Over the past two years, U.S. public companies faced an unpredictable risk environment. Two geopolitical crises – the Covid-19 pandemic, and the Russian invasion of Ukraine – strained international supply chains and destabilized financial markets.
It is tempting to view these events as temporary departures from the stable climate for international commerce of the past 75 years. There are reasonable grounds for that position. After all, Covid-19 was the first global pandemic since 1919, and the conflict in Ukraine marks the first large-scale conventional conflict in Europe since World War II. However, geopolitical instability may be the new normal, and the resulting risks may require companies to consider how these risks affect their business, and for public companies, disclosure of such information to shareholders.
In this article, we begin with the Securities and Exchange Commission (“SEC”) regulations that mandate risk disclosures, and the federal statutes that create civil liability for misleading statements. We also summarize the pandemic-related disclosure guidance issued by the SEC (“Pandemic Guidance”), and the recently-released Sample Letter to issuers regarding Ukraine-related risk (“Sample Letter”).
We then examine the Covid-19 pandemic – the most disruptive geopolitical event since the 2008 financial crisis. Using the Pandemic Guidance as a blueprint, we discuss how some issuers disclosed pandemic-related supply chain risk, while others now face claims for allegedly misleading shareholders about the impact of the pandemic for their supply chain.
Turning next to the invasion of Ukraine, we analyze the conflict, and the resulting disruption to supply chains and commodities. We examine how some issuers learned from Covid-19, and offer examples of proactive Ukraine-related disclosures. We then apply the Sample Letter and the Pandemic Guidance to this conflict, and discuss potential disclosure risks for issuers as the conflict continues.
Finally, we look to the future. We examine the PRC-Taiwan relationship, and identify emerging risks to the status quo. We analyze the potential effects of an escalation of the conflict between the PRC and Taiwan on raw materials, semiconductors, communications, and shipping. We then identify how forward-thinking companies have already disclosed this risk, and share recent filings we consider particularly noteworthy, in light of the Pandemic Guidance and the Sample Letter. We close with Taiwan-focused recommendations for all issuers to consider when drafting future filings.
I. THE DISCLOSURE LANDSCAPE
To understand the disclosure landscape, it is helpful to first review the statutes that govern company filings, and the SEC rules that mandate the disclosure of material risks.
A. Regulation S-K
Two items in Regulation S-K focus on the disclosure of material risks and uncertainties affecting corporate operations: Item 105 and Item 303. Starting with Item 105, issuers are required to disclose in certain filings any factors that might make the purchase of their securities “speculative” or “risky.” Issuers are also required to explain how each disclosed risk affects the offered security.
Item 303 identifies a broader range of circumstances where companies must disclose material events and uncertainties. The rule requires issuers to provide, among other things, management’s discussion and analysis (“MD&A”) regarding the impact of material events and uncertainties on (1) operations, liquidity, and capital resources; (2) critical accounting estimates; (3) overall financial condition; and (4) forward-looking statements. Management is also required to identify and disclose known trends or uncertainties likely to have a material impact on sales, revenues, or income.
B. Material Misrepresentations and Omissions
There is currently an unresolved circuit split concerning whether a mere failure to comply with Regulation S-K can create private civil liability in connection with secondary market transactions. Compare In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014) (violations of Section 303 do not give rise to private right of action under Section 10(b) and Rule 10b-5) with Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. Jan 12, 2015) (holding that violations of Section 303 may permit plaintiffs to bring claims for violations of Section 10(b) and Rule 10b-5).
Regardless of the above, issuers still remain liable for false and misleading statements in all manner of public statements. Specifically, Section 10(b) of the Securities Exchange Act of 1934 (“1934 Act”) and its implementing regulation, Rule 10b-5, prohibit issuers from making materially false or misleading statements. There is also a private right of action for shareholders to pursue claims for violations of Section 10(b) and Rule 10b-5 in federal court. Thus, issuers face the risk of painful and expensive civil litigation from any allegedly false or misleading statements.
C. The Pandemic Guidance
Shortly after Covid-19 emerged, the SEC issued disclosure guidance for issuers. The SEC’s Division of Corporate Finance first issued Guidance Topic No. 9 on March 25, 2020. The SEC staff provided a detailed list of Covid-related topics for issuers to consider in drafting subsequent disclosures. These included (1) the impact of Covid on current and future operations; (2) the impact on capital and financial resources; (3) any material impairments on financial statements; (4) Covid-related impacts on business continuity plans; and (5) disruptions in supply chains and the methods for distributing products.
Several months later, the SEC issued a second round of guidance: Topic 9A. In this supplemental publication, the SEC added additional examples of Covid-related risks, including (1) material changes to liquidity; (2) material operational challenges identified by management and the Board of Directors; (3) impacts on existing lines of credit and corporate debt; (4) reductions in capital expenditures; and (5) the use of funding instruments to ensure ongoing access to critical supplies, including loans to vendors and the use of factoring.
D. The Sample Letter
On May 4, 2022, the SEC issued the Sample Letter. The letter came in two parts. The first part was a short summary that directly addressed the nexus between Ukraine and Regulation S-K. It emphasized that issuers may have “disclosure obligations under the federal securities laws” for any “direct or indirect impact[s]” of the invasion on operations, liquidity, supply chain, or assets. The SEC also identified three risks that it considered particularly material to Ukraine: cybersecurity, supply chain integrity, and commodity price volatility. The SEC then advised companies to carefully review their sanctions compliance function, given the extensive sanctions imposed on Russian entities and individuals.
