December 13, 2002
Jonathan G. Katz,
Dear Mr. Katz:
We are pleased to respond to Release Nos. 33-8145, 34-46768 (the "Proposing Release"), in which the Securities and Exchange Commission solicits comments on its proposed rules implementing Section 401(b) of the Sarbanes-Oxley Act of 2002 (the "Act") relating to disclosure of non-GAAP financial measures.
We have set forth below specific comments on the proposed rules that we respectfully request the Commission consider in order to promote the underlying purposes of Section 401(b) of the Act.
The Prohibitions on the Use of Certain Non-GAAP Financial Measures in
We recognize the concerns of Congress (as reflected in Section 401(b) of the Act) and of the Commission that the presentation of non-GAAP financial measures in reports filed with the Commission under the federal securities laws might, in some circumstances, be confusing and potentially misleading. Accordingly, we fully support the statutory directive of Section 401(b) of the Act and the Commission's proposal to implement that section through amendments to Item 10 of Regulation S-K to require that issuers using non-GAAP financial measures in Commission filings:
We believe that these proposed requirements are appropriately responsive to Section 401(b) of the Act and, more importantly, would minimize any risk of confusion that a non-GAAP financial measure might otherwise present by ensuring that investors receive sufficient information to place in appropriate context the basis for and significance of any non-GAAP financial measures.
Where we differ from the Commission, however, is the proposal to flatly prohibit the use of certain non-GAAP financial measures in filings with the Commission, including the prohibitions against presenting non-GAAP per-share measures and presenting a non-GAAP performance measure that "eliminates" or "smooths" items identified as non-recurring, infrequent or unusual if the nature of the charge or gain is such that it is reasonably likely to recur. The Proposing Release does not explain why the Commission proposes to ban the specified activities other than stating that the ban is "consistent with current staff policy."
Specifically, we believe that the Commission's proposed ban on specified non-GAAP per-share measures is not required by Section 401(b) of the Act. Neither the text of Section 401(b) nor the limited legislative history require the Commission's proposed prohibition, which appears to us at odds with the overriding statutory and public policy interest of encouraging disclosure that is relevant, accurate and not misleading regarding a company's financial affairs, while also being presented in a manner that investors can understand and that the market may expect. We believe that non-GAAP per-share measures may be useful (and in some cases necessary) tools for focusing investors on critical data and understanding company performance and financial condition "through management's eyes", which the Commission has acknowledged is an important function of MD&A disclosure. Provided this information is accompanied by a clear explanation from management of why such information is being provided and why management believes it is useful, we believe investors can make an informed decision on the usefulness and of any limitations inherent in this information. Rather, we suggest that the Commission reverse the current guidance in Financial Reporting Certification § 202.04 and specifically permit non-GAAP per-share measures subject to the specific protections mandated by Section 401(b) of the Act and implemented through the other proposed amendments to Item 10 of Regulation S-K.
With respect to the proposed prohibition against adjusting a non-GAAP performance measure to "eliminate" or "smooth" items, we believe the concern expressed by the proposed ban is more appropriately addressed through application of the overriding requirement that the presentation of non-GAAP measures not be misleading rather than through categorical proscription. Companies should not be put in the position of determining whether a specific item, the effect of which management believes is reasonable to exclude are "of a nature" that they are likely to recur. For example, should management be precluded from presenting adjusted data when faced with an unusual specific item that is "of a nature" that is likely to recur, but that management believes is unlikely to recur at the company. What is the relevant time frame in which the recurrence should be viewed? How should management treat what of items that by their nature may recur but at significantly different orders of magnitude? All of these factors are most properly subject to management's judgment in deciding how to evaluate and present its evaluation of the company's financial performance.
