The SEC announced charges against alcohol producer Diageo plc for failing to make required disclosures of known trends relating to the shipments of unneeded products by its North American subsidiary to distributors. Diageo agreed to pay $5 million to settle the action. Diageo did not admit or deny the findings in the SEC order.
According to the SEC’s order, employees at Diageo North America (DNA), Diageo’s largest and most profitable subsidiary, pressured distributors to buy products in excess of demand in order to meet internal sales targets in the face of declining market conditions. The resulting increase in shipments enabled Diageo to meet performance targets and to report higher growth in key performance indicators that were closely followed by investors and analysts. The order finds that Diageo failed to disclose the trends that resulted from shipping products in excess of demand, the positive impact the overshipping had on sales and profits, and the negative impact that the unnecessary increase in inventory would have on future growth. The order further finds that investors were instead left with the misleading impression that Diageo and DNA were able to achieve growth in certain key performance indicators through normal customer demand for Diageo’s products.
DNA’s practice of overshipping relative to demand also involved the use of extraordinary sales practices. For example, under its contracts with distributors, DNA had the right to terminate the relationship if distributors failed to meet certain depletion targets. When distributors told DNA that they would not meet their targets, DNA agreed to waive its termination clauses if distributors would purchase additional unneeded innovation products. Other examples included DNA waiving penalty payments distributors were contractually required to pay to DNA for failing to meet targets if the distributors agreed to purchase unneeded innovation products.
By early fiscal 2015, inventory levels at some distributors were so high that they were resisting additional purchases. For these distributors, the purchase of unneeded inventory from DNA had become unsustainable. In response, DNA prepared and Diageo approved a plan to reduce inventory levels at certain DNA distributors. This would be achieved principally through a reductions in sales, a process known as “destocking.” The plan, to take effect beginning in fiscal 2016, would reduce distributor inventory over a period of years in an amount that would have been material if it occurred in a single reporting period.
DNA, as part of a series of proposals to alter its relationship with distributors, negotiated new contracts with its main distributors, to take effect in fiscal 2016, which provided for a reduction in inventory levels and which required the distributors to make additional payments to DNA. One effect of those additional payments was to mitigate the lost revenue arising out of the inventory reduction provisions.