The novel strain of the coronavirus (COVID-19) has led to a trend of companies patching-up reporting by adding estimates of pre-COVID-19 profits to its EBITDA. Recently, COVID-19 prompted Schenck Process to add back €5.4 million, resulting in an adjusted EBITDA of €18.3 million (termed, unsurprisingly, as ‘EBITDAC’ [1]). This may spark a trend of US corporations using an EBITDAC metric in initial public offerings, which may result in litigation under §11 of the Securities Act of 1933 (Securities Act) for omissions or material misstatements. This post seeks to analyze the usage of EBITDAC against the civil liability provisions of §11 of the Securities Act, and argues that EBITDAC may solidify certain unintended underwriting practices.

EBITDA-related adjustments are typically disclosed in the MD&A, which is prepared pursuant to Item 303(a) of Regulation S-K (Reg. S-K) and requires disclosure of financial condition, results of operations, and financial metrics that are crucial to evaluate a company. However, EBTIDA is a non-GAAP financial measure, which allows for its easy malleability. For companies that have to file reports under the Securities and Exchange Act of 1934 (Exchange Act), non-GAAP measures are governed by Regulation G (Reg. G) and Item 10(e) of Reg. S-K. In accordance with these, a non-GAAP measure must be ‘reconciled’ with a GAAP measure by providing a directly comparable GAAP measure and a quantitative reconciliation of the differences between the GAAP and the non-GAAP measure. This reconciliation is crucial, since non-GAAP measures may mislead investors, as the SEC has previously pointed out. 

Item 10(e) of Reg. S-K also requires issuers to disclose reasons behind the management’s belief that non-GAAP financial measures provide useful information to investors regarding an issuer’s financial condition and results of operations. However, Item 10(e) prohibits adjustments to non-GAAP financial measures that eliminate or smooth items identified as ‘non-recurring, infrequent or unusual’, when the nature of the gain is such that it is reasonably likely to recur within two years. The question that arises is: can COVID-19 count as ‘non-recurring or infrequent’ for the purposes of Item 10(e)? The SEC answered the question by stating that the prohibition was based on the description of the gain that was being adjusted and a corporation may make appropriate adjustments, subject to Reg. G and the other requirements of Item 10(e) of Reg. S-K. However, the uncertainty surrounding future waves of COVID-19 prevents it from being neatly siloed into the non-recurring category. It remains to be seen whether COVID-19 is a ‘natural disaster’ or a ‘natural occurrence’, though Xtract Research argues that it is a mere ‘natural occurrence’ and therefore, the natural disaster EBITDA adjustments are inapplicable to a corporation affected by COVID-19. 

A carelessly formulated EBITDAC metric, reported to the SEC as part of the registration statement during an IPO, is subject to liability under §11 of the Securities Act. Upon the effectiveness of an allegedly false registration statement, §11(a) allows plaintiffs to sue persons signing the registration statement, directors, accountants, and underwriters for misstatements of material facts or omissions to state material facts necessary to make the included statements not misleading (§11 Liability Provisions). A §11 plaintiff is a person that has purchased a security as part of the public offering pertaining to the registration statement, containing the alleged misstatement (the Tracing Requirement). There is no burden to prove scienter, reliance, privity or that the loss resulted from the alleged material misstatement.

On March 25, 2020, the SEC released disclosure guidance addressing disclosure issues faced by public corporations (March Guidance). The March Guidance states that the impact of COVID-19 on a corporation is a factual analysis [2] and reiterates the SEC’s view on the fluidity of non-GAAP measures. However, a trigger-happy plaintiff may choose to bring a §11 suit by stating that the adjusted financials present a façade and, the management’s analysis of the accounting entries and line items is incomplete, and therefore, that the registration statement attracts the §11 Liability Provisions. 

The scheme of federal securities laws provides §11 defendants with formidable defences. The Tracing Requirement may be defeated by showing that the plaintiff acquired the shares from a pool of publicly traded shares. A defendant may further parry a plaintiff’s blow by alleging that the financials represented by the EBITDAC metric are forward-looking statements, and therefore, attract the safe harbors in the Rules promulgated under the Securities Act (175) and the Exchange Act (3b-6). Forward looking statements, made by or on behalf of an issuer, shall not be deemed to be fraudulent statements, unless they were made or reaffirmed without reasonable bases or were disclosed in bad faith. However, the safe harbors in §27A (Securities Act) and §21E (Exchange Act), do not apply in the context of an IPO or to enforcement proceedings brought by the SEC. Interestingly, in the March Guidance, the SEC specifically extended the protection of §27A and §21E to forward-looking statements without mentioning Rules 175 and 3b-6 [3]. 

