Abstract
Item 503(c) of the United States Securities and Exchange Commission’s (SEC’s) Regulation S-K requires firms to disclose the ‘most significant’ factors that affect them in their Item 1A risk factor disclosures made in their 10-K (annual) or 10-Q (quarterly) SEC filings. Prior to COVID-19, firms discussed risk factors such as liquidity, competition, etc. as part of their Item 1A disclosures. The current pandemic has resulted in the COVID-19 risk factor being widely discussed as part of firms’ Item 1A risk factor disclosures. A ‘firm-specific’ discussion on this transient risk factor is unique in the sense that it can affect the salience of other, already disclosed, less transient but significant risk factors to investors and other stakeholders. Using a sample of 68 firms hard hit by COVID-19 with prior poor performance, I find that market reactions to their Item 1A risk factor disclosures were significantly more positive for firms that disclosed the COVID-19 risk factor in a certain firm-specific manner compared to those that didn’t. These results suggest that stakeholder perceptions of firms’ risk profiles are being biased to some extent as the less transient but other significant risk factors that were already affecting these firms seem to be underweighted by them in evaluating the firms’ risk profiles. I explain this bias further using the meta-theoretical framework of the elaboration likelihood model. I also propose a solution to this problem that involves making these disclosures in the form of risk matrices.
Keywords
Overview and Institutional Background
In this paper, I seek to determine whether firms are biasing stakeholder expectations by attributing prior poor performance to the COVID-19 (C-19) pandemic through their Item 1A risk factor disclosures made in their 10-K (annual) or 10-Q (quarterly) United States Securities and Exchange Commission’s (SEC’s) filings. I argue and predict that firms with prior poor performance that were ‘hardest hit’ by the pandemic had an incentive to disclose the C-19 risk factor in a certain firm-specific manner that, in turn, affected stakeholder perceptions of other significant risks that were already negatively affecting the performance of these firms. I find results consistent with my predictions. Specifically, I find that market reactions to Item 1A risk factor disclosures were significantly more positive for the hardest hit C-19 firms with prior poor performance if they disclosed the C-19 risk factor in a certain firm-specific manner compared to those that didn’t. Thus, investors of the former group of firms seemed to have been detracted from making normative assessments of the firms’ true risk profiles.
Item 503(c) of the SEC’s Regulation S-K requires firms to disclose the ‘most significant’ factors that affect them in their Item 1A risk factor disclosures made in their 10-K or 10-Q SEC filings (SEC, 1998, 1999). 1 It is widely documented that firms engage in a firm-specific discussion on only some of the risk factors (hereafter referred to as ‘specific risk factors’) and not on others (hereafter referred to as ‘general risk factors’), thus creating a potential for biases in what investors and other stakeholders can take away from these disclosures about a firm’s overall risk profile (Bao & Dutta, 2014; Campbell et al., 2014; SEC, 2016). Firms are also known, at times, to give a lengthy boilerplate explanation of relevant risk factors (Beatty et al., 2019). The incomplete revelation associated with the readability of different sections of firms’ annual reports has always been a concern (Bloomfield, 2002); for example, Jayasree and Shette (2021) find, in the context of Indian banks, that firms with weak performance structured their reports to cover up the causes of poor performance.
We have seen many examples of different ways in which information has been obfuscated during the pandemic (Das & Ahmed, 2021). The current pandemic has resulted in the C-19 risk factor being widely discussed as part of firms’ Item 1A risk factor disclosures. A firm-specific discussion on this risk factor is unique in the sense that it can affect how other already disclosed significant risk factors are perceived by investors and other stakeholders. Specifically, the C-19 risk factor can have an effect of decreasing the perceived likelihood of other significant risks disclosed by a firm in their Item 1A disclosures if a firm engages in a lengthy firm-specific discussion on this risk factor, thus making it more salient compared to the others that are discussed more generally. However, it is important to remember that these other risks disclosed were always relevant to the firm’s risk profile, and the pandemic may have actually exacerbated them.
Prior to C-19, firms discussed risk factors such as liquidity, competition, etc. as part of their Item 1A disclosures. All these aforementioned risk factors were ‘significant’ based on the SEC rules (Hope et al., 2016), and were thus representative of the firm’s overall risk profile. Moreover, these risk factors were separately discussed, either in a general or in a firm-specific manner, with minimal to no overlap.
