Portugal Telecom Settles Financial Reporting Allegations
 

On September 13, 2016, Pharol SGPS, S.A., formerly known as Portugal Telecom SGPS, S.A. (“Portugal Telecom”), agreed to pay a $1.25 million civil penalty to resolve the SEC’s investigation into its alleged accounting and controls failures.  In the Matter of Portugal Telecom, SGPS, S.A., File No. 3-17534 (Sept. 13, 2016).  The alleged accounting and control failures related to Portugal Telecom’s 2013 disclosure of its short-term investments in debt securities.  Portugal Telecom neither admitted nor denied the SEC’s allegations, which were made as a part of a settled cease and desist order alleging violations of Section 13 of the Exchange Act. 

By way of background, Portugal Telecom announced plans to merge with Brazilian telecommunication giant Oi, S.A. in 2013, and the two parties valued their assets as of December 31, 2013.  At the time, Portugal Telecom maintained a €750 million investment—representing approximately 29% of its short-term investments and cash equivalents—in the debt of Espirito Santo International, S.A. (“ESI”), an affiliate of the large Portuguese conglomerate Grupo Espirito Santo (“GES”).  Portugal Telecom reinvested its maturing ESI investments in the debt of a separate GES affiliate, Rio Forte Investments, in February 2014.  That same month, Portugal Telecom and Oi signed a final merger agreement whereby Portugal Telecom would transfer its operating assets—including the Rio Forte debt—to Oi in exchange for shares of Oi.  Rio Forte defaulted on its debt obligations five months later.  As a result, Oi returned the Rio Forte investments to Portugal Telecom, and Portugal Telecom was forced to accept a reduced share of 27.5% of Oi; it had been poised to secure a 39.7% share of Oi before the default.

The SEC’s cease and desist order against Portugal Telecom focused on two key allegations relating to the company’s reporting of its 2013 ESI debt investments.  First, the SEC contended that although a footnote to Portugal Telecom’s 2013 financial statements described its ESI investment, the footnote failed to name ESI—mistakenly naming a Portugal Telecom entity instead—or disclose ESI’s credit quality as is required under International Financial Reporting Standards (“IFRS”).  The SEC explained this was deficient since shareholders could not fully evaluate the credit risk that the ESI debt posed.  Second, the SEC alleged that while Portugal Telecom had technically made short-term investments primarily in GES affiliates since 2001, it had routinely rolled them over which—in essence—created long-term investments, notwithstanding Portugal Telecom’s stated policy to shareholders of investing “for short time periods” with reputable financial institutions and diverse counterparties.

A key takeaway from this cease and desist order is that the SEC scrutinized Portugal Telecom’s disclosures in great detail—its alleged reporting deficiencies stemmed entirely from two footnotes in the company’s financial statements and concerned only investments in the debt of ESI, which did not default on that debt before it matured.  The choice to impose a high fine in this case, even without any allegations that Portugal Telecom’s accounting caused direct financial harm to shareholders, signals the importance that the SEC attaches to accounting failures that obscure shareholder risk.