SECURITIES EXCHANGE ACT OF 1934
Release No. 41578 / June 30, 1999
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1140 / June 30, 1999
ADMINISTRATIVE PROCEEDING
File No. 3-9926
| In the Matter of W. R. Grace & Co., |
ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS, AND IMPOSING CEASE-AND-DESIST ORDER |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate to institute public administrative proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against W. R. Grace & Co. ("Respondent").
II.
In anticipation of the institution of these administrative proceedings, Respondent has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of the proceeding, which are admitted, Respondent consents to the entry of this Order Instituting Public Administrative Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Cease-And-Desist Order ("Order").
Accordingly, it is ordered that proceedings pursuant to Section 21C of the Exchange Act be, and hereby are, instituted.
III.
On the basis of this Order and Respondent's Offer of Settlement, the Commission makes the following findings:1
A. STATEMENT OF FACTS
1. Settling Respondent
Respondent, W. R. Grace & Co., a Delaware corporation, is the successor registrant to W. R. Grace & Co., a New York corporation that, during the period from 1991 through 1995 (the "relevant period"), had its principal executive offices in Boca Raton, Florida (hereinafter "Grace FL" or "Grace"). During the relevant period, Grace's businesses included, among other things, packaging, specialty chemicals and health care services. At all times relevant hereto, Grace was required to make and file periodic reports with the Commission. After the relevant period, Grace engaged in a series of restructuring transactions that resulted in the formation of the successor company, W. R. Grace & Co., which is the respondent in this Order.
2. Others
a. National Medical Care, Inc. ("NMC") was Grace's main health care subsidiary, with its headquarters in Waltham, Massachusetts. During the relevant period, NMC was wholly owned by Grace and was not publicly-traded, and it did not file periodic reports with the SEC. NMC provided kidney dialysis and home health services and manufactured specialized medical products. During the relevant period, NMC comprised the bulk of Grace's Health Care Group, which group was, through the first quarter of 1995, one of Grace's core businesses and was reported as a segment in Grace's consolidated financial statements. The Health Care Group contributed a significant portion of the consolidated pre-tax earnings of Grace during the relevant period. Grace disposed of NMC in 1996.
b. "Former Grace senior management," as used herein, refers to individuals who filled the following positions at Grace FL during all or most of the relevant period: (a) Grace's president and chief operating or executive officer, (b) Grace's executive vice president and chief financial officer, and (c) Grace's vice president and controller. Respondent does not employ any member of former Grace senior management referred to herein.
c. "Former NMC senior management," as used herein, refers to individuals who filled the following positions during all or most of the relevant period: (a) Grace FL's executive vice president and NMC's chairman and chief executive officer, (b) NMC's vice president and chief financial officer, and (c) NMC's vice president and controller. Respondent does not employ any member of former NMC senior management referred to herein.
3. Overview
During the relevant period, and prior to the restructuring that resulted in the formation of Respondent, former Grace and NMC senior management engaged in fraudulent conduct by falsely reporting the results of Grace's operations and those of its Health Care Group and by making false and misleading statements in press releases and at teleconferences with analysts. As a result of this fraudulent activity, Grace FL made materially false filings with the SEC, publicly disseminated materially false statements, failed to maintain accurate books and records, and failed to maintain adequate accounting controls.
As described below, during the relevant period, the former Grace and NMC senior management deferred reporting income earned by NMC primarily to smooth the earnings of the Health Care Group, i.e., to bring the reported earnings of the Health Care Group in line with Grace's targeted earnings. At the direction and/or with the knowledge of former Grace and NMC senior management, Grace deferred reporting income by increasing or establishing reserves not in conformity with generally accepted accounting principles ("GAAP") (hereinafter, the "excess reserves"). Grace, as directed by former Grace senior management and implemented by former NMC senior management, used the reserves to manipulate the reported quarterly and annual earnings of the Health Care Group and Grace.
4. Excess Reserves at NMC
a. Creation and Amount of the Excess Reserves
NMC experienced a significant and unanticipated increase in revenues and earnings, in excess of Grace's forecasts, beginning in 1990 or 1991 due to changes in Medicare reimbursement. During the first half of 1991, former NMC senior management deferred some of the unanticipated income by increasing or establishing reserves. Rather than report its actual earnings, NMC, at the direction of former Grace senior management, underreported its earnings for 1991 and 1992. NMC accomplished this by creating or increasing reserves (an expense), often referred to as the "excess reserves." There were no probable and reasonably estimable exposures to justify the excess reserves; i.e., they were not recorded in conformity with GAAP.2 Most of the excess reserves were placed in an account of NMC's Dialysis Services Division, an account used to record liabilities to the physicians who managed NMC's dialysis clinics. These excess reserves accumulated above $50 million by the end of 1992. During the years 1993 through at least the first quarter of 1995, the excess reserve balance ranged from about $36-63 million.3
b. Use of the Excess Reserves
During the relevant period, former Grace senior management directed NMC to use the excess reserves primarily for profit planning purposes, i.e., to bring the reported quarterly and annual earnings of the Health Care Group in line with Grace's targets.
