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Law360 (April 14, 2020, 1:58 PM EDT) --
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| Adele Hogan |
Given the coronavirus disease, or COVID-19, situation and other economic and market developments related to it, many entities, both for-profit and nonprofit, across industries are handling economic and liquidity issues. Many have in the past and will continue to thrive after going concern statements, but if it is possible to minimize the likelihood of getting such a statement, particularly given the unique COVID-19 situation, then there may be one less obstacle on the road to recovery from the COVID-19 hit.
This going concern issue not only relates to Form 10-K audit opinions, but other situations such as offerings where auditors must reaffirm audit opinions and disclosure in Form 10-Qs where management may have to assume that the entity will continue as a going concern in the critical accounting estimates and assumptions.
Proactive steps on liability management and strategy may convince auditors that there is no need for them to have substantial doubt about an entity's ability to continue as a going concern over the next 12 months.
The Public Company Accounting Oversight Board's Audit Standard 2415 relates to an entity's ability to continue as a going concern.
Auditors' are required to insert a going concern statement in audit opinions if there is substantial doubt about the ability of an entity to continue for that "reasonable period of time," not to exceed one year beyond the date of the financial statements being audited.
Auditors are directed to consider conditions and events, which include:
- Negative trends, such as recurring operating losses, working capital deficiencies, negative cash flows from operating activities or adverse key financial ratios;
- Other financial difficulties, such as defaults, dividend arrearages, supplier trade credit denials, debt restructuring, statutory capital noncompliance and the need for new financing or substantial asset disposals;
- Internal matters, such as labor difficulties, project dependence, uneconomic long-term commitments and significant operations revisions needed; and
- External matters, such as legal proceedings, legislation or matters that might jeopardize an entity's ability to operate; losses of a key franchise, license or patent; losses of a principal customer or supplier; and uninsured or underinsured catastrophes such as droughts, earthquakes or floods.
COVID-19 ticks many of these requirements for some companies and industries.
Fortunately, the auditors are directed to consider management's plans for dealing with the adverse effects outlined above. The auditor should consider whether it is likely the adverse effects will be mitigated for a reasonable period of time, and that such plans can be effectively implemented.
Management's mitigation plans could include asset disposals — with acknowledgment of covenant restrictions and marketability work-arounds — debt restructurings and new debt, expenditure delays, increased equity ownership, dividend reductions and accelerated liquidity from affiliates or investors.
In light of the unique factors involved with COVID-19, government assistance and new regulations should also be factored into management's plans should be factored into the going concern analysis. This is where entities can try to forestall any going concern statement, and 10 steps are noted below.
Steps to Proactively Try to Avoid a Going Concern Statement Related to COVID-19
Steps entities might take to evidence strong management plans that would cause an auditor not to have "substantial doubt" about an entity's ability to continue as a going concern might include the following.
Tone at the Top
A tone at the top of proactivity, creativity and ability to process information and adjust from management may go a long way to help convince an auditor that the management's plans for recovery are sufficient to avoid substantial doubt on an entity's viability.
A recognition of the impact on the many stakeholders shows leadership. Demonstrating when new COVID-19 economic related data became available and management's proactive consideration and responses, if necessary, to that information may be helpful.
Business Continuity Plan
A business continuity plan, or BCP, should be drafted and/ or updated and cover at least three scenarios related to COVID-19 and its impact, with adjustments to the best-, middle- and worst-case scenarios being made in a timely and realistic manner.
New Regulations and Governmental Support
BCPs should cover which of the many regulatory changes and benefits that are becoming available for entities impacted by COVID-19 on all stakeholders of an entity may show a holistic understanding of the COVID-19 situation and management's ability to manage through it.
Documentation
Documentation that is thoughtful, complete and timely may help provide a sense that management is and has been on it, and is proactively addressing COVID-19 related issues.
Minutes of meetings should be kept that cover the dates, duration, attendees and topics covered. Agendas and materials should be saved. External resources, including outside reports, should be saved and separate actions should be pulled into an overall plan to support for the auditors that there is a management plans to get through the COVID-19 situation.
Board Oversight
Board oversight that is engaged, timely, constructive and professional may be very helpful in avoiding a going concern statement, particularly where board directors have crisis management experience and evidences sound business judgements, strong attendance and active participation at meetings.
The board should not only be watching matters related to COVID-19, but keep continued vigilance on other threats, such as cybersecurity attacks, and governmental actions with unintended consequences.
Governance
Strong governance with evidence that there is a methodology of policies, procedures and controls that do not break down in a COVID-19 situation may be reassuring to auditors. Keep regulatory and U.S. Securities and Exchange Commission filings current. Stay abreast of environmental, social and governance trends, even though entities are under COVID-19 stress, because there may be small things that can be done in this area that will be remembered or important later on.
Liability Management
Consider what the cash burn rate and liquidity needs are and might be under the different BCP scenarios, and act where necessary. This may include negotiating with lenders, suppliers and customers to increase liquidity and/or decrease costs.
