Over the last several weeks we discussed the details of the SEC’s November 2020 MD&A changes in a series of eight blog posts. These posts were also the basis for a series of articles in the PLI Chronicle: Insights and Perspectives for the Legal Community. To bring all this information together in one easy-to-use tool, we combined all the posts and articles into this document. We hope it helps you in your implementation process.
As usual, your thoughts and comments are welcome!
As part of his commitment to investor education, SEC Chair Gary Gensler (who was a professor at MIT) has launched “Office Hours with Gary Gensler,” a series of short videos about topics ranging from climate change to cryptocurrency. You can find the current videos and future releases at the SEC’s YouTube channel. Chair Gensler’s Twitter account (an interesting follow!) also announces new videos.
As always, your thoughts and comments are welcome!
One of the example comments in the SEC’s recent Sample Letter to Companies Regarding Climate Change Disclosures addresses information that companies may include in separate ESG related reports:
We note that you provided more expansive disclosure in your corporate social responsibility report (CSR report) than you provided in your SEC filings. Please advise us what consideration you gave to providing the same type of climate-related disclosure in your SEC filings as you provided in your CSR report.
In a recent Workshop, one of our participants asked about the pros and cons of mentioning or linking to a separate ESG report in Form 10-K. One of the risks in such a reference is that the ESG report could become part of the Form 10-K and become “filed” information. This would potentially subject the information in the ESG Report to the liability provisions set forth in section 18 of the 1934 Act and, if the 10-K is incorporated by reference into a 1933 registration statement, the strict liability provisions of section 11 of the 1933 Act.
Neither of these outcomes would be advisable for all the information in an ESG report.
If a company does want to make such a reference, or if it wants to file this information with the SEC, one way to do this would be through the submission of the report as an exhibit to an Item 7.01 (Regulation FD) Form 8-K. Information so submitted to the SEC is deemed “furnished” rather than “filed” – therefore, the liability sections above are not applicable. Of course, Rule 10b-5 applies; however, that always applies in a “fraud on the market” case to all statements made by the company, whether in press releases, its website or other communications (hence, the importance of ensuring the ongoing accuracy of those materials).
If you do make references to website disclosures in your SEC filings, it is important to include language that makes it clear the report (or other items from the website) is not being incorporated into Form 10-K. A Workshop participant found this example of qualifying language in NIKE, Inc.’s 2020 Form 10-K:
Additional information related to our human capital strategy can be found in our FY20 NIKE, Inc. Impact Report, which is available on the Purpose section of our website. Information contained on or accessible through our websites is not incorporated into, and does not form a part of, this Annual Report or any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only.
As you can see, NIKE did not include a hyperlink to their Impact Report in the Form 10-K, additional insurance in avoiding the Impact Report becoming included in the Form 10-K.
As always, your thoughts and comments are welcome!
The unparalleled success of the SEC’s Whistleblower Program in uncovering hidden financial crimes and achieving successful enforcement has been well publicized. In this September 21, 2021, blog post we highlight that the program has paid out over $1 billion in awards to whistleblowers.
In this related Press Release Chair Gary Gensler emphasized the importance of the program:
“Today’s announcement underscores the important role that whistleblowers play in helping the SEC detect, investigate, and prosecute potential violations of the securities laws. The assistance that whistleblowers provide is crucial to the SEC’s ability to enforce the rules of the road for our capital markets.”
One frequently overlooked aspect of the program’s success is how companies may need to adjust governance and policy related to whistleblower activity.
In this environment that provides such strong incentives for whistleblowers to come forward, companies need to build appropriate governance and policies. To help companies in this process, PLI’s InSecurities podcast, in Episode 47 – Whistleblower Tips: Advice From a Former Chief of the SEC’s Whistleblower Office, provides crucial information about developing policies and governance surrounding whistleblower processes. Included are suggestions about how to develop parallel internal reporting systems and encourage, triage and investigate whistleblower tips.
As always, your thoughts and comments are welcome!
The SEC reinforced its focus on accounting for contingencies in an August 24, 2021 enforcement case against Health Care Services Group, Inc. Accounting Standards Codification Topic 450 requires that loss contingencies be recorded when it is probable that a loss will be incurred, and the amount can be reasonably estimated. Contingencies frequently involve high stakes and appropriate accounting requires complex and subjective judgments. Contingencies are lightning rods for SEC review and enforcement.
