Latham & Watkins
December 16, 2002
Via E-mail - firstname.lastname@example.org
Attention: Jonathan G. Katz, Secretary
Re: File No. S7-43-02
Ladies and Gentlemen:
This letter is submitted in response to the request of the Securities and Exchange Commission (the "Commission") for comments on its November 13, 2002 release entitled Conditions for Use of Non-GAAP Financial Measures, Release Nos. 33-8145; 34-46788 (the "Release").1 This letter responds to one specific question raised by the Commission in the Release: "Consistent with current staff policy, our proposals would prohibit specified types of disclosures. Is such a prohibition necessary and appropriate?"
In response to this question, we will limit our comments to the proposed changes to Item 10 of Regulation S-K that would prohibit issuers from:
Section 401(b) of the Sarbanes-Oxley Act of 20022 (the "Act") directed the Commission to adopt rules requiring all issuers (except registered investment companies) filing reports under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), to make any public disclosure or release of "pro forma financial information" in a manner that is not misleading and that includes a reconciliation of the disclosed non-GAAP measure to the most comparable GAAP financial measure. The Release addresses this mandate by introducing the term "non-GAAP financial measures"3 and proposing Regulation G and, in tandem, amendments to Item 10 of Regulation S-K, Item 10 of Regulation S-B and Form 20-F to govern disclosure of non-GAAP financial measures by public companies. Independently, the Release also proposes a requirement that registrants file on Form 8-K within two business days any public announcement or release disclosing material non-public information regarding such registrant's results of operations or financial condition for an annual or quarterly fiscal period that has ended.
We support the Commission's rulemaking efforts both to implement the provisions of the Act, itself a monumental task, and to improve and modernize corporate disclosure and financial reporting. To the extent that the proposals in the Release promote "best practices" in order to make the use of non-GAAP financial measures more reliable, we support them. However, we do not believe the Act mandates the proposed Item 10 adjustment prohibitions, and we are concerned that the strict rules-based approach of these prohibitions will limit flexibility and have the unintended effect of restraining the flow of useful supplemental information in our dynamic securities markets. In particular, the prohibitions would prevent issuers from discussing their operating results in the vocabulary routinely used by management and analysts and would deprive investors and analysts of important supplemental information that is regularly used to understand a variety of industries and companies (particularly debt issuers). We believe this could adversely affect the capital formation process.
Moreover, we expect that investors and analysts will continue to demand the supplemental information that the proposal would ban from filings with the Commission. As a result, the proposal would have the perverse effect of forcing these continuing discussions out of the disciplined spotlight of public filings, which are reviewed by the Commission's Division of Corporation Finance and have the most serious liability implications for issuers, and into the less inclusive domain of conference calls and investor presentations. To us, this result would directly contradict the Commission's insistence on expanded, widely dispersed disclosure in the era of Regulation FD4 and substantially more extensive requirements for Management's Discussion and Analysis5. Furthermore, equipping issuers with a disclosure toolbox that contains only GAAP line items runs counter to the principles-based approach now under serious consideration for GAAP revisions pursuant to the Act.6 Plainly, strict compliance with GAAP is no assurance of investor protection.7 Importantly, when Section 302 of the Act requires certification that financial statements and other financial information included in a periodic report "fairly present in all material respects the financial condition and results of operations of the issuer", the words "in accordance with GAAP" are conspicuously missing. The proposed Item 10 prohibitions, by contrast, seem to make GAAP the be-all and end-all.
If adopted as proposed, these prohibitions would force hundreds of companies to change the way they present themselves to investors and analysts. Non-GAAP financial measures are widely used in specific industries, including virtually all publicly traded real estate investment trusts (REITs), which disclose "funds from operations" (FFO)8; retailers which often disclose EBITDAR (EBITDA before rental expense)9; broadcasters and media companies, which often disclose "broadcast cash flow"10 ; lodging companies, which often disclose "revenue per available room" (RevPAR)11; and energy companies, which often disclose EBITDAX (EBITDA before depletion and exploration costs)12. We see no reason why the investors and analysts who follow these industries should be denied access to this information from the issuers themselves, disclosed within the rigorous discipline of the public filing process. Measures such as these have become commonplace because GAAP line items do not, by themselves, tell "the whole story" necessary to understand specific businesses and industries. In short, the marketplace for financial analysis has determined that this non-GAAP information is material to an understanding of these businesses.
