July/August 2016 • Volume 24, Number 4 EARNINGS GUIDANCE CONTENTS EARNINGS GUIDANCE Non-GAAP: The Pendulum Non-GAAP: The Pendulum Swings Back Swings Back 1 By Pam Marcogliese and Dase Kim By Pam Marcogliese and Dase Kim DISCLOSURE The practice of reporting non-GAAP earn- Reinventing Disclosure: The SEC’s ings is back on the Security and Exchange Commission’s (SEC) radar, highlighted in recent Regulation S-K Concept Release 7 speeches by SEC Chair Mary Jo White,1 Chief By Mark Plichta, John Wilson, Accountant James Schnurr2 and Deputy Chief Megan Odroniec, and Richard Dancy Accountant Wesley Bricker.3 A series of news articles focusing on the increasing number of companies that report non-GAAP earnings SHAREHOLDER ENGAGEMENT (often confusingly called “pro forma” earnings) Shareholder Engagement: Governance and the widening gap between these companies’ Experts Share Perspectives 12 reported GAAP and non-GAAP earnings have By Abby E. Brown, Carolyn J. Buller, also shed negative light on using NGFMs.4 and Wendy K. LaDuca The ‘New’ Old Problem EXECUTIVE COMPENSATION The use of non-GAAP financial measures (NGFMs) and the concerns they raise are not Gender Pay Equity In Focus 16 new. In the 1990s, it was popular for compa- By Jon Weinstein and Ashley Meischeid nies, especially Internet technology firms dur- ing the first “dot-com” boom, to use NGFMs to report earnings. The SEC took note. In CYBERSECURITY September 1998, Arthur Levitt, then-chairman of the SEC, gave a speech titled “The ‘Numbers Director Cyber Risk: Insights from Game’,” in which he expressed concerns about Shareholder Derivative Lawsuits 17 By Melissa J. Krasnow Continued on page 2 AUDIT COMMITTEES © 2016 Cleary Gottlieb Steen & Hamilton LLP. Pam Marcogliese is a partner, and Dase Kim is an associate, of PCAOB Again Issues Proposal Cleary Gottlieb Steen & Hamilton LLP. to Change Audit Report 22 By Michael Scanlon, Brian Lane, Lori Zyskowski, and Michael Titera the widespread practice of “earnings manage- Not long after publishing the C&DIs, ment” (lamenting that there is a gray area the SEC staff exhibited signs of regret. In “where earnings reports reflect the desires of December 2011, at an AICPA national confer- management rather than the underlying finan- ence, then-Director of the SEC’s Division of cial performance of the company”).5 Corporation Finance Meredith Cross warned companies against abusing NGFMs under the A few years later in October 2000, Lynn new guidance (telling them to “knock it off”), Turner, then the SEC’s Chief Accountant, and Deputy Chief Accountant Craig Olinger coined the term “EBS” or “Everything but reminded the audience that although NGFMs Bad Stuff,” and told investors to be wary of can be helpful to investors, “non-GAAP mea- EBS earnings releases that provide “incomplete sures that are misleading are not allowed or inaccurate” information.6 As the use of anywhere.”12 NGFMs continued to proliferate, in December 2001, the SEC issued “Cautionary Advice,” In the same year, SEC comments on Groupon’s alerting companies and their advisors that an IPO registration statement led to the removal NGFM, “under certain circumstances, can mis- of an NGFM called “Adjusted Consolidated lead investors if it obscures GAAP results,”7 Segment Operating Income,” because the exclu- and in January 2002, the SEC brought its first sion of online marketing expenses (which the enforcement action based on a misleading use SEC viewed as a “normal, recurring operating of NGFMs.8 cash expenditure”) from the company’s results of operations was potentially misleading to After the Enron scandal and the dot-com investors.13 In 2013, David Woodcock, chairman market crash, the Sarbanes-Oxley Act of 2002 of the SEC’s newly created Financial Reporting directed the SEC to adopt rules on NGFMs, and Audit Task Force, said in a speech that the and in January 2003 it adopted Regulation G task force was scrutinizing companies’ use of and Item 10(e) of Regulation S-K requiring NGFMs.14 companies to satisfy certain conditions in con- nection with the use of NGFMs.9 The cumula- Highly publicized news reports about the tive effect of the Cautionary Advice, the new use of NGFMs by companies whose shares rules and the related FAQs published in June are under-performing, such as Valeant15 or 2003, and SEC comments on company filings, Twitter,16 added to the perception that NGFMs generally chilled the use of NGFMs for the bet- were being used by certain companies to mis- ter part of a decade. characterize their performance. Then in 2010, the SEC seemed to acknowl- Renewed SEC Focus edge that the pendulum had swung too far against NGFMs. The SEC staff published new Now it looks as though the swing toward Compliance and Disclosure Interpretations discouraging NGFMs is gathering