As the pandemic has unfolded, a recession has followed in its wake, as a result of which many companies are struggling. Some will not survive – a number of high profile companies, such as Hertz and Neiman Marcus, have already filed for bankruptcy. Many others have issued financial filings containing a “going concern” disclosure or received an audit opinion with a going concern modification. The government shutdowns and other disruptions that have followed in the wake of the coronavirus outbreak have placed an enormous burden on many businesses. The going concern disclosures filed in the year’s first half reveal how many companies are struggling to stay afloat and what might be in store in the months ahead.
Companies and their auditors have the ongoing obligation to assess the companies’ financial health; if either management or the auditor has a substantial doubt regarding the company’s ability to continue as a going concern within the next twelve months, this information must be included in the footnotes of the financial statements and in the auditor’s unqualified opinion. In assessing a company’s ability to continue, auditors much consider adverse conditions and events in the aggregate to determine whether there is a substantial doubt regarding the entity’s ability to continue, taking into account such factors as recurring operating losses, works stoppages, or loan defaults. The auditors must also inquire whether management has made or is making any effort to ease the concerning conditions and, if so, whether those efforts are sufficient to address the issues afflicting the company.
As economic disruption has followed in the pandemic’s wake, consideration of going concern issues has become increasingly pertinent for many companies. According to a June 8, 2020 Wall Street Journal article (here), “nearly 16% of [reporting] U.S. companies … had a going concern modification,” a figure that is line with last year, but fewer companies were reporting this year, which suggests that more companies are in trouble now that a year ago. According to the Audit Analytics (here), as of May 20, 2020, there were thirty companies that received going concern audit reports that specifically cited COVID-19 as contributing substantial doubt as to the company’s ability to continue. Fourteen of the thirty companies were already experiencing difficulties before the pandemic, as evidenced by going concern opinions from the past five years. And the number of going concern opinions likely will continue to rise in the months ahead.
While COVID-19 presents countless unknowns that could affect a company’s continuing ability to operate, Audit Analytics found that, rather than citing future potential yet indeterminate issues, many companies instead attributing their troubles to the very specific current reality that an inability to open their doors has caused liquidity issues. Other frequently cited issues include debt covenant uncertainty; debt maturity; operating losses; absence of significant revenues; and negative cash flow.
Unsurprisingly, many companies that have received going concern audit opinions depend on their customers’ physical presence, such as Norwegian Cruise Lines, Dave & Buster’s, and health club operator Town and Sports International. The worldwide oil price decline is also a contributing concern for some energy companies’ ability to continue, such as CEMEX, a building materials company, Mitchum Industries, a marine technology products company, and oil and gas driller Templar Energy, which filed for Chapter 11 bankruptcy on June 1, 2020.
According to a 2013 study, there is an 85 percent correlation between a company’s inclusion of going concern disclosure in a public company’s filings (or that otherwise refer to “insolvency” or similar language) and the company’s future bankruptcy, 50 percent being pure chance and 100 percent being a perfect predictor.
The Going Concern Challenge
With so much uncertainty surrounding both the pandemic and the economy, management and auditors face a difficult task in evaluating their companies and clients. Most critically, there can be significant downsides for companies that are the subject of going concern disclosure. For example, a going concern disclosure could trigger a steep drop in the company’s share price. The week after a going concern disclosure in March, movie-theater chain owner Cineworld’s shares fell 75%. But, as the Journal article to which I linked above noted, months into the pandemic, investors now appear to be more forgiving; when AMC warned of financial difficulties when releasing their first quarter results in early June, the company’s stock price dropped less than 3%. Companies subject to a going concern qualification also may face a credit rating downgrade. Companies may also risk debt covenant violations by disclosing a going concern, as happened to Francesca’s Holdings, a chain boutique operator, when the company received a going concern audit opinion that cited COVID-19 as a contributing factor earlier this year.
While there may be downsides to going concern disclosure, issuers and auditors assessing going concern issues, according to a May 27, 2020 memo from the Gibson Dunn law firm (here), “should anticipate that they will face potential legal exposure for failing to accurately predict the future.” Given the litigation exposure, management may prefer to take a more conservative approach, particularly in the current environment, when evaluating their company’s ability to continue.
Even if management’s preference is to be more optimistic, their auditors may take a different view. A 2017 study found that since the global financial crisis in 2008, auditors have remained conservative in their going concern evaluations. Nevertheless, as the economy recovered following the financial crisis, the number of going concern audit opinions has steadily declined, going from 3,356 in 2008 to only 1,689 in 2018. However, given the sheer uncertainty that surrounds COVID-19, it is possible that going concern opinions could meet or exceed 2008 numbers this year. At a minimum, in the current economic environment, auditors will be asking more and more probing questions about the clients’ ability to continue.
In the current economy, many companies may become insolvent. As I noted in a recent blog post, under Delaware law, directors’ fiduciary duties do not change when companies enter the “zone of insolvency”; directors must continue to discharge their fiduciary duties to the corporation and its shareholders, rather than to creditors. However, management always has a duty to be aware of relevant circumstances that may affect the company’s ability to continue as a going concern. During the pandemic, this means understanding how COVID-19 will impact their business and affect their company’s ability to continue in business. Thus, as noted in a June 5, 2020 New York Law Journal article (here), companies that require the physical presence of their customers must weigh “the benefits of opening for business, which mainly would be revenue generations, against the potential cost of resuming operations, such as costs of operating at less than full capacity and possible liability resulting from employees or customers who may become infected at the company’s premises.” One of the requirements of the business judgment rule is that management be informed; the extra leg work required in fully considering the consequences of the pandemic may help aid the defense in event of future litigation.