The SEC -- On Disclosure of Known Trends and Uncertainties; Ranges of Material Loss Contingencies. . . .

[UPDATE:Well -- this site just had a very-interesting returning visitor "hit". See the visit image, below. These visits last up to two-hours (a few weeks ago), and over three-minutes, once again, this morning. . . . Cool!]

New Monthly IMS data out of Schering this morning -- but first (and I'll have more on this here, in a few minutes), this new text disclosure will likely not serve Schering very well, with the staff of Corporation Finance, at the SEC:

". . . .Q: What is Schering-Plough’s comment on Merck’s guidance regarding the cholesterol franchise?

A: Schering-Plough does not provide numeric guidance and does not comment on the guidance of other companies.

The Merck/Schering-Plough cholesterol joint venture developed potential scenarios about the 2008 equity income. Merck chose an estimate that is within the ranges established in those scenarios. . . ."
[Emphasis supplied.]

"Hold on a sec., there, pard'. . . ." Didn't Schering announce a $1.5 billion charge, a good chunk of which will likely be booked into its First Quarter 2008 results? Now, doesn't that press release indicate that the charge is, in part due to ". . .to the confusion in the U.S. market around cholesterol management that impacts the products of the Merck/Schering-Plough joint venture, Zetia and Vytorin. . ."?

Well, as a matter of fact, yes sir -- it does. So, Schering, according to well-settled SEC law, needs to provide the range of the fall-off in the Cholesterol Franchise Joint Venture. It is clearly the reason for at least $1 billion of that charge. More on that below. [By the way, when was the last time you saw a Fortune 200 company take a $1 billion bath, and credit the write-down to "confusion"? wouldn't it be cheaper, and easier, if it were simply confusion, to get out there, with factual, forceful, proactive advertising -- and promptly "clear up" the confusion, rather than cut-out 10 percent of your workforce, and spend $1B, grande? So -- is it really "confusion", guys -- or something else? Ah, but I digress.]

The notion that Schering is not going to provide that range -- the fall-off that drove the $1 billion of incremental cuts/charges -- unless it does so on tomorrow's call -- is plainly frowned upon by SEC rules and releases. There can be no dispute that almost no number is more material to the future earnings of Schering, than the range of loss in profits now expected from the Cholesterol Joint Venture.

I'll have a cite to the SEC literature on this in a moment below, but once a range has been established (jointly by agents of Schering and agents of Merck & Co., not some third party/interloper, here!), as to a material loss contingency, the range must be disclosed (unless the loss contingency is deemed "remote" by the auditors, and that is not the case here -- what audit firm is going to take the risk that something Merck said was real, is "remote" as to Schering, a much, much smaller company?!) -- even if the actual amount, with precision, cannot be determined, by tomorrow's call.

The range must be disclosed. This franchise is over 55 percent of Schering's (previously-) expected 2008 profitability.

This is not some goofy "the-Sky-is-falling" pronouncement from a crazy blogger, here (Heh!) -- this is Schering's 50-50 Joint Venture partner, a huge public company whose lawyers decided this was material, estimable and probable -- as to their joint $5 billion business relationship. To persist in denying this, seems not only unwise from a legal point of view, it seems unsound from a public investor relations point of view.

So -- I'd expect Schering to disclose the range tomorrow -- and it will certainly be as high as $900 million (as I predicted yesterday), but may be even higher. . . . $1 or even $1.2 billion.

Other than the above, the SEC Form 8-K filed by Schering just now essentially confirmed what MRK said yesterday, about IMS trends, so I'll not repeat it here.

On to the SEC's rules and releases then -- and Reg. S-K, Item 303(a):

". . . .(3) Results of operations.

(i) Describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected. In addition, describe any other significant components of revenues or expenses that, in the registrant's judgment, should be described in order to understand the registrant's results of operations.

. . . .(ii) Describe 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. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

(iii) To the extent that the financial statements disclose material increases in net sales or revenues, provide a narrative discussion of the extent to which such increases are attributable to increases in prices or to increases in the volume or amount of goods or services being sold or to the introduction of new products or services. . . ."

Indeed.

The SEC's financial statement rules, collected under Reg. S-X (which incorporate FASB releases), provide thus -- via SFAS No. 5:

". . . .Disclosure of the nature of an accrual made pursuant to the provisions of paragraph 8, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading. . . . [Editorial Note: Remember here that Schering has indicated it will take a $1.5 billion charge, or accrual, in large part to address the fall-off in the Joint Venture's business.]

If no accrual is made for a loss contingency because one or both of the conditions in paragraph 8 are not met, or if an exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 8, disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. Disclosure is not required of a loss contingency involving an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable. . . .