At some point in mid-1991, as the reserves reached a level of between $10 and $20 million, former Grace senior management directed that NMC keep the excess reserves and report Health Care Group earnings consistent with targeted levels (specifically a 24% growth rate for 1991). Former Grace senior management believed that Grace would not be credited by the investing public for growth rates beyond the targeted levels.
During the relevant period, the Health Care Group's reported earnings and growth rates were materially misstated. In general, from 1991 through the first quarter of 1995, the reported Health Care Group growth rates remained relatively steady--from about 23-37%--whereas the actual growth rates fluctuated from about an 8% decline to a 61% increase. For example, maintaining the excess reserves led to a final reported 1991 growth rate for the Health Care Group of 24%, as had been targeted, rather than the actual rate of 35%. Similarly, former Grace senior management directed NMC to use the reserves to report a 27-28% growth rate for the Health Care Group's net income for 1992. The final reported 1992 growth rate was 27%, rather than the actual rate of 28%. Also, in 1993, the final reported growth rate was 35%, rather than the actual rate of 14%.
At various times, former Grace senior management also decided to release some of the excess reserves to increase Grace's earnings per share. For example, former Grace senior management directed former NMC senior management to decrease the excess reserves in order to report an additional $1.5 million in income for the fourth quarter of 1994 because Grace needed the additional income for its consolidated results of operations.
c. Reversal of the Excess Reserves
In the second quarter of 1995, Grace's Board of Directors decided to dispose of NMC in a spin-off transaction. As a result, the Health Care Group was reported as a discontinued operation on Grace's financial statements as of June 30, 1995.
Grace reversed the excess reserves from its financial statements in their entirety in the fourth quarter of 1995. The reversal was improperly netted with other charges and adjustments associated with discontinuing the Health Care Group operations. Former Grace senior management, falsely described this reversal of the excess reserves in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") section of Grace's Form 10-K for 1995 as "a change in accounting estimate." In actuality, the excess reserves had never been an estimate of anything and, therefore, had never been recorded in conformity with GAAP.
5. False and Misleading Filings and Statements
During the relevant period, Grace issued a press release and conducted an analyst teleconference at or about the same time it filed each of its Forms 10-Q and 10-K. Throughout the relevant period, the Health Care Group's and Grace's earnings discussed in the teleconferences and reported in the press releases and filings included the effects of the excess reserves. Therefore, those filings, press releases and teleconferences were materially false and misleading because they included, at the direction of former Grace senior management, earnings amounts for the Health Care Group and Grace that were materially affected by the excess reserves. Moreover, Grace's consolidated earnings figures were materially misstated in one or more of Grace's Forms 10-K, Forms 10-Q, press releases and teleconferences.
During the relevant period, the MD&A section of Forms 10-Q and 10-K and the press releases misleadingly included discussions of the results of operations for the Health Care Group and Grace without disclosing the excess reserves. These discussions and statements were materially false and misleading because they did not provide complete and accurate disclosure of all factors relevant to an assessment of the Health Care Group's and Grace's results of operations.
Moreover, during the relevant period, Grace's filings and press releases did not accurately portray the Health Care Group's earnings trends. The Health Care Group growth rates reported by Grace from 1991 through the first quarter of 1995 fluctuated materially less than the actual growth rates. In addition, over the fiscal years 1991 through 1993, Grace reported a steadily increasing growth rate in annual pretax earnings for the Health Care Group; however, the actual trend was a steady decline in the growth rate.
In addition, another factor affecting materiality is that it was former Grace and NMC senior management that was engaged in a scheme to manipulate the Health Care Group's and Grace's reported earnings.
Grace, through former Grace and NMC senior management, filed the following Forms with the Commission that contained materially false and misleading statements concerning reported earnings and growth rates and omitted to disclose material information as described in Sections III.A.3 and III.A.4. above:
a) For fiscal year 1991, Form 10-Q for the third quarter, and Form 10-K;
b) For fiscal year 1992, Forms 10-Q for the first, second and third quarters, and Form 10-K;
c) For fiscal year 1993, Forms 10-Q for the first, second and third quarters, and Form 10-K;
d) For fiscal year 1994, Forms 10-Q for the first, second and third quarters, and Form 10-K; and
e) For fiscal year 1995, Forms 10-Q for the first, second and third quarters, and Form 10-K;
6. Failure to Maintain Adequate Internal Controls and Make and Keep Accurate Books and Records
Because Grace, at the direction of former Grace and NMC senior management, maintained excess reserves for which there were no probable and reasonably estimable exposures, Grace failed to make and keep books and records which accurately reflected its transactions. Because former Grace and NMC senior management had the ability to override Grace's and NMC's accounting controls, Grace failed to maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions were recorded as necessary to permit the preparation of financial statements in conformity with GAAP.
