Public companies should consider recent guidance from the US Securities and Exchange Commission, increased examination and enforcement activity at both federal and state levels, and possible shareholder activism, among other effects of the coronavirus (COVID-19) pandemic.
Calendar year-end public companies have now completed their first fiscal quarter reporting during which they faced disclosure and related challenges, which can be expected to continue into second fiscal quarter reporting and beyond. Companies faced the challenge of painting an accurate picture of the impact of the COVID-19 pandemic to date, balanced with the need to let investors know what companies anticipate going forward. While quarter-end filings and reports, including earnings reports and Forms 10-Q, traditionally have utilized primarily historical quantitative data (i.e., balance sheets, income statements, cash flow statements) as key predictors of future performance, COVID-19 has led many companies to change this approach.
At the same time, the regulatory landscape has become more challenging as the US Securities and Exchange Commission (SEC) has increased its scrutiny of company disclosure and trading practices and the US Department of Justice (DOJ) and state attorneys general have increased investigations into company business practices, and there is an increase in stockholder activism activity as stock prices have decreased and whistleblower tips rise. In this LawFlash, we provide a summary of many of the issues facing public companies as they move toward the end of their second fiscal quarter amid COVID-19.
SEC COVID-19 GUIDANCE
The SEC has published both staff written guidance and a public statement, both of which companies should continue to consider as they move into next quarter’s reports.
Staff Disclosure Guidance Topic No. 9
CF Disclosure Guidance Topic No. 9 (Guidance), published on March 25, 2020, provides the SEC staff’s views regarding disclosure and other securities law obligations that companies should consider with respect to COVID-19 and related business and market disruptions. The Guidance formalized SEC staff guidance provided to registrants informally during the course of routine reviews of SEC filings. Consult our March 25 LawFlash for a detailed summary of the Guidance and a nonexhaustive list of topics that companies assessing COVID-19-related effects and their disclosure obligations may wish to consider.
April 8, 2020 Public Statement
In an April 8 Public Statement (Public Statement), SEC Chairman Jay Clayton and SEC Director William Hinman focused not only on typical themes in discussing the value of robust disclosure, but also the manner in which public company disclosure can help foster a meaningful, responsible increase in economic activity. See our April 15 LawFlash for a detailed summary of the Public Statement and the recommended disclosures addressed therein.
Special Focus on Use of Non-GAAP Financial Measures and Key Performance Indicators
As second-quarter financial results for many companies are likely to be more negatively impacted by the pandemic, second-quarter reporting will raise increased questions about earnings releases and the communication of financial results. The Guidance addresses considerations regarding how to report the evolving impact of COVID-19 on financial results in light of unexpected nonrecurring charges and expenses. Of particular note are the SEC staff’s comments regarding the presentation of non-GAAP (generally accepted accounting practices) financial measures, as well as the SEC’s recent guidance regarding performance metrics disclosure, including the following:
- Where a company presents a non-GAAP financial measure or performance metric to adjust for or explain the impact of COVID-19, it should highlight why management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position and results of operations.
- Where a GAAP financial measure is not available at the time of the earnings release, 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, so long as
- the non-GAAP financial measure is not disclosed more prominently than the most directly comparable GAAP financial measure or range of GAAP measures;
- the approach is limited to those non-GAAP financial measures the company is using to report financial results to the board of directors; and
- the company explains, to the extent practicable, why the line item(s) or accounting is incomplete, and what additional information or analysis may be needed to complete the accounting.
While this approach is acceptable for earnings releases and other presentations not filed with the SEC, where GAAP financial statements are required, such as in 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.
- As to performance metrics, if a company is considering using or presenting metrics related to COVID-19, or changing the method by which it calculates a metric as a result of COVID-19, the company must consider the principles explained in the SEC’s January 30, 2020, guidance related to metrics: SEC Release No. 33-10751, Commission Guidance on Management’s Discussion and Analysis of Financial Condition and Results of Operations.
