The SEC filed and settled on November 12, 2009, its first enforcement action under Regulation G, which places conditions on the use of non-GAAP financial measures by public companies. The SEC’s action against SafeNet, Inc. and five of SafeNet’s former officers and accountants alleges a number of actions (including option backdating and improper accounting). However, the SEC’s focus on the Regulation G issues provides interesting and timely guidance for reporting companies considering using non-GAAP financial measures in their financial disclosures.
The SEC adopted Regulation G in 2003, in the wake of the Sarbanes-Oxley Act, intending to address public companies’ disclosure of financial information calculated and presented on the basis of methodologies other than GAAP. Regulation G applies whenever a reporting company, or a person acting on the company’s behalf, discloses publicly any material information that includes a non-GAAP financial measure. Regulation G prohibits companies from disseminating false or misleading non-GAAP financial measures, and from using a presentation of non-GAAP financial measures that obscures the company’s GAAP results. Public companies releasing non-GAAP financial measures must reconcile them to the most directly comparable GAAP financial measure. For reports filed with the SEC, a corollary rule goes further to require a statement of the reasons why management believes the presentation of the non-GAAP financial measure is useful to investors.
According to the SEC’s complaint, SafeNet characterized certain integration expenses relating to recent acquisitions as non-recurring or one-time, and as such, excluded them from its calculation of non-GAAP earnings per share. As alleged by the SEC, by deliberately misclassifying these recurring operating expenses (over the insistence of its auditors that such expenses not be characterized as integration expenses) SafeNet was able to meet or exceed Wall Street earnings per share estimates in 2004 and 2005. The alleged actions by SafeNet and the other defendants led to SafeNet publicly disclosing misleading non-GAAP financial measures in violation of Regulation G.
The defendants in this action settled the matter without admitting or denying the allegations in the complaint. Elements of the settlement include permanent injunctions against future violations of the federal securities laws (including Regulation G), fines and, for the individual defendants, a prohibition against serving as an officer or director of any public company or from appearing or practicing before the SEC; these settlements reflected the defendants’ cooperation with the SEC in its investigation.
Although the allegations in this case indicate that the SEC would have proceeded with other causes of action with respect to materially false and misleading disclosures by the defendants, this first enforcement action under Regulation G suggests some guidance for officers, employees and audit committees of public companies.
- Understand why you are excluding expenses to arrive at the non-GAAP financial measure. Maintain a careful record of the analysis and accounting principles and other support used to arrive at the conclusion that the expenses may be excluded from the presentation.
- Distinguish ordinary operating expenses from non-recurring expenses. It is crucial to remember that a non-ordinary course event such as an acquisition does not, in itself, make ordinary operating expenses nonrecurring. Be careful not to characterize excluded expenses as non-recurring where the nature of the charge is such that it is reasonably likely that it will reoccur within the next two years or there was a similar charge within the preceding two years. If properly characterized, excluding these charges is not per se prohibited, but rather companies that exclude them must meet the burden of demonstrating the usefulness of any measure that excludes recurring items, especially if the non-GAAP financial measure is used to evaluate performance.
- Strictly comply with the disclosure requirements of Regulation G. Ensure that non-GAAP disclosures contain the required reconciliation to the most comparable GAAP financial measure. In SEC reports, include a thoughtful statement why the non-GAAP presentation provides information useful to investors.
- Work with your audit committee and financial staff to establish guidelines for the use of non-GAAP financial measures, including the types of exclusions permitted. These guidelines will aid the financial staff in preparing financial disclosures and the audit committee in reviewing the disclosures and the supporting analysis. These guidelines should be reviewed annually (or more frequently if circumstances warrant) and updated to reflect reasonable proposals for additional types of adjustments.