This article originally appeared in Law360 and is republished with permission.
Key performance indicators, or KPIs, have been a topic of interest of the U.S. Securities and Exchange Commission for some time. Recent remarks by Chairman Jay Clayton and others at the SEC, however, along with a recent set of enforcement actions, suggest that interest in the topic may be increasing. Given the nature of KPIs, it is to be expected that a commission focused on the “Main Street” investor would also be focused on the accurate disclosure of this kind of information. In June and August 2018, the SEC brought enforcement actions against two companies and three individuals for manipulating certain KPIs. While not a trend, the combination of commission statements and these enforcement actions suggests it is an issue worth watching.
A KPI is essentially a measurement that assesses a company’s performance in relation to a key business objective. Depending on the industry and the company, the KPI might be different. In other words, what is a KPI in one industry or even at one company might not be in other industries or at other companies. A KPI also is often not subject to generally accepted accounting principles and outside the audited financial statements.
On June 5, 2018, the SEC announced that it had reached a settlement in In the Matter of Constant Contact Inc. and Endurance International Group Holdings Inc. According to the SEC, Constant Contact Inc. and Endurance International Group Holdings Inc., public companies offering web hosting and online and email marketing products to small- and medium-sized businesses, materially misrepresented subscriber/customer metrics and the growth of those metrics. Both Constant Contact and Endurance (Constant Contact was acquired by Endurance in 2016) considered, and actively promoted, subscriber/customer metrics and the growth of those metrics as KPIs because a significant portion of the companies’ revenue was from subscription-based products. This information, therefore, could provide insight into the companies’ financial performance.
The SEC claimed that Constant Contact reported “unique paying customers” as a KPI used by Constant Contact “to understand and improve its business, review its historical performance, benchmark its performance versus other companies and identify current and future trends, and for planning purposes.” Constant Contact targeted 10,000 new unique paying customers per quarter. Beginning in the third quarter of 2014, however, internal reports suggested that the company’s performance was trending below the levels needed to reach the 10,000 target. In response, the company instituted a new program in which customers who were going to cancel their subscription and who were going to receive an invoice before the last day of the quarter (and therefore would be removed from the unique paying customers count), were offered a free month of service.This allowed Constant Contact to postpone customer cancellations until the next quarter and functioned to artificially inflate its unique paying customers count. This was not only contrary to its public disclosures — Constant Contact specifically described the count as including “paying customers” — but also contrary to its previous practice, as Constant Contact had to manually include such customers into the company’s calculation who, under the company’s policy, would otherwise have been excluded.
Similarly, the SEC claimed that Endurance reported subscriber count and average revenue per subscriber as a KPI used by Endurance “to evaluate the operating and financial performance of its business, identify trends affecting its business, develop projects and make strategic business decisions.” In connection with an error in the subscriber counting calculation, however, Endurance had materially overstated its subscriber count since its initial public offering in October 2013. Endurance did not become aware of the subscriber counting calculation error until May 2014 and, while its analysis of the error was not complete, at least some members of senior management were informed that the work that was done suggested the error was larger than initially thought. Despite this discovery and the increased extent of the error known by at least some members of senior management, Endurance continued to report subscriber metrics for the second and third quarters of 2014 that failed to take into account the error and even failed to acknowledge the existence of the error. Endurance finished its analysis of the error, which reflected a more than 10 percent overstatement of the company’s subscriber count, in advance of reporting its fourth-quarter 2014 results.
Compounding the issue, also in the fourth quarter of 2014, Endurance changed its definition of total subscribers to include customers who had not previously been included in the subscriber count.The change in definition functioned to offset the reduction that resulted from correcting the error in the subscriber counting calculation. Therefore, despite Endurance disclosing that it had changed the definition of total subscribers, it did not provide reconciliation between the subscriber counts under the two definitions, covering up a 424,000 decrease in subscribers as a result of the error with a 482,000 increase in subscribers as a result of the new definition. According to the SEC, Endurance also changed its calculation of average revenue per subscriber in the fourth quarter of 2014, further masking the error.
