The Annual Report on Form 10-K and Quarterly Reports on Form 10-Q attempt to present, among other things, a picture of a company’s results of operations, liquidity and financial condition through the eyes of management. Specifically, we’re referring to Management’s Discussion and Analysis of the Company’s Financial Condition and Results of Operations, better known as the MD&A. This required, and important, disclosure of management’s take on the company’s results, liquidity and financial condition can seem fairly straightforward when describing past and even present conditions; however, it can begin to feel like the SEC has played a dirty trick on companies when they are forced to turn their attention to the future.
With a host of various parties reading the MD&A every quarter, including shareholders, regulators and potential litigants, management may wonder how to adequately and appropriately disclose uncertainties looming in the company’s future, especially given all of the variables that can impact a company specifically and the economy generally. Unfortunately, SEC rules don’t permit management to just live in the present and ignore the “known uncertainty” concept, but how should a company publicly discuss uncertainties about the future?
Perhaps the best place to begin the analysis of a company’s obligations regarding disclosure about the future in the MD&A is with the basic text of the relevant SEC rule - Item 303 of Regulation S-K. This important item that impacts disclosure in each Annual Report on Form 10-K and each Periodic Report on Form 10-Q, and which is also incorporated by reference into registration statements, requires that companies disclose forward-looking information regarding liquidity, capital resources and results of operations in the following ways:
- Liquidity – Companies are required to identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the company’s liquidity increasing or decreasing in any material way.
- Capital Resources – Companies are required to describe any known material trends, favorable or unfavorable, in the company’s capital resources, indicating any expected material changes in the mix and relative cost of such resources. The discussion should consider any changes between equity, debt and any off-balance sheet financing arrangements.
- Results of Operations – Companies are required to describe any known trends or uncertainties that have had or that the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the company knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship must be disclosed.
The general instructions to Item 303 go on to state that the MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”
It is important to note that the rule continually refers to “known” trends and uncertainties. The SEC isn’t requiring companies to use a crystal ball to venture guesses that wouldn’t be helpful to shareholders, and that could potentially be misleading. Nonetheless, management is regularly privy to a constant flow of information that could very well be deemed “known” and that presents uncertainties regarding the company’s future. How should management go about deciding which information should be singled out for disclosure, and when should that disclosure take place? These are the decisions virtually every public company CEO, CFO and General Counsel are forced to grapple with each quarter. Fortunately, the SEC has provided guidance to companies regarding the MD&A, and specifically with respect to its disclosure obligations regarding the future.
Twice in the last twenty-five years, the SEC has issued comprehensive guidance related specifically to MD&A disclosure, first in 1989 and then in 2003. While the SEC has updated it guidance on more discrete MD&A issues in recent years, it generally still refers back to its 1989 and 2003 guidance, now a fairly old and timetested, with respect to broader questions regarding MD&A disclosure. Much of the discussion below is taken directly from these two very significant SEC releases that would likely be referenced by the SEC in any enforcement actions and used by courts in the course of litigation regarding a company’s duty to discuss the future in the MD&A.
Why Does the SEC Require Disclosure About the Future?
In its 2003 guidance, the SEC stated the following three principal objectives that the MD&A requirements are generally intended to satisfy:
- To provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management;
- To enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
- To provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance (emphasis added);
The end of the third bullet is instructive. The SEC knows that past performance is not always indicative of what we can expect in the future. Just because revenue doubled in each of the last three years, doesn’t mean that an investor should expect the same going forward. Management knows that the company may have penetrated the market as much as it is likely to do and that growth will naturally slow in the future, or that an important patent will expire in the next year, allowing competitors to begin taking back market share. The MD&A is a picture of the company’s business through the eyes of management, and it would be naïve to think that any company’s management is simply making its future decisions based solely on past numbers and performance. Management is always looking forward, and good MD&A disclosure should allow shareholders to do the same.
