Financial Reporting and the Law

The analysis of known trends and uncertainties is critical when preparing the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section for annual reports on Form 10-K and quarterly reports on Form 10-Q. The SEC’s Division of Corporation Finance (Corp. Fin.) routinely issues comments on the MD&A and, particularly, the need for them to discuss known trends and uncertainties. Recently, at a December 2013 conference hosted by the AICPA, the Corp. Fin. staff discussed appropriate disclosures about trends that may affect the return on pension plan assets, or the repatriation of earnings from foreign subsidiaries or that may require an impairment of goodwill or some other intangible. In addition, the SEC’s Division of Enforcement is focusing on the adequacy of disclosure about known trends and uncertainties in the MD&A.

In an October 2013 disclosure and accounting fraud case involving the MD&A, the U.S. District Court for the Southern District of Florida ruled in favor of the SEC at the summary judgment stage. The court held, among other things, that undisclosed trends in the MD&A created a fact issue as to whether a reasonable investor would view the trends as material. In the case, the SEC alleged that defendants BBX Capital Corporation and its chairman and CEO violated section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 by failing to disclose known trends and making misrepresentations regarding the company’s commercial residential portfolio. During the first two quarters of 2007, the credit quality of the loans in BBX’s commercial residential portfolio declined, due mainly to the downturn in the Florida real estate market. Although management was clearly monitoring this trend and disclosed in its 10-Qs that declines in the real estate market could, in the future, negatively affect the entire loan portfolio, the MD&A in the 10-Qs for these quarters did not discuss the increase in extension requests by borrowers and loan downgrades.

In light of this case—as well as other courts’ denying motions to dismiss claims under section 11 of the Securities Act of 1933 based on failures to discuss known trends or uncertainties in the MD&A, as well as Corp. Fin.’s focus on trends and uncertainties—companies should ensure that they disclose known trends and uncertainties in their MD&As. Any trend or uncertainty that management is closely monitoring, has identified in risk factors, or has discussed in earnings calls or with the board should be evaluated for disclosure. In addition, if a company discloses a trend and the company’s circumstances change regarding the trend, the disclosure must be updated to reflect the changed circumstances. Simply disclosing that there is a risk in the future that something may happen is not sufficient in instances where events have caused the risk to be realized.

For additional observations on the SEC’s continuing focus on MD&A cases, read the Securities Regulation & Law Report article by Linda L. Griggs, John J. Huber, and Christian J. Mixter, The SEC’s Renewed Interest in Accounting Cases — A New Beginning or a Victim of Fait ?.