David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on a client memorandum by Mr. Katz and David K. Lam.
The Securities and Exchange Commission recently filed its first civil enforcement action under Regulation G, alleging that a public company intentionally misclassified certain ordinary operating expenses as nonrecurring expenses in order to increase its earnings. SEC v. SafeNet, Inc., Litig. Rel. No. 21290 (Nov. 12, 2009). Regulation G provides that, if a public company discloses material information that includes a financial measure not calculated in conformity with generally accepted accounting principles (GAAP), the company must reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure. Regulation G also prohibits public companies from disseminating false or misleading non-GAAP financial measures or presenting non-GAAP financial measures in a manner that would mislead investors or obscure the company’s GAAP results.
The SEC alleged that the company failed to comply with Regulation G by making improper adjustments to the company’s expenses. The improper adjustments allegedly included reclassifying ordinary expenses as nonrecurring integration expenses, reducing accruals for professional fees and reducing inventory reserve accruals. According to the SEC’s complaint, these adjustments were made without factual support in order to inflate the company’s earnings, and the company provided false and misleading explanations to its independent auditors when the auditors questioned the adjustments. The SEC complaint also alleged that former corporate officers and internal accountants engaged in a fraudulent scheme to backdate stock option grants without recording the requisite compensation expense for the option grants and used improper accounting adjustments to achieve earnings targets.