If the Commission decides not to eliminate the proposed bans, the language of the proposed rule should be clarified. First, with respect to the prohibition on adjusting 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, it would be helpful for the Commission to identify the degree of generality in which companies should view the nature of the charge or gain. For example, many companies identify certain non-recurring charges arising from, for example, litigation, research and development, restructuring and mergers and acquisitions. While these charges result from unique facts and circumstances that likely will not recur with similar materiality or impact on continuing operations, it may be reasonably likely to expect that in the future, different litigation and future acquisitions will give rise to other non-recurring charges. The proposed rules are unclear as to whether the proposed prohibition is aimed at charges that are reasonably likely to recur in future periods arising from the similar facts and circumstances or, rather, are categories of facts and circumstances that are reasonably likely to give rise to different non-recurring charges in the future. Any final rules, or at least the text of any adopting release, should provide further guidance.
Second, as far as the exemption in the proposed instruction to paragraph (e) for foreign private issuers is concerned, we believe there should be no limitation that the non-GAAP financial measures must be "expressly" permitted under home country rules. Does this mean that a particular ratio must be expressly permitted by, for example, IFRS, or whether it is sufficient that IFRS permits ratios generally? We believe that the word "expressly" should be deleted from the condition permitting use of non-GAAP financial measures under home country GAAP. The fact that the non-GAAP financial measure is in fact used in a home country report should be sufficient.
The proposed rule requires reporting companies to "file" earnings releases and announcements under a new item of Form 8-K, which may subject companies to heightened risk of liability for these disclosures. Regulation FD currently allows a company to disclose, at its option, material nonpublic information similar to the earnings releases and announcements covered under the proposed rule by "furnishing" the information under Item 9 of Form 8-K instead of filing it under Item 5. Filing information subjects an issuer to liability under Section 18 of the Exchange Act for the information. Similarly, information that is filed rather than furnished will be incorporated by reference into Securities Act registration statements, which may subject a company to liability under Sections 11 and 12(a)(2) of the Securities Act for that information.
We believe this creates unnecessary and inappropriate liability risks for issuers with current shelf registration statements that incorporate by reference their current reports on Form 8-K. We believe the proposed enhanced liability is simply unnecessary. It also unfairly burdens shelf issuers vs. other issuers. We agree with the legitimate concern expressed at the open meeting by at least one of the Commissioners that the risk of liability could have a chilling impact, potentially delaying or diluting the content of earnings releases. Earnings releases are prepared under great time pressure. We believe the existing Rule 10b-5 standard strikes the appropriate balance between accuracy and liability in these situations. Raising the liability risk to the Section 11 standard (involving strict liability for issuers) could cause a shelf issuer to reduce the explanatory content, delay the earnings release, or both. Further, Regulation FD already operates to ensure that earnings releases are promptly brought to the attention of investors. We believe the interests of investors are not served by overriding the developing practices under Regulation FD by unnecessary measures that risk less transparent, less timely and less complete disclosure of earnings because of enhanced liability concerns. This proposal is not in the best interests of investors. Many companies currently furnish earnings releases under Item 9 of Form 8-K in order to meet their obligations under Regulation FD. We believe most others would not object to a requirement to make such an Item 9 filing.
The Requirement to File Form 8-K Containing Comments About A Completed Fiscal
The proposed rules would require a further filing of a Form 8-K for any public announcement or release, whether oral or written, that includes additional or updated material non-public information about a completed fiscal year or quarter if made more than 48 hours after the written release or announcement filed on a previous Form 8-K. We expect that, in the course of analyst conferences and webcast mid-period conference calls, issuer representatives will frequently make some comment about material non-public historical information that would trigger this new Form 8-K filing requirement. We believe this presents two problems. First, it will significantly remove the practical benefit of webcasting (and other Regulation FD compliant announcements), which have become a widespread and effective means for companies to disseminate information to investors through the widest practical medium. Second, as with the earnings release proposals, this proposal will unnecessarily increase the risk of liability. For issuers with shelf registration statements it will create unnecessary liability and disclosure complications for relatively minor pieces of information. Disclosing the information in context could require significant effort or repetition of other disclosures - and appears unnecessary where the information has already been disseminated in a Regulation FD-compliant way. We do not believe either of these likely consequences are overcome by any corresponding benefit to investors and would strongly suggest the Commission eliminate this proposed requirement and limit the Form 8-K requirement to earnings releases themselves.
