SEC’s EPS Initiative: Duty to Report Litigation Expenses?


Earlier this week, the United States Securities & Exchange Commission (“SEC”) announced that Healthcare Services Group Inc. (“HCSG.o”) agreed to pay a $6 million dollar fine to settle claims the SEC brought against the company for failing to properly account for its legal expenses. Under this civil claim, the SEC accused the company of inaccurately reporting litigation expenses paid to settle its employees’ claims in an effort to inflate the company’s quarterly earnings.

According to the SEC, the company’s underreporting of costly litigation deliberately inflated the company’s earnings to ensure that they were consistent with Wall Street’s earnings forecasts. This intentional misrepresentation, the SEC alleged, allowed the company to avoid the SEC’s detection and disguised the company’s true financial position to investors. The SEC explained that HCSG failed to accurately capture in its quarterly financial statements loss contingencies for settlements the company knew were “probable and reasonably estimable” as a result of class and collection litigation the company underwent in 2014 and 2015. In support of its position, the SEC asserted that such a failure was inconsistent with generally accepted accounting principles.

Director of SEC Enforcement in a statement explained that “HCSG repeatedly failed to record loss contingencies related to litigation settlement despite mounting evidence that such liability was probable and reasonably estimable, while misleading investors by reporting inflated net income and consistent EPS growth.” The director further cautioned companies that “it is critical for public companies to ensure that accounting judgments, including those involving loss contingencies, are not being used to manage earnings and distort financial statements.”

This case is yet another example of the SEC pursuing actions against companies as part of its recently created earnings per share (“EPS”) initiative. Implemented by the SEC in September 2020, the EPS initiative utilizes risk-based data analytics to uncover potential accounting and disclosure violations of companies’ earnings and management practices. These analytics aim to track a company’s financial progression to identify sudden drops in EPS following consecutive positive quarterly reporting that meet or exceed that company’s estimated EPS. These sudden drops or dips alert the SEC’s enforcement branch of a company’s potential financial misreporting, which result from, among other things, failing to properly account for the company’s legal expenses. A company’s failure to accurately report its company’s financials violate Sections 17(a)(2) and (3) of the Securities Act of 1933 and may also violate the financial reporting, books and records, and internal control provisions of the Securities Exchange Act of 1934.

Litigation is costly. With the SEC’s EPS initiative, a failure to accurately capture a company’s earnings may cost the company even more money. Directors and officers alike, particularly those in a financial position, should be cognizant of the SEC’s continued watchful eye—particularly as it pertains to litigation expenses and settlements. While the SEC has not established a rule-of-thumb to determine when litigation expenses are “probable and reasonably estimable,” companies should consult financial experts and generally accepted accounting principles to determine how and when litigation expenses are disclosed on a company’s quarterly earnings.

SEC Increasing Oversight over SPAC Markets



What are SPACs?

SPACs (special purpose acquisition companies) are formed by sponsors—usually former industry executives, institutional investors or private equity firms—for the sole purpose of acquiring one or more private companies after going public. SPACs are not operating companies; instead, they are blank-check shell companies used to identify a merger target and facilitate access to public markets. Once the SPAC’s initial public offering is completed, the SPAC begins evaluating and approaching potential merger targets. When a suitable target company is identified, and an agreement is reached and approved by the SPAC’s shareholders, the transaction closes and the target company survives as the publicly listed entity. SPACs generally have two years to find a target. If unsuccessful, SPACs return the money raised to investors.

Recent SEC Enforcement Action

The Securities and Exchange Commission (SEC) recently charged Stable Road Acquisition Corp. and its merger target, Momentus, Inc., in connection with a planned merger. As a SPAC, Stable Road has no operations of its own and exists for the purpose of merging with a privately held company with the effect of taking that company public. It completed its IPO in November 2019. Momentus is a privately held spaceflight technology company, which aspires to provide satellite-positioning services with in-space propulsion systems.

The SEC alleged that Stable Road and Momentus falsely represented to investors that Momentus successfully tested its spaceflight technology. Although Momentus was the initial source of this misrepresentation, the SEC noted that Stable Road’s due diligence failures compounded Momentus’s misrepresentations and “resulted in the dissemination of materially false and misleading information to investors.” In short, Stable Road “unreasonably failed both to probe the basis of Momentus’s claims that its technology had been ‘successfully tested’ in space.”

Further, Stable Road’s S-1 registration statement omitted concerns raised by the Committee on Foreign Investment, and Stable Road’s amended registration statement omitted that the Department of Commerce denied Momentus’s CEO’s application for an export license. As a result, the SEC charged both Stable Road and Momentus with fraud, and it charged Stable Road with reporting violations under 13(a) of the Securities Exchange Act of 1934 and soliciting a proxy containing a materially false statement under Section 14(a). The parties resolved the SEC’s misrepresentation claims, agreeing to a fine in excess of $8 million.

