Introduction
Frank Hubach
Partner-in-Charge
Jones Day Dallas
Regulation of Non-GAAP
Financial Matters
Mark Betzen
Dallas Business Practice Group
New Rules Regarding Non-GAAP
Financial Measures
• Effective March 28, 2003
• Regulation G:
• Applies to all public disclosures of material
information containing non-GAAP financial
measures
• Amendments to Item 10 of Regulation S-K:
• Applies to the use of non-GAAP financial
measures in SEC filings
New Rules Regarding Non-GAAP
Financial Measures
• Exceptions:
– Certain communications regarding proposed business
combinations
– Non-GAAP measures required under GAAP or SEC
rules (e.g., exclusion of prior period goodwill
amortization; pro forma effects of acquisitions and
dispositions)
– Non-GAAP measures required under regulatory
accounting principles
What is a Non-GAAP Financial Measure?
• Definition: A numerical measure of financial
performance, financial position or cash flows
that:
– Excludes amounts that are included in the
most directly comparable GAAP measure;
or
– Includes amounts that are excluded from the
most directly comparable GAAP measure
What is a Non-GAAP Financial Measure?
(cont)
• Examples of Non-GAAP Financial Measures:
– Analytical measures such as EBIT and
EBITDA
– Ad hoc adjustments to GAAP measures to
derive “normalized” or “recurring” results
of operations
Requirements For All Public
Disclosures
• Reconciliation Requirement: A non-GAAP financial measure
must be accompanied by:
– Presentation of the most comparable GAAP financial measure; and
– Quantitative reconciliation of the differences between the non-GAAP
financial measure and the most comparable GAAP financial measure
• Non-Misleading: A non-GAAP financial measure must not
misstate a material fact or omit to state a material fact
necessary to make the presentation of the non-GAAP financial
measure not misleading
Requirements For All Public
Disclosures (cont)
• Oral Disclosures: If a non-GAAP financial measure is
disclosed orally, the company must:
– Post the comparable GAAP measure and reconciliation on the
registrant’s web site; and
– Disclose the location and availability of that information during the
oral presentation
Additional Requirements for SEC
Filings
• Additional Requirements for SEC Filings:
– Reasons why management believes the non-GAAP financial measure is
useful to investors
– If material, any additional purposes for which management uses the nonGAAP financial measure
– Presentation of the non-GAAP financial measure may not be more
prominent than presentation of comparable GAAP financial measure
Additional Requirements for SEC
Filings (cont)
•
Prohibited Presentations of Non-GAAP Financial Measures in SEC Filings:
– Excluding cash charges or liabilities from non-GAAP liquidity measures (other than
EBIT and EBITDA)
– Adjusting a non-GAAP performance measure to eliminate a “non-recurring,
infrequent or unusual” item when (1) the item is reasonably likely to recur within
the next two years or (2) a similar item occurred within the prior two years
– Presenting non-GAAP measures on the face of GAAP financial statements or in the
accompanying notes
– Presenting non-GAAP measures on the face of pro forma financial statements
required to be disclosed by Article 11 of Regulation S-X
– Using titles or descriptions of non-GAAP financial measures that are confusingly
similar to those used for GAAP financial measures
New Rules Regarding Earnings
Releases
• New Item 12 of Form 8-K:
– Applies to earnings releases and similar announcements made after
March 28, 2003
– A Form 8-K must be furnished to the SEC within five business days
after any public release or announcement of material non-public
information regarding results of operations or financial condition
for a completed quarter or year
– The release or announcement should be identified and included as
an exhibit
New Rules Regarding Earnings
Releases (cont)
– Consequences of “furnishing” versus “filing”:
• Not subjected to lower liability standard applicable to “filed”
information
• Not incorporated into Securities Act registration statements
• However, any non-GAAP financial measures must conform to
certain requirements applicable to SEC filings (i.e., may not be
more prominent than comparable GAAP measures; reasons for
perceived utility to investors and others uses by management
must be disclosed)
New Rules Regarding Earnings