The second part provides an example of a Ukraine-focused disclosure inquiry from the Division of Corporate Finance. Importantly, the Sample Letter addresses the role of the company and the board of directors in disclosing Ukraine-related risk. Starting first with the board, the Sample Letter requests information on its role in “overseeing risks related to Russia’s invasion of Ukraine,” including those related to sanctions, cybersecurity, supply chains, and employees in the region. The Sample Letter can therefore be understood as a direct message to directors to proactively gather information and identify risks created by the Ukraine conflict.
Turning to issuers, the Sample Letter bears many similarities to the Pandemic Guidance. It asks for information on the impact of the Russian invasion on operations, assets, and liquidity, with a particular focus on assets that may be seized by the Russian government. And the SEC suggests that supply chain and commodity risks are a primary consideration, by asking for information on the impact of the invasion on energy, raw materials, the “costs and risks associated with transportation,” and “whether and how … products, lines of service … or operations are materially impacted by supply chain disruptions.” But arguably the most important language focuses on post-Ukraine efforts by issuers to adapt and asks whether issuers expect to “de-globalize” their supply chains.
E. Key Takeaways of the Pandemic Guidance and the Sample Letter
While the Pandemic Guidance and the Sample Letter are, in many ways, cut from the same cloth, there are important differences for issuers to consider. Most significantly, the Pandemic Guidance has broader application than the Sample Letter. The Pandemic Guidance applies to all publicly traded companies. The Sample Letter applies only to publicly traded companies with material operations in or with other companies in Russia/Belarus/Ukraine.
But that does not mean issuers can take the Sample Letter lightly. Unlike the Pandemic Guidance, the Sample Letter focuses in greater detail on issues of supply chain integrity, sanctions compliance, and the effect of the Russian invasion on raw materials, energy, and transportation. Therefore, the Sample Letter potentially requires issuers to make a more searching and comprehensive examination of Ukraine-related risks. Further, the Sample Letter reflects the SEC’s emphasis on the actions of the board of directors. The board is largely absent from the Pandemic Guidance, and the inclusion of the board as a separate line item in the Sample Letter should be understood as a warning from the SEC that directors must carefully vet the impact of Ukraine on corporate operations. And most importantly, nothing in the Pandemic Guidance can be read to suggest that the SEC is encouraging issuers to diversify or de-globalize their supply chain.
Despite these differences, the collective impact of the Pandemic Guidance and the Sample Letter, as we discuss in greater detail below, is to provide issuers with the best available template for complying with SEC rules and regulations in the event of geopolitical instability. Companies that apply the Pandemic Guidance and the Sample Letter to their finances, supply chain, and operations during a crisis are more likely to issue disclosures that satisfy shareholders, avoid private civil litigation or reduce the likelihood that such litigation is successful, and withstand potential SEC scrutiny.
II. THE COVID-19 PANDEMIC
Turning from regulation to recent events, we begin with the Covid-19 pandemic—the first major disruption in global supply chains since the admission of China to the World Trade Organization. In February of 2020, lockdowns in China resulted in significant shortages of raw materials, finished goods, transportation, and international shipping.
Making matters worse, many issuers embraced “Just in Time” inventory management to reduce cost. Supply chain managers in these companies were assigned key performance indicators driven exclusively by cost reduction. As a result, many companies lacked inventory, and suffered significant reductions in share price. For these issuers, the identification and timely disclosure of Covid-19 related risk was possibly the most important factor in avoiding shareholder litigation. Other companies that failed to make or allegedly failed to make disclosures about risks from Covid-19 have been sued for securities fraud.
A. Applying the Pandemic Guidance: Timely Covid-19 Risk Disclosures
A number of issuers identified the potential risks of Covid-19 to supply chains and corporate operations, and made disclosures to shareholders—ahead of the Pandemic Guidance. For example, Toll Brothers Inc. filed a 10-Q on March 10, 2020—before Covid-related lockdowns began in the United States—that provided the following warning to shareholders:
“There is significant uncertainty around the breadth and duration of business disruptions related to COVID-19 …. The extent to which COVID-19 impacts our results will depend on future developments … if the virus causes significant negative impacts to economic conditions … our results … could be adversely impacted.
Three days later, Burlington Stores, Inc.—a retail chain heavily dependent on finished goods from Asia—filed a 10-K that also made Covid-related risk disclosures. Burlington informed shareholders that “if the COVID-19 pandemic continues to grow, our import supply chain could experience severe delays due to closed factories and/or reduction in processing capacity.”
These issuers and a number of others stand out for the rapid identification of Covid-related risk, and the communication of those risks to shareholders—even before the SEC issued the Pandemic Guidance. While that is obviously the ideal approach, it should not take credit away from the many other issuers that quickly responded to the Pandemic Guidance.
As discussed above, the SEC released the first Pandemic Guidance on March 25, 2020. Many issuers immediately incorporated Covid-related risks into their SEC filings. For example, on March 26, CSX corp. issued a Form 8-K, informing investors that “COVID-19 and the related initiatives may result in supply chain disruption, which could have an adverse impact on volumes and make it difficult for the company to serve its customers.” The next day, Owens & Minor Inc. issued a Form 8-K, where it informed shareholders that “COVID-19 may impact our supply chains relative to global demand for our … products. COVID-19 may also affect the ability of suppliers and vendors to provide products and services to us.”
