Internal Control Versus Internal Accounting Control

By: George Wilson

 

On October 15, 2020, the SEC announced a settled enforcement case against Andeavor, LLC.  The case centers on stock buybacks Andeavor made while in discussions to be acquired by another oil and gas company.  This case is relevant for all public companies as it potentially expands the concept of internal accounting control to include administrative controls.

 

In January 2018, Andeavor and a potential acquirer agreed to resume acquisition discussions which had been suspended in October 2017.  Just before the scheduled resumption of the talks Andeavor’s CEO directed its CFO to initiate a stock buyback program.

 

According to the SEC’s press release:

 

The order finds that Andeavor used an abbreviated and informal process to evaluate whether the requirements for the buyback were satisfied, including that the company was not in possession of material non-public information. The order finds more specifically that the process for evaluating the materiality of the acquisition negotiations did not include discussing, with the CEO, the likelihood of a deal between Andeavor and Marathon.

 

In addition, Associate Director Melissa Hodgman stated:

 

While buybacks can be an important part of a company’s capital allocation plan, this case makes clear the importance of effective controls when a company is contemplating transactions with its shareholders.

 

The reason all companies should become familiar with this case is that the 1934 Act provisions it alleges that Andeavor violated focus on internal control.  It is not a Rule 10b-5 case.

 

Commissioners Peirce and Roisman published a Statement to explain why they voted against this enforcement decision.  A major issue in their dissent is that the Commission is taking the concept of internal accounting control and expanding it in ways that may not be appropriate.

 

In the dissent they make this important point about internal control:

 

Thus, accounting control “is within the scope of the study and evaluation of internal control contemplated by generally accepted auditing standards, while administrative control is not.”  Put another way, “accounting controls...generally bear directly and importantly on the reliability of financial records and require evaluation by the auditor,” while “[a]dministrative controls...ordinarily relate only indirectly to the financial records and thus would not require evaluation.” 

 

They then raise this concern:

 

We are concerned that the Commission’s resolution of this case—if pursued to its logical conclusion in future cases—risks uprooting the core concept of “internal accounting controls” from the language, statutory context, and history of Section 13(b)(2)(B).  There may be temptation to simply view this provision as a generic “internal controls” requirement.  While this case is unprecedented in its application of the provision to the insider trading compliance context, the Commission has settled other actions in the recent past based on similar theories of inadequate internal controls that go well beyond the realm of “accounting controls.”  It has found a violation, for example, where controls were inadequate to ensure that an airline’s approval of a domestic flight route was consistent with its ethics policy.[33]  No court, however, has adopted the expansive view of Section 13(b)(2)(B) that such actions seem to require.

 

They conclude with this thought:

 

While we agree that Andeavor’s decision processes in this case left substantial room for improvement, and inadequate processes may expose a company to potential Rule 10b-5 liability, we doubt it is our role under Section 13(b)(2)(B) to second-guess management’s decision processes on matters that do not directly implicate the accuracy of a company’s accounting and financial statements. 

 

As always, your thoughts and comments are welcome!

 

 

 

 

 

 

 

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