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Stepping Through The Financial Restatements Minefield

Merrill Disclosure Solutions | September 11, 2012

Merrill Corporation - Dimensions eNewsletter - August 2012

Be proactive when errors pop up. Public companies file hundreds of financial restatements each year. Most begin the complex, lengthy, costly process by determining whether there have been accounting errors and, if so, whether they are material and whom to notify. Unless the errors are clearly not material, those receiving notice should stop trading company shares, consultant John Huber (FTI Consulting) and attorney Steve Bochner (Wilson Sonsini Goodrich & Rosati, Palo Alto) advise in “Surviving a Restatement,” published in Insights: Corporate & Securities Law Advisor (Vol. 26, No. 4, Pgs. 15-26), until either public disclosure of the errors and their repercussions or a final determination that they are not material. Management ought to consider the immediate and ongoing effects on the company's federal disclosure duties and its marketing communications, as well as the need to safeguard relevant documents. Executives, the audit committee, the independent auditors, securities counsel, and the directors should form a working group to find out the character and extent of the errors; analyze their materiality; and decide whether to file a Form 8-K, Item 4.02, declaration that financial statements filed earlier cannot still be relied on.

See if insiders balk at outside help. The audit committee must decide whether to hire outside attorneys to complement in-house counsel. The authors list factors to consider, including: the two groups' ability to work together under pressure for a long time; fiduciary duties under state law and possible personal liability; whether outside lawyers will enhance the process's credibility; and the nature of the errors (e.g., how they were spotted and where they occurred). The committee must also choose whether to hire outside forensic accountants skilled in restatements. For the working group, the initial step is to follow the guidance in Staff Accounting Bulletin No. 99 (SAB 99): material errors are those a reasonable investor is substantially likely to regard as significantly changing the entire mix of facts. SAB 99 has both a quantitative test and a qualitative test, the latter being factors that could make a small error material, but no factors that could make a big error immaterial.

Disclose with kid gloves. The company must carefully time the press release disclosing accounting errors, being mindful of factors beyond its control (e.g., discovery shortly before a required SEC filing is due). The press release should be comprehensive and accurate, the authors counsel, and should foresee the market's questions; but it should omit restated numbers, unless the company and the outside auditors are very sure of them. Disclosure must balance the interests of all constituencies-shareholders, customers, vendors, workers, and regulators-with the demands of Regulations FD, G, and S-K Item 10; Rule 10b-5; non-GAAP financial rules; SAB 99; and the fiduciary duty to update. If the company decides the errors are material and files a Form 8-K, Item 4.02, declaration, it might have to fully restate earlier financial statements by means of amended SEC filings. For immaterial errors, prospective correction is sufficient but necessary, since altered circumstances could render them material later and since plaintiffs' attorneys or regulators could insist they are already material.

Expect misfortune to strike. A restatement can have many unintended consequences, the authors warn. It could trigger default under agreements and indentures requiring timely delivery of financial statements contained in SEC filings. It could cause rating agencies' downgrades. Late SEC filings could lead to loss of status as a well-known seasoned issuer and the inability to use Form S-8 and S-3 registration statements; a ban on shareholder sales of restricted or control shares under Rule 144(c); violation of the Delaware corporation statute's requirement of an annual meeting; and breach of stock-exchange rules. The company would have to consult with the outside auditors as to whether internal or disclosure controls are defective. Finally, publicizing a restatement could prompt shareholder suits, particularly if the stock price has fallen or senior management has committed intentional misconduct; derivative suits; an SEC Division of Enforcement investigation, possibly followed by recommendation of enforcement action; and proceedings (e.g., license revocations) by other federal or state regulators.

[Insights: Corporate & Securities Law Advisor, mentioned in this blog is published by Aspen Publishers, 76 Ninth Avenue, 7th Floor, New York NY 10011. To subscribe, call (800) 638-8437; or visit]

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