While businesspeople and investors continue to speculate on how far oil prices may drop and how long they may remain low, the upcoming 2015 Form 10-K and proxy season will force public companies to carefully consider and disclose the impact of the slump in oil prices on their businesses. To avoid the risk of receiving SEC staff comments, the need to amend SEC filings in the future, and the potential of derivative lawsuits arising out of material misstatements or omissions relating to the affect that lower oil prices may have on a company’s business, it is essential to proactively review and revise any affected company’s disclosure. This client alert touches upon the Form 10-K and proxy disclosures that demand the highest level of scrutiny.
For over a decade, the SEC has made it a priority to encourage companies to improve the quality of MD&A to provide a clear narrative that is “necessary to an understanding of [a company's] financial condition, changes in financial condition and results of operations.”1 The SEC has repeatedly emphasized that MD&A should not restate information provided in financial statements, but rather should “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenue or income from continuing operations.”2 In addition to providing information specifically required to be contained within MD&A, the SEC expects that management will provide an analysis of that information and its significance for the company. Thus, a company impacted by lower oil prices should carefully consider the potential impacts that may be significant to the company – are any of its major customers or counterparties likely to experience a degradation in credit that could affect the company? Have hedging techniques used by the company left it vulnerable to significant or prolonged drops in oil prices? What are E&P companies’ break-even costs and how will their E&P activities be impacted by current pricing levels and price uncertainty? The SEC staff has also examined companies’ public statements and presentations on trends or events and has compared those statements to companies’ MD&A disclosure for consistency. To the extent events or trends are disclosed publicly but not developed as part of MD&A, companies should expect to receive SEC comments.
MD&A is also required to include a discussion of liquidity and capital resources that provides detail regarding sources and uses of cash and material changes in particular items underlying the major captions reported in a company’s financial statements. The SEC believes this information is critical to an assessment of a company's prospects for the future and even the likelihood of its survival. In particular, the SEC staff has recently stressed the need for expanded disclosure of material terms of debt agreements. If there is, or is projected to be, a failure to meet a financial covenant, such as the result of a ceiling test write-down as discussed below, registrants will be expected to describe the financial covenant, the company’s covenants measurements for the most recent reporting period, sensitivities of those measurements, anticipated future covenant performance, and the potential impact of a covenant failure on the availability of credit. Companies should also be prepared to include a detailed discussion about difficulties the company has experienced or may face in accessing the credit or capital markets due to recent declines in oil prices.
The SEC’s adoption of a 12-month average price for reserve estimates as part of the 2010 modernization of oil and gas reporting will delay the full impact of the abrupt price drop on reserves for many companies with a calendar year end.3 MD&A should address any changes in reserves and the underlying impact of the drop in oil prices, as well as the impact of declining proved reserves on DD&A.4
Write-Downs and Impairments
Many companies may experience so called “ceiling test write-downs” as their net capitalized costs for proved oil and gas properties exceed the SEC’s ceiling limit, which largely reflects the estimated future net cash flows from proved reserves. Companies may also face impairment of unproved properties. The SEC accounting staff will be paying close attention to write-downs and impairments given the current price environment, and companies should take extra care in documenting their determinations with an eye towards subsequent SEC scrutiny. Perceived errors in write-downs and impairments have been a frequent cause of restatements in past downturns.
The SEC views the risk factor section of Form 10-K, which is required under Item 1A of Form 10-K, as the opportunity for a company to “identify and disclose known trends, events, demands, commitments and uncertainties that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating performance or future financial condition.”5 In order to meet these expectations, a company should carefully review existing risk factors to make sure the statements correctly reflect management’s current assessments about risks the company faces that could have a material adverse impact on its business, financial condition and results of operations. Companies should also spend adequate energy considering and crafting new risk factors that appropriately consider the affect that current pricing and the potential for a prolonged environment of lower commodities prices would have on the company’s future business, reserve carrying values, financial condition and results of operations.
Executive Compensation and Say on Pay
Favorable industry trends in recent years led to growth in executive compensation levels for many oil and gas companies. Declining stock prices that have resulted from lower oil prices may force some companies to review and reconsider whether current compensation programs will continue to adequately incent and reward executives. At the same time, in light of lower commodity prices and deteriorating total stockholder return (a favorite metric of proxy advisors), companies should expect to face headwinds on say-on-pay votes as stockholders and proxy advisory firms view executive compensation packages for energy executives more critically, especially for companies facing a say on pay advisory vote this year. Companies whose equity-based incentive programs call for grants to be made at fixed values (for example, grant date values as a multiple of base salary), should consider whether continuing this practice under current conditions might cause stockholders and proxy advisory services to view such grants as excessive given the increased number of shares granted if stock prices rebound. Companies that decide instead to augment or substitute equity compensation grants with cash incentives or other cash-based retention programs due to these or other concerns should explain these changes as part of their CD&A. Companies adjusting their incentive compensation programs in light of these or other concerns should also closely monitor compliance with Section 162(m) of the Internal Revenue Code in order to make sure that their performance based compensation remains tax deductible.