I believe my paper contributes to the literature on risk factor disclosures and the impact of the C-19 pandemic, which is an understudied topic area. I believe the results from my study are timely, and they help inform stakeholders and regulators about how these disclosures can affect the way a firm’s performance and risk profile are judged by the market.
Theory
I use the meta-theoretical framework of the elaboration likelihood model (ELM) from prior psychology research (Petty & Cacioppo, 1986a, 1986b) for interpreting and understanding how a firm-specific discussion of the C-19 risk factor as part of a firm’s Item 1A risk factor disclosures might affect stakeholder judgments on a firm’s risk profile. The ELM discusses how attitudes (here, evaluation of a firm’s risk profile) may be formed and changed by careful consideration and integration of information (here, the risk factor disclosures of the firm) relevant to the target object (here, the firm). Attitudes influence individual judgments by shaping their perceptions of the target object (Griffith et al., 2018; Krosnick & Petty, 1995).
The ELM posits that variables such as information source quality and credibility can affect individual attitudes, and in turn their judgments, positively or negatively by indirectly determining an individual’s level of elaboration (i.e., amount of thought or cognitive motivation). A higher (lower) level of elaboration leads to better (worse) judgments since individuals make more (less) reasoned judgments due to (lack of) enhanced thinking. However, higher elaboration can lead to higher quality judgments, provided the enhanced thinking is not biased (Petty et al., 1995; Wegener et al., 1994).
In the context of this paper, the disclosure of risk factors and a firm-specific discussion on some of them provides stakeholders with an information source that they may believe is of quality and is credible. This may result in higher elaboration by stakeholders (e.g., investors and analysts) because they are interested in evaluating a firm’s risk profile. 2 However, if the information source quality and credibility is negatively affected by the C-19 risk factor being more representative than other general but significant risk factors, then the higher elaboration will result in stakeholders making biased evaluations of a firm’s risk profile. This type of situation undermines the purpose for which risk factor disclosures are made by firms in the first place.
Let’s take the example of J.C. Penney Inc., a department store chain with hundreds of physical stores across the United States, that was taken private in 2020 by Brookfield Property Partners and the Simon Property Group after it filed for Chapter 11. Since 2017, J. C. Penney had been closing store locations due to high competition within the industry. In 2018–19, J. C. Penney closed more than 100 of its stores, with analysts predicting more store closures to come in 2020. One can reasonably discern that the company was experiencing some difficulty to stay relevant within the industry and had been struggling for the past few years now. The C-19 pandemic merely exacerbated these challenges that the company was already facing.
In its Item 1A risk factor disclosures made in the last 10-K that the company filed on March 2020, J. C. Penney discussed its concerns with respect to the pandemic in great detail as the first risk factor and the potential effect it would have on the company’s business. The disclosed C-19 risk factor, in this case, was merely exacerbating an issue that J.C. Penny seems to have been experiencing for years until the start of the pandemic (Hirsch, 2020). Thus, a firm-specific discussion of the C-19 risk factor in this fashion may have influenced stakeholder perceptions by making other significant risk factors disclosed less salient, thus, attributing the prior poor performance of the company to the pandemic and not poor business decisions.
Let’s look at another example. In the Item 1A risk factor disclosures made in its recent 10-Q filing on October 2020, Bed Bath & Beyond Inc. discussed the C-19 risk factor as the first risk factor and engaged in a lengthy firm-specific discussion on how the pandemic negatively impacted its business operations and how that could negatively impact the company and its earnings. The company, in one of the other significant but more generally discussed risk factors, talked about how they are in a serious amount of debt and may experience difficulty in making interest and principal payments. However, in its discussion of the C-19 risk factor, the company also attributed the financial trouble it is facing due to the C-19 pandemic and mentioned it as the main cause behind the difficulty in servicing its debt. However, the financial distress faced by the retailer was evident long before the pandemic. Earlier in 2020, the company had failed to meet investor expectations for the year-end financial targets, causing an 11% drop in its stock price (Meyersohn, 2020).
