November 12, A Partnership Including Professional Corporations. New York One New York Plaza New York, NY

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1 T O O U R F R I E N D S A N D C L I E N T S November 12, 2002 SEC Proposes Rules under the Sarbanes-Oxley Act of 2002 on the Use of Non- The U.S. Securities and Exchange Commission recently proposed rules to regulate the disclosure or release of certain financial information by reporting issuers 1 and enhance their disclosure responsibilities. 2 These rules, some of which have been mandated by Sections 401(a) and (b) of the Sarbanes-Oxley Act, would: require issuers to file disclosure on Form 8-K within two business days after any press release or other public announcement (such as an earnings release) disclosing material non-public information regarding an issuer s results of operations or financial condition for an annual or quarterly period that has ended; regulate the use in disclosures or press releases and in filings with the SEC of "non-gaap financial measures" that are derived on the basis of methodologies other than in accordance with Generally Accepted Accounting Principles ("GAAP"), such as "as adjusted" and "pro forma" presentations; lower the threshold that triggers disclosure of off-balance sheet arrangements; require disclosure relating to off-balance sheet arrangements to be set apart in a designated section of the Management s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") contained in an issuer s disclosure documents; and require disclosure of aggregate contractual obligations and contingent liabilities and commitments in an issuer s MD&A. 1 See Proposed Rule: Conditions for Use of Non-GAAP Financial Measures (November 4, 2002), available at 2 See Proposed Rule: Disclosure in Management s Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities (November 4, 2002), available at A Partnership Including Professional Corporations New York One New York Plaza New York, NY Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC Los Angeles 250 South Grand Avenue Los Angeles, CA London 99 City Road London EC1Y 1AX United Kingdom Paris 7, rue Royale Paris France Copyright November 12, 2002 Fried, Frank, Harris, Shriver & Jacobson

2 Foreign private issuers would generally be subject to these rules on the same basis as US domestic companies, other than the rules requiring issuers to file timely disclosure on Form 8-K of any public announcement or release containing material non-public information, although in some cases foreign private issuers would face different requirements. New Requirement to File Earnings Press Releases on Form 8-K Announcement or Release of Non-Public Information The SEC has gone past the requirements of the Sarbanes-Oxley Act and proposed sweeping new amendments to Form 8-K that add new Item 1.04, "Disclosure of Results of Operations and Financial Condition." This new item would require issuers to file a Form 8-K within two business days of any public announcement or release, such as an earnings release or announcement, disclosing material non-public information regarding an issuer s results of operations or financial condition for a completed annual or quarterly period. The rule would not apply to issuers that make these announcements and disclosures only in their quarterly reports filed with the SEC on Form 10-Q or their annual reports filed with the SEC on Form 10-K. Repetition of information that was previously publicly disclosed or release of the same information in a different form would not trigger a new filing requirement. However, release of additional or updated material non-public information regarding the issuer s results of operations or financial condition for a completed fiscal year or quarter would trigger an additional filing requirement. Issuers that make earnings announcements or other disclosures of material non-public information regarding a completed fiscal year or quarter in an interim or annual report to shareholders would be permitted to specify which portion of the report contains the information required to be filed. At present, announcements such as earnings releases or similar announcements are subject to Regulation FD. However, unlike material "furnished" to satisfy Regulation FD under existing Item 9 of Form 8-K, information filed pursuant to the new Form 8- K requirement would be considered "filed" with the SEC for Section 18 liability purposes, and would be considered to be incorporated by reference into a registration statement, proxy statement or other report. A Form 8-K filed to provide the new information required under the proposed Item 1.04 would satisfy an issuer s obligation under Regulation FD, but only if the Form 8- K were filed within the time frame required by Regulation FD. Disclosure of Information Orally, Telephonically or by Webcast or Broadcast If non-public information is disclosed orally, telephonically, or by webcast, broadcast Fried, Frank, Harris, Shriver & Jacobson 2

