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Item 9A. Controls and Procedures

2024-03-15 compared with 2023-03-16 · 93 added, 55 removed, 116 unchanged (56% of the section changed)

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Evaluation of Disclosure Controls and Procedures

The Company's management, with the participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual Report on Form 10-K.

Based on this evaluation, and the information described below in this Item 9A, the Company's Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls and procedures were not effective at December 31, 2022, due to the material weaknesses described below.

Management’s Annual Report on Internal Control Over Financial Reporting and Auditor Attestation

The Company's management, under the supervision and with the participation of its principal executive officer and principal financial officer and effected by its board of directors, is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13(a)-15(f) or 15(d)-15(f) under the Securities Exchange Act of 1934, as amended.

The Company's internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States.

The Company's management, with the participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in the Securities Exchange Act of 1934, as amended (“Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual Report on Form 10-K.

Based on this evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls and procedures were not effective at December 31, 2023, due to the material weaknesses described below.

Management’s Annual Report on Internal Control Over Financial Reporting

The Company's management, under the supervision and with the participation of its Chief Executive Officer and Chief Financial Officer and effected by its board of directors, is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13(a)-15(f) and 15(d)-15(f) under the Exchange Act.

The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.

Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation of the Company's principal executive officer and principal financial officer, management conducted an evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2022 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control -- Integrated Framework (2013 framework).

Based on this assessment, management concluded that as of December 31, 2022, its internal control over financial reporting was not effective due to material weaknesses as described below.

A material weakness is a deficiency, or a combination of control 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.

Material Weaknesses in Internal Control and Plan for Remediation

Management has determined that the Company has the following material weaknesses in its internal control over financial reporting at December 31, 2022:

• Control Environment, Risk Assessment, and Monitoring Activities

Under the supervision and with the participation of the Company's Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2023 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in “Internal Control - Integrated Framework” (2013).

Based on this assessment, management concluded that as of December 31, 2023, its internal control over financial reporting was not effective due to the material weaknesses described below.

A material weakness is 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.

Management has determined that the Company has the following material weakness in its internal control over financial reporting at December 31, 2023:

Management did not maintain appropriately designed entity-level controls impacting the control environment, risk assessment procedures and monitoring activities to prevent or detect material misstatements to the consolidated financial statements.

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(i) lack of structure and responsibility, insufficient number of qualified resources and inadequate oversight and accountability over the performance of controls, including retention of control evidence, and (ii) ineffective identification and assessment of risks impacting internal control over financial reporting, and (iii) insufficient evaluation and determination as to whether the components of internal controls were present and functioning based upon evidence maintained for certain management review controls and activity level controls across substantially all financial statement areas.

• Control Activities , and Information and Communication

These material weaknesses contributed to the following additional material weaknesses within certain business processes and the information technology environment:

• Management did not design and maintain effective general controls over information systems that support the financial reporting process.

Specifically, management did not design and maintain (i) effective logical user access controls, including user access reviews, to ensure appropriate segregation of duties and adequate restrictions of users, including those with privileged access, and (ii) appropriate review and authorization of change management in the systems.

• Management did not design and maintain effective controls over the completeness and accuracy of underlying data used in the operation of certain management review controls and activity level controls across substantially all financial statement areas.

This material weakness did not result in any material misstatements of the Company’s financial statements or disclosures for any prior or current reporting periods, but did result in immaterial misclassification adjustments to net sales, cost of goods sold, selling expenses and general and administrative expenses with no impact on net income for the quarter and year ended December 31, 2023 and an immaterial adjustment to deposits as of December 31, 2023.

This material weakness contributed to the following additional material weakness:

Management did not design and maintain effective controls over certain information technology ("IT") general controls for information systems that are relevant to the preparation of their financial statements.

Specifically, management did not design and maintain (i) program change management controls to ensure that program and data changes are

identified, tested, authorized and implemented appropriately, and (ii) user access controls to ensure appropriate segregation of duties and to adequately restrict user and privileged access to appropriate personnel.

These IT deficiencies did not result in a material misstatement to the financial statements.

Each of these material weaknesses could result in a misstatement of substantially all account balances or disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected.

Plan of Remediation of Material Weaknesses in Internal Control Over Financial Reporting

As reported in the 2022 Form 10-K, we have engaged in remedial actions in response to the deficiencies discussed above.

These efforts were on-going during 2022 and 2023 and will continue into 2024.

The following remedial actions were taken in the year ended December 31, 2022:

• Increased the number of personnel with the appropriate level of knowledge related to accounting transactions, accounting matters, and relevant systems, including the addition of a Chief Financial Officer and Controller.

