Another MD&A Known Trend Disclosure and Materiality Lesson

In our workshop discussions dealing with MD&A the disclosure of “known trends” is always a complex topic.  The idea of disclosing something that isn’t hurting your business currently but might hurt it in future periods is rarely easy to deal with.  Regulation S-K Item 303 makes this a requirement though if it meets a “reasonably likely” probability threshold:

(3) Results of operations.


(ii) Describe 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 revenues or income from continuing operations. If the registrant 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 shall be disclosed.

This clearly forward-looking disclosure means that if a company knows of something that is “reasonably likely” to have an impact on the company in the future it should be disclosed to shareholders.  Problems with this requirement almost always come to light when a company makes an announcement that surprises shareholders and it results in a drop in stock price. This was exactly the case in August 2014, when SeaWorld filed their earnings release Form 8-Kfor the second quarter of 2014.  Tucked away in the discussion was this sentence:

“In addition, the Company believes attendance in the quarter was impacted by demand pressures related to recent media attention surrounding proposed legislation in the state of California.”

When this announcement was made, SeaWorld’s stock price fell from $28.15 to $18.90.  This 33% fall in stock price decreased SeaWorld’s market capitalization by approximately $830 million.  The issue beneath this disclosure was the movie “Blackfish” and how the film had affected SeaWorld’s business.

Two major questions arise from such an announcement:

When did SeaWorld’s management know they had a problem?

Should SeaWorld’s management have known the problem was material?

On September 18, 2018, the SEC announced in a press releasethat the company and two of its officers had settled fraud charges for misleading investors about the impact of the documentary on the company’s business.

Interestingly, as is true for almost all of these kinds of known trend cases, there was no involvement of the actual financial statements.  The basis for the case was that forward-looking information that should have been included in the MD&A was withheld from investors.

As you can read in the complaint concerning the company and its former CEO,the SEC enumerates the issues that underlie the enforcement. Over a fairly lengthy period of time the company dealt with the impact of the film on its business by surveying customers and using other resources.  It is clear that the company knew the film was having an impact.  The company’s data showed that customers were affected by the film.  Management, however, asserted in public forums that the film had not affected attendance.

In the complaint (paragraph 37) the SEC makes this important point:

  1. Securities Act Regulation S-K, Item 303(a)(3)(ii) (“SK-303”) requires issuers, such as SeaWorld, to disclose “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 revenues from continuing operations.”Despite the above events indicating that Blackfish either was affecting or would affect SeaWorld’s financial performance, SeaWorld never conducted an evaluation of Blackfish’s potential impact on SeaWorld’s operational results, or made any disclosure regarding the known trends or uncertainties associated with Blackfish under SK-303 in connection with the filing of its FY 2013 Form 10-K on March 21, 2014, or its Q1 2014 Form 10-Q on May 15, 2014.

The complaint, starting at paragraph 11, also includes discussion of why management should have known the information was material, including this interesting observation related to the impact of a news article early in the series of events:

  1. On August 28, 2013, an article in the financial press suggested that, despite SeaWorld’s denial, there might have been a link between Blackfish and SeaWorld’s declining attendance. Immediately following the article, SeaWorld’s share price dropped by five percent (5%). The Defendants should have known that the Blackfish effect, if and when such occurred, would be material to investors.

At the time of this article management was still asserting there was no impact from the movie.

The company and the CEO paid fines totaling more than $5 million.  Another important aspect of the case is that the CEO actually sold stock during the period when the company knew there was a “Blackfish effect.”

As always, your thoughts and comments are welcome!

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