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.

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(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:

37. 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:

13. 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!

Thanks to a reader of the blog and a member of our SEC reporting community, here is a late change and an interesting difference between the originally published Final Rule for Disclosure Update and Simplification and the version that was published later which is conformed to the Federal Register version.

In the originally published version of the final rule (which is no longer on the SEC’s webpage) the S-K Item 201(d) table was removed as a disclosure requirement in Form 10-K Item 12 and was also removed from the proxy rule disclosures in Schedule 14A.

In the conformed version now on the SEC’s webpage both these changes have been removed!  So, interestingly, this change has been undone!

This language is from page 55 of the conformed version of the final rule:

After further consideration, we are retaining the equity compensation plans disclosure requirements and are referring them to the FASB for potential incorporation into U.S. GAAP. We recognize the concerns expressed by commenters that U.S. GAAP does not explicitly require certain information, such as the formula for calculating the number of securities available for issuance under the plan. This information may be material to investors in making informed decisions about the scope of an issuer’s equity compensation program and the potential dilutive effect, both economically and in voting power, of awards authorized for issuance under all equity compensation plans.

So, even when a rule is final, corrections can still be made!  In fact, this language appears on page 1 of the conformed version:

Corrected to Conform to Federal Register Version

We have updated our PDF document that you can download here, and also taken down the post that originally discussed this change.

Thanks to all of you who read the blog and contribute!

And, as always, your thoughts and comments are welcome!

Thanks to Gary Brown, Partner at  Nelson Mullins Riley & Scarborough LLP, who is also a workshop leader and speaker here at PLI, for finding the comment below and planting the seed for this post!

Way back when, in the days before Sarbanes-Oxley (and yes, that really is way back when!), the SEC was concerned about the use of what was then called “pro-forma” information.  The term “pro-forma” was used to describe information that started with GAAP measures which were then “adjusted” to present what companies maintained (or perhaps hoped), was more relevant information to investors.

In those pre-SOX days the SEC was concerned that such “pro-forma” presentations could be misleading. For example, some companies would maintain that presenting operating results with the impact of restructuring charges removed was a better way to evaluate the future earnings potential of a business.  This may be the case, but some companies that had restructuring charges every year, and sometimes in multiple quarters within a year, would present such measures in this fashion.  Clearly such a presentation could be misleading.

In response to this situation Congress, in the Sarbanes-Oxley Act, gave the SEC the power and responsibility to regulate the use of such measures.  Here is where the terminology had to be clarified.  Companies, in their earnings releases, would use the term “pro-forma” when presenting such adjusted measures.  However, the SEC’s guidance already used this term, particularly in Regulation S-X Article 11.  As a result, the SEC had to create new terminology.

This Final Rule for the use of Non-GAAP measures was effective on March 28, 2003.  It is where the pendulum of non-GAAP guidance started swinging back and forth, and is still a great summary of both Regulation G(applicable to any presentation anywhere of a non-GAAP measure) andS-K Item 10(e)(for presentations in filed documents).  If you read footnote 12in the Final Rule you will see this language:

Section 401(b) of the Sarbanes-Oxley Act directs the Commission to adopt rules concerning the public disclosure or release of “pro forma financial information” by a company filing reports under Section 13(a) [15 U.S.C. § 78m(a)] or 15(d) [15 U.S.C. § 780(d)]. Because the Commission’s rules and regulations address the use of “pro forma financial information” in other contexts, particularly in Regulation S-X, and use that term differently from its use in the Sarbanes-Oxley Act, we are adopting the term “non-GAAP financial measures” to identify the types of information targeted by Section 401(b) of the Sarbanes-Oxley Act.

Why all this historical trivia?  Check out this comment from an August 22, 2018 comment letter:

Selected Historical Consolidated Financial and Other Data 

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures, page 17

1.  We note that you have titled several of your non-GAAP measures as “pro forma.” Based on the information in the filing, it does not appear that this information is pro forma financial information based on the guidance in Article 11 of Regulation S-X. If true, please revise your presentation to more clearly present your non-GAAP measures eliminating the use of the words pro forma.

As always, your thoughts and comments are welcome!

