Risk Factor Disclosures for the Recovery Era

Valerie Ford Jacob, Doru Gavril, and Sarah Solum are partners at Freshfields Bruckhaus Deringer LLP. This post is based on a Freshfields memorandum by Ms. Jacob, Mr. Gavril, Ms. Solum, and Drew Liming.

It’s early 2021. With a new year comes a new Form 10-K. Among other things, your outside counsel is (hopefully) asking you to review and update your disclosures about risks related to COVID-19. That’s good advice, of course. We are still in the midst of a pandemic on a scale previously unseen in the modern era. No one knows how much longer its impact and uncertainties will persist. But this is also time to look at your COVID-19 risks through a new lens: consider whether your filings should also include risk disclosures about the post-pandemic recovery period. [1]

Not all companies were affected the same way by the pandemic. Most public companies experienced the same macroeconomic instability, workforce disruption, and distribution/supply chain upheaval and uncertainty. Beginning last spring, companies and their outside counsel scrambled to describe ever-changing risks regarding contagion, working from home, shifting consumption patterns, various shortages, and evolving government safety mandates. Soon, a new set of risk disclosures emerged, with their own lexicon of pandemic-related terms.

For a number of companies, though, the pandemic shifted consumer and competitive behaviors to create growth, both in demand from existing customers or in the number of new customers. This growth was accompanied by very positive financial or operational results. Several industries that grew during the pandemic should consider risk disclosures tailored for the “recovery era”: social media, home entertainment, video communications, collaboration tools, delivery services, online payments, e-commerce, to name a few.

Companies that benefited from the shifts associated with the pandemic should also carefully consider whether they have reason to believe that those benefits may taper off, or be reversed even, during a post-pandemic recovery era. Some companies, like home entertainment services, for example, might see their numbers tick down when we can be with friends and family again. On the other hand, other companies might find that the behavioral changes resulting from the pandemic are more persistent. For example, it’s a near certainty that the widespread use of videoconferencing has fundamentally changed how people work and meet and that these activities will continue. But the question, of course, is what “normal” collaboration and communication will look like once offices reopen and travel is possible again.

Some may think that it is premature to think about the recovery period when we are possibly at the worst moment of the pandemic. We disagree. The transition between pandemic and recovery will not be readily apparent, predictable, and neatly delineated. It will come in fits and starts, and it will not be fully recognizable except in hindsight. As importantly, consumer behavior may begin to shift in anticipation of recovery, even before that period has actually begun. If one thing is certain about the recovery period, it’s that it will be as unpredictable as the pandemic itself.

Companies should be ready for the litigation risk that always accompanies change. Investors in companies that experience post-pandemic dips may look to mitigate their losses by filing shareholder lawsuits claiming that the company inadequately disclosed the temporary nature of its pandemic-era growth or its sensitivity to recovery-era conditions. A robust set of risk factors can limit or eliminate this liability and give pause to any litigious shareholders looking to blame someone for the reversal in the company’s fortune.

Below we offer some practical considerations to jumpstart this essential and inevitable exercise. As always, companies should be guided by experienced counsel working in close collaboration with knowledgeable operational and financial company leaders. That’s fancy talk for: talk to your inhouse and outside lawyers, discuss what worries you and your board, discuss the scenarios or models being considered, and the patterns emerging from the data you have accumulated in 2020.

Some Questions to Ask Yourself About the Recovery Period

Here are some of the questions we would ask if we were your lawyers. We tried to make them industry-agnostic, but it’s easy to see how replacing “users” with “buyers” or “customers” and platform with “online store” will expand their applicability across many more industries.

New “Pandemic Era” Users/Customers

  • Has your company seen an increase in the number of users during the pandemic? Did the user number increase at a higher than expected rate?
  • Are the new users different in some way (geographically, demographically, age, income, gender, etc.) than your user base so far? Do these unique characteristics make them susceptible to a reversal of the pandemic-era behavior that caused them to join your platform?
  • How do the new users interact with your platform? Are they using it like your usual user base, or is it some unusual use or feature that has led them to join your platform to solve a specific pandemic-related problem?
  • How strong are network effects on your platforms? Are you seeing the same recruitment/referral efficiency with new pandemic users as with your legacy pre-pandemic users? If network effects are strong, is it possible that they could also operate in reverse by causing large swaths of connected individuals to drop off the platform once the pandemic-related problem they sought to address by using your platform is over?
  • Is the accumulation of new users during the pandemic saturating certain markets or segments of your user base? What happens usually when one of your markets is saturated? Is the same effect likely to occur now?

