REITAlert. Use of FFO in SEC Filings after Recent Rulemaking on Non-GAAP Financial Information. Summary

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Dylan Edwards
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1 March 4, 2003 REITAlert An update from Goodwin Procter s Real Estate Securities and Capital Markets Group Use of FFO in SEC Filings after Recent Rulemaking on Non-GAAP Financial Information Funds from Operations (FFO) has been a key metric for real estate investment trusts (REITs) since the National Association of Real Estate Investment Trusts (NAREIT) first adopted a definition of FFO in The SEC recently adopted final rules governing disclosure of non-gaap financial measures, including FFO. These rules were the subject of great interest and much comment, especially from NAREIT and individual REITs. The final SEC rules provide welcome clarification of the use of non-gaap financial measures, including per share information, and present the REIT industry with an opportunity to refocus on FFO disclosure practices. However, the SEC has also made it clear that some non-gaap financial information is prohibited, and has provided cautions about other non-gaap information. REITs in particular should be aware of the impact of the new rules on FFO, which in some cases may require changes in how individual REITs define and calculate FFO. The SEC rulemaking creates a two-part structure for disclosure of FFO and other non- GAAP financial measures: Regulation G: applies to all public disclosures, including press releases and SEC filings Item 10 of Regulation S-K: applies only to SEC filings The primary focus of this alert is the impact of the new SEC rules on use of FFO in SEC filings and related disclosure practices in the REIT industry. Because Regulation G also applies to SEC filings, however, we are including a brief overview of these requirements as well. For more information on Regulation G, the definition of non-gaap financial measure in the SEC rules, and other related information, see our Public Company Advisory SEC Adopts Conditions on Use of Non-GAAP Financial Information and Mandatory Furnishing to the SEC of Earnings Announcements. Summary The recent SEC rules provide a solid foundation for continued, and possibly expanded, use of FFO, including disclosure of FFO per share in SEC filings. However, they also require REITs to review their operative definition of FFO and any supplemental adjustments they make to NAREIT-defined FFO in their public disclosures. We believe that REITs will generally be well-served by FFO disclosure that: reports FFO in strict adherence to the NAREIT definition, without making supplemental adjustments to include or exclude items from the calculation; provides a clear, quantitative reconciliation of FFO to GAAP net income as the most directly comparable GAAP metric; and if a REIT believes that supplemental adjustments to FFO as defined by NAREIT are appropriate to reflect its financial performance, reports FFO with Boston New York New Jersey Washington DC 2003 Goodwin Procter LLP. All rights reserved.

2 these adjustments separately, in addition to FFO as defined by NAREIT; in these cases, the REIT should generally: (i) reconcile FFO after supplemental adjustments to FFO as defined by NAREIT, (ii) include a meaningful description of each separate adjustment, and (iii) include a statement of why management believes each adjustment is warranted. Of course, any non-gaap disclosure must also comply with all applicable elements of the new SEC rules, which are summarized below. REITs that make adjustments to FFO as defined by NAREIT also need to consider the impact of two important prohibitions on adjustments in the new SEC rules, which are discussed in more detail below: The new SEC rules prohibit any smoothing adjustments to FFO or other non-gaap measures in SEC filings; in general terms, the rules define these adjustments as unusual or infrequent items that are reasonably likely to recur within the following two years or that have occurred in the past two years. The new SEC rules also make clear that per share disclosure of non-gaap cash flow measures will continue to be prohibited in any document filed with or furnished to the SEC, which includes not only SEC reports but also earnings releases and similar announcements that must be furnished to the SEC; as a result, REITs that make supplemental adjustments to FFO that have the effect of changing FFO from an accrual basis measure of earnings/performance into a measure of stabilized cash flow generated by operations/liquidity for example, adjustments to reflect cash-basis rents or to eliminate premiums or discounts under SFAS 141 will generally not be able to disclose this information on a per share basis in SEC reports or earnings releases. Regulation G All Disclosures Regulation G imposes three conditions on companies that use non-gaap financial measures, such as FFO, NOI, EBITDA or EBIT, in any public disclosure, including press releases, on or after March 28, Briefly, these conditions are: the non-gaap financial information must not contain a material misstatement or omission; the disclosure must include the most directly comparable GAAP financial measure; and the disclosure must provide a quantitative reconciliation between the non-gaap financial measure and the most directly comparable GAAP financial measure. The new rules provide exceptions for some oral disclosures of non-gaap financial information and for some disclosures by foreign private issuers, if the company satisfies specified conditions. Item 10 SEC Filings The SEC has amended Item 10 of Regulation S-K to impose several conditions for use of non-gaap financial measures in SEC filings. These conditions are in addition to the requirements of Regulation G, which also apply to SEC filings. However, unlike Regulation G, Item 10 applies only to SEC filings. Thus, Item 10 does not apply to press releases or other public announcements containing material non-public information regarding a company's results of operations or financial condition for a completed fiscal period that must be furnished to the SEC within five business days under the new Form 8-K requirement. These requirements apply to SEC periodic reports for fiscal periods ending after March 28, Requirements and Prohibitions for Non- GAAP Financial Information in SEC Filings The principal new requirements of Item 10 include: an equally or more prominent presentation of the most directly comparable GAAP financial measure; 2

