Though routine, review of a public company’s financials by the Securities and Exchange Commission’s (SEC) Division of Corporate Finance (Corp Fin) can, in unique circumstances, lead to an enforcement action and should not be taken lightly. This is especially true given the backdrop of an announcement by the SEC’s enforcement division regarding its creation of a new Financial Reporting and Audit Task Force and statements by the staff reflecting a refocus of efforts on accounting cases. The SEC’s settlement with PACCAR, Inc. (PACCAR) for relatively minor issues that did not involve fraud allegations, or even a financial restatement, demonstrates how the staff is pursuing less significant violations and reinforces that disclosure revisions or accounting errors identified during a Corp Fin review could trigger such charges.


The PACCAR case

PACCAR, a Fortune 200 company based in Bellevue, Wash., is one of the world’s largest manufacturers of commercial trucks and related aftermarket parts under the Kenworth, Peterbilt and DAF nameplates. Its wholly-owned subsidiary, PACCAR Financial Corporation (PFC), provides financing and leasing of PACCAR-manufactured equipment to U.S.-based customers. On April 24, 2012, PACCAR received notice that the SEC had initiated a formal investigation relating to the company’s financial reporting from 2008 to 2011. More specifically, the SEC requested information about the company’s loan loss reserves, troubled debt restructuring and segment reporting, all of which had been addressed by Corp Fin comment letters in 2010. After a relatively short inquiry, the SEC convinced PACCAR to settle to a complaint, without admitting or denying any wrongdoing, that contained allegations involving relatively minor books and records issues (i.e., non-scienter based charges for the mere failure to have perfect accounting records). The complaint contained no allegations of fraud, PACCAR did not restate its prior financials and no individuals were charged by the SEC.

The SEC’s complaint first focused on PACCAR’s segment reporting with respect to its truck and aftermarket parts businesses. The SEC alleged that, while PACCAR internally viewed aftermarket parts as a separate business with its own management team and set of financials, the company’s public filings failed to reflect this understanding. After the start of the SEC’s investigation, PACCAR began providing detailed segment level information for its parts business in its Form 10-K for 2012, filed on Feb. 27, 2013. Prior to that date, PACCAR’s SEC filings did not separately report net income before income taxes for the truck and aftermarket parts segments, though the company did report separate revenues and gross margins for truck and parts sales.

Two and a half years before PACCAR changed its disclosure, a Corp Fin comment letter requested additional information on the relative impact of certain enumerated factors cited as causes of variances in truck segment operating and net income results. In response, PACCAR noted it was generally aware of a mix shift to lower margin replacement parts but could not calculate the resulting financial statement influence and did not intend any reporting changes. Though Corp Fin concluded its review in May 2011, the SEC’s ultimate enforcement action was brought on the basis that the disclosures were incomplete in a manner similar to that identified by Corp Fin, namely that, when combined with the parts business, investors were unable to understand what drivers impacted PACCAR’s truck segment’s operating and net income results. The additional disclosure in PACCAR’s recent filings, likely prompted by the SEC’s action, allows investors to understand the truck and parts business better by providing net income level information, but it is important to note that PACCAR’s prior presentation enabled investors to understand whether each business was profitable on a gross margin basis and to what extent.

The SEC’s complaint also alleged non-material misstatements arising from PACCAR and PFC’s disclosures regarding impairment on outstanding loans and leases as well as loan origination and collection sums. In its complaint, the SEC asserted on a number of occasions that PACCAR “admitted” or “acknowledged” many of these financial statement errors in comment letter responses to the SEC between June 2010 and February 2011. In response to Corp Fin questions, PACCAR revised a footnote to its financials to include an additional $42.5 million in impaired receivables and disclosed equal and offsetting classification errors regarding loan origination and collection amounts for the second and third quarters of 2009. PACCAR concluded that neither error was material at the time and has not since issued a restatement correcting its financial statements. Regardless, the SEC appropriated statements made by the company in responses to Corp Fin comment letters as a basis to assert books and records and internal controls violations of the securities laws.


How should public companies respond to PACCAR?

The PACCAR settlement is yet another reminder that responses to comment letters sent by Corp Fin should not be treated lightly. This basic concept is certainly not groundbreaking, as other SEC actions have included allegations regarding failures to respond or inaccurate responses to such letters. The SEC’s litigation release in the PACCAR case, however, signals a focus on more technical areas of accounting revised by the company as a result of correspondence with Corp Fin. As context, the lion’s share of SEC enforcement actions against public companies for accounting misstatements involve scienter-based fraud allegations as to the target company or as to executive employees related to materially misstated financial statements or disclosure. The SEC has also had recent success in enforcing the Foreign Corrupt Practices Act by bringing books and records cases against issuers for immaterial mischaracterizations of alleged bribes on the companies’ books. Here, however, the SEC’s allegations focus on finer points of accounting guidance and include assertions that inaccurate statements were made by PACCAR to Corp Fin as a result of internal controls deficiencies not alleged to be known by the company at the time those statements were made.

As the SEC’s Financial Reporting and Audit Task Force gets up to speed, public companies can only expect to face more scrutiny in the future. The Task Force will work closely with, among others, Corp Fin in an effort to “expand and strengthen the Division’s efforts to identify securities-law violations relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures.” (July 2, 2013 Press Release.) With that background in mind, public companies should engage in a continuing process to review and strengthen their control environment. In addition, when responding to a Corp Fin comment letter, public companies must evaluate broader disclosure and internal controls ramifications.