SEC’s Disclosure Review Reignites Debate Over Forward-Looking Information

Bereft of crystal balls, companies are nevertheless under more pressure to predict the future.

For their own internal strategies, estimating future cash flows, revenues, and reserves is a vital responsibility for management. But when investors want more access to forecasts and estimates, it is easy to predict plenty of push-back from companies.

The Securities and Exchange Commission is currently conducting a review, as part of the JOBS Act, of the effectiveness of public company disclosures in financial statements and other disclosures, such as the Management Discussion & Analysis. As it wrestles with the task, investor advocates are calling on the SEC to not just trim what is unnecessary and duplicative, but to finally draw a dividing line between the forward-looking information—quantitative and qualitative disclosures of risks, exposures, and liquidity issues—that belongs within financial statements and that which belongs outside them.

The call to include more future views in financial statements is not new and issuers have traditionally resisted the idea. Among their concerns are murky definitions (U.S. Generally Accepted Accounting Principles do not include a definition of “forward-looking information” or “forward-looking statement”) and ambiguous—some say ineffectual—safe harbors offered by the SEC and Congress. Even the most carefully considered financial projection could prove to be wrong and lead to litigation. Some are urging the SEC, as part of its review, to provide long-sought clarity.

The CFA Institute, a global association of investment professionals, has long advocated for more forward-looking measurements to enhance the usefulness of financial statements for investors. Urging the SEC to do the same as it reviews its disclosure regime, it issued a new report in October, “Forward-Looking Information: A Necessary Consideration in the SEC’s Review on Disclosure Effectiveness,” by Sandy Peters, who heads its Financial Reporting Policy Group. The report concludes that investors want, and deserve, more forward-looking information and proposes that a dividing line can indeed be drawn between what belongs inside and outside the financial statements.

“It seems self-evident that financial statements incorporating forward-looking information—such as liquidity and interest rate risk disclosures and fair-value measurements—would be most useful to investors in making investment decisions,” Peters says. Offering investors additional quantitative and qualitative disclosures would have the beneficial side-effect of increasing management’s own assessment, understanding, and monitoring of risks, she says.

An Ongoing Debate

The cause is nothing new, and similar efforts have emerged over the years with mixed results. Responding to a call for better risk disclosures, a type of forward-looking information, the Financial Stability Board, an international body with the goal of coordinating global regulation of financial markets, recommended a variety of voluntary disclosures, but the effort yielded few results.

Critics, demanding that forward-looking information remain outside financial statements, derailed changes regarding liquidity and interest rate risk proposed by the Financial Accounting Standards Board in 2012, the CFA report notes.

“It is a minefield in terms of litigation and I can understand why companies are reluctant to put forth more forward-looking information—fuzzy information—on estimate projections and the like because the liability landscape for them is still unclear.”
Allan Horwich, Professor, Northwestern University School of Law

Concurrent with the debate over that FASB exposure draft, SEC officials announced the development of a staff paper intended to clarify the dividing line between information that belongs in financial statements and what belongs outside them, in particular for the MD&A section of annual reports. That effort was later folded into the ongoing Regulation S-K review.

Some see adding more forward-looking statements to the disclosure mix as a recipe for increased liability and litigation. “It is a minefield in terms of litigation, and I can understand why companies are reluctant to put forth more forward-looking information—fuzzy information—on estimate projections and the like, because the liability landscape for them is still unclear,” says Allan Horwich, a professor at the Northwestern University School of Law and an attorney who specializes in securities litigation at law firm Schiff Hardin.

Despite misconceptions and claims to the contrary, however, U.S. Generally Accepted Accounting Principles already require plenty of forward-looking information. FASB’s attempt to define “future-oriented information,” is essentially a type of forward-looking information that can be included within financial statement disclosures. Its most recently proposed credit loss model, for example, requires companies to make an assessment of expected credit losses—incorporating expectations regarding current and future economic conditions as they see them today—and to recognize these losses throughout the life of the financial instrument.

“There is this automatic association, when accountants say information is forward-looking, that it can’t go in financial statements,” Peters says. “Lawyers think there is this bright line about what goes into financial statements. I want people to think a little more deeply about the fact that there is already so much forward-looking information in financial statements and it only going to become greater.”

Sailing Into Safe Harbors

Demands for legal protections connected to the predictive, uncertain nature of those disclosures, has been at the heart of the debate for decades.

For many years, the SEC would not allow forward-looking information in filings. Beginning in the early 1970s, however, it began to encourage voluntary projections concerning future economic performance, viewing them as valuable for investors. By the end of that decade, it adopted safe harbor rules for projections of financial information, management’s plans for future operations, and statements of future economic performance that were contained in an issuer’s MD&A. Under that safe harbor, forward-looking statements would not be considered fraudulent unless it was shown they lacked a reasonable basis or were not made in good faith.