• With the assistance from the third-party service provider, and under the supervision of the Company's Audit Committee, Chief Executive Officer and Chief Financial Officer, initiated the design and implementation of significant process transaction flows and key controls in the Company's overall IT environment.

The following remedial actions were taken in the year ended December 31, 2023:

• As part of management's risk assessment and evaluation of the design of key controls, management updated control objectives and refined control design and documentation, including such design and documentations as related to the appropriate segregation of duties and monitoring activities.

• Enhanced policies and procedures to improve Information Technology General Controls and the Company's overall IT environment.

Examples of some of management's efforts include:

◦ Adopted the policy and procedure to regularly review user's access rights relating to the Company's significant information technology systems;

◦ Designed and started to perform review of users’ access rights to our significant information technology systems;

◦ Maintained and enforced certain procedures, controls and developed IT policies around change management.

Additionally, the following remedial actions are currently in the process of being taken :

• Continue to evaluate the Company's needs for additional personnel and add, as needed, additional headcount primarily within the information technology department.

Management continues to onboard individuals with the appropriate education, experience, certifications, and training.

• Continue to enhance policies and procedures to improve Information Technology General Controls and the Company's overall IT environment, including continue to enforce newly or enhanced policies and controls around user provisioning, access reviews and change management.

Management is committed to remediating the material weaknesses in a timely fashion and to making continuous improvements to the Company's internal control over financial reporting.

Management believes the measures described above have strengthened the Company's internal control over financial reporting, Management will continually assess the effectiveness of the remediation efforts and may determine to take additional measures to address control deficiencies or modify the remediation plan described above.

Remediation of Previously Identified Material Weaknesses

We have previously identified and disclosed the following material weaknesses in our internal control over financial reporting for the year ended December 31, 2022:

• Management did not design and implement management review controls at a sufficient level of precision to detect a material misstatement across substantially all financial statement areas that include complex and judgmental areas of accounting and disclosure.

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• Management did not design and maintain effective activity level controls over the procurement process, including controls over (i) vendor master file changes, (ii) the approval and matching of purchase orders, invoices, and receiving documents, and (iii) authorization of vendor payments.

Plan of Remediation of Material Weakness in Internal Control Over Financial Reporting

In response to the material weaknesses noted above, the Company's management began to take actions to remediate the identified material weaknesses in internal control over financial reporting.

As part of management's remediation plan, certain efforts were put into place and underway prior to December 31, 2022.

All new and revised controls that management started to implement towards the end of 2022 as part of the remediation plan require a period of seasoning to allow for a sufficient operating effectiveness testing sample.

Management plans to build on and continue such efforts going into the next fiscal year in order to successfully remediate the identified material weaknesses.

The following remedial actions were taken during 2022 to remediate the material weaknesses in internal control over financial reporting:

As of December 31, 2023, management sufficiently completed its remediation of these material weaknesses by taking the following measures:

• Engaged a third-party service provider to assist management with the design and implementation of internal controls.

• Started an initial risk assessment based on the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") to identify internal controls over financial reporting ("ICFR") risks and control objectives

• With the assistance from the third-party service provider, and under the supervision of the Company's Audit Committee, Chief Executive Officer and Chief Financial Officer, started the design and implementation of significant process transaction flows and key controls in the Company's business processes, including revenue, inventory, income taxes, and overall IT environment.

As discussed above, all new processes and controls were in the seasoning period as of December 31, 2022.

• Management started to adopt a process to identify and assess the Company's disclosure controls and procedures, including the preparation and review of presentation and disclosure requirement checklists.

Additionally, management is in the process of implementing the below changes to the Company's processes to improve its internal control over financial reporting:

• Evaluate the Company's needs for additional personnel and add, as needed, additional headcount primarily within the accounting and information technology departments.

Management will onboard individuals with the appropriate education, experience, certifications, and training.

The hiring of new employees is expected to create and ensure proper reporting lines and segregation of duties, while also providing additional oversight and structure to the organization.

• Continue to update the risk assessment, objectives, processes and control design and documentation, including such design and documentation as related to the completeness and accuracy of underlying data and a sufficient precision level in management review controls to detect material misstatement across all financial statement areas.

• Improve the process of retaining evidence of sales arrangements with customers including adopting a required retention period for applicable customer purchase orders.

Management is in the process of holding additional training for warehouse employees to appropriately perform and document the three-way match between sales orders, shipping documents, and sales invoices.

• Update and enhance the standard operating procedures of both periodic and year-end physical counts to ensure all inventory items are counted at all warehouses in a consistent manner.

Management is also in the process of continuing to enforce the newly-implemented controls requiring inventory adjustments to be reviewed and approved by the appropriate level of management and to be appropriately recorded and inventory costing analysis to be appropriately reviewed.