In the Health Care Services Group case the SEC found that the company failed to record loss contingencies surrounding private litigation against the company in the proper periods. The Enforcement Division found that the company, by failing to record loss contingencies in the appropriate period, managed its earnings to meet analyst’s estimates for several quarters.
A fascinating aspect of this case is that, according to Enforcement Division Director Gurbir Grewal, the company “reported EPS that met analyst estimates for multiple quarters as a result of accounting violations that were uncovered by the Division of Enforcement’s ongoing EPS Initiative,” Mr. Grewal also said:
“As today’s actions demonstrate, we will continue to leverage our in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations.”
Accounting for contingencies is not a new theme in SEC enforcement. In 2007 the SEC fined Cardinal Health $35 million for engaging in a four-year long accounting fraud that, among other misstatements, involved manipulation of a number of reserve and contingency accounts creating misstatements of over $65 million. The company also accrued $22 million of expected proceeds from a litigation settlement before recognition under GAAP was appropriate. As you would suspect, these steps helped Cardinal meet earnings estimates.
BorgWarner provided another example of the SEC’s ongoing focus on accounting for contingencies. This case is more complex. It is based on ASC 450’s guidance about when to record a contingent liability. It started with this comment the company received on its December 31, 2016 Form 10-K in a May 11, 2017 comment letter:
Note 14: Contingencies
Asbestos-related Liability, page 95
You also state that you hired a third party consultant in the third quarter of 2016 to further assist you in the analysis of potential future asbestos-related claims. It appears that with the assistance of this external consultant and the updated data and analysis resulting from your claims review process, you determined that your best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, is $879.3 million as of December 31, 2016, which is $770.8 million higher than the prior year.
Please tell us your consideration of accounting for this as a correction of an error in previously issued financial statements rather than as a change in estimate. Refer to ASC 250- 10-20.
The key issue in this comment is the timing of recording the contingent liability related to potential asbestos claims. Given the material increase in the accrual in 2016, it is logical to ask if the amount was “probable” and capable of reasonable estimation in an earlier period. In its lengthy response, the company included this language:
In connection with the preparation of its annual financial statements for 2016, the Company was able to determine for the first time that its potential liability for asbestos-related claims not yet asserted was capable of reasonable estimation. That determination became possible at such time for several reasons:
The culmination of all of the foregoing factors in 2016 led the Company to consider, as part of its ongoing review process, that it had become possible to make a reasonable estimate of its potential liability for asbestos-related claims not yet asserted. The Company engaged a third-party consultant in the third quarter of 2016, as the Staff notes in the May 11 letter, to assist the Company with its evaluation of such potential liability. The consultant prepared its analysis during the third and fourth quarters of 2016, and presented its final analysis to the Company in the first quarter of 2017. The Company reviewed the analysis and made its own assessment in connection with the Company’s preparation of its annual financial statements for 2016 that the best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, was $879.3 million, and adjusted its liability on its consolidated balance sheet in accordance with ASC 450-20-25-2.
The Company does not consider this additional reserve to be a correction of an error in prior financial statements because no error was made. There were no mistakes in the application of GAAP, mathematical errors or oversight or misuse of facts in previously issued financial statements. The Company was diligent in its efforts to monitor and track available information to measure the potential liability for future asbestos-related claims, and appropriately recorded a reserve when information sufficient to support a reasonable estimate became available. The Company followed generally accepted accounting principles – specifically, ASC 450-20-25-2 – in only accruing a liability once such amount was capable of being reasonably estimated.
After this response by BorgWarner, the SEC issued this follow-up comment:
Based on your response, it appears you believed a liability for potential claims not asserted was probable prior to the quarter ending December 31, 2016, but that such liability was not recognized because it could not be reasonably estimated. Please confirm whether our understanding is correct.
Regarding periods prior to the quarter ending December 31, 2016, please tell us whether you (1) attempted to estimate a liability for potential claims but concluded the resulting estimate of loss (or range) was not reasonable or (2) did not attempt to estimate a liability because you believed you could not develop a reasonable estimate. If the former, please tell us the results of your estimation including your estimated liability (or range thereof) as of December 31, 2015 and why you did not believe the estimate(s) to be reasonable.
