SEC Proposes Rules Implementing Provisions of The Sarbanes-Oxley Act of 2002 Requiring Companies to Reconcile Non-GAAP Financial Information ...

by John F. Olson, Ronald O. Mueller, Brian J. Lane, Amy L. Goodman, Michael J. Scanlon and Ashley Wakefield

On October 30, 2002, the United States Securities and Exchange Commission (the "Commission") proposed several rules implementing the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"). These proposed rules will be included in Commission releases to be issued shortly (and posted on the Commission's website). Rules were proposed under Section 401 (Disclosures in Periodic Reports) and Section 306(a) (Insider Trades During Pension Fund Blackout Periods – Prohibition of Insider Trading During Pension Fund Blackout Periods) of the Sarbanes-Oxley Act. This summary is based on information provided at the Commission's open meeting and therefore may not reflect nuances that appear in the official text.

1. Conditions for Use of Non-GAAP Financial Information

Section 401(b) of the Sarbanes-Oxley Act directs the Commission to, not later than 180 days after the enactment of the Sarbanes-Oxley Act (January 26, 2003), issue rules providing that pro forma financial information included in any periodic or other report filed with the Commission, or in any public disclosure or press or other release, be presented in a manner that (a) does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the pro forma financial information, in light of the circumstances under which it is presented, not misleading, and (b) reconciles such pro forma information with the financial condition and results of operations of the issuer under generally accepted accounting principles ("GAAP"). In order to implement the Section 401(b) directive, the Commission has proposed to amend Item 10 of Regulations S-K and S-B and to adopt a new Regulation G. Additionally, the Commission has proposed to amend Form 8-K to require public companies to file certain press releases, as discussed below.

The proposed Regulation G would require any public company that publicly discloses material information that includes a non-GAAP financial measure to also present the most direct comparative GAAP financial measure and provide a quantified reconciliation of the non-GAAP financial measure with the most direct comparative GAAP financial measure. A non-GAAP financial measure would be defined as a numeric measure of an issuer's financial performance that either (i) excludes amounts or is subject to adjustments that have the effect of excluding amounts that are included in the comparative measure calculated and presented in accordance with GAAP (in the statement of income, balance sheet or statement of cash flows of the issuer), or (ii) includes amounts or is subject to adjustments that have the effect of including amounts that are excluded from the comparative measure calculated and presented in accordance with GAAP. A non-GAAP financial measure would not include operating and other statistical measures such as unit sales and number of employees. The proposed Regulation G would also prohibit public companies from making public disclosure of a non-GAAP financial measure which, when taken together with the information accompanying it, contains an untrue statement of material fact, or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure in light of the circumstances presented, not misleading. In response to a question posed by Commissioner Harvey J. Goldschmid, the Division of Corporation Finance noted that statements deemed to be materially misleading under proposed Regulation G would not independently constitute a violation of Rule 10b-5 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), although the same facts may lead to a violation of Rule 10b-5.

As proposed, Regulation G would apply to all public companies, including foreign private issuers. An exception would exist, however, for certain disclosures or releases of non-GAAP financial measures made by foreign private issuers when the following three conditions are met: (i) the securities of the foreign private issuer are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States; (ii) the non-GAAP financial measure and comparative financial measure is not presented in accordance with United States GAAP; and (iii) the disclosure is made outside the United States or is included in a written communication released only outside the United States.

As noted above, the Commission also proposed amendments to Item 10 of Regulations S-K and S-B to codify the Commission's policy on the use of pro forma financial information by requiring any non-GAAP presentations to be accompanied by a quantified reconciliation to GAAP as well as a discussion of why investors may find such non-GAAP financial measures useful. The proposal also would codify previous Commission positions on the use of non-GAAP financial measures in public filings. See Release No. 33-8039 (avail. Dec. 4, 2001).

Finally, the Commission proposed to require public companies to file on Form 8K any earnings release or earnings announcement for any completed fiscal period. The amendment would not, however, require companies to issue earnings releases or other press releases. The filing requirement would be triggered when material non-public information is released regarding results of operations or financial operations for a completed fiscal quarter or year but would not be triggered by earnings updates during a fiscal period unless such earnings updates include material non-public earnings information for a completed fiscal period. Further, any public disclosure of financial information for a completed fiscal period in a presentation that is made orally, telephonically, by webcast or similar means would not be required to be filed if: (i) the presentation occurs within 48 hours of the related release filed on Form 8-K; (ii) the presentation is accessible to the public; and (iii) the information is posted on the company's website.

2. Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments

Section 401(a) of the Sarbanes-Oxley Act directs the Commission to, not later than 180 days after the enactment of the Sarbanes-Oxley Act (January 26, 2003), issue rules providing that each annual and quarterly report required to be filed with the Commission disclose all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that "may" have a current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.

In order to implement the Section 401(a) directive, the Commission proposed to require disclosure of the above information unless the likelihood of an occurrence of a future event or the materiality of the effect of that event is "remote". The proposed rules would thus lower the threshold triggering disclosure relating to off-balance sheet transactions from "reasonably likely" (the current MD&A standard) to a requirement that the transaction must be reported if the likelihood of the transaction having a material effect on the company is more than "remote". Note that the proposed standard is also different than the "may" standard used in Section 401(a) of the Sarbanes-Oxley Act.

The proposal would also require additional disclosure of aggregate contractual obligations and contingent liabilities and commitments in a single location (such disclosure is currently disbursed throughout the filings of public companies). While this is not explicitly mandated by Section 401(a), the Commission indicated in Release No. 33-8056 (avail. Jan. 23, 2002) that putting such information in a single location would be beneficial to investors. As such, the Commission proposed to amend the Item 303 of Regulation S-K (the MD&A rules) to require registrants to include tabular disclosure about aggregate contractual obligations and tabular or textual disclosure about aggregate contingent liabilities and commitments in the MD&A section of quarterly and annual reports. Such disclosure would include information about a registrant's known contractual obligations and contingent liabilities and commitments including both on and off-balance sheet arrangements as of the latest balance sheet date. These disclosure requirements would not apply to small business issuers.

3. Insider Trades During Pension Fund Blackout Periods

Section 306(a) of the Sarbanes-Oxley Act prohibits directors or executive officers of an issuer from, directly or indirectly, purchasing, selling, or otherwise acquiring or transferring any equity security of the issuer (other than an exempted security) during any pension fund blackout period with respect to such equity security if the director or officer acquired the equity security in connection with his or her service or employment as a director or executive officer.

Section 306(a) also directs the Commission to issue rules to clarify its application. In issuing its proposed rules, the Commission proposed to incorporate many of the concepts used in Section 16 of the Exchange Act. The Commission stated that it proposed to apply the rules to directors and executive officers of reporting companies (including foreign private issuers, banks and savings associations and small business issuers). The term "director" would have the same definition given to it under the Exchange Act rules and the term "executive officer" would mean "officer" as defined in Section 16(a) of the Exchange Act (as opposed to the definition of "officer" in Rule 3b-2 under the Exchange Act).

As drafted, Section 306(a) of the Sarbanes-Oxley Act applies to equity securities, but under the proposed rules, this term would also include derivative securities (as defined in the Section 16 rules) relating to equity securities. The proposed rules also apply to indirect and direct acquisitions and dispositions of equity securities where a director or executive officer has a pecuniary interest in the transaction. The term "pecuniary interest" would also have the same meaning as under the Section 16 rules, thereby including certain acquisitions and dispositions made by family members, partnerships, corporations, limited liability companies and trusts.

As Section 306(a) allows the Commission to exempt certain transactions from the trading prohibition, the proposed rules would exempt the following transactions: (i) acquisitions of equity securities under dividend or interest reinvestment plans; (ii) purchases or sales of equity securities that satisfy the affirmative defense conditions of Exchange Act Rule 10b5-1(c) (Rule 10b5-1 trading plans); (iii) purchases or sales of equity securities pursuant to certain employee benefit plans, other than discretionary transactions; and (iv) increases or decreases in equity securities holdings resulting from a stock split, stock dividend or pro rata rights distribution.

The Section 306(a) statutory prohibition is only triggered if the blackout period lasts more than 3 consecutive business days and temporarily suspends the ability of at least 50% of the participants or beneficiaries under all individual account plans maintained by the issuer to purchase or sell an interest in issuer equity securities held in an account plan. Different standards are proposed to apply to foreign private issuers. Commissioner Paul S. Atkins expressed some concern over imposing the Section 306(a) restrictions on foreign private issuers as such an action might dissuade such foreign entities from investing in the United States. The Commission encouraged comments on this issue. The proposed rules will also specify the timing and content of an issuer's notice obligations to directors, executive officers, participants or beneficiaries under individual plans and the Commission.

Section 306(a) also provides remedies for violating of the prohibition. An issuer or a security holder of that issuer (on behalf of the issuer) may bring an action to disgorge profits realized by a director or executive officer who trades during a blackout period. Additionally, a violation of the trading prohibition will subject the director or executive officer to possible enforcement action by the Commission.

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