No Gaming the System – The SEC’s Interest in Enforcing Pure Disclosure Violations Continues

The SEC alleged that NVIDIA’s inadequate disclosures violated Sections 17(a)(2) and (3) of the Securities Act of 1933 (the “Securities Act”) and Section 13(a) of the Exchange Act of 1934 (the “Exchange Act”) and Rules 13a-13 and 13a-15(a) thereunder. Notably, the SEC did not allege that there was any misconduct that hadn’t been disclosed or that there was anything inherently wrong with NVIDIA capitalizing on the growth of the cryptomining business. Instead, the violations focus on the fact that the importance of crypto-related sales to its gaming business was not disclosed to investors, and therefore investors were not able to adequately evaluate the risks that it posed to the business.

This action is not the first recently whereby the SEC has charged an issuer for disclosure violations even where there is no underlying misconduct or wrongdoing alleged. For instance, in September 2020, the SEC announced a $6 million settlement with HP Inc. alleging violations of Section 17(a) of the Securities Act and Section 13(a) of the Exchange Act for allegedly “misleading investors by failing to disclose the impact of sales practices undertaken in an effort to meet quarterly sales and earnings targets.” SEC Press Release 2020-241, SEC Charges HP Inc. With Disclosure Violations and Control Failures (Sept. 30, 2020). Notably, the SEC did not allege that any of the sales practices themselves violated securities laws just that investors had not been adequately informed of their impact on HP’s financials.

Here, the SEC alleges that, prior to fiscal year 2018, cryptomining did not meaningfully impact demand for graphics processing units (“GPUs”) from the company’s gaming business segment (“Gaming”) and, as such, was not referenced in NVIDIA’s Form 10-K for fiscal year 2017. But, as the prices for crypto assets rose throughout 2018, the revenue from the Gaming segment’s GPU sales was increasingly coming from sales related to cryptomining. During the relevant period, NVIDIA experienced material changes to its total and Gaming revenue as compared to the corresponding period of the prior fiscal year. The company’s Gaming revenue increased by 52%, year over year for the second fiscal quarter 2018, and by 25%, year over year for the third fiscal quarter of 2018. The SEC further alleges that NVIDIA was aware that cryptomining was a significant factor in the material year-over-year growth in NVIDIA’s Gaming and total revenue.

The SEC’s cease-and-desist order notes that Section 13(a) of the Exchange Act and Rule 13a-13 thereunder require companies such as NVIDIA to file Forms 10-Q containing Item 303 of Regulation S-K disclosures. At the relevant time period, Item 303(b)(2) required issuers to disclose in the MD&A section of quarterly reports “any material changes in the registrant’s results of operations . . . with respect to that fiscal quarter and the corresponding fiscal quarter in the preceding fiscal year.” Former 17 C.F.R. 4§ 229.303(b)(2) (subsequently amended, 17 C.F.R. § 229.303(c)(2)). Regulation S-K also required that the discussion of material changes in results of operations during the quarter “shall identify any significant elements of the registrant’s income or loss from continuing operations which do not arise from or are not necessarily representative of the registrant’s ongoing business.” Former 17 C.F.R. § 229.303(b), Instruction 4 (subsequently amended, 17 C.F.R. § 229.303(c), Instruction 2). The cease-and-desist order also notes that the SEC stated in a 2003 MD&A interpretive release:

[I]f events and transactions reported in the financial statements reflect material unusual or non-recurring items, aberrations, or other significant fluctuations, companies should consider the extent of variability in earnings and cash flow, and provide disclosure where necessary for investors to ascertain the likelihood that past performance is indicative of future performance.

Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operation, Securities Act Release No. 33-8350, Exchange Act Release No. 34-48,960, 68 Fed. Reg. 75,056, 75,062 (Dec. 29, 2003), available at www.sec.gov/rules/interp/33-8350.htm.

When NVIDIA filed its Forms 10-Q for the second and third fiscal quarters of 2018, NVIDIA failed to disclose that cryptomining was a significant factor in the material year-over-year growth in NVIDIA’s Gaming revenue. Notably, the SEC emphasized the fact that, in light of the volatility in crypto prices, analysts and investors were interested in understanding, and routinely asked senior management about, the extent to which the company’s Gaming revenue was impacted by cryptomining and how sustainable that growth was going forward. Moreover, the fact that NVIDIA did disclose that cryptomining was a significant element of a separate business segment’s sales during that period led the SEC to conclude that investors were given the misimpression that the year-over-year growth in the company’s Gaming revenue was not meaningfully impacted by cryptomining.

Accordingly, the SEC charged NVIDIA with breaching the disclosure requirements of Sections 17(a)(2) and (3) of the Securities Act and Section 13(a) of the Exchange Act and failing to maintain effective disclosure controls and procedures as required by Exchange Act Rule 13a-15(a). Without admitting or denying the SEC’s findings, NVIDIA agreed to a cease-and-desist order and to pay a $5.5 million penalty.

It is clear that the SEC is going to continue to enforce the disclosure provisions of the Securities and Exchange Acts with vigor. As Kristina Littman, Chief of the SEC Enforcement Division’s Crypto Assets and Cyber Unit, explained in the SEC’s press release, “[a]ll issuers, including those that pursue opportunities involving emerging technology, must ensure that their disclosures are timely, complete, and accurate.” Accordingly, it is important for issuers (and their disclosure committees) to constantly assess whether all of their internal practices that have any impact on their earnings or financial reporting both comply with all applicable rules and regulations and have been properly disclosed to investors.