Proposed Regulation G would expressly provide that nothing in the rule would affect a company's liability under Section 10(b) and Rule 10b-5 of the Exchange Act (the principal liability provisions for misleading and deceptive statements). However, the Commission notes that the facts and circumstances giving rise to a violation of the proposed rule could independently implicate Rule 10b-5. Although it appears that a violation of the proposed rules would not by itself be actionable under Rule 10b-5, failure by a company to comply with the rule could result in enforcement action by the Commission. In the Proposing Release the Commission solicits comment on whether the proposed rule should also confer an express right of private action or whether enforcement should be confined to the SEC alone. We believe it would not be necessary or appropriate to create an express private right of action for violation of Regulation G. Commission enforcement should be sufficient to ensure compliance with the rule and for the protection of investors.
To avoid ambiguity we believe it will be important for the Commission to explicitly "grandfather" the past use of non-complying non-GAAP figures in previously issued audit reports and other documents that have been previously filed but continue to be incorporated by reference in Commission filings or are incorporated by reference in new filings, such as a new registration statement on Form S-3 or Form F-3 that incorporates pre-Regulation G Exchange Act reports. Without a specific provision permitting historical filings to be incorporated by reference into current registration statements, it will not be clear whether the registration statement is in compliance with Regulation G. Faced with such questions about compliance, auditors may be unwilling to consent to inclusion or incorporation by reference of previously issued audit reports and may be unwilling to deliver "comfort" letters with respect to procedures performed with respect to the registration statement and incorporated documents. Similarly, counsel may be unwilling to provide customary opinions and disclosure letters with respect to securities transactions in such cases.
The Commission Should Eliminate Circularity and Clarify That the Mere Filing of a
U.S. companies that file earnings releases with Commission or other public announcements under Form 8-K and foreign private issuers that file or furnish earnings releases under Form 6-K clearly would not expect such filings would be subject to the proposed stricter requirements and content restrictions for Commission filings. However, as drafted this potential circularity exists in the proposed rules. They should be revised to clarify that merely making an 8-K or 6-K filing does not subject the enclosed material to the stricter requirements.
In addition, the rules of the New York Stock Exchange, among others, require issuers with listed securities to file with the exchange copies of various press releases issued by them. In the case of foreign private issuers, these rules may require the issuer to file with the exchange a copy of press releases that would otherwise benefit from the foreign private issuer exception to proposed Regulation G. Regulation G should specify that, as in the case of a filing made under cover of Form 6-K, a notice filing to a U.S. stock exchange or inter-dealer quotation system pursuant to the rules thereof should not defeat the availability of the foreign private issuer exception where it is otherwise available.
We believe the Commission's approach in extending Regulation G to foreign private issuers is not consistent with its current disclosure regime for foreign private issuers and its established policy of balancing the need to ensure that the disclosure standards for foreign private issuers are consistent with acceptable standards of investor protection while encouraging access by foreign private issuers to U.S. capital markets by principled deference to home country requirements. We believe that the Commission should treat disclosures of non-GAAP financial measures under Regulation G in the same way that it treats the requirements of Regulation FD - i.e., by exempting foreign private issuers. By accessing the U.S. capital markets, foreign private issuers should and do accept that their principal U.S. periodic report, the Annual Report on Form 20-F, must comply with applicable U.S. disclosure standards. As such, subject to our comments above, we consider it appropriate with the policy balance the Commission has historically struck to extend the Commission's proposed Item 10 of S-K to Form 20-F filings. However, we believe that to extend proposed Regulation G to foreign private issuer disclosures other than the Form 20-F or Securities Act registration statements would tilt the balance away from appropriate respect for home country securities laws and practices. To mandate that foreign private issuers also consider specific Commission rules and regulation in connection with the full range of public announcements would be, in effect, to impose U.S. standards on foreign disclosure regimes that have historically been governed by home country rules, customs and policies, a practice which U.S. investors in non-U.S. securities have considered and accepted in making these investments. Such an imposition is inconsistent with Commission policy and not required by Section 401(b) of the Act, which clearly gives the Commission wide discretion to exempt foreign private issuers from the Commission's implementing rules as warranted.