Content/Products/Services

  • Are your users consuming or creating on your platform? Does the traditional pattern match what you have seen during the pandemic? Is that true of both new users and legacy users?
  • If your platform provides content/products, are the content/products that you are seeing consumed in the pandemic era related to specific pandemic activities or limitations, such as working from home?
  • Is there a type of content or benefit on your platform that could become less valuable during the recovery era when substitutes will be available?
  • On what devices has content been created/consumed during the pandemic? Is use of those devices likely to decline in the recovery era?
  • When do users engage with the platform? Are old users and new users similar in habits? If users access the platform at times they’d normally be at work, would you expect a decline in usage if users return to working from the office?
  • Were your products or services supporting COVID-19 response? If so, is demand or pricing likely to decline?

KPIs and Other Metrics

  • Are your old metrics enough to capture the dynamic of the new user base and their consumption/creation? If you have created new metrics during the pandemic, do you expect to continue using them after the pandemic? Have they been disclosed?
  • Is the user growth accompanied by similar increases in retention metrics? If not, is there a risk that newly acquired users will churn?
  • Is there a risk that macroeconomic volatility or other factors during the recovery would reduce your ability to model or forecast your business performance?

Personnel

  • Has working from home resulted in savings regarding real estate or personnel? Benefits, compensation, rent and building expenses, travel costs, marketing expenses for industry conferences all come to mind. Were these benefits material? If so, how likely is it that the recovery would see different working arrangements that might reduce or offset those benefits?

Subs, Divisions, and Recently Acquired Businesses

  • If, like many companies, you acquired other businesses in 2020, and their impact is material, or their performance is reported separately, consider whether they are more susceptible to some of the risks noted above than the rest of the business;
  • Also consider whether these new acquisitions would behave differently than the rest of the business during the recovery.

This is not a comprehensive list, but just a few topics to consider. Each company will require a bespoke approach to evaluating and disclosing material risks related to the recovery period. As you engage in this process, it is important to keep in mind that the goal is to identify risks, not forecast what the recovery period will mean for your business.

It’s also important to understand the limitations of such disclosures in terms of avoiding stock-drop lawsuits. A meritless lawsuit can still be filed, claiming that the risk factors were insufficient or incomplete, or even misleading because they portrayed as a risk something that (the plaintiffs will claim) the company knew as an actual fact. Such claims would be significantly weakened, however, by robust risk disclosures and make a motion to dismiss such meritless lawsuits much more likely to succeed.

As you consider recovery-era risk disclosures, please keep in mind some basic best practices:

  • Risk factors should be company-specific, in addition to any generalized conditions applicable more broadly;
  • Once the company is aware of an uncertainty that could materially impact results, it should consider disclosure, even if the specific impact remains unknown or even unknowable; [2]
  • If the effect of the recovery period cannot be predicted, as will often be the case, it may be appropriate to consider identifying the pandemic period pattern and note that its evolution will be uncertain during recovery;
  • If the company has considered various scenarios and believes that the recovery period may affect business patterns seen during the pandemic, it may consider disclosing, without limitation, those specific anticipated effects;
  • Risk disclosures should also be prepared with their future use as cautionary statements in mind, so they should take into account the potential forward-looking statements the company might make during the recovery period. [3]

If you’ve read this far, you probably work for a company that has been impacted during one of the most challenging periods in contemporary history. The road to recovery will also be bumpy and fraught with risks. Now is the time to think about those risks and help investors understand how they may affect your company.

Endnotes

1Risk disclosures are required under Item 105 of Regulation S-K. 17 C.F.R. § 229.105. They should include “a discussion of the material factors that make an investment in the registrant or offering speculative or risky.” 17 C.F.R. § 229.105(a).(go back)

2Risk disclosures should also be considered in light of “known trends or uncertainties” that the company “reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income.” 17 C.F.R. § 229.303(a)(3)(ii). Item 303 of Regulation S-K also requires disclosure of “any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected.” 17 C.F.R. § 229.303(a)(3)(i).(go back)

3Specific, thoughtful risk factors can establish the applicability of the safe harbor for forward looking statements, which requires that such statements to be “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” 15 U.S.C. § 78u–5(c)(1)(A)(i).(go back)

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