EBITDA. By far the most widely used non-GAAP financial measure is EBITDA (earnings before interest, taxes, depreciation and amortization), which is routinely reported by hundreds of public companies and widely used by analysts. Textbooks on corporate finance teach EBITDA as a tool in financial analysis.13 In analyzing companies' abilities to incur and service debt for rating purposes, the major rating agencies include EBITDA- based ratios for all of the companies they cover, from investment grade to high yield rating categories.14 Equity analysts and mutual funds often use EBITDA as a tool in valuing businesses15. Private equity firms and their financing sources routinely value issuers on the basis of EBITDA multiples. Lending sources analyze their willingness to lend based on maximum "leverage ratios" (total debt/ EBITDA) and "coverage ratios" (EBITDA/interest expense). Many management compensation plans are based on achieving targeted levels of EBITDA.
In the high yield debt market, EBITDA has become a universally used and accepted tool for evaluation of an issuer's capacity to service debt. Virtually all high yield issuers disclose EBITDA, and analysts covering high yield issuers present EBITDA analysis for virtually every issuer.16 This is hardly surprising, since high yield issuers are party to credit agreements and bond indentures in which their ability to take any significant corporate action is governed by ratios tied to non-GAAP measures such as EBITDA. In some cases, the most heavily negotiated provision of the credit agreement or indenture is the definition of "EBITDA," which is used in many of the critical financial covenants. Many sub-investment grade credit agreements even have "grid pricing" mechanisms where interest rates are tied to the borrower's level of EBITDA or a related non-GAAP measure. For these reasons, investors and analysts have demanded that issuers of high yield bonds provide EBITDA data to supplement their GAAP financial statements.
Literally read, the proposed Item 10 revisions would prohibit inclusion of EBITDA in Commission filings17 if EBITDA is used as a "liquidity measure" since interest and taxes (both cash items) are added back to earnings to calculate EBITDA. Proposed Item 10, consistent with comments our clients have recently received from the Staff during the registration process and published Staff accounting guidance,18 seems to force what we consider to be a false distinction as to whether EBITDA is a "liquidity measure" or a "performance measure." Ironically, a forced categorization as one or the other contradicts a disclosure that the Staff has required for years - namely that EBITDA should not be considered as a substitute for GAAP income or cash flow measures.
Simply put, EBITDA is EBITDA. EBITDA is a hybrid that cannot generally be categorized as a "liquidity measure" or a "performance measure." On the one hand, all of its elements are derived from (and easily reconciled to) the income statement and it is a carefully watched "performance measure" for management, investors and analysts, and serves as a common covenant compliance test and valuation tool. On the other hand, it serves an important function as an indicator of a company's ability to generate "free cash flow"19 and cash available for debt service, and is therefore something of a "liquidity measure." Indeed, the ubiquitous use of EBITDA for this purpose (compared to the use of GAAP line items) makes it clear that many investors and analysts consider EBITDA to be a more useful measure of a company's ability to generate "free cash flow" than the much broader GAAP cash flow measures, which reflect a variety of trends on the balance sheet such as changes in working capital and financing transactions.
We expect that other non-GAAP financial measures also serve multiple purposes, and we believe it is unwise to build a regulatory scheme that forces issuers to make an arbitrary distinction between "performance measure" and "liquidity measure" to determine whether the non-GAAP measure can be used at all, or what calculations may be included. We suspect that in many cases the categorization would conveniently be defined by the type of adjustments the issuer is seeking to make rather than any real classification. Nevertheless, if the proposed rule stands as written and issuers are forced to artificially pigeonhole EBITDA into one category or the other, it should still be permitted as a "liquidity measure" because it is primarily measuring the availability of cash to service debt. In that context, interest expense and taxes (which are paid after interest expense is deducted) are cash add-backs that are generally available to service debt.