Releases (cont)
• Subsequent Releases of Additional Material
Information:
• Generally trigger a new Item 12 filing obligations
New Rules Regarding Earnings
Releases (cont)
• Exception for Certain Post-Release Presentations:
• Presentation must be complementary to, and occur within 48 hours after, a
related earnings release or announcement;
• The related earnings release or announcement must have been previously
furnished under Item 12;
• The presentation must be accessible to the public by dial-in conference call,
webcast or similar technology;
• The financial and statistical information contained in the presentation must be
posted on the company’s website; and
• The presentation must have been announced in advance by a press release that
included instructions as to how to access the presentation and the location on
the Company’s web site of the financial and statistical information
New Rules Regarding Off-Balance
Sheet Arrangements
• Apply to MD&A Disclosure for Years Ending On or
After June 15, 2003
• Apply to Arrangements that are “Reasonably Likely”
to Have Material Effects
New Rules Regarding Off-Balance
Sheet Arrangements (cont)
• Definition of “Off-Balance Sheet Arrangement”:
• Obligations under certain guarantee contracts;
• Retained or contingent interests in assets transferred to an
unconsolidated entity or similar arrangements that provide credit
liquidity or market risk support to such an entity;
• Obligations under derivative instruments that are classified as
equity; and
• Obligations under material variable interests in certain
unconsolidated entities
New Rules Regarding Off-Balance
Sheet Arrangements (cont)
• Evolution of the Definition:
• The definition originally proposed by the SEC would
have included all contractual obligations and liabilities -contingent or otherwise -- not fully reflected in the
financial statements
Definition of “Off-Balance Sheet
Arrangement”
• The final definition is intended to target typical offbalance sheet transaction structures and other typical
arrangements where risks of loss are not fully
transparent
• The final definition employs recognized accounting
concepts in order to define covered categories of
arrangements with precision
Definition of “Off-Balance Sheet
Arrangement” (cont)
• Guarantee Contracts Include:
• Guarantees protecting third parties against changes in specified
prices, rates or other variables
• Contingent obligations to make payments upon another person’s
failure to perform (e.g., performance guarantees)
• Indirect guarantees of the indebtedness of others in the nature of
“keepwell” agreements
Definition of “Off-Balance Sheet
Arrangement” (cont)
• Derivative instruments include instruments issued or held by a
company that are indexed to its stock and classified as equity
• Variable interests in unconsolidated entities include such
interests in entities that provide financing, liquidity, market
risk or credit support or leasing, hedging, or R&D services
Disclosure Concerns Associated with the
Use of Off-Balance Sheet Arrangements
• Does the disclosure reflect the economic
substance of the arrangement and, in
particular, the risks and exposures to which the
company is subject?
Disclosure Concerns Associated with the
Use of Off-Balance Sheet Arrangements
(cont)
• Does the disclosure effectively “unmask” costs
and risks associated with a company’s
operations that might otherwise be hidden by
the arrangement?
Disclosure Concerns Associated with the
Use of Off-Balance Sheet Arrangements
(cont)
• Would a termination of the arrangement have a
material effect on the company and, if so, are
the risks and consequences adequately
disclosed?
Specific Disclosure Requirements
• Specific disclosure requirements include:
• the nature and business purpose of the arrangements;
• the importance of the arrangements to the company
in respect of liquidity, capital resources, risk
management or other benefits;
• the financial impact of the arrangements;
Specific Disclosure Requirements
(cont)
• Specific disclosure requirements include:
• the exposure to risk resulting from the arrangements;
• known events, demands, commitments, trends or
uncertainties that may affect the company’s ability to
continue to benefit from the arrangements; and
• such other information that the company believes is
necessary for an understanding of the arrangements
and their material effects.
Tabular Presentation of Contractual
Obligations
• Applies to the MD&A Disclosures for Years
Ending On or After December 15
• Does Not Apply to “Small Business Issuers”
• Proposed tabular presentation of payments due
under specified contractual obligations
Tabular Presentation of Contractual
Obligations (cont)
Contractual Obligations
Payments due by period
Total
[Long-Term Debt Obligations]
[Capital Lease Obligations]
[Operating Lease Obligations]
[Purchase Obligations]
[Other Long-Term Liabilities Reflected on the
Company's Balance Sheet Under GAAP]
[Total]
Less than
1 year
1-3
years
3-5
years
More than
5 years
Audit Committee Matters
Jim O’Bannon
Dallas Business Practice Group
Audit Committee Financial Expert
• Disclose whether or not this issuer has at least one audit
committee financial expert serving on its audit committee
• Identify the audit committee financial expert or experts by
name
• Disclose whether the audit committee financial expert is
independent
• If the issuer does not have an audit committee financial
expert, it must explain why
• For most issuers effective for annual reports filed after July
15, 2003
Liability Safe Harbor
SEC rules provide that the designation of an
individual as an audit committee financial expert
does not increase the duties, obligations or
liability of that individual
Code of Ethics
• Disclose whether the issuer has adopted a code of ethics
that applies to the issuer’s principal executive, financial
and accounting officers
• If the issuer has not adopted a code of ethics, it must
explain why it has not done so
• Publication by exhibit filing, website posting or
undertaking to provide a copy upon request
• Mandatory reporting of amendments to or waivers of the
Code of Ethics
Approval of Non-Audit Services
• Prohibited Services
• Tax Services
• Approval Process and Procedures
Concerns Regarding Questionable
Accounting or Auditing Matters
• Confidential And Anonymous
Submissions
• Committee Procedures
Other Audit Committee Issues
•
•
•
•
•
Relationship with the Audit Firm
Audit Committee Charter
Review of Quarterly Financial Statements
Earnings Releases and Forecasts
Audit Fees
Other Audit Committee Issues
(cont)
•
•
•
•
•
Review of Internal Controls
Use of Independent Advisors
Time Commitment
Retention/Recruitment
Compensation
Lawyers: Up The Ladder
Reporting
Bob Estep
Dallas Business Practice Group
What The Act Requires
• Section 307 requires the Commission to adopt minimum
standards of professional conduct for attorneys appearing
and practicing before the Commission. The standard
would require attorneys to report evidence of a material
violation of securities law, breach of fiduciary duty or a
similar violation “up the ladder”
– first to the chief legal officer or chief executive officer
– next, if the response is not “appropriate” to the audit
committee, another committee of independent directors
or the full board
Broad Outline Of
Proposed Sec Rule 205
November 2002
•
•
•
Would have required “up the ladder” reporting
Added concept of “qualified legal compliance committee” of the board
(“QLCC”) as an alternative to which reports could be made
Added “noisy withdrawal” requirement -- if response “up the ladder” to a
report of a material violation, which is ongoing or about to occur and likely to
result in substantial injury to the company or investors, was not appropriate,
attorneys were required to
– withdraw for “professional reasons” (outside attorneys only)
– inform the Commission in writing of the withdrawal within one day
– disaffirm to the Commission in writing any document filed with the
Commission (outside and inside attorneys)
Broad Outline Of
Proposed Sec Rule 205
November 2002 (cont)
• added permission to follow the same procedures if the violation was
past (not ongoing or about to occur)
• Specifically added permission to reveal client confidences to (1)
prevent illegal acts likely to result in substantial injury to the company
or investors, (2) prevent an illegal act likely to perpetuate a fraud on
the Commission or (3) rectify the consequences of an illegal act in
which the attorney’s services had been used.
Commentary On And Controversy
About Proposed Rule 205
• “Noisy Withdrawal” not required by Section 307 and contrary to
legislative intent
• Unwarranted attack on the attorney/client relationship - bad public
policy
• Power of Commission to “federalize” ethics rules and conflicts with
state ethics rules
• Scope of attorney coverage
• Improper definition of some statutory terms and utter failure to define
others at all
• Guts board responsibility under corporate law
• “Objective” reasonable lawyer standard -- hindsight judgment of
whether there was “evidence”
Rule 205 As Adopted What Does The Rule Require
(Cautionary Note: Rule Text Not Out Yet)
• Commission deferred noisy withdrawal and notice requirements
for further comments
• Rule requires “up the ladder” reporting of “material violations” to
either
– the chief legal officer (“CLO”) or the chief executive officer
(“CEO”) and, if no appropriate response, to the audit
committee, an independent directors’ committee or the full
board
or
– a QLCC
Rule 205 As Adopted (cont)
• TIME OUT -- what is a QLCC?
The Rule permits a QLCC to handle certain aspects of the Rule’s
reporting, inquiry and remedial steps. The QLCC must
– Consist of one audit committee member and two or more non-employee
directors
– be authorized to investigate reports of material violations
– have written procedures for confidential receipt, retention and consideration
of reports
– have authority and responsibility for
• informing the CLO/CEO of any reports
• deciding whether an investigation is necessary
• if an investigation is necessary, notifying the audit committee (or full board),
initiating the investigation and retaining expert personnel
Rule 205 As Adopted (cont)
What is a QLCC (cont)
• directing the issuer to adopt appropriate remedial steps
• informing the CLO/CEO and the board of the results of the
investigation
Each member (and each of the CLO/CEO) must have the individual
authority and responsibility, if the issuer fails to take any remedial
steps directed by the QLCC, to notify the Commission of a
material violation and in writing disaffirm any document filed with
the Commission that he or she materially believes false or
misleading
END OF TIME OUT
Rule 205 As Adopted (cont)
• The new Rule’s reporting obligation applies to inside and outside
attorneys (and supervising attorneys?) “appearing and practicing
before the Commission”
• “Appearing and practicing before the Commission” means
– providing legal services to an issuer in an attorney/client relationship
– while “having notice” documents the attorney is preparing or assisting in
preparing will be filed with or submitted to the Commission
• What triggers the reporting obligation?
