As public companies are well aware, the staff of the SEC’s Division of Corporation Finance (Staff) has become increasingly focused on disclosure of non-GAAP financial measures, as evidenced by its guidance in May 20161 and numerous issuer comment letters. The SEC’s Division of Enforcement (Enforcement) recently took action against one such issuer, which resulted in an enforcement action2 that puts issuers on notice of the risks of using non-GAAP financial measures without due regard for the Staff’s positions. In connection with this action, the Director of the SEC’s Philadelphia Regional Office warned issuers that the “lack of equal or greater prominence for GAAP measures is a practice that we will continue to focus upon.”
The latest enforcement action is the second involving non-GAAP measures since the release of the Staff’s May 2016 guidance.3 Reports of an “enforcement sweep” commenced last year, focusing on disclosures made before the Staff’s May 2016 guidance. In August 2016, some issuers received letters from Enforcement regarding potential violations of Regulation G and/or Item 10(e) of Regulation S-K, requesting production of documents, e-mails and other information related to non-GAAP disclosures over a period of years. Of particular concern for issuers is the production of e-mails regarding earnings releases and adjustments to non-GAAP measures, which may include a range of confidential and sensitive comments by senior management.
Although the Staff acknowledges that compliance has increased since the issuance of the May 2016 guidance, Enforcement remains active. Many comments issued during the second half of 2016 were “futures” comments, but after an apparent grace period the Staff may increasingly require amendment of prior filings.
Issuers and their Audit Committees should review non-GAAP disclosures, not just in SEC filings and earnings releases, but wherever a non-GAAP measure is publicly communicated, to ensure compliance with Regulation G, Item 10(e) and Staff guidance, as applicable. Non-GAAP disclosures should also align with Staff comment letters issued to peer companies after May 2016, as well as any prior Staff comments received by the issuer. The recent enforcement action cited the issuer’s apparent failure to abide by its prior undertaking made to the Staff to comply with the prominence requirement in future earnings releases.
This client alert briefly discusses the Staff’s guidance and recent comments on the prominence requirement and Enforcement’s recent action.
Prominence Requirement – Background
Non-GAAP measures disclosed in documents filed with the SEC or furnished to the SEC under Item 2.02 of Form 8-K (including in earnings releases furnished under that Item) must include a presentation of the most directly comparable GAAP measure with a prominence equal to or greater than that of the non-GAAP measure. Observing the prominence requirement in all filings and public statements ensures consistency in investor communications and may also avoid undue prominence of a non-GAAP measure that is deemed to be misleading in violation of Regulation G.
Staff Guidance on the Prominence Requirement
As discussed in our prior alert, the Staff’s May 2016 guidance identified improper practices that provide greater prominence for the non-GAAP measure in violation of Item 10(e), including:
- Order of presentation: The non-GAAP measure precedes the most directly comparable GAAP measure, including in an earnings release headline or caption;
- Omission from title: The comparable GAAP measure is omitted from an earnings release headline or caption that includes a non-GAAP measure;
- Style: The presentation unduly emphasizes a non-GAAP measure, for example, using boldface type or a larger font size;
- Narrative (non-numeric) description: A non-GAAP measure is described as, for example, “record performance” or “exceptional” without an equally prominent description of the comparable GAAP measure;
- Tabular disclosure: The comparable GAAP measure does not precede or accompany a tabular disclosure of a non-GAAP measure;
- Forward-looking statements: A quantitative reconciliation of a forward-looking non-GAAP measure is excluded, citing reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B), without disclosing that reliance and identifying the unavailable information and its probable significance;
- Disproportionate discussion and analysis: Discussion and analysis of a non-GAAP measure does not include a similar discussion and analysis of the most directly comparable GAAP measure in a location of equal or greater prominence; and
- Full non-GAAP income statement: A full income statement of non-GAAP measures is presented when reconciling to the most directly comparable GAAP measures.
Post-Guidance Staff Comments on the Prominence Requirement
Following the issuance of the May 2016 guidance, the Staff increased its focus on the prominence requirement by issuing comments related to issuers’ failure to comply with the requirement. These comments have included, among other things, a failure to:
- Describe or characterize the most comparable GAAP measure in equally prominent terms if a characterization was provided for the non-GAAP measure (for example, “strong overall results” and “record EBIT”);
- Present the most comparable GAAP measure first in a tabular presentation, including in the required quantitative reconciliation (meaning that the reconciliation should begin with the GAAP measure instead of the non-GAAP measure);
- Present the GAAP measure first in the body of an earnings release or in its headline;
- Provide similar percentages or prior period amounts for the GAAP measure when provided for the non-GAAP measure; and
- Include the required disclosure if the issuer relies on the “unreasonable efforts” exception to exclude a quantitative reconciliation for forward-looking non-GAAP measures, specifically identifying the information that was unavailable and its probable significance.
Guidance on Revenue Adjustments
In the May 2016 guidance, the Staff singled out adjustments made to GAAP revenue as potentially misleading under Regulation G. In the Staff’s words, “[n]on-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP” could violate Regulation G. As a result, issuers who disclose non-GAAP adjusted revenue measures may expect a Staff comment.
Recent Enforcement Action
In January 2017, the SEC announced the settlement of charges against a New York-based marketing company, who agreed to pay $1.5 million for its failure to disclose certain CEO perks and for its violation of the non-GAAP financial measure disclosure rules. As a result of its alleged disclosure deficiencies, the SEC charged the issuer with violations of, among other securities laws, Exchange Act Section 13(a) and Rules 13a-1, 13a-11 and 13a-13 (related to the failure to comply with Item 10(e)) and Regulation G. As noted above, this was the second enforcement action involving non-GAAP measures following the Staff’s May 2016 guidance.
In its release, the SEC identified several important factors that led to this action, and stated “non-GAAP measures must be accurate and must be reconciled to the appropriate GAAP measures so investors and analysts can compare them.”
Failure to comply with the prominence requirement. In a November 2012 comment letter to the issuer, the Staff expressed concerns about compliance with the prominence requirement in the issuer’s most recent earnings release. While in response the issuer pledged to comply with the prominence requirement in future earnings releases, the SEC alleged that the issuer continued to emphasize non-GAAP financial measures such as EBITDA, EBITDA margin and free cash flow without providing equal or greater prominence to the comparable GAAP measures.
Failure to reconcile. The SEC also alleged that from July 2012 through March 2014, the issuer failed to properly reconcile “organic revenue growth,” a non-GAAP financial measure, to GAAP revenue. Despite publicly disclosing that organic revenue growth represented revenue growth excluding the effects of acquisitions and foreign exchange impacts, the issuer’s earnings releases and Forms 10-K and 10-Q filed during this period failed to disclose the existence of a third reconciling item that was used in its calculation of the non-GAAP measure. The SEC alleged that the incomplete reconciliation resulted in the issuer overstating organic revenue growth during the period in question. Moreover, during this same period, the issuer’s earnings releases and Forms 10-K and 10-Q omitted the required tabular reconciliations to GAAP revenue.
This action demonstrates that the SEC will continue to push for improved disclosures of non-GAAP financial measures and will pursue charges when rules are violated. Although the SEC’s action related to non-GAAP measures was likely driven by the issuer’s allegedly repeated violations after it was warned by the Staff, we expect that continued investor transparency will be a prominent focus of the SEC under the new Administration and expect to see more non-GAAP disclosure investigations and cases.