3 or similar means, the proposed rule would not require an issuer to file a Form 8-K if: the disclosure initially occurs within 48 hours of a written release or announcement filed on Form 8-K; the presentation is accessible to the public by dial-in conference call, webcast or similar technology; the financial and statistical information contained in the presentation is provided on the issuer s website, together with any information related to non- GAAP financial matters that would be required under proposed Regulation G; and the presentation was announced by a widely disseminated press release that included instructions as to when and how to access the presentation and the location on the issuer s website where the information would be available. Forward Looking Information The new Form 8-K filing requirement would apply only to publicly disclosed or released material non-public information concerning an annual or quarterly fiscal period that has ended. Proposed Item 1.04 would not apply to public disclosure of earnings estimates for future or ongoing fiscal periods, unless those estimates are included in the public announcement or release of material non-public information regarding an annual or quarterly fiscal period that has ended. In such a case, specifically identified forward-looking information could be furnished under proposed Item 6.01 (currently Item 9) as a Regulation FD disclosure rather than filed under proposed Item Information furnished under Item 6.01 of Form 8-K would not be considered filed with the SEC for liability purposes, nor would it be incorporated by reference into a registration statement, proxy statement or other report. Foreign Private Issuers The new Form 8-K requirement would not apply to foreign private issuers, who are not required to make filings on Form 8-K. However, foreign private issuers that file reports with the SEC would still have to file any material information publicly released in their home jurisdiction under cover of Form 6-K. Regulation of Use of Non-GAAP Financial Measures The SEC has proposed new Regulation G, as well as significant changes in Forms 10-Q, 10-K and 20-F, to regulate the use of "non-gaap financial measures." As discussed below, this term is defined to include financial measures based on GAAP Fried, Frank, Harris, Shriver & Jacobson 3

4 financial statements that are not recognized under GAAP (such as EBIT and EBITDA). As proposed, any entity that has a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or that is required to file reports under Section 15(d) of the Exchange Act, including foreign private issuers but not any registered investment company, would be required to comply with Regulation G. Regulation G Governs Any Public Disclosure of a Non-GAAP Financial Measure Regulation G would apply whenever an issuer, or a person acting on behalf of an issuer, discloses or releases publicly any material information that includes a non- GAAP financial measure. Regulation G would require an issuer to provide the following information as part of such disclosure or release: a presentation of the most comparable financial measure calculated and presented in accordance with GAAP; and a reconciliation (by schedule or other clearly understandable method), which must be quantitative for historic measures, and quantitative, to the extent available without unreasonable efforts, for prospective measures, of the differences between the non-gaap financial measure presented and the comparable financial measure calculated and presented in accordance with GAAP. Under Regulation G, if the issuer discloses or releases publicly any material information that includes a forward-looking non-gaap financial measure, the issuer must provide a reconciliation to the comparable financial measure calculated and presented in accordance with GAAP unless doing so would require unreasonable efforts. According to the proposing release, if the reconciliation to the comparable financial measure calculated and presented according to GAAP is not available for a forward-looking non-gaap financial measure, an issuer must disclose that fact, explain why it is not available on a forward-looking basis and provide any reconciling information that is available without an unreasonable effort. The issuer must identify any information that is unavailable and disclose its probable significance. Regulation G also provides that a non-gaap financial measure, taken together with the accompanying information, may 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, in light of the circumstances under which it is presented. Disclosure of Information Orally, Telephonically or by Webcast or Broadcast If an issuer releases a non-gaap financial measure orally, telephonically or in a webcast or broadcast, proposed Regulation G would permit an issuer to provide the Fried, Frank, Harris, Shriver & Jacobson 4

5 required accompanying information by posting the disclosure on its website. The issuer would be required to disclose the location and availability of the required accompanying information during its presentation. Definition of Non-GAAP Financial Measures Regulation G defines a non-gaap financial measure as a numerical measure of an issuer's historical or future financial performance, financial position or cash flow that: excludes amounts that are included in the comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the issuer; or includes amounts that are excluded from the comparable measure calculated and presented in accordance with GAAP. Non-GAAP financial measures include all measures of performance or liquidity (financial statement or cash flow) that have the effect of being different from the measures calculated in accordance with GAAP. Examples of non-gaap financial measures include: a measure of operating income that excludes one or more expense or revenue items that are identified as "non-recurring"; EBITDA (earnings before interest, taxes, depreciation and amortization), which could be calculated using elements derived from GAAP financial presentations but, in any event, is not presented in accordance with GAAP; and a ratio, with either one or both of the components calculated other than in accordance with GAAP. Non-GAAP financial measures would not include financial information that does not have the effect of providing numerical measures that are different from the comparable GAAP measures, e.g., operating and other statistical measures (such as unit sales, numbers of employees, numbers of subscribers or numbers of advertisers) and ratios or measures that in each case are calculated using only financial measures calculated in accordance with GAAP. Regulation G also would not apply to the disclosure of financial information that does not have the effect of providing numerical measures that are different from the comparable GAAP measure. Examples of financial measures to which Regulation G would not apply would include the following: Fried, Frank, Harris, Shriver & Jacobson 5