Another relevant example is that of Biglari Holdings Inc., a holding company that has many subsidiaries that include Steak ‘n Shake, Western Sizzlin’, First Guard Insurance and Maxim Magazine. In its 10-K filed on March 2021, the company engaged in a lengthy firm-specific discussion on the C-19 risk factor and how it has adversely affected and will be adversely affecting its business operations and financials. Even in this case, the company was facing financial troubles long before the pandemic started. It was reported that Steak ‘n Shake restaurants had been closing by the hundreds across the United States since 2019 along with many Western Sizzlin’ restaurants (Maze, 2019).
To sum it up, I hypothesize that:
One reason why firms might engage in a more specific discussion on the C-19 risk factor vis-à-vis other general risk factors is because they may genuinely believe that the C-19 risk factor is more important or pressing with respect to the firm’s situation. Firms may have no motivation to misinform stakeholders or obfuscate their true risk profile. However, the manner in which these disclosures are made in practice may still result in the representativeness of the C-19 risk factor being made more salient than other general but significant risk factors, resulting in biased stakeholder judgments on the firm’s risk profile. The SEC has been concerned about how Item 1A risk factor disclosures are being made for quite some time and have also invited comments from stakeholders in its concept release on this topic, though it didn’t follow through with any of the submitted comments at the time (SEC, 2016). Thus, the issue of management accountability and fair reporting practices with respect to these disclosures still persists.
Sample, Research Design, Tests and Results
Sample
The impact of the C-19 pandemic is confounded with several other factors that occurred at the same time, such as political instability, supply chain disruptions, migration to technology, U.S. treasury yield curve inversion, stock market crash, etc. To establish causality and isolate the specific impact of C-19 on firm performance, I identify and include 71 firms in the full sample if they were mentioned by at least one or more major U.S. business media sources as being specifically impacted by the pandemic. Some examples of relevant U.S. business media sources that were searched include BLOOMBERG, CNBC, CNN, DNB, FINANCIAL TIMES, FORBES, FOX, MORNINGSTAR, REUTERS, WALL STREET JOURNAL, ETC. The search was first performed using the LexisNexis and ProQuest digital news archives. However, since these archives are known to miss several stories (Weaver & Bimber, 2008), I also supplemented the search through the Google News web portal.
Table 1 Panel A provides a break-up of these firms by industry. We can see that ~42% of these firms are from BEACH industries, which is a newly coined term for firms operating in the booking (B), entertainment and live events (E), airlines/aviation (A), cruises and casinos (C), and hotels and resorts (H) industries that were particularly hard hit by the pandemic (Neufeld, 2020). Around 41% of the firms are from retail and the remaining (~17%) are from the oil and gas industry, which also faced significant disruption (Unglesbee, 2020; Wood, 2020). I do not include other firms from these industries since they may not have been specifically affected by C-19 or they may have changed their business models effectively to contend with the situation (e.g., Walmart immediately expediting its move to an ecommerce business model and putting up a superior performance during the pandemic).
Sample Selection.
As the next step, I determine which firms out of the 71 in my full sample do not have prior poor performance. Based on prior accounting studies (Comiskey & Mulford, 2010), I remove three firms having no indication of prior poor performance in any of the three years immediately preceding the start of the C-19 pandemic (2017, 2018 and 2019), based on (a) year-over-year revenue, operating income, or net income degrowth, (b) net losses, or (c) substantial decline (greater than 25%) in market capitalization. 3 Thus, my final sample comprises 68 firms.
Table 2 provides descriptive statistics for the final sample of 68 firms, all of whom included a discussion of the C-19 risk factor in their 10-K (annual) or 10-Q (quarterly) SEC filings. We can see that 45% of the firms made a ‘firm-specific’ disclosure of the C-19 risk factor in their Item 1A disclosures, while the remaining firms discussed it more generally. This result demonstrates how pervasive the discussion of the C-19 risk factor has been as part of firms’ Item 1A risk factor disclosures. In Appendix 1, I provide an example of a firm discussing the C-19 risk factor in a ‘firm-specific’ manner and another example of a firm discussing it more ‘generally’ (in which case the discussion would apply to any other firm in the same industry).
Descriptive Statistics.
We can also note that a median firm in my final sample had a market capitalization of $7.5 billion, 11 analysts following it, a three-day cumulative abnormal return of 1.6% immediately following the disclosures and included an appropriate discussion on the C-19 risk factor in its SEC filings (Item 1A) around 408 days since the pandemic started in January 2020 in the United States.
