COVID-19 Considerations. Following the onset of the COVID-19 pandemic, the SEC has twice issued guidance for public companies addressing disclosure considerations in light of COVID-19.¹ This guidance remains useful as companies move towards preparation of their 2020 annual reports. The SEC’s guidance amplifies its long-standing focus on a principles-based disclosure system that is designed for investors to see the company “through the eyes of management.”

As companies prepare their annual reports, they should consider addressing COVID-19 in a holistic manner that includes not just MD&A² and Risk Factors³, but also the necessary disclosures required by the Description of Business⁴ item in the Form 10-K. As the pandemic continues, what was a trend or uncertainty at the time of preparation and filing of a previous periodic report may have evolved into a standard practice or attribute of a company’s business that should be discussed in the “Business” section (e.g., supply chains and the availability of products and materials). Companies should consider addressing the impact of COVID-19 with respect to the following disclosure items:

• Liquidity and Capital Resources
• Have you accessed credit lines?
• Do you have credit lines in place and available?
• Debt covenant compliance
• Financing sources and availability
• Capital raising efforts and needs, completed or contemplated
• Government assistance (including CARES Act loans)
• COVID-19 risk factors
• Consider whether to address comprehensively in one or several COVID-19 specific risk factors, or address holistically in each risk factor that is implicated
• For filings during the earlier part of 2020, in our experience companies generally addressed COVID-19 in one or several specific risk factors; however, as the pandemic continues, consider whether this remains the appropriate approach
• Strategy for liquidity shortfalls
• Controls and procedures (impact of remote working arrangements)
• Demand for products and services
• Supply chain disruptions (both procurement and distribution aspects)
• Manufacturing inefficiencies due to enhanced safety protocols and reduced worker availability
• Border closings and travel restrictions
• Increased costs due to safety protocols
• Customer collection trends and challenges
• Dispositions of assets or lines of business; strategic plant or store closures
• Capital expenditures, expected expenditures and discussion if strategy has changed
• Dividends: continued, decreased or eliminated?
• Stock repurchases: continued, decreased or eliminated?
• Human capital considerations
• Safety
• Furloughs
• Terminations
• Remote working
• School closures
• Travel restrictions

Beyond the above disclosure items, the following considerations will likely necessitate enhanced attention in light of the pandemic as companies complete their annual audits and prepare their Form 10-Ks:

• Going concern analysis
• Significant deficiencies and material weaknesses resulting from changed control environments, whether from remote working or other COVID-19 related impacts and effects
• Asset impairments
• Discontinued operations

SEC Comment Letter Trends. During the 12 months ended June 30, 2020, the most common comment area by the SEC was non-GAAP financial measures (number 2 in the prior year), followed by MD&A.⁵ In the prior year, revenue recognition was the top comment area, followed by non-GAAP financial measures.⁶ Also of note, segment reporting rose from number 8 to number 4.⁷ According to Ernst & Young, other common comment areas included revenue recognition, fair value measurements, intangible assets and goodwill, contingencies, inventory and costs of sales, income taxes, and signatures and exhibits, with contingencies returning as a common comment area after dropping out in prior years.⁸

Non-GAAP financial measures continue to be an area of focus for the SEC Staff. As noted in “SEC Guidance on Key Financial and Operating Metrics” below, the SEC encourages companies to disclose key financial and operating metrics. The SEC’s comments and guidance are aimed at soliciting a better understanding concerning which measures are non-GAAP financial measures and which are operating and statistical measures, as the latter are not considered non-GAAP measures necessitating reconciliation and related disclosures. Regarding segment reporting, the SEC continues to ask companies to explain inconsistencies between how their business is described in various public information channels (e.g., press releases and investor presentations) and how it is described in the segment footnote to the financial statements.⁹ The SEC often asks companies to provide detailed organizational information about the company’s reporting structure as to who directly reports to the Chief Operating Decision Maker (“CODM”), including their roles and responsibilities and interactions with the CODM. The SEC also seeks to understand how the CODM makes decisions, including how budgets and forecasts are prepared.¹⁰

The return of loss contingencies as a frequently commented upon topic should serve as a reminder to companies that for reasonably possible losses, they must disclose the amount or range of reasonably possible loss, or make an affirmative statement that such an estimate cannot be made.¹¹ And, where companies make a statement that a reasonable estimate cannot be made, they should be prepared to defend and support that statement if challenged by the SEC.

SEC Guidance on Key Financial and Operating Metrics. In January 2020, the SEC issued guidance concerning disclosure of key performance indicators and metrics in MD&A. Regulation S-K, Item 303(a) (including as revised per the Item 300 Amendments discussed above) requires a discussion and analysis of statistical data that in the company’s judgment enhances the reader’s understanding of MD&A. These metrics, such as same store sales, sales per square foot, traffic growth, revenue per subscriber, and operating margin, can vary significantly from company to company and industry to industry. The SEC’s guidance states that a company should first consider the extent to which an existing regulatory framework applies, such as GAAP or Regulation G/Item 10 of Regulation S-K for non-GAAP financial measures. Importantly, the SEC reiterates its previous guidance that operating and other statistical measures such as unit sales, number of employees, number of subscribers or number of advertisers are not non-GAAP financial measures.

