The recent SEC enforcement action against ADT Inc. for its failure to comply with the SEC’s equal prominence requirements applicable to non-GAAP financial measures, as outlined in our recent blog post, is a clear reminder that public companies need to continue to be vigilant about the SEC’s non-GAAP financial measure rules. Also, the Staff has continued to focus on non-GAAP compliance in its comment letters, with non-GAAP financial measures being one of the leading areas of Staff comment over the last couple of years.
There are different layers of the SEC’s non-GAAP financial measures rules which apply to public companies in varying circumstances, depending on the nature of the public disclosure. Comprehensive knowledge regarding which level of the SEC’s non-GAAP financial measure rules applies to any particular disclosure is a key component when assessing legal considerations and risk in connection with the disclosure of non-GAAP financial measures.
Earnings Calls and Investor Presentations
When a public company makes a public statement that is not included in earnings release, periodic/current reports, annual reports or proxy statements, registration statements, or other SEC filings, such a disclosure is subject to the least restrictive non-GAAP financial measure legal paradigm by virtue of being subject to Regulation G (which applies to all “public statements”), but not Item 10(e) of Regulation S-K. Key types of disclosures that generally fit within this legal paradigm include quarterly earnings calls and (assuming not filed under Item 2.02 of Form 8-K) investor presentations. There may also be circumstances (such as in roadshows in connection with offerings made by public companies) where communications may not be deemed to be a public statement but where prudence and/or market practice counsel in favor of complying with Regulation G where non-GAAP financial information is presented.
Regulation G requires reconciliation to the most comparable GAAP measure and compliance with Regulation G’s anti-fraud requirements. However, public statements made within earnings calls and investor presentations are generally not subject to the more extensive non-GAAP requirements under Item 10(e) of Regulation S-K, the most important of which is the equal prominence requirement outlined in Item 10(e)(1)(i)(A) of Regulation S-K which is further discussed below. Although the non-applicability of the equal prominence requirement is significant, even when non-GAAP financial information is disclosed in earnings calls or other public disclosures not subject to Item 10(e) of Regulation S-K, public companies are cautioned (taking into account Staff guidance) not to overly hype non-GAAP financial measures at the expense of GAAP financial measures.
Moreover, public companies should be mindful that the reconciliation requirement of Regulation G applies not only to written disclosures (such as included in investor presentations) but also to public statements made via verbal communications such as those made in earnings calls. Moreover, this reconciliation requirement applies not only to inherent non-GAAP financial measures (such as Adjusted EBITDA), but also to ad hoc non-GAAP financial measures that may be used to highlight the impact of certain developments in the quarter (for example, the disclosure of net income, excluding the impact of a particular development in the quarter). In this regard, if non-GAAP financial measures are verbally presented in an earnings call, these non-GAAP financial measures do not need to be reconciled in the earnings call itself (although in certain circumstances a public company may be able to take the position that self-reconciliation occurs in connection with the presentation of the non-GAAP financial measure in the earnings call such that no further reconciliation is required), but must (if not reconciled in the earnings call) be reconciled in materials presented along with the earnings call, such as in an earnings release or investor deck presentation.
Earnings Release (and other disclosures under Item 2.02 of Form 8-K)
The level of SEC rules applicable to the presentation of non-GAAP financial measures in earnings calls and other disclosures under Item 2.02 of Form 8-K is more extensive than disclosures made in earnings calls and investor presentations but is less extensive than disclosures made in other SEC filings. In this regard, Item 10(e)(1)(i) of Regulation S-K applies to any disclosures made under Item 2.02 of Form 8-K pursuant to Instruction 2 of such Item, which requires disclosure where a public company “makes any public announcement or release (including any update of any earlier announcement or release) disclosing material non-public information regarding the registrant’s results of operations or financial condition for a completed quarterly or annual fiscal period.”
As such, earnings releases are subject both to Regulation G and Item 10(e)(1)(i) of Regulation S-K. The most significant incremental requirement applicable to earnings releases under Item 10(e)(1)(i) of Regulation S-K not applicable to earnings calls is the requirement to provide equal or greater prominence to the GAAP measure. Also, Item 10(e)(1)(i) requires public companies to disclose “why the registrant’s management believes that presentation of the non-GAAP financial measure provides useful information to investors.”
