New York, January 25, 2021 – The SEC sent a message to public companies recently when it settled an investigation involving well-known eatery, Cheesecake Factory (see SEC Order). The company’s failure to make accurate disclosures about its financial condition, as prompted by Covid-19 realities, was egregious, yet the SEC’s order allowed the company to neither admit nor deny liability, to pay a civil money penalty of $125,000, a slap on the wrist for a public company, and agree to cease and desist from committing or causing any violations and any future violation of the reporting standards of Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-11 thereunder. What is the message? The Staff is watching – closely.
Public companies should not underestimate that Staff continues to monitor public companies’ disclosures carefully despite the pandemic. Companies in vulnerable industries that may be tempted to present a rosy scenario about their financial performance or employ a “big bath” strategy to mask already deteriorating financial condition should reflect before doing so because future penalties will likely be more severe, particularly with a more muscular SEC expected under a Biden administration.
This case marks the first time that the SEC has charged a public company for misleading investors about the financial impacts of the Covid-19 pandemic. In the Cheesecake Factory settlement, the Staff found that the company’s filings from March 23 and April 3 were “materially false and misleading” when it disclosed that its business model was “operating sustainably” even though it had transitioned to takeout service exclusively because Covid-19 restrictions had shuttered in-store dining at restaurants. The company failed to disclose that it:
- 1. Was excluding expenses attributable to corporate operations from its claim of sustainability and was losing approximately $6 million in cash per week;
- 2. Had 16-weeks of cash reserves remaining;
- 3. Needed a capital infusion soon to continue operations; and
- 4. Had informed its landlords that it would not pay rent in April due to the impacts that Covid-19 inflicted on business.
Omitting that a capital infusion was desperately needed to remain operational was significant and material. The company ultimately received funding from a private equity firm to give it more runway. But without the last-minute rescue it was negligent to claim that the company’s business model was sustainable given the pandemic, consumers decision to stay home reduced consumer spend, and uncertainty around the prescriptive measures that public health officials advocated.
These omissions are also material because they closely resemble when companies are approaching bankruptcy. As a company approaches the zone of insolvency, advisors prepare a 13-week cash (91 days) flow projection to show the anticipated “cash burn” during that period. The 13-week period is also a line of demarcation where, provided certain conditions are met, debtor’s payments to creditors may be clawed back as preferential transfers in an insolvency proceeding. The 16-week cash reserves that the company identified is dangerously close to when the bankruptcy planning process commences.
The Cheesecake Factory settlement, while small, should remind public companies about the importance of being transparent and consistent when making disclosures about material events, regardless of whether the disclosure is written or oral, formal or informal. Companies must have a robust process to ensure accuracy and transparency, including corporate, governance, insolvency, and litigation counsel. Transparency and consistency are particularly important during the current environment as companies face pressure to address the implications of the pandemic on their operations. And looking forward, we expect the SEC to increasingly scrutinize disclosures ranging from Covid-19 representations to climate change’s impact on businesses.