THE ASSOCIATION OF THE BAR
OF THE CITY OF NEW YORK
42 WEST 44TH STREET
NEW YORK, NY 10036-6689
COMMITTEE ON SECURITIES REGULATION
December 13, 2002
Via email: email@example.com
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan G. Katz, Secretary
File No. S7-43-02; Release No. 33-8145, 34-46788
Proposed Rule: Conditions for Use of Non-GAAP Financial Measures
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Securities Regulation of the Association of the Bar of the City of New York (the "Committee") in response to Release No. 33-8145, 34-46788 dated November 4, 2002 (the "Release"). Among other things, the Release proposes rules of the Securities and Exchange Commission (the "Commission") that will require reporting companies that publicly disclose or release certain material information containing or accompanied by financial measures derived on the basis of methodologies other than in accordance with generally accepted accounting principles ("GAAP") to include, in that disclosure or release, a presentation of the most comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most comparable GAAP financial measure. Our Committee is composed of lawyers with diverse perspectives on securities issues, including academics, members of law firms and counsel to corporations, investment banks and investors.
Section 401(b) of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") directs the Commission to adopt rules requiring that any public disclosure or release of non-GAAP financial measures by a company required to file reports (a "reporting company") under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), be presented in a manner that does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading. Also, the non-GAAP financial measure presented must be reconciled with the financial condition and results of operations of the reporting company under GAAP. Section 409 of the Sarbanes-Oxley Act added to the Exchange Act a new Section 13(l), which obligates reporting companies to "disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations, as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest."
To comply with Sections 401(b) and 409 of the Sarbanes-Oxley Act, the Commission has proposed Regulation G ("Regulation G"), which will apply whenever a reporting company publicly discloses or releases material information that includes a non-GAAP financial measure. As used in the Release, a "non-GAAP financial measure" is a numerical measure of a reporting company's historical or future financial performance, financial position or cash flows that:
- excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the reporting company; or
- includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable measure so calculated and presented.
As part of the public disclosure or release containing a non-GAAP financial measure, Regulation G would require the reporting company to provide a presentation of the most comparable financial measure calculated and presented in accordance with GAAP and a reconciliation of the difference between the non-GAAP financial measure to such comparable GAAP financial measure. Regulation G also provides that the presentation of a non-GAAP financial measure, together with the accompanying information, may not misstate a material fact or omit to state a material fact necessary to make the presentation of the non-GAAP financial measure not misleading, in light of the circumstances under which it is presented.
The Commission is also proposing amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B to specifically address the use of non-GAAP financial measures in filings with the Commission. The proposed amendments to Item 10 of each of Regulation S-K and Regulation S-B will apply to the same categories of non-GAAP financial measures as covered by Regulation G, but with more detailed requirements. The proposed amendments would require reporting companies using non-GAAP financial measures in filings with the Commission to also include a presentation of the most comparable GAAP financial measures, with equal or greater prominence, along with a clearly understandable quantitative reconciliation between each non-GAAP financial measure and the comparable GAAP financial measure. In addition, reporting companies would have to provide statements disclosing management's purpose for using the non-GAAP financial measures and describing the reasons why such measures are useful to investors. Also, presenting certain types of information in Commission filings would be prohibited under the proposed amendments to Item 10 of each of Regulation S-K and Regulation S-B.
Finally, the Commission is proposing a new Item 1.04 to Form 8-K to require the filing with the Commission of public announcements or releases disclosing material non-public financial information about results of operations or financial condition for completed annual or quarterly fiscal periods. Such announcements or releases must be filed with the Commission within two business days of public announcement. In addition, the proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B will apply to releases and announcements filed under the proposed new item to Form 8-K.