Research Design
To test whether firms hard hit by the C-19 pandemic that have prior poor performance have positive market reactions to their risk factor disclosures if they make a firm-specific disclosure of the C-19 risk factor, I construct the following indicator variable: Firm-specific C-19 risk factor disclosure, which equals 1 if a firm discloses the C-19 risk factor in a firm-specific manner in its Item 1A risk factor disclosures, and 0 otherwise. The key dependent variable is Cumulative Abnormal Returns (+1 to +3), which captures the three-day cumulative abnormal return immediately following a firm’s Item 1A disclosures in its 10-K or 10-Q SEC filings. These returns are measured relative to the S&P Composite 1500 index. 4
I estimate the following baseline economic model in Model (1) for the final sample, and a significantly positive coefficient on β1 suggests that the firms in my sample exhibit positive market reactions to their risk factor disclosures if they make a firm-specific disclosure of the C-19 risk factor.
This finding would suggest that investors, despite the higher elaboration in this setting, make biased risk assessments of these firms due to the salience of the transient but firm-specifically discussed C-19 risk factor, making them downplay the likelihood of other less transient but ‘significant’ risks that these firms disclose.
Following prior studies, I control for the following variables that may play a role in affecting firms’ cumulative abnormal returns: (i) Firm size, which is proxied using logged market capitalization (larger firms face a higher scrutiny from stakeholders); (ii) Analyst following (the more analysts following a firm, the more complete its information environment); and (iii) Proximity of disclosures to C-19 start, which captures the number of days since the 10-K or 10-Q SEC filing that included the C-19 risk factor disclosure was made after the pandemic started on 15 January 2020 (stock returns have varied significantly closer to the date of the pandemic). 5 I also include industry fixed effects in the analysis to control for any industry differences in returns.
Tests and Results
I begin by presenting results from the univariate t-tests of means. From Table 3, I find that the mean value of CAR (+1 to +3) is significantly higher (t = 4.38***, ρ < 0.01) when the value of the Firm-specific C-19 risk factor disclosure variable equals 1 (M = 0.0540, SD = 0.066) vis-à-vis when the variable equals 0 (M = -0.008, SD = 0.051). This shows that firms in my sample that discussed the C-19 risk factor in a firm-specific manner exhibited a positive mean cumulative abnormal return of 5.40%, which was significantly greater than the negative mean cumulative abnormal return of -0.80% experienced by firms that discussed this risk factor more generally. Thus, my evidence is consistent with my prediction in H1.
Univariate Results.
In Table 4, I report results from estimating the regression in Model (1) using ordinary least squares. I find that the coefficient on β1 is significantly positive in both columns, which suggests that firms hard hit by C-19 that had prior poor performance experienced a higher cumulative abnormal return in the three days immediately following their Item 1A disclosures if they engaged in a firm-specific discussion of the C-19 risk factor rather than discussing it generally (consistent with H1). This finding corroborates my argument that investors of these firms failed to appropriately assess their risk profiles, and they seemed to have underweighted other non-pandemic but ‘significant’ risks that affect these firms and are responsible for their prior poor performance. As a robustness check, I also winsorize the dependent variable CAR at the 5% level and re-rerun the regression to ensure that my results are not driven by outliers. The results remain qualitatively the same with the winsorized data.
Market Reactions to Firm-specific COVID-19 Risk Factor Disclosures.
I also find a weakly significant but positive coefficient on the Proximity of disclosures to C-19 start variable. This finding, which suggests that the longer the date of the C-19 risk factor disclosure from the start of the pandemic the higher the cumulative abnormal return following the disclosure, is quite intuitive. This is because the farther out the C-19 risk factor disclosure is made from the start date of the pandemic, the more information stakeholders would have in terms of how it impacts their focal firms, resulting in a lower risk assessment and thus a greater market adjusted return.
Risk Matrices—A Possible Solution
There is a genuine need to ensure that firms present a risk matrix accompanying the Item 1A disclosures to aid stakeholders in gauging a firm’s true risk profile and prevent firms from attributing poor prior performance to transitory factors, such as a pandemic. An example of such a risk matrix is presented in Figure 1. This additional information presented in the matrix will make it possible for investors to link a particular risk factor on which the management has engaged in a firm-specific discussion to its position in the risk matrix (Cox, 2008). It may also mitigate stakeholder biases in evaluation of a firm’s risk profile to some extent because they will now be able to quickly assess the relative likelihood and impact of a risk factor.