3 an explanation of why management believes the non-gaap financial measure provides useful information to investors regarding the company s financial condition and results of operations; and if material, a statement disclosing any other purposes for which management uses the non-gaap financial measures. Item 10 imposes a variety of restrictions and prohibitions on the use of non-gaap financial measures in SEC filings. Among the prohibitions are the following: adjusting a non-gaap performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual if (i) the nature of the charge or gain is such that it is reasonably likely to recur within the following two years, or (ii) there was a similar charge or gain within the prior two years; excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-gaap liquidity measures other than EBIT and EBITDA; presenting non-gaap financial measures on the face of the financial statements or accompanying notes, or in pro forma financial information required by Article 11 of Regulation S-X; and using titles or descriptions of non-gaap financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures. Definition of FFO While there is no requirement in the SEC rules that REITs use the NAREIT definition of FFO, we believe that REITs that do so can expect tangible and intangible benefits. REITs that do not do so should clearly state they are using their own definition and may face additional scrutiny. The SEC s rules distinguish between EBITDA and other non- GAAP financial measures because of the wide and recognized existing use of EBITDA. We believe that over time FFO as defined by NAREIT can, and should, achieve a similar status. Conversely, ad hoc definitions of FFO may face skepticism in the investment and analyst communities, and their usefulness may be discounted if the prevalent practice in the REIT industry continues to be to report FFO as defined by NAREIT. In addition, based on our experience, the SEC staff can be expected to issue comments when it reviews SEC filings in which a REIT: (i) states it is using the NAREIT FFO definition, but makes changes in the included and excluded items or (ii) mixes earnings/performance and cash flow/liquidity concepts when discussing the rationale for disclosing FFO. We expect these SEC staff practices to continue or intensify in light of the new disclosure requirements. Smoothing and Similar Adjustments In 1999, NAREIT clarified the definition of FFO to include non-recurring items, except for those that are defined as extraordinary items under GAAP. In 2002, a further clarification stated that FFO should include operating revenue and expenses treated as discontinued operations under SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (i.e., FFO related to assets held for sale, sold or otherwise transferred). Thus, under NAREIT s current definition of FFO, only unusual or non-recurring items treated as extraordinary under GAAP can be excluded from FFO. As noted above, the new SEC rules now prohibit adjusting a non-gaap performance measure to eliminate or smooth items identified as nonrecurring, infrequent or unusual if they have occurred in the prior two years or are reasonably likely to occur in the following two years. The SEC rules do not appear to prohibit adjustments for charges or gains that qualify as extraordinary under GAAP. Disclosure of NAREIT-Defined FFO with Supplemental Adjustments. Some REITs that use the NAREIT FFO definition make supplemental adjustments to FFO when clearly defined and disclosed items warrant it, and neither prior SEC guidance nor the new SEC rules prohibit these adjustments per se. At the same time, the dividing line between (1) adjustments that have the effect of distorting trends or presenting unbalanced, misleading disclosure and (2) meaningful adjustments that 3