The Committee supports the Commission's efforts to improve the quality of disclosure of non-GAAP financial measures by requiring reporting companies to use clear and consistent methods and terminology when presenting financial information to investors. However, in order to improve the proposed rules, to provide greater clarity and to ensure the flow of information to investors, the Committee proposes the following modifications: (i) identify certain classes of issuers, such as foreign private issuers and issuers of asset backed securities, to whom some or all of the proposed rules should not apply; (ii) eliminate the Item 10 prohibitions on excluding cash charges and non-recurring, infrequent or unusual charges from non-GAAP financial measures and on non-GAAP per share measures so that investors can determine for themselves the nature and appropriateness of such measures; (iii) clarify that the prohibition of non-GAAP financial measures on the face of a reporting company's historical and pro forma financial statements should not serve as a bar from including such measures in the selected and summary financial information included elsewhere in a Commission filing; (iv) not require reporting companies to file earnings releases or announcements on Form 8-K; (v) to the extent that the new Item 1.04 on Form 8-K is adopted, permit reporting companies who are filing an earnings release or announcement on Form 8-K to comply with Regulation G only (and not with the proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B) and to treat the earnings release or announcement as a Regulation FD filing; (vi) clarify how the proposed rules will interact with Regulation FD; (vii) clarify additional methods of disclosure that reporting companies disclosing a non-GAAP financial measure can use to satisfy Regulation G in an effort to be more consistent with Regulation FD; and (viii) clarify that business combination transactions subject to Rule 165 or Rule 14a-12 are exempt from Regulation G, Item 10 of Regulation S-K and Item 10 of Regulation S-B.
Foreign Private Issuers
The Committee believes that any application of the proposed rules and regulations to foreign private issuers could have an adverse impact on the U.S. capital markets. The Release states that the Commission intends to adopt rules under Section 401(b) of the Sarbanes-Oxley Act that will apply, with limited exceptions, to foreign private issuers in the same manner as domestic issuers. The proposed amendments to Item 10 of Regulation S-K will apply to foreign private issuers and proposed Regulation G will apply to such issuers, except in limited circumstances.1
The Commission should treat disclosures of non-GAAP financial measures under Regulation G the same way it approached selective disclosure under Regulation FD. As such, the regulation of disclosures of non-GAAP financial measures would be limited to the rules applicable to filings with the Commission, namely the rules governing the content of Form 20-F and registration statements filed under the Securities Act of 1933, as amended (the "Securities Act"). Foreign private issuers recognize that their U.S. periodic reports must comply with applicable disclosure rules and approach the preparation of their annual reports on Form 20-F with an expectation that the disclosure requirements must not only meet the form requirements as to content, but also the materiality standards under the rules and interpretations of the Commission.
To require that foreign private issuers also consider specific Commission rules and regulations in respect of a range of public statements would be to impose U.S. notions of full and fair disclosure on disclosure practices that traditionally have been shaped by local rules, custom and practices. The Committee believes that the Commission's approach to Regulation FD was shaped in large part by a recognition of these practices and acknowledgment of principles of comity.
Therefore, the Commission should limit the applicability of its rules on non-GAAP financial measures to those instances in which such measures are actually contained in an annual report on Form 20-F, in a registration statement filed under the Securities Act or in an interim report that is incorporated by reference in a registration statement filed under the Securities Act. The Committee does not believe that the narrow exception that tracks practices under Rule 135e is sufficient. The limited exception could lead to the unintended result that an increasing range of press releases will be subject to embargoes on U.S. distribution and, in doing so, the Commission will be depriving U.S. investors of access to information about foreign private issuers.
Issuers of Asset-Backed Securities
The proposed regulations should also not apply to special purpose entities that issue asset-backed securities. These entities have operations that are different from those of an operating company. Given the nature of their operations, they do not typically produce traditional financial statements. In the past, the Commission has acknowledged the unique operating structure of asset-backed issuers and has allowed such issuers to comply with Exchange Act reporting obligations by filing modified periodic reports. Asset-backed issuers file modified annual reports on Form 10-K and current reports on Form 8-K that are tied to the payments on the securities. The modified reports filed by asset-backed issuers generally disclose specific information about the performance of the underlying assets that service the payment obligations of the asset-backed securities, rather than the information specified on Form 10-K and Form 10-Q.2 If the Commission determines that the proposed rules should apply to these types of issuers, it should further study these issuers and their special circumstances before adopting and applying them to such issuers. If the Commission decides to do that, the Committee would be happy to work with the Commission to develop comparable rules more appropriate for asset-backed issuers.
Proposed Rules Impacting Filings With The Commission.
The proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B would prohibit (i) the exclusion of charges or liabilities that require cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, (ii) adjustments of a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur and (iii) the presentation of non-GAAP per share measures.