Moreover, the risk matrix framework also helps to solve the ‘lengthy’ and ‘boilerplate’ problem of these disclosures as investors can now choose to focus on the upper-right corner of the matrix highlighted in red regardless of the number or type of risk factors disclosed. Some risk factors may be more permanent in nature while others may be more transient, and the risk matrix may be tailored accordingly. Moreover, the relative impact of transient risk factors (e.g., the C-19 pandemic) on non-transient risk factors may also be disclosed by adding another dimension to the risk matrix.
What is interesting about the C-19 risk factor at this point is that it would be considered to have a ‘high’ relative impact and a ‘low’ relative likelihood (since it is a pandemic), and thus would be assigned to the lower-right (green) corner of the risk matrix. However, if the pandemic turns into an endemic in the future (CNBC, 2021), the C-19 risk factor would be considered to have a ‘high’ relative impact but a ‘high’ relative likelihood, and it may end up being assigned to the upper-right (red) corner of the risk matrix or, if its impact attenuates over time, to the lower-left (yellow or green) areas of the risk matrix.
Conclusion
I conclude that firms hard hit by the C-19 pandemic and with poor prior performance biased stakeholder perceptions of their risk profiles by engaging in a firm-specific discussion on the transient C-19 risk factor and making it more salient than other less transient but significant risk factors disclosed in their Item 1A risk disclosures that were already affecting their performance. I also propose an un-tested risk matrix framework that could be used to mitigate this bias to some extent.
Future research can examine how different risk factor disclosures in the form of risk matrices affect stakeholder evaluations of a firm’s risk profile and reinforce the early inferences drawn in this paper. Since country-level factors can also affect corporate disclosures (Roy & Ghosh, 2019), I believe this study needs to be replicated in other geographical jurisdictions with unique institutional settings, in which my findings may not be generalizable. At some point in the future, with adequate archival data available, researchers may also be able to conduct a more longitudinal analysis in the form of an event study to determine how the C-19 risk factor disclosures changed after the effect of the pandemic mitigates to a large extent or when it turns into an endemic.
Footnotes
Declaration of Conflicting Interests
The author declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The author received no financial support for the research, authorship, and/or publication of this article.
Appendix 1
An Example of a ‘Firm-specific’ versus ‘General’ C-19 Risk Factor Discussion
Item 1 A. Risk Factors
In addition to the other information contained in this annual report, you should carefully consider the following risk factors in evaluating our business. If any of the risks discussed or additional risks and uncertainties not currently known to us or that we currently deem to be immaterial actually occur, our business, financial condition and results of operations could be materially adversely affected. The COVID-19 pandemic has also had the effect of heightening many of the risks described below. The ordering of the risk factors below is not intended to reflect an indication of priority or likelihood. In connection with the forward-looking statements that appear in this annual report, you should also carefully review the cautionary statement referred to under “Cautionary Statement Concerning Forward-Looking Statements.”
COVID-19 and Debt/Liquidity Related Risk Factors
COVID-19 has had, and is expected to continue to have, a significant impact on our financial condition and operations. The current, and uncertain future, impact of the COVID- 19 pandemic, including its effect on the ability or desire of people to travel (including on cruises), is expected to continue to impact our results, operations, outlook, plans, goals, growth, reputation, cash flows, liquidity, demand for voyages and share price.
The spread of COVID-19 and the developments surrounding the global pandemic are having significant negative impacts on all aspects of our business. In March 2020, we implemented a voluntary suspension of all cruise voyages across our three brands, which has subsequently been extended through May 31, 2021. We are currently expecting a gradual phased relaunch of cruise voyages in the future, but due to the uncertainties surrounding the COVID-19 pandemic, the suspension may be extended again or could potentially be reinstated after we have begun sailing, and the total length of the suspension may be prolonged. In addition, we have been, and will continue to be, further negatively impacted by related developments, including heightened governmental regulations and travel advisories, including recommendations and orders by the U.S. Department of State, the CDC and the Department of Homeland Security, and travel bans and restrictions, each of which has impacted, and is expected to continue to significantly impact, global guest sourcing and our access to various ports of call around the globe. On October 30, 2020, the CDC issued a Conditional Order that introduces a phased approach for the resumption of passenger cruises. We continue to work through the requirements of the Conditional Order, but as currently drafted, it is unclear whether we will be able to comply with the Conditional Order and the timing for our ability to resume cruises is therefore uncertain. Additionally, compliance with the Conditional Order may involve significant costs and could create significant uncertainties about our ability to continue to operate our cruise voyages once sailing resumes. We will continue to incur COVID-19 related costs as we implement additional health-related protocols on our ships, such as physical distancing measures, which may have a significant effect on our operations. In addition, the industry will be subject to enhanced health and safety requirements which may be costly and take a significant amount of time to implement across our fleet. There is no guarantee that the health and safety protocols we implement will be successful in preventing the spread of COVID-19 onboard our ships and among our passengers and crew.