Going Forward

This enforcement action signals that increased regulatory oversight of SPAC transactions may be on the horizon, especially given the exponential increase in SPAC transactions. In 2010, only two SPACs came to market. In 2020, 115 SPACs completed or announced mergers and netted record IPO proceeds of $83.4 billion. According to data from SPAC Research, SPACs have raised more than $115 billion so far this year.

An advantage for SPAC sponsors is that the IPO process is relatively simple. Because SPACs have a straightforward business purpose, they can typically complete their paperwork within three months with little comment from the SEC. Further, target companies benefit from the SPAC transaction insofar as it offers them an expedited path to public listing and greater price and timing certainty.

But as the above SEC enforcement action demonstrates, there are also risks associated with SPAC transactions. SPAC sponsors should be aware of due diligence requirements when evaluating target companies and the evolving SEC regulation of SPAC transactions. Relatedly, potential SPAC board members should understand the D&O insurance being carried by the SPAC sponsor and assess whether they are comfortable with the level of coverage under the policy.

SEC to Increase Scrutiny on Good Faith in Rule 10b5 1 Insider Stock Plans


This month, newly-appointed SEC Chair Gary Gensler delivered remarks regarding how the SEC might “freshen up” Rule 10b5-1, which permits corporate insiders and others to buy and sell stock pursuant to trading plans adopted in good faith prior to learning material non-public information. Gensler’s focus on Rule 10b5-1 continues in the footsteps of his predecessor, Jay Clayton, who was appointed by the previous administration. In September of last year, Clayton wrote a letter to U.S. Representative Brad Sherman (D Ca), Chairman of the House Financial Services Subcommittee on Investor Protection, expressing concerns about interest alignment and fairness of law compliant Rule 105b 1 plans under the current SEC regulations. Congress has acknowledged the SEC’s concerns. Just this week Senators Chris Van Hollen (D-Md) and Deb Fischer (R-Neb) reintroduced the latest version of the Promoting Transparent Standards for Corporate Insiders Act, which formally directs the SEC to explore amendments to Rule 105b 1 and, within three months, provide Congress with a report discussing possible abuses of the Rule.

Rule 10b5-1 plans provide a “safe harbor” for insiders, commonly directors and officers, in possession of a company’s material non-public information (MNPI), to purchase or sell stock of that company without running afoul of insider trading laws. The Rule relies on the premise that if an insider agrees to a trading plan in good faith before possessing MNPI, then the insider will not be making decisions based on subsequently acquired MNPI at the time the transaction occurs in the future.

The increasingly widespread use of Rule 10b5-1 plans has led to what Gensler characterized as “cracks in our insider trading regime.” Gensler noted: 1) there is no required “cooling off” period before the first trade can occur, 2) plans can be canceled at any time, 3) there are no disclosure requirements, and 4) insiders can adopt more than one Rule 10b5 1 plan. Gensler further noted the SEC would consider reforms related to share buybacks in connection with a Rule 10b5 1 plan. In early 2016, as the popularity of Rule 10b5 1 plans continued to grow, the Harvard Law School Forum on Corporate Governance republished an article first published in Insights, that forecasted many of Gensler’s remarks. The article highlights the benefits of Rule 10b5 1 plans and provides suggestions on best practices that should be implemented to comply with the intent of the Rule’s safe harbor, including, amongst other recommendations: establishing only one plan, adopting the plan during an issuer’s open trading window, public disclosure of the plan, establishing a waiting period before the first trade, and avoiding multiple modifications, suspensions, and terminations.

With increased scrutiny of Rule 10b5 1 plans on the horizon, companies and their insiders should review their Rule 10b5-1 plans in light of anticipated SEC scrutiny and regulatory changes. A report published in January this year offers recommendations on how the SEC should regulate Rule 10b5-1 plans that rely on the safe harbor of the Rule, including: requiring minimum cooling-off periods of four to six months before the first trade can occur, eliminating single trade plans that effectively act as an option, eliminating plans in which the first trade occurs before the next earnings announcement, and requiring public disclosure by electronic filing when a plan is adopted, modified, suspended, or terminated, rather than a non-public filing only after the sale of restricted stock. These recommendations are consistent with the Chairs’ comments over the past year and are a good starting point for insiders when reviewing their Rule 10b5 1 plans.

Please contact your Carrington Coleman securities counsel should you have any questions related to Rule 10b5 1 plans, or any other securities related questions.

SEC CAN STILL SEEK DISGORGEMENT, BUT SCOTUS EXPLAINS LIMITATIONS


Earlier this week, the Supreme Court handed down its ruling in Liu v. Securities and Exchange Commission, No. 18-1501. This ruling is significant for two reasons. First, it resolves the previously unsettled question as to whether the SEC is empowered to seek a disgorgement award. The SEC is. Second, it explains limits upon disgorgement awards necessary to ensure it is not an improper penalty. 