B. VIOLATIONS
1. Violations of Antifraud Provisions of the Federal Securities Laws
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful to make with scienter any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. A statement is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to purchase or sell securities or if a reasonable investor would have viewed disclosure of the omitted fact as altering the total mix of information available.
As described above, during the relevant period Grace, at the direction or with the knowledge of former Grace and NMC senior management, manipulated the Health Care Group's and Grace's income and growth rates reported in financial statements filed with the Commission on Forms 10-Q and 10-K, in press releases disseminated to the public, and in teleconferences with analysts in violation of Section 10(b) of the Exchange Act and Rule 10b-5. Also at the direction or with the knowledge of former Grace and NMC senior management, Grace filed periodic reports with the Commission on the Forms 10-K for fiscal years ended 1991 through 1995, and the Forms 10-Q for the quarters ended September 30, 1991 through June 30, 1995, that contained materially false and misleading statements about the Health Care Group's and Grace's financial condition, specifically their reported earnings and growth rates. As described above, this was false because the Health Care Group's and Grace's earnings were materially misstated through the use of the excess reserves. Furthermore, in addition to the quantitative impact, another factor affecting materiality is that it was former Grace and NMC senior management that was manipulating the income of the Health Care Group and/or Grace. In this instance, the misstatements and omissions, especially when considered in light of the fact that the manipulation involved former Grace and NMC senior management, had a direct bearing on the Health Care Group's and Grace's profitability trends, and were therefore material.
2. Violations of Recordkeeping and Internal Control Provisions of the Federal Securities Laws
Section 13(b)(2)(A) of the Exchange Act requires certain issuers such as Grace to "make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer." Section 13(b)(2)(B) requires certain issuers such as Grace to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are booked accurately, in accordance with management directives, and in a manner designed to permit the preparation of financial statements in conformity with GAAP. Based on the foregoing, Grace FL failed to maintain accurate books and records and failed to maintain an adequate system of internal accounting controls, in violation of Sections 13(b)(2)(A) and 13(b)(2)(B).
3. Violations of Reporting Provisions of the Federal Securities Laws
Section 13(a) of the Exchange Act requires issuers such as Grace to file periodic reports with the Commission containing information prescribed by specific Commission rules. Such reports must be complete and accurate. Rules 13a-1 and 13a-13 require, respectively, the filing of Forms 10-K and 10-Q. Rule 12b-20 requires, in addition to information required in periodic reports by Commission rules, such further material information as may be necessary to make the required statements not misleading.
Grace, at all times relevant, was subject to the reporting requirements of Section 13(a) of the Exchange Act and the rules promulgated thereunder. The requirement that reports be filed necessarily includes the requirement that they be accurate. Where, as here, an issuer files false and misleading reports, those provisions are violated. Additionally, the filing of financial statements not prepared in conformity with GAAP violates those provisions because Regulation S-X specifically provides that financial statements not prepared in conformity with GAAP are presumed to be misleading or inaccurate. 17 C.F.R. 210.4-01(a)(1). Based on the foregoing, Grace FL violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 by filing Forms 10-K and 10-Q that contained material misrepresentations and omissions concerning the Health Care Group's and Grace's income and results of operations.
IV.
Based on the foregoing, the Commission finds that Grace FL committed or caused violations of Sections 10(b), 13(a) and 13(b)(2) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder.
V.
Accordingly, the Commission hereby accepts Respondent's Offer of Settlement and orders that:
A. Pursuant to Section 21C of the Exchange Act, Respondent cease and desist from committing or causing any violation and any future violation of Sections 10(b), 13(a) and 13(b) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder.
B. Respondent undertakes, pursuant to agreement with the Commission and not pursuant to Section 21C of the Exchange Act, to establish within 30 days a fund of $1 million to be used within 12 months, in a manner not unacceptable to the Commission staff, for program(s) to further awareness and education relating to financial statements and generally accepted accounting principles. Within 30 days of the expiration of the 12 month period, Grace will provide the Commission staff with an accounting of all funds paid.
By the Commission.
Jonathan G. Katz
Secretary
FOOTNOTES
| 1 | The findings herein are made pursuant to the Respondent's Offer and are not binding on any other person or entity in this or any other proceeding. |
| 2 | See, Statement of Financial Accounting Standards No. 5, Accounting for Contingencies. |
| 3 | During the relevant period, former Grace and NMC senior management discussed the excess reserves with Grace's independent auditors. For each year during the relevant period, those independent auditors issued reports containing unqualified opinions on Grace's consolidated financial statements. |