Year-end financial reporting: Hot SEC enforcement and securities litigation issues

Tuesday, March 8, 2016

Speakers

Karyl M.Van Tassel Managing Director, Navigant karyl.van.tassel@navigant.com

Mark T. Oakes Partner, Norton Rose Fulbright US LLP mark.oakes@nortonrosefulbright.com

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Peter A. Stokes Partner, Norton Rose Fulbright US LLP peter.stokes@nortonrosefulbright.com

SEC enforcement trends

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• Accounting-related enforcement actions up 46% in 2015

• Probing companies for non-GAAP financials, MD&A, risk/trends disclosures and impairments

• Strong emphasis on companies that do not timely report material weaknesses in internal controls

• Increasingly willing to bring non-fraud-based claims • Has obtained big penalties without proving fraud

• $80 million against Monsanto (Feb. 2016) • $46.9 million against Life Partners (Jan. 2015)

• Deploying software to detect outliers and anomalies (similar to sophisticated short sellers)

• Targeting companies with frequent audit adjustments

Non-GAAP Financial Measures

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• Non-GAAP financial measures are numerical measures of financial performance that (1) exclude amounts that would be included in the most directly comparable GAAP measure, or (2) include amounts that would not be included in the most directly comparable GAAP measure.

• Common examples includes: • EBIT/EBITDA • Adjusted EBITDA • Distributable Cash Flow • Adjusted Net Loss/Net Income

Non-GAAP Financial Measures – Recent SEC Interest

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• SEC Chair Mary Jo White in December 2015 on non-GAAP financial measures: • “This area deserves close attention, both to make sure

that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.”

• “By some indications, such as analyst coverage and press commentary, non-GAAP measures are used extensively and, in some instances, may be a source of confusion.”

Non-GAAP Financial Measures – Recent Market Interest

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• WSJ Article (Feb. 24, 2016): • The gap between reported and pro forma earnings for 2015

reached its widest level since the financial crisis. • S&P 500 companies reported earnings that were 25% lower than

the pro forma figures – the widest difference since 2008. • S&P 500 energy companies had an estimated 2015 GAAP loss of

$48 billion. On a pro forma basis these companies reported $45 billion in income.

• “To be sure, there are instances when ignoring items like that which are required under GAAP can make sense. But companies have had a history of treating the ordinary as extraordinary when business conditions worsen.”

Non-GAAP Financial Measures – 10-K Requirements

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1. A presentation, with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with GAAP.

2. A reconciliation of the differences between the non-GAAP and GAAP measures.

3. A statement disclosing the reasons why the company’s management believes the non-GAAP measurements provide useful information.

4. The purposes for which the company’s management uses the non-GAAP financial measure.

5. Catch All: “A registrant . . . shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.”

Non-GAAP Financial Measures – 10-K Restrictions

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An issuer may not: • Exclude from non-GAAP liquidity measures (other than EBIT

and EBITDA) charges or liabilities that required, or will require, cash settlement, or would have required cash settlement, absent an ability to settle in another manner.

• Adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge within the prior two years.

• Present non-GAAP financial measures on the face of the GAAP financial statements or in the accompanying footnotes.

• Use titles or descriptions that are confusingly similar to GAAP terms.

Advice from SEC Chair

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Ask the following: • Why are you using the non-GAAP measure, and how

does it provide investors with useful information? • Are you giving non-GAAP measures no greater

prominence than the GAAP measures, as required under the rules?

• Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate?

• Are there appropriate controls over the calculation of non-GAAP measures?

More Tips Re: Non-GAAP Financial Measures

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• To the extent non-GAAP financial measures are used in an SEC filings such as the 10-K, issuers should carefully review the rules to ensure compliance. • The requirements for an SEC filing exceed those that

apply to most press releases. • Audit committees should ensure that they

adequately oversee management’s use of non-GAAP measures and consider whether the issuer’s proposed use of such terms differs from the issuer’s prior practice or industry practice.

Liquidity and Covenant Risks

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• Items 303(a)(1) and (2) of Regulation S-K require that a registrant discuss known trends, demands, commitments, events or uncertainties that are reasonably likely to materially affect liquidity or capital resources.

• SEC frequently questions disclosures in this area; focus on (1) sources and uses of cash and (2) availability to fund liquidity needs.

• Uncertain economic environment and weak operating results in sectors like energy continue to affect the ability of many companies to comply with financial covenants. • When there is an elevated risk of default or when it is likely

covenants will not be met, the SEC requests expanded disclosure.

SEC Scrutinizing MD&A Disclosures

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• SEC sent numerous comment letters to energy companies asking for “quantified information regarding the reasonably possible effects of a continuation of current commodity prices to the extent that quantified information is reasonably available”

• Issuers should provide more detailed discussion about impact of low oil prices or other adverse trends on liquidity, covenant compliance, borrowing base calculations, hedging, results of operation, and future drilling and exploration plans

• Some issuers are disclosing potential impact of prolonged energy price downturn on future impairments (e.g., “if prices stay at x through the next 12 months, we will need to impair y in future periods”)

PUD Writedowns

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To keep proved undeveloped reserves on books, companies must have plan to drill within five years. Economic unfeasibility caused by low oil and gas prices will not excuse inability to drill within five years Question 131.04 from SEC’s May 16, 2013 Compliance and Disclosure Interpretations ("C&DIs"). • Question: The definition of "undeveloped oil and gas

reserves" requires that the company have adopted a development plan with respect to the reserves. What constitutes adoption of a development plan?

