When confronted with government inquiries, public companies commonly grapple with the issue of when events have escalated to the point that they are subject to disclosure obligations—or, further yet, require recognition as a loss reserve in the financial statements. Is one or both of these requirements triggered when the government initially informs the company of the inquiry’s existence? When the magnitude and frequency of the government’s informational requests provide reasonable notice of a full-blown investigation? When the government rejects the company’s efforts to discontinue the investigation? Or when the government and company commence settlement discussions? While the seminal moment when each of these obligations solidifies can be quite fact-specific, the Division of Enforcement provided its own guidepost last week as to when disclosure and loss recognition become necessary.

On September 27, 2019, the SEC filed charges against pharmaceutical company Mylan, N.V. for allegedly failing to timely disclose and account for loss contingencies that materially impacted the company’s periodic filings in 2015 and 2016. SEC v. Mylan N.V., No. 1:19-cv-2904 (D.D.C. 2019). These purported failures derived from a DOJ probe into whether Mylan had significantly overcharged Medicare for EpiPen, the company’s largest and most profitable product, by classifying the product as a “generic” drug under the Medicaid Drug Rebate Program, rather than a “branded” drug. Without admitting or denying the SEC’s allegations, Mylan concurrently settled alleged violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934, and Rules 12b-20, 13a-1, 13a-11 and 13a-13 thereunder. The company also agreed to a $30 million civil penalty.

This enforcement action centered on the two particular points in time when, from the SEC’s perspective, the DOJ investigation ripened into loss contingency obligations under GAAP. Pursuant to Accounting Standard Codification 450 (ASC 450), an issuer must disclose a material loss contingency—such as (a) required actual or possible claims or (b) pending or threatened litigation—if a loss is at least reasonably possible. A loss is considered “reasonably possible” when the chance of the future event or events occurring is more than remote but less than likely. Additionally, ASC 450 requires an issuer to record an accrual for a material loss contingency as a charge against income in its financial statements, if a loss is probable and reasonably estimable. “Probable” means the future event or events are likely to occur.

As alleged in the SEC’s complaint, the timeline of key events surrounding the DOJ probe of Mylan occurred as follows:

• 3Q2013 to 2Q2014: The Centers for Medicare and Medicaid Services (CMS) send emails questioning EpiPen’s classification as a generic drug; Mylan responds with its explanation; Mylan expresses internal uncertainty about this classification
• 4Q2014: CMS objects to Mylan’s explanation and requests that the company reclassify EpiPen to a branded drug; Mylan retains generic classification; Mylan receives DOJ document subpoena seeking documents relating to EpiPen classification
• 1Q2015 to 3Q2015: Mylan receives additional DOJ document subpoenas and a civil investigative demand (i.e., interrogatories) seeking information relating to the government’s potential damages; DOJ takes testimony from a Mylan employee involved with government price reporting
• 3Q2015: DOJ rejects Mylan’s responsive arguments and request to close investigation; Mylan agrees to toll statute of limitations
• 4Q2015: Mylan provides DOJ with an estimated range of potential government damages for one fiscal quarter during the relevant period; Mylan continues to produce documents and information to DOJ during the “following months”
• 2Q2016: Mylan provides DOJ with an estimated range of potential government damages in 2015; Mylan agrees to continuation of the tolling agreement
• 3Q2016: Mylan makes settlement offers; DOJ provides counteroffers
• 4Q2016: Mylan and DOJ reach a settlement in principle; Mylan makes initial public disclosure of the DOJ investigation and of the company’s liability from classifying EpiPen as a generic drug

The SEC’s interest in pursuing this enforcement proceeding probably stemmed in large measure from what it perceived as Mylan’s delinquency in providing the investing public with any notice that the DOJ probe existed until it effectively had been resolved. However, rather than simply alleging in its complaint that the company failed to satisfy its reporting obligations under GAAP, the SEC elected to provide greater specificity as to when it believed the collective circumstances definitely had caused the prospect of loss to be “reasonably possible” and, then later, “probable and reasonably estimable.”

The SEC claimed, “by at least the filing of its Form 10-Q for the third quarter of 2015, Mylan knew or should have known that the likelihood of a material loss relating to the EpiPen classification and DOJ investigation was reasonably possible,” thereby requiring Mylan to disclose the investigation and the “best estimate of the range of loss.” In singling out the filing date (rather than quarterly end date), the complaint seemingly sought to capture Mylan’s preliminary government damages estimate, which occurred early in the fourth quarter, and thus would have been subject to subsequent event disclosure. According to the SEC, the absence of any mention of the DOJ probe in the Form 10-K and Forms 10-Q from the third quarter of 2015 through the second quarter of 2016 rendered these public filings materially false and misleading.

The SEC further alleged, “by at least the filing of the Form 10-Q for the second quarter of 2016, Mylan knew, or should have known, that a material loss resulting from the DOJ investigation and claims that Mylan incorrectly classified EpiPen was probable…. [and] reasonably estimable, as Mylan had sufficient information in its possession to estimate a range of losses.” Again, the complaint presumably applied the filing date in order to capture settlement offers exchanged early in the third quarter. Accordingly, the SEC asserted that Mylan’s reported earnings in the second quarter 2016 Form 10-Q (and in its Form 8-K reporting results for that quarter) were materially overstated because of the company’s failure to accrue for the loss.

Although this settlement should not be interpreted as bright-line guidance for when public companies need to address contingent losses in their public filings, it is nonetheless instructive in that it extends beyond GAAP’s textbook definitions and offers to public companies a real-world example of when the SEC believes that these obligations definitively arise. As evidenced by the complaint, the SEC apparently considers the “reasonably possible” threshold crossed when the company is unable to convince the government to close its investigation while able to estimate the government’s possible damages (or at least for a portion of the relevant period). The complaint also seemingly indicates that the SEC deems a company’s demonstrated willingness to settle coupled with the exchange of settlement offers, as sufficient proof that the contingent loss is both probable and reasonably estimable. Naturally, where caution remains after this particular settlement is whether the SEC might argue under a different factual predicate that one or both of these obligations should attach at some earlier juncture during a government investigation.