On 10 March 2016, Magnum Hunter Resources Corporation (“MHR”), its CFO, chief accounting officer (the “CAO”), an external audit engagement partner and a consultant reached settlements through cease-and-desist orders with the SEC to resolve charges that they had failed to properly maintain MHR’s internal control over financial reporting (“ICFR”) between 31 December 2011 and 30 September 2013.

As set forth in the orders containing the terms of the parties’ settlements, MHR’s rapid growth and significant acquisitions in 2010 and 2011 strained its accounting resources, preventing the company from completing its standard monthly close process on time. On this basis, the SEC found a “material weakness” in MHR’s internal control over financial reporting. A “material weakness” is defined in Regulation S-X as a “deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

The SEC found that the CFO and CAO were in full knowledge of the stress placed on MHR’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.

Before the SEC commenced this proceeding, MHR had engaged a public accounting firm to provide consulting and internal auditing services. The consulting firm documented and tested the company’s controls and identified problems in the accounting department that evidenced “inadequate and inappropriately aligned staffing.” Nevertheless, the partner of the consulting firm concluded that the staffing deficiency in the company’s accounting department did not rise to the level of a material weakness.

Similarly, MHR’s independent auditor recognised during the 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, the external audit partner concluded that the weakness did not rise to the level of “material weakness.” The SEC found that there was inadequate documentary support for such a conclusion, that the independent auditor did not apply the applicable auditing standards appropriately and that the CFO and CAO did not sufficiently consider the independent auditor’s findings. Accordingly, the public was not informed that MHR had a material weakness in its ICFR.

SEC rules require company management to evaluate and annually report on the effectiveness of ICFR, including disclosing any identified material weaknesses that create a reasonable possibility that the company will not timely prevent or detect a material misstatement in its financial statements. Management may not conclude ICFR is effective if a material weakness exists.

Without admitting or denying the findings in the cease-and-desist orders, MHR agreed to pay a penalty of $250,000 subject to bankruptcy court approval, the CFO and the partner of the consulting firm agreed to pay penalties of $25,000 and $15,000, respectively, and the CAO and the partner of MHR’s independent auditor agreed to be suspended from appearing and practicing before the SEC as an accountant until reinstatement after at least one year. This matter shows the SEC’s willingness to initiate an enforcement action against senior executives and outside audit parties for internal control deficiencies even though the practices at issue could be portrayed as not material weaknesses.