by Arthur Greenspan, James Walker, David Massey and Jakob Sebrow
Accounting fraud has long been a staple of the enforcement program at the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ), as corporate officers and employees continue to engage in efforts to improperly enhance financial results. Based on the widespread use of “non-GAAP” financial metrics by public companies and recent SEC and DOJ emphasis on such measures, we believe that non-GAAP metrics will feature prominently in the government enforcement priorities that are likely to follow the significant market correction caused by COVID-19.
As we discuss below, companies and their senior executives risk SEC and criminal fraud charges based on misuse of non-GAAP metrics, and audit committee members risk scrutiny for failure to maintain adequate internal controls concerning non-GAAP metrics. United States v. Carroll, a criminal case currently pending before Chief Judge Colleen McMahon in the Southern District of New York, is an important example of the government’s expansive theories of materiality and the real risks faced by companies and executives who emphasize non-GAAP measures in their public disclosures and comments. Indeed, a confluence of factors—including the prosecutors’ core theory that the defendants sought to “smooth” an ancillary non-GAAP metric, their reliance on qualitative materiality, and their willingness to bring criminal charges notwithstanding the conclusion of the outside auditors that the misstatements were immaterial—makes Carroll a striking and novel prosecution.
SEC Scrutiny of Non-GAAP Reporting
For U.S. public companies, traditional performance and liquidity measures such as revenue, net income, earnings per share, and cash flow must be calculated and presented in accordance with U.S. generally accepted accounting principles (GAAP) and audited annually by independent auditors. In recent years, nearly all U.S. public companies have chosen to report, and sometimes emphasize, “non-GAAP” financial measures such as EBITDA (earnings before interest, taxes, depreciation and amortization), “adjusted net income,” “core earnings,” “free cash flow” and “funds from operations.” Such measures reflect adjustments to the comparable GAAP metric and, in theory, are designed to present to investors and analysts an alternative, and arguably more meaningful, picture of a company’s results by eliminating items that are deemed non-recurring or otherwise extrinsic to the company’s core operations. Non-GAAP measures generally have no uniform definition or method of calculation and are not audited by a company’s independent auditors.
In 2003, the SEC adopted Regulation G and Item 10(e) of Regulation S-K, which address the potentially manipulative or misleading use of non-GAAP financial measures. For SEC-registered companies presenting non-GAAP measures, the regulations require, among other things, that the company (i) present the most directly comparable GAAP measure “with equal or greater prominence,” (ii) include a quantitative reconciliation of the differences between the two measures, and (iii) explain why management believes that the non-GAAP measure is useful to investors. In 2016, the SEC’s Division of Corporation Finance issued new Compliance and Disclosure Interpretations that contained additional guidance on the various disclosures required under Regulation G and Item 10(e), and the circumstances in which such disclosures could be viewed as misleading by the SEC.[1] The Division of Corporation Finance, in its comment letters to registered companies, frequently raises concerns about the use of non-GAAP metrics and related disclosures.
Not surprisingly, the SEC has imposed penalties against companies who have abused the presentation of non-GAAP metrics in their financials. In a 2017 settlement, the Commission imposed a $1.5 million penalty against the marketing company MDC Partners based in part on non-fraud charges that the company had repeatedly included an undisclosed element in its calculation of a non-GAAP metric (“organic revenue growth”) and had repeatedly emphasized non-GAAP measures such as EBITDA and free cash flow in earnings releases without giving equal or greater prominence to the comparable GAAP measures.[2] Similarly, in a 2018 settlement, the SEC assessed a $100,000 penalty against the home security company ADT Inc. based on non-fraud charges that, in two earnings releases, the company had emphasized non-GAAP measures such as adjusted EBITDA and adjusted net income, without giving equal or greater prominence to the comparable GAAP measures.[3]
SEC and Criminal Cases Based on Misleading Non-GAAP Metrics
Both the SEC and federal criminal prosecutors have pursued fraud charges against companies and individuals based on allegations of materially false reporting of non-GAAP financial metrics. For example, in 2016, both the U.S. Attorney’s Office for the Southern District of New York and the SEC charged Brian Block, the former CFO of American Realty Capital Properties, Inc., a publicly traded real estate investment trust (or “REIT”), with securities and accounting fraud based on allegations that he falsely inflated a non-GAAP metric, known as “adjusted funds from operations,” that was cited in the company’s public disclosures.[4] In 2017, following a three-week jury trial, Block was convicted on all counts and sentenced to eighteen months’ imprisonment. He also consented to a final judgment in favor of the SEC that included an officer and director bar and a $160,000 penalty.
