Today's Judgments, Tomorrow's Enforcement: Accounting and Business Judgments Most Vulnerable to Hindsight
To help our clients navigate the coronavirus (COVID-19) crisis, Arnold & Porter has established a Coronavirus Task Force covering a wide range of issues and challenges. Subscribe to our "Coronavirus (COVID-19)" mailing list to receive our latest client Advisories and register for upcoming webinars.
* * * * *
The pandemic and its impact have presented disclosure challenges, especially in light of the significant judgment calls that public companies will make over the next several months. Over the past few weeks, the Securities and Exchange Commission (SEC) has repeatedly urged companies to provide as much information as is practicable regarding their current financial and operating status, as well as their future operational and financial planning. But doing so will be complicated, and a one-size fits all approach will not be appropriate.
On April 8, SEC Chair Jay Clayton and Corporation Finance Division Director William Hinman issued a statement emphasizing the importance of COVID-19 related disclosures, particularly in light of the pandemic's uncertain duration and substantial economic impact.1 Their statement followed other very recent SEC guidance (i) reiterating the need for "high-quality financial information more than ever"2 and (ii) posing a wide range of questions that companies need to consider when updating disclosures in light of recent events.3
In particular, Messrs. Clayton and Hinman emphasized the increased importance of forward-looking disclosures in the current environment and encouraged companies to avail themselves of applicable safe harbors. They also offered reassurance that they do not expect the SEC to second-guess good faith disclosures that are appropriately framed. Similarly, the SEC's Chief Accountant stated that his Office "has consistently not objected to well-reasoned judgments . . . and will continue to apply this perspective." Among the areas the Chief Accountant highlighted as involving significant judgments and estimates are fair value and impairment considerations, debt modifications and restructurings, revenue recognition, going concern, and subsequent events, as well as other topics. The Chief Accountant "stress[ed] the importance of required disclosures of judgments and estimates in these and other areas."
But how can companies feel confident that their "well-reasoned" judgment and "good faith" attempts to disclose information adequately today will survive the scrutiny of regulators tomorrow who are armed with the benefit of hindsight? And even if a company can successfully navigate the rigors of the SEC's scrutiny, how forgiving will shareholders be when the dust finally settles? Today's judgments may well be the subject of tomorrow's enforcement actions, and shareholder litigations. Simply put, the unprecedented breadth and depth of COVID-19's impact, and the speed with which it is unfolding, presents significant challenges for even the most robust financial reporting and disclosure infrastructures, and any shortcomings in those functions will surely be magnified.
Based on prior experience, we expect the SEC will be on the lookout in a variety of areas:
- Don't Take a Bath. A pandemic affects virtually every business, but that impact does not mean that all negative company news is the result of COVID-19. Affected companies should be careful not to attribute ordinary poor performance to COVID-19. So-called "big bath" charges are a tempting way to write off underperforming assets or hide negative news in a manner the market will often excuse. But companies should take care to ensure that charges labeled as non-recurring are accurately characterized as such, particularly if those charges are used as adjustments in non-GAAP measures. These charges will be scrutinized.
- Asset Valuation. Even in a normal economy, corporate judgments about asset valuation are subject to significant scrutiny, particularly for illiquid assets. Asset valuation will be especially challenging now, as the price at which willing buyers and sellers would transact may swing wildly from one day to the next. Even if decisions later prove wrong, exercising defensible judgment based on evident, documented information will often prevent successful second-guessing. And, when a company's methodology for valuing assets requires adjustment, its leadership should document the reasons for the change to avoid creating the impression that such change was driven by an interest in either under- or over-reporting the value of a particular asset in the midst of the pandemic. Among other things, the SEC Enforcement Staff often looks for discrepancies between what corporate insiders discuss in reaching valuation conclusions and what they portray or describe to auditors and the public. Companies would do well to make sure that they use data consistently for both internal and external projections, and consider whether there is a need to disclose changes in approach.
- Earnings Smoothing. Given that much of the negative COVID-19 related performance occurred in March, which is a quarter-end for many companies, there may be a temptation to shift losses to the next quarter, particularly if management expects results to improve. In addition, the initial costs of outbreak-related expenses can be substantial. The reasons for these increased costs in February and March of 2020 are best described in Management Discussion and Analysis, and charges incurred in Q1 should not be inappropriately spread over subsequent quarters.
- Subsequent Events and Going Concern Disclosures. As filing deadlines are extended, the amount information that needs to be covered in year-end financial statements changes. For example, the time period covered by subsequent events disclosures extends. We would expect the resulting financial statement footnotes to be lengthy for many companies. Similarly, companies may need to consider whether, given the specific events that have unfolded since year-end, they need to consider going concern disclosures. These considerations require judgment calls and ongoing discussions between the company and their auditors.