These disclosures are not incredibly precise. This is not surprising given the uncertainty and pace of events at the time. What is more important is that these issuers prioritized the timely and factual disclosure of Covid-related risks to shareholders, knowing it was possible to supplement as the global impact of the pandemic became more clear. This transparent, proactive approach significantly reduced the risk of shareholder claims.
B. Pandemic-Related Shareholder Litigation
Having reviewed filings by issuers that proactively disclosed COVID-19 related risk, we now look to companies that have faced shareholder claims over pandemic-related supply-chain disruption. The common thread in the cases we discuss below, and others, is the absence of specific disclosures about the potential risks from the Covid-19 pandemic, or statements that failed to fully capture the impact of Covid-19 on corporate operations and supply chains.
- Canaan, Inc.
The first Covid related claims related to deficient supply chains arose against Canaan, Inc. in April of 2021. Shareholders alleged that Canaan—a manufacturer of Bitcoin mining machines operating primary in China—failed to disclose material disruptions in its supply chain caused by the Covid-19 pandemic. (See Complaint, Denny v. Canaan, Inc., No. 1:21-cv-03299 (S.D.N.Y. 2021) (ECF No. 1). More specifically, the plaintiffs alleged that in early 2021, Canaan issued a press release announcing significant revenue improvements, and highlighting significant recent orders from large customers. But then in April of 2021, Canaan issued its FY 2020 financials, showing a reduction in total revenue of nearly 93 percent versus the prior year.
In bringing claims for securities fraud, Canaan shareholders pointed to statements by the company’s CEO in November of 2020, acknowledging the impact of Covid-19 but emphasizing that order volume would ensure continued growth. After the FY 2020 results were announced, Canaan executives publicly attributed the shortfalls in revenue to Covid-related supply chain disruption. This case remains pending in the United States District Court for the Southern District of New York with the defendants having recently filed a motion to dismiss.
- Lucid Group, Inc.
There is a similar shareholder case against Lucid Group, Inc. (“Lucid”) brought last month in the United States District Court for the Northern District of California. Lucid designs, engineers, builds, and sells luxury electric vehicles. The plaintiff alleges that Lucid “assured investors that supply chain issues, which were plaguing other auto manufacturers, would not interfere with the Company’s ability to reach its production targets.” (See Complaint, Manning v. Lucid Group, et. al, No. 3:22-cv-02094 (N.D. Ca. 2022) (ECF No. 1). The company, however, did not meet its production targets for 2021 and reduced its targets for 2022. Among other reasons, the company noted that it faced “extraordinary supply chain and logistic challenges” and that “in some cases, the pandemic meant that our teams could not visit our suppliers in person to ensure alignment on engineering specifications and tooling.”
C. Lessons of the Pandemic for Geopolitical Risk Disclosures
These are but two examples of many recent shareholder cases focused on Covid-19. A similar case is currently pending against Cerence Corp. (See Complaint, City of Miami Firefighters Trust v. Cerence, Inc. et. al, No. 1:22-cv-10321 (D.Mass. 2022) (ECF No. 1). Additional claims are likely as the downstream supply chain effects of the Covid-19 continue.
Reading these claims alongside the Pandemic Guidance demonstrates that in addition to creating economic risk, geopolitical events pose a downstream litigation risk for companies that fail to inform shareholders about the material impact on supply chains, or understate that risk. Of course, the companies discussed above have only been sued for securities fraud. No court has actually held that the complaints state a viable claim, much less entered a verdict. But the defense of these lawsuits is costly, a distraction to management, and potentially disruptive to corporate operations.
It is important to recognize that while the Covid-19 pandemic did disrupt supply chains, the disruption was relatively brief—factories in the PRC generally re-opened within weeks, and in many other Asian countries factories and ports either remained open, or continued to operate on reduced shifts. That brief disruption, and subsequent lockdowns in the U.S. and Europe, resulted in substantial, long-term interruptions to supply chains that continue to the present. In the following sections, we will examine the litigation risk from geopolitical crises that could last far longer—starting with the ongoing conflict in Ukraine.
III. THE INVASION OF UKRAINE
Issuers may reasonably ask what the Covid-19 pandemic and the invasion of Ukraine have in common. The answer is simple. Both have geopolitical ramifications that create litigation risk and require careful consideration by issuers in the preparation of public filings. And with the release of the Sample Letter, both events arguably expose issuers to regulatory scrutiny.
Below, we summarize the key developments in the Russian invasion of Ukraine. We discuss the macroeconomic impacts of the conflict, and the potential for ongoing disruption. We then turn to disclosures. With the Pandemic Guidance as a metric, we share examples of timely disclosures by issuers—including several that predated the outbreak of hostilities. We then discuss the Sample Letter, and share how the failure to properly identify and disclose risks related to Ukraine could trigger future shareholder claims.
A. The Geopolitical Context
A concise summary of events leading to the invasion is helpful to the analysis that follows. In February of 2014, the Ukraine Parliament removed then-President Viktor Yanukyvich. Days later, pro-Russia forces seized the parliament in the Crimea and proclaimed independence from Kyiv. In April of 2014, Russia announced the annexation of Crimea. The following month, Ukraine elected a pro-western candidate, Petro Poroshenko, as President. Around the same time, Russian separatists attempted to seize urban centers of Eastern Ukraine.