Contingency disclosures have historically been specifically addressed in the SEC’s interim financial statement requirements.  Regulation S-X Article 10’s interim financial statement disclosure requirements included this language:

(a)

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(5) The interim financial information shall include disclosures either on the face of the financial statements or in accompanying footnotes sufficient so as to make the interim information presented not misleading. Registrants may presume that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year and that the adequacy of additional disclosure needed for a fair presentation, except in regard to material contingencies, may be determined in that context. Accordingly, footnote disclosure which would substantially duplicate the disclosure contained in the most recent annual report to security holders or latest audited financial statements, such as a statement of significant accounting policies and practices, details of accounts which have not changed significantly in amount or composition since the end of the most recently completed fiscal year, and detailed disclosures prescribed by Rule 4-08 of this Regulation, may be omitted. However, disclosure shall be provided where events subsequent to the end of the most recent fiscal year have occurred which have a material impact on the registrant. Disclosures should encompass for example, significant changes since the end of the most recently completed fiscal year in such items as: accounting principles and practices; estimates inherent in the preparation of financial statements; status of long-term contracts; capitalization including significant new borrowings or modification of existing financing arrangements; and the reporting entity resulting from business combinations or dispositions. Notwithstanding the above, where material contingencies exist, disclosure of such matters shall be provided even though a significant change since year end may not have occurred.

 Interestingly, essentially duplicating this disclosure requirement for continencies from the SEC, US GAAP (ASC 270-10-50-6) requires disclosure in interim financial statements of material information about contingencies:

50-6     

Contingencies and other uncertainties that could be expected to affect the fairness of presentation of financial data at an interim date shall be disclosed in interim reports in the same manner required for annual reports. Such disclosures shall be repeated in interim and annual reports until the contingencies have been removed, resolved, or have become immaterial. The significance of a contingency or uncertainty should be judged in relation to annual financial statements. Disclosures of such items shall include, but not be limited to, those matters that form the basis of a qualification of an independent auditor’s report.

Because this requirement is part of US GAAP, the SEC decided to remove this requirement from S-X Article 10 in their Disclosure Update and Simplification Rule.  The marked version of paragraph 5 from the demonstration version(page A-59) shows this deletion:

(5) The interim financial information shall include disclosures either on the face of the financial statements or in accompanying footnotes sufficient so as to make the interim information presented not misleading. Registrants may presume that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year and that the adequacy of additional disclosure needed for a fair presentation, except in regard to material contingencies, may be determined in that context. Accordingly, footnote disclosure which would substantially duplicate the disclosure contained in the most recent annual report to security holders or latest audited financial statements, such as a statement of significant accounting policies and practices, details of accounts which have not changed significantly in amount or composition since the end of the most recently completed fiscal year, and detailed disclosures prescribed by Rule§4-08of this Regulation, may be omitted. However, disclosure shall be provided where events subsequent to the end of the most recent fiscal year have occurred which have a material impact on the registrant. Disclosures should encompass for example, significant changes since the end of the most recently completed fiscal year in such items as: accounting principles and practices; estimates inherent in the preparation of financial statements;  status of long-term contracts; capitalization including significant new borrowings or modification of existing financing arrangements; and the reporting entity resulting from business combinations or dispositions. Notwithstanding the above, where material contingencies exist, disclosure of such matters shall be provided even though a significant change since year end may not have occurred.

This is a great example of a simplification that is more perhaps a “clean-up” in the SEC’s rules where an issue is already addressed by GAAP.

And, the key issue here is that even though the SEC’s rules have changed for disclosures about contingencies in interim financial statements, the disclosure requirements have not changed!

As always, your thoughts and comments are welcome!

One of the topics that frequently surprises folks in our workshops is that the annual report to shareholders (ARS) is a formal requirement in the Proxy Rules.  Rule 14a-3(b)  states, that when a company is soliciting proxies for a meeting (or process in lieu of a meeting), which will include the election of directors:

(b)  ****  each proxy statement furnished pursuant to paragraph (a) of this section shall be accompanied or preceded by an annual report to security holders  ***

The rule then goes on to enumerate what must be included in the ARS, including S-X financial statements, selected financial data, MD&A and more.  Almost all the requirements for the ARS encompass information that is also required in Form 10-K.  This is why many companies use the economical strategy of meeting this requirement with a “10-K wrap”.

(Check out our next post for another important aspect of the ARS, namely, that the ARS is “furnished” rather than “filed”.)