6 disclosure of amounts of expected indebtedness, including contracted and anticipated amounts; disclosures of amounts of repayments that have been planned or decided upon but not yet made; disclosures of estimated revenues or expenses of a new product line, so long as such amounts were estimated as GAAP figures; measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP; and ratios and measures calculated in accordance with GAAP, such as sales per square foot (sales figure calculated in accordance with GAAP) or same store sales (sales figures calculated in accordance with GAAP). Foreign Private Issuers Regulation G would apply to foreign private issuers, but a foreign private issuer would be exempted if it satisfies the following test: the securities of the issuer are also listed or quoted on a securities exchange or inter-dealer quotation system outside the United States; the non-gaap financial measure and the most comparable GAAP financial measure are not calculated and presented in accordance with generally accepted accounting principles in the United States; and the disclosure is made by or on behalf of the issuer outside the United States, or is included in a written communication that is released by or on behalf of the issuer only outside the United States. These conditions will be difficult to satisfy since most foreign private issuers disseminate information on a worldwide basis. With respect to foreign private issuers, references to GAAP in the proposal also include references to the generally accepted accounting principles under which the issuer s primary financial statements are prepared. Liability under the Exchange Act Regulation G expressly provides that nothing in Regulation G affects any person s liability under Exchange Act Section 10(b) or Rule 10b-5 under the Exchange Act. Regulation G also states that a person s compliance or non-compliance with the requirements of Regulation G would not affect that person s liability under Section Fried, Frank, Harris, Shriver & Jacobson 6

7 10(b) or Rule 10b-5. In this regard, the SEC reminded companies of its warning in December 2001 that, under certain circumstances, non-gaap measures could mislead investors if they obscure an issuer s GAAP results. In the proposing release, the SEC states that it continues to be of the view that some disclosures of non-gaap financial information could give rise to actions under Rule 10b-5. Conversely, however, if an issuer or a person acting on behalf of an issuer fails to comply with Regulation G, the issuer and/or the person acting on its behalf could be subject to an enforcement action by the SEC alleging a violation of Regulation G. In addition, if the facts and circumstances warrant, the SEC has stated that it could bring an action under both Regulation G and Rule 10b-5. The SEC's proposing release also notes that a failure to include all the information required by Regulation G would not affect the issuer's ability to use Form S-2, S-3 or S-8 or the determination whether the issuer has made available adequate public information for purposes of Rule 144(c). More Stringent Requirements for Use of Non-GAAP Financial Measures in 10- Ks, 10-Qs and 20-Fs The SEC also proposes to amend Regulation S-K to impose requirements regarding the use of non-gaap measures in SEC filings. While the proposed Regulation G would apply to every disclosure of non-gaap financial measures, the new Regulation S-K requirement would apply only to non-gaap financial measures disclosed in SEC filings. The Regulation S-K requirements are similar to, but tougher than, those in Regulation G. The proposed Regulation S-K amendments would also apply to foreign private issuers under proposed amendments to Form 20- F. Required Disclosures in Periodic Reports The proposed amendments to Regulation S-K provide that issuers using non-gaap financial measures in SEC filings would have to include: a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP (Regulation G lacks the "equal or greater prominence" requirement); a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-gaap financial measure disclosed and the most directly comparable measure or measures calculated and presented in accordance with GAAP; a statement disclosing the purposes for which the issuer s management uses the non-gaap financial measure presented (this is not included in Regulation G); and Fried, Frank, Harris, Shriver & Jacobson 7

8 a statement describing the reasons why the issuer s management believes such non-gaap financial measures provide useful information to investors (this is not included in Regulation G). Prohibited Disclosures in Periodic Reports In addition to these mandated disclosure requirements, the SEC proposes to amend Regulation S-K to prohibit the use of certain kinds of non-gaap financial measures either generally or in specified contexts. The proposed prohibitions cover the following: presenting a non-gaap financial measure in a manner that would give it greater authority or prominence than the comparable GAAP financial measure or measures; 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; adjusting a non-gaap performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur; presenting non-gaap financial measures on the face of the issuer s financial statements prepared in accordance with GAAP or in the accompanying notes; presenting non-gaap financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; 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; and presenting a non-gaap per-share measure. The requirement under Regulation G that the presentation of a non-gaap financial measure, taken together with the information accompanying the measure and any other accompanying discussion, not contain a material misstatement or material omission necessary in order to make the presentation not misleading, in light of the circumstances in which the presentation is made, would also apply to disclosures in documents filed with the SEC. The proposed rules would require much more detailed and extensive disclosures regarding non-gaap financial measures in Form 10-K, 10-Q or 20-F filings than in a press release or oral statement. In particular, in filings with the SEC, the presentation of the comparable GAAP financial measure must have equal or greater prominence, and, in contrast to Regulation G, would not be subject to an "unreasonable effort" exception for forward-looking information to the requirement for a quantitative Fried, Frank, Harris, Shriver & Jacobson 8