SEC EXAMINATIONS AND ENFORCEMENT IN THE COVID-19 ERA
As evidenced by the Guidance and the Public Statement, in the face of the COVID-19 crisis, robust disclosure is a primary focus of the SEC. In the Public Statement, the SEC recognized the challenges of disclosure, particularly with regard to forward-looking statements. While urging public companies to release as much information in their communications as practicable, Chairman Clayton and Director Hinman sought to reassure issuers by noting that “[w]e encourage companies that respond to our call for forward-looking disclosure to avail themselves of the safe-harbors for such statements and also note that we would not expect good faith attempts to provide appropriately framed forward-looking information to be second guessed by the SEC.”
The theme of disclosure carried through subsequent SEC statements regarding the reporting risks associated with emerging market investments and the importance of disclosure in the municipal securities markets. However, requests and reassurances aside, we see increased activity by the SEC Division of Enforcement on several fronts associated with COVID-19, and we note that even where a company believes its forward-looking statements are within the safe harbor, there remains the risk of stockholder litigation.
Reporting Risk Related to Paycheck Protection Program
For those who receive loans pursuant to the Paycheck Protection Program (PPP), the Public Statement provided an early warning about the reporting issues that may arise from such aid.
[C]ompanies and financial institutions may be receiving financial assistance under the CARES Act or other similar COVID-19 related federal and state programs. Such assistance may take various forms and is intended to mitigate COVID-19 effects for companies and their workers. If these or other types of financial assistance have materially affected, or are reasonably likely to have a material future effect upon, financial condition or results of operations, the affected companies should provide disclosure of the nature, amounts and effects of such assistance.
Reports are that the SEC’s enforcement division has recently issued a series of requests for information to registrants and issuers seeking information regarding the bases for PPP relief. We expect the SEC to focus, in part, on the consistency of disclosures across public statements and requests for PPP aid.
Material Nonpublic Information and Insider Trading
Early in the crisis, Co-Directors of the SEC Division of Enforcement (Division) Stephanie Avakian and Steven Peikin emphasized the importance of appropriate handling and use of material nonpublic information. Their March 23, 2020 statement noted:
[I]n these dynamic circumstances, corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances. This may particularly be the case if earnings reports or required SEC disclosure filings are delayed due to COVID-19. Given these unique circumstances, a greater number of people may have access to material nonpublic information than in less challenging times. Those with such access – including, for example, directors, officers, employees, and consultants and other outside professionals – should be mindful of their obligations to keep this information confidential and to comply with the prohibitions on illegal securities trading.
This focus on the detection and prosecution of insider trading is consistent with the long-term priorities of the Division. Further, with the Division’s improved capabilities to detect insider trading through data analytics, this type of investigation is particularly suited for a time, like now, where the staff is working remotely. We read the statement as a warning that the Division will vigorously pursue actions involving material nonpublic information in the COVID-19 era.
Division of Enforcement’s Financial Reporting and Audit (FRAud) Group
Co-Director Peikin, speaking on May 12 at the virtual Securities Enforcement Forum West 2020 Conference, made it clear that, in the Division’s view, the current climate is ripe for “exposing preexisting accounting or disclosure improprieties, or leading issuers to engage in improper conduct.” In a signal that the Division will continue to leverage technology to drive investigations, Peikin described a “systematic process to review public filings from issuers in highly impacted industries” to identify reporting trends and disclosures that are “out of step” with a company’s peers or its own past performance.
The Division’s Financial Reporting and Audit (FRAud) Group, created several years ago, will likely be involved in those efforts. The FRAud Group is tasked with ongoing review of financial statement restatements and revisions and the analysis of performance trends by industry, in part through the use of technology-based tools and data analytics, and was involved in the recent enforcement initiative concerning a series of issuers that the SEC asserted “fail[ed] to maintain internal control over financial reporting for seven to 10 consecutive annual reporting periods.”
Increased Whistleblower Activity
Investor anxiety combined with the business environment, including employee downsizing, will likely result in a significant increase in tips, complaints, and referrals (TCRs) to the SEC. The SEC disclosed in February that the Division handled 17,000 TCRs in fiscal year 2019 and predicted 19,000 and 20,000 for fiscal years 2020 and 2021, respectively. Those estimates were made without considering the significant impact COVID-19 has had—and continues to have.