4 enhance investors understanding of FFO as a measure of performance can be subjective, and is likely to continue to be a topic for debate with the staff of the SEC and within the investment and analyst communities. We believe that supplemental adjustments to FFO should continue to be permitted under appropriate circumstances, so long as: the adjustments comply with the new SEC rules that strictly prohibit adjustments unless: the charge or gain it is not reasonably likely to recur within the following two years, and there was no similar charge or gain within the prior two years; REITs present FFO reflecting these supplemental adjustments separately from FFO as defined by NAREIT, with a clear reconciliation to GAAP financial measures and to NAREIT-defined FFO; REITs separately note and clearly explain the nature of these adjustments and why they are useful to investors; the disclosure complies with anti-fraud requirements, including the specific prohibition in Regulation G and the other prohibitions in the federal securities laws and rules; and as discussed below, if FFO reflecting these supplemental adjustments is presented on a per share basis, the supplemental adjustments (i) should not result in the asadjusted disclosure becoming a cash flow metric and (ii) should be presented on a diluted basis. FFO and the New SEC Prohibition on Smoothing Adjustments in SEC Filings. Under the new rules, REITs will no longer be able to adjust FFO to exclude unusual or infrequent in SEC filings. The new rules impose a four-year prohibition on smoothing adjustments. This four-year period includes not only the two-year period following disclosure of FFO with this type of adjustment, but also a two-year look-back on similar adjustments to FFO. It is important to note that the two-year look-back is a bright-line test that results in an absolute block on similar adjustments in SEC filings during the subsequent two-year period: there is no exception for charge or gain items that were believed to be not reasonably likely to recur when made. As noted above, Item 10 prohibits smoothing adjustments only in documents filed with the SEC. Item 10 does not prohibit these adjustments in press releases, even if they are furnished to the SEC under the new Form 8- K requirement for earnings releases and other public announcements. However, if a REIT makes these types of adjustments to FFO in a press release it must be careful not to file the press release under Item 5 of Form 8-K, and the REIT must not include the adjustments in a Form 10-K or 10-Q report. It is worth noting that public companies do sometimes file earnings press releases (for example, to update material information included as part of the disclosure package for a take-down offering under a shelf registration statement). It may also be worth considering the risk of potential confusion to investors from disclosing adjustments to FFO in a press release that cannot be disclosed as included in FFO disclosure in the company s periodic SEC reports. It is possible that the prohibition on making smoothing adjustments to non-gaap financial measures that are included in SEC filings will lead some REITs to adopt a twotrack approach to FFO disclosure: FFO without any smoothing adjustments would be disclosed in accordance with the NAREIT definition in both press releases and SEC filings, in compliance with both Regulation G and Item 10; and FFO reflecting adjustments that fail the anti-smoothing test would be only disclosed in press releases or other materials that are not filed with the SEC, complying with Regulation G, but not with Item 10. For the reasons stated in the preceding paragraph, it remains to be seen whether a two- 4

