Last Thursday, the SEC announced settled charges against SafeNet, Inc. and certain of its former officers and employees in connection with an alleged earnings management scheme that materially misstated SafeNet's GAAP and non-GAAP financial results. What's unique about this case is that one of the charges is that the defendants violated Regulation G by reporting non-GAAP earnings that improperly excluded certain ordinary expenses as non-recurring charges. This is the first enforcement action under Regulation G since its enactment in 2003, and it serves as a reminder that the regulation is another tool within the SEC's already powerful enforcement arsenal.
Regulation G prohibits disseminating false or misleading non-GAAP financial measures (i.e., measures that are not calculated in conformity with GAAP, and that often exclude non-recurring, infrequent, or unusual expenses) or presenting the non-GAAP financial measures in such a manner that they mislead investors or obscure the company's GAAP results. Regulation G requires companies to reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure.
The SEC alleges that, in order to meet earnings targets, SafeNet's CEO and CFO directed SafeNet's accounting personnel to improperly reclassify various expenses in both its GAAP and non-GAAP numbers. This improper accounting included:
- reclassifying ordinary operating expenses (such as ongoing advertising expenses and Sarbanes-Oxley compliance costs) as integration expenses incurred in connection with acquisitions;
- the improper reduction of accruals for certain professional fees; and
- the improper reduction of inventory reserve accruals.
The CEO and CFO also allegedly mischaracterized these items in SafeNet's earnings calls. For example, in response to questions about the nature of advertising costs classified as integration expenses, the CEO asserted that these costs were "one-time in nature" when they actually related to ongoing expenses.
Even after SafeNet's auditors required SafeNet to reclassify a significant portion of these costs as ordinary expenses and called its use of integration costs "abusive" and "a means of meeting [non-GAAP] EPS guidance," SafeNet continued to misclassify certain items for purposes of its non-GAAP numbers. To address the disparity between its GAAP and non-GAAP numbers, SafeNet created certain bogus categories in its non-GAAP reconciliation including: "Research and Development—non-recurring;" "Sales and Marketing—non-recurring;" and "General and Administrative—non-recurring." SafeNet used these categories to offset the ordinary recurring expenses that its auditor had refused to allow SafeNet to treat as integration expenses.
A few observations:
- Although this is the first Regulation G enforcement action, it has been clear for many years that the SEC views non-GAAP measures with suspicion and that the burden is on companies to demonstrate not only that the non-GAAP measures are useful to investors but that they have been compiled in good faith and on a reasonable basis.
- SafeNet's alleged conduct in this case suggests that the SEC could have brought an enforcement action against SafeNet and its executives under Section 10b-5 for material misstatements even in the absence of Regulation G.
The complaint uses that ill-defined multi-purpose SEC term of opprobrium, "earnings management", to describe the conduct in question. Our experience is that cases like these are generally grounded in an underlying rule violation, and that "earnings management" is alleged not as the actual offense but as a motive that turns what might otherwise have been an innocent mistake into the basis for enforcement.
- Despite this case, we continue to believe that companies that are accurately disclosing and reconciling their non-GAAP numbers should feel comfortable using them. In fact, at a recent PLI conference, Meredith Cross, Director of the Division of Corporation Finance, said that she has asked the staff to review the Division's current Regulation G interpretations and guidance to see whether any adjustments are needed because she does not want companies to feel constrained from using non-GAAP numbers that they think accurately tell their story.
See the SEC's Litigation Release announcing the SafeNet enforcement action.