Transitioning to the present, two events focused the attention of President Putin on seizing Ukraine. First, President Poroshenko approved amendments to the Ukraine Constitution that endorsed membership in the European Union (“EU”) and the North Atlantic Treaty Organization (“NATO”). Second, in 2019 Ukraine voters elected President Volodmyr Zelensky, who ran on an expressly pro-NATO platform.
B. The Russian Invasion and the NATO Response
In late December of 2021, western media sources identified large-scale Russian troop movements into Belarus and Crimea. By February of 2022, 175,000 Russian troops stood on the Ukraine border.
Russia invaded Ukraine on February 20, driving south from Belarus towards Kyiv, while also moving west towards Kharkiv, and into Southeast Ukraine from Crimea. President Putin described the effort as a “special military operation” to forestall encroachment by NATO on Russian borders.
To date, Russia has found success on the battlefield, but at high cost. While Russian forces made gains in Southeast Ukraine, efforts to capture Kyiv and Kharkiv met with severe resistance, and Russia appears to have abandoned these lines of advance. Ukraine, meanwhile, has galvanized global support through tactical proficiency and a cunning use of information warfare. Ukraine has also benefitted substantially from the military and economic assistance of NATO member-states.
C. Economic Consequences of the Invasion
To date, the economic and supply-chain impact of the Ukraine invasion has been substantial, but largely isolated to specific economic sectors—agriculture, oil and gas, shipping and transport, and financial institutions subject to economic sanctions.
- Economic Sanctions
The Biden Administration has announced two rounds of economic sanctions on Russia. On February 24, President Biden imposed sanctions on Russia’ financial sector. The U.S. sanctioned Sberbank (Russia’s largest financial institution), effectively prohibiting U.S. dollar-denominated transactions. The U.S. froze assets controlled by VTB Bank, and imposed blocking sanctions on three other major Russian financial institutions.
Several weeks later, the Biden Administration banned imports of Russian oil. Then, on March 11, the Administration announced a second round of sanctions, barring Russian access to the International Monetary Fund and the World Bank, and banning luxury imports. The U.S. also began the revocation of Russia’s Most Favored Nation (“MFN”) status.
- Energy and Raw Materials
At this time, two Ukraine-driven trends are emerging in energy disruption. First, bans on Russian exports and sanctions on Russian financial institutions have driven crude oil prices above $100. The same is true for coal, with prices surging past $400 per ton. Second, oil producers have chosen to terminate extraction projects. ExxonMobil, for example, announced on March 1 that it would discontinue operations at the Sakhalin 1 natural gas field, and discontinue corporate operations in Russia.
Russia also exports many minerals for industrial production, including nickel, iron ore, steel, and platinum. On March 17, Bloomberg noted the significant price impact that sanctions were having on the global commodities markets. Nor are the effects confined to Russia. Ukraine presently produces more than fifty percent of the world’s neon—a critical component in the manufacture of semiconductors.
The Russian invasion of Ukraine has largely shut down access to the Black Sea. In recent weeks, merchant vessels have struck mines near the ports of Mariupol and Odessa. For example, on March 3, an Estonia-flag container ship sank after striking an underwater mine. And as mines drift with currents, Turkey has repeatedly closed the Bosphorus—a critical link in global shipping. These developments have affected the cost of shipping insurance, with policy premiums now exceeding the cost of chartering the vessel.
The most immediate impact of the Russian invasion on global agriculture has been a dramatic increase in the price of fertilizer. Russia and Ukraine produce a significant portion of the world’s ammonia, urea, and potash—critical components for modern industrial fertilizer. Within one month of the invasion, fertilizer prices hit record highs. Ukraine is also major exporter of wheat and corn. Huge portions of Ukraine farmland have been devastated, and United Nations estimates suggest that thirty percent of the wheat crop may be lost. And those estimates assume the timely resumption of grain export operations at Odessa and Mariupol.
D. Ukraine-Related Disclosures
With these facts in mind, we turn to the question of disclosure. When the Russian build-up to Ukraine began, issuers had in hand the Pandemic Guidance, but not the Sample Letter. And while the Pandemic Guidance obviously does not reference the Ukraine invasion, the principles therein—and the considerations of geopolitical risk—arguably applied to the downstream consequences of the conflict. Issuers that used the Pandemic Guidance as a blueprint for effective disclosure of Ukraine-related risk were therefore more likely to maintain positive relationships with shareholders and reduce litigation exposure.
- Examples of Proactive Disclosure
While many issuers amended or revised disclosures after the Russian invasion, several had the foresight to include the Russia-Ukraine crisis in disclosures filed in late 2021 and early 2022. For example, Alexandria Real Estate Equities Inc. filed a 10-K on January 31, 2022 that identified the Russia-Ukraine crisis as a risk factor, and stated that an invasion would create “… global security concerns that could have a lasting impact on regional and global economies,” and ultimately, “a material and adverse effect on our business, financial condition, and results of operations.”
Similarly, Microchip Technology, Inc. made a very proactive disclosure on February 3, in a form 10-Q. The company noted the threat of sanctions against Russia made by President Biden in January of 2022 if Russia were to invade Ukraine, and informed shareholders that if sanctions were imposed, there would be downstream impacts on customer demand, and the ability of the company to sell products in Russia.
