Enforcement News: The Pressure To Meet Analysts’ Expectations

• Posted on: Apr 3 2023

Market analysts study publicly traded companies and make recommendations on the securities of those companies.¹ Most analysts specialize in a particular industry or sector of the economy.² As noted by the Securities and Exchange Commission (“SEC” or “Commission”), analysts exert considerable influence on a company. “Analysts’ recommendations or reports can influence the price of a company’s stock—especially when the recommendations are widely disseminated through television appearances or through other electronic and print media.”³ In fact, “[t]he mere mention of a company by a popular analyst can temporarily cause its stock to rise or fall—even when nothing about the company’s prospects or fundamentals has recently changed.”⁴

It is no wonder, therefore, that at many publicly traded companies, “the pressure to meet or beat consensus-earnings estimates is strong.”⁵ Many corporate executives believe that doing so “will reward the company [and investors] over the longer term with a higher share price.”⁶ If the company were to report “earnings below consensus estimates—even by a small amount—[corporate executives believe that] investors will penalize them with a lower share price.”⁷ 

“As a result, executives often go to some lengths to meet or beat consensus estimates—even acting in ways that could damage the longer-term health of the business.”⁸ It is not uncommon, therefore, for companies to give customers steep discounts in the final days of a reporting period to increase sales numbers, “in effect borrowing from the next quarter’s sales.”⁹ As many companies have shown, corporate executives will forgo value-creating investments in favor of short-term results, or worse manage earnings inappropriately to create the illusion of growth.¹⁰

The pressure to meet analysts’ estimates was a reason for the alleged accounting fraud charged by the SEC against three executives of Mobile, Alabama-based shipbuilder, Austal USA LLC (collectively, the “Individual Defendants”).

On March 31, 2023, the SEC announced (here) that it charged three Austral USA executives for orchestrating a fraudulent revenue recognition scheme that allowed its parent company, Australia-based Austal Limited, to meet or exceed analyst expectations.

In its complaint (here), the SEC alleged that, from at least January 2013 through July 2016, Austal USA’s former president, its current director of financial analysis, and former director of the Littoral Combat Ships program engaged in a scheme to artificially reduce the cost estimates to complete certain shipbuilding projects for the U.S. Navy by tens of millions of dollars. The SEC further alleged that the Individual Defendants knew that Austal USA’s shipbuilding costs were rising and higher than planned, but they directed others to arbitrarily lower the cost estimates to meet Austal USA’s revenue budget and revenue projections.

In addition, the SEC alleged that Austal USA’s parent company, Austal Limited, prematurely recognized revenue and, as a result, met or exceeded analyst consensus estimates for earnings before interest and tax (EBIT), a key financial metric for the company.

Commenting on the charges, Jason Burt, Regional Director of the SEC’s Denver Regional Office, stated: “We allege that Austal USA’s executives manipulated its financial results, causing harm to U.S. investors in the securities of its parent company, Austal Limited. As the complaint articulates, if the defendants had not fraudulently manipulated the cost estimates, Austal Limited would have missed, by wide margins, analyst consensus estimates for EBIT.”

The SEC filed its complaint in the U.S. District Court for the Southern District of Alabama. The SEC claimed that the Individual Defendants violated the antifraud provisions of the Securities Exchange Act of 1934. The SEC seeks disgorgement plus prejudgment interest, civil money penalties, and officer and director bars.

In addition to the SEC’s enforcement action, a federal grand jury returned an indictment against the Individual Defendant for orchestrating the alleged accounting fraud.¹¹ In the press release announcing the indictment (here), the DOJ explained that the Individual Defendants and their co-conspirators allegedly conspired to mislead investors about Austal USA’s financial condition. Making many of the same allegations as the SEC, the government alleged that the Individual Defendants artificially reduced and suppressed an accounting metric known as “estimate at completion” (“EAC”) in relation to multiple LCS ships that Austal USA was building for the U.S. Navy. Suppressing the EACs allegedly falsely overstated Austal Limited’s reported earnings in its public financial statements.

According to court papers, the Individual Defendants and their co-conspirators allegedly manipulated the EAC figures in part by using so-called “program challenges” – ostensibly cost-savings goals – but which in reality were “plug” numbers and fraudulent devices to hide growing costs that should have been incorporated into Austal USA’s financial statements, and ultimately reflected in Austal Limited’s reported earnings. Similar to the SEC, the government claimed that the Individual Defendants allegedly committed the accounting fraud to, among other reasons, maintain and increase the share price of Austal Limited’s stock. When the higher costs were eventually disclosed to the market, the stock price was significantly negatively impacted and Austal Limited wrote down over $100 million.

The Individual Defendant were each charged with one count of conspiracy to commit wire fraud and wire fraud affecting a financial institution, five counts of wire fraud, and two counts of wire fraud affecting a financial institution. If convicted, they each face a maximum penalty of 30 years in prison for the conspiracy count and each count of wire fraud affecting a financial institution, and 20 years in prison for each count of wire fraud.

Footnotes

1. Investor Publications, “Analyzing Analyst Recommendations” (SEC.gov., Aug. 30, 2010) (here).
2. Id.
3. Id.
4. Id.
5. Tim Koller, Rishi Raj, and Abhishek Saxena, “Avoiding the Consensus-Earnings Trap” (Mckinsey.com, Jan. 1, 2013) (here).
6. Id.
7. Id.
8. Id.
9. Id.
10. Id. See also Shawn Huang, et al., “The Dark Side of Analyst Coverage: Firms Pressured to Meet Forecasts” (AZ. State Univ., W. P. Carey News, Dec. 6, 2017) (noting, the pressure to deliver good news often causes “managers whose compensation and careers depend on meeting forecasts … to manage the financial reports accordingly and even guide analysts’ forecasts downward — in effect, making the earnings bar easier for the company to clear.”) (here).
11. An indictment is merely an allegation. All defendants are presumed innocent until proven guilty beyond a reasonable doubt in a court of law.

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. 

This article is for informational purposes and is not intended to be and should not be taken as legal advice.