While we’ve never been fans of the OSC, we have to applaud the commission’s enforcement division for its recent continuous disclosure reviews of two public companies.
In the case of Home Capital Group, the OSC filed an enforcement notice in February 2017, stating that the company failed to meet its continuous disclosure obligations regarding the discovery of fraud in its broker channels in early 2015 or prior. The matter escalated when the OSC issued a more detailed statement of allegations in April 2017.
And Callidus Capital, a Toronto-based alternative lender, rejigged some of its non-GAAP disclosures in May 2017 after the OSC conducted a continuous disclosure review.
The cases share few, if any, similarities. Despite the OSC’s spotty record on enforcement, these recent actions could signal a new direction.
Continuous disclosure reviews
It appears the OSC takes on late-disclosure cases, like Home Capital’s, once it’s aware of such situations. Certainly, part of the challenge of enforcement in such cases is having the inclination to push the investigation ahead even though the evidence may not be apparent up front.
In the matter of Callidus, the issue is about the substance of the disclosure, as opposed to the timeliness. But, it seems the company received special attention from the regulator, since we’d argue many other companies also need to revise their disclosure. And yet, not many have been required to make significant improvements, as Callidus was.
After the review, Callidus changed its disclosures in two notable ways. Firstly, it reshuffled items to ensure that the standard GAAP/IFRS figures received greater prominence in investor communications than the non-GAAP amounts. Secondly, it stopped using certain non-GAAP measures that the OSC likely deemed unsuitable for investors.
Non-GAAP figures shouldn’t mislead investors
CSA Notice 52-306 details the expectations for publication of non-GAAP measures. One key tenet is that, when companies use a non-GAAP measure, they must “present with equal or greater prominence to that of the non-GAAP financial measure, the most directly comparable measure specified, defined or determined under the issuer’s GAAP.” For example, when presenting adjusted net income, companies must give equal or greater prominence to net income as prescribed by GAAP.
But the CSA notice lays out criteria that are easy for companies to meet, which allows companies to legally issue misleading financial measures. For instance, a company is allowed to exclude recurring cash business costs from a non-GAAP measure provided to investors.
Therefore, it’s unclear why the OSC took umbrage at Callidus’s disclosures. (This is not to excuse Callidus—the company reported 2016 adjusted EPS of $1.77 per share, versus GAAP net income of $0.02.)
The Callidus case seems to mark a potential shift in the OSC’s focus, and follows a similar path to that forged by the U.S. Securities and Exchange Commission over the past few years. U.S. regulators started taking issue with the calculation of non-GAAP measures. With Callidus discontinuing several non-GAAP measures, it seems the OSC objected to their calculation, as opposed to the format of their disclosure only (which is the focus of the CSA notice).
All this comes early in the tenure of the new OSC enforcement director, so maybe it’s a sign of things to come. If so, there’s lots of ground to cover, since a large majority of companies report non-GAAP measures (see “Why to watch a company’s adjusted earnings,” AER January 2016), and many of those measures are arguably unfair to investors.
For instance, BCE changed its disclosure in November 2015 (we had written about our concerns in AER December 2014). The company started giving prominence to the GAAP measure of cash from operations before mentioning its non-GAAP measure of free cash flow. This meets the boilerplate requirements of the CSA notice.
But our issue isn’t—and never was—with prominence. It’s with whether a company’s calculation of free cash flow misleads investors. That’s trickier to pin down and requires a regulator’s considered view, similar to what appears to have happened with Callidus.
The CSA guidelines note that a non-GAAP measure should be presented so that it’s not misleading. If you asked 100 educated investors, you’d get multiple definitions of free cash flow. Some might exclude growth capex, while others might include long-term investments. But, all would likely agree that the starting point is cash from operations.
BCE doesn’t start with cash from operations; it excludes cash outflows from that core number, taken from the audited cash-flow statement and prescribed by GAAP, and then the company makes additional adjustments. That sets BCE apart from several other companies that report a non-standard free cash flow.
Could Canadian regulators finally be waking up to the manipulations possible with non-GAAP financial reporting? Are they moving beyond the policing of disclosure, and asking fundamental questions about fairness in reporting? If so, this change could represent a heightened investment risk for those companies pushing the envelope on non-GAAP reporting.