Halliburton adopted the same approach. On February 4, Halliburton released a form 10-K that identified Russia’s intentions toward Ukraine as a risk factor. The company then informed shareholders that “if Russia invades Ukraine,” its “ability to engage in certain future projects in Russia or involving certain Russian customers” would be adversely affected.
The proactive approach taken by these issuers correlates to the Pandemic Guidance, and reflects, at a minimum, a sophisticated understanding of SEC expectations. We further believe that this approach will significantly reduce exposure to future shareholder litigation.
- Post-Conflict Supply Chain Disclosures
But what about companies that did not identify and disclose Ukraine-related risk before the invasion? The absence of a pre-invasion disclosure is understandable and defensible under the Pandemic Guidance, and the general principle that companies must be afforded reasonable time after a material event to produce an accurate and fulsome disclosure. (See, e.g., Higginbotham v. Baxter International, Inc., 495 F.3d 753 (7th Cir. 2007). But to their credit, many issuers promptly shared Ukraine-related risks with shareholders in the first thirty days of the conflict. Below, we identify several examples of post-invasion disclosures that we consider particularly helpful in light of the Pandemic Guidance.
McCormick & Co included disclosure language related to Ukraine in its March 29 10-Q. McCormick emphasized that “the invasion of Ukraine by Russia and the sanctions imposed” have “increased global economic and political uncertainty”, and therefore “we will continue to evaluate the extent [of the impact on] our business, financial condition, or results of operations.”
Solaredge Technologies, meanwhile, made a more comprehensive disclosure on March 21. Solaredge informed shareholders that the Ukraine conflict “may significantly amplify already existing disruptions to our supply-chain and logistics,” by increasing raw materials costs, increasing oil prices, and delaying “the transit of goods by train from China to Europe.”
Note that these disclosures are neither definitive, nor overly lengthy. But they reflect an astute recognition of supply chain vulnerability, and a recognition of the litigation risk of non-disclosure—particularly because each of these disclosures pre-dated the Sample Letter.
- The Impact of the Sample Letter
The release of the Sample Letter significantly reduces potential arguments that issuers can still avoid consideration and disclosure of Ukraine-related risks. With its publication, issuers are now on notice that all future filings should take into account and, where necessary, disclose risks related to the invasion of Ukraine, and the sanctions imposed on the Russian economy.
a. Impact on Prior Ukraine Disclosures
For issuers that have already made Ukraine-related disclosures, the Sample Letter may require supplemental filings, to provide investors with more specific information. For example, the Ukraine-related disclosures identified above speak largely to potential operational and financial risks that have yet to fully materialize. The Sample Letter imposes a more stringent standard, and suggests issuers should disclose all material operational, financial, and supply-chain risks involving Russia and Ukraine, and the remedial measures taken to address these risks. Issuers with Ukraine and Russian exposure should therefore carefully review the Sample Letter, and conduct a detailed analysis of all actual and potential consequences of the Russian invasion. Similarly, issuers who determined that no disclosure of Ukraine-related issues was required may wish to re-evaluate that posture in light of the Sample Letter.
For issuers that have yet to identify a material risk in line with the Pandemic Guidance or the Sample Letter, we advise keeping a watchful eye on developments in Ukraine. Recent decisions by Russia to terminate delivery of energy to Poland and Bulgaria, for example, may just be the beginning of Russian retaliation against NATO member states. The slow pace of the Russian offensive in the Donbass may increase the risk of a broader mobilization of Russian reserves. And the recent disclosure that the United States assisted Ukraine in conducting targeted strikes on senior Russian military leadership may further escalate tensions with NATO. Therefore, even issuers with no present nexus to either Ukraine or Russia should carefully consider the downstream effects of the conflict, particularly for agriculture, shipping, and raw materials.
b. The SEC Focus on Supply Chains
The subject of supply chains, meanwhile, deserves particular attention. Supply chain disruption is discussed in the Pandemic Guidance, but in nowhere near the level of detail provided in the Sample Letter. Issuers should therefore recognize that the SEC is laser-focused on supply chain disclosures. The Sample Letter contains no fewer than twelve references to supply chains—including questions about interruptions in consumer demand, costs of raw materials, downstream effects on prices, lost revenue, disclosure controls, and internal controls.
The Sample Letter also marks the first time, to our knowledge, that the SEC has discussed, let alone suggested it may request information on, the “de-globalizat[ion]” or de-risking of a company’s supply chain. Many companies took steps during the pandemic to diversify their supply chain. But those efforts were a response to market conditions, not regulatory demands. It appears the SEC has now taken these market developments and identified them as a suggested response to geopolitical instability. Taken to their logical conclusion, these statements in the Sample Letter arguably counsel that issuers facing supply-chain difficulties in Ukraine and Russia need to reduce reliance on key suppliers therein.
c. Sanctions Compliance and OFAC Investigations
There is also the issue of sanctions. The Sample Letter arguably requires companies with substantial operations in Russia to disclose their exposure to the sanctions regime. Companies must ensure that any disclosures made in response to this SEC recommendation are fulsome and accurate. In particular, issuers should be wary of overly broad statements regarding the adequacy of their sanctions compliance function, as language describing such a program as “robust” or “well-resourced,” without more, could be problematic if violations later come to light.
