Protecting the Public Interest

It’s the time of year when companies provide earnings guidance to investors and financial analysts about their future prospects for 2021. Uncertainties abound because we are in unchartered territory with respect to the impact of Covid-19 on the financial position, operating results, and future cash flows of businesses. The purpose of this blog is to provide a perspective of what kinds of disclosures are needed and how to avoid falling short of the mark. I was motivated to do write this blog because of what just happened to The Cheesecake Factory.

Earnings Guidance

Earnings guidance reflects the comments management makes about what it expects the company will do in the future. Earnings guidance is given by management to provide investors and financial analysts with data that indicates expected future earnings, earnings per share, and other items. These comments are known broadly as forward-looking statements.

The statements focus on sales revenues or earnings expectations in light of industry and macroeconomic trends. These comments are given for the sake of transparency and to guide investors and financial analysts in their decision-making needs. The problem is misleading and fraudulent earnings guidance statements can be motivated by a desire to put the best spin on future performance.

Earnings guidance can be given in conference calls with investors and analysts and in press releases available to the public. One concern with earnings guidance statements is they represent management’s subjective view of the company’s future financial performance, which is exposed to uncertainties and risks. For this reason, the company’s reported information is accompanied by cautions and disclaimers regarding the forward-looking statements to prevent any legal issues.

The Cheesecake Factory

A good example of where a company provided false and misleading information in its public releases is The Cheesecake Factory. On December 4, 2020, the company settled an enforcement action by the SEC it had provided misleading Covid-19 related disclosures. This was the first ever enforcement action against a public company for misleading Covid-19 information.

The SEC charges centered on alleged misrepresentations the company made in two press releases during the early days of the pandemic regarding how Covid-19 was impacting the company’s business operations and financial condition. The SEC determined that the press releases—attached to Forms 8-K submitted to the SEC on March 23 and April 3, 2020—contained material misstatements and omissions which failed to adequately inform investors of the extent of the virus’s negative impact on the company.

The SEC further states on March 2, The Cheesecake Factory filed a Form 8K and a press release disclosing that it was “withdrawing previously issued financial guidance due to economic conditions caused by the pandemic and that it was transitioning to an ‘off-premise model’ – to go and delivery services – that was ‘enabling the company’s restaurants to operate sustainably at present under this this current model’”. The press release further disclosed a $90 million draw down on its revolving credit facility, that it curtailed planned growth, and that it was “evaluating additional measures to further preserve financial flexibility.”

In support, of its charges, the SEC alleged that the statement did not disclose other information contained in internal corporate documents demonstrating that the company was excluding operational expenses from its claim of “sustainability,” was losing approximately $6 million per week, and it had rapidly depleting cash reserves. The SEC also noted that the company separately shared information from the internal documents with private equity investors and lenders in connection with then-ongoing fundraising efforts.

Financial Disclosure Issues

Operating and financial disclosures are a key part of ensuring that the financial statements are accurate and reliable and do not contain any material misstatements. The failure to disclose all the information that an investor and creditor needs to make their decisions is wrong. From an ethical perspective, honesty is about what you don’t disclose as well as what is disclosed.

Since the pandemic began, the SEC has encouraged companies to provide disclosures that allow investors to evaluate the current and future expected impact of Covid-19 through the eyes of management and to proactively revise and update disclosures as facts and circumstances change. These disclosures should enable an investor to understand how management and the Board of Directors are analyzing the current and expected impact of the pandemic on the company’s operations and financial condition, including liquidity and capital resources.

The disclosure involves a contingent event that, under generally accepted accounting principles, should be evaluated whether it is probable that a liability or loss will be incurred and the estimated amount of loss (record a journal entry), it’s only reasonably possible that a future liability exists (footnote disclosure to the financial statements), or its highly unlikely that any liability exists at the time the disclosure is made (ignore).

Auditors also have to determine what, if anything, these disclosures mean to audit firms’ ability to render an unmodified (unqualified) opinion about The Cheesecake Factory’s results of operations. At a minimum, it would seem that a going concern alert should be given by the auditors.

Ethics Issues 

The SEC’s actions send a clear message that Covid-19 disclosures will be carefully scrutinized to ensure that they meet established standards. Companies that fall short of the mark expose themselves to SEC action that could include fines and other penalties. The failure to disclose adequate information about material events, such as the impact of Covid-19 on current and future business, violates the rights of users of the financial statements to receive full and fair operating and financial information about any material events including:

• Whether disclosures are made on a timely basis
• The ability of the company to continue operating as planned (i.e., going concern).
• The effects of Covid-19 on current and future cash flows including the ability to pay off debts when due.
• The role of management and the audit committee in dealing with current and future effects of Covid-19 on operations.

There is no doubt that we need a complete picture of the current and future impact of Covid-19 and its after-effects on financial position, operating results, and future cash flows. The challenges during the pandemic are significant but still have to be met so that the right of the public to know is met.

In the spirit of the holiday season, I am giving away signed copies of my book to the first ten people who contact me at: [email protected] and provide a mailing address. May your 2021 be better than 2020. Let's face it, it can't be worse!

Posted by Dr. Steven Mintz, aka Ethics Sage, on December 30, 2020. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.