What a Wells Notice Means for GE

General Electric’s GE 8-K filing on Oct. 6 disclosed that the U.S. Securities and Exchange Commission issued a Wells notice on Sept. 30 for possible violations of securities laws. The shares dipped over 5% upon the filing, implying that the market feared a loss of over $3 billion. While the stock has nearly recovered, we believe the initial sell-off was an overreaction and therefore leave our $9.60 fair value estimate intact.

While we don’t believe GE has a legal duty to disclose Wells notices, we’re glad it did.

We reviewed the SEC Division of Enforcement 2019 annual report. In fiscal 2019, parties on the opposite end of the SEC’s actions and proceedings were ordered in aggregate to pay $4.3 billion in total money ordered (of which about one fourth included penalties). In other words, the market’s Oct. 6 reaction implied that GE would ultimately have to pay over 70% of the total money ordered from SEC actions for all companies in 2019. We find this determination excessive. The median SEC action required parties to pay $550,00 in total money ordered in 2019. While bears may point out that the top 5% of cases constitute 70% of total money ordered, that still amounts to about 43 of the 862 total enforcement actions brought by the SEC. If we take straight division, this implies an average responsibility of $71 million in total money ordered from the top 5% of companies in 2019. That’s a higher amount of total money ordered than any year since 2004 (and the second-highest number of enforcement actions ever, narrowly failing to eclipse 2016 by seven actions). The SEC’s highest total money ordered collected in fiscal 2019 amounted to $100 million in civil penalties alone, which was against Facebook for the Cambridge Analytica controversy.

Importantly, we did not see any disgorgement remedies from any publicly traded companies in 2019. Disgorgement is a heavier, punitive award. While the SEC has collected disgorgement from publicly listed companies, the heaviest penalties are commonly reserved for offering fraud and violation of the Foreign Corrupt Practices Act. The highest disgorgement we’ve ever seen in the United States was leveraged against Petrobras with $933 million in disgorgement and prejudgment interest and $853 million in penalties. However, alleged violations of the FCPA are alleged criminal violations, which is not the situation GE finds itself in. Hypothetically deducting the full $100 million penalty that Facebook faced in 2019 from our GE enterprise valuation would reduce our fair value estimate by a penny, while applying the second-highest corporate disgorgement ever--a far more egregious antibribery fact pattern--would reduce our fair value estimate by $0.04. This would be more than offset by the time value of money and lower interest-rate headwinds to pensions than we expected earlier in the year.

We’re not undermining the seriousness of the news, however. There are multiple potential outcomes from this exchange. A Wells notice is a notification that the SEC’s enforcement staff conducting the investigation plans to recommend that an action begin against a potential defendant. GE investors have known about the subjects of the underlying investigation, which have gradually progressed and expanded, for quite some time. They include (1) an investigation of GE’s revenue recognition and accounting practices related to long-term service agreements; (2) the reserve capitalization requirements related to its ERAC and UFLIC runoff insurance policies; and (3) the goodwill impairment related to the ill-conceived purchase of Alstom.

While the Division of Enforcement recommends proceedings, it’s a majority vote of five presidentially appointed commissioners (of which only three can belong to the same political party) who decide whether to bring an action against a potential defendant. This notification is typically used as a catalyst to encourage potential defendants to settle, since the commissioners rarely second-guess enforcement recommendation. The Dodd-Frank Act requires a 180-day limit after a Wells notice for the SEC to commence an enforcement proceeding.

The SEC could ultimately elect not to pursue an action. A study by The Wall Street Journal in 2013 found that during a two-year period, about 20% of individuals (not corporations) who had received a Wells notice didn't end up facing charges. That said, it's difficult to extrapolate these figures to the present day, to corporations, and to whether the cause was due to a Wells submission or the SEC's own volition.

Wells notices typically include all charges that the SEC could possibly bring and the relief it could possibly seek. Depending on the nature of the allegations and the remedies the SEC may pursue, it’s typically in the best interest of a public company’s current shareholders for a firm like GE to solve the matter as quickly as possible, given the costs of litigation, adverse findings that could be binding in collateral litigation, the chance to settle without admitting wrongdoing, and the ability to influence how the SEC describes the alleged misconduct. It’s also possible that the SEC’s enforcement staff may agree to lesser charges, reduced sanctions, or a narrower set of issues. Importantly, at this point in the process the SEC staff can only to recommend to the commission the terms of the negotiated settlement. And while it mostly agrees, it is not unusual for the commission to ultimately reject or refine those terms.

GE’s 8-K filing makes clear that the SEC plans to recommend a civil injunctive action related to the historical premium deficiency testing for GE Capital’s runoff insurance operations and its related disclosure (which was poor). This is one of two types of enforcement actions the SEC could bring--the other is an administrative proceeding--but it’s also the most common (though theoretically the SEC could pursue both). The pursuit of a civil injunction action means that the SEC can pursue remedies like civil penalties, disgorgement (which is a deterrent penalty designed to protect the public independent of the claims of individual investors), and an injunction (which either prevents or compels a certain action). The 8-K did not disclose the specific causes of action that the SEC will advance, but that’s typical, from our understanding.

GE has the option of responding to the SEC through the Wells process, which its 8-K filing telegraphed it will do. A written rebuttal comes with appreciable risks, however. Most of the literature from securities attorneys we surveyed suggests that best practice is to generally elect not to respond through a written Wells submission. The risks of doing so include that any written documentation is admissible in court, and any admission contained in the document can be shared with other regulators, like the Kansas Insurance Department.

Finally, a written submission could be obtained through a Freedom of Information Act request or other means, perhaps for use by plaintiffs in pending shareholder derivative suits. This would certainly not benefit current shareholders. Notably, GE did not state it would proceed through written avenues. Therefore, we suspect GE may prefer contacting SEC staff through oral communications regarding any contested questions of fact or law or contravention of SEC policy. That said, it’s important to point out that the SEC wouldn’t issue a Wells notice unless it had collected significant amounts of evidence to draw its conclusions.

The SEC’s own enforcement manual suggests that a Wells notice recipient will generally not be accorded more than one post-notice meeting. As a practical matter, however, we’ve read that this is typically a two-step process, with (1) an initial post-notice meeting to collect information (nature of the evidence, legal theories, and potential relief sought) and (2) a follow-up meeting with more senior enforcement supervisors at the SEC to present a defense, even without a written Wells submission.

Civil penalties are imposed under a three-tier structure reflecting the gravity of GE’s potential alleged violations regarding its insurance reserve accounting practices. Third-tier penalties are reserved for violations involving “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulation” and that “directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons,” while first-tier penalties are assigned to violations. Depending on the severity, GE could face anywhere from about $96,000 to nearly $964,000 per incident. While we won’t speculate which category GE falls under, we suspect that much of the debate between regulators and the company will be around how violations will ultimately be characterized. For its part, GE clearly does not believe any misconduct transpired during the Jeff Immelt era. In a 2019 annual meeting, CEO Larry Culp implied that the board had not uncovered serious misconduct on the part of his predecessor that would merit a compensation clawback.