Moreover, the Office of Foreign Asset Control (“OFAC”) and the Department of Justice have settled numerous high-profile investigations in recent years over sanctions violations. While shareholder litigation over sanctions violations and sanctions compliance are relatively rare, such claims are not unheard of. For example, in September of 2011 the Louisiana Municipal Police Retirement System brought derivative claims against JP Morgan Chase, alleging that the company’s $88 million settlement agreement with OFAC in 2011 was the product of reckless business decisions and a breach of fiduciary duty. (See Complaint, Louisiana Municipal Police Employees Retirement System v. Dimon, et. al., No. 1:11-cv-06231 (S.D.N.Y. 2011)). Issuers must therefore carefully monitor their exposure to the Russia sanctions regime, and ensure their sanctions compliance function has adequate resources and comports with prevailing best practices.
IV. THE NEXT DOMINO – TAIWAN
We now turn from the present to the future, and analyze what we consider the most significant geopolitical risk that issuers may face in the future: a decision by the PRC to militarize the “One China” policy, and invade Taiwan. Below, we build on our previous discussions of Covid-19 and Ukraine, to explain how a potential move by the PRC in Taiwan would create disruptive effects on a far greater scale. We begin with a brief summary of the Taiwan-PRC relationship, and identify threats to the status quo. We then discuss the potential implication of an invasion of Taiwan, focusing on the impacts on shipping, trade, and supply chains. With the Sample Letter and the Pandemic Guidance as a backdrop, we then close with a discussion of best practices for issuers to consider in disclosing Taiwan-related risks, and recommendations for avoiding future litigation.
A. The Historical Background
The current PRC-Taiwan relationship began in 1949. When PRC founder Mao Zedong defeated the nationalist forces of Chiang Kai-Shek, Chiang and more than one million others fled to the island of Formosa, and established the Republic of China (Taiwan). The PRC considered Taiwan part of China, and vigorously contested independence—a stance that became known as “One China.” Indeed, in early 1950 the PRC began amassing troops for an invasion. The outbreak of war on the Korean Peninsula in 1950 led to the deployment of U.S. naval assets to the South China Sea, as a deterrent against conflict.
With China focused on internal developments, the situation with Taiwan evolved to an ongoing stalemate. The situation changed in the early 1970s. Mao and then-U.S. President Richard Nixon signed the Shanghai Communique—where the U.S. acknowledged, but did not endorse, the One China policy. Then in 1979, the U.S. formally recognized the PRC, while abrogating a mutual defense treaty with Taiwan. Since the formal recognition of the PRC, the relationship between Taiwan and the PRC has consisted of long periods of stable tension, punctuated by bursts of substantial hostility. However, that hostility never escalated to open conflict. Meanwhile, the U.S. developed strong informal relationships with Taiwan, and continued to provide Taiwan with access to modern weapons and tactics.
B. Threats to the Status Quo
In light of this lengthy history of stable relations, it may be reasonable to ask why there is a risk of instability. The answer is simple. Since emerging as a global power during the U.S. subprime mortgage crisis in 2008, the PRC has increasingly projected its influence outside of its territorial boundaries, while also becoming more vocal about its right to govern Taiwan, and the “sacred” relationship between the PRC and its former territory. And to some extent, the Russian Federation has “broken the ice” on post-Cold War conventional engagements by invading Ukraine—making subsequent conflict more likely. It is worth noting that the PRC failed to condemn the Russian invasion of Ukraine—perhaps because of the potential parallels with a future invasion of Taiwan.
- Military Developments
From a military perspective, the PRC has increased its defense budget by an annual average of nearly eight percent. The PRC has invested heavily in submarines, missile-capable surface combatants, armored vehicles, and amphibious transports—all necessary components of a cross-Strait maneuver. The PRC has also invested in capabilities to deny any opposing Navy access to the Taiwan Strait in the event of a conflict. Most importantly, the PRC has repeatedly tested in recent years anti-ship ballistic missiles capable of reaching targets at up to 2,000 miles. These weapons systems may allow the PRC to deny access to the South China Sea. Finally, the PRC recently negotiated an agreement with the Solomon Islands—a strategically-placed island chain in the South Pacific proximate to Australia—that allows the island government to request PRC military assistance.
- Political Messaging
These military efforts have coincided with increasingly militarized messaging from PRC leadership on the “One China” policy. Chinese military writings have long advocated for a force structure that could successfully conduct a “large-scale, relatively high-intensity” conflict to “safeguard the reunification of the nation.”
Meanwhile, PRC political elites have made numerous public statements about pending efforts to enforce the “One China” policy. On October 9, 2021, for example, President Xi Jinping called for “peaceful reunification” with Taiwan, emphasized the “glorious tradition” of resisting “separatism” among the Chinese people, and emphasized that “Taiwan independence separatism is the biggest obstacle to achieving the reunification of the motherland, and the most serious hidden danger to national reconciliation.”
Based on these statements and many others, the Department of Defense has identified the PRC as the only country “capable of combining its economic, diplomatic, military, and technological power to mount a sustained challenge to a stable and open international system.” The Department of Defense has also determined that the PRC intends to possess the ability to seize Taiwan no later than 2027.