9 reconciliation between the non-gaap financial measure and the comparable GAAP financial measure. Foreign Private Issuers Unlike under Regulation G, the proposed amendments to Form 20-F or 40-F do not contain an exception that might apply to foreign private issuers. However, a non- GAAP financial measure that would otherwise be prohibited would be permitted in a Form 20-F filing of a foreign private issuer if the measure was expressly permitted under the generally accepted accounting principles used in the issuer s primary financial statements and was included in the issuer s annual report or financial statements used in its home country jurisdiction or market. Off-Balance Sheet Arrangements Off-Balance Sheet Arrangements Falling Under the Proposed Rules The SEC believes that, in light of the increasing complexity of off-balance sheet arrangements and the mandate of Section 401(a) of the Sarbanes-Oxley Act, the proposed disclosure regarding off-balance sheet arrangements should address a wide variety of arrangements. As a result, the proposed rules define the term "off-balance sheet arrangement" as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the issuer is a party, under which the issuer, whether or not a party to the arrangement, has, or in the future may have: any obligation under a direct or indirect guarantee or similar arrangement; or a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement. "Off-balance sheet arrangements" also include: derivatives, to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or any obligation or liability, including a contingent obligation or liability, to the extent that it is not "fully reflected" in the financial statements (excluding the footnotes thereto). Obligations or liabilities that are not considered "fully reflected" on the face of the financial statements would include, without limitation: obligations that are not classified as a liability according to GAAP; contingent liabilities as to which, as of the date of the financial statements, it Fried, Frank, Harris, Shriver & Jacobson 9

10 is not probable that a loss has been incurred or, if probable, is not reasonably estimable; or liabilities as to which the amount recognized in the financial statements is less than the reasonably possible maximum exposure to loss under the obligation as of the date of the financial statements. A liability is only considered to be fully reflected on the financial statements by the SEC, and therefore outside the scope of the proposed definition, if it is recorded at its "fair value" on the face of an issuer s financial statements. Fair value is the amount at which a liability could be incurred or settled in a current transaction between willing parties other than in a forced or liquidation sale. Contingent liabilities arising out of litigation, arbitration or regulatory actions are not off-balance sheet arrangements. The SEC has stated that it believes that the contemplated off-balance sheet arrangement should be "contractual" in order to require disclosure. Therefore, the SEC has proposed to include these arrangements within its policy that MD&A disclosure is not necessary for preliminary negotiations. As a result, the proposals include an instruction that no obligation to make disclosure of an off-balance sheet arrangement shall arise until an unconditionally binding definitive agreement, subject only to customary closing conditions, exists or, if there is no such agreement, when settlement of the transactions occurs. Proposed Lower Disclosure Threshold for Off-Balance Sheet Arrangements Under the Sarbanes-Oxley Act and the new rules, the threshold for disclosure of offbalance sheet arrangements is whether they "may have a current or future material effect on the registrant s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources" (emphasis added). Under the SEC s 1989 Interpretive Release on MD&A disclosure, "reasonably likely" is the existing disclosure threshold under which information that could have a material effect on financial condition, changes in financial condition or results of operations must be included in the MD&A. The SEC has interpreted the language of Section 401(a) of the Sarbanes-Oxley Act as requiring the SEC to mandate a standard for disclosure of off-balance sheet items more stringent than the "reasonably likely" standard. The proposed rule would require disclosure of offbalance sheet arrangements that "may" have a material current or future effect where management concludes that the likelihood of the occurrence of a future event and its material effect on the issuer is higher than remote. This standard is significantly different from that used in current practice and would result in disclosure regarding a variety of matters that are not required to be disclosed under current rules. Fried, Frank, Harris, Shriver & Jacobson 10

