Transparency is key when an adverse event occurs.

The worst has happened. You have had a significant adverse event that may affect your company’s financials and threatens the very existence of your company. If you are a fund manager, what do you tell your investors? How much do you tell your investors? What steps do you take immediately to protect the company, its management, and the investors?

Honesty and Transparency Are Key

As a rule, fund managers of limited partnerships, limited liability companies, and corporations have a fiduciary duty to their limited partners and investors. Black’s Law Dictionary defines fiduciary duty as “a duty to act for someone else’s benefit, while subordinating one’s personal interests to that of the other person.” Black’s further expands this definition to mean “one who owes to another the duties of good faith, trust, confidence, and candor.” The key word in these definitions is “candor,” which is defined as “being open and honest in expression.”

Being open and honest with your investors is the only reasonable option in such a case. No one has ever been sued by their investors for over-disclosing. They may be sued for the underlying action that caused the adverse event, but the disclosure itself is not the issue. Secrets rarely remain secrets in these scenarios. However, thousands of lawsuits have been filed against managers, members, and owners due to lack of disclosure, even if the underlying actions were not actionable on their own. Full disclosure is a requirement of meeting a duty to your investors, whether or not required under the terms of your partnership agreement or operating agreement; it’s the law.

How to Disclose

Disclosing what has happened to your investors as early as possible is very important. This is true even if you don’t fully know the extent of the harm at the time. It is important to let them know as early as you do that there has been an adverse event, what the implications are, what you know and do not know, and what you are doing to fact find. Take the time you need to understand what happened, but don’t wait until you know all the details and have a resolution. There is a fine line between waiting until you know enough to inform investors that something is going on and withholding information.

If you send monthly or quarterly updates to your investors, you must include it in the communication that takes place on this schedule. It is very bad form to send an update that does not include this important information, even if it is merely to say that something happened and you are still fact finding. It is also critically important to let them know you will update them when you know more. Finally, do not raise capital from investors without full disclosure of the ongoing issue. Not disclosing is almost a guaranty of litigation if a significant loss occurs.

Make the disclosure in writing with as specific information as possible, including what happened, how you believe it may impact the company, whether you think it will impact distributions, whether it will impact capital accounts, and the steps you are taking to determine the extent of the harm and your efforts to mitigate loss. Take a worst-case scenario approach rather than a best case. You are better off telling your investors later that the company did better in resolving the issue than telling them the result was worse than previously disclosed.

Such broad disclosure lets your investors know the problem exists and they may not get distributions of income as expected. It gives them a chance to ask questions and feel part of the process. Because of the immediate and transparent disclosure, investors will generally accept what they are being told and trust management to keep them updated when more information about the details and impact of the event become known.

Examples of Real-World Disclosures

On the next page is an example of such a disclosure. This is a letter from Tim Cook to Apple investors on January 2, 2019. Notice that he specifically states what the issue is and then recites the factors causing the issue.

To Apple investors:

Today we are revising our guidance for Apple’s fiscal 2019 first quarter, which ended on December 29. We now expect the following:

• Revenue of approximately $84 billion
• Gross margin of approximately 38 percent
• Operating expenses of approximately $8.7 billion
• Other income/(expense) of approximately $550 million
• Tax rate of approximately 16.5 percent before discrete items

We expect the number of shares used in computing diluted EPS to be approximately 4.77 billion. Based on these estimates, our revenue will be lower than our original guidance for the quarter, with other items remaining broadly in line with our guidance. 

While it will be a number of weeks before we complete and report our final results, we wanted to get some preliminary information to you now. Our final results may differ somewhat from these preliminary estimates. 

When we discussed our Q1 guidance with you about 60 days ago, we knew the first quarter would be impacted by both macroeconomic and Apple-specific factors. Based on our best estimates of how these would play out, we predicted that we would report slight revenue growth year-over-year for the quarter. As you may recall, we discussed four factors:

• First, we knew the different timing of our iPhone launches would affect our year-over-year compares. Our top models, iPhone XS and iPhone XS Max, shipped in Q4’18—placing the channel fill and early sales in that quarter, whereas last year iPhone X shipped in Q1’18, placing the channel fill and early sales in the December quarter. We knew this would create a difficult compare for Q1’19, and this played out broadly in line with our expectations.
• Second, we knew the strong US dollar would create foreign exchange headwinds and forecasted this would reduce our revenue growth by about 200 basis points as compared to the previous year. This also played out broadly in line with our expectations.
• Third, we knew we had an unprecedented number of new products to ramp during the quarter and predicted that supply constraints would gate our sales of certain products during Q1. Again, this also played out broadly in line with our expectations. Sales of Apple Watch Series 4 and iPad Pro were constrained much or all of the quarter. Air Pods and MacBook Air were also constrained.
• Fourth, we expected economic weakness in some emerging markets. This turned out to have a significantly greater impact than we had projected. 