– “evidence” of a “material violation of securities law or breach of fiduciary
duty or similar violation by the Company or any agent”
Rule 205 As Adopted (cont)
– “evidence” means “credible evidence, based upon which it would
be unreasonable, under the circumstances, for a prudent and
competent attorney not to conclude that it is reasonably likely that
a material violation has occurred, is ongoing or is about to occur”
(i.e., an “objective” standard)
– “material” means “conduct or information about which a
reasonable investor would want to be informed before making an
investment decision”
Rule 205 As Adopted (cont)
• Which laws?
– State and federal securities laws - clearly an omission
or misleading statement in a prospectus, proxy
statement or report filed with the Commission, in a
press release or other public statement
– breaches of fiduciary duty recognized at common law
– other “similar violations” undefined - (?)
Rule 205 As Adopted (cont)
• How does the reporting obligation work?
– The initial report must be made “forthwith” directly (in person, by
telephone, e-mail electronically or in writing) to the CLO, the CEO or both
or
– to a QLCC
• The reporting attorney must take reasonable steps to document the
report and the response from the CLO/CEO
• CLO/CEO, after receiving initial report, must either cause an inquiry to
be made or refer the report to a QLCC
• If inquiry results in CLO/CEO making a “reasonable” determination
there is no material violation, the CLO/CEO must so advise the
reporting attorney
Rule 205 As Adopted (cont)
• If inquiry results in “reasonable” belief there is a material violation,
CLO/CEO must either
– remedy the violation (including rectifying a past violation), document the
inquiry and report the actions taken to both the reporting attorney and the
audit committee (or full board)
or
– report the evidence to the QLCC
• Reporting attorney duties upon response
– if response is “appropriate,” no further action required
– if it is not (or no timely response), reporting lawyer must go “up the
ladder”
Rule 205 As Adopted (cont)
– if the audit or other board committee (or the board) does not
“appropriately” (or timely) respond, the reporting lawyer must document
that fact and explain the reasons the attorney thinks the response is not
appropriate to the CLO/CEO or directors to whom the attorney reported
• The Rule also expressly permits attorneys to reveal confidential client
information to
– prevent the issuer from committing a material violation likely to cause
substantial injury to the financial interests or property of the issuer or
investors
– Prevent the issuer from committing an illegal act
– Rectify the consequences of a material violation or illegal act in which the
attorney’s services have been used
• The Rule is effective 180 days after publication
Other Actions At
Commission Meeting
on January 23
• Extended comment period for 60 days
• Will accept comments on Rule 205 as adopted
• Solicited further comments on the originally
proposed “noisy withdrawal” and related
provisions. This proposal is not dead.
Other Actions At
Commission Meeting
on January 23 (cont)
• Proposed a “compromise” alternative to the noisy
withdrawal provisions
– Attorney would be required to withdraw if response not
appropriate but not required to report to the Commission or
disaffirm Commission filings
– The issuer would have to report the withdrawal on Form 8-K
within two days
– The attorney would be permitted, but not required, to report
withdrawal to the Commission if the issuer did not timely file the
8-K report
What Steps Need To Be Taken?
• Defer until text of Rule is known
• For management of issuers, a priority will
clearly be deciding whether or not to
encourage boards to establish QLCCs
• Directors and management will need to be
familiarized with the Rule, how it works
and what the consequences are
What Steps Need To Be Taken?
(cont)
• Inside and outside counsel should consider
establishing protocols for compliance
– Protocol for relationship of inside counsel and issuer on
the one hand and outside counsel on the other, perhaps
including modified or new engagement agreements
– Protocol for inside counsel reporting compliance,
including control and education of “supervised” and
other lawyers
– Protocol in law firms for outside counsel reporting
compliance, including control and education of
“supervised” and other lawyers
Getting Back To Business:
The New SEC Rules
Lawyers: Up The Ladder Reporting
1.
2.
3.
ATTACHMENTS
Jones Day Client Advisory re: Adopted
Rule 205
Jones Day Client Advisory re:
Proposed Rule 205
Jones Day Comment Letter to Securities
and Exchange Commission re: Proposed
Rule 205