In addition to receiving many TCRs from investors, the SEC also may receive TCRs from more employee whistleblowers seeking credit for providing helpful information to the SEC, and monetary awards for doing so, than it ordinarily would. This may be particularly true for employees who have been subject to workforce reductions and layoffs caused by the current economic downturn. We also expect there will be an increase in employee whistleblowers alleging health and safety concerns related to their work environment.
Co-Director Peikin has revealed that the Division staff triaged 4,000 TCRs since mid-March 2020, a 35% increase over the same period last year. The Division also says it has opened hundreds of new investigations, many COVID-19 related, but many in other traditional areas since mid-March.
To prevent or mitigate the risk of whistleblower complaints, companies should ensure that there is adequate communication around “close calls,” whether related to financial statement disclosures or workplace issues in general. During this pandemic, when many employees are physically separated from their colleagues, it is more likely that business decisions may be made without adequate communication and collaboration. This increases the risk of disgruntled employees becoming whistleblowers.
The pandemic also makes it especially important for companies to ensure that their managers regularly engage with their direct reports. Whistleblower complaints are often first made directly to managers, and those managers’ responses could increase or mitigate the potential exposure a company faces. Thus, companies should train their managers on how to address any concerns raised by their employees and avoid potential retaliation claims under various laws, such as the Dodd Frank Wall Street Reform and Consumer Protection Act or the Sarbanes-Oxley Act of 2002. Any credible whistleblower complaints should be promptly investigated and addressed, with advice from legal counsel if necessary. Ultimately, by being proactive in addressing employee concerns, companies can significantly reduce their exposure from potential whistleblower claims.
PROTECTING AGAINST ACTIVISM
The market volatility caused by COVID-19 has impacted the shareholder activism landscape and has made many public companies attractive targets for activist investors. Given the current environment, companies should assume that they may be targeted by an activist investor, either alone or in concert with others, and should take steps to prepare accordingly.
Public companies should conduct a comprehensive assessment of their structural vulnerabilities to determine how they may be vulnerable to an activist hedge fund or hostile raider. Companies should consider reviewing their organizational documents and their overall corporate governance from an activist and hostile takeover defense perspective. Upon completion of that review, companies should determine whether they should make any corporate governance changes to mitigate structural vulnerabilities or enhance structural protections, including in particular any amendments to their charter or bylaws.
Public companies should also consider whether they should adopt a shareholder rights plan, also known as a “poison pill.” A poison pill may be adopted for the purpose of protecting against an unsolicited acquisition of the entire company or a significant portion thereof, or to protect the company’s federal net operating loss carryforwards from being limited under Section 382 of the Internal Revenue Code. Even if a poison pill is not imminently necessary, companies should consider going through the exercise of preparing a “shelf” poison pill.
While the benefits of actually adopting a poison pill may not outweigh some of the countervailing considerations, companies should consider having a shelf poison pill and related documents prepared and internally vetted so a poison pill can be adopted and publicly announced on very short notice.
STATE AND FEDERAL INVESTIGATIONS AND ENFORCEMENT
Public companies also face the risks of state and federal investigations and enforcement related to the COVID-19 pandemic. The DOJ has made the investigation and prosecution of COVID-19-related wrongdoing a top priority, and has encouraged US Attorneys’ offices to work and consult with state and local authorities in this effort. To that end, DOJ has required each US Attorney’s office to appoint a coronavirus coordinator.
State attorneys general, for their part, have been equally vigilant in investigating not just crisis-related fraud and other criminal conduct, but also issues such as workplace safety and consumer privacy. In addition, numerous states have announced joint federal-state task forces dedicated to COVID-19 enforcement.
While some early enforcement has focused on the low-hanging fruit of criminal schemes, targeting snake-oil schemes and the like, over time, enforcement is likely to reach much more broadly into all aspects of the crisis and associated relief efforts.
As part of the CARES Act, Congress created three oversight bodies with responsibility for investigating and overseeing the use of funds made pursuant to the act: the Special Investigator General for Pandemic Recovery, the Pandemic Response Accountability Committee, and the Congressional Oversight Commission. To the extent this oversight resembles anything like the oversight of the 2008 financial crisis stimulus, by, among others, the Special Investigator General of the Troubled Asset Relief Program, it will continue for years and could involve any recipient of CARES Act relief, even if the underlying conduct is unrelated to the pandemic.