The Commission's proposals relating to Item 10 of Regulation S-K and Item 10 of Regulation S-B would result in a significant change in practice for a number of reporting companies, particularly high yield debt issuers. Many high yield debt issuers present "EBITDA" or "Adjusted EBITDA" in their Commission filings as a non-GAAP measure of the issuer's ability to service the interest expense on its indebtedness. EBITDA and Adjusted EBITDA are measures that are often required by investors, analysts and rating agencies. In various industries, other non-GAAP financial measures are common. For example, broadcast cash flow is often presented in Commission filings by radio and television broadcasters, and funds from operations is often presented by REITs in their Commission filings. While the Committee does not believe that such non-GAAP financial measures are per se prohibited under the Item 10 proposals (e.g., in the case of EBITDA, merely because the tax component of EBITDA is a cash charge), the Commission should clarify that such measures, when accompanied by the appropriate reconciliation and the other information required by the proposed amendments, will be permitted in filings with the Commission.
Also, companies, particularly high yield debt issuers, sometimes undergo fundamental changes in their business, such as major acquisitions or recapitalizations. Therefore, a number of reporting companies present Adjusted EBITDA to show potential investors the company's ability to service its indebtedness on a more "normalized" basis by adjusting for items such as:
- gains or losses from asset sales outside the ordinary course of business;
- restructuring charges and planned cost savings from "synergies", such as severance costs, operating costs of facilities to be closed and executive compensation of prior executives whose positions are to be eliminated or revised;
- unusual litigation settlements paid or received;
- write-offs of assets in connection with a change of strategic focus or discontinuation of a product line;
- losses attributable to natural disasters, and related insurance recoveries;
- losses attributable to acts of terrorism, such as the September 11th attack;
- the impact of unusual work stoppages;
- reserves established for contingencies such as environmental clean-up costs and litigation (and any subsequent reversal of such reserves);
- unusual plant start-up and shutdown costs;
- "extraordinary" items such as write-offs of debt issuance costs upon a refinancing; and
- elimination or revision of payments made and received pursuant to material contracts that are being terminated or materially amended.
Under the proposed Item 10 amendments, any of these adjustments for items involving cash payments or reserves for future payments or items that may be characterized by issuers as non-recurring, infrequent or unusual charges would be prohibited when the nature of the charge or gain is such that it is reasonably likely to recur. An issuer that is unable to conclude that an item is not reasonably likely to recur would be prohibited from adjusting for that item in a Commission filing notwithstanding the issuer's belief that such adjustment is appropriate and better reflects the ability of the issuer to service its indebtedness. Furthermore, if there is a per se prohibition in a Commission filing, to be conservative, an issuer may determine not to provide these adjustments in disclosures under Regulation G as well. These prohibitions, as well as the prohibition on the presentation of any non-GAAP per share measures, could deprive investors of financial information that could be useful in making certain determinations about a reporting company's performance. The Committee proposes that no non-GAAP financial measure be subject to a blanket prohibition, but rather be the subject of a case-by-case analysis by the reporting company as to whether such adjustments (i) are important to understanding the issuer's financial performance and (ii) do not mislead investors. The Committee believes the other protections in the proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B will provide adequate disclosure for investors.
Finally, the proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B would prohibit the presentation of non-GAAP financial measures on the face of a reporting company's financial statements prepared in accordance with GAAP or in the accompanying notes. Although the Committee supports this proposal, the Commission should confirm that the proposal would not prohibit the inclusion of non-GAAP financial measures in an issuer's selected financial data or summary financial data in a Commission filing. When management is relying on non-GAAP financial measures when making strategic decisions about the reporting company's future and believes that such measures are appropriate to disclose to investors, the reporting company should be permitted to include such non-GAAP financial measures in its selected and summary financial tables in order to assist investors with analyzing business trends and to make it easier for investors to follow a discussion of such non-GAAP financial measures in the MD&A.
Proposed Amendments to Form 8-K
Under the proposed new Item 1.04 to Form 8-K, each domestic reporting company that issues an earnings release or makes a public announcement disclosing material non-public information concerning the financial results for a completed annual or quarterly fiscal period will need to file that release or announcement on Form 8-K within two business days. The Form 8-K filing requirements also apply to oral, webcast, telephonic or similar communications, except for such communications that are made as part of a presentation within 48 hours of a written earnings release or public announcement filed under Item 1.04. All filings pursuant to this new Item 1.04 of Form 8-K would be subject to proposed Item 10(e) of Regulation S-K or Item 10(h) of Regulation S-B which contain more detailed requirements and prohibitions on certain practices, in contrast to the more limited requirements of proposed Regulation G. The Committee believes that the Commission should not require issuers to file their earnings releases or public announcements on Form 8-K because Regulation G and Regulation FD will provide appropriate disclosure on non-GAAP financial measures to investors. Furthermore, such a requirement could chill the disclosure regime implemented under Regulation FD as discussed below.
