MD&A Lessons Learned from Broadwind Energy

On February 5, 2015, the Securities and Exchange Commission charged Broadwind Energy, Inc. (Broadwind), its former Chief Executive Officer and its Chief Financial Officer for accounting and disclosure violations that, as the SEC stated in its press release, “prevented investors from knowing that reduced business from two significant customers had caused substantial declines in the company’s long-term financial prospects.”  The penalties were not earth-shattering: subject to the court’s approval, Broadwind agreed to pay, $1 million penalty and its former CEO and its CFO agreed to pay approximately $700,000 in combined disgorgement and penalties.

The SEC brought various charges, including, but not limited to, the violation of Section 17(a)(2) of the Securities Act (in connection with an offering conducted by Broadwind) and the violation of Section 13 of the Exchange Act and Rule 13a-14 under such act, but this case is interesting because it deals with the eternal question that public company management and their securities lawyers are dealing with every day: how much disclosure is enough disclosure for the investors to make a reasonable decision whether to buy or sell the company’s securities?

Broadwind’s fact pattern, as outlined in the SEC’s complaint filed in the U.S. District Court for the Northern District of Illinois, makes it clear that during the third quarter of 2009, Broadwind began to plan more definitively for the impairment of its subsidiary’s intangible assets related to contracts with two major customers and Broadwind’s internal documents identified an expected impairment charge of $48 million related to the contract with one of such customers.  Broadwind shared this expectation and these documents with its outside audit firm, its investment bankers and the subsidiary’s primary lender. Broadwind also incorporated impairment in its planning for the upcoming audit of 2009 financial results. Broadwind’s revenues from the two major customers declined 43% and 25%, respectively, for the nine months ended September 30, 2009 compared to the same period ended September 30, 2008.

The SEC argued that Broadwind’s disclosure in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of its Form 10-Q for the third quarter of 2009 was materially misleading.  Such disclosure read, in part, as follows:

[A] continued economic slowdown may result in impairment to our fixed assets, goodwill and intangible assets. We perform an annual goodwill impairment test during the fourth quarter of each year, or more frequently when events or circumstances indicate that the carrying value of our assets may not be recovered. The recession that has occurred during 2008 and 2009 has impacted our financial results and has reduced purchases from certain of our key customers. We may determine that our expectations of future financial results and cash flows from one or more of our businesses has decreased or a decrease in stock valuation may occur, which could result in a review of our goodwill and intangible assets associated with these businesses. Since a large portion of the value of our intangibles has been ascribed to projected revenues from certain key customers, a change in our expectation of future cash from one or more of these customers could indicate potential impairment to the carrying value of our assets.

Item 303 of Regulation S-K requires a public company to disclose in its MD&A “any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”  MD&A also requires a description of “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.”

The SEC’s position outlined in the complaint is that, based on the revenue decline combined with the customers’ lower forecasts of revenue and other developments, Broadwind and its CEO (the CFO started at Broadwind in mid-August 2009) “should have known that the intangible assets were impaired.” However, Broadwind “failed to disclose the impairment of its assets in Form 10-Q” for the quarter ended September 30, 2009, but instead used a “generalized risk disclosure of the possibility of such a charge.”  The SEC also stated in its complaint that if Broadwind had conducted impairment testing in connection with its Form 10-Q for the 3rd quarter 2009, Broadwind would have concluded that its contracts with two significant customers were fully impaired and recorded impairment charges of approximately $60 million in connection with such contracts.” Broadwind ultimately disclosed the impairment in its Form 10-K for the fiscal year ended December 31, 2009. Following the disclosure of the impairment charge, the stock price declined by 29%.

Putting aside the speculation about when it was the right time for Broadwind to conduct the impairment testing, it has been the SEC’s position for more than a decade that MD&A “trends” disclosure should include the “[q]uantification of the material effects of known material trends and uncertainties,” which can promote better understanding of whether the company’s past performance is indicative of future performance.  The SEC’s 2003 Interpretive Release: Commission Guidance Regarding MD&A (Release No. 33-8350) made it clear that “[a]scertaining this indicative value depends to a significant degree on the quality of disclosure about the facts and circumstances surrounding known material trends and uncertainties in MD&A. … Quantitative disclosure should be considered and may be required to the extent material if quantitative information is reasonably available.”

In light of the current 10-K season, the SEC’s complaint in SEC v. Broadwind is a timely reminder that “boiler plate” generalized MD&A disclosure regarding known trends may be inadequate and misleading if management had an opportunity to provide more detailed and meaningful information.

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