In February, the Securities and Exchange Commission (SEC) announced a settlement with Diageo plc, a London-based producer of liquor, wine and beer, for failure to make required disclosures of known trends and uncertainties, thereby rendering its required periodic filings materially misleading with respect to its financial results. The SEC found that Diageo’s employees at its subsidiary, Diageo North America, Inc. (DNA), pressured distributors to buy products in excess of demand to meet performance targets in a flagging market. The SEC further found that as a result of this pressure, distributors in North America held substantial unneeded inventory, which was a known trend or uncertainty (i.e., the continued selling over demand was unsustainable because distributors would likely purchase less product in future periods). Additionally, the SEC found that this overshipping allowed Diageo to report higher growth in key performance indicators (KPIs) that were closely followed by financial analysts, including organic net sales and organic operating profit growth.

The SEC concluded that, in failing to disclose the known demand and inventory level trends and uncertainties to investors, Diageo violated negligence-based anti-fraud provisions Section 17(a)(2) and 17(a)(3) of the Securities Act of 1933. The SEC also found that these omissions constituted reporting violations under Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-1 thereunder. Diageo agreed to the entry of a cease-and-desist order and to pay a civil penalty of $5 million.

Diageo Order Context: Timely Test of the SEC’s Recent MD&A Guidance

The matter is interesting for several reasons, including its timing. As discussed in our prior alert, just weeks before the SEC announced the settlement with Diageo, the SEC issued Guidance on KPIs and metrics in Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A). In the Guidance, the SEC noted that Item 303(a) of Regulation S-K requires companies to disclose information that they believe is necessary for an understanding of its financial condition or that speaks to changes in financial condition and results of operations, even if that information is not specifically referenced in the Guidance. Item 303(a) also requires companies to discuss and analyze other statistical data that, in the company’s judgment, enhances a reader’s understanding of the MD&A. The SEC encouraged companies to identify and address key variables and other qualitative and quantitative factors that are pertinent to and necessary for an understanding and evaluation of the individual company.

In addition, the Guidance recommends that, when including KPIs in their disclosure, companies “should consider what additional information may be necessary to provide adequate context for an investor to understand the metric presented.” Depending on the facts and circumstances, the SEC expects to see:

• “A clear definition of the metric and how it is calculated.”

• “A statement indicating the reasons the metric provides useful information to investors.”

• “A statement indicating how management uses the metric in managing or monitoring the performance of the business.”

The SEC suggested that companies should also consider “whether there are estimates or assumptions underlying the metric or its calculation, and whether disclosure of such items is necessary for the metric not to be materially misleading.”

Finally, the Guidance reminds companies of the need for effective disclosure controls and procedures in connection with “material key performance indicators or metrics that are derived from the company’s own information.” For instance, the Guidance continues, “when key performance indicators and metrics are material to an investment or voting decision, the company should consider whether it has effective controls and procedures in place to process information related to the disclosure of such items to ensure consistency as well as accuracy.”

Assessing the Diageo Order

In the Diageo Order, the SEC found Diageo’s Annual Report on Form 20-F contained statements about DNA’s financial performance, including statements of organic net sales growth and organic operating profit growth that were “rendered materially misleading by the failure to include material trends and uncertainties concerning Diageo’s revenues and profit.” Specifically, the SEC found that Diageo failed to indicate in its statement of sales growth that the growth was due to overshipping. The failure to disclose the overshipping also rendered information related to organic net sales growth and organic operating profit growth materially misleading, as the data met or exceeded analyst expectations in large part because of channel stuffing. The SEC concluded that without the overshipping, the company’s KPIs would have been “materially lower.” Investors were, therefore, left with the impression that the company achieved growth in these KPIs through normal customer demand, impairing their ability to evaluate the company’s future performance.

The Diageo Order is also interesting because the SEC did not charge any individuals relating to the overshipping scheme. In the last three years, the SEC has increased efforts to hold individuals — and not just corporate entities — liable for violations. It is clear from the Order that the SEC investigation concluded that “certain DNA employees” pressured distributors to purchase additional products to make up the gap to meet its performance targets and “certain DNA financial personnel” closely tracked the gap between actual and forecasted revenue and profits. It is not clear, however, why those individuals were not charged. As the Diageo Order does not contain any provision requiring the company to further cooperate with the staff’s investigation, it is unlikely that we will see subsequent actions filed against employees.

Finally, the SEC connected the violations of Sections 17(a)(2) and 17(a)(3) to issuances of securities pursuant to employee benefit plans and to employees through the exercise of stock options. For settlement purposes and where the staff does not believe they could prove intent, Sections 17(a)(2) and 17(a)(3) provide a way for the staff to charge negligence-based violations, but technically those violations must relate to a primary issuance of securities as opposed to Section 10(b) of the Exchange Act, which requires a purchase or sale in secondary markets. In the past, the SEC has not been as careful in its orders to identify the “primary issuance” when charging violations of Section 17. The Diageo Order may be an indication that the staff is going to be more precise in future orders. It could also signal that the staff will not be willing to use Sections 17(a)(2) and 17(a)(3) absent a primary issuance.

Based on the SEC’s recent Guidance and the Diageo enforcement action, public issuers should carefully review their disclosure of key performance indicators and ensure they have appropriate disclosure controls and procedures in place.