United States: Securites Legal Update - SEC Issues Final Rules on Use of Non-GAAP Financial Measures and Furnishing Earnings Releases on Form 8-K

In our Securities Legal Alert dated December 3, 2002, we discussed the SEC’s proposed rules to implement Section 401(b) of the Sarbanes-Oxley Act of 2002. The SEC has adopted final rules setting forth the following principal requirements:

• Public disclosure of non-GAAP financial measures must be accompanied by the most directly comparable GAAP measures.
• Non-GAAP financial measures must be reconciled to the most directly comparable GAAP measures.

• Issuers must furnish earnings releases and similar public disclosures about historical financial performances (oral as well as written) to the SEC on Form 8-K.

In addition to these affirmative items, the final rules contain a number of significant prohibitions, as discussed below.

These rules are first effective for disclosures made as of March 28, 2003; however, the special portion of the new rules that is applicable only to disclosures made in SEC filings is effective only for filings covering periods ending after March 28. The requirement to furnish disclosures containing non-GAAP financial measures on Form 8-K is effective for disclosures made after March 28.

The rules apply to any SEC reporting company, other than investment companies. Their application to foreign issuers differs in some important respects from their application to domestic issuers—we do not cover these distinctions here.

The new rules regarding non-GAAP financial measures are contained in two places:

• New Regulation G, which applies to any public disclosure—not only SEC filings, but also press releases and website and oral disclosures.
• New Item 10 of Regulation S-K (and Regulation S-B for small issuers), which provides additional rules for SEC filings only.

Under the final rules, earnings releases (and certain similar public disclosures) must be "furnished" to the SEC pursuant to new Item 12 of Form 8-K, but they do not need to be "filed", as the SEC had initially proposed to require. Consequently, these releases furnished on Form 8-K will not be subject to Item 10 of Regulation S-K, which applies only to SEC filings.

Although the Regulation S-K requirements that apply only to SEC filings cover some additional, more stringent matters, companies should be wary of over-reliance on these distinctions in assessing compliance with Regulation G. For example, if an issuer would be prohibited by Item 10 of Regulation S-K from adjusting a measure for a "non-recurring" charge in an SEC filing, the issuer should think twice before disclosing the same adjustment in a press release or in another non-filed format, even though Regulation G might not expressly forbid it in that context. It is possible that Regulation G’s general prohibition against misleading uses of non-GAAP financial measures in any type of public disclosure may be interpreted in some situations in light of the additional specific matters contained in Item 10 of Regulation S-K.

General. The basic definition of non-GAAP financial measure is a numerical measure of a 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 most directly comparable GAAP measure in the financial statements; or

• includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable GAAP measure.

What’s Included in the Definition: Non-GAAP financial measures include any item that has the effect of depicting either:

• a measure of performance that is different from net income or similar performance measures in the financial statements, or

• a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.

Consequently, a measure of operating income that excludes one or more expenses, or a revenue item that is characterized as "non-recurring," is a non-GAAP financial measure. And, of course, EBIT or EBITDA are such measures that are subject to the rules.

What’s Not Included: Non-GAAP financial measures do not include:

• operating and other statistical measures that are not derived from a GAAP-required item in the issuer’s financial statements (such as unit sales, numbers of employees, numbers of subscribers, or numbers of advertisers); and

• ratios or statistical measures that are calculated using exclusively one or both of (a) GAAP measures and (b) operating measures or other measures that are not non-GAAP measures.

Permissible ratios and measures include sales per square foot and same store sales (assuming in both cases that the sales figure is derived from GAAP), and operating margin calculated by dividing revenues into operating income, where both revenue and operating income are GAAP figures.

Non-GAAP financial measures also do not include numerical measures that do not provide information different from the comparable GAAP measure, including:

• disclosure of amounts of expected indebtedness;

• disclosure of amounts of repayments that have been planned or decided upon but not yet made;

• disclosure of estimated revenues or expenses of a new product line, so long as such amounts were estimated according to GAAP; and GAAP-required segment information.

