January 31, 2013

Which Way is Up? Describing the Economy in Risk Factors and MD&A

One of the perennial challenges arising this time of year is trying to update Form 10-K disclosure about the state of the economy and the impact on a company’s business, results of operation and financial condition. While your 10-K is by no means meant to be a version of The Kiplinger Letter, some discussion of present, past and future economic conditions is usually necessary, particularly in the context of the MD&A and Risk Factors sections of the 10-K.

As we discussed in November-December 2008 issue of The Corporate Counsel, the SEC is of the view that required disclosure need not be firm-specific or not otherwise publicly available; therefore, disclosure about matters such as the economy, industry-specific trends and financing conditions are fair game, even if you would have to be living under a rock not to know that trends in these areas are having an impact on the overall business climate and the business of individual issuers.

The disclosure challenges with regard to these matters became readily apparent in 2008 and 2009, as rapidly deteriorating financial markets and the onset of a severe economic recession caused many issuers to revisit what they said in their periodic reports and registration statements about the economy and their access to capital, and the resulting effect of trends in those areas on their business. A challenge since that time has been what to say in MD&A and Risk Factors in particular about the aftermath of those events, as the economy and financial markets have improved, but underlying concerns remain.

This topic has remained of interest to the SEC Staff in the post-financial crises era, as we continue to see comments from the Staff requesting that issuers address macroeconomic or financing conditions as part of their MD&A. A representative comment that we see from time to time is:

Please consider expanding your overview in future filings to provide insight into material opportunities, challenges and risks, such as those presented by known material trends and uncertainties, on which the company’s executives are most focused for both the short and long term. Refer to Section III.A of SEC Release 33-8350. For example, please tell us what consideration you gave to discussing in your overview the impact on your financial condition of the continued weakness in the macro economy and the expansion of your international operations.

The particular challenge that issuers are facing this year is the fact that while the economic recession has ended, the economy remains weak and we are still plagued with high unemployment, shaky consumer confidence and diminished consumer spending. At the same time, we see improvements in the housing sector that run counter to this trends. On the financing front, we are now roughly four years past the financial crisis, and arguably markets have settled for now into what seems like a “new normal.” All that said, the macroeconomic and financial markets still seem quite fragile, so significant optimism in disclosures may be going too far. With all of that in mind, here are some tips for revisiting MD&A and risk factors this 10-K season:

1. Are you still describing the financial crisis as if it just happened yesterday? Improvements have occurred since 2008-2009, although access to capital remains a concern. If anything, the financial crisis demonstrated that financing alternatives can be cut off in the blink of an eye, so that is something that remains worth talking about.

2. Are you still describing the macro economy as experiencing a recession? In some cases we have seen disclosure that has not kept pace with the turnaround in the economy, although it should be noted that recent economic data has suggested a contracting economy again (although not long enough to be considered a recession). Given the uncertainty as to the direction of the economy, it is best to balance the discussion of the post-recessionary economy with a description of the uncertainty as to continued economic growth and the possibility of another recession, including a discussion of the potential impact of these trends on the issuer.

3. Are you adequately addressing the potential trends in the global economy? Given the potential impact of the global economy and world market conditions on issuers (including those whose business is principally in the US), it may be appropriate to address conditions abroad, including the continued impact of European debt concerns.

4. As you overemphasizing economic or market trends? As noted in the November-December 2008 issue of The Corporate Counsel, one particular concern is the potential for overemphasis on external economic, market and credit conditions as a source for adverse business trends specific to an issuer. In some instances, issuers may be tempted by the fact that it is much easier to blame or credit the economy than analyze the underlying business considerations. Given this concern, issuers need to strike a balance in discussing both company-specific and macro-economic trends and uncertainties and the potential impact of those trends and uncertainties on the issuer.

An Iran Sanctions Disclosure Risk Factor?

With the clock ticking on issuers trying to determine whether they have to disclose any covered activities involving Iran under new Exchange Act Section 13(r) (see, e.g., the November-December 2012 issue of The Corporate Counsel and Broc’s latest blog on the topic), we understand some issuers have been considering whether to add a new risk factor into this year’s 10-K about the possibility of having to disclose this information, even if no particular disclosure is required under Exchange Act Section 13(r) after the February 6th effective date. At this point, there doesn’t appear to be a one-size-fits-all approach to this sort of risk factor disclosure, although I would suspect that it would only be relevant for those issuers who consider themselves at risk of having their activities (or the activities of affiliates) subject to the disclosure and notice provisions specified in Section 13(r).

More on “The Mentor Blog”

We continue to post new items daily on our blog – “The Mentor Blog” – for members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:

– CAQ Issues Guide on PCAOB Inspections
– Do LLC Managers and Controlling Members Have Default Fiduciary Duties? Maybe.
– Proposed EU Board Gender Quotas Delayed
– Analysis: Supreme Court Arguments in Amgen Case
– Chamber of Commerce Attacks PCAOB, Asking SEC to Reject Auditor-Audit Committee Rulemaking

– Dave Lynn