To dale, the COVID-19 pandemic has resulted in significant costs and lost revenue as a result of the suspension of cruise voyages, reduced demand for cruise vacations, guest compensation, itinerary modifications, redeployments and cancellations, travel restrictions and advisories, the unavailability of ports and/or destinations, costs to return our passengers to their home destinations and expenses to transport our crew to and from our ships and to assist some of our crew that have been unable to return home in an optimal time frame with food and housing.
We have actively worked to disembark our crew members who will not remain with our ships through the suspension and transport them safely to their home countries, but our ability to transport crew to and from our ships in the future is dependent on a number of factors, including the ability to transport crew members to and from their home countries due to the limited number of commercial flights and charter options available, and governmental restrictions and regulations with respect to disembarking crew members and travel generally. Such restrictions on crew travel could impact our ability to re-staff our ships once operations resume.
Between March 12,2020 and April 30, 2020, three class action lawsuits were filed against us under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-5 promulgated thereunder, alleging that we made false and misleading statements to the market and customers about COVID-19. In addition, in March 2020 the Florida Attorney General announced an investigation related to our marketing during the COVID-19 pandemic. Following the announcement of the investigation by the Florida Attorney General, we received notifications from other attorneys general and governmental agencies that they are conducting similar investigations. We may be the subject of additional lawsuits and investigations stemming from COVID-19. We cannot predict the number or outcome of any such proceedings and the impact that they will have on our financial results, but any such impact may be material.
We have nine newbuilds on order, scheduled to be delivered through 2027. The impacts of COVID-19 on the shipyards where our ships are under construction or will be constructed, have resulted in some delays in expected ship deliveries, and the impacts of COVID-19 could result in additional delays in ship deliveries in the future, which may be prolonged.
Due to the unknown duration and extent of the COVID-19 pandemic, travel restrictions, bans and advisories, uncertainties around our ability to comply with the Conditional Order, the potential unavailability of ports and/or destinations, unknown cancellations and timing of redeployments and a general impact on consumer sentiment regarding cruise travel, there are continuing uncertainties about when our full fleet will be back in service at historical occupancy levels even if we are able to relaunch cruise voyages. Moreover, even after we relaunch our cruise voyages, demand for cruises may remain weak for a significant length of time and we cannot predict if and when each brand will return to pre-pandemic demand or pricing levels. Due to the discretionary nature of leisure travel spending and the competitive nature of the cruise industry, our revenues are heavily influenced by the condition of the U.S. economy and economies in other regions of the world. Unfavorable conditions in these broader economies have resulted, and may result in the future, in decreased demand for cruise vacations, changes in booking practices and related reactions by our competitors, all of which in turn have had, and may continue to have in the future, a strong negative effect on our business. In particular, our bookings may be negatively impacted by enhanced health and safety protocols, including potential vaccination requirements, concerns that cruises are susceptible to the spread of infectious diseases as well as adverse changes in the perceived or actual economic climate, including higher unemployment rates, declines in income levels and loss of personal wealth resulting from the impact of COVID-19. The ongoing COVID-19 pandemic and associated decline in economic activity and increase in unemployment levels are expected to have a severe and prolonged effect on the global economy generally and, in turn, is expected to depress demand for cruise vacations into the foreseeable future. Due to the uncertainty surrounding the duration and severity of this pandemic, we can provide no assurance as to when and at what pace demand for cruise vacations will return to pre-pandemic levels, if at all. Accordingly, we cannot predict the full impact of COVID-19 on our business, financial condition and results of operations. In addition, we cannot predict the impact COVID-19 will have on our partners, such as travel agencies, suppliers and other vendors. We may be adversely impacted by any adverse impact our partners suffer.
