Oil and gas producer Magnum Hunter Resources and several individuals settled charges this week with the Securities and Exchange Commission for deficient evaluation of the company’s internal controls over financial reporting, and failures to maintain internal control over financial reporting.
As Compliance Week previously reported, Magnum Hunter Resources disclosed in a Form 8-K filing with the SEC in April 2015 that it has received a Wells Notice for potential material weaknesses in the company’s internal control over financial reporting. Magnum Hunter said the SEC made a preliminary determination to recommend an enforcement action against the company, following a formal investigation the SEC launched in 2013 “regarding the company’s internal controls, change in outside auditors during 2012 and 2013 and public statements to investors and asking the company to preserve documents relating to these matters.”
Internal control over financial reporting (ICFR) refers to a company’s process for providing reasonable assurance to the public regarding the reliability of its financial reporting. SEC rules require company management to evaluate and annually report on the effectiveness of ICFR, including disclosing any identified material weaknesses that creates a reasonable possibility that the company will not timely prevent or detect a material misstatement of its financial statements. Management may not conclude ICFR is effective if a material weakness exists.
The SEC alleges that Magnum Hunter Resources (MHR) and two senior officers—Ronald Ormand, former chief financial officer, and David Krueger, former chief accounting officer—failed to properly evaluate and apply applicable ICFR standards and improperly concluded that MHR had no material weaknesses.
The SEC also charged Joseph Allred, a former MHR consultant, and Wayne Gray, former MHR audit engagement partner, with improperly evaluating the severity of MHR’s internal control deficiencies and misapplying relevant standards for assessing deficiencies and material weaknesses. As a result, the public was not told that MHR had a material weakness in its ICFR, the SEC said.
“Effective internal controls are a critical safeguard against false and inaccurate information that may harm shareholders,” said Shamoil Shipchandler, director for the SEC’s Fort Worth regional office. “This action emphasizes that all those involved in ICFR assessments—companies, management, external auditors and consultants—must take their responsibilities seriously and rigorously assess controls, including those over financial reporting.”
According to the SEC’s orders:
MHR’s rapid growth, which included multiples of revenue growth in 2010 and significant acquisitions in 2010 and 2011, strained its accounting resources. The acquisition and revenue growth caused Magnum Hunter to be unable to complete its standard monthly close process on time.
Ormand and Krueger knew of the stresses placed on Magnum Hunter’s accounting department as a result of its rapid growth. Nonetheless, they failed to apply appropriate standards when determining the severity of MHR’s internal control deficiency.
Allred, a partner at a PCAOB-registered public accounting firm that provided consulting and internal auditing services to Magnum Hunter, led consulting engagements to document and test Magnum Hunter’s controls and identified problems in the company’s accounting department that exhibited “inadequate and inappropriately aligned staffing.” These problems caused delays in Allred’s testing.
Despite identified problems, and his belief that “[t]he potential for error in such a compressed work environment presents substantial risk,” Allred concluded that the staffing deficiency in the company’s accounting department did not rise to the level of a material weakness.
Gray, an engagement partner at a PCAOB-registered public accounting firm that served as Magnum Hunter’s independent auditor, recognized during his audit that MHR lacked “adequate internal control over financial reporting due to inadequate and inappropriately aligned staffing” which “increases the possibility of a material error occurring and being undetected.” Despite this assessment, Gray concluded that the weakness did not rise to the level of material weakness and failed to adequately document the basis for his conclusion.
Without admitting or denying the findings in the cease-and-desist orders covering various reporting and internal control provisions of the federal securities laws, MHR agreed to pay a penalty of $250,000 subject to bankruptcy court approval.
Ormand and Allred agreed to pay penalties of $25,000 and $15,000 respectively, and Krueger and Gray agreed to be suspended from appearing and practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies. The SEC’s order permits them to apply for reinstatement after one year.