In addition, these and other factors resulted in fewer iPhone upgrades than we had anticipated. 

These last two points have led us to reduce our revenue guidance. I’d like to go a bit deeper on both. 

Emerging Market Challenges

While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac, and iPad.

China’s economy began to slow in the second half of 2018. The government-reported GDP growth during the September quarter was the second lowest in the last 25 years. We believe the economic environment in China has been further impacted by rising trade tensions with the United States. As the climate of mounting uncertainty weighed on financial markets, the effects appeared to reach consumers as well, with traffic to our retail stores and our channel partners in China declining as the quarter progressed. And market data has shown that the contraction in Greater China’s smartphone market has been particularly sharp.

Another example of such a disclosure from a publicly traded company is below. This one, from Williams Industrial Services, was sent in early August 2022. Notice that this disclosure previews the items to be discussed in an upcoming earnings call with investors.

“While the long-term outlook for Williams remains favorable, it has become necessary to adjust 2022 guidance due to several non-recurring issues negatively impacting the achievement of previously forecast performance levels,” said Tracy Pagliara, president and CEO. “As will be explained in greater detail during our upcoming earnings call on August 12, these items include additional start-up costs associated with our transmission and distribution business; further litigation expense related to a competitor and former employee; and continued margin pressure pertaining to previously-disclosed Florida projects, which are expected to be substantially complete this calendar year. In addition to these transitional costs, some awards and project work have been delayed until the second half, dampening revenue projections.

Again, notice the naming of the problem and the contribution factors.

It is not necessary to recite every possible outcome to your investors. It is sufficient to tell them what you believe is the likely result at the end of the day. Do not speak in absolutes. Avoid using words like “definitely,” “guaranteed,” etc.; rather, use words such as “likely” and “probably.” Always include a sentence saying the statement is your opinion as of the date of the notification but that the future is unpredictable and the situation is subject to change. Most important, convey to your investors that you are being truthful and transparent.

Additional Considerations

There are other things that management should consider with regard to adverse events and investors. If the potential loss is enough to make the company unprofitable for the year, distributions of income should be shut down immediately. There is no justification for distributing income from a company mid-year when the end of the year will show a loss. Hopefully, the entity documents allow management to withhold distributions in its sole discretion in case of adverse events. Any well-drafted document should outline these parameters. If you do not have the right, consider amending your entity documents to allow this before you need it. Investors will not take kindly to this change after the fact.

Another action you should take immediately is to shut down any right to redemptions your investors may have. Again, this assumes your well-drafted entity documents allow you to do so. The reasons for this are easy to understand. Redemptions deprive a company of its capital and make the investor base smaller, so that each redemption increases the loss risk of the remaining investors. All your investors shared in the bounty of income from your business when things were profitable; they should share equally in the downside. By allowing redemptions, you increase the loss burden on your most loyal investors who did not pull their funds. It is simply a matter of being fair and equitable.

You must also check any other agreements you may have with banks, warehouse lenders, or other sources of capital. Even if you believe it is not necessary to suspend distributions and/or redemptions, your agreements with these entities may require it. Taking the same approach with your funding sources as you do with your investors is advocated here. Disclose everything you know, keep them updated, and share any projections you may have on the impact of the adverse event. Your very important relationship with your capital source is governed by the requirements of the written agreements between you. As painful as it may be, you need to tell them. In many cases, if you can present enough information to show them it will not affect them, they will listen, ask some questions, thank you for your candor, and not change a thing about your relationship.

Finally, and this is perhaps the hardest, senior management and ownership should defer any end-of-year profit sharing compensation (assuming there is profit) for the benefit of the investors. This approach helps to avoid investors feeling they were victims of management decisions. When the top of the company can show significant financial loss to themselves personally for the benefit of the investors, it goes a long way towards taking responsibility for the management decisions that led to the adverse event. Not everyone will agree with this strategy, but it is hard to argue and accuse someone who gave up their piece of the pie so you could get more.

The importance of extensive and complete disclosure cannot be overstated. Equally important is to update the investors as you learn more. Do not keep them in the dark. Tell them both the good and the bad news. When you have done enough fact finding to be able to guestimate the potential loss, let them know. If your guestimate shows there will still be income at the end of the year, send the distributions you missed and issue the remainder of the distributions on time for the rest of the year.

If you are as transparent as possible if an adverse event occurs, you may be surprised at the support you get from your investors.