Finally, the definition does not include:

• non-GAAP disclosure required by regulators;

• non-GAAP per share information; and

• non-GAAP information about a business combination transaction that is presented in a business combination communication subject to SEC rules.

Regulation G and Item 10 of Regulation S-K both require that, whenever a company or person acting on its behalf publicly discloses material information that includes a non-GAAP financial measure, the non-GAAP measure must be accompanied by:

• a presentation of the most directly comparable financial measure as calculated and presented in accordance with GAAP; and

• a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP measure and such most directly comparable GAAP measure.

In addition to the above common affirmative disclosure requirements, all non-GAAP financial measures are subject to the following condition. Neither a company nor a person acting on its behalf can disclose publicly a non-GAAP financial measure that, taken together with the information and discussion accompanying the measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP measure, in light of the circumstances under which it is presented, not misleading.

Forward-Looking Information. If the non-GAAP financial measure is forward-looking, the quantitative reconciliation to the most directly comparable GAAP measure must be provided "to the extent available without unreasonable efforts". If the forward-looking GAAP measure is not available, companies must disclose that fact, disclose the probable significance of its unavailability, and provide whatever reconciling information is available without unreasonable efforts.

As previously noted, Item 10 of Regulation S-K, applicable only to SEC-filed documents, contains express requirements beyond those applicable to public disclosures generally pursuant to Regulation G.

All SEC filings containing non-GAAP financial measures must disclose:

• the reasons why management believes the non-GAAP financial measure provides useful information to investors; and

• to the extent material, any additional reasons why management uses the non-GAAP financial measure.

The fact that analysts use the particular measure will not be considered a sufficient reason. To the extent management’s reasons have not changed at the time of a particular filing, companies can rely on complying statements in their most recent Form 10-K (or a more recent filing), provided the statements are updated asnecessary.

By virtue of requirements included in new Item 12 of Form 8-K (which is discussed below), the requirement for these statements also applies to non-filed public disclosures (that are otherwise only subject to Regulation G) in connection with "furnishing" those disclosures to the SEC on Form 8-K. But, the prohibitions of Regulation S-K described next do not apply to non-filed disclosures.

Under new Item 10 of Regulation S-K, a company must not, in an SEC filing:

• exclude 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 (EBIT and EBITDA are excepted from this prohibition);

• adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent, or unusual, when (a) it is reasonably likely that the item will recur within two years, or (b) there was a similar item within the prior two years;

• present non-GAAP financial measures on the face of GAAP financial statements or notes thereto;

• present non-GAAP financial measures on the face of any pro forma historical financial information related to business combinations or significant asset sales or dispositions that is required pursuant to Article 11 of Regulation S-X; or

• use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP measures.

If a non-GAAP financial measure is used in a public disclosure that is transmitted orally—including telephonically, by webcast or by broadcast— companies may provide the required Regulation G information by posting it on the company’s website and disclosing the location and availability of the required information during the presentation. As discussed below, such oral and similar disclosures are subject to the Form 8-K furnishing requirement, unless the disclosure is covered under the exception applicable to the typical earnings conference call.

General. The SEC has added new Item 12 to Form 8-K to require companies to "furnish" to the SEC,Page 3 of 5within five business days of the disclosure, any written or oral public announcement or release, or update of the foregoing, disclosing material non-public information regarding the company’s results of operations or financial condition for completed quarterly or annual fiscal periods.

While the requirement covers disclosures relating to the historical financial performance of a company, such as the typical earnings release, it does not apply to disclosures that are solely forward-looking, such as earnings estimates.

The new rules do not require that companies disseminate earnings information prior to filing the SEC report for the most recently completed fiscal period. But, if a company does so, the new furnishing requirement comes into play.