5 track approach will be an attractive or practical option for REITs. Use of and Limitations on Per Share FFO Information Another key aspect of the new SEC rules is that they expressly permit use of per share non- GAAP measures specifically including FFO per share both in press releases and in SEC filings. We believe this modifies in significant ways the SEC s earlier guidance in ASR 142, Cash Flow and Other Related Data. However, the SEC also clearly stated that some uses of per share non-gaap information are prohibited, and issued serious cautions about other uses. Of special interest to REITs is the prohibition on per share disclosure of non- GAAP cash flow measures and an SEC caution against disclosing per share information except on a diluted basis. Prohibition on Per Share Cash Flow Measures in Earnings Releases and SEC Filings. Although the new rules specifically allow per share FFO disclosure, the SEC also noted that both GAAP and existing SEC rules prohibit per share cash flow information in materials filed with or furnished to the SEC under paragraph 33 of FASB Statement No. 95, Statement of Cash Flows. As a result of the new Form 8-K requirement to furnish earnings releases for completed fiscal periods, REITs will no longer be able to disclose per share cash flow measures in earnings releases, Form 10-K or Form 10-Q reports, or other documents filed with or furnished to the SEC. While there are other types of press releases that would not be subject to this prohibition, it is hard to imagine that REITs would choose to disclose per share non-gaap cash flow data at all under the new SEC rules. We will follow closely how the accounting literature and the SEC accounting staff apply this element of the new rules in practice. Adjustments May Make FFO a Cash Flow Measure. While it has not been common for REITs to disclose per share cash flow data as such, the SEC s prohibition on use of per share non-gaap cash flow measures presents potential issues for REITs. FFO as defined by NAREIT is accepted as an accrual basis measure of earnings and operating profitability, and as such the new SEC rules clearly permit per share presentation. However, if a REIT makes adjustments to FFO that have the effect of turning FFO into a measure of stabilized cash flows generated by operations, dividendpaying capacity or liquidity, the new SEC rules prohibit per share presentation of FFO as so adjusted in earnings releases, SEC reports, and other documents filed with or furnished to the SEC. The most common such types of these adjustments include: translating rents from a straight-line, GAAP accrual basis to a cash basis (i.e., reversing the so-called straighlining of rents ); adding non-cash amortization of deferred financing costs back to GAAP net income; adding back deferred income taxes to GAAP net income; adding the non-cash portion of compensation expense back to GAAP net income; adjusting GAAP basis contingent rental income to reflect billing of contingent rents; adjusting GAAP rental income/expense for amortization of premium/discount attributable to above/below market rents in accordance with SFAS 141, Business Combinations; and adding back to GAAP net income noncash write-offs of investments in new ventures. It is important to note that making these adjustments, or disclosing non-gaap measures like Adjusted FFO (AFFO), Cash Available for Distribution (CAD) and Funds Available for Distribution (FAD), is not per se prohibited by the new SEC rules. However, the new SEC rules do prohibit disclosure of cash flow metrics on a per share basis in earnings releases and other documents filed with or furnished to the SEC. It remains to be seen whether disclosure of AFFO, CAD or FAD without per share data, or disclosure on a twotrack basis as outlined above, will be an attractive or practical option. It also appears 5

6 that many of the adjustments designed to turn FFO into a liquidity measure, as well as the disclosure of AFFO, CAD or FAD, have become less common in the REIT industry, a trend we would expect to continue in light of the new SEC rules. In any event, REITs should consider the risk of added scrutiny if they choose to depart from the NAREIT definition of FFO or adopt a two-track disclosure approach. In addition, REITs that disclose AFFO should ensure that this disclosure will not be potentially confused with FFO and inadvertently mislead investors. To be clear, REITs must in all cases comply with the various definitional and presentation requirements of Regulation G and the amendments to Item 10 summarized above, as well as applicable anti-fraud provisions. Diluted Basis Presentation. When the SEC adopted the new rules governing use of non- GAAP financial measures, it cautioned companies to consider whether the use of any per share measure that is not calculated using a diluted share figure complies with (i) the Regulation G requirement that disclosure of non-gaap financial measure contains no material misstatements or omissions; and (ii) GAAP requirements (see, e.g., FASB Statement No. 128, Earnings Per Share). While not an express prohibition against presenting non- GAAP measures on an undiluted basis, this is a potentially serious caution that REIT executives, and accountants and attorneys who work with REITs, should bear in mind. The new SEC rules on use of non-gaap financial measures will provide welcome clarifications on use of FFO and other non- GAAP metrics by REITs. At the same time, however, these rules present significant, and sometimes subtle, compliance issues in an atmosphere of enhanced scrutiny. Interested REIT industry executives, as well as attorneys and accountants that work with REITs, will want to follow developments in this area closely. We welcome any questions concerning these new rules. For more information, please feel free to contact us directly or through your regular Goodwin Procter contact. Copies of this alert and related materials are available on our Web site at Gilbert G. Menna, P.C. gmenna@goodwinprocter.com Ettore A. Santucci, P.C. esantucci@goodwinprocter.com John O. Newell jnewell@goodwinprocter.com This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys Goodwin Procter LLP. All rights reserved.

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