An ability to pay assessment and why it may matter the most

UPDATED (2) December 2020: Included in the 4,000-plus pages of the National Defense Authorization Act for Fiscal Year 2021 ("NDAA") recently approved by Congress is an amendment to the Securities Exchange Act of 1934 which gives the Securities and Exchange Commission ("SEC") statutory authority to seek disgorgement of any unjust enrichment resulting from violation of a securities law and establishes a 10-year statute of limitations for disgorgement and equitable remedies. The amendment will be applicable not just to future cases but also to those still pending at the time the NDAA is enacted, at a stroke increasing the potential size of the disgorgement sought by the SEC through federal courts. For those cases where illicit profits have been 'earned' by wrongdoers over many years, the return of ten years' worth of ill-gotten gains could well result in a significant increase to the size of payments being made by the targets of SEC disgorgement actions, further raising the importance of ability to pay as a factor to be considered.

See also Liu v. SEC Continues to Impact the Disgorgement Landscape.

UPDATED November 2020: The recent plea agreement between Sargeant Marine and the DOJ explained that the significant reduction of the 'appropriate total criminal penalty' from $90 million to a final $16.6 million was due to recognition that a larger penalty 'would substantially threaten the continued viability of the Company'.

This demonstrates once again that authorities will listen to arguments for reduction in penalties based on inability to pay from any company negotiating a settlement under conditions of genuine financial hardship.

July 8, 2020

The challenges faced by companies from the near closure of the global economy in response to the evolving COVID-19 pandemic are certainly without precedent in modern times. For many, demand for products or services has fallen precipitously. Even with government support, the number one concern is preserving cash to maximise the chances of outlasting the pandemic and having the financial firepower to restructure and rebuild in the new normal which follows. Further the majority of the COVID-19 impact to date has yet to appear in their published financials.

Before the 'new normal'

What, then, of companies which are currently or will soon be negotiating financial settlements to regulatory investigations into business activity undertaken in less challenging times? Where a financial settlement quantum would likely have been painful but manageable in less interesting times, in the midst of the pandemic, it could well hasten the demise or threaten the future viability of a company.

It is important to recognise that, in general, regulators have no interest in putting otherwise good companies out of business. Where a company can objectively demonstrate that it has a limited ability to make a financial settlement, this will be taken into account.

The COVID-19 pass?

However, no one should be under the impression that this makes the COVID-19 pandemic into a free pass. Regulators' view of ability to pay is not a static, point in time assessment. It takes into account a company's ability to pay in instalments over a period of several years. A reduction in settlement based on ability to pay requires clear arguments and evidence as to why a company cannot reasonably expect to pay a settlement even with the benefit of deferral and instalments.

A high level understanding of how regulators approach ability to pay can be gleaned from the eponymous "Benczkowski Memo" published by the attorney general of the US Department of Justice in October 2019.

'The burden of establishing an inability to pay rests with the business organization making such a claim'.

Credibility is key

Unsurprisingly, the onus is on the company to develop its inability to pay argument. The credibility of its argument is, of course, paramount. In our experience, arguments should be based on objective, quantitative data and forecasts which have been produced in the normal course of business and subject to scrutiny by operations, external auditors and/or at board level to be credible. Likewise, arguments which demonstrably explore all areas of a company's business, identify all potential sources and uses of funds and apply credible stress tests are also required to establish credibility.

Regulators understand that forecasting is not an exact science. They accept that company forecasts are often more aspirational than central case. Regulators also understand that a company will need to maintain a working capital buffer sufficient to survive credible fluctuations. A clear exposition of the company's planning process will help to bridge the gap between aspirational, central case and the downside stress test scenarios which inform on ability to pay, as highlighted in the aforementioned memo.

'The organization must cooperate fully in providing information and access to appropriate company personnel to respond to prosecutors' inquiries.'

Squaring the circle

Engagement with regulators on ability to pay can involve disclosures, presentations, responses to enquiries and negotiations over an extended period which may run over several quarterly reporting periods and potentially a financial year end. It is inevitable that a company's business will evolve over such a period. Contracts may be won or lost. Claims may be initiated or resolved. Market conditions may change. Regulators do not expect a company to foresee black swan type events. However, their perception will be harmed if there was a failure to be fully transparent about the existence and potential outcomes of an issue which subsequently, in their opinion, had a material impact on a company's ability to pay.

A company which prepares and presents its own ability to pay assessment to regulators faces two major hurdles to overcome. The first is that the company starts with perhaps limited credibility with the regulators given the investigative context in which the engagement is taking place as well as its inherent interest in minimising the fine. The second is that the company starts with no experience of what is expected by regulators. Engaging independent advisers with experience of conducting and presenting ability to pay studies to regulators addresses both of these issues by providing assurance as to objectivity and independence. Furthermore, the individuals in a company with the knowledge and experience required to contribute to an ability to pay assessment are typically in business critical positions which take up the majority, if not all of their working hours. Cooperation with regulators does not take a break for quarter or year ends.

Interesting times

While every business operates under a different financial landscape and are subject to a variety of industry specific economic and trading sensitivities, the current pandemic has complicated the landscape. Prior business plans drawn up for 2020 have been rendered obsolete. Companies' focus has been on survival. None can reliably forecast when their business will recover or what it will look like when the new normal settles in.

In the current environment, there may be an argument for regulators to defer the setting of a penalty. However, given the uncertain duration of the pandemic and their usual focus on closing out investigations, in our opinion regulators are unlikely to accept this. We think it more likely that regulators will want to set a penalty as soon as possible taking into account inability to pay if a company can make the case for this but deferring payment until the pandemic is likely to have passed. Given uncertainty about the future business environment and their aim not to put otherwise good companies out of business, regulators may be willing to reconsider a penalty prior to payment if a company's viability is threatened.