Negotiations with lenders and investors to execute waivers, amendments, settlements, stock/debt transactions may be appropriate. Plans that defer or eliminate expenses or terminate contracts may help, depending on the associated costs and regulatory implications.
Consideration of distressed M&A alternatives both as a buyer and a seller might help. Some M&A targets may be cash rich but have lower stock or asset prices, and that may make them more attractive. Buyers' and sellers' motives may be different than they were a year ago.
Acquisition, disposition or investment strategies should get a fresh look. Some sellers of assets or stock who have resisted selling in the past may take a fresh look at offers given COVID-19. Prior plans and discussions that may have started and then been abandoned can be restarted. Be aware of asset impairment issues if assets are sold at a substantial discount and similar assets are still held.
Tax issues may also be relevant, as well as derivatives. Labor and employment decisions should be made carefully with an view towards harmonizing them with new regulations and benefits and toward minimizing unnecessary disputes down the road.
As part of the BCP, demonstrating an understanding of how bankruptcy works may be useful. Even if not applicable to your entity, entities may be dealing with customers' or suppliers' bankruptcies and should know what rights they have and possible timelines, positions and outcomes to plan accordingly. For example, understand how rejection of leases works in bankruptcy.
Keep track of and store supporting documentation and provide timely notices on potential insurance claims and dispute/litigation claims. Map out supply chains. Consider alternative sources or reducing product and service offerings temporarily. Simplify business lines to core operations, at least in the short term.
Review distribution channels. Consider installment contracts and other customer support while monitoring old and potential new customers.
Dispute Management
Keep documentation and data in accordance with the entity's data retention policies and with an eye to possible future dispute resolution and litigation. Keep lawyers involved in planning and strategy stages to help solve legal and regulatory issues up front. Send notices as required under contracts or regulations to preserve claims.
Inventory Key Contract Provisions and Other Obligations
Organize and inventory contract provisions that may protect the entity or may entitle it to compensation or contractual relief or benefits. Review termination provisions that can be exercised for and against the entity as well as cross defaults, covenants, borrowing base and other financial calculations.
Make sure reviews of any other obligations, such as consent orders, settlement agreements, credit and debt agreements, and shareholders' agreements are done in light of COVID-19 and management's plans to manage through the COVID-19 impacts.
Secure Up Skilled Negotiators, Advisers and Legal Team
Participation by external advisers — such as strategic advisers, investment banks, consultants, accounting firms, public relations firms, investors, lenders, directors and lawyers — may help lend credibility and gravitas to management's going concern plans as well as enhanced strategic advice.
Management and in-house lawyers can upskill their liability management and other skills with external support on selected topic to support and enhance their strategic leadership through the COVID-19 situation and going concern procedures.
Since short-term and immediate survival may be top of mind for many entities, having or enlisting experienced and skilled negotiators and advisers who provide timely and insightful updates on fast moving global, federal, state and local developments and who can negotiate timely results, even if they are suboptimal, may be necessary in the suboptimal situation that is COVID-19.
SEC Disclosure Obligations if COVID-19 Going Concern Is Triggered
There are a number of SEC disclosures that have to be made by SEC reporting companies if a going concern path is taken by auditors. These disclosures include addition of new risk factors under Regulation S-K Item 105, risk factors and additional disclosure under Regulation S-K Item 303 — management's discussion and analysis of financial condition and results of operation.
The SEC also provided guidance related to COVID-19 in its March 25 CF Disclosure Guidance: Topic No. 9. Although risk factors and other SEC or private offering disclosure information must be drafted for each entity to cover its particular facts and circumstances, possible risk factors would include the going concern issue, plans to fix it may not work, delisting from a stock exchange and history of losses, if relevant, as well as risk factors related to COVID-19.
Going Concern as Evidence of Faltering Business and Its Reduction-in-Force Implications
If a going concern substantial doubt is raised, there may be exception to some of the federal, state and local requirements for a faltering business.
The burden of proof may be on the faltering business, so much of the advice related to bolstering management's plans that a going concern statement should not be required may need to be harmonized with the burden of proof on the faltering business exceptions of those labor and employment laws and regulations.
Entities are encouraged to consult employment counsel and have them actively engaged in broader business and legal discussions related to strategic and going concern matters.
Conclusion
Entities should consider ways to try to avoid the possibility they might receive a going concern statement in an audit opinion. There may be ways to implement a management action plan to forestall that occurring.
If a going concern designation is made for a public SEC reporting entity, there are additional SEC disclosure obligations that will be triggered.
The SEC has also issued guidance on extensive COVID-19 disclosure and other obligations. This is a time when clients and their advisors and stakeholders need to pull together to move to more solid footing.
Correction: A previous version of this article incorrectly attributed Audit Standard 2415. The error has been corrected.
Adele Hogan is a partner at Nelson Mullins Riley & Scarborough LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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