If the Commission determines it is in the best interest of investors to require the filing of earnings releases or public announcements concerning financial results on Form 8-K, such filings should only have to comply with Regulation G, and not the more stringent provisions of Regulation S-K or Regulation S-B. If the more stringent provisions apply, reporting companies will be incentivized to omit non-GAAP financial measures from earnings releases or other forms of communication subject to Item 1.04, which could deprive investors of useful information. Alternatively, they would only provide non-GAAP financial measures orally in presentations within 48 hours of a written earnings release. Investors would be better served if these non-GAAP financial measures were included in press releases or other public announcements that were filed on Form 8-K with the Commission.
In the Release, the Commission states that information filed under Item 1.04 would be filed for purposes of the Exchange Act, including for purposes of liability under Section 18. Also, specifically identified forward-looking information in an earnings release or other public announcement could be furnished under Item 6.01 of Form 8-K as Regulation FD information, and therefore not be filed for purposes of the Exchange Act. This regime could create duplicative quarterly filing requirements for reporting companies that are both unnecessary and confusing. Also, because information filed under Item 1.04 would be automatically incorporated by reference into certain registration statements, it could lead to reporting companies limiting the information included in earnings releases or other public announcements, delaying their earnings releases or other public announcements to allow a more comprehensive review of the content of the release or announcement, or doing both. This would not be consistent with the "rapid and current" disclosure of additional information envisioned by Section 409 of the Sarbanes-Oxley Act. Therefore, the Committee proposes that reporting companies be permitted to file any earnings releases on Form 8-K as if they were doing a Regulation FD filing. This would not materially change any liability standards since the earnings release or public announcement would still be subject to Regulation G and the general anti-fraud provisions of the Exchange Act, and the reporting company would ultimately have to file a Form 10-Q or Form 10-K for the reported period.
Interplay of Proposed Rules with Regulation FD
In order to avoid duplicative disclosure requirements, the Commission should harmonize the proposed rules with Regulation FD. For example, Regulation G and new Item 1.04 of Form 8-K would apply to communications made by a "person acting on behalf of an issuer." In order to facilitate compliance by reporting companies, the Commission should define these persons as those who are covered by Item 101(c) of Regulation FD. Also, as drafted, Item 1.04 of Form 8-K applies to any public announcement or release disclosing material non-public information regarding financial results from a completed fiscal quarter or year. The language in proposed Item 1.04 suggests that this includes oral, webcast, telephonic or similar communications. If the Commission adopts Item 1.04, the Committee believes that Item 1.04 should not apply to these types of communications and that Regulation FD and Regulation G should adequately protect investors.3
The Committee also believes that Regulation G should grant reporting companies greater flexibility. Under the current proposal, companies releasing a non-GAAP financial measure orally, telephonically, in a webcast or broadcast or by similar means, may provide the accompanying GAAP financial information as required under Regulation G on its website. The proposal should clarify what additional methods of disclosure are acceptable. For example, the rule should provide that the required GAAP information may be alternatively provided orally as part of the same presentation, by the reporting company referencing its filings with the Commission, such as a current report on Form 8-K or an annual or quarterly report on Form 10-K or Form 10-Q, or through another Regulation FD compliant disclosure method. In addition, if a reporting company discloses a non-GAAP financial measure in writing, it will be required to provide the accompanying GAAP financial information even if there have been no changes to the non-GAAP financial measure and the required accompanying information has been previously disclosed in a Commission filing, such as an earnings release on a Form 8-K, on the company's website or through another Regulation FD compliant disclosure method. In such situations, reporting companies should be permitted to satisfy the proposed Regulation G requirements by referencing the information that is publicly available. We believe that this approach would be more consistent with Regulation FD and eliminate confusion with reporting companies and investors.
