What is Channel Stuffing?

Channel stuffing is an improper revenue recognition practice in which a company fraudulently inflates its sales and earnings by sending excessive amounts of products to its distributors ahead of demand. This practice typically occurs near the end of reporting periods when a company needs to increase its revenues to meet financial projections and market expectations. In order to “make the numbers,” a deceptive company will engage in channel stuffing by: (1) overselling inventory to its distributors in amounts that far exceed the public’s demand for the products; and (2) prematurely recognizing revenue on these future sales in the current period. By improperly pulling sales forward, the company will naturally experience sales and revenue shortfalls in future periods when its distributors are unable to sell the excess inventory. This slippery slope has led companies to engage in additional accounting fraud to cover up the channel stuffing.

Covering Up Channel Stuffing

Companies have used a variety of undisclosed ploys to cover up channel stuffing. The most common schemes are:

• Making secret payments to distributors to induce them to hold excess inventory, rather than return it to the company for a refund;

• Using a wholly-owned subsidiary of the company to repurchase the excess inventory previously sold to distributors; and

• Offering distributors significant price discounts and rebates on amounts that distributors already owed to the company for prior product purchases.

Such schemes further distort a company’s true performance and are unsustainable. As such, they eventually implode and result in significant harm to a company’s shareholders. The U.S. Securities and Exchange Commission (SEC) has identified red flags for accounting frauds like channel stuffing, which include:

• Significant pressure to meet earnings and other performance expectations;

• Excessive focus on short term performance rather than longer term success;

• Poor oversight in units and subsidiaries;

• Growth outpacing the reporting and accounting infrastructure; and

• Management’s over-reliance on processes and poor “tone at the top.”

SEC Targets Channel Stuffing

The SEC has long prioritized identifying and halting fraudulent accounting schemes, especially schemes that manipulate earnings like channel stuffing. According to a Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002, during the five years preceding the enactment of SOX, the “SEC brought the greatest number of actions [involving issuer financial-report violations] in the area of improper revenue recognition: 126 of the 227 enforcement matters involved such conduct…” Since then, the SEC has continued to focus its enforcement efforts on accounting frauds. Some of the SEC’s largest enforcement actions against companies engaged in channel stuffing include:

• Bristol-Myers Squibb Company agreed to pay $150 million for selling excessive amounts of pharmaceutical products to its wholesalers ahead of demand, improperly overstating its revenues by $1.5 billion.

• Symbol Technologies Inc. agreed to pay $131 million for fraudulent revenue-recognition practices, including quarter-end “stuffing” to help meet revenue and earnings targets imposed by its CEO.

• McAfee, Inc. agreed to pay $50 million for channel stuffing, which resulted in the company improperly overstating its revenues by $622 million.

SEC Whistleblower Program   

The SEC Whistleblower Program, established in 2011 under the Dodd-Frank Act, provides whistleblowers with a strong monetary incentive to report wrongdoing to the SEC. Under the program, the SEC will issue awards to whistleblowers who provide original information about violations of the federal securities laws, such as information about channel stuffing, that leads to enforcement actions with total monetary sanctions in excess of $1 million. A whistleblower may receive an award of 10% to 30% percent of the total monetary sanctions collected. Importantly, even auditors and accountants may be eligible for awards under the program.

The SEC Whistleblower Program also protects the confidentiality of whistleblowers and does not disclose information that might directly or indirectly reveal a whistleblower’s identity. Whistleblowers can even submit a tip anonymously to the SEC if represented by an attorney in connection with their tip.

SEC Whistleblower Awards

Since 2012, the SEC Whistleblower Office has issued more than $384 million in awards to whistleblowers. The largest SEC whistleblower awards to date are $50 million, $39 million and $37 million. According to a recent article, the SEC Whistleblower Office may soon issue a multi-million dollar award to two whistleblowers who tipped off the SEC about channel stuffing at Orthofix International. (See other SEC whistleblower cases that have resulted in multi-million dollar awards.)

How to Report Channel Stuffing to the SEC

To report channel stuffing or other federal securities laws violations and qualify for an award under the SEC Whistleblower Program, the SEC requires that whistleblowers or their attorneys submit the tip online through the SEC’s Tip, Complaint or Referral Portal or mail/fax a Form TCR to the SEC Office of the Whistleblower. Prior to submitting a tip, whistleblowers should consult with an experienced whistleblower attorney and review the SEC whistleblower rules to, among other things, understand eligibility rules and consider the factors that can significantly increase or decrease the size of a future whistleblower award.

For more information about the SEC Whistleblower Program and how to report channel stuffing, download the eBook: Tips from SEC Whistleblower Attorneys to Maximize an SEC Whistleblower Award.

Largest Accounting Fraud Scandals

The table below identifies some of the largest SEC enforcement actions against companies for accounting fraud:

Company                       Monetary Sanctions                   Violation