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.
Recently the SEC award to $2.5M to two whistleblowers that disclosed channel stuffing at Orthofix International N.V. According to the SEC’s announcement of an $8.25M penalty, “Orthofix improperly recording certain revenue as soon as a product was shipped despite contingencies requiring certain events to occur in order to receive payment in the transaction. In other instances, Orthofix immediately recorded revenue when it had provided customers with significant extensions of time to make payments. The accounting failures caused the company to materially misstate certain financial statements from at least 2011 to the first quarter of 2013.”
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 $700 million in awards to whistleblowers. The largest SEC whistleblower awards to date are $144 million, $50 million, $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. And click below to hear SEC whistleblower lawyer Matt Stock’s tips for SEC whistleblowers:
SEC Whistleblower Attorneys
If you would like more information on reporting accounting fraud, contact an SEC Whistleblower Attorney at Zuckerman Law for a free, confidential consultation. Zuckerman Law is one of the nation’s leading law firms representing whistleblowers in whistleblower rewards and retaliation cases. For more information about SEC whistleblower awards, download our 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:
|American Insurance Group (AIG)||$800 Million||Insurance company booked loans as revenue at an estimated $3.9 billion in accounting fraud and conspired to induce traders to inflate the prices of the stocks.|
|WorldCom||$750 Million||WorldCom inflated earnings by more than $11 billion and cost investors close to $200 billion. The deal reflects a civil penalty of $2.25 billion, which was reduced as part of the bankruptcy reorganization.|
|Fannie Mae||$350 Million||Fannie Mae “issued materially false and misleading financial statements in SEC filings and in various reports disseminated to investors.”|
|Time Warner||$300 Million||Time Warner engaged in securities fraud related to its accounting for online advertising revenue. It used “round-trip transactions” to inflate its online advertising revenue to hide the business slow down.|
|Qwest Communications||$250 Million||Qwest intentionally recognized over $3.8 billion in revenue and excluded $231 million in expenses that did not meet generally accepted accounting principles (GAAP) in an attempt to meet their predicted revenue and earnings projections.|
|Computer Associates||$225 Million||Computer Associates prematurely recognized over $3.3 billion in revenue by manipulating its quarter end cutoff dates to meet Wall Street’s quarterly earnings estimates. SEC’s Northeast Regional Office Director Schonfeld compared it to a team “that plays on after the final whistle has blown … until it had all the points it needed to make every quarter look like a win.”|
|Panasonic Corp||$143 Million||Panasonic overstated pre-tax and net income by prematurely recognizing more than $82 million in revenue by backdating an agreement with an airline. Additionally, Panasonic “lacked sufficient internal accounting controls and failed o make and keep accurate books and records in connection with purported consultant retained by PAC.”|
|Weatherford||$140 Million||Weatherford inflated earnings by using deceptive income tax accounting which included an international tax avoidance structure that reduced its effective tax rate (ETR) and tax expense. False financial statements inflated earnings by over $900 million.|
|Healthsouth||$100 Million||Shortly after Healthsouth went public in 1986, it began to “artificially inflate its earnings to meet Wall Street analysts’ expectations and maintain the market price.” Since 1999, it overstated its earnings by over $1.4 billion.|
|Lehman Brothers||$80 Million||Lehman intentionally manipulated their accounting reports through numerous Repo105 transactions that hid their actual debt. When they declared bankruptcy they were $615 billion in debt.|
Accounting Fraud SEC Whistleblower Lawyers
How to Qualify for an SEC Whistleblower Bounty
- See our column in Forbes: One Billion Reasons Why The SEC Whistleblower-Reward Program Is Effective.
- See our column in Going Concern: Sarbanes-Oxley 15 Years Later: Accountants Need to Speak Up Now More Than Ever.
- See our post in Accounting Today: Whistleblower Protections and Incentives for Auditors and Accountants.
- See our post in The Compliance and Ethics Blog: Shkreli Trial Reveals the Challenges Faced by Compliance Whistleblowers.
Are Accounting Fraud Whistleblowers Protected from Retaliation?
Click here to learn more about anti-retaliation protections for SEC whistleblowers under the Dodd-Frank Act and Sarbanes-Oxley Act.