4.14 Credit Agreement Covenants
Credit agreements often require registrants to comply with certain
financial or non-financial covenants. The financial covenants, which may be based on
GAAP or on non-GAAP measures such as EBITDA or adjusted EBITDA, are often material
to an investor’s understanding of the registrant’s financial condition and
liquidity. Accordingly, disclosure of information about covenants may be required in
the MD&A section of a filing.
C&DIs — Non-GAAP Financial Measures
Question: Item
10(e)(1)(ii)(A) of Regulation S-K prohibits “excluding
charges or liabilities that required, or will require, cash
settlement, or would have required cash settlement absent an
ability to settle in another manner, from non-GAAP liquidity
measures, other than the measures earnings before interest
and taxes (EBIT) and earnings before interest, taxes,
depreciation and amortization (EBITDA).” A company’s credit
agreement contains a material covenant regarding the
non-GAAP financial measure “Adjusted EBITDA.” If disclosed
in a filing, the non-GAAP financial measure “Adjusted
EBITDA” would violate Item 10(e), as it excludes charges
that are required to be cash settled. May a company
nonetheless disclose this non-GAAP financial measure?
Answer: Yes. The
prohibition in Item 10(e) notwithstanding, because MD&A
requires disclosure of material items affecting liquidity,
if management believes that the credit agreement is a
material agreement, that the covenant is a material term of
the credit agreement and that information