Without admitting or denying these findings, Constant Contact agreed to violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act, and Endurance agreed to violations of Section 17(a)(2) of the Securities Act. In addition, both companies agreed to violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11 and 13a-13 thereunder, and Section 13(b)(2)(A) of the Exchange Act. Constant Contact and Endurance also agreed to certain undertakings, to cease and desist from committing or causing any violations and any future violations of the above sections and rules, and to pay a civil money penalty of $8 million.
In August 2018, the SEC announced that it also had reached settlements with two former officers of Endurance, Hari Ravichandran, the former CEO, and Waruna Ellawala, the former chief financial officer, and had filed charges against a former officer of Constant Contact, Harpreet Grewal, the former CEO. In a statement in connection with the enforcement actions against these individuals, the director of the SEC’s Boston regional office commented: “For companies who provide subscription-based services, size and growth of subscriber base can be critical metrics .... Investors depend on the integrity of management in reporting such figures, which commonly fall outside the scope of formal audits. Holding senior executives accountable for failures of oversight as well as outright manipulation of such metrics is vital to protecting our markets.”
The existence of KPIs and the SEC’s targeting of them are not new. KPIs are subjective, possibly non-GAAP measures that generally are not part of the audited financial statements. As such, they are particularly susceptible to being manipulated and misleading investors. The charges brought against Constant Contact and Endurance and several of the companies’ officers, coupled with recent statements by commission officials, however, may suggest that KPIs will become even more of a focus for this SEC and this Division of Enforcement.
In the early 2000s, commission officials regularly remarked on the need for better disclosures regarding KPIs, while simultaneously encouraging companies to include KPIs in their public filings. In 2000 and 2001, then-Chief Accountant Lynne Turner gave several speeches suggesting that companies include KPIs in their public filings since the information was often available elsewhere and was used by management internally to assess business objectives. He explained that “greater disclosure in a neutral, comparable, consistent fashion of key performance indicators would be helpful and would enhance the quality of information investors receive” because the “indicators do provide information about value creation in a business.” In the following years, the SEC brought several enforcement actions against companies for failing to accurately disclose KPIs. In fact, after several years of companies increasing the inclusion of KPIs in their public filings, in May 2016, the Division of Corporation Finance issued a significant compliance and disclosure interpretations update regarding non-GAAP financial measures, including KPIs, and has issued several updates since that time.
More recently, in remarks at a conference in October 2017, Clayton commented that while non-GAAP measures and KPIs can be useful to investors, they can also misrepresent financial outcomes. He further warned that companies should not provide different non-GAAP and KPI information in their public filings than management uses. Similarly, at the December 2017 American Institute of Certified Public Accountants conference, several commission officials mentioned their interest in non-GAAP measures and KPIs in their remarks. While acknowledging that he thought disclosures had improved in response to commission statements, Mark Kronforst, then chief accountant for the Division of Corporation Finance, said that the staff would continue to closely monitor the use of KPIs.
As mentioned previously, KPIs have been a topic of concern for the SEC over the years, though more recently, enforcement actions have been less prevalent. As the remarks of Clayton and others at the SEC and the Constant Contact and Endurance set of enforcement actions suggest, however, there might be a renewed interest. The SEC’s restated commitment to the “Main Street” investor and to pursuing individuals for violations of the federal securities laws is exhibited by the companies and the individuals charged in the Constant Contact and Endurance set of enforcement actions. In light of these developments, KPIs are an aspect of disclosures that justify heightened scrutiny. The definition of KPIs can be imprecise and are often not part of a company’s audited financial statements, making them more exposed to manipulation and presenting a particular risk to the “Main Street” investor. KPIs, such as quarter-over-quarter subscriber/customer counts and related growth, are information that is understandable and quickly digestible, as opposed to more complicated, dense financial statements. As a result, it might be the kind of information that the “Main Street” investor looks to first in considering investments. Companies reporting KPIs in their public filings or otherwise disclosing them, therefore, should be paying attention to the Constant Contact and Endurance set of enforcement actions and be sure to provide sufficient context about KPIs — define the KPI, explain how it is calculated, and if a company changes the KPI quarter over quarter, clearly disclose those changes and the effects on assessing previous quarters.