SEC comment letters are a good source of information about the inner workings of a company. Even if the company may be well covered in the press, SEC comment letters still can offer additional information or new points of view.
Back in March 2015, Lumber Liquidators (LL) came under fire for the discovery of a potentially dangerous level of formaldehyde in their laminate flooring products sourced from China.
The case was widely covered by the media. Recently, the DOJ and SEC launched investigations of potential Lacey Act violations, and the company faces a number of shareholder legal actions. Moreover, since March a number of executives – including CEO, CFO, and Chief Merchandising Officer – have parted ways with the company through resignation or termination.
In situations like this, a comment letter from the SEC with requests for clarification is almost guaranteed. Indeed, on March 16, 2015 the SEC issued the first of many letters to Lumber Liquidators. Unsurprisingly, it asked about virtually everything related to the matter – from quality assurance procedures to pending legal actions to inventory management.
On April 10, 2015 Lumber Liquidators responded with an explanation of their QA procedures. The response detailed QA procedures by region, and parts of it were later included in the subsequent 10-Q. Among other things, the difference in procedures between North America and China became readily apparent. While in North America the HQ or Regional organizations have dedicated QA teams, QC in China is largely in the hands of local manufacturers at the mills.
More letters from the SEC and Lumber Liquidators followed, discussing inventory and legal implications. Perhaps the most interesting comments came towards the end of the conversation in letters dated May 15 and June 26.
In the May 15 letter, the SEC requested an explanation of the nature of a reserve of $0.5 million for estimated future costs to “service certain customers not satisfied by the results of the air quality testing program.”
All Other Costs, page 21
2. You indicate that you have recorded a reserve of $0.5 million for estimated future costs to service certain customers not satisfied by the results of the air quality testing program. Please clarify whether this reserve also includes an estimate for the cost of sending additional test kits to customers. If not, please tell us why you did not accrue for these costs. Tell us how many additional test kits were requested and the cost of those kits to date.
The company responded a month later, on June 19, following two extension of time requests. In the letter, Lumber Liquidators stated that the reserve was recorded based on ASC 450-20 (Loss Contingencies) and ASC 855-10 (Subsequent Events) and does not include costs of sending additional kits. For the quarter ended March 30, 2015, Lumber Liquidators recorded costs about $1.8 million related to 22,800 kits. The company also disclosed that it failed to record costs of an additional 3,100 kits, with total costs of $245,000. The company stated that the accounting error was corrected by recording an out-of-period adjustment in the quarter ended June 30, 2015. This is evidence that accounting for contingencies involve significant judgment calls; according to the company, “the rate at which customers request test kits is impacted by media events discussing the Company and/or its products”.
The Company recorded an expense of approximately $1.8 million in its results for the quarter ended March 31, 2015 representing the cost of approximately 22,800 test kits, which had already been sent to customers. Prior to the filing of the March Form 10-Q on April 29, 2015, the Company received approximately 3,100 additional test kit requests that were probable of being sent to customers with a total cost of $245,000. The Company unintentionally failed to record a reserve for these additional requests. The Company believes this reserve was quantitatively and qualitatively immaterial to its financial position and results of operations for the three months ended March 31, 2015 and will record the additional amount in our results of operations for the three months ended June 30, 2015.
For the period from April 30, 2015 through June 15, 2015, the Company advises that its customers have requested approximately 13,400 additional test kits with a total cost of approximately $1.1 million. Approximately 12,000 of those additional test kits were requested after the Company’s announcement on May 7, 2015 that it was suspending sales of all laminates sourced from China. The Company believes that the rate at which customers request test kits is impacted by media events discussing the Company and/or its products.
The last letter in the conversation focused on products other than laminate floors. In the letter filed June 26, the SEC requested that Lumber Liquidators quantify the sales of products other than laminate floors sourced from China. Unfortunately, the company requested that its response remain confidential, based on reasons of business confidentiality. It is not apparent whether the confidentiality request was associated with the materiality of sales sourced from China, or whether there are other reasons for the request. Lumber Liquidators also stated that it disclosed some legal actions related to these products (such as Gold Matter and the Litigation Relating to Products Liability), and that other pending actions linked to these issues are deemed to be immaterial.
As we’ve noted before, comment letters are not a substitute for periodic and event filings. They can, however, provide additional insight into less-covered aspects of significant events and disclosures, such as accounting policies and legal risks.