The back and forth continued and ultimately resulted in a restatement by BorgWarner to record the contingent liability for the asbestos-related claims in earlier years, as you can see in this
Form 10-K/A.
As each of these three cases demonstrates, the SEC carefully scrutinizes the accounting, disclosures and judgments surrounding contingencies. This is a reminder that we should carefully make and document judgments surrounding contingent liabilities.
As always, your thoughts and comments are welcome!
On September 22, 2021, CorpFin staff posted this “Sample Letter to Companies” to provide example climate change disclosure comments. These Sample Letters, which are a successor to older “Dear CFO” letters, provide illustrative comments about emerging and “hot-button” issues companies should consider in their disclosure processes. (For example, one of the previous letters dealt with securities offerings during times of extreme price volatility.)
This Sample Letter is a next step in CorpFin’s focus on climate change, which was directed by then Acting Chair Allison Herren Lee in this February 24, 2021 Public Statement.
The Sample letter references the SEC’s current climate change disclosure guidance in FR-82 (Release 33-9106, 34-61469) Commission Guidance Regarding Disclosure Related to Climate Change.
Many of the example comments have their roots in FR-82. For example, FR-82 includes this paragraph dealing with separate ESG reports that many companies issue:
“Although much of this reporting is provided voluntarily, registrants should be aware that some of the information they may be reporting pursuant to these mechanisms also may be required to be disclosed in filings made with the Commission pursuant to existing disclosure requirements.”
The Sample Letter includes this related example comment:
General
The Sample Letter focuses on risk factor and MD&A disclosure and, consistent with topics addressed in FR-82, provides example comments focused on indirect and physical effects of climate change.
As we move towards our next quarter and year-end reporting cycles, and as disclosure committees consider current disclosure issues, this letter is a reminder to review FR-82 and any other climate change related reports our companies and clients prepare and to carefully consider how to address these matters in our reporting.
You can learn more and review the SEC’s Request for Comment on Climate Disclosure on this ESG section of SEC.gov.
As always, your thoughts and comments are welcome!
The SEC’s very successful whistleblower program has, as of September 15, 2021, paid out over $1 Billion in awards. As you can read in this Press Release, the first award was paid in 2012 and the pace of awards has increased regularly.
You can learn more about the SEC’s Office of the Whistleblower here.
As always, your thoughts and comments are welcome!
In this post from June 28, 2021, we reviewed an SEC enforcement action focused on the relationship between cybersecurity risks and disclosure controls and procedures. This relationship was emphasized in the SEC’s February 26, 2018 Release, Commission Statement and Guidance on Public Company Cybersecurity Disclosures:
“Crucial to a public company’s ability to make any required disclosure of cybersecurity risks and incidents in the appropriate timeframe are disclosure controls and procedures that provide an appropriate method of discerning the impact that such matters may have on the company and its business, financial condition, and results of operations, as well as a protocol to determine the potential materiality of such risks and incidents.”
On August 16, 2021, less than two months after the June case, the SEC announced another cybersecurity-related enforcement involving failure to make appropriate disclosures about a breach and the related lack of necessary disclosure controls and procedures.
You can read the details in this Press Release and the related SEC Order. According to the SEC the company, an educational publisher, learned in March 2019 that:
“…millions of rows of data stored on the AIMSweb 1.0 server had been accessed and downloaded by a sophisticated threat actor using an unpatched vulnerability on this server.”
Further, according to the SEC Order, even though an actual breach had occurred, the company referred to the risk as hypothetical in its mid-year report:
“In its July 26, 2019 report furnished to the Commission, (the company’s) risk factor disclosure implied that (the company) faced the hypothetical risk that a “data privacy incident” “could result in a major data privacy or confidentiality breach” but did not disclose that (the company) had in fact already experienced such a data breach.”
According to the Press Release, in a July 2019 statement, released after the company had been contacted by the media about the breach, it indicated that “the breach may include dates of births and email addresses.” When the company released this statement, it knew that this information had been breached. In addition, the statement said the company had “strict protections” in place. In reality, it had failed to patch the critical vulnerability behind the breach for six months after a vendor notified it about the problem.