The SEC’s Two-Pronged Test
In the 1989 Release, the SEC set forth a two-pronged test that must be performed in order to determine whether or not a known contingency or uncertainty is required by Item 303 to be discussed in the MD&A. Before applying the two-pronged test, public companies must first develop a consistent process to compile and assess data regarding all known trends, demands, commitments, events and uncertainties. This process will differ for various companies based on their size, the nature of their business, and either the centralized or decentralized nature of the company. Regardless, public companies are required to have adequate disclosure controls and should, as a best practice, have a disclosure committee that meets throughout the year and, among other things, reviews the forward-looking information and data, including financial and non-financial information, that may need to be disclosed. In other words, a methodology needs to exist for companies to assess what is known about the company’s future. The company’s CEO, CFO and General Counsel should generally sit on this committee, but each company must decide which individuals, including perhaps the head of finance and accounting, the head of sales, and the head of operations, as well as other relevant legal and accounting personnel, may be best positioned to help inform the committee about items that may impact the company’s future results and evaluate disclosure decisions.
Once management has all of the known information about the future on its radar, it must then, of course, begin the filtering process to determine what needs to be disclosed. In its guidance, the SEC has laid out the following two-pronged test that it expects management to apply with respect to required disclosure regarding the future impact of known contingencies and uncertainties:
- Step One – Determine whether the known trend, demand, commitment, event or uncertainty is likely to occur? If management is able to affirmatively determine that it is not reasonably likely to occur, no disclosure is required. (Note that if management is unable to conclude whether the event is reasonably likely to occur or not, step one has not been satisfied, and the company must move on to step 2; consider, for example, a potential lawsuit from a third party that is not currently aware of its claim; in such a situation, the company may be unable to conclude whether a lawsuit is reasonably likely or not and must therefore move to step 2.)
- Step Two – If management cannot affirmatively conclude that the event is not reasonably likely to occur, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will occur. Disclosure is then required unless management affirmatively determines that, in the event of such occurrence, a material effect on the company’s financial condition or results of operations is not reasonably likely to occur.
In sum, disclosure of known uncertainties will ultimately be required unless management can affirmatively determine one of two negatives: that (i) the known uncertainty is not reasonably likely to occur, or (ii) assuming the occurrence of the known uncertainty, that it is not reasonably likely to have a material impact on the company’s financial condition or results of operations. And while “reasonably likely” is difficult to define with precision, this disclosure threshold is lower than a “more likely than not” standard, which is met only if there is a greater than fifty percent chance of occurrence.
It is important to note that the reasonableness of management’s determination resulting from this assessment will be viewed as of the time the determination is made, but will of course be made with the benefit of hindsight (for example, a significant number of claims made with respect to the failure to disclose a known contingency are made after the contingency has in fact occurred, which occurrence had a material adverse impact on the company). In the course of a company’s history, there are bound to be some close calls as to which management determines not to disclose a known uncertainty that ultimately turns out to occur and to have a material impact on the company. To protect management and the company from being found to have acted with scienter in a Rule 10b-5 claim, the disclosure committee should document the difficult judgment calls at the time the determination is made. For instance, if the disclosure committee meets two weeks before the filing of the Form 10-K and determines not to disclose its knowledge that, based on conversations and certain data available to management, the company’s largest customer may begin purchasing less product from the company in the future, the disclosure committee should draft a brief internal memorandum or report regarding the determination based on the above two-step analysis prior to filing the Form 10-K. If the customer does, in fact, significantly reduce its orders six months later in a way that materially impacts the company and causes the company’s stock price to drop, this could be helpful in convincing a regulator, court or shareholder that management and the company acted in good faith in applying the two-pronged test (despite the fact that their analysis turned out to be incorrect). Be warned, however, that no amount of good faith or detailed documentation can protect a company from a Section 11 liability claim (which is frequently referred to as strict liability with respect to material misstatements and omissions in registration statements), or perhaps even from an SEC enforcement action.