- Force Majeure; MAC. While performance contracts often include force majeure provisions, such provisions are often narrowly construed and may not provide any relief from contractual obligations even in very difficult circumstances. As a result, companies should carefully vet public disclosures suggesting that contractual obligations will be excused. At the same time, companies need to consider disclosure concerning both their own efforts to avoid performance based on such clauses, and their contractual counterparties' efforts to do the same. The impact of such provisions should be assessed before making force majeure disclosures that could be viewed as unrealistic. The same considerations apply to any contracts with material adverse change or material adverse effect provisions.
- Which Risk Factors Have Materialized Due to COVID-19? The SEC has previously criticized companies that describe risk factors in general, or even hypothetical, terms when those conditions have actually come to pass. With that history in mind, companies should revisit general disclosures about risks such as global health crises and should instead identify specific, potential harms that this pandemic might cause. Companies should also consider updating any risk factors discussing specific regions or countries, vendors, supply chains, or other business considerations tied to a specific workforce or area affected by COVID-19. Similarly, companies should consider whether they have become dependent, even in the short-term, on any particular government-backed programs or regulatory/legislative exceptions to the extent that risk disclosures are warranted. For example, companies should disclose whether they have received financial assistance under the CARES Act or other similar, COVID-19 related federal or state program that has materially affected, or is reasonably likely to have a material future effect upon, the financial condition or results of operations. Under those circumstances, companies should describe the nature, amounts, and effects of that assistance.
- Have Other Risk Factors or Events Occurred That Require Disclosure? Right now, companies are focused on the impact the pandemic may have on their current business operations. However, other events may occur during this period that require revisiting historic disclosures. For example, companies whose employees are working remotely while handling sensitive information may have new cybersecurity concerns, particularly as regulators and shareholders express their own concerns in this area.4 Companies should not become so focused on COVID-19 that they lose sight of other emerging risks and issues.
- Employee Health. With due regard to any privacy-related obligations, companies should carefully consider disclosures regarding the health of key executives, particularly if a single individual is viewed as material to the business. Disclosures regarding the health of the workforce in general, and the impact of employee illness and absences on the company's ability to operate, may also be at issue.
- Insider Trading. Market volatility leaves public companies at increased risk for insider trading by their employees. Moreover, the nature of the pandemic means that the number and scope of employees who have access to material nonpublic information has significantly expanded. For example, many employees may now be privy to nonpublic information about supply chain disruptions or significant reductions in workforce. At the same time, employees' genuine need for cash in a time of financial stress may justify a sale of company stock. Accordingly, companies should remind all employees that, with some exceptions, SEC Rule 10b5-1 equates awareness of material nonpublic information with use of that information in a trading decision. Moreover, while trading windows are a useful prophylactic against insider trading, they rest on the presumption that the company disclosed all material information to the public immediately prior to opening the window. In this environment, when a company's fortunes are buffeted by fresh news every day, those windows become a trap rather than an escape. Trading windows are not a substitute for the employees' independent obligation to avoid trading while aware of material information that has not been disclosed. To help employees and the company avoid future regulatory scrutiny, companies should consider whether to close or alter the timing or applicability of trading windows, or to require certain employees to pre-clear trades with the General Counsel or a designee.
- Regulation FD. The frenzied pace with which facts are unfolding, and decisions are being made, poses increased risk of selective communication. Companies should ensure that business decisions, including layoffs and furloughs, are communicated in a manner compliant with Regulation FD. For example, companies should avoid announcing workforce reductions to employees (who may also be shareholders) without also considering whether broader dissemination of such information is also required.
While the SEC's public statements may provide some comfort, auditors and executives should exercise caution as upcoming elections, potential changes in SEC enforcement philosophy and approach, and the unique facts confronting each company may nevertheless leave companies disclosure judgments subject to second-guessing. The SEC's current reassuring sentiments notwithstanding, history shows that unforgiving hindsight is often the fodder for tomorrow's enforcement and litigation. Attending to these risks now should help companies survive the regulatory, law enforcement and shareholder scrutiny that will inevitably descend once present conditions abate.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
Chairman Jay Clayton & Division of Corporation Finance Director William Hinman, The Importance of Disclosure - For Investors, Markets and Our Fight Against COVID-19 (Apr. 8, 2020).
Chief Accountant Sagar Teotia, Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19 (Apr. 3, 2020).
Division of Corporation Finance, CF Disclosure Guidance: Topic No. 9: Coronavirus COVID-19 (Mar. 25, 2020).
See, e.g., Drieu v. Zoom Video Comm’ns, Inc. et duo, Case No. 5:20-cv-02353 (N.D.Cal.); New York State Department of Financial Services, Guidance to Department of Financial Services (“DFS”) Regulated Entities Regarding Cybersecurity Awareness During COVID-19 Pandemic (Apr. 13, 2020).