We believe proposed Item 10 fundamentally misunderstands the use of EBITDA by analysts and investors, and that banning EBITDA from Commission filings (except for issuers who arbitrarily label it as a "performance measure"), would serve no useful purpose for companies or investors. Instead, because EBITDA is such a widely used measure, we believe that any rulemaking focused on non-GAAP financial measures should squarely address EBITDA. We suggest that, in the final rulemaking, the Commission acknowledge that EBITDA is a permitted non-GAAP financial measure (without any categorization requirement) and expressly clarify the type of reconciliation to GAAP measures that should be used for EBITDA. In that regard, we believe that the most logical GAAP measures are net income or operating income, since EBITDA is derived directly from income statement line items.20 Further, we believe that issuers should be permitted to start with either GAAP net income (before extraordinary items, if applicable) and add back interest, taxes, depreciation and amortization, or with operating income and add back depreciation and amortization.
Adjusted EBITDA. The utility of EBITDA as an analytical tool would be severely limited by the proposed Item 10 prohibitions, which would effectively eliminate most common adjustments used by companies and analysts. For example, in presenting credit ratios that include a number of EBITDA-based measures, Standard & Poor's eliminates non-recurring gains and losses such as gains and losses on asset sales, significant transitory income items, unusual losses, charges due to asset write-downs, plant shutdowns and retirement programs.21 In our review of research coverage of approximately 150 high yield issuers, a clear majority included Adjusted EBITDA presentations.
Adjusted EBITDA is a commonly used non-GAAP measure in high yield debt offerings, because sub-investment grade companies are often undergoing fundamental changes in their businesses, such as major acquisitions or recapitalizations. In this context, many companies have taken the view that historical GAAP financial statements and EBITDA derived therefrom do not alone provide investors with a basis for understanding their ability to service debt on a "normalized" basis. In many cases, it is "Adjusted EBITDA" that is used in compensation plans, in financial covenants, in setting maximum debt levels in the "pricing grids" in credit agreements and indeed in setting values in enterprise sale transactions. Whenever an issuer's operating results are disclosed, understanding the impact of particular events is often necessary to allow investors to better see those results through the eyes of management.22 Issuers may quite appropriately wish to focus investors' attention on critical components of quarterly or annual financial results in order to provide a meaningful comparison to results for the same period of prior years or to emphasize the results of core operations. Many high yield issuers (and the analysts that cover them) routinely disclose EBITDA as adjusted for a variety of items such as:
Because many of these items "required, or will require, cash settlement," proposed Item 10 would flatly prohibit adjustments for them in any presentation of non-GAAP financial measures. In effect, the Commission seems to be saying that such adjustments are never appropriate and are misleading per se. We do not believe such an outright ban is necessary or appropriate to implement Section 401(b) of the Act. We believe that this common practice by which many issuers, analysts and investors seek to supplement their analysis of GAAP financial performance and EBITDA by "backing out" the effect of certain items that management feels are not illustrative of expected future results should be permitted within appropriate guidelines, so that investors can be allowed to look at the company's results the same way management and its lenders do.23 This approach is inherently company-specific and transaction-specific and does not lend itself to rigid rules or prohibitions. We suggest that adjustments to non-GAAP measures should instead be governed by principles-based guidelines (such as those specified elsewhere in the proposal) and the overriding influence of potential liability for material misstatements or omissions.
Presentation. We agree with many of the presentation requirements suggested in the Release. We agree that EBITDA should not be presented as part of an income statement, should not be given priority over GAAP cash flow, net income or operating income. We believe EBITDA should be reconciled to net income or operating income as suggested above. Adjustments to EBITDA should be balanced, should reflect only transactions outside the ordinary course of business and should be itemized, quantified, explained and justified under a clearly labeled caption, with the resulting adjusted number clearly labeled "Adjusted EBITDA." A requirement for explanations of this kind would impose greater discipline and uniformity on the content and presentation of EBITDA and Adjusted EBITDA. Within these parameters, we believe EBITDA and Adjusted EBITDA presentations by issuers as "Other Data" within an offering document, periodic report or press release are helpful to investors and analysts and should be permitted.
The excesses that Congress and the Commission are responding to arose from bad disclosure about "pro forma" results. In our view, better disclosure is the appropriate response, not less disclosure. We believe that requiring more discussion and improved disclosure will better serve the intent of Section 401(b) of the Act than a strict prohibition of these non-GAAP measures.
Differential Disclosure Issues. We think it is clear that institutional investors24 and analysts will continue to demand non-GAAP measures such as EBITDA and Adjusted EBITDA. This would raise differential disclosure concerns if they are only permitted to be discussed within the investment community and prohibited in filings with the Commission.
