SEC Charges Highlight Need for Timely Disclosure of Loss Contingencies and Material Business Risks

Background

According to the SEC complaint, from 2014 through 2016, EpiPen was Mylan’s most important drug, generating annual sales of approximately $1 billion. During this period, Medicaid patients accounted for approximately 20% of Mylan’s annual EpiPen sales. For a drug to be covered by Medicaid, pharmaceutical manufacturers must participate in the MDRP. Under this program, Medicaid paid Mylan for sales of EpiPen to Medicaid patients and Mylan was required to rebate a portion of these revenues to the government. The amounts of the required rebates are determined, in part, by whether a drug is classified under the program as a generic or a branded drug. Mylan classified EpiPen as a generic drug, enabling it to pay significantly lower rebates.

In 2013, the Centers for Medicare & Medicaid Services (CMS) began contacting Mylan to question this classification and, in October 2014, CMS informed Mylan that Mylan had misclassified EpiPen as a generic drug. Shortly thereafter, the complaint alleges that Mylan became aware of a DOJ investigation into its EpiPen classification. From that point through the summer of 2016, the complaint alleges that Mylan responded to multiple DOJ subpoenas and other requests for information and made several requests that the DOJ abandon its investigation, which the DOJ rejected. Mylan and the DOJ began settlement negotiations in July 2016 and reached a settlement in principle for $465 million in October 2016.

Failure to Timely Disclose Loss Contingencies and Take Accruals

The SEC complaint alleges that by the time Mylan filed its quarterly report on Form 10-Q for the third quarter of 2015, the company knew or should have known that a material loss relating to the DOJ investigation was reasonably possible and made appropriate disclosures regarding the associated loss contingencies. However, the company did not disclose or accrue for any losses relating to the DOJ investigation before October 2016.

Under generally accepted accounting principles (GAAP) and Accounting Standard Codification 450 (ASC 450), “loss contingencies” represent any existing condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future events occur or fail to occur and include actual or possible claims and assessments and pending or threatened litigation. To determine whether disclosure of loss contingencies is required, companies must assess the likelihood of material loss. There are three levels of probability that can be assigned to contingencies:

• Remote: The chance of the future event occurring is slight.

• Reasonably possible: The chance of the future event occurring is more than remote, but less than likely.

• Probable: The future event is likely to occur.

Once the probability of a material loss has been deemed reasonably possible, the company must determine whether it can estimate the possible loss or range of loss. If it can estimate a loss or range of loss, it must disclose the nature of the contingency and the estimated loss or range of loss. If it cannot estimate a loss or range of loss, it must disclose the nature of the contingency and why an estimate cannot be made.

If the possibility of material loss has been deemed probable and the company can estimate a loss or range of loss, it must disclose the nature of the contingency and the estimated loss or range of loss in addition to taking an accrual for the estimated loss or range of loss. The accrual should be in the amount of the company’s best estimate of the loss, if available, or alternatively the minimum amount in the estimated range of loss.

The SEC’s complaint alleges that Mylan knew or should have known that a material loss relating to the DOJ investigation was reasonably possible by the time it filed its Form 10-Q for the third quarter of 2015, due to the numerous contacts between the DOJ and the company and the company’s knowledge of the DOJ’s refusal to halt its investigation. For example, the complaint refers to the DOJ’s request following a meeting in August 2015 that Mylan sign a tolling agreement to stop the statute of limitations from running and permit the DOJ to charge the company for conduct spanning a longer time period.

Additionally, the SEC complaint alleges that Mylan knew or should have known by the time it filed its Form 10-Q for the second quarter of 2016 that a material loss relating to the DOJ investigation was probable and furthermore that Mylan had enough information to reasonably estimate the potential loss or range of loss by that time. To support this argument, the complaint refers to events including an extension of the tolling agreement that Mylan agreed to in June 2016, damages estimates for the year 2015 that Mylan provided to the DOJ in June 2016, a July 2016 meeting at which the DOJ indicated it was prepared to sue Mylan unless a settlement was reached and provided damages estimates, a settlement offer that Mylan made to the DOJ on July 29, 2016, and a settlement counteroffer Mylan received from the DOJ on August 3, 2016.

Because Mylan failed to disclose the nature of the contingency when it became reasonably possible, failed to disclose an estimated loss or range or loss when it became reasonably estimable and failed to accrue for the loss when it became both probable and reasonably estimable, the SEC complaint alleges that the company’s quarterly reports on Form 10-Q and annual report on Form 10-K from at least the third quarter of 2015 through the second quarter of 2016 were materially false and misleading. Furthermore, the complaint alleges that the company’s failure to accrue for the loss resulted in a material overstatement of reported earnings in the Form 10-Q and earnings release for the second quarter of 2016.

Misleading Risk Factors

The SEC complaint also alleges that Mylan’s annual reports on Form 10-K for 2014 and 2015 included materially misleading risk factors relating to how to properly calculate and report payments under the MDRP. Specifically, both annual reports included risk factor disclosure stating that “a governmental authority may take a position contrary to a position we have taken,” and the 2015 annual report also stated, “We cannot assure you that our submissions will not be found by CMS . . . to be . . . incorrect.”

Because CMS had communicated to Mylan in October 2014 that the company had misclassified EpiPen as a generic drug, the SEC complaint alleges that the hypothetical phrasing created the misleading impression that CMS had not yet taken a position on Mylan’s classification of EpiPen.

Key Takeaways

These charges emphasize the SEC staff’s focus on loss contingencies disclosures and accruals. When subject to a governmental or regulatory investigation, threatened or potential legal proceedings or other scenarios that could result in a loss, companies should be mindful of their disclosure and accrual obligations and should consult with their legal and accounting advisers throughout the process. This analysis must be revisited regularly in light of new facts and developments. In addition to disclosure and accrual obligations pursuant to GAAP, companies should also consider whether circumstances giving rise to loss contingencies disclosures may also require disclosure pursuant to other requirements, such as material trends disclosure pursuant to Item 303 of Regulation S-K (Management’s Discussion and Analysis of Financial Condition and Results of Operations), Item 103 of Regulation S-K (Legal Proceedings), Item 105 of Regulation S-K (Risk Factors), Form 8-K and exchange rules.