As a result of these unprecedented circumstances we are not able to predict the full impact of the COVID-19 pandemic on our Company. In particular, we cannot predict the impact on our financial performance and our cash flows required for cash refunds of fares for cancelled sailings as a result of the effects of the COVID-19 pandemic and the public’s concern regarding the health and safety of travel, including by cruise ship, and related decreases in demand for travel and cruising. Depending on the length of the suspension and number of cancellations, we may be required to provide cash refunds for a substantial portion of the balance of our advanced ticket sales.
Moreover, our ability to attract and retain guests and crew depends, in part, upon the perception and reputation of our Company and our brands and the public’s concerns regarding the health and safety of travel generally, as well as regarding the cruise industry and our ships. Actual or perceived risk of infection could have an adverse effect on the public’s perception of the Company, which could harm our reputation and business.
As a result of the impacts of COVID-19, provisions in our credit card processing and other commercial agreements have and may continue to adversely affect our liquidity. We have agreements with several credit card companies to process the sale of tickets and provide other services. Under these agreements, the credit card companies could, under certain circumstances and upon written notice, require us to maintain a reserve, which reserve would be funded by the credit card companies withholding or offsetting our credit card receivables, or our posting of cash or other collateral. As a result of the impacts of COVID-19, we have seen an increase in demand from consumers for refunds on their tickets, and we anticipate this will continue to be the case for the near future. As of December 31,2020, we had a reserve of approximately $200 million with a credit card processor recognized in other long-term assets, and in January 2021, we provided additional cash collateral of $250 million. Additionally, we are required to fund all refunds until further notice and 100% of incoming advance ticket sales deposits with this credit card processor will be withheld and are not expected to be released until the credit card processor’s exposure is fully collateralized. As of December 31, 2020, the exposure was approximately $780 million. The reserve shortfall of approximately $330 million, after taking into effect the January additional collateral provided, will decrease as refunds are funded, cruises are provided and amounts withheld by the credit card processor are allocated to the reserve rather than remitted to the Company. We may be required to find new credit card processors, pledge additional collateral and/or post cash reserves or take other actions that may further reduce our liquidity. As a consequence, our financial position and liquidity could be further materially impacted.
As a result of all of the foregoing, we will report a net loss for the three months ending March 31,2021 and expect to report a net loss until we are able to resume voyages. Our ability to forecast our cash inflows and additional capital needs is hampered, and we could be required to raise additional capital in the future. Our access to and cost of financing will depend on, among other things, global economic conditions, conditions in the global financing markets, the availability of sufficient amounts of financing, the terms and conditions of our existing debt agreements and any agreements governing future indebtedness, our prospects and our credit ratings. Since March 2020, Moody’s has downgraded our long-term issuer rating to B2, our senior secured rating to B1 and our senior unsecured rating to Caal. Since April 2020, S&P Global has downgraded our issuer credit rating to B+, lowered our issue-level rating on our $875 million Revolving Loan Facility and $1.5 billion Term Loan A Facility to BB, our issue-level rating on our $675 million 2024 Senior Secured Notes and $750 million 2026 Senior Secured Notes to BB- and our senior unsecured rating to B. We anticipate that S&P Global will further downgrade our issuer credit rating to B and lower our senior unsecured rating to B- or CCC+. If our credit ratings were to be further downgraded, or general market conditions were to ascribe higher risk to our rating levels, our industry, or us, our access to capital and the cost of any debt or equity financing will be further negatively impacted. There is no guarantee that debt or equity financings will be available in the future to fund our obligations, or that they will be available on terms consistent with our expectations.
The agreements governing our indebtedness contain, and any instruments governing future indebtedness of ours may contain, covenants that impose significant operating and financial restrictions on us, including restrictions or prohibitions on our ability to, among other things: incur or guarantee additional debt or issue certain preference shares; pay dividends on or make distributions in respect of our share capital or make other restricted payments, including the ability of our subsidiaries to pay dividends or make distributions to us; repurchase or redeem capital stock or subordinated indebtedness; make certain investments or acquisitions; transfer, sell or create liens on certain assets; and consolidate or merge with, or sell or otherwise dispose of all or substantially all of our assets to other companies. As a result of these covenants, we are limited in the manner in which we conduct our business, and we may be unable to engage in favorable business activities or finance future operations or capital needs. The terms of any instruments governing future indebtedness may also require us to provide incremental collateral, which may further restrict our business operations
In addition, the COVID-19 pandemic has significantly increased economic and demand uncertainty. The current pandemic and continued spread of COVID-19 has caused a global recession, which could have a further adverse impact on our financial condition and operations, and this impact could exist for an extended period of time.