Background of United States v. Carroll
Last summer, the U.S. Attorney’s Office for the Southern District of New York brought criminal securities and accounting fraud charges against Michael Carroll, former CEO of Brixmor Property Group Inc. (another REIT), and Michael Pappagallo, its former CFO, based on an alleged scheme to manipulate and falsely report non-GAAP financial metrics cited in the company’s public disclosures.[5] The SEC filed parallel securities and accounting fraud charges against the company and the executives.[6] The non-GAAP metrics that were allegedly misstated were (i) a measure known as “same property” (or “same store”) net operating income (referred to by the government as “SS-NOI”) and (ii) the percentage growth in SS-NOI as compared with the same period during the prior year (referred to by the government as “SS-NOI Growth”). Notably, the defendants were charged by the SEC and the DOJ even though the company’s outside auditors for the relevant time period, Ernst & Young and Deloitte, each concluded that the misstatements in question were immaterial, both quantitatively and qualitatively.[7]
Brixmor agreed to settle the SEC charges and pay a $7 million penalty. Two lower-level company executives pleaded guilty to criminal charges; consented to judgment in favor of the SEC including a public-company officer and director bar; and are cooperating with the U.S. Attorney’s Office and the SEC.[8] Carroll and Pappagallo, however, have moved to dismiss the criminal case on materiality grounds.[9]
Materiality Issues in Carroll
According to the indictment, defendants Carroll and Pappagallo and their co-conspirators used improper accounting practices to manipulate Brixmor’s reported quarterly SS-NOI and SS-NOI Growth. These practices consisted primarily of: (i) including in reported SS-NOI a category of income the company had publicly said would be excluded from SS-NOI; (ii) arbitrarily removing a property from the “same store” pool; and (iii) using a “cookie jar” reserve to arbitrarily reduce or increase reported SS-NOI. The defendants are charged with engaging in this manipulation to “smooth” the reported quarterly SS-NOI Growth numbers, and therefore keep those growth numbers within Brixmor’s publicly stated guidance ranges for annual SS-NOI Growth.
Carroll and Pappagallo argue that the alleged quarterly misstatements of SS-NOI Growth are not material, as a matter of law, under the relevant quantitative and qualitative standards. Given the broad standards of materiality under both the case law[10] and SEC Staff Accounting Bulletin No. 99 (“SAB 99”),[11] and the high threshold for dismissing an indictment on materiality grounds,[12] the odds would seem to be against the defendants. [Editors’ note: After publication of this post, the district court indeed denied the defendants’ motion to dismiss the indictment, and the court noted that materiality “will no doubt be a central issue” for the jury. See United States v. Carroll, No. 19 Cr. 545 (CM), 2020 WL 1862466, at *5 (S.D.N.Y. Apr. 14, 2020).]
But, for reasons we discuss, the government’s theories of criminal wrongdoing in Carroll are aggressive and its decision to make this a criminal case is novel. In the following paragraphs we summarize the key arguments raised by the defendants and by the government concerning quantitative and qualitative materiality.
