFOs aren’t pleased with all the questions the SEC poses. Although they admit some queries are warranted, they also believe that most run counter to the SEC’s vow to simplify financial reporting.

Indeed, as the commission continues to push for more information, and as accountants and lawyers continue to track the queries, companies are increasingly attempting to appease all parties by using boilerplate language and negative assertions. Notes Cawley, “The 10-Qs and 10-Ks and proxy statements are getting longer — but not necessarily more helpful.”

Sarah Johnson is senior editor for regulation at CFO.



The SEC’s Top 10 Concerns

1. Management discussion and analysis. The Securities and Exchange Commission wants more color in companies’ descriptions of their operating results, their liquidity and capital resources, and how they develop critical accounting estimates. “Companies are still struggling with making their MD&As a story and not a recitation of the financial statements,” says Bridgette Hodges, a Grant Thornton partner.

2. Executive compensation. Shelley Parratt, deputy director of the SEC’s Division of Corporation Finance, warned last fall that companies not yet reviewed under 2006 pay disclosure rules will get their turn by the end of 2010.

3. Fair-value measurements. “Part of the [SEC] staff’s job is to test the judgment of management,” particularly at times when the fair value of an asset fluctuates, notes James Vieceli, a partner at law firm Manatt, Phelps & Phillips.

4. Intangible assets and goodwill. Companies were frequently questioned about their testing for goodwill impairment last year. Goodwill must be tested when a “triggering event,” such as a drop in stock price, occurs. In that instance, “if fair value is depressed because of the downturn, you may need to take a charge,” says Trevor Donelan, managing director at consultancy StoneTurn Group.

5. Disclosure controls. The regulator expects companies to use the exact wording in the certification rules for internal controls over financial reporting.

6. Segment reporting. The SEC frequently questions how a company breaks out its business units and notes inconsistent disclosures, according to Grant Thornton’s review of 2009 comments.

7. Non-GAAP measures. The SEC is closely watching whether companies are using consistent figures in their analyst calls, press releases, Websites, and regulatory filings.

8. Revenue recognition. Questions usually address a company’s accounting policy for recognizing revenue.

9. Debt, warrants, and equity issues. Queries center around valuations and proper disclosures.

10. Related-party transactions. The SEC often asks for additional disclosures to understand the nature of the transactions and the relationships involved.

List based on SEC comment letters on U.S. companies’ annual and quarterly filings dated between January 1, 2009, and January 1, 2010. Data based on CFO’s analysis of Audit Analytics’s comment-letter database, as of March 24, 2010.



Rapid Response

How to respond to a query from the SEC

Steven Gatoff was just a few months into his job as CFO of mobility services provider iPass when he received questions from the Securities and Exchange Commission on previously filed financial statements, some of which were put together before he joined the firm in the summer of 2009. But consistent with his attitude toward the comment-letter process, he took a positive approach, deciding to own the filing under question. “It doesn’t matter that it was done under someone else’s regime,” he says.

He measures a successful go-round with the SEC on whether the company has to amend any of its filings and whether it can end the back-and-forth with the regulator with just one response letter. Although CFOs tend not to do the legwork in drafting a response, he recommends that finance executives drive the process to respond efficiently and minimize the discussion. Gatoff also suggests that companies:

• Communicate. Keep the chief executive, board members, and outside advisers up to date on SEC queries. “Transparency and early messaging are critical,” he says.

• Get experienced help. Find out whether your outside advisers have had exposure to the same inquiries and how they’ve handled them. “You don’t want to be on the bleeding edge in this part of the sandbox and come out with something new,” says Gatoff.

• Reserve judgment. Refrain from coming to any conclusions until the internal and external groups have gathered all the facts, evaluated the data, and made recommendations.

• Be thorough. Make sure to address all the points raised in the SEC comment letter to avoid another round.

• Engage constructively. Keep your responses concise, transparent, and thoughtful. Explain the business and the issues it faces just as you would to an important stockholder. Avoid taking an adversarial tone. — S.J.