• Continue to enforce the newly adopted Company-wide approval matrix that establishes clear guidelines on authority levels for all types of cash disbursement transactions.

Management is in the process of reviewing user access and establishing appropriate reporting lines within the accounts payable department to ensure proper segregation of duties for and performance of controls and procedures including vendor master file changes and the three-way match between purchase orders, receiving documents, and vendor invoices.

• Enhance training programs for personnel that provide key information and perform key roles associated with ICFR.

Management plans to design such training programs in order to improve the level of understanding of the design and proper implementation of controls by the control owners and to instruct such individuals on appropriate level of documentation practices for evidencing review, especially over the completeness and accuracy of underlying data and the precision level used in the review.

• Continue to enhance policies and procedures to improve Information Technology General Controls and the Company's overall IT environment.

Examples of some of management's planned efforts include:

◦ Adopt the policy and procedure to regularly perform a thorough review of user's access rights relating to the Company's significant information technology systems.

◦ Maintain and monitor restrictions to user access where needed to allow for appropriate segregation of duties, and

◦ Maintain and enforce procedures and controls around system development and change management.

Management is committed to remediating the material weaknesses in a timely fashion and to making continuous improvements to the Company's internal control over financial reporting.

Management will continually assess the effectiveness of the remediation efforts and may determine to take additional measures to address control deficiencies or modify the remediation plan described above.

The material weaknesses identified did not result in the restatement of any previously reported financial statements or any related financial disclosure, nor does management believe that they had any effect on the accuracy of the Company’s financial statements for the current reporting period.

• Completed a risk assessment based on the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") to identify internal control over financial reporting ("ICFR") risks and control objectives.

• With the assistance from the third-party service provider, and under the supervision of the Company's Audit Committee, Chief Executive Officer and Chief Financial Officer, designed and implemented significant process transaction flows and key controls in the Company's business processes, including revenue, inventory, and procurement.

• Improved the process of retaining and reviewing evidence of sales arrangements with customers including adopting a required retention period for applicable customer purchase orders and internal review of sales order.

• Held additional training for warehouse employees to appropriately perform and document the three-way match between sales orders, shipping documents, and sales invoices.

• Enhanced training programs for personnel that provide key information and perform key roles associated with ICFR.

Management designed such training programs in order to improve the level of understanding of the design and proper implementation of controls by the control owners and to instruct such individuals on appropriate level of documentation practices for evidencing review, especially over the completeness and accuracy of underlying data and the precision level used in the review.

• Enhanced controls requiring inventory adjustments to be reviewed and approved by the appropriate level of management and to be appropriately recorded and inventory costing analysis to be appropriately reviewed.

• Adopted a Company-wide approval matrix that establishes clear guidelines on authority levels for all types of cash disbursement transactions.

• Established appropriate reporting lines within business processes, including the accounts payable department to ensure proper segregation of duties for and performance of controls and procedures including vendor master file changes and the three-way match between purchase orders, receiving documents, and vendor invoices.

• Updated and enhanced the standard operating procedures of year-end physical counts to ensure all inventory items are counted at all warehouses in a consistent manner.

• Updated objectives, processes and control design and documentation, including such design and documentation as related to the completeness and accuracy of underlying data and a sufficient precision level in management review controls to detect material misstatement across all financial statement areas.

Management has completed the documentation and review of the corrective actions described above, and concluded that the design and operation of our financial reporting processes and controls related to the corrective actions were effective and therefore that the related previously identified material weaknesses have been fully remediated as of December 31, 2023.

Changes in Internal Control Over Financial Reporting

Other than the matters set forth above, there have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, except as described above.

There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

OTHER INFORMATION

On March 14, 2023, the Company amended the Line of Credit, which among other things, (1) extended the maturity date to March 14, 2025, and (2) revised the interest on any line of credit borrowings to an annual rate of one month term Secured Overnight Financing Rate ("SOFR") plus 2.50 %, with a SOFR floor of 1.0 %.

Amendments to Alan Yu's and Jian Guo's Employment Agreements

On March 12, 2024, the Company and Mr.

Yu entered into an amendment to his employment agreement (the “CEO Amendment”), effective as of March 12, 2024, which amends his employment agreement previously filed as Exhibit 10.16 to the Registration Statement on Form S-1, filed with the Securities and Exchange Commission (the "SEC") on February 18, 2021 and declared effective on April 14, 2021.

The CEO Amendment reflects that Mr.

Yu will continue in his role as Chief Executive Officer for an initial term expiring on March 12, 2026, subject to automatic extensions, unless either party provides the other with 60 days' prior written notice.

Pursuant to the CEO Amendment, Mr.

Yu's base salary will increase to of $300,000 per year.

The CEO Amendment also provides that Mr.

