Bradford Updike, LLM, JD
Mick Law, P.C.
April 15, 2020
On March 25, 2020, the Securities and Exchange Commission’s (SEC’s) Division of Corporate Finance released guidance regarding risk disclosures and other securities law obligations that companies should consider with respect to the coronavirus disease (COVID-19) and its related business disruptions (hereafter “Disclosure Guidance”). This was followed on April 8, 2020, with a Public Statement, whereby SEC Chairman Jay Clayton and Director of Corporate Finance William Hinman reiterated the SEC’s preference for companies to be proactive in their future efforts to inform the public about the specific effects of COVID-19 upon a disclosing company’s operations in filings and in offering related materials.
The SEC acknowledged in the Disclosure Guidance that the impact of COVID-19 upon companies is evolving rapidly, with many unknowns and contingencies remaining to be addressed. Notwithstanding, the SEC advised that it will monitor how companies under its supervision are reporting the effects and risks of COVID-19 on business activities, financial condition and results of operations. The Disclosure Guidance and related Public Statement both addressed several recommended practices that involve (i) assessments and disclosures of COVID-19 and its business impact within offering materials and public filings; (ii) the need for certain persons associated with public reporting companies to refrain from trading prior to dissemination of material non-public information; and (iii) the reporting of earnings and financial results. These topics are addressed below.
Assessing/Disclosing the Impact of COVID-19
According to the Disclosure Guidance, companies should consider the need for COVID-19-related disclosures within the context of federal securities law and a principles-based disclosure system. While the SEC acknowledges that the exact impact of COVID-19 upon a business is largely unknown and uncontrollable, the SEC has advised that (i) the general effect of COVID-19 upon the company, (ii) what management expects the company’s future impact will be, (iii) how management intends to respond to evolving events, and (iv) how the company is responding to COVID-19 related uncertainties, can all be material to investment-related decisions. According to the SEC, areas within offering documents and public filings that may be impacted by the need for company-specific disclosures include: (i) management’s discussion and analysis about a company’s business plan and future prospects; (ii) risk factors affecting a company; (iii) discussions about legal proceedings; (iv) discussions about internal controls over financial reporting; and (v) financial statement explanations.
The Disclosure Guidance and Public Statement advise that disclosures regarding COVID-19 and its effects should be specific to a company’s situation. As companies assess their situations, the SEC’s recommended questions on disclosure obligations would include:
In the Public Statement, the SEC articulated a strong preference for disclosures specific to the operations of the companies as opposed to boiler plate disclosures that are generic and that apply broadly to many companies. While companies have been historically cautioned to limit their forward-looking disclosures, the SEC clarified in the Public Statement that it now encourages forward-looking estimates regarding a company’s operations and future financial fortunes if made in good faith based upon COVID-19 related circumstances relevant to the company at the time the disclosures are made.
Depending upon the longevity of the pandemic, the effects of COVID-19 will play out very differently for various sponsors depending upon their financing strategies and asset sectors. In real estate, for example, supply/demand fundamentals for a particular type of real estate will generate different movements in occupancies, net operating income, capitalization rates and debt/distribution serviceability (e.g., retail/hospitality vs. warehouse/multi-family real estate due to the effects of social distancing upon the underlying businesses of the tenants). On the oil/gas side, mineral rights may also have a stronger ability to weather the pricing storm than traditional tax-driven drilling programs syndicated by sponsors that have used debt at various levels to finance their businesses (with commodity prices and reserve impairments possibly causing reductions in credit lines and loan defaults if a borrowing deficiency arises as a result of the same).
On a related point, the ability of a broker-dealer or financial advisor to appropriately assess whether a company is making reasonable disclosures on a sponsor-level or program-level basis will require vigilant ongoing reviews of (i) sponsor and program-level financials, (ii) loan compliance documentation, (iii) updated appraisals/reserve reports, and (iv) program-level distribution coverage (i.e., distributions vs. earnings). It also goes without saying that the need to have independent asset experts analyze the economics and valuation of program assets is extremely important in today’s environment given the challenges COVID-19 can present to a program’s ability to generate a return. As such, those broker-dealers and advisors that require independent asset-level underwriting and ongoing sponsor-level due diligence will be in a better position to understand the true impacts of COVID-19 upon the sponsors raising capital in the retail, RIA and family office channels.
