Disclosure to Investors Regarding Financial Distress, Straightline

During and industry downturn, public disclosures of potential exposure to bankruptcy become more prominent for financially distressed companies, as well as for companies with exposure to distressed counterparties. Many financially sound companies add bankruptcy-related disclosures in their filings with the Securities and Exchange Commission (SEC), and may make similar disclosures to lenders and private investors. These disclosures alert investors of financial distress, insolvency and bankruptcy risks that may affect counterparties and the industry as a whole. When appropriately used, risk factors and “meaningful cautionary statements” can offer protection against liability to investors for forward-looking statements under the court-interpreted “bespeaks caution” doctrine or under the Private Securities Litigation Reform Act (PSLRA).

Potential Industry Risks

A company may disclose to shareholders and other investors potential risks and effects of an industry downturn on its business, even if the company does not have any counterparties known to be in financial distress or bankruptcy at the time. For example, a publicly traded company in the oil and gas industry may disclose in its Annual Report on Form 10-K industry-specific risk factors such as risks from decreases in commodity prices, reductions in capital spending by customers, and potential bankruptcy of joint venture partners, customers or suppliers. Disclosures of this kind put investors on notice that the company’s current performance may not be indicative of future results if the downturn continues.

Disclosures Regarding a Specific Counterparty

A public company must publicly disclose “known trends and uncertainties,” including risks or disruptions in business caused by a counterparty’s financial distress. The detail in the disclosure may vary, potentially including the status of any bankruptcy filing, the financial effects on the reporting company (such as estimated bad debt expense) and how the company seeks to mitigate the business impact going forward. For example, if a reporting company’s key purchaser of oil files for bankruptcy, the company’s disclosures to investors may include: (1) plans to sell its oil production to other purchasers, (2) the amount and treatment of bad debt expense and (3) the status of any contracts with the key purchaser going forward. The counterparty should not be identified by name until its insolvency proceedings are filed or financial distress is reported publicly, and in fact the reporting company may be bound by confidentiality restrictions under its contracts with a counterparty.

Disclosure Regarding a Significant Shareholder’s Bankruptcy

In addition to disclosing a counterparty’s bankruptcy or financial distress, a public company must publicly disclose specific risks or disruptions in business caused by a shareholder’s bankruptcy or financial restructuring that has already affected or is expected to affect the company’s business and financial results materially. As with other disclosures, the detail may vary, but generally includes (1) the status of the bankruptcy filing or restructuring process, (2) the financial effects on the reporting company (such as the treatment of the shareholder’s shares in the reporting company under a plan of reorganization, and potential change of control if debtors may acquire a controlling interest) and (3) how the company seeks to structure its relationships with the shareholder going forward and to mitigate the effects of the shareholder’s bankruptcy or restructuring (subject to any approvals needed from the bankruptcy court). In addition, a reporting company may disclose the risk of possible consolidation of the company with the shareholder in bankruptcy, if the company risks being drawn into bankruptcy.

Disclosure of Company’s Own Distress or Imminent Bankruptcy

During a market downturn, business conditions may deteriorate gradually. Disclosures may be appropriate if, for example, a company is forced to seek waivers under its debt covenants, or if the auditors may include a going concern qualification in the audit opinion. Additionally, a company may disclose to investors its inability to service all of its indebtedness in advance of a bankruptcy filing or out-of-court restructuring, and may disclose the adverse impact on its stock price and value of its equity. 

Disclosure Regarding Impact of Bankruptcy Case Law

Bankruptcy courts regularly decide significant issues that may have material adverse effects on a company’s business in an industry downturn. Risks and uncertainties arising from bankruptcy court decisions may warrant close analysis and disclosure to investors if material.

Conclusion

As an integral part of its disclosure controls and procedures, a public company should regularly monitor its own financial health and material contingencies, as well as relationships with counterparties and any signals that insolvency may be imminent (such as covenant defaults, downgraded bonds or a significant decline in stock price). To protect the company and its officers and directors during a market downturn, companies are well advised to assess and disclose the risks of financial distress when appropriate in their communications with auditors, lenders and investors.