For statistical and operating measures that are not non-GAAP financial measures, the SEC’s guidance set forth a list of disclosures that the SEC would expect to accompany the metric, including:

• A clear definition of the metric and how it is calculated;
• A statement of the reasons why the metric is useful to investors; and
• A statement indicating how management uses the metric in managing its business.

The SEC also set forth a number of considerations and disclosure points that a company should consider if it changes the way it calculates or presents the metric. Finally, the SEC emphasized that when disclosing performance metrics, companies need to maintain effective disclosure controls and procedures to process the information used in preparing or calculating the metrics.¹²

MD&A Enforcement Actions re Trends and Uncertainties. During 2020, the SEC settled two enforcement actions involving the failure to disclose “known trends”, in each case resulting from aggressive sales and inventory management practices. It is important to note that neither action resulted in a finding that either registrant had engaged in inappropriate revenue recognition practices. As a reminder, Regulation S-K, Item 303 requires issuers to discuss “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."¹³

In the first enforcement action against Diageo plc, an international brewer and distiller of alcoholic beverages, the SEC alleged that Diageo engaged in channel stuffing by shipping unneeded products to distributors through aggressive sales practices.¹⁴ The practices later resulted in increased distributor inventory levels that ultimately resulted in Diageo entering into various contractual arrangements with its distributors to reduce their inventory levels through a process referred to as “destocking.” Although these practices are not problematic in the abstract, the SEC alleged that Diageo failed to disclose significant known trends and uncertainties resulting from such actions—specifically, that the overshipments versus demand resulted in increased distributor inventory levels; the initial positive impacts on sales and profit growth; and the ultimate negative impact they were reasonably likely to have on future sales.

The second enforcement action, against HP, Inc., involved similar allegations of failing to disclose trends involving aggressive inventory management and sales practices and the resulting impact on current and future results.¹⁵ In an effort to meet quarterly sales targets, regional managers at HP used a variety of incentives to accelerate, or “pull-in”, sales that were otherwise forecasted to materialize in later quarters. In addition, in one international region, HP sold printing supplies at substantial discounts to distributors known to be selling outside of their territory in violation of HP policy and the respective distributor agreements. These out of territory sales resulted in significant margin erosion compounded by the cannibalization of other HP sales in these territories. Similar to the Diageo enforcement action, there was no finding that any of these practices resulted in improper revenue recognition. Rather, the SEC alleged that HP failed to disclose known trends and uncertainties associated with these sales practices, including that the trend of increased quarter-end discounting, resulting in margin erosion and channel inventory buildup, would have an adverse impact on future quarterly results causing HP’s results to not be indicative of future operating results.

Perquisites Enforcement Action. On September 30, 2020, the SEC settled an enforcement action against Hilton Worldwide Holdings, Inc. for failing to disclose $1.7 million worth of travel-related perquisites and personal benefits to its named executive officers, including the Chief Executive Officer.¹⁶ The implicated perquisites include personal use of Hilton’s corporate aircraft and hotel stays by executive officers. In its enforcement order, the SEC emphasized that the exception from disclosure for benefits that are integrally and directly related to an executive’s job is very narrow. Business purpose or convenience does not affect the classification of an item as a perquisite where it is not “integrally and directly” related to the performance of the executive’s job. Also of note, the SEC touted in its press release announcing the enforcement action that it was generated through the use of risk-based data analytics to uncover potential violations related to corporate perquisites.

Notes:

¹ CF Disclosure Guidance: Topic 9 (Issued March 25, 2020) and CF Disclosure Guidance: Topic 9A (issued June 23, 2020).

² For a discussion of recently adopted changes to Regulation S-K, Item 101, Item 105 and Item 303 see “SEC Reporting Update”.

³ See id.

⁴ See id.

⁵ See Ernst & Young LLP, SEC Reporting Update, Highlights of trends in 2020 SEC comment letters (Sept. 2020).

⁶ See id.

⁷ See id.

⁸ See id.

⁹ See id.

¹⁰ See id.

¹¹ See id.

¹² As a sharp illustration, in September 2020, the SEC settled an enforcement action against BMW for inaccurate disclosures of its retail sales in the United States, which BMW had held out as a key performance indicator. See In re Bayerische Motoren Werke Aktiengesellschaft, BMW of North America, LLC, and BMW US Capital, LLC (SEC Admin. Proc. File No. 3-20060; Sept. 24, 2020).

¹³ Regulation S-K, Item 303(a)(3)(ii). See also the discussion of recently adopted changes to this standard under “SEC Reporting Update—November Amendments—Item 303: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

¹⁴ See In re Diageo plc (SEC Admin. Proc. File No. 3-19701; Feb. 19, 2020).

¹⁵ See In re HP, Inc. (SEC Admin. Proc. File No. 3-20112; Sept. 30, 2020).

¹⁶ See In re Hilton Worldwide Holdings Inc. (SEC Admin. Proc. File No. 3-20109; Sept. 30, 2020).