C. Relevant Characteristics of Conflict in the Taiwan Strait
Given the strategic importance of the PRC to U.S. corporate supply chains, it is critical for issuers to understand the likely ramifications of a potential PRC invasion of Taiwan. It is also critical for issuers to examine the challenges that such a conflict would create for maintaining corporate operations and supply chain integrity.
- Limited Warning
The first key feature to note is that issuers should not expect a prolonged build-up of forces. Taiwan possesses long-range weapons capable of striking targets in the PRC. Taiwan is actively seeking to bolster its standoff strike capability, and the U.S. and other nations have provided assistance. It is therefore highly unlikely that PRC leadership will endorse any operational plans that give Taiwan a lengthy period of advanced notice. Issuers should instead anticipate that a crisis in the Taiwan Strait could develop very quickly, and may not offer much time to respond. Issuers with extensive operations and expatriate populations in the PRC and Taiwan may therefore wish to consider contingency plans that can be implemented on short notice.
- Disruption to Satellite Communications and GPS
Regardless of how the U.S. responds, a PRC move against Taiwan is likely to result in satellite and GPS disruption. Without satellite access, it will be extremely difficult for Taiwan’s leadership to communicate with the outside world. The PRC is also likely to note that in Ukraine, access to commercial satellites was key to the generation of global support.
In 2020, the U.S. Department of Defense (“DOD”) published its annual report on military developments in the PRC. The report suggests that in the event of an invasion, the PRC is likely to disable not just commercial and military satellites in Low-Earth Orbit, but also to strike navigation, reconnaissance, and communications satellites in geosynchronous orbit. In terms of practical effects, this means that Taiwan and the mainland PRC may be beyond the reach of most communication methods from the Continental U.S. This will obviously make it difficult for issuers to communicate with employees, subsidiaries, and suppliers in the PRC and Taiwan.
- Cyberattacks on Key Institutions
Along the same line, any move by the PRC in the Taiwan Straits is likely to feature cyberattacks against Taiwanese and PRC government institutions, military networks, and civilian infrastructure. While intelligence on Chinese cyber-warfare capabilities is highly restricted, open-source intelligence suggests that were the PRC to move on Taiwan, it would coordinate lethal force deployments with a carefully scripted cyber offensive designed to cripple air defense, electrical power, mobile communications, and food distribution. Taiwan is likely to retaliate with a similar offensive.
- Denial of Access to the South China Sea
If the PRC moves on Taiwan, issuers can expect both states to deploy submarines, surface vessels, anti-ship ballistic missiles and other “over the horizon” strike capabilities. The implications for ocean-going trade is at once simple, and terrifying.
Because both states possess significant quantities of long-range anti-ship missiles, a PRC invasion of Taiwan could result in a termination of all commercial shipping within 1,500 nautical miles of Taiwan. Issuers would not only lose access to the PRC, but also to ports and markets in Japan, the ROK, Vietnam, Thailand, and Indonesia. It is also highly unlikely that insurers would underwrite any coverage for vessels transiting the Pacific, given the distinct possibility that either Taiwan or the PRC would misidentify a merchant vessel as a combatant. The same is likely true for air freight passing within missile range of the PRC or Taiwan borders.
- Nationalization of Critical PRC Resources
A final feature of a PRC-Taiwan conflict is the likely nationalization of PRC natural resources and manufacturing facilities owned by western companies, or controlled by U.S.-PRC joint ventures. The same is true for manufacturing facilities used by U.S. issuers to source production from private PRC entities. In the event of an invasion of Taiwan, the PRC is likely to seize these facilities, and issuers are unlikely to have any viable means to recover resulting losses.
D. Implications of Taiwan for Disclosures and Shareholder Litigation
These disruptive effects—which have the aggregate potential to destabilize the global economy—make the risk of a Taiwan invasion an important risk for issuers to evaluate. The Pandemic Guidance and Sample Letter provide a valuable blueprint for doing so. More specifically, the SEC’s request that issuers analyze supply chain disruption, access to debt and lines of credit, overall liquidity, and “material operational challenges” are all relevant for issuers that (1) conduct substantial business in the PRC and/or Taiwan; (2) source a significant percentage of raw materials and finished goods from the PRC and/or Taiwan; or (3) rely on Taiwan for semiconductors.
- Proactive Disclosures of Taiwan-Related Risk
To that point, several issuers already identify and disclose the risk of a conflict in the Taiwan Strait to their shareholders. Best Buy, for example, disclosed in its most recent 10-K filed on March 18, 2022 that “further deterioration between Taiwan and China” could disrupt the manufacture of “hardware components in the region.” Similarly, Gravity Co. Ltd. filed a Form 20-F on April 28, 2022 that noted “a significant percentage of  revenue” came from customers in Taiwan, and therefore “an increase in tensions between Taiwan and China and the possibility of instability and uncertainty” could affect customer demand, and the business in general. And Micron Technology Inc., in its March 30 Form 10-Q, disclosed “political and economic instability, including the effects of disputes between China and Taiwan” as a risk to international sales and operations.
Note once again that these disclosures are concise, and relatively broad—but nonetheless provide enough information to allow shareholders to understand the potential risks of conflict between the PRC and Taiwan. They also satisfy the expectation the SEC set forth in the Pandemic Guidance and Sample Letter—that issuers carefully consider, and where necessary disclose, risks created by unanticipated crises. Should the PRC move on Taiwan, these issuers arguably already have in place some protection against shareholder claims.