• Answer: The mere intent to develop, without more, does not constitute "adoption" of a development plan and therefore would not, in and of itself, justify recognition of reserves. Rather, adoption requires a final investment decision. [Oct. 26, 2009]

Item 303 as Basis for Class Action Suits

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• Courts have split over whether Item 303 omission can support Rule 10b-5 liability • Item 303 of Reg. S-K requires issuers to disclose “any

known trends and uncertainties” expected to have a material unfavorable impact on revenues or income from continuing operations

• In re NVIDIA Corp. (9th Cir.) • Because plain language of Section 10(b) does not

countenance pure omission claims, mere omission of facts required by Item 303 insufficient to support Exchange Act claim

• Stratte-McClure v. Morgan Stanley (2d Cir.) • Because Item 303 is “obligatory,” nondisclosure conveys

affirmative representation that the issuer knows of no adverse trends

• Affirmed dismissal for lack of scienter, but opens door to Section 10(b) claims based on Item 303 omissions

Omissions and Opinions

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• Matrixx Initiatives, Inc. v. Siracusano (materiality) • Omissions actionable if company fails to disclose material facts that would

render an affirmative statement misleading • Materiality judged from standpoint of reasonable investor, not

management • No bright-line “statistical insignificance” exception for contrary facts

• Omnicare Inc. v. Laborers District Council (opinions) • No liability for “pure” opinions that are “sincerely held” by speaker

But… • Embedded facts in statements of opinion can be actionable if untrue • Opinions can trigger Matrixx-style omissions liability • If opinion conveys impression that it was based on reasonable inquiry,

speaker can be liable if it did not perform such inquiry • Mere fact that speaker knew of facts “cutting the other way” will not create

liability unless it would render opinion misleading to reasonable investor

Application to Financial Guidance

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US case study: In re Aeropostale (S.D.N.Y.) • Retailer ordered new clothing line that fared poorly with

customers and created inventory backlog • Provided guidance without disclosing that it had pre-

ordered three additional quarters of poor-selling designs • Created impression backlog being cleared faster than it

was • Dismissal denied because company “failed to disclose

historical and existing material facts” about inventory problem

• Even “puffery” actionable if omitted facts render it misleading; executives “knew that their half-true expressions of optimism were both overly rosy and highly unlikely”

• Company paid $15 million to settle

SEC Scrutinizing Internal Control Certifications

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• CEOs and CFOs must certify internal controls were designed and that they personally evaluated effectiveness of ICFR

• A material weakness only requires a “reasonable possibility” that a material misstatement will not be detected

• SEC pursuing companies and individuals for: • Not timely disclosing material weaknesses • Not personally evaluating effectiveness of ICFR • Not maintaining documentation to support evaluation • Using incorrect standard for evaluating deficiencies • Relying excessively on outside consultants

But arguments about false SOX and auditor certifications are gaining traction • In re OSG Securities (S.D.N.Y.): Inaccurate auditor “opinion” on tax liability

held to be actionable misstatement under Section 11 • In re Symbol Technologies (E.D.N.Y.): Restated SOX certifications found to

support 10b-5 fraud claim

Recent Enforcement Actions

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• QGSI: Penalty and D&O bar where executive unfamiliar with Treadway Commission standards and concealed inventory control deficiencies from auditors

• Saba Software: $2.5 million clawback against CEO where deficient controls did not detect time-entry scheme

• JDA Software: $750,000 penalty for nonfraudulent control deficiencies in not establishing VSOE

• PolyCom: $750,000 penalty for control deficiencies leading to $200,000 in fudged expenses going undetected

• Stein Mart: $800,000 penalty for allowing marketing department to make accounting decisions about markdowns

But arguments about false SOX and auditor certifications are gaining traction • In re OSG Securities (S.D.N.Y.): Inaccurate auditor “opinion” on tax liability held to be

actionable misstatement under Section 11 • In re Symbol Technologies (E.D.N.Y.): Restated SOX certifications found to support

10b-5 fraud claim

Fraudulent Intent Not Required for Many Violations

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• Section 13(a) of Exchange Act prohibits companies from filing false or untimely Form 10-Ks and Form 10-Qs

• Section 13(b)(2)(A) requires companies to keep books, records, and accounts which in reasonable detail accurately and fairly reflect the company’s transactions and dispositions of assets

• Section 13(b)(2)(B) requires companies to devise internal controls

• Rule 13a-14 requires Sarbanes-Oxley certifications • Sections 17(a)(2) and 17(a)(3) of Securities Act

prohibits obtainment of money or property by untrue statement or omissions

Material Weaknesses as Basis for Class Action Liability

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• Accounting restatements and internal control deficiencies are traditionally insufficient to support Rule 10b-5 liability

• But arguments about false SOX and auditor certifications may be gaining traction • In re OSG Securities (S.D.N.Y.): Inaccurate auditor

“opinion” on tax liability held to be actionable misstatement under Section 11

• In re Symbol Technologies (E.D.N.Y.): Restated SOX certifications found to support 10b-5 fraud claim

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