This equal prominence requirement was the subject of an SEC enforcement sweep in 2016 (where a significant number of public companies received letters from the SEC Division of Enforcement regarding their non-GAAP compliance) and remains a key area of focus for the SEC, including in comment letters. In complying with this requirement, public companies should (consistent with Staff guidance in C&DI 102.10) first present the most comparable GAAP measure before presenting a non-GAAP financial measure (once a particular non-GAAP financial measure has been utilized once in the earnings release, a public company may have greater flexibility to reference such non-GAAP financial measure later in the earnings release without first presenting the GAAP measure). Public companies should also be mindful, taking into account Staff guidance, not to provide a more extensive narrative discussion regarding the qualitative drivers of non-GAAP financial measures without providing a similar level of detail regarding the quantitative drivers of GAAP measures.
Other SEC Filings
The most extensive level of non-GAAP financial measure restrictions applies to Exchange Act filings (not including information furnished under Items 2.02 or 7.01 of Form 8-K), periodic/current reports, annual reports or proxy statements, registration statements, and other documents filed with the SEC (SEC filings) This disclosure requirement arises due to the fact that all of Item 10(e) of Regulation S-K (not just Item 10(e)(1)(i), which applies to earnings releases) applies to SEC filings of this nature.
While the equal prominence, reconciliation and anti-fraud requirements set forth in Item 10(e)(1)(i) of Regulation S-K and Regulation G, as applicable, collectively apply to both earnings releases and SEC filings, there are certain incremental aspects of Item 10(e) of Regulation S-K which apply to SEC filings but do not apply to earnings releases. As an example, the requirement in Item 10(e)(1)(ii)(A) of Regulation S-K that a registrant must not generally exclude cash settlement items from non-GAAP liquidity measures applies to SEC filings, but not earnings releases.
A practice tip in this regard is that a non-GAAP financial measure which has historically been utilized by a public company in its earnings releases should not similarly be disclosed in SEC filings (such as in a periodic report or registration statement) without an analysis confirming that the incremental non-GAAP restrictions set forth in Item 10(e) of Regulation S-K would not create issues with the inclusion of such non-GAAP financial measure in such SEC filing.
This stricter regulatory paradigm applicable to SEC filings does not mean that public companies should not present non-GAAP financial measures in SEC filings such as periodic reports or public offering documents. In this regard, while many public companies do not provide as extensive non-GAAP financial measure disclosure in periodic reports or public offering documents as they do in earnings releases, there may be considerations which weigh in favor of the disclosure of certain non-GAAP financial measures in SEC filings in certain circumstances, such as if a non-GAAP financial measure highlights significant trends impacting performance that would not be apparent from a company’s GAAP measures (or if industry or peer company practice otherwise dictates the inclusion of a particular non-GAAP financial measure in an SEC filing).
Target Compensation Levels
The final non-GAAP financial measure legal paradigm relates to the disclosure of non-GAAP financial measures when they are used as a target measure for compensatory purposes (such as in the CD&A of proxy statements).
In this regard, non-GAAP financial measures disclosed in proxy statements outside of this target measure context are subject to the same non-GAAP financial measure disclosure requirements applicable to other SEC filings as highlighted under (3) above. In contrast, as noted in the Staff’s guidance in C&DI 108.01, where non-GAAP financial measures are disclosed as a target metric for compensatory purposes, the applicable non-GAAP requirements set forth in Item 10(e) and Regulation G (reconciliation, equal prominence, etc.) do not apply. However, even though non-GAAP financial measure rules do not generally apply when non-GAAP financial measures are presented as a target metric for compensatory purposes, public companies should nevertheless be mindful when presenting non-GAAP financial measures in this context to be clear regarding how the non-GAAP financial measure is calculated.
If you have any questions about SEC rules regarding non-GAAP financial measures (including the information in this blog), or you would like a perspective as to how your company’s existing non-GAAP financial disclosures may implicate the SEC’s non-GAAP financial measure rules or compare to current market practices, your regular contact within our corporate and securities group or the author would welcome the opportunity to discuss further.
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