11 Proposed Required Disclosure About Off-Balance Sheet Arrangements Under the proposals, an issuer would be required to disclose: the nature and business purpose of its off-balance sheet arrangements; to the extent necessary to an understanding of the proposed disclosure, the significant terms and conditions of the arrangements, including those between the issuer and any entity in which off-balance sheets activities are conducted and between the issuer or that entity and other persons; the nature and amount of the total assets and total obligations and liabilities (including contingent obligations and liabilities) of an entity in which offbalance sheet arrangements are conducted; the amounts of revenues, expenses and cash flows of the issuer arising from the arrangements; the nature and amounts of any interests retained, securities issued and other indebtedness incurred by the issuer; any other obligations and liabilities (including contingent obligations and liabilities) of the issuer arising from the arrangements that are, or may become, material and the triggering events or circumstances that could cause them to arise; management's analysis of the material effects of any of the above items on the issuer s financial condition, revenues or expenses, results of operations, liquidity, capital resources and capital expenditures; and an analysis of the degree to which the issuer relies on off-balance sheet arrangements for its liquidity and capital resources or market risk or credit risk support. Management would also have to discuss the effects of a termination or material reduction in the benefits of off-balance sheet arrangements. Separate Disclosure Section The proposals would require an issuer to present the proposed disclosure of offbalance sheet arrangements set apart in a designated section of the MD&A. In contrast, an issuer would be able to present disclosure regarding contractual obligations and contingent liabilities and commitments (as described below) in an MD&A location that the issuer deems to be appropriate. Fried, Frank, Harris, Shriver & Jacobson 11

12 Forward Looking Information The SEC realizes that some of the disclosure required by the proposed rules on offbalance sheet transactions would require disclosure of forward-looking information. Accordingly, the statutory safe-harbor protections are explicitly applied to forwardlooking information that would be required to be disclosed by the proposals. Contractual Obligations and Contingent Liabilities and The SEC believes that the presentation of aggregated information concerning contractual obligations and contingent liabilities and commitments in a single location would improve transparency of an issuer s short- and long-term liquidity and capital resource needs and demands. Therefore, the SEC proposes to require issuers to include in the MD&A (1) tabular disclosure about contractual obligations and (2) either tabular or textual disclosure about contingent liabilities and commitments. The required tabular disclosure for contractual obligations would require information as to contractual obligations coming due at various different points in the future, i.e., less than one year, one to three years, three to five years and more than five years. The table would require disclosure of all contractual obligations, including debt, capital lease obligations, operating leases and unconditional purchase obligations, and would require issuers to list their total contractual obligations. In addition, the issuer would have to disclose, either in tabular format or in text, the expected amount, range of amounts or maximum amount of contractual contingent liabilities or commitments that are expected to expire in various time frames. The disclosure should indicate whether the amount disclosed is an expected amount or a maximum amount if a range is not presented. The contingent liabilities or commitments would be aggregated by type in a manner suitable for the issuer's business. Examples include lines of credit, standby letters of credit, guarantees, and standby purchase obligations. The rules on off-balance sheet transactions and contractual obligations and contingent liabilities and commitments would apply equally to all reports on Form 20-F and Form 40-F filed by foreign private issuers that are required to include an MD&A discussion. They would also apply to registration statements on Forms F-1, F-2, F-3 and F-4. However, the SEC has not proposed to extend the requirements to interim reports of foreign private issuers that are submitted on Form 6-K. Final Rules Comments on the proposed rules regarding off-balance sheet arrangements are due by December 7, Comments regarding the new Form 8-K requirements and conditions for use of non-gaap financial measures and the new Form 8-K requirements are due by 30 days after the proposed rules are published in the federal register. The Sarbanes-Oxley Act requires the SEC to issue final rules relating to Fried, Frank, Harris, Shriver & Jacobson 12

13 disclosure about off-balance sheet arrangements and conditions for use of non-gaap financial measures by January 26, Information in this memorandum has been provided by Fried, Frank, Harris, Shriver & Jacobson for general information purposes only and does not constitute legal advice in any manner whatsoever. For further information about the proposed rules, please feel free to call any of the Fried Frank attorneys listed below: New York Valerie Ford Jacob Stuart H. Gelfond Jean E. Hanson Michael A. Levitt London Timothy E. Peterson +44 (0) Karen C. Wiedemann +44 (0) Daniel J. Bursky +44 (0) Fried, Frank, Harris, Shriver & Jacobson 13