Merrill Corporation – Dimensions eNewsletter – August 2012
One problem for filers that fail to comply with the SEC's XBRL requirements is they may be ineligible to use short-form registration statements, such as Forms S-3 and S-8, and Form 144 (used when an individual resells restricted stock), however, the loss of eligibility to use these forms isn't the only problem they may face. Filers also face the risk of liability, including lawsuits by the SEC and investors, which may follow if XBRL tagging and instance documents are inaccurate.
Initial Limit During Phase-In Period
Fortunately, the risk of liability currently does not begin with the initial XBRL submission. For the first 24 months after a company must start submitting XBRL (but no later than October 31, 2014), SEC Rule 406T (b)(2) protects Interactive Data filers from liability under Section 11 or 12 of the Securities Act of 1933, Section 18 of the Securities Exchange Act of 1934, or Section 34(b) of the Investment Advisers Act of 1940. Under Rule 406T, an XBRL instance document filed during this 24-month period is considered “furnished” rather than “filed” or “part of the registration statement or prospectus.” If a company voluntarily submits an Interactive Data file before it is required to do so, that voluntary submission does not start the rule's 24-month modified liability period.
Nevertheless, SEC Rule 406T (b)(1) does subject the Interactive Data filer to the antifraud provisions of 1933 Act Section 17(a)(1), 1934 Act Section 10(b) (including Rule 10b-5), and 1940 Act Section 206(1). However, under Rule 406T(c), no liability will result if the electronic filer:
- makes a good-faith attempt to comply with Rule 232.405 (i.e., Regulation S-T on the General Rules and Regulations for Electronic Filings); and
- promptly amends the Interactive Data file to comply with Rule 232.405 after becoming aware of the compliance failure.
This provision requires a company to file an amendment to correct the material error in its Interactive Data file. Once the filer becomes aware of the error, it must quickly correct the data file to be eligible for the 24-month liability limit under Rule 406T. In the discussion section of the SEC's rules on XBRL, “promptly made” corrections are those occurring within the later of either 24 hours after discovery of the filing error or 9:30 AM Eastern Time on the next business day (see page 85 of the final rules, at www.sec.gov/rules/final/2009/33-9002.pdf). If the correction is late, the SEC's determination of whether a filer has corrected promptly depends on the facts and circumstances.
Rule 103of Regulation S-T provides the only liability protection that continues beyond the first two years. This rule provides filers with protection from errors and omissions beyond their control in electronic transmissions. The company must correct the problem by filing an amendment in electronic format as soon as it reasonably can after becoming aware of the error or omission.
Two-Year Limited Liability Period Depends On Phase-In Schedule
After the initial two-year limited liability period, liability applies in the same way as it would with the underlying official EDGAR filing, regardless of whether the problem is an exhibit to a filing or something incorporated by reference. The two-year limited liability period for each XBRL filer begins according to the company's phase-in schedule. For each phase-in group, the two-year period starts with the due date of the first quarterly report on Form 10-Q or the annual report on Forms 20-F or 40-F containing financial statements for a fiscal period ending on or after June 15th of the specific year.
Large Accelerated Filers with more than $5 billion in public float that prepare financial statements in accordance with US GAAP were phased in during 2009; therefore, they no longer have limited liability protection. Large Accelerated Filers with $5 billion or less in public float that prepare financial statements in accordance with US GAAP were phased in during 2010; therefore, most of those that have a calendar year-end will lose the limited liability starting with their third-quarter filings for 2012. All other filers that prepare financial statements in accordance with US GAAP were phased in during 2011; therefore, most of those that have a calendar year-end will lose the limited liability starting with their third-quarter filings for 2013.
New reporting companies are not in a phase-in group. In general, the requirement to submit XBRL exhibits begins with their first Form 10-Q. (To learn the details of the requirements for newly public companies, see the article When XBRL Tagging Requirements Apply To 1933 Act Registration Statements in the June 2012 issue of Dimensions.) Reduced liability then extends until either 24 months from the due date of the first XBRL submission or October 31, 2014, whichever occurs earlier.