As you may know, disgorgement is an equitable remedy intended to deprive wrongdoers of the net profits of unlawful conduct. The SEC often seeks a disgorgement award in connection with securities fraud claims. In the 2017 case of Kokesh v. SEC, the Supreme Court found disgorgement to be a penalty for statute of limitations purposes, but did not go so far as to decide whether disgorgement could still be imposed as a form of equitable relief. Equitable relief has generally not permitted recovery that would be punitive. This left a big question for the SEC and defendants alike. Can the SEC keep seeking disgorgement in these cases?

In this case, appellants challenged a $27 million award of disgorgement stemming from a visa scheme as an improper penalty. While the Supreme Court vacated the disgorgement award and remanded for further proceedings, it reaffirmed that the SEC had authority to seek disgorgement and explained certain restrictions on that recovery to ensure it is correctly calculated and used to reimburse victims of the fraud found in the lawsuit. More specifically, the Supreme Court clarified that courts must consider factors including what the actual profits from the fraud net of “legitimate expenses” are as well as ensuring that the money awarded is actually returned to defrauded investors and not the SEC.

This is a partial win for both the SEC and defendants against whom the SEC seeks disgorgement. For the SEC, it can still seek disgorgement, which has been a vital tool in its tool belt for enforcement in recent years. For defendants, they are now armed with significant arguments to limit the amount of disgorgement awarded. It remains to be seen exactly how or to what extent this will impact securities litigation, but for now we expect the SEC to continue pursuing and receiving disgorgement awards, but the size of those awards to shrink under the Supreme Court’s new guidance of what is necessary to avoid constituting an improper penalty.

CLAYTON AND HINMAN GO ON THE RECORD URGING CORPORATE DISCLOSURES RELATED TO COVID-19

In a Public Statement issued by the SEC, Chairman Jay Clayton and Division of Corporate Finance Director William Hinman urged public companies to include corporate disclosures related to the effects of COVID-19 in their “quarterly earnings releases and analyst calls, as well as in subsequent communications to the marketplace.” The SEC requested that corporate disclosures address: “(1) where the company stands today, operationally and financially, (2) how the company’s COVID-19 response, including its efforts to protect the health and well-being of its workforce and its customers, is progressing, and (3) how its operations and financial condition may change as [ ] efforts to fight COVID-19 progress.” Suggested disclosures include, “[d]etailed discussions of current liquidity positions,” “expected financial resource needs,” “efforts to protect worker health and well-being and customer safety,” and “financial assistance received under the CARES Act or other similar COVID-19 related federal and state programs.”

The SEC acknowledged that “providing detailed information regarding future operating conditions and resource needs is challenging . . . but is important on many levels.” For investors, forward-looking COVID-19 disclosures foster more well-reasoned investment decisions. For the market more-generally, such disclosures “enhance valuable communication and coordination across our economy—Including between the public and private sectors." And for the greater fight against COVID-19, such disclosures increase confidence and understanding about particular business and industries which, in turn, “reduces risk aversion and facilitates action.” As an example of this third, “less familiar” policy consideration, the SEC explained, for example, that “if the owner of an industrial laundry business becomes comfortable that the hotel industry is soon to pursue a credible plan for increasing activity, the laundry business may be less likely to furlough (or may plan to rehire) employees.”

The SEC warned that even though “it may be tempting to resort to generic, or boilerplate, disclosures,” such disclosures “do little to inform investors.” Instead, the SEC urged companies to convey “meaningful information” that give investors “a level of insight that allows them to see the key operation and financial considerations and challenges the company faces through the eyes of management” even though such information will be “unavoidably based on a mix of assumptions, including assumptions regarding matters beyond the control of the company.”

Of course, companies are typically cautioned to limit the forward-looking disclosures—they are discouraged from making forward-looking financial estimates. Recognizing this, the SEC stated that companies should still try their best to make forward-looking disclosures related to COVID-19 and to “avail themselves of the safe-harbors” found in Section 27A of the Securities Act and Section 21E of the Exchange Act. In effect, companies should avoid making boilerplate COVID-19 disclosures, but should identify them as “forward-looking statement[s]” and couple them with customary “cautionary statements identifying factors that could cause actual results to differ materially from those in the forward-looking statement.”

The SEC concluded by assuring public companies that “[g]iven the uncertainty in our current business environment, we would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information.” Nevertheless, the SEC continues to closely monitor markets for fraud relating to COVID-19, suspending trading of stock for companies making questionable claims. See, e.g., Predictive Tech. Group, Inc., SEC Order of Suspension of Trading, File No. 500-1 (April 21, 2020) (suspending trading “because of questions regarding . . . statements PRED made about being able to immediately distribute large quantities of serology tests to detect the presence of COVID-19 antibodies”). The best course remains for public companies to follow the SEC’s guidance in order to inform their investors, assure markets, assist in the nation-wide fight against COVID-19, and ultimately protect themselves from enforcement actions and shareholder litigation.