Statute aside, defendants may employ judicially crafted doctrines, such as the ‘pure opinion’ and ‘due diligence’ defences. Per Omnicare Inc. v. Indiana State District Counsel of Laborers (575 US 175 (2015)), a defendant may allege that the COVID-19 adjusted financials were statements of pure opinion, bereft of any omissions, with complete disclosures under Reg. G and Reg. S-K, and not untrue statements of material fact. In a post-COVID-19 era, to succeed in the pure opinion defence, the March Guidance aids public corporations on two counts. First, it provides that a defendant must highlight the rationale behind the management’s assessment of the usefulness of the metric, which helps investors assess the impact of COVID-19 on the company’s financial position [4]. Second, the SEC has permitted a corporation to include provisional amounts based on a range of reasonably estimable GAAP results [5].

To mount the due diligence defence in the context of EBITDAC, the Securities Act requires an expert defendant, preparing an expertised portion of the registration statement (the MD&A), to demonstrate that, after reasonable investigation, they had reasonable grounds to believe that the metric was appropriate, and the §11 Liability Provisions were not attracted (§11(b)(3)(B)(i) of the Securities Act of 1933). ‘Reasonable investigation’, as the accounting and underwriting world saw it, was a question of degree, which paved the way for the seminal case of WorldCom. 

In re WorldCom, Inc. Securities Litigation (346 F Supp. 2d 628 (SDNY 2004), referencing public information and ‘blindly relying’ on an EBITDAC metric prepared by the auditors does not absolve the underwriters of their duty to prepare financials with due care. Unintentionally, the WorldCom opinion, coupled with the EBITDAC metric, may lead to a change in the underwriting business. Judge Denise L. Cote’s provident observation [6] on underwriters seeking accounting input to gauge the proper preparation of accounts may be implemented with renewed vigour, especially after being implicitly recognized by the SEC in the March Guidance[7]. 

In the years to come, we may observe new paradigms—the erratic effect of pandemics and other natural disasters or occurrences—leading to miscalculated EBITDA add-backs across a swathe of industries. The underwriting business may be subject to greater perils and corporations wanting to go public may witness frequent litigation concerning the usage of non-GAAP metrics. It remains to be seen, however, if the §11 defences remain evergreen. 

Suprotik Das is a corporate lawyer.


[1] Earnings Before Interest, Taxes, Depreciation, Amortization and COVID-19. 

[2] ‘Assessing the evolving effects of COVID-19 and related risks will be a facts and circumstances analysis. Disclosure about these risks and effects, including how the company and management are responding to them, should be specific to a company’s situation’.

[3] ‘We remind companies that providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding COVID-19, can be undertaken in a way to avail companies of the safe harbors in Section 27A of the Securities Act and Section 21E of the Exchange Act….’

[4] ‘To the extent a company presents a non-GAAP financial measure or performance metric to adjust for or explain the impact of COVID-19, it would be appropriate to highlight why management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position and results of operations’.

[5] ‘We understand that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by COVID-19-related adjustments that may require additional information and analysis to complete.  In these situations, the Division would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results’.

[6]  ‘…[I]f aggressive or unusual accounting strategies regarding significant issues come to light in the course of a reasonable investigation, a prudent underwriter may choose to consult with accounting experts to confirm that the accounting treatment is appropriate, and that additional disclosure is unnecessary’. (346 F. Supp. 2d 628 (SDNY 2004)) 

[7] ‘We also recognize that the impact of COVID-19 on businesses may present a number of novel or complex accounting issues that, depending on the particular facts and circumstances, may take time to resolve. For example, to the extent a company or its auditors will need to consult with experts to determine how the evolving COVID-19 situation may impact its assets, including impairment of goodwill or other assets, it should consider engaging with those experts promptly so that its reporting remains as timely as possible, as well as complete and accurate’.