Impact on Business Combination Transactions
The Committee believes that Regulation G, Item 10 of Regulation S-K and Item 10 of Regulation S-B should not apply to disclosures relating to business combination transactions that are subject to Rule 165 or Rule 14a-12. The proposed rules restricting disclosure on non-GAAP financial measures would significantly undermine the comprehensive revisions to the rules relating to security holder communications in business combination transactions which became effective on January 24, 2000. See Regulation of Takeovers and Security Holder Communications, Release No. 34-42055 (October 22, 1999) (the "Communications Release"). The Communications Release acknowledged the "special nature of business combination transactions", as well as the need of parties to release "information on proposed transactions including pro forma financial information for the combined entity, estimated cost savings and synergies." (text at notes 17, 22) The Communications Release addressed the goal of providing the maximum amount of flexibility to disclose material information to market participants early, without changing the requirement that security holders receive the mandated disclosure document before being asked to make a voting or investment decision. The Commission instituted several investor safeguards to balance the increased flexibility for issuers in communicating material information to the market:
- All written communications must be filed on or before the date of first use;
- All written communications must include a prominent legend advising investors to read the registration, proxy or tender offer statement, as applicable; and
- Oral and written communications remain subject to Section 10(b) liability, Section 12(a)(2) liability and/or Rule 14a-9 liability, as applicable.
In view of these special investor safeguards for communications relating to business combinations, the Commission should extend the special treatment it provided for such communications under Rule 165 to exclude such communications from the new rules relating to non-GAAP financial measures. In addition, we request that the Commission confirm that Regulation G and the other proposals in the Release would never apply to the financial analysis of the financial advisor supporting the fairness opinion that is summarized in the proxy statement or registration statement relating to a merger or other business combination transactions. Disclosure of non-GAAP financial measures in the context of business combination communications (such as estimated cost savings, synergies and accretion or dilution in earnings per share), unlike the use of non-GAAP financial measures in earnings releases, does not have the same risk of misleading investors by "obscuring GAAP results." The non-GAAP financial measures commonly used in presenting business combination transactions are not intended to substitute for any comparable GAAP results, but rather to provide information to assist investors and analysts in understanding the expected effect on the combined companies if the proposed transaction is consummated. Indeed, the Commission does not even propose to apply the new rules to the pro forma information relating to a merger presented in a registration statement or proxy statement pursuant to Article 11 of Regulation S-X. (See footnote 12 of the Release.) In view of the existing filing, disclosure and liability requirements applicable to communications under Rule 165 and Rule 14a-12 relating to business combinations, the Committee does not believe it is necessary to require further specific disclosure of the assumptions or bases underlying these estimates in order to qualify for an exemption from proposed Regulation G and the proposed amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B.
Finally, we believe that the Commission should confirm that Regulation G is enforceable only by the Commission and that there is no right of action by private plaintiffs for violations of Regulation G.
* * *
Please note that Committee member Wayne Carlin of the United States Securities and Exchange Commission did not participate in the preparation of this letter or the decision by the Committee to submit this letter to the Commission. In addition, this letter does not necessarily reflect the individual views of members of the Committee.
Members of the Committee would be pleased to answer any questions you might have regarding our comments, and to meet with the staff of the Commission if that would assist the Commission's efforts.
/s/ Charles M. Nathan
Charles M. Nathan, Chair of Committee on Securities Regulation
cc: Alan Beller, Director
Division of Corporation Finance
Securities and Exchange Commission
|1|| Proposed Regulation G would not apply to disclosure of a foreign private issuer if the issuer's securities are listed on an exchange outside of the U.S., the non-GAAP financial measure and the most comparable GAAP financial measure are not presented in accordance with U.S. GAAP and the disclosure is made or released only outside of the U.S.
|2|| Issuers of asset-backed securities have been permitted to file monthly servicing or pooling reports under Form 8-K in lieu of regular reports. In addition, in adopting Rule 144A, the Commission stated that in the case of asset-backed securities, the requirement that would otherwise mandate the availability of specified financial information may instead be satisfied with information concerning the structure and assets of the securitization.
|3|| If the Commission determines to leave Item 1.04(b) in its present form, we suggest that the time period be increased from 48 hours to one week to reflect the typical period in which a reporting company issues a quarterly earnings release, holds an earnings conference call and responds to analyst and investor inquiries.