For questions regarding this post, please contact the authors:


DELAWARE SUPREME COURT UPHOLDS FEDERAL-FORUM-SELECTION PROVISIONS FOR ’33 ACT CLAIMS


Salzberg v. Sciabacucchi (opinion linked here) presented the Delaware Supreme Court with a clash of policies regarding forum-selection provisions: Helping Delaware corporations avoid the inefficiencies in having to defend claims under the Securities Act of 1933 in multiple forums, state and federal, versus preventing those corporations from barring the state courts of Delaware (the Chancery Court in particular) from adjudicating cases involving the internal affairs of Delaware corporations. Carefully parsing pertinent language from statutes and case law—drawing distinctions among “internal affairs,” “internal corporate claims,” and “intra-corporate affairs”—the Court managed to preserve and promote the former policy while doing no harm to the latter, as it held Delaware corporate charter provisions that require ’33 Act claims to be brought in federal court, rather than the state courts of Delaware, to be facially valid.

GOING TO JAIL WITHOUT PASSING GO – SECOND CIRCUIT HOLDS “PERSONAL BENEFIT” NOT REQUIRED TO MAINTAIN TITLE 18 SECURITIES FRAUD CLAIM


On December 30, 2019, the Second Circuit issued its United States v. Blaszczak1 opinion, eliminating a serious hurdle that might otherwise dissuade federal prosecutors from pursuing a Title 18 fraud claim against an alleged inside trader. The court determined that, unlike Title 15 securities fraud, federal wire fraud and Title 18 securities fraud claims do not require proof that the alleged insider received any personal benefit in exchange for the disclosure of non-public information.

In Blaszczak, federal prosecutors alleged that an employee of the Centers for Medicare & Medicaid Services (CMS) had been illegally disclosing information about reimbursement rate adjustments to a political consultant, who in turn, had been forwarding the information to a group of hedge fund managers, who were trading and profiting on the non-public information.

After the presentation of evidence, the district court instructed the jury that, in order to convict the defendants with Title 15 securities fraud, they would have to find the defendants received a “personal benefit” in exchange for the disclosure of non-public information. However, the court did not include the same “personal benefit” instruction in its Title 18 charge. After many days of deliberation, the jury acquitted each defendant on all counts alleging Title 15 securities fraud, but found the CMS employee guilty on one count of wire fraud, the political consultant guilty on two counts of wire fraud and two counts of Title 18 securities fraud, and the hedge fund managers guilty on one count of wire fraud and one count of Title 18 securities fraud.

On appeal to the Second Circuit, the appellants argued that pursuant to the Supreme Court’s Dirks v. SEC2 opinion, the district court erred by not including the “personal benefit” instruction in its Title 18 question. The Second Circuit rejected appellants’ argument, reasoning that Title 15 and Title 18 were enacted for very different purposes. Title 15 (the statute at issue in Dirks) was enacted as part of the Securities and Exchange Act of 1934. While Title 18 was enacted as part of the Sarbanes-Oxley Act of 2002. And, despite both statutes prohibiting schemes to “defraud,” the meaning of the operative term was not shared.

According to the court, Title 15 was enacted for the limited purpose of eliminating insider trading for “personal advantage.” Whereas, Title 18 “was intended to provide prosecutors with a different and broader—enforcement mechanism to address securities fraud than what had been previously provided in the Title 15 fraud provision;” it was purposed to overcome the “technical legal requirements” that other fraud provisions created.

The court determined that because the statutes were enacted for two very different purposes and because the personal benefit test in Dirks was “judge-made doctrine” specifically premised on the limited purpose of Title 15, the personal benefit test should not apply to Title 18 securities fraud claims. Still, the court rejected appellants’ argument that the district court had opened a “backdoor” through which prosecutors could effectively pursue securities fraud claims that would otherwise require proof of a personal benefit. The court rejected this argument, stating that there will always be statutory overlap—where prosecutors can choose between multiple statutory causes of action for the same underlying conduct—but that such overlap is no reason to ignore legislative intent. According to the court, if the legislature believed they had inadvertently created a “backdoor,” it was up to them to intentionally close it.

The takeaway is simple. Whether or not the alleged disclosing party has secured any benefit by sharing non-public information, it could face criminal liability for its actions. Defense attorneys should be cognizant of Title 18’s requirements when assessing the chances of acquittal and make their clients aware of such risk.



1 18-2811, 2019 WL 7289753 (2nd Cir. Dec. 30, 2019).
2 463 U.S. 646, 662 (1983).

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