WHAT COUNTS AS FORWARD-LOOKING?

The following, from the CFA Institute’s report, “Forward-Looking Information: A Necessary Consideration in the SEC’s Review on Disclosure Effectiveness,” addresses how forward-looking statements and information is defined.
U.S. Generally Accepted Accounting Principles does not include a definition of “forward-looking information” or “forward-looking statement.”
In the Private Securities Litigation Reform Act of 1995, the term “forward-looking statement,” which can be oral or written statements, is broadly defined as

A statement containing a projection of revenues, income (including income loss), earnings (including earnings loss) per share, capital expenditures, dividends, capital structure, or other financial items;

A statement of the plans and objectives of management for future operations, including plans or objectives relating to the products or services of the issuer;

A statement of future economic performance, including any such statement contained in a discussion and analysis of financial condition by the management or in the results of operations included pursuant to the rules and regulations of the Commission;

Any statement of the assumptions underlying or relating to any statement described in subparagraph (a), (b), or (c);

Any report issued by an outside reviewer retained by an issuer, to the extent that the report assesses a forward-looking statement made by the issuer; or a statement containing a projection or estimate of such other items as may be specified by rule or regulation of the Commission.
In addition, from our perspective, the inclusion of projections of “other financial items” and the assumptions underlying or relating to other financial items results in a very broad definition of forward-looking statements or information.
When used colloquially, the term “forward-looking information” is, in our view, generally meant to be in line with the definition of forward-looking statement in the Private Securities Litigation Reform Act. As a result, accountants in the United States have a nearly automatic association with the term forward-looking information—an association that tells them that any such information must be included outside the financial statements—given that the PSLRA defines the term and US GAAP does not. However, this term—and its automatic association with information to be included outside the financial statements—requires further analysis and critical thinking to evaluate the precise characteristics that constitute forward-looking information and why it might belong outside the financial statements relative to the characteristics of similar information included in the financial statements.
Source: CFA Institute.

Nevertheless, many issuers were still reluctant to risk the threat of litigation, calling the intended protection ineffective and ambiguous. Subsequent court decisions codified a new potential protection for defendants, known as the “bespeaks caution” doctrine—an assumed protection from liability if forward-looking statements include cautionary language that stresses their predictive nature.

Congress, looking to stem the abuse of private securities lawsuits, passed the Private Securities Litigation Reform Act of 1995 (PSLRA), broadened the safe harbor on forward looking information. The legislation covered statements containing projections of financial matters, plans, and objectives for future operations or future economic performance (such as statements contained in the issuer’s MD&A), as well as the assumptions underlying those statements.

PSLRA, however, has failed to fully sooth companies’ litigation fears. The safe harbor does not apply to a forward-looking statements included in financial statements, “even if it is in the textual footnotes it is not protected, Horwich says.  “I’m not saying there should be some sort of blanket immunity, but the standards that are out there are certainly not sufficient for the comfort of corporate America,” he adds.

In time, courts may offer issuers stronger legal protections. A case set to go before the Supreme Court this week, Omnicare v. Laborers District Council Construction Industry Pension Fund, deals with liability for opinions in registration statements. Are they facts or opinions? What are the elements of liability a plaintiff must prove in the event that the opinion turned out to be wrong? Although the case doesn’t pertain to ongoing financial statements, “there are potentially broader implications,” Horwich says.

Not everyone things the SEC’s disclosure review presents an opportunity to rethink how much and what kinds of forward-looking information corporate disclosures should contain.  The debate over forward-looking information is unlikely to gain much traction during the SEC’s current review of its disclosure regime, says David Lynn, co-chair of the law firm Morrison & Foerster’s corporate finance practice and former chief counsel of the SEC’s Division of Corporation Finance. “It is way outside of the scope of what I think the SEC is trying to accomplish,” he says.

Management’s assumptions can, and often do, miss the mark, Lynn says. When those predictions fall short, no matter what safe harbors exist, the threat of litigation will continue to loom large. “Unless we gather up all the plaintiffs lawyers there is no way to stop that possibility,” he says.

Lynn does think forward-looking information is “a worthwhile area of discussion.” “The SEC has written 30 years of interpretive releases trying to compel people to disclose more forward-looking information and I still don’t think they are satisfied,” he says.  But, as he witnessed during his time at the SEC, disclosure reform efforts get caught between the competing interests of investors demanding more disclosure and issuers burdened by the amount and complexity of what they already provide. “It makes it very hard for these projects to see the light of day,” he says.