Quantitative materiality: Choice of metric and size of misstatement
Carroll and Pappagallo contend that the relevant financial metric is SS-NOI, not SS-NOI Growth, and that the indictment should be dismissed because it is undisputed that the size of the alleged misstatements of SS-NOI fell well below the baseline 5% threshold for quantitative materiality. There is some factual support for the defendants’ argument on choice of metric. The SS-NOI Growth metric highlighted by the government is not explicitly defined in any of Brixmor’s quarterly filings, and the growth percentages that form the heart of the government’s case are cited only once in each quarterly filing and are treated as derivative of the underlying SS-NOI figures and not as a standalone metric.[13] The SS-NOI numbers, in contrast, are cited numerous times in the quarterly filings by the name “Same Property NOI,” and the filings provide a definition and calculation methodology for that metric. The government’s choice to focus on SS-NOI Growth, as opposed to the more often-used SS-NOI metric, has led the defendants to accuse it of cherry-picking the relevant metric in order to satisfy the 5% threshold.
In response, the government contends that its allegations regarding the less-cited SS-NOI Growth metric are appropriate because (i) the quarterly percentage growth in SS-NOI does appear in Brixmor’s quarterly filings, even if it is cited only once, (ii) quarterly percentage growth in SS-NOI was important to investors and was explicitly touted by the defendants in earnings calls as consistently falling within guidance, and (iii) the defendants took specific actions to fraudulently “smooth” the quarterly growth numbers.[14] The government argues that the quantitative materiality threshold is met because, in most quarters, the size of the misstatement of the growth metric was much greater than 5%. For example, the government alleges that in Q3 2014 Brixmor reported SS-NOI Growth of 3.9% when the actual growth was 2.6%, which the government labels an overstatement of 50% (i.e., 3.9 is 50% larger than 2.6). The defendants label this “percentage of a percentage” calculation “contrived arithmetic,” arguing that the government’s approach—both in choice of metric and calculation of size of deviation—distorts the true size of the relevant alleged misstatements and allows objectively small deviations to be characterized as large when a percentage of a percentage calculation is employed.[15]
Although some courts have rejected the “percentage of a percentage” approach in assessing private civil accounting fraud claims,[16] we believe that the issue in Carroll will ultimately turn on the choice of relevant metric. If, as alleged in the indictment, Carroll and Pappagallo intentionally misrepresented the reported growth figures, then, notwithstanding their facially-appealing arguments that the underlying net operating income figures were more widely reported and that small changes in SS-NOI can yield large changes in SS-NOI Growth, the concept of relative size as discussed in the case law and SAB 99 seems to support the government’s arithmetic.
Qualitative materiality: Does the mere touting of a metric make it material?
As noted, materiality in securities fraud cases is essentially an assessment of the importance of a fact to a reasonable investor. The courts view materiality as a “mixed” question of law and fact that is usually most-appropriately determined by the jury, who will typically be instructed on the general standards of materiality adopted by the U.S. Supreme Court. Moreover, as the Carroll case demonstrates, a conclusion by a company’s auditors that particular misstatements were not material does not preclude the SEC or DOJ (or private plaintiffs) from asserting otherwise and is not determinative of the issue in the civil or criminal litigation.
More specifically with respect to “qualitative” materiality, both case law and SAB 99 explain that quantitatively small misstatements can still be considered material based on qualitative considerations relating to the context and effects of the misstatements. SAB 99 provides a non-exclusive list of factors that may be considered in making that assessment, including whether a misstatement “masks a change in earnings or other trends” or “hides a failure to meet analysts’ consensus expectations.”
Carroll and Pappagallo contend that the quarterly SS-NOI Growth percentages were not important to the reasonable investor, arguing that what mattered most to investors was the reported annual growth numbers and the overall trend of increasing SS-NOI, neither of which was misrepresented.[17] Moreover, the defendants cite evidence that analysts generally do not use SS-NOI in their REIT valuation models, relying instead on other metrics.[18] The defendants also note that the Brixmor SEC filings cautioned investors that SS-NOI “is not intended to be a performance measure that should be regarded as an alternative to, or more meaningful than, [the company’s] GAAP financial measures.”[19]
In response, the government emphasizes that in quarterly earnings calls and industry conferences Carroll and Pappagallo regularly “touted Brixmor’s consistent quarter-to-quarter SS-NOI Growth performance results” and “promoted Brixmor . . . based on its pattern of smooth, steady growth, typically illustrated through use of the SS-NOI Growth metric and its quarterly conformity to the firm’s annual projections.”[20] The government also argues that the defendants’ intentional efforts to “smooth” quarterly SS-NOI Growth to conform to guidance is equivalent to intentional management action to “‘manage’ reported earnings,” a practice that SAB 99 specifically says may constitute evidence of qualitative materiality.[21] In reply, the defendants argue that alleged smoothing of a non-GAAP growth metric that addresses only a portion of a company’s income is very far afield from management of earnings, which is a core GAAP measure.[22] Because the law provides that materiality is an “objective” standard based on what a “reasonable” investor would consider important, this is obviously a critical issue for the defendants.