- Mitigating Potential Litigation Risk
Obviously, for issuers that do not face any potential risks related to Taiwan, or that do not do business in our source from the PRC, disclosure is not required. And given that an invasion of Taiwan is a potential, rather than an actual geopolitical risk, there are obviously no cases as exemplars of what can happen if issuers fail to identify and disclose the potential downstream effects. There are nonetheless steps that issuers can take, short of making a Taiwan-related disclosure, to mitigate the risk of future shareholder claims.
a. Review all Statements Referencing Supply Chains
As an initial matter, issuers should look beyond risk disclosures, and review all statements in public filings that address supply chain integrity. In particular, language that reassures investors that a company has, by way of example, a “robust” or “diverse” supply chain should be carefully vetted against the company’s actual network of suppliers and vendors. If a company sources the majority of its raw materials or finished goods from the PRC, for example, the use of broad descriptive language may require caveats that inform shareholders about the concentration of suppliers in a specific market.
b. Consider Single Points of Failure and Inventory
Companies should also be cognizant of any single points of failure in their supply chain. For example, Taiwan’s market-leading position as a manufacturer of semiconductors creates a failure point for manufacturers and end-users that rely on advanced computers and devices. If these companies lost access to Taiwan, the downstream impact would be severe. This likely explains the decision of Best Buy to disclose the risk of a conflict in the Taiwan Strait, even absent a present threat.
Similarly, issuers that depend on frequent deliveries from the PRC should evaluate the impact of a cessation of China-based shipping. If an issuer utilizes “Just in Time” inventory management and relies exclusively on the PRC or Taiwan for critical components or finished goods, any change in PRC-Taiwan relations will be highly disruptive, and may require amendments to existing risk disclosures.
The SEC’s comments in the Pandemic Guidance and the Sample Letter make this even more critical. These two documents, read together, demonstrate the SEC’s concerns that companies ensure their stockholders are aware of material supply chain vulnerabilities. The Sample Letter in particular shows that the SEC is highly attuned to supply chain risk, and encourages companies to respond rapidly to geopolitical crises by diversifying supply chains and, where necessary, by reshoring production. The Sample Letter also suggests that issuers that continue to reply on suppliers in markets with potential exposure to supply chain risk, or, even worse, with the potential for geopolitical conflict, could face regulatory scrutiny if they fail to disclose and ultimately mitigate these risks.
Indeed, the failure to consider and address these issues could give rise, not just to shareholder litigation, but to stockholder derivative lawsuits asserting that a board of directors failed to provide adequate oversight. Claims of this nature, also called Caremark claims (based on In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996)) are “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” (Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).
Nonetheless, in 2019 the Delaware Supreme Court reversed the dismissal of a Caremark claim related to a listeria outbreak at an ice cream manufacturing plant. Subsequently, a few other Caremark cases have survived motions to dismiss, including cases involving Clovis Oncology, a subsidiary of AmerisourceBergen, and Boeing. These cases have all involved alleged failures of oversight with respect to “mission critical” functions that resulted in the issuers violating positive law.
It is possible, however, that stockholder might bring a Caremark claim based on a failure of oversight with respect to a “mission critical” function that does not violate positive law but which impacts the operational viability of the company. Under that scenario, there is a risk of stockholder derivative litigation for failure of oversight with respect to single points of failure in a company’s supply chain.
c. Carefully Monitor Developments in Asia
Issuers should also carefully monitor developments in the PRC and Taiwan, and not blindly assume that prior stability or economic interests will prevent future conflict. In the event that either the PRC or Taiwan begin deployments similar to the movement of Russian troops toward Ukraine, issuers should immediately consider whether to (1) amend existing disclosures to identify new material risks, and (2) assess the need to issue a new filing to inform investors of future threats to earnings. To ensure any necessary amendments can be rapidly published to investors, companies should ensure that the accountants and attorneys responsible for preparing SEC filings have full visibility into vendors, suppliers, and supply chain risks.
 There have been many lawsuits alleging securities fraud related to the Covid-19 pandemic. We focus on issues related to supply chain disruptions in this article because those issues are most likely to apply to both the Russian invasion of Ukraine and a potential conflict between the PRC and Taiwan. There are obviously other operational and customer-focused effects of these developments that we do not address here.
 On February 4, 2022 the PRC and the Russian Federation issued the “Joint Statement of the Russian Federation and the People’s Republic of China.” The statement, published with President Putin in Beijing for the Winter Olympics, expressed support for the “One China” policy, and also expressed support for the right of Russia to secure its borders from NATO—an implicit reference to Ukraine. See Joint Statement of the Russian Federation and the People’s Republic of China, February 4, 2022, available at http://en.kremlin.ru/supplement/5770.
 See Shou Xiaosong, ed., The Science of Military Strategy (Beijing, China: Military Science Press, 2013). Translation.
 The reader should note that the following analysis of supply chain effects of a Taiwan invasion is limited to a bilateral engagement between the PRC and Taiwan. Real-world scenarios will obviously differ, and may include intervention by the U.S., Australia, Japan, and/or the Republic of Korea. Such intervention would, of course, magnify the downstream impacts on U.S. companies.
This post comes to us from Katten Muchin Rosenman LLP. It is based on the firm’s article, “Managing Shareholder Litigation Risk in an Unstable Geopolitical Environment.