On March 10, 2016, the SEC settled charges against Magnum Hunter Resources Corporation (MHR) and two of its officers for deficient oversight of the company’s internal controls over financial reporting (ICFR). This marks a continuation of a trend of imposing penalties on individuals for insufficient responsiveness to red flags and oversight of the company’s internal control procedures. Importantly, the deficiency that was central to the SEC concerns was the inadequacy of the resources devoted to ICFR. Audit committees who have responsibility for ICFR and counsel who assist those committees are cautioned to include in their reviews inquiries with respect to the adequacy in the size of the staff devoted to these activities and the experience and qualification of that staff. See, e.g., http://www.sec.gov/litigation/litreleases/lr18104.htm and https://www.sec.gov/litigation/litreleases/2010/lr21451.htm.
Item 308 of Regulation S-K requires a company’s management to provide an annual report summarizing its conclusions regarding the effectiveness of the company’s ICFR. Management is required to disclose any material weaknesses in the company’s ICFR that it has identified, where “material weakness” is defined as “a deficiency, or a combination of deficiencies . . . such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.” (Reg. S-X Rule 1-02(a)(4)) In contrast, management is not required to disclose in its report any “significant deficiencies,” which are deficiencies important enough to merit attention but not severe enough to rise to the level of material weaknesses. In addition, under Item 308, management is required to “maintain evidential matter, including documentation, to provide reasonable support for management’s assessment” of the effectiveness of its ICFR.
MHR is a Texas-based oil company that underwent substantial growth in 2009 and 2010. While it was expanding, MHR’s accounting department didn’t expand quickly enough to meet its increased workload. These shortages worsened when MHR completed another acquisition in 2011. Revenues grew from approximately $6 million in 2009 to $100 million in 2011, while total employee head count grew from 139 to 305 during that time. This increased burden slowed down the accounting department’s productivity and led it to begin closing its books on a quarterly basis instead of a monthly basis as it had previously done.
As of December 31, 2011, the outside auditors delivered a report to the audit committee, the chief accounting officer (CAO), and chief financial officer (CFO) of MHR concluding that the accounting department was experiencing manpower issues, “With complex financial and reporting structures there are few individuals within the team with the capacity to perform many tasks and there is little time for senior reporting personnel to review, analyze, and evaluate because they are performing transaction level tasks.” As a result of these shortages, the accounting department would not be able to complete all of its required tasks on a timely basis. It concluded that “the potential for error in such a compressed work environment presents substantial risk,” but determined that the staffing deficiency represented only a significant deficiency, not a material weakness. It provided no evidence for this conclusion. Having received the notice in this report, MHR didn’t publicly disclose the manpower deficiency and stated that its ICFR was effective in its 10-K for that year.
In November 2012, MHR amended its June 30, 2012, 10-Q to restate the financial statements therein and disclose the material weakness in ICFR. It also disclosed this material weakness in its 10-Q for September 30, 2012, and its delinquently filed 10-K for the year 2012. (MHR drew attention from the SEC by delinquently filing its third quarter 2012 10-Q on November 15, 2012, its fiscal year 2012 10-K on June 14, 2013, and its first quarter 2013 10-Q on June 9, 2013.) In light of this late filing and disclosure of deficiencies, the SEC pressed charges pertaining to the 2011 10-K, alleging that the failure to disclose and failure to keep sufficient records justifying its determination that the staffing issues were only a significant deficiency were violations of Reg. S-K Item 308. In connection with these charges, MHR entered into a settlement to pay a penalty of $250,000. Moreover, the CFO and CAO were individually fined $25,000 and $15,000, respectively, for their lack of oversight regarding the monitoring of internal controls. See the full order summarizing the facts and charges here.
This settlement is another example in the trend of the SEC issuing private penalties against individual directors or officers of a corporation, and it is a demonstration of the penalties that a company may face for inappropriate monitoring of its internal controls. In particular, the MHR matter reaffirms the need for audit committee members and financial and accounting officers to confirm that company staffing is sufficient to maintain adequate internal controls. Moreover, this matter reinforces the need for companies and audit committees to actively inquire of the auditors, internal audit staff and financial executives about the adequacy of staffing to prepare financial statements and insure required segregation of duties.