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CALIFORNIA CORPORATE & SECURITIES LAW

The SEC’s Sorcerer’s Stone – Changing EBITDA From A Performance Measure Into Liquidity Measure

Recently, Broc Romanek hosted another one of his excellent webcasts.  This one covered the SEC’s Division of Corporation Finance’s recent issuance of several new and modified Compliance & Disclosure Interpretations regarding Non-GAAP financial measures.  The three panelists were Mark Kronforst, Chief Accountant, SEC’s Division of Corporation Finance Meredith Cross, Partner, WilmerHale LLP, and Dave Lynn, Editor, TheCorporateCounsel.net and Partner, Morrison & Foerster LLP.   Ms. Cross is a former director and Mr. Lynn is a former chief counsel of the Division of Corporation Finance.

My interest was piqued by the following interchange between Messrs. Lynn and Kronforst regarding the permissibility of disclosing EBIT and EBITDA on an earnings per share basis:

Lynn: One follow-up question, while we’re on that topic – can you comment on whether EBIT and EBITDA are viewed by the Staff as liquidity measures, even if a company views them as a performance measure?

Kronforst: For purposes of presenting EPS, yes. I think the CDI [Question 103.02] is clear on that. As you recall, the Commission scoped those two measures out of the liquidity prohibitions because at the time, after the proposal was made, there was a bit of an outcry over those measures, because they were so widely used. But we don’t believe that just because you call something a performance measure it necessarily changes its substance.

EBIT and EBITDA were fairly easily identifiable as liquidity measures because they were scoped out. So we are going to object to EPS based on those measures. That said, at least our experience so far is that EPS on those numbers is not very common. I’m not sure that it’s particularly widespread.

The other point on this interpretation, once you get past the EPS issue, is that it’s well known that those measures can be used either as liquidity or performance measures. However management chooses to use those measures should guide what GAAP measure they reconcile to. I don’t think you’ll find, with respect to those particular measures which are mentioned specifically by the Commission in the rules, that we will get into any kind of dialogue. We recognize that those measures can be used for both purposes.

While it is true that the C&DI 103.02 clearly states that EBIT and EBITDA “must not be presented on a per share basis”, I find the rationale for this puzzling.  The C&DI clearly assumes that EBIT and EBITDA may be used as a performance measure (“If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP.”).  Mr. Kronforst himself acknowledges “that it’s well known that those measures can be used either as liquidity or performance measures” and “[w]e recognize that those measures can be used for both purposes”.

So, it seems to me that the Staff is taking the position that something that may be a performance measure suddenly becomes a liquidity measure when it is divided by the number of shares.  I am not an accountant, but I fail see how the simple arithmetic act of division converts a performance measure into a liquidity measure.

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