The Securities and Exchange Commission just announced settled charges against The Cheesecake Factory for making misleading disclosures about COVID-19’s impact on its financial situation. According to the SEC’s press release, “[t]he action is the SEC’s first charging a public company for misleading investors about the financial effects of the pandemic.” It appears to be the first concrete action arising out of the SEC’s Coronavirus Steering Committee that was announced this past spring.
The Cheesecake Factory Case
The settlement itself was a slap on the wrist: a $125,000 fine and agreement to cease and desist misleading statements. But it could be a harbinger for actions to come, particularly in a Biden Administration that is sure to be much more aggressive on corporate enforcement matters.
The facts are fairly simple. In March and April 2020, The Cheesecake Factory stated that its restaurants were “operating sustainably,” despite the pandemic. According to the order, the filings were materially false and misleading because the company’s internal documents demonstrated that The Cheesecake Factory was bleeding cash—to the tune of $6 million a week in cash losses. Plus, its financial future was grim, as it had only 16 weeks of cash remaining.
The Cheesecake Factory was disclosing this situation to potential funding sources, such as to “potential private equity investors or lenders in connection with an effort to seek additional liquidity.” Plus, the company had told its landlords that it could not pay rent in April 2020, due to the pandemic.
I’ll be honest: Those financial markers do not necessarily mean that the company was not “operating sustainably.” Maybe The Cheesecake Factory thought that its current revenue would allow it to continue to operate, perhaps with an infusion of capital to survive the pandemic over the next several months. Maybe it had concrete plans to cut labor expenses to offset the lowered revenue. Or maybe it was on the cusp of renegotiating some major leases to lessen overhead.
Regardless of what I thought, the SEC thought it was false and misleading. As the Co-Director of Enforcement at the SEC said:
When public companies describe for investors the impact of COVID-19 on their business, they must speak accurately. The Enforcement Division, including the Coronavirus Steering Committee, will continue to scrutinize COVID-related disclosures to ensure that investors receive accurate, timely information, while also giving appropriate credit for prompt and substantial cooperation in investigations.
What Is the Coronavirus Steering Committee?
Let’s back up a bit.
In May 2020, the SEC announced the formation of its Coronavirus Steering Committee. Steven Peikin, the Co-Director, Division of Enforcement, explained that the Committee’s mandate is to “proactively identify and monitor areas of potential misconduct,” among other tasks.
Mr. Peikin highlighted a few areas of focus. He explained that the volatility of the market, “along with a regular stream of potentially market-moving announcements by issuers, provide increased opportunities for insider trading and market manipulation.” The SEC was trying to take a proactive approach:
To detect such misconduct, the Steering Committee is working with the Division’s Market Abuse Unit to monitor trading activity around announcements made by issuers in industries particularly impacted by COVID-19 and to identify other suspicious market movements for possible manipulation.
He focused on the increased risks of fraud in this financial environment, noting that previous economic downturns led to (1) exposure of pre-existing accounting or disclosure improprieties, or (2) issuers to engage in improper conduct. It had developed a “systematic process to review public filings from issuers in highly-impacted industries, with a focus on identifying disclosures that appear to be significantly out of step with others in the same industry.” The SEC was “looking for disclosures, impairments, or valuations that may attempt to disguise previously undisclosed problems or weaknesses as coronavirus-related.”
Well, you can’t say they didn’t warn you.
Insider Trading Risk
The order against The Cheesecake Factory may be the first domino to fall. It will likely lead to other settled matters surrounding misleading disclosures about the effect of the pandemic.
But the most interesting result may be that this order could lead to an increase in insider trading investigations at other companies. And the SEC will be on the lookout for them.
Let me explain what I mean. The SEC releases this order—the first of its kind. Now, other companies know that the Coronavirus Steering Committee is not just for show. Other public companies will realize that the SEC will examine their disclosures about the pandemic’s effect on their business more closely—particularly those companies in the industries most affected by the pandemic, such as travel, hospitality, and fitness.
In light of this order, companies in those industries may decide that they should amend their disclosures to make sure they are being transparent about their financial condition, or file an 8K to disclose an “unscheduled material event,” or make sure that their upcoming quarterly financial disclosures truly explain the company’s financial condition.
[To be clear, these orders from the SEC can be helpful from outside counsel’s perspective if you have a client that fears tanking its stock price with a detailed disclosure. Rather than telling our clients, “hey, you need to disclose it,” we have concrete evidence of the consequences for not disclosing it. Some clients need a little more . . . how shall I say this? . . . encouragement to disclose fully.]
Back to the point. Once those new disclosures hit the street, the stock price for those companies is likely to drop. Investors who learn that a company, like The Cheesecake Factor, has only 16 weeks of cash on hand in an industry that is not likely to rebound soon, will sell the stock.
That’s where the insider trading concern arises.
Many of the SEC’s insider trading cases arise from the agency’s forensic examination of trades broadly, without any specific information in advance that certain trades are questionable. The SEC looks for unusual trades that happened just ahead of bad—or good—news. The SEC has already announced that the Coronavirus Steering Committee is doing exactly that. For example, you can bet that the SEC looked closely at every substantial trade in pharma company stock just before the company announced a successful vaccine trial.
So, if an “insider” (someone at the company who has nonpublic information) trades the stock just before news hits the street about a precarious financial situation, then that’s a situation ripe for an investigation into insider trading. An insider who knew that the company was about to disclose its precarious financial situation due to the pandemic may dump stock to avoid huge losses once the information is disclosed.
The SEC is not stupid. It knows that even this small settlement shows the market that it is keeping its promise to examine pandemic-related disclosures. Most public companies are well aware of this fact. My clients are the people accused of insider trading, so this post is directed at them.
Be careful. Be very careful. The SEC is watching.
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