Furnishing vs. Filing. Pursuant to the new disclosure item, information is "furnished" to the SEC, rather than filed, even though a Form 8-K is used. The differences between furnishing and filing information is that, in the case of the former:

• furnished information that contains non-GAAP financial measures are not subject to Item 10 of Regulation S-K;

• furnished information does not become part of the issuer’s reported information and, therefore, does not create liability exposure under Section 18 of the Securities Exchange Act of 1934; and

• for the above reason, furnished information is not automatically incorporated by reference into previously-filed registration statements on Form S-3 or S-8, and consequently does not subject the issuer to liability under Section 11 of the Securities Act of 1933.

It should be noted, however, that any materially deficient non-GAAP financial measure or other disclosure in the underlying material being furnished would be subject, in any case, to the ubiquitous antifraud remedies under Section 10(b) and Rule 10b-5 of the Securities Exchange Act. It is only that the "furnishing" per se on Form 8-K does not create an additional liability exposure to a private action.

Reasons for Use. It is also important to note that new Item 12 of Form 8-K incorporates the portion of the Regulation S-K requirements for statements about the company’s belief in the utility of non-GAAP financial measures it uses and its reasons for their use. Accordingly, as discussed above, that information must be included with the "furnished" document (unless adequately disclosed in an earlier annual or quarterly report), even though it is not required in the public disclosure as initially made.

Earnings Conference Calls. The furnishing requirements apply to oral as well as written disclosure, but the rules contain an exception that should cover a typical earnings conference call. Companies are not required to furnish on a new Form 8-K material non-public information that is disclosed orally, telephonically, by webcast, by broadcast, or by similar means if:

• the information is provided as part of a presentation that is complementary to, and initially occurs within 48 hours after, a related, written announcement or release that has been furnished on Form 8-K prior to the presentation;
• the presentation is broadly accessible to the public by dial-in conference call, by webcast, by broadcast, or by similar means;

• the financial and other statistical information contained in the presentation is provided on the company’s web site, together with any required Regulation G disclosure; and

• the presentation was announced in advance by a widely disseminated press release that included instructions as to when and how to access the presentation, and the location on the company’s website where the information would be available.

Most companies that release periodic earnings data prior to filing the related SEC report for the fiscal period already follow substantially similar procedures to comply with Regulation FD (discussed below). The principal addition to these procedures is that the earnings release, in addition to dissemination via the news wire services, must be furnished on Form 8-K pursuant to new Item 12 prior to the call.

An important question is to what extent can company personnel venture outside the subject matter of the furnished earnings release in the subsequent conference call and still be covered by the exception.The SEC has stated that it does not intend to change "current practices where presentations include information that, although not already included in the related, written release or announcement, is complementary thereto." However, the SEC also does not want to encourage a shift in the disclosure emphasis from the release to the oral presentation. This approach seems largely consistent with Regulation FD, which permits a company to go outside of its earnings release in the conference call, provided that the company follows procedures similar to those described above.

Companies should be cognizant of the relationship (and differences) between new Item 12 of Form 8-K and Regulation FD, the SEC’s rule prohibiting selective disclosure of material non-public information to certain prohibited persons, such as analysts and other investment professionals.

Regulation FD requires simultaneous disclosure to the public, via press release or similar means such as a Form 8-K, of any material non-public information disclosed to one of the prohibited recipients. If a company is required to publicly disclose material non-public historical financial information because of Regulation FD, the company will now be required to "furnish" such information on Form 8-K pursuant to new Item 12 as well. Moreover, to the extent such information contains non-GAAP financial measures, the disclosure rules of Regulation G also will apply.

Regulation FD requires simultaneous public disclosure if a selective private disclosure is made, while the new rules allow a company five business days to furnish subject information on Form 8-K, and even provides an exception if the company can meet the criteria previously described that should cover earnings conference calls. Moreover, the new Form 8-K requirement is only triggered if the information relates to historical financial performance, whereas Regulation FD is triggered by any material non-public disclosure.

Accordingly, compliance with the new rules does not ensure compliance with Regulation FD. Companies necessarily will need to focus attention to both sets of requirements.