Refraining from Securities Trading
Within the Disclosure Guidance, the SEC advised that public companies and their associated persons need to consider their market activities, including the issuance or purchase of securities, in light of their obligations under the federal securities laws. For example, where COVID-19 has affected a company in a way that would be material to investors or where a company has become aware of a risk related to COVID-19 that would be material to investors, the company, its directors and officers, and other corporate insiders who are aware of these matters, should refrain from trading in the company’s securities until such information is disclosed to the public.
Public Companies - Earnings Calls
The SEC acknowledges that quarterly earnings calls are fundamental to the functioning of the U.S. equity and credit markets, as public companies that include over 60 of the world’s 100 largest companies provide investors and markets with extensive information regarding their operations during these calls. This information, particularly the quantitative information (such as financial statements) is predominantly historical, and investors and analysts use this information, including management commentary regarding trends and future expectations of financial condition and risks, to gauge value and estimate future firm performance. In cases where the public company is also a sponsor of alternative investment programs, we note that this information has been relied upon very heavily by broker-dealers and financial advisors in their due diligence of sponsors and in support of their preferences for products of public sponsors with higher capitalizations.
For Q1 2020 and possibly future quarters, the SEC has warned that the earnings statements and calls will not be routine. In many cases, the SEC warns that historical earnings-related information may be substantially less relevant due to the need for the public to understand where companies stand today and, importantly, how they have adjusted, and expect to adjust in the future, their operational and financial affairs to most effectively work through the COVID-19 health crisis. The SEC recognizes these challenges, as well as the heightened importance of issuer-investor communications in this uncertain time, and the SEC encourages earnings and related disclosures that are as timely, accurate and robust as practicable under the circumstances. On a related point, and in the opinion of this author, a company’s present cash flow, liquidity and ability to service debt in the wake of substantial revenue reductions would be some examples of information, the importance of which is far greater than earnings driven by pre-COVID-19 business conditions (i.e., Q1, 2020).
Reporting Financial Results
Within the Disclosure Guidance, the SEC reminded companies of (i) their obligations under Item 10 of Regulation S-K and Regulation G with respect to the presentation of non-GAAP financial measures (e.g., EBITDA, adjusted EBITDA, and non-GAAP income) in public filings, as well as (ii) the SEC’s prior guidance with respect to performance metrics disclosures. To the extent a company presents a non-GAAP financial measure or performance metric to adjust for or explain the impact of COVID-19 (i.e., by way of example, the presumed future use of “modified funds from operations,” or MFFO, by registered non-traded REITS to adjust for non-reoccurring expenses due to COVID-19), the SEC states that it is appropriate for the disclosing company to highlight why its management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position.
Revisiting earnings calls and press statements, the SEC acknowledged that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by COVID-19-related adjustments that may require additional information. In these situations, the SEC will not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate or a range of reasonably estimable GAAP results. For example, under this position, if a company intends to disclose in an earnings release its earnings before interest, taxes, depreciation and amortization (EBITDA), it could reconcile that measure to its GAAP earnings, a reasonable estimate of its GAAP earnings that includes a provisional amount, or its reasonable estimate of a range of GAAP earnings. The provisional amount or range should reflect a reasonable estimate of COVID-19 related charges not yet finalized, such as impairment charges.
In respect to earning releases, the SEC states that a non-GAAP financial measure should not be disclosed more prominently than the most directly comparable GAAP financial measure or range of GAAP measures. In addition, in filings where GAAP financial statements are required, such as filings on Form 10-K or 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.
Conclusion
On a positive note, the SEC’s issued guidance should help provide a measure of comfort to companies and their selling groups that capital raising efforts and communications with investors can continue in earnest if discipline is exercised with respect to the presentation of sponsor-specific and issuer-specific COVID-19 information. As stated previously, and depending upon the longevity of the pandemic, the effects of COVID-19 will play out differently across various sponsors depending upon their respective financing strategies and asset sectors. As such, those broker-dealers and advisors that require independent asset-level underwriting and ongoing sponsor-level due diligence should be in a better position to understand the true impacts of COVID-19 upon the sponsors raising capital in their respective financial markets.