In the event that the Commission is not persuaded fully to exempt foreign private issuers, we respectfully request that it consider the following additional concerns in applying Regulation G to foreign private issuers. Each of these specific concerns also underscores the conceptual awkwardness and policy inconsistency in applying Regulation G to foreign private issuers at all.
We believe that the exception for foreign private issuers from the application of Regulation G would, as proposed, unfairly penalize those foreign private issuers whose primary financial statements are prepared in accordance with U.S. GAAP. The difficulty arises as a result of the second condition to the exception's availability: the requirement that the non-GAAP financial measure and the most comparable GAAP financial measure not be calculated in accordance with U.S. GAAP.
Many foreign private issuers that are reporting companies under the Exchange Act have adopted U.S. GAAP for their primary financial statements. In doing so, such issuers have gone beyond the requirements of the Securities Act which permits reporting in accordance with home country GAAP accompanied by a U.S. GAAP reconciliation. In our experience, foreign private issuers that have adopted U.S. GAAP for their primary financial statements often use those statements as the basis for reporting in their home country and may present little or no information prepared in accordance with their home country GAAP. The second condition to the proposed exception would penalize these issuers as compared with others that use only home country GAAP with a U.S. GAAP reconciliation. Issuers in the latter category would generally have the benefit of the exemption for the non-GAAP financial information they report, while the former could not avail themselves of the exemption. The problem is especially acute for those foreign private issuers located in countries where non-GAAP financial measures are legitimate, customary and in many cases required tools for communicating financial performance. For issuers in these countries, the exemption as currently proposed would discourage the adoption of U.S. GAAP for use in primary financial statements, because any foreign private issuer doing so would lose the use of the exception for any non-GAAP financial information derived from the financial information it would thereafter report.
The Proposing Release provides that "GAAP" refers to generally accepted accounting principles in the United States, except that, in the case of foreign private issuers with primary financial statements prepared in accordance with other generally accepted principles, reference to GAAP "also includes" the principles under which those primary financial statements are prepared. Literally read, those foreign private issuers whose primary financial statements are presented in accordance with home country GAAP would be required to reconcile non-GAAP measures in U.S.-directed press activities both to home country GAAP and U.S. GAAP. This provision would appear to require U.S. GAAP reconciliation of home country non-GAAP financial information even in circumstances (such as a 6-K containing a quarterly results announcement) where the home country GAAP financial information itself is not required to be reconciled to U.S. GAAP. The Commission should clarify that, for a foreign private issuer, reconciliation of a non-GAAP financial measure is required only to the system of accounting principles from which that non-GAAP financial measures is derived. In the alternative, the Commission should consider limiting the requirement to reconcile home country non-GAAP financial information to U.S. GAAP solely to those circumstances where the comparable home country GAAP information is required to be so reconciled (e.g., in Annual Reports on Form 20-F).
In addition, for those foreign private issuers that prepare their primary financial statements in accordance with U.S. GAAP but are also required to file home country GAAP financial statements in accordance with local laws or rules, the home country GAAP financial statements would not qualify as "GAAP" within the meaning of the proposed rule, literally read. Presumably, such home country GAAP financial statements would have to be characterized as non-GAAP financial information. We assume this is an unintended result. Accordingly, the Commission should clarify the definition of GAAP so that financial statements prepared in accordance home country GAAP would not be characterized as "non-GAAP financial information" solely because the foreign private issuer's primary financial statements are presented in accordance with U.S. GAAP.
