COVID-19 has led companies to patch-up financial reporting by adding estimates of pre-COVID-19 profits to their EBITDA. Recently, COVID-19 prompted measuring-equipment manufacturer Schenck Process, for example, to add back €5.4 million, resulting in an adjusted EBITDA of €18.3 million (termed, unsurprisingly, as ‘EBITDAC’ [1]). This may spark other U.S. corporations to use an EBITDAC metric in initial public offerings, which may result in litigation under Section 11 of the Securities Act of 1933 (Securities Act) over alleged omissions or material misstatements. This post seeks to analyze the use of EBITDAC against the civil liability provisions of Section 11 and argues that EBITDAC may solidify certain unintended underwriting practices.

EBITDA-related adjustments are typically disclosed in the MD&A, which is prepared pursuant to Item 303(a) of Regulation S-K (Reg. S-K) and requires disclosure of financial condition, results of operations, and financial metrics that are crucial to evaluate a company. However, EBTIDA is a non-GAAP financial measure, which allows for its easy malleability. For companies that have to file reports under the Securities and Exchange Act of 1934 (Exchange Act), non-GAAP measures are governed by Regulation G (Reg. G) and Item 10(e) of Reg. S-K. In accordance with these, a non-GAAP measure must be “reconciled” with a GAAP measure by providing a directly comparable GAAP measure and a quantitative reconciliation of the differences between the GAAP and the non-GAAP measures. This reconciliation is crucial, since non-GAAP measures may mislead investors, as the SEC has previously pointed out.

Item 10(e) of Reg. S-K also requires issuers to disclose reasons behind the management’s belief that non-GAAP financial measures provide useful information to investors regarding an issuer’s financial condition and results of operations. However, Item 10(e) prohibits adjustments to non-GAAP financial measures that eliminate or smooth items identified as “non-recurring, infrequent or unusual,” when the nature of the gain is reasonably likely to recur within two years. The question that arises is: Can COVID-19 count as non-recurring or infrequent” for the purposes of Item 10(e)? The SEC answered by stating that the prohibition was based on the description of the gain that was being adjusted, and a corporation may make appropriate adjustments, subject to Reg. G and the other requirements of Item 10(e) of Reg. S-K. However, the uncertainty surrounding future waves of COVID-19 prevents it from being neatly siloed into the non-recurring category. It remains to be seen whether COVID-19 is a “natural disaster” or a “natural occurrence,” though Xtract Research argues that it is a mere natural occurrence and, therefore, the natural disaster EBITDA adjustments are inapplicable to a corporation affected by COVID-19.

A carelessly formulated EBITDAC metric, reported to the SEC as part of the registration statement during an IPO, may cause liability under Section 11 of the Securities Act. Upon the effectiveness of an allegedly false registration statement, Section 11(a) allows plaintiffs to sue persons signing the registration statement, directors, accountants, and underwriters for misstatements of material facts or omissions to state material facts necessary to make the included statements not misleading (Section 11 Liability Provisions). A Section 11 plaintiff must have purchased a security as part of the public offering pertaining to the registration statement, containing the alleged misstatement (the Tracing Requirement). There is no burden to prove scienter, reliance, privity, or that the loss resulted from the alleged material misstatement.

On March 25, 2020, the SEC released disclosure guidance addressing disclosure issues faced by public corporations (March Guidance). The March Guidance states that the impact of COVID-19 on a corporation is a factual analysis [2], and reiterates the SEC’s view on the fluidity of non-GAAP measures. However, a trigger-happy plaintiff may choose to bring a Section 11 suit by stating that the adjusted financials present a façade, and the management’s analysis of the accounting entries and line items is incomplete, and therefore that the registration statement creates liability under the §11 Liability Provisions.

Federal securities laws provide Section 11 defendants with formidable defenses. The Tracing Requirement may be defeated by showing that the plaintiff acquired the shares from a pool of publicly traded shares. A defendant may further parry a plaintiff’s blow by alleging that the financials represented by the EBITDAC metric are forward-looking statements and, therefore, attract the safe harbors in the rules promulgated under the Securities Act (175) and the Exchange Act (3b-6). Forward looking statements, made by or on behalf of an issuer, shall not be deemed to be fraudulent statements unless they were made or reaffirmed without reasonable bases or were disclosed in bad faith. However, the safe harbors in Section 27A  of the Securities Act and Section 21E of the Exchange Act do not apply in the context of an IPO or to enforcement proceedings brought by the SEC. Interestingly, in the March Guidance, the SEC specifically extended the protection of sections 27A and 21E to forward-looking statements without mentioning rules 175 and 3b-6 [3].