Rule 14a-3 was not changed by the SEC’s Disclosure Update and Simplification Rule.  That said, the rule does include these requirements:

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(7) The report shall contain information relating to the registrant’s industry segments, classes of similar products or services, foreign and domestic operations and exports sales required by paragraphs (b), (c)(1)(i) and (d) of Item 101 of Regulation S-K (§229.101 of this chapter).

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(9) The report shall contain the market price of and dividends on the registrant’s common equity and related security holder matters required by Items 201(a), (b) and (c) of Regulation S-K (§229.201(a), (b) and (c) of this chapter). If the report precedes or accompanies a proxy statement or information statement relating to an annual meeting of security holders at which directors are to be elected (or special meeting or written consents in lieu of such meeting), furnish the performance graph required by Item 201(e) (§229.201(e) of this chapter).

Both S-K Item 101 and 201 were changed by the Disclosure Update and Simplification rule.  Among the changes were the elimination of the segment and foreign operations disclosures in Item 101 and the market price information in Item 201.

What does this mean for the ARS requirements?  Do companies still need to provide this information in the ARS even though it is no longer required in the Form 10-K? 

A first reading of the two paragraphs above might leave that question a bit up in the air, but a very literal reading would be that since S-K Items 101 and 201 no longer require information about segments and stock prices, the information is no longer required in the ARS.

But, perhaps more appropriately, the rational for these changes in the Final Rule(check out page 101 of the final rule for an example) clearly also apply to the ARS.  So, a common sense reading also would say that even though Rule 14a-3 still refers to this information, the elimination of this information in Form 10-K means it is also eliminated in the ARS.

Lastly, as a bit of ARS trivia, and a reminder to never read these rules too literally (and also to make sure you look for related guidance), the same proxy rule has this requirement in paragraph c:

(c) Seven copies of the report sent to security holders pursuant to this rule shall be mailed to the Commission, solely for its information, not later than the date on which such report is first sent or given to security holders or the date on which preliminary copies, or definitive copies, if preliminary filing was not required, of solicitation material are filed with the Commission pursuant to Rule 14a-6, whichever date is later. The report is not deemed to be “soliciting material” or to be “filed” with the Commission or subject to this regulation otherwise than as provided in this Rule, or to the liabilities of section 18 of the Act, except to the extent that the registrant specifically requests that it be treated as a part of the proxy soliciting material or incorporates it in the proxy statement or other filed report by reference.

If you stopped reading here, you might think this is still a requirement.  As we blogged about a while back, an important source of information is the Compliance and Disclosure Interpretations, in which this Corp Fin statement provides relief from the requirement to submit seven copies:

Proxy Rules and Schedule 14A (Regarding Submission of Annual Reports to SEC under Rules 14a-3(c) and 14c-3(b))

Last Update: November 2, 2016

Question: Exchange Act Rule 14a-3(c) and Rule 14c-3(b) require registrants to mail seven copies of the annual report sent to security holders to the Commission “solely for its information.” A similar provision in Form 10-K requires certain Section 15(d) registrants to furnish to the Commission “for its information” four copies of any annual report to security holders. Can a registrant satisfy these requirements by means other than physical delivery or electronic delivery pursuant to Rule 101(b)(1) of Regulation S-T?

 Answer: Yes. The Division will not object if a company posts an electronic version of its annual report to its corporate web site by the dates specified in Rule 14a-3(c), Rule 14c-3(b) and Form 10-K respectively, in lieu of mailing paper copies or submitting it on EDGAR. If the report remains accessible for at least one year after posting, the staff will consider it available for its information. [November 2, 2016]

As always, your thoughts and comments are welcome!

One of the hot topics in the world of public company reporting right now is the interaction between quarterly reporting and whether or not management makes decisions with a short-term focus that could be less beneficial in the long-term.  Bob Laux, an Associate Director at SEC Institute, conducts programs on various reporting and financial accounting topics, and also serves as the North American Lead for the International Integrated Reporting Council (the IIRC).  Bob shares his insights along with a substantial amount of background about the complex relationship between quarterly reporting in short-term thinking in this blog posted on the IIRC’s web page.  You can also learn much about IIRC at their web page after you read Bob’s post.

As always, your thoughts and comments are welcome!