For now, however, prosecutions have focused on fraud related to CARES Act programs themselves, such as alleged fraud by borrowers in the PPP. As we explained in a previous LawFlash, enforcement in this area is not limited to criminal enforcement, as participants in these programs also face potential claims under the civil False Claims Act (FCA), brought by the government or whistleblowers.
Another area of COVID-19 related enforcement—and one that has already begun—is state and federal price gouging and hoarding regulation. Typically the realm of state enforcement, these restrictions prohibit excessive price increases on specified goods during the course of an emergency. During this economic and health crisis, states actively have been enforcing these laws, and have rolled out awareness campaigns resulting in drastic increases in price gouging complaints.
While, at the extremes, these types of cases seem obvious and easy to avoid, they can actually be more complicated than initially meets the eye. Different states have laws that can apply very differently with respect to the goods covered, the relevant price comparison period, and the specificity with which prohibited price increases are described (a numeric percentage versus an “unconscionably excessive” increase). Most, but not all, states have exemptions that recognize that increases in prices may be warranted because of higher costs during the emergency. Still other states do not even have specific price gouging statutes, instead relying on general fraud and consumer protection laws to regulate perceived wrongdoing. Despite these state regulatory differences, however, state attorneys general have collectively urged nationwide retailers to enact measures to identify and prevent price gouging.
Furthermore, although pricing regulation has generally been left to state enforcement, the federal government also has been involved in investigating and prosecuting price gouging and hoarding during this crisis. On March 23, 2020, President Trump, exercising authorizing under the Defense Production Act (DPA), issued an executive order permitting the secretary of Health and Human Services (HHS) to designate items that are prohibited from being accumulated “(1) in excess of the reasonable demands of business, personal, or home consumption, or (2) for the purpose of resale at prices in excess of prevailing market prices.”
The next day, the DOJ announced the creation of a Hoarding and Price Gouging Task Force, staffed by members from every US Attorney’s office, and led by the New Jersey US Attorney. And notwithstanding that the federal statute contains many of the vagaries as certain of the state restrictions (“reasonable demands” and “prevailing market prices”), the federal government has brought price gouging charges against individuals alleged to have hoarded medical supplies and devices designated by HHS.
In short, this is unquestionably an area of enforcement focus at both the state and federal levels, and participants at every level of the distribution chain need to be mindful of their pricing practices.
The COVID-19 health crisis has resulted in billions of dollars of federal and state government spending on, among other things, necessary PPE, medical equipment, and testing. This has both included voluntary contracting and compelled production and/or governmental commandeering under the DPA and similar state laws.
As we explained in our March 26 LawFlash, this increased level of federal government contracting carries with it potential criminal and civil risk, including under the FCA, for false information contained in claims presented to the government. These concerns similarly apply with respect to state and local procurement. Most states have false claims acts that, like the FCA, allow whistleblowers to bring qui tam actions and many municipalities have their own laws.
Complicating matters further is the coordinated effort of certain states to purchase equipment and supplies collaboratively and efficiently. Thus, manufacturers and suppliers must be cognizant of the laws and regulations that apply to the governmental entity making a particular purchase, which, in certain circumstances, could be more than one. Even in the emergency environment in which this government procurement is occurring, companies must take steps to mitigate future risk of criminal and civil liability, including by maintaining sufficient controls to ensure accurate recordkeeping and billing.
 50 U.S.C. § 4512.
 Long Island Man Charged Under Defense Production Act with Hoarding and Price-Gouging of Scarce Personal Protective Equipment; Brooklyn Man Arrested for Assaulting FBI Agents and Making False Statements About His Possession and Sale of Scarce Medical Equipment; Two Individuals Arrested for Conspiring to Violate the Defense Production Act; Licensed Pharmacist Charged with Hoarding and Price Gouging of N95 Masks in Violation of Defense Production Act; New Jersey Man Arrested for $45 Million Scheme to Defraud and Price Gouge New York City During COVID-19 Pandemic.