XBRL Problems That Can Lead To Liability
After the initial two-year period, a filing error has to be “material” for fraud liability to apply. The company must evaluate whether any errors in the XBRL file that are not in the filed underlying financial statements are material. A question that arises is whether
having the correct information in the official filing makes the XBRL file's error immaterial. According to David Lynn, an attorney in the Washington DC office of Morrison & Foerster, the company should evaluate the total mix of available information, both accurate and inaccurate, to assess what a court might find material (see the Supreme Court's 1991 decision in Virginia Bankshares v. Sandberg, 501 U.S. 1083). “I don't think a court could disregard that a correct financial statement is out there that is readily available,” Mr. Lynn explains. “The court would look at whether it is unreasonable for an investor not to check the official filing.”
Although it remains hard to predict how liability can occur, another former SEC staffer, now in private practice, told us that this is “uncharted territory.” He sees two possible avenues for liability: either an SEC action under 1934 Act Section 13(a) for violation of an SEC reporting or disclosure requirement; or an action brought by an investor under one of the sections currently protected by Rule 406T (i.e., 1933 Act Sections 11 or 12; 1934 Act Section 18).
For Section 13(a) actions, materiality and a showing of fraud are not needed. The SEC merely has to prove that the company violated a filing or disclosure rule. On page 87 of the XBRL adopting release, the SEC indicates that these 13(a) actions are not limited even when Rule 406T modified liability rules still apply. However, given the SEC's finite resources, the Commission is unlikely to bring a suit unless materiality exists, in the view of the practitioners we contacted.
Although the SEC has published its observations on common XBRL mistakes (see the May and June 2012 issues of Dimensions), it has not indicated what would constitute a material error. Given the published SEC observations, it seems likely that materiality would be found when a filer repeatedly avoids the SEC's suggestions and makes egregious errors as a result. An example could be significantly inaccurate numbers in the XBRL exhibit (e.g., billions instead of millions).
While the filer could argue that the correct information was publicly available in the underlying financial statement, it is too early to know whether this defense has a chance of success-and no company wants to be a test case of XBRL liability. The SEC's determination of whether an XBRL mistake is material may also evolve, as investors start to rely more on the raw XBRL data than on the underlying document. This will happen when the XBRL data becomes the key information parsed and used by the aggregators (e.g., Thomson Reuters, Bloomberg, CapitalIQ) that distribute financial data to investors, and as various XBRL applications become more popular. In those circumstances, liability is more likely to lie where the XBRL data is wrong and then broadly relied upon.
“The key to liability prevention is careful and thorough preparation of the XBRL instance document,” asserts Lou Rohman, VP of XBRL Strategy at Merrill Corporation. “Many steps are involved to make sure that the XBRL files are conveying the same message as the traditional financial statements, including proper tag selection, accurate structuring of those tags, and appropriate entry of amounts in the XBRL instance document.”
The XBRL submission does not have to be audited, and Sarbanes-Oxley officer certifications are not required. Companies need to have controls and procedures in place related to their financial disclosures and SEC submissions, and this includes accurate, complete preparation of their XBRL filings. “Filers should worry about having controls up front so no discrepancies appear between the XBRL and official filings,” notes attorney Lynn.
Material Errors In The XBRL Filing But Not The Financial Statement
In its Compliance and Disclosure Interpretations (“C&DIs”) for Interactive Data, the SEC addresses the question (see C&DI 115.03) of whether a company must file a Form 8-K when it discovers a material error in its Interactive Data file, even if the financial statements upon which they are based do not contain an error and may continue to be relied on. The SEC explains that this is needed only when the filer determines that previously issued financial statements should no longer be relied upon because of an error. A filer can voluntarily provide a non-reliance disclosure, similar to Item 4.02(a) of Form 8-K, that pertains only to the Interactive Data. It does this by making the disclosure under either Item 7.01 or Item 8.01 of Form 8-K.