When investing in a company, one has to be sure that he is aware of all the investment risks associated with that company. In order to gauge potential investment risks, I specifically look at 2 places – 1. Risk Factors and 2. Notes on commitments, including leases and contingent liabilities. The “Risk Factors” in the annual report (10K) outline all risks that the management foresees could affect the profitability of the business. These risks could range from very specific items such as the IRS auditing past tax filings and fines associated with those findings to something very broad such as the possibility of a cyber attack, which could affect the bottom line of the business. The risk factors are listed early on in the annual report, and it is hard to miss. Now, the notes on commitments and contingencies is a different story. In this week’s blog post, we will focus on contingent liabilities as they are the hidden landmines that mostly go unrecorded on income statement and balance sheet.
First, what is a contingency? A contingency exists when a company stands to gain or lose due to a past event or transaction. In other words, the amount of gain or loss is “contingent”, since it depends on another event. For example – assume that a Starbucks customer spilled hot coffee all over his lap because the drive thru representative was in a hurry and decided to just throw the hot coffee cup at the customer to catch. That customer got severe burns, and decides to file a lawsuit against Starbucks. Starbucks is now in a contingency situation. The injury gave rise to a possible loss; the amount of loss would be determined in the future by settlement or court verdict. In the annual report, the footnote disclosures describe the nature of the contingency and the estimated range of loss. These contingent liabilities will not show up on the balance sheet if the management can not estimate the amount of loss or if the loss is possible but not probable.
Let’s look at a recent IPO stock, Uber. New public companies are filled with some juicy contingent liabilities that “investors” are willing to overlook in return for the company’s possible glittering future. If we look at Uber’s most recent quarterly report (10Q), note 14 goes over all the commitments and contingencies (pages 34-37). Here are the contingency topics that Uber discussed:
- O’Connor, et al., v. Uber Technologies, Inc. and Yucesoy v. Uber Technologies, Inc., et al.
Contractor misclassification claims brought on behalf of certain Driver Partners – Possible loss between $146 million to $170 million.
- State Unemployment Taxes
Uber received a notice retroactively imposed various payroll tax liabilities on the Company, including unemployment insurance, employment training tax, state disability insurance, and personal income tax. Possible loss unknown.
- Google v. Levandowski & Ron; Google v. Levandowski
Google filed arbitration demands against each of Anthony Levandowski and Lior Ron, former employees of Google, alleging breach of their respective employment agreements with Google, fraud and other state law violations. The ultimate resolution of the matter could result in a possible loss of up to $62 million or more (depending on the date of the final award) in excess of the amount accrued.
- Taiwan Regulatory Fines
On January 6, 2017, a new Highways Act came into effect in Taiwan which increased maximum fines from New Taiwan Dollar (“NTD”) 150,000 to NTD 25 million per offense. The Company suspended its service in Taiwan from February 10, 2017 to April 12, 2017, but a number of these fines were issued to Uber Taiwan in connection with rides that took place in January and February 2017 prior to the suspension. These fines have remained outstanding while Uber appeals the tickets through the courts. Possible loss unknown.
- Copenhagen Criminal Prosecution
In May 2017, the Danish police announced that they would use tax data about Driver Partners obtained from the Dutch tax authorities to prosecute Driver Partners for unlicensed taxi traffic. In September 2018, the Danish Supreme Court ruled that the Driver Partners were carrying out illegal taxi operations and fined them in the total amount of their earnings from performing ridesharing services. On May 29, 2018, the Company received another set of indictment papers from the Danish prosecutor. On February 19, 2019, the Company was informed by the Danish prosecutor that it has issued a request for legal aid to the Danish prosecutor to serve additional indictment papers, relating to the Company’s activity in Denmark in 2016 and 2017. Uber has not operated these services in Denmark since 2017 and currently does not have operations in Denmark. Possible loss unknown.
- Malden Transportation v. Uber Technologies, Inc.
Seven consolidated actions were filed in the United District Court for the District of Massachusetts by taxi medallion owners in late 2016 and early 2017 against the Company alleging unfair competition violations (on the grounds that the Company failed to comply with local taxi laws), as well as state and federal antitrust violations (on the grounds that the Company prices trips below cost in order to achieve a monopoly). Antitrust claims were dismissed, but the unfair competition claims remain. Possible loss unknown.
- Swiss Social Security Reclassification
Several Swiss government bodies currently classify Driver Partners as employees of Uber Switzerland for social security purposes. On July 5, 2019, the Swiss governmental bodies issued four decisions by which they reclassified four drivers as Uber B.V. and Rasier B.V. employees and consider that Uber Switzerland should pay social security contributions. The Company plans to appeal those decisions. The Company’s chances of success on the merits are still uncertain and any possible loss or range of loss cannot be estimated.
- Non-Income Tax Matters
The Company recorded an estimated liability for contingencies related to non-income tax matters and is under audit by various domestic and foreign tax authorities with regard to such matters. The subject matter of these contingent liabilities and non-income tax audits primarily arises from the Company’s transactions with its Driver Partners, as well as the tax treatment of certain employee benefits and related employment taxes. For example, in UK, being classified as a transportation provider would result in a VAT (20%) on Gross Bookings or on the service fee that the Company charges Drivers, both retroactively and prospectively. Possible loss unknown.
- Other Legal and Regulatory Matters
The Company has been subject to various government inquiries and investigations surrounding the legality of certain of the Company’s business practices, compliance with global regulatory requirements, such as antitrust and Foreign Corrupt Practices Act requirements, data protection and privacy laws, and the infringement of certain intellectual property rights. Possible loss unknown.
In the ordinary course of business, the Company often includes standard indemnification provisions in its arrangements with third parties. Pursuant to these provisions, the Company may be obligated to indemnify such parties for losses or claims. It is not possible to determine the maximum potential loss under these indemnification provisions / obligations because of the unique facts and circumstances involved in each particular situation.
Now that you know about Uber’s contingency losses, you can make a more informed decision about investing in Uber. Knowing these facts, you won’t be caught off guard if in the near future, you see the verdict of one of these court cases in the news. You can think of contingency losses as time bombs waiting to blow apart a profitable company. I have learned to always ask these two questions when looking into contingencies:
- If the possible contingency loss comes to pass, what will be the impact on the company’s cash flow?
- Is the company’s liquidity and debt structure capable of handing contingency losses?
Hope you learned a little and found this blog post helpful. We talked about commitments and contingencies, which are hidden notes that can rip apart a profitable company. We also talked about Uber’s contingency liabilities. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions.