introduction frank hubach partner-in-charge jones day dallas

Introduction

Frank Hubach

Partner-in-Charge

Jones Day Dallas

Regulation of Non-GAAPFinancial 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 non-GAAP 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)


• Subsequent Releases of Additional Material Information:

• Generally trigger a new Item 12 filing obligations


• 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 off-balance 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?


(cont)

• Does the disclosure effectively “unmask” costs and risks associated with a company’s operations that might otherwise be hidden by the arrangement?


(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

TotalLess than

1 year1-3

years3-5

yearsMore than

5 years

[Long-Term Debt Obligations]

[Capital Lease Obligations]

[Operating Lease Obligations]

[Purchase Obligations]

[Other Long-Term Liabilities Reflected on theCompany's Balance Sheet Under GAAP]

[Total]

Audit Committee Matters

Jim O’Bannon


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


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 OfProposed 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 OfProposed 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


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


• 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”


– “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”


• 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 - (?)


• 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


• 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”


– 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 AtCommission 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 AtCommission Meetingon 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

ATTACHMENTS

1. Jones Day Client Advisory re: Adopted

Rule 205

2. Jones Day Client Advisory re:

Proposed Rule 205

3. Jones Day Comment Letter to Securities

and Exchange Commission re: Proposed

Rule 205

introduction frank hubach partner-in-charge jones day dallas

Documents