Proposed Regulation G would provide that the mere filing of a Form 6-K will not be deemed to violate the foreign private issuer exemption requirement that the disclosure be made outside the United States. Likewise, we strongly urge the Commission to expressly provide that a release outside the U.S. includes a release to a local regulator or exchange even if the regulator or exchange posts the release on its website and the release is accessible from the United States.
Business Combination Disclosures Subject to Existing Commission Rules Should be
Proposed Regulation G and proposed Item 10 of Regulation S-K would apply to disclosures of non-GAAP financial measures used in business combination transactions. We believe there should be a specific exemption from these proposed rules for disclosures relating to business combination transactions that are subject to Rule 165 under the Securities Act or Rule 14a-12 or Rule 14d-2(b) under the Exchange Act. We believe this is consistent with the Commission's policy of balancing the need to ensure adequate investor protection and the desirability to afford companies flexibility in communicating information to the market in business combination transactions. Indeed, this is the policy underpinning the Commission's recent liberalization of security holder communications expressed in Release No 33-7760 (the "Security Holder Communications Release").
In the Security Holder Communications Release, the Commission noted the special nature of business combinations, including the need to disclose information early in the proposed transaction. Furthermore, the Commission observed that in many cases parties to business combination transactions release information on proposed transactions that includes pro forma financial information for the combined entity, estimated cost savings and synergies. While recognizing the importance of facilitating increased and early communications in the business combination context, the Commission adopted or reaffirmed several investor protections, including (i) the requirement that all written communications be filed on or before the date of first use, (ii) that security holders receive the mandated disclosure document before being asked to make a voting or investment decision, (iii) that all written communications include a prominent legend advising investors to read the registration, proxy or tender offer statement, as applicable, and (iv) confirmation that oral and written communications remain subject to antifraud liability under the applicable sections of the federal securities laws.
More importantly, the policy concern of proposed Regulation G and Item 10 of Regulation S-K is not implicated in the business combination context because, unlike the use of non-GAAP financial measures in earnings releases, disclosure of non-GAAP financial measures in the context of business combination communications are not used as a substitute for comparable GAAP results (which will be contained in the subsequent mandated disclosure document to the extent required by the applicable Commission form) but rather to assist investors and analysts in evaluating the impact on the combined companies of the proposed transaction by providing information on estimated cost savings, synergies and accretion or dilution of earnings per share.
In this sense, the non-GAAP financial measures used in business combination transactions are truly pro-forma measures rather than GAAP substitutes and, therefore, do not have the same risk of misleading investors by "obscuring GAAP results". Indeed, the Commission does not propose to apply the 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.
In addition, we request that the Commission make clear in the final rules that the rules would not apply, under any circumstances, to financial analyses performed by any financial advisor, including any such analyses supporting a fairness opinion rendered by such financial advisor, that are summarized in the proxy statement, registration statement or tender offer document relating to the business combination.
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We appreciate the opportunity to comment to the Commission on the proposed rules, and would be happy to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to John T. Bostelman (212-558-3840), Robert E. Buckholz, Jr. (212-558-3876), David B. Harms (212-558-3882), Robert W. Reeder III (212-558-3755) or Donald C. Walkovik (212-558-3911) in our New York office, Scott D. Miller (650-461-5620) in our Palo Alto office or David B. Rockwell (011-4969-7191-2633) in our Frankfurt office. Any specific questions about our suggestion to exempt certain business combinations from Regulation G or Item 10 of Regulation S-K or any other questions concerning the implications of the proposed rules on M&A transactions may also be directed to James C. Morphy (212-558-3988), Mitchell S. Eitel (212-558-4960) or Stephen M. Kotran (212-558-4963) in our New York office.