. . . .After the date of an enterprise's financial statements but before those financial statements are issued, information may become available indicating that an asset was impaired or a liability was incurred after the date of the financial statements or that there is at least a reasonable possibility that an asset was impaired or a liability was incurred after that date. . . . [T]he information may relate to a loss contingency that did not exist at the date of the financial statements, e.g., threat of expropriation of assets after the date of the financial statements or the filing for bankruptcy by an enterprise whose debt was guaranteed after the date of the financial statements. In none of the cases cited in this paragraph was an asset impaired or a liability incurred at the date of the financial statements, and the condition for accrual in paragraph 8(a) is, therefore, not met. Disclosure of those kinds of losses or loss contingencies may be necessary, however, to keep the financial statements from being misleading.
If disclosure is deemed necessary, the financial statements shall indicate the nature of the loss or loss contingency and give an estimate of the amount or range of loss or possible loss or state that such an estimate cannot be made. . . .

Occasionally, in the case of a loss arising after the date of the financial statements where the amount of asset impairment or liability incurrence can be reasonably estimated, disclosure may best be made by supplementing the historical financial statements with pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements. . . .

. . . .The SEC expands the disclosures about the nature of operations whenever a concentration exists that places the well-being of the entity at risk. The SEC believes that readers need to know about operational concentrations which, if the relationship with the concentration is severed or significantly reduced, could cause significant harm to the entity.

Concentrations come in many forms -- so many, in fact, that the SEC felt compelled to list the particular concentrations that concern it the most. Specifically, the following four concentrations require disclosure if they meet the disclosure criteria:

▲ Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor or contributor;

▲ Concentrations in revenue from particular products, services or fund-raising events. . . .

. . . .When an entity has a concentration that belongs on the above list, the concentration must be disclosed when all three of the following criteria are met:

▲ The concentration exists at the date of the balance sheet;

▲ The concentration makes the enterprise vulnerable to the risk of near-term severe impact; and

▲ It is at least reasonably possible the events that could cause the severe impact will occur in the near term.

The SEC defines a "severe impact" as a ". . .significant financially disruptive effect on the normal functioning of the entity." The term implies a higher threshold than a "material impact." A material impact implies information that would alter decisions about an entity and may, in turn, alter the valuation of an entity's capital stock or outstanding debt. A severe impact implies a more serious effect, one that would seriously upset the central manufacturing or marketing operations of the entity. To judge whether a severe impact is possible, the focus is on the core operating processes of the company. The question is how seriously the operating environment would be affected if the relationship with the concentration were disrupted. . . .

[Editorial Comment, here: This page had some fascinating traffic, today, no?]
. . . .The disclosure of the concentration should contain sufficient information to inform the reader of the nature of the risk caused by the concentration. Normally, this would consist of a narrative statement. The SEC only encourages the use of quantitative measures for the degree of the concentration. In addition, the SEC realizes that information about concentrations may already be presented in efforts to comply with other pronouncements such as SFAS No. 14, Financial Reporting for Segments of a Business Enterprise. . . .

The SEC mandates particular requirements for certain types of concentrations. When an entity has a concentration of customers or contributors or has a concentration of operations located outside the entity's home country, the SEC removes some judgement: The entity should always consider it reasonably possible that the relationship or operations will be disrupted in the near term. . . ."

At the risk of repeating here, then, it seems obvious beyond peradventure, that if Merck & Co., at twice Schering's size, believed this estimated $700 million profit decline is probable (not just "possible"), material, and estimable, then Schering simply must disclose its own view of the range, tomorrow. Up or down -- whether it agrees, disagrees, or has some other path, here. It seems difficult to find any other lawful reading of the SEC's 30-plus years of guidance, here.

Now, consider this, from the SEC's MD&A literature:

". . . .In assessing whether disclosure of a trend, event, etc. is required, management must consider both whether it is reasonably likely to occur and whether a material effect is reasonably likely to occur. As the Commission noted when it adopted the requirement, the "reasonably likely to occur" test is to be used rather than the Basic v. Levinson probability and magnitude test for materiality of contingent events. See Securities Act Release No. 6835 (May 18, 1989) [54 FR 22427] at fns. 27-28 and accompanying text. . . ."

That pretty much seals it.

And, while not directly applicable to these facts, this is illuminating, from the Form 8-K Release, as Schering chose to make this disclosure by way of a Form 8-K, so updates are now required:

". . . .If at the time of filing the company is unable to make a good faith estimate of the amount. . . . it need not disclose an estimate at that time, but must nevertheless file the Form 8-K report describing the company's commitment to a course of action under which it will incur a material charge. Within four business days after the company formulates an estimate, the company must amend its earlier Form 8-K filing to include the estimate. . . ."

As ever, more to come.