Should a Company Disclose Everything about its Future Uncertainties?
With respect to the two-pronged test described above, and with respect to MD&A disclosure in general, the SEC has taken great care to advise companies to be thoughtful about what information is material to investors and what information may actually end up obscuring an investor’s understanding regarding what is material to the company. This is particularly important given the increased amount of information that is available to management in more modern times. If the CEO passed along to investors every bit of information that comes across his or her desk each quarter, the result would be overwhelming.
As early as 2003, the SEC had recognized how advancements in business enterprise systems, communications and information technology were increasing the amount of information available to management and the speed at which it is received. In its release, the SEC commented that, “there is therefore a larger and more up-to-date universe of information, financial and non-financial alike, that companies have and should evaluate in determining whether disclosure is required. This situation presents companies with the challenge of identifying information that is required to be disclosed or that promotes understanding, while avoiding unnecessary information overload for readers by not disclosing a greater body of information, just because it is available, where disclosure is not required and does not promote understanding.”
Management is in a unique position to filter the rapid flow of company information and data for shareholders, so that only material forward-looking information is provided in a consistent manner each quarter for the company’s shareholders.
As a practical matter, companies are also well advised to properly filter immaterial information because a fair amount of information that is immaterial to investors would still be deemed of interest to competitors. As such, it makes sense for companies to develop and apply a consistent approach to considering all relevant information regarding known future uncertainties in order to avoid over-disclosure or under-disclosure.
Must We Discuss Preliminary Merger Negotiations? Couldn’t that Jeopardize the Transaction?
Premature disclosure of preliminary merger negotiations could jeopardize the transaction, but luckily the 1989 Release makes clear that you aren’t required in most circumstances to discuss preliminary merger negotiations in the MD&A. While disclosure of material probable acquisitions and dispositions is generally required when a company files a registration statement to sell securities, the SEC has, to some degree, relaxed the disclosure requirements regarding preliminary merger negotiations with respect to a company’s ongoing disclosure obligations, including within the MD&A. In its 1989 guidance, the SEC stated that “where disclosure is not otherwise required, and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the [company’s] view, inclusion of such information would jeopardize completion of the transaction.” However, the analysis changes once a company begins making public statements about a potential merger, as the need for avoiding premature disclosure about the transaction ceases to exist (or at least is reduced). Generally, once you begin discussing a potential transaction, the negotiations become subject to the same forward-looking disclosure of known uncertainties as discussed above.
Is there any Protection for Companies when Discussing the Future?
Yes, fortunately the MD&A contained in periodic reports is generally covered by the protections contained in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which provides for, among other things, protections for companies that make forward-looking statements in their filings with the SEC if the statements have been identified as a forward-looking statements and are accompanied by meaningful cautionary statements identifying important factors that could cause the actual results to differ materially from those in the forward-looking statements. Generally, if a company has identified its forward-looking statements and provided meaningful cautionary language, the statute places the burden of proof on the plaintiff in a liability claim to prove that the statement was not properly identified or surrounded with cautionary language, that the statement was made with actual knowledge that it was false or misleading, and that the statement was material. If the plaintiff cannot prove all of the above with respect to statements made under the protection of this safe harbor, then the claim would be dismissed. What’s the takeaway on this point? Carefully review the draft of your MD&A each quarter, and make sure that each forwardlooking statement is (i) identified and (ii) accompanied by meaningful cautionary language. It’s, of course, understandable for management to want to discuss the company’s future only in the best possible light; however, you may only find protection from the SEC (and potential litigators) if investors are given a meaningful discussion of potential negative factors relative to the forecast. Most importantly, though, remember that the failure to disclose or discuss a known trend or uncertainty, regardless of a company’s good faith application of the two-pronged test, will not be protected under PSLRA, while a good faith projection that complies with the PSLRA requirements will be protected (even if it turns out to be wrong).
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