Friday, May 15, 2020

Securities Docket panelists weigh in on enforcement implications of COVID-19 pandemic

By Amanda Maine, J.D.

Challenges presented by the COVID-19 pandemic to SEC enforcement efforts and defense responses dominated the Securities Docket’s recent Securities Enforcement West 2020 conference. The first panel of the day-long conference featured perspectives from the SEC’s Division of Enforcement, the defense bar, and the accounting and auditing profession. The panelists discussed the logistics of conducting business remotely, how to approach financial statement disclosures, and both SEC and private litigation related to COVID-19.

Litigation and logistics. The panelists observed that moving forward with enforcement investigations while working remotely has presented challenges on both the government and defense sides. Jason H. Lee, assistant regional director in the SEC’s San Francisco office, said that the staff is continuing to operate as usual even while working remotely. This includes conducting interviews, taking testimony, obtaining documents, and conducting regular staff meetings. Video testimony more or less replicates in-person meetings, Lee said, and assured that the staff is cognizant that the logistics of conducting these meetings has changed and has tried to be understanding in the current situation.

From a defense point of view, Susan Resley of Morgan Lewis & Bockius said that in the remote world, it can be more time-consuming to prep witnesses and examine documents. She also lamented the inability to conduct face-to-face meetings. Having the opportunity to sit across the table can help the staff in assessing credibility, she said. In some cases, a tolling agreement is arranged so the client can be interviewed at a later date in person; however, this is not always in the client’s best interest, Resley advised. Lee added that tolling agreements can give added flexibility on the scheduling of interviews, but cautioned that an "indefinite delay" in interviewing a witness is not something the staff will entertain.

Trading suspensions and litigation. Lee noted that the SEC has temporarily suspended trading in the securities of at least 29 issuers due to statements related to COVID-19, including statements about the production and supply of personal protective equipment, the development of a possible vaccine, COVID-19 testing kits, and COVID-19 treatments, including one issuer who touted cedar leaf oil as a possible treatment. Lee also pointed to charges the SEC brought in April against Praxsyn Corp. and its CEO for allegedly issuing false and misleading press releases claiming that the company was able to acquire and supply large quantities of N95 or similar masks.

Disclosure issues. Another potential enforcement implication involves disclosures that companies make regarding risks associated with COVID-19. Resley advised that the SEC does not expect "clairvoyance" in these disclosures, but companies should aim for specific disclosures and not hypotheticals or boilerplate language. For example, a statement that COVID-19 may affect company operations but that the company is unable to predict how it will affect operations will likely come under scrutiny by the SEC. A more appropriate disclosure would be to state that COVID-19 has materially affected a company’s operations and will have a likely adverse effect on the financial statements, Resley suggested. The Commission’s Disclosure Guidance No. 9, issued by the Division of Corporation Finance in March, gives companies some "wiggle room" on what to disclose, but specificity should be encouraged, Resley said.

Lee urged companies and their counsel to consult the statement issued on April 8 by Chairman Jay Clayton and CorpFin Director William Hinman when considering COVID-19-related disclosures. Among other things, Clayton and Hinman encouraged companies to avail themselves of safe harbors for forward-looking statements. Lee said that the SEC is aware that actual financial results may differ from what was disclosed at the time and advised that the staff will not second-guess good faith attempts and reasonable estimates when evaluating coronavirus-related disclosures.

Accounting and auditing. Thomas Heck of KPMG outlined accounting and auditing issues that should be taken into consideration during the pandemic. The COVID-19 business environment is different from past economic downturns in the sense that it is bifurcated, he observed. While some industries are extremely distressed, others (like some retail and grocery outlets such as Costco) are booming, according to Heck. This can lead to different incentives and opportunities for financial statement manipulation, he said.

Regarding distressed industries, Heck advised that the SEC will be on the lookout for a "hero" mentality that may occur in an attempt to save a particular business unit through creative accounting, especially in the areas of revenue recognition, fair value measurements, and goodwill impairments. Companies in booming industries, in contrast, may be tempted to pad reserves or recognize revenue prematurely while things are going well, he remarked. Companies should also be mindful of supply chain concerns, as seen in the toilet paper shortage in the U.S.

There are also accounting and auditing implications relating to employees working from home, Heck said. Internal controls may be affected, such as whether segregation of duties can be accomplished. Other risks include increased rationalizations for some employees to commit fraud and potential cyberattacks, according to Heck.

Echoing Resley’s earlier comments about the importance of face-to-face communication, a remote workforce can make it difficult for auditors, Heck said. Face-to-face time with clients during an audit is vital because auditors have the ability to ask a question and to read a client’s reaction, which can enhance the auditor’s professional skepticism. Heck observed that these types of evaluations are more difficult to do when walk throughs are conducted via videoconferencing platforms rather than in person.

Private litigation. The COVID-19 crisis will certainly result in lawsuits by private plaintiffs against companies, Resley said, particularly in the leisure and healthcare industries. Resley observed that several lawsuits have already been filed against Norwegian Cruise Lines, which had touted in a Form 8-K that it was well-equipped to handle pandemic-related issues and touted the safety of its passengers. A March Miami New Times article published leaked emails from a Norwegian Cruise Lines employee showing that the company directed its sales staff to lie to customers regarding COVID-19 using high-pressure sales tactics, and shareholder lawsuits soon followed.

In the healthcare industry, Resley remarked that a shareholder is suing Inovio Pharmaceuticals for statements the company’s CEO made about developing a COVID-19 vaccine, including that it was in the process of developing such a vaccine and that it would hit the market in the summer. The Norwegian Cruise Lines and Inovio lawsuits are signs of cases to come, and companies should expect more private securities litigation related to COVID-19, she said.

Resley also observed that private plaintiffs have a higher burden to prove loss causation. Shareholders suing companies for COVID-19-related statements must show that it was the fraud itself that caused the company’s share price to drop, and not intervening market events. Being able to segregate investor losses that are caused by the fraud as opposed to broader market events may prove to be difficult, Resley advised.