The government relies heavily on the notion that non-GAAP metrics can be “managed” or “smoothed” fraudulently (even if the misstatements are not quantitatively material) based on the concept of qualitative materiality. In the end, although the government’s emphasis on management’s decision to tout the SS-NOI Growth metric and efforts to smooth that metric may be novel, SAB 99’s discussion of the evidentiary value of management conduct and intent in assessing qualitative materiality suggests that the government’s approach may be appropriate.
The New Norm of Aggressive Accounting Fraud Enforcement
As the regulatory and enforcement history of the past two decades shows, SEC and DOJ scrutiny of non-GAAP financial measures and reliance on qualitative materiality is here to stay, and public companies and their executives and boards need to pay serious attention. The Carroll case, in particular, should serve as a wake-up call regarding the challenges and perils of non-GAAP reporting, especially given that the defendants were indicted even though the company’s outside auditors concluded that the misstatements in question were not material. Given the widespread use of non-GAAP metrics by public companies, it seems likely that the government’s aggressive approach in Carroll will be replicated in future enforcement actions, especially if Carroll and Pappagallo are convicted at trial.
The Importance of Compliance and Internal Controls
Carroll also serves as a cautionary tale on the critical importance of compliance and internal controls with respect to non-GAAP measures. Management and boards of directors cannot fall into the trap of perceiving that non-GAAP measures are less important, or less worthy of internal control and scrutiny, than the audited GAAP metrics. The SEC and the DOJ can, and will, bring fraud charges where they believe that investors have been intentionally or recklessly misled with respect to a key financial metric, whether GAAP or non-GAAP, and they will not hesitate to do so based on qualitative materiality.
Accordingly, companies should ensure that they have clear and robust definitions, written policies, and internal controls around the calculation, reporting, and public messaging of non-GAAP metrics. Properly designed and implemented, such internal measures should prevent the sort of misconduct that Carroll and Pappagallo and their colleagues are alleged to have committed. Companies should also ensure that both earnings releases and earnings call scripts are carefully reviewed, both for compliance with SEC regulatory requirements and to ensure that all metrics that are touted, whether GAAP or non-GAAP, are entirely defensible and not misleading.
Finally, boards of directors, and especially their Audit Committees, should focus on the issues and risks around non-GAAP metrics and make sure they provide sufficient oversight of the CEO, the CFO, and the finance and accounting function with respect to the public reporting of non-GAAP measures.
Footnotes
[1] Non-GAAP Financial Measures, available at: www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.
[2] See Order Instituting Cease-and-Desist Proceedings, In the Matter of MDC Partners, Inc., Rel. No. 33-10283 (Jan. 18, 2017).
[3] See Order Instituting Cease-and-Desist Proceedings, In the Matter of ADT Inc., Rel. No. 34-84956 (Dec. 26, 2018).
[4] See Indictment, United States v. Block, No. 16 Cr. 595 (JPO) (S.D.N.Y. Sept. 7, 2016); Complaint, SEC v. Block, No. 16 Civ. 7003 (LGS) (S.D.N.Y. Sept. 8, 2016).
[5] See Indictment, United States v. Carroll, No. 19 Cr. 545 (CM) (S.D.N.Y. July 30, 2019) (“Carroll Indictment”).