The extent of the effects of the pandemic on our business and the cruise industry at targe is highly uncertain and will ultimately depend on future developments, many of which are outside of our control, including, but not limited to, the duration, spread, severity and any recurrence of the pandemic, the severity and transmission rates of new variants of COVID- 19, the availability, distribution, and efficacy of vaccines and therapeutics for COVID-19, the duration and scope of related federal, state and local government orders and restrictions, the extent of the impact of COVID-19 on overall demand for cruise vacations and the length of time it takes for demand and pricing to return and normal economic and operating conditions to resume, all of which are highly uncertain and cannot be predicted, COVID-19 has also had the effect of heightening many of the other risks described herein, such as those relating to our need to generate sufficient cash flows to service our indebtedness, and our ability to comply with the covenants contained in the agreements that govern our indebtedness.
Additionally, epidemics, pandemics and viral outbreaks or other wide-ranging health scares in the future would likely also adversely affect our business, financial condition and results of operations.
As a result of the COVID-19 pandemic, we have paused our global fleet cruise operations, and if we are unable to recommence normal operations, we may not be in compliance with maintenance convenants in certain of our debt facilities.
ITEM 1A. RISK FACTORS.
Our business faces a variety of risks. The risks described below are the items of most concern to us, however these are not all of the risks we face. Additional risks and uncertainties not presently known to us, that apply to similar businesses more generally, or that we currently consider immaterial may also impair our business operations. If any of these risks occur, our business prospects, reputation, financial condition or results of operations could materially suffer, and the market price of our common stock could decline.
EXTERNAL RISK FACTORS
The COVID-19 pandemic could continue to adversely affect our business operations, store traffic, employee availability, financial condition, liquidity and cash flow.
Since being reported in December 2019, COVID-19 has spread globally, including to every state in the United States, and has been declared a pandemic by the World Health Organization. The COVID-19 pandemic and preventative measures taken to contain or mitigate such have caused, and are continuing to cause, business slowdown or shutdown in affected areas and significant disruption in the financial markets both globally and in the United States. This has led to a decline in discretionary spending by consumers, which has materially impacted our business, sales, financial condition and results of operations. The impacts include, but are not limited to:
retail and outlet store closures or reduced operating hours and/or decreased traffic; disruption to our distribution centers and our third-party manufacturing partners and other vendors, including the effects of facility closures, reductions in operating hours, labor shortages, and real time changes in operating procedures, including for additional cleaning and disinfection procedures, which could, among other things, make it difficult or impossible to operate our eCommerce business; and significant disruption of global financial markets, which could have a negative impact on our ability to access capital in the future.
The further spread of COVID-19, and the requirements to take action to help limit the spread of the illness, will impact our ability to carry out our business as usual and may materially adversely impact global economic conditions, our business, results of operations, cash flows and financial condition. The extent of the impact of COVID-19 on our business and financial results will depend on future developments, including the duration and spread of the outbreak within the markets in which we operate, the related impact on consumer confidence and spending, the effect of governmental regulations imposed in response to the pandemic, whether there are additional outbreaks, mutations or related strains of the virus in locations where we operate, the availability of, and prevalence of access to, effective medical treatments and vaccines for COVID-19, and the pace of recovery when the pandemic subsides, all of which are highly uncertain and cannot be predicted. The sweeping nature of the COVID-19 pandemic makes it extremely difficult to predict how our business and operations will be affected in the long run. However, the likely overall economic impact of the pandemic is viewed as highly negative to the general economy. Any of the foregoing factors, or other cascading effects of the COVID-19 pandemic, could materially increase our costs, negatively impact our sales and damage our results of operations and liquidity, possibly to a significant degree. While we currently believe liquidity will be sufficient to fund our lease obligations, capital expenditures, and working capital for the next 12 months and the foreseeable future, inclusive of levers we have available to alleviate our gross risk, the duration of any such impacts cannot be predicted.