United States: Mandatory Disclosure In A Recessionary Environment -- MD&A For The Potentially Troubled Company

Public companies must consider disclosure of material uncertainties that they face from economic downturns each time they file a 10-K or 10-Q or register securities for a public offering. These filings include a Management's Discussion & Analysis of Financial Condition and Results of Information, or "MD&A," which requires a company to identify and quantify the effects of a potential cash crunch or downturn in revenues, or to disclose that it is on the verge of bankruptcy.

It is important to distinguish the legal duty to disclose imposed by the MD&A requirements from voluntary disclosures -- such as most earnings warnings -- that a company may choose to make. Although failing to make a voluntary disclosure can have horrendous practical implications for investor relations, there is no legal penalty for not talking. The company faces legal liability for voluntary disclosure only when it is either materially untruthful or contains a material half truth. In contrast, a legal duty of disclosure, such as the MD&A requirements, forces the company to speak, and means that the company, and the company's managers individually, can be punished, not just for lying, but for a failure to disclose.

The MD&A is the only section of the company's periodic reports that requires routine disclosure of forward-looking information. The purpose of the MD&A is "to give investors an opportunity to look at the registrant through the eyes of the company's management by providing a historical and prospective analysis of the registrant's financial condition and results of operations, with particular emphasis on the registrant's prospects for the future." While a great deal of space in MD&A is spent discussing historic results, companies often overlook the obligation to discuss the company's future prospects.

In preparing the MD&A, management must make the following inquiry, known as the "Key MD&A Test":

• Is there a trend, demand, commitment, event or uncertainty affecting the company that is known to management?
• If so, is it likely to happen? If not, no disclosure is required.
• If it is likely to happen (or management can't say it is unlikely to happen), then management must ask if, when it happens, is the impact on the company likely to be material? If not, no disclosure is required. If yes, or if management can't say, then disclosure is required.

Management must disclose the potential impact of known trends, events and uncertainties that either are likely to have a material adverse effect, or that management can't reasonably say will only have immaterial effects. A 50:50 situation requires MD&A disclosure.

The test of whether or not a particular fact or development is material is tested on its materiality to a reasonable investor: "Would the fact be viewed by the reasonable investor as having significantly altered the total mix of available information?" If the answer is "yes," the fact is material; if "no," it is not. This is an area of extremely subjective judgment. Management must look at quantitative and qualitative factors in making this assessment. Each segment, each line item, must be separately judged. Changes in trends may be material. Even a change in depreciation schedules or tax rate can be material.

Management must examine every potentially material aspect of the company to identify potentially material trends, events and uncertainties. Here are examples of the questions that management should ask:

• Changes in trends of revenue growth. Are sales likely to drop for the company or for a material segment? What about margins? What is the anticipated effect on earnings?
• Increasing prices for energy. Will rising energy costs be offset by raising prices? Will there be any timing differences? Are energy supplies adequate?
• Increasing interest rates and tougher credit markets. Will earnings be adversely affected by higher interest charges? Are worsening debt ratings or tougher credit markets a problem for new borrowings? Will the company have adequate liquidity? Will coverage ratios limit the company's ability to borrow? Can it get waivers for missed ratios?
• Cash flow problems. Will slower growth affect the company's debt repayment strategy? Might the company face a liquidity crisis? Does the company have assets it may need to sell to pay off debt? Will the assets be adequate in amount, and are they actually saleable, given the economy? Might the company face bankruptcy?
• Special effects of recession. Are there special concerns for the company because of recessionary effects on its customers or suppliers? Is the company exposed to bankruptcies of its customers or suppliers? Will the company's contingent liabilities be worsened by a recessionary environment?

If the answer to any of these questions is "yes," then unless the company determines the uncertainty is unlikely to happen or that the impact on the company is likely to be immaterial, the company must disclose (1) the uncertainty and (2) the potential outcome.

Managers will argue, "If I tell people that I might go bankrupt, I will go bankrupt because no one will give me any more credit." This leads management to balk at making the required disclosures. Be warned: The SEC doesn't accept the self-fulfilling prophecy argument. Management that fails to make the required disclosure may be held personally responsible by the SEC.

In fact, many companies have made dire warnings without overly negative results. And some companies have used the MD&A disclosure as a weapon to obtain concessions from creditors. But careful drafting is a must; remember the many audiences that will read the MD&A.

It is important that all senior managers participate in preparing and reviewing the MD&A. This is not a task to be left to junior members of the company's financial staff. It is important that the MD&A consider any matters discussed at the Board level -- whether or not it is in the minutes. The MD&A draftsman should know what the Board has heard or discussed, and what the real concerns of senior management are. The company's audit committee should review the MD&A.

The MD&A's forward-looking analysis must report material trends, events, or uncertainties that exist at the time the report is filed with the Securities and Exchange Commission. That means it isn't enough to think about the MD&A as it would have been written at the end of the fiscal period that is being reported on; instead, the MD&A must be reviewed and refreshed down to the filing date.

In drafting the MD&A discussion, reporting public companies should use the safe harbor for forward-looking statements afforded by the Federal securities laws. Many disclosures driven by the "Key MD&A Test" will be predictive in nature (for example, "We expect to spend $2 million" or "We expect continued losses") and should be protected against private lawsuits by use of the safe harbor.

To use the safe harbor, the company must identify the statements that are forward looking and state that actual results may differ materially because of specifically identified factors. It is not necessary to identify all factors that could affect the results, or actually to identify the factor that from hindsight was the factor that caused results to differ. But you must identify real, non-boilerplate factors. For example, in the recession context, it might be appropriate to identify factors such as (a) the cost and continuing availability of credit, (b) the impact of economic conditions on the company's customers and suppliers, (c) the ability to sell assets or to obtain alternative sources of refinancing for the company's debt, or (d) the ability of the company to successfully restructure its loan obligations.

The company should be thinking about what it will need to say in the MD&A whenever it makes earnings releases or holds financial webcasts. A well-crafted earnings release should touch on all of the material disclosures that will be in the MD&A to avoid the risk of securities lawsuits based on a charge of "omission." Ideally, the MD&A will be prepared at the same time as the earnings announcement.

As long as the MD&A is first published in the company's periodic reports on Form 10-K or 10-Q, there is no selective disclosure under Regulation FD. But if the MD&A is first circulated by mail to shareholders or others, rather than through filing a report with the SEC, a concurrent filing should occur.

The company's investor relations officer ("IRO") should participate in preparing or reviewing the MD&A. The IRO will have a good feel for questions that may be material and the kinds of information that the market will want to see. An IRO can also help craft consistent wording with prior disclosures, such as webcasts and press releases.