Statutes aside, defendants may employ judicially crafted doctrines, such as the “pure opinion” and “due diligence” defenses. Per Omnicare Inc. v. Indiana State District Counsel of Laborers (575 U.S. 175 (2015)), a defendant may allege that the COVID-19 adjusted financials were statements of pure opinion, bereft of any omissions, with complete disclosures under Reg. G and Reg. S-K, and not untrue statements of material fact. In a post-COVID-19 era, to succeed in the pure opinion defense, the March Guidance aids public corporations on two counts. First, it provides that a defendant must highlight the rationale behind the management’s assessment of the usefulness of the metric, which helps investors assess the impact of COVID-19 on the company’s financial position [4]. Second, the SEC has permitted a corporation to include provisional amounts based on a range of reasonably estimable GAAP results [5].

To mount the due diligence defense in the context of EBITDAC, the Securities Act requires an expert defendant, preparing a portion of the registration statement (the MD&A), to demonstrate that, after reasonable investigation, he had reasonable grounds to believe that the metric was appropriate, and the Section 11 Liability Provisions were not triggered (§11(b)(3)(B)(i) of the Securities Act of 1933). “Reasonable investigation,” as the accounting and underwriting world saw it, was a question of degree, which paved the way for the seminal case of In re WorldCom, Inc. Securities Litigation (346 F Supp. 2d 628 (SDNY 2004).

Under WorldCom, referencing public information and “blindly relying” on an EBITDAC metric prepared by the auditors does not absolve the underwriters of their duty to prepare financials with due care. Unintentionally, the WorldCom opinion, coupled with the EBITDAC metric, may lead to a change in the underwriting business. Judge Denise L. Cote’s provident observation [6] on underwriters seeking accounting input to gauge the proper preparation of accounts may be implemented with renewed vigor, especially after being implicitly recognized by the SEC in the March Guidance[7].

In the years to come, we may observe new paradigms – the erratic effect of pandemics and other natural disasters – leading to miscalculated EBITDA add-backs across a swath of industries. The underwriting business may be subject to greater perils, and corporations wanting to go public may witness frequent litigation concerning the use of non-GAAP metrics. It remains to be seen, however, whether the  Section 11 defenses remain evergreen.

ENDNOTES

[1] Earnings Before Interest, Taxes, Depreciation, Amortization and COVID-19.

[2] “Assessing the evolving effects of COVID-19 and related risks will be a facts and circumstances analysis. Disclosure about these risks and effects, including how the company and management are responding to them, should be specific to a company’s situation.”

[3] “We remind companies that providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding COVID-19, can be undertaken in a way to avail companies of the safe harbors in Section 27A of the Securities Act and Section 21E of the Exchange Act….”

[4] “To the extent a company presents a non-GAAP financial measure or performance metric to adjust for or explain the impact of COVID-19, it would be appropriate to highlight why management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position and results of operations.”

[5] “We understand that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by COVID-19-related adjustments that may require additional information and analysis to complete.  In these situations, the Division would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results.”

[6]  “…[I]f aggressive or unusual accounting strategies regarding significant issues come to light in the course of a reasonable investigation, a prudent underwriter may choose to consult with accounting experts to confirm that the accounting treatment is appropriate, and that additional disclosure is unnecessary.” (346 F. Supp. 2d 628 (SDNY 2004))

[7] “We also recognize that the impact of COVID-19 on businesses may present a number of novel or complex accounting issues that, depending on the particular facts and circumstances, may take time to resolve. For example, to the extent a company or its auditors will need to consult with experts to determine how the evolving COVID-19 situation may impact its assets, including impairment of goodwill or other assets, it should consider engaging with those experts promptly so that its reporting remains as timely as possible, as well as complete and accurate.”

Suprotik Das is a corporate lawyer and an LLM graduate of NYU School of Law. A version of this piece appeared on the Oxford Business Law Blog.