The company’s share price fell by 3.3% after this announcement. The SEC Order discusses various considerations in determining the materiality of the breach, including this statement in paragraph 11:
“The breach at issue was material because (the company’s) business, including but not limited to AIMSweb 1.0, involved collection and storage of large quantities of private data on school-age children around the world.”
Disclosure controls and procedures were directly addressed in this part of the SEC Order:
“(The company’s) processes and procedures around the drafting of its July 26, 2019 Form 6-K Risk Factor disclosures and its July 31, 2019 media statement failed to inform relevant personnel of certain information about the circumstances surrounding the breach. Although protecting student and user data is critical to (the company’s) business, and (the company) had identified the potential for improper access to such data as a significant risk, it failed in this way to maintain disclosure controls and procedures designed to analyze or assess such incidents for potential disclosure in the company’s filings.”
The message in this case is clear. Companies must assure that cybersecurity breaches are communicated in the disclosure process and carefully evaluated for materiality and disclosure to investors.
As always, your thoughts and comments are welcome!
This is the eighth and last in a series of blog posts in which we are diving into the details of the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information Final Rule. This rule was published in the Federal Register on January 11, 2021. It is effective for filings on or after February 10, 2021.
The rule’s transition provisions include a mandatory transition date but also allow voluntary early compliance. The mandatory transition date is each company’s first fiscal year that ends after August 9, 2021, 210 days after the effective date. Companies may voluntarily apply the new rule, on an S-K item-by-item basis, in any filing made on or after the effective date of February 10, 2021.
This means a company that files a Form 10-K on or after February 10, 2021, has the option to early implement this new MD&A (S-K Item 303) guidance. Even if a company does not implement the rule early, it is not too soon to start planning for any required changes. And, hopefully, this exploration can be a possible stepping-off point for a process to review and possibly improve MD&A as a communication document.
In this first post, we overviewed the MD&A changes. The second, third, fourth, fifth, sixth, and seventhposts reviewed and discussed:
The addition of an objective to S-K Item 303,
New critical accounting estimate disclosures,
Changes to results of operations and known trend discussions,
Replacing the Contractual Obligations Table with a Principles-Based Requirement, and
Sequential Quarterly Analysis In Interim MD&As.
This eighth and last post addresses perhaps the most significant change in the final rule, expansion and clarification of the requirements for the discussion of liquidity and capital resources. The old guidance for this part of MD&A was very brief and “high level”:
Old S-K Item 303 (A):
(1) Liquidity. 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 registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.
(2) Capital resources. (i) Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose of such commitments and the anticipated source of funds needed to fulfill such commitments.
(ii) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.
This old MD&A guidance did not provide a clearly articulated goal for the discussion of liquidity and capital resources. As a result, in many MD&As, it is challenging to understand how a business has funded itself in its most recent year and how it plans to fund itself in future years.
The new liquidity and capital resources disclosure requirements clarify the purpose and objective of this disclosure and add helpful detail. Included are requirements to:
Provide an overall analysis of cash requirements by type of obligation and discuss how the company will generate or obtain liquidity to meet these requirements,
Analyze liquidity and capital resources in both the short-term and long term, and
Include cash requirements related to contractual obligations in the discussion.
These requirements are spelled out in this new language in S-K Item 303:
(1) Liquidity and capital resources. Analyze the registrant’s ability to generate and obtain adequate amounts of cash to meet its requirements and its plans for cash in the short-term (i.e., the next 12 months from the most recent fiscal period end required to be presented) and separately in the long-term (i.e., beyond the next 12 months). The discussion should analyze material cash requirements from known contractual and other obligations. Such disclosures must specify the type of obligation and the relevant time period for the related cash requirements. As part of this analysis, provide the information in paragraphs (b)(1)(i) and (ii) of this section.
(i) Liquidity. 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 registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.
(ii) Capital resources. (A) Describe the registrant’s material cash requirements, including commitments for capital expenditures, as of the end of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements and the general purpose of such requirements.
(B) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any reasonably likely material changes in the mix and relative cost of such resources.
The primary focus of these new requirements is a clear discussion of cash requirements, including requirements from contractual obligations, and an analysis of how those cash requirements will be met. This discussion must include both short- and long-term analyses. While we could discuss how old FR 72 included similar guidance, it is now included in the core S-K Item 303 requirements.