[6] See Order Instituting Cease-and-Desist Proceedings, In the Matter of Brixmor Property Group Inc., Rel. No. 34-86538 (Aug. 1, 2019); Complaint, SEC v. Carroll, No. 19 Civ. 7199 (AT) (S.D.N.Y. Aug. 1, 2019).
[7] See Memorandum of Law in Support of Michael Carroll’s Motion to Dismiss the Indictment, United States v. Carroll, No. 19 Cr. 545 (CM) (S.D.N.Y.), filed Dec. 20, 2019 (ECF 56) (“Carroll Moving Brief”), at 7-8; Reply Memorandum of Law in Support of Michael Carroll’s Motion to Dismiss the Indictment, etc., United States v. Carroll, No. 19 Cr. 545 (CM) (S.D.N.Y.), filed Feb. 7, 2020 (ECF 72) (“Carroll Reply Brief”), at 1.
[8] See United States v. Mortimer, No. 19 Cr. 556 (VEC) (S.D.N.Y.); United States v. Splain, No. 19 Cr. 519 (VSB) (S.D.N.Y.); SEC v. Carroll, et al., No. 19 Civ. 7199 (AT) (S.D.N.Y.).
[9] The SEC case against them has been stayed pending the conclusion of the criminal case.
[10] Under the standard of materiality established by the U.S. Supreme Court, a fact is material if there is a substantial likelihood it would be “viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available,” TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976), or “considered significant to the trading decision of a reasonable investor.” Basic Inc. v. Levinson, 485 U.S. 224, 236 (1988). As interpreted by the courts and the SEC, an assessment of materiality includes both quantitative and qualitative elements. Materiality judgments are mixed questions of law and fact that are “especially ‘well suited for jury determination.’” United States v. Litvak, 808 F.3d 160, 175 (2d Cir. 2015) (citation omitted).
[11] 64 Fed. Reg. 45,150 (Aug. 19, 1999). SAB 99, which is considered persuasive authority by the courts, states that “[t]he use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that . . . a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statements is unlikely to be material.” Id. at 45,151. The bulletin goes on to say, however, that “quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality: it cannot appropriately be used as a substitute for a full analysis of all relevant considerations.” Id. SAB 99 explains that quantitatively small misstatements can be material based on “qualitative” considerations relating to the context and effects of the misstatements and provides a non-exclusive list of factors that may be considered in this regard. Id. at 45,151-52.
[12] As Judge Oetken stated in the Block case, “[a]t this stage, in order to dismiss the Indictment due to a failure to allege materiality, the Court would have to conclude that the alleged misstatements are ‘so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance.’” United States v. Block, 16 Cr. 595 (JPO), 2017 WL 1608905, at *4 (Apr. 28, 2017) (quoting Litvak, 808 F.3d at 175).
[13] See November 4, 2014 Form 10-Q (“Same Property NOI increased $7.5 million or 3.9% for the three months ended September 30, 2014”).
[14] Carroll Indictment, at 6-7.
[15] See Carroll Moving Br. 12.
[16] See id. at 12-13 (citing, for example, In re Ply Gem Holdings, Inc. Sec. Litig., 135 F. Supp. 3d 145, 153 (S.D.N.Y. 2015)).
[17] See generally Carroll Moving Br.; Carroll Reply Br. 1-10.
[18] See Carroll Moving Br. 4.
[19] Id. at 3 (quoting Brixmor Form S-11 dated July 18, 2013).
[20] Memorandum of Law of the United States of America in Opposition to Defendants’ Pretrial Motions, United States v. Carroll, No. 19 Cr. 545 (CM) (S.D.N.Y.), filed Jan. 24, 2020 (ECF 65) (“Government Brief”), at 5.
[21] See 64 Fed. Reg. 45,150, 45,152.
[22] See Carroll Reply Br. 7-8.
Arthur Greenspan, James Walker, and David Massey are partners at Perkins Coie. Jakob Sebrow is an associate at Richards Kibbe & Orbe LLP.
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