It remains to be seen whether Item 10 would spawn a dual track disclosure model in which only strict GAAP information is filed with the Commission while tabular non-GAAP measures are made available in private (subject to Regulation FD disclosure when appropriate). It is inconceivable, for example, that EBITDA and Adjusted EBITDA will not be discussed among high yield issuers, investors and analysts at investor conferences, in "road shows" for offerings of high yield securities, and in any other meaningful forum for review of the issuers' results and prospects. We assume other industries will find a way to discuss the non-GAAP measures that their investors and analysts care about. Perhaps issuers will discuss the non-GAAP measures and adjustments they consider meaningful in the Management's Discussion and Analysis portion of their public filings, and leave the tabular presentations that investors and analysts have come to expect to private forums. In those circumstances, the tabular presentations that are now routinely vetted in public disclosure documents might never see the public light of day. We question how investors will benefit from a regime that restricts access to supplemental information that is now routinely available and useful.
In conclusion, we respectfully submit that inasmuch as measures such as EBITDA and Adjusted EBITDA are routinely used by management, lenders, bondholders, rating agencies, compensation committees, investors and analysts as well as in the valuation of equity securities and companies in M&A transactions, these measures are material and, consequently, have become ubiquitous. The proposed prohibitions in Item 10 would take most of these non-GAAP disclosures, which have evolved over time in the free flow of information surrounding our dynamic capital markets, and throw them out of the most important forum for full and fair disclosure: Commission filings. In our view, it cannot be the case that disclosure documents would be improved by eliminating this material supplemental information. Improving the presentation of non-GAAP financial measures is a goal we support. Any flat prohibition on properly explained supplemental information would be inappropriate.
To assist the Commission with this rulemaking, we have attached as Appendix A a blackline of the proposed amendments to Item 10 consistent with the suggestions contained in this letter and, we submit, the Commission's approach to principles-based changes to MD&A and other disclosure requirements.
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We appreciate the opportunity to submit comments. We are available to meet with the Commission or the Staff and to respond to any questions. Please call Mark Stegemoeller at (213) 891-8948, John Huber at (202) 637-2242 or Kirk Davenport at (212) 906-1284 if you would like to discuss any of our comments.
cc: Hon. Harvey L. Pitt
Hon. Cynthia A. Glassman
§229.10 (Item 10) General.
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(B) A quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure disclosed with the financial measure or measures calculated and presented in accordance with GAAP identified in paragraph (e)(1)(i)(A) of this section;
(D) A statement disclosing the reasons why the registrant's management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant's financial condition
1. Certain non-GAAP measures serve more than one purpose and may have no single GAAP financial measure that is "most directly comparable." In such cases, more than one GAAP financial measure may need to be presented with equal or greater prominence to the non-GAAP financial measure. For example, "EBITDA" (generally defined as earnings before interest, taxes, depreciation and amortization) is used in a variety of ways and should be presented, for purposes of clause (e)(i)(A), together with both (i) GAAP operating income or net income and (ii) GAAP cash flow from operations, cash flow from investing activities, and cash flow from financing activities, and ratios of EBITDA to interest expense or fixed charges should be presented together with ratios of earnings to fixed charges prepared in accordance with Item 503(d) of Regulation S-K. EBITDA should be reconciled either to GAAP operating income by adding GAAP depreciation and amortization or to GAAP net income (before extraordinary items, if applicable) by adding GAAP interest expense, taxes, depreciation and amortization. A similar approach should be used in presenting other non-GAAP financial measures for which no single GAAP financial measure is "most directly comparable."
(iii) If the filing is not an annual report on Form 10-K or Form 20-F (17 CFR 249.220f), a registrant need not include the information required by paragraphs (e)(1)(i)(C) and (e)(1)(i)(D) of this section if that information was included in its most recent annual report on Form 10-K or Form 20-F or a more recent filing, provided that the required information is updated to the extent necessary to meet the requirements of paragraphs (e)(1)(i)(C) and (e)(1)(i)(D) of this section at the time of the registrant's current filing.
(i) 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 issuer; or
(3) For purposes of this paragraph (e), "GAAP" refers to generally accepted accounting principles in the United States, except that in the case of foreign private issuers whose primary financial statements are prepared in accordance with other generally accepted accounting principles, references to GAAP also include the principles under which those primary financial statements are prepared.