As we discussed in this post, the requirement for the contractual obligations table was removed in the Final Rule and replaced with this more principles-based instruction:
The SEC made this overall comment about improving this disclosure in the Final Rule:
The amendments to Item 303(b) are intended to clarify the requirements while continuing to emphasize a principles-based approach focused on material short- and long-term liquidity and capital resources needs, while also specifying that material cash requirements from known contractual and other obligations should be considered as part of these disclosures. Specifically, these amendments:
The Final Rule’s principles-based expansion and clarification of the liquidity and capital resources discussion provides an important opportunity to improve MD&A. This discussion is, unfortunately, frequently hard to understand. While there are many causes for this lack of clarity, the brevity of the old requirements is likely one of them. With the new requirements in S-K Item 303, many companies have a chance to improve the liquidity and capital resources section of their MD&A.
As always, your thoughts and comments are welcome!
In this Form 10-Q for the quarter-ended May 31, 2021, Pure Cycle reflected a “little-r” prior-period adjustment related to public improvement reimbursables and related interest. The Form 10-Q includes this footnote
The Company discovered certain errors in the amounts previously reported for the three and six months ended February 28, 2021, which if these errors though immaterial in the given periods, were corrected in the three months ended May 31, 2021, management believes these corrections would have a material impact on the current reported three month consolidated statement of operations, specifically the recognition of Public improvement reimbursables including interest income – related party. The Company’s President and the Chief Financial Officer evaluated the effects of the errors on the consolidated financial statements for the three and six months ended February 28, 2021, which each concluded that the errors were not material to those presented results. Based on this evaluation, the errors did not rise to the level of requiring a restatement of the financial information for the three and six months ended February 28, 2021, contained in the Form 10-Q as previously filed. Accordingly, management has corrected these errors by adjusting opening accumulated deficit for the three month period ended May 31, 2021 and has retrospectively adjusted the cumulative periods for the impact of such errors in the financial statements presented for the three and nine months ended May 31, 2021. The errors were a result of ineffective controls related to management’s preparation and review of spreadsheets which compromised the integrity of the spreadsheets used to support and record the transactions related to the recording and tracking of the public improvement reimbursable amounts. Please see Item 4 in this Quarterly Report on Form 10-Q for our remediation plans.
As required by SAB 108 (Topic 1-N), even though no individual period was misstated by a material amount, the company still adjusted all periods because the cumulative amount was considered material to the current period. This is the “roll-over” versus “iron-curtain” analysis required by SAB 108 (Topic 1-N).
Perhaps the most interesting aspect of this adjustment is controls over the use of spreadsheets, an on-going and complex issue. It provides a timely reminder to be sure we establish appropriate controls over the creation, maintenance and use of spreadsheets in the accounting process.
As you would expect, there is an ICFR impact from this financial statement adjustment. While a full report on ICFR is not required in a Form 10-Q, the company included this disclosure of a material weakness in Part I – Item 4:
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures as defined in Rule 13a-15(e) of the Exchange Act that are designed to ensure that information required to be disclosed in our reports filed or submitted to the SEC under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that information is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures. The President and the Chief Financial Officer evaluated the effectiveness of disclosure controls and procedures as of May 31, 2021, pursuant to Rule 13a-15(b) under the Exchange Act. Based on that evaluation, the President and the Chief Financial Officer each concluded that, during the period covered by this report, our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective due to a material weakness in internal controls over financial reporting resulting from ineffective controls related to the management preparation and review of spreadsheets which compromised the integrity of the spreadsheets used to support and record transactions related to the public improvement reimbursable amounts and related interest income.
To address this material weakness, management has devoted, and plans to continue to devote, significant effort and resources to the remediation and improvement of its internal control over financial reporting by implementing additional steps in the review process of various complex schedules that support accounting entries on a monthly and quarterly basis or moving these manual tracking and reconciliation processes to a purchase software system.
This disclosure is a great reminder that Disclosure Controls and Procedures include ICFR and a material weakness in ICFR likely means that Disclosure Controls and Procedures are not effective.
As always, your thoughts and comments are welcome!