momentum. (C&DIs) in January 2010 that reflected a policy The recent speeches by White and Schnurr men- change to allow more liberal use of NGFMs by tioned previously indicate that the short-lived era companies in public disclosures.10 For example, of the SEC’s relaxed attitude toward NGFMs is the SEC staff made it clear in the C&DIs that over and there is now a renewed effort by the adjustments reflected in an NGFM would be SEC to scrutinize the use of NGFMs. In her permissible, subject to Regulation G and Item speech, White noted that the use of NGFMs 10(e) of Regulation S-K, even if such adjust- “deserves close attention, both to make sure ments are not “non-recurring, infrequent or that our current rules are being followed and to unusual.”11 Companies embraced this new guid- ask whether they are sufficiently robust in light ance by steadily increasing their use of NGFMs of current market practices.” She recommended in SEC filings and earnings reports ever since— that companies’ finance and legal teams, along perhaps a little too enthusiastically. with audit committees, carefully consider the The Corporate Governance Advisor 2 July/August 2016 reasons for using NGFMs and whether such company either revise the disclosure or discon- NGFMs are useful to investors.17 tinue using the NGFM in question.21 Schnurr confirmed that the SEC staff will “continue to be vigilant in their review of the What Does the SEC Expect use of [NGFMs] for compliance with the rules,” Companies to Do? but believed that company management and the audit committee should go beyond mere com- The SEC has begun to give some indication pliance and ask “probing questions on why” of the way it expects companies to act through certain NGFMs are appropriate and provide the C&DIs, as well as the speeches and recent useful information to investors compared to comment letters. So what should a company do? GAAP financial measures. Mark Kronforst, Chief Accountant of the SEC’s Division of • Management and the audit committee should Corporation Finance, was more explicit – at a re-examine the company’s use of NGFMs in conference held in May 2016, Mr. Kronforst SEC filings and other public disclosures, par- was quoted as saying “[the SEC is] going to ticularly in light of the SEC staff’s focus on crack down” on the companies’ misuse of general prohibition of misleading measures, NGFMs.18 and evaluate the number of NGFMs it uses, the complexity of the NGFMs and whether The SEC staff were not bluffing. On May 17, it has substantive justification for using each 2016, the SEC Division of Corporation Finance of the NGFMs. released new and updated Compliance and Disclosure Interpretations (“C&DIs”) on the • Give equal or greater prominence to the use of NGFMs, which introduced new prohibi- directly comparable GAAP measure con- tions on practices that were previously consid- sistent with the C&DIs, particularly when a ered permissible and clarified which practices NGFM is used in headings or bullet points the SEC staff would consider to be mislead- in an earnings release. Pay close attention to ing.19 Overall, the C&DIs signal a tightening of the order of appearance (a NGFM cannot the SEC’s policy toward NGFMs and renewed precede the most directly comparable GAAP SEC focus on their use. measure) and style of presentation (a NGFM cannot be emphasized by using a descrip- After these speeches and the C&DIs, we tive characterization or a different font size/ expect the SEC to continue to carefully scru- style without equally emphasizing the most tinize the use of NGFMs in company filings, directly comparable GAAP measure). earnings releases and other public disclosures, and to ramp up its efforts to enforce full com- • Avoid presenting a non-GAAP revenue mea- pliance with the existing rules and its guid- sure that backs out the effect of GAAP ance. Following the release of the C&DIs, Mr. revenue recognition principles applicable to Kronforst reiterated at a PCAOB panel discus- the company’s business, which the SEC staff sion that companies should expect an uptick could view as per se misleading. A similar in the number of SEC comments on NGFMs approach to other financial statement line and that the SEC intends to curb the use of cer- items may also be problematic under the SEC tain NGFMs.20 The SEC appears particularly staff’s guidance.22 focused on general prohibition of NGFMs that could be misleading: Even when a company is • Do not present a NGFM on a per-share in technical compliance with the rules, if the basis if the NGFM can be used as a liquidity SEC is not satisfied with the purported useful- measure, regardless of whether management ness of the NGFM or finds the NGFM to be presents it as a performance or liquidity mea- potentially misleading to investors, the SEC sure.