Yu will be granted 24,000 RSUs pursuant to the terms of the CEO Amendment and the Company's Stock Incentive Plan, in which 24,000 RSUs shall vest in three, equal installments on May 12, 2024, May 12, 2025 and May 12, 2026.

In the event the Mr.

Yu resigns or is terminated before the vesting of the last installment on May 12, 2026, Mr.

Yu is entitled to receive such RSUs subject to Section 5 of the his employment agreement.

Additionally, on March 12, 2024, the Company and Ms.

Guo entered into an amendment to her employment agreement (the “CFO Amendment”), effective as of March 12, 2024, which amends her employment agreement previously filed as Exhibit 10.1 to the Current Report on Form 8-K, filed with the SEC on February 1, 2022.

The CFO Amendment reflects that Ms.

Guo will continue in her role as Chief Financial Officer for an initial term expiring on March 12, 2026, subject to automatic extensions, unless either party provides the other with 60 days' prior written notice.

The CFO Amendment provides that Ms.

Guo will be granted 24,000 RSUs pursuant to the terms of the CFO Amendment and the Company's Stock Incentive Plan, in which 24,000 RSUs shall vest in three, equal installments on May 12, 2024, May 12, 2025 and May 12, 2026.

In the event the Ms.

Guo resigns or is terminated before the vesting of the last installment on May 12, 2026, Ms.

Guo is entitled to receive such RSUs subject to Section 5 of the employment agreement.

The foregoing descriptions of the CEO Amendment and the CFO Amendment do not purport to be complete and is qualified in its entirety by reference to the full texts of the CEO Amendment and the CFO Amendment, copies of which are included as Exhibits 10.32 and 10.33, respectively, to this Annual Report on Form 10-K and incorporated herein by reference.

Rule 10b5-1 Trading Arrangements

During the fiscal quarter ended December 31, 2023, no director or officer of the Company adopted or terminated a “Rule 10b5-1 trading arrangement” or a “non-Rule 10b5-1 trading arrangement” (in each case, as defined in Item 408 of Regulation S-K).

DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS

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10.25 Change In Terms Agreement, dated August 18, 2022, by and between Lollicup USA Inc and Hanmi Bank (Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q, filed with the Securities and Exchange Commission on November 14, 2022).

10.26* Change In Terms Agreement, dated March 14, 2023, by and between Lollicup USA Inc and Hanmi Bank

10.26 Change In Terms Agreement, dated March 14, 2023, by and between Lollicup USA Inc and Hanmi Bank (Incorporated by reference to Exhibit 10.26 to the Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 16, 2023).

10.27 Agreement by and between Lollicup USA Inc., Keary Global Ltd., Happiness Moon Co.

Ltd., and Bio Earth Technology, dated May 8, 2023 (English Translation) (incorporated by reference to Exhibit 10.1 of the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 10, 2023).

10.28 Share Transfer Agreement by and between Lollicup USA Inc.

and Keary Global Ltd., dated May 8, 2023 (English Translation) (incorporated by reference to Exhibit 10.2 of the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 10, 2023).

10.29 Change In Terms Agreement, dated June 20, 2023, by and between Lollicup USA Inc and Hanmi Bank (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on June 22, 2023).

10.30 Separation Agreement and General Release, dated August 30, 2023 (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on August 31, 2023).

10.31 Employment Agreement, dated October 5, 2023, between Karat Packaging Inc.

and Daniel Quire, Chief Revenue Officer (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on October 11, 2023).

Amendment to Employment Agreement, dated March 12, 2024, between Karat Packaging Inc.

and Alan Yu, Chief Executive Officer.

Amendment to Employment Agreement, dated March 12, 2024, between Karat Packaging Inc.

and Jian Guo, Chief Financial Officer.

Karat Packaging Inc.'s Amended Insider Trading Policy, effective as of March 12, 2024

21.1 List of Subsidiaries (Incorporated by reference to Exhibit 21.1 to the Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 2022).

23.1* Consent of BDO USA, LLP, independent registered public accounting firm

23.1* Consent of independent registered public accounting firm (PricewaterhouseCoopers LLP)

Consent of independent registered public accounting firm ( BDO USA, P.C.

31.1* Certification pursuant to Section 302 of the Sarbanes-Oxley Act

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32.2** Certification pursuant to Section 906 of the Sarbanes-Oxley Act

97.1* Karat Packaging Inc.'s Clawback Policy, effective as of October 2, 2023.

101.INS* XBRL Instance Document.

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(Principal Executive Officer)

Chief Financial Officer

Chief Financial Officer and Director

March 15, 2024

(Principal Financial Officer and Principal Accounting Officer)

/s/ Joanne Wang

Director and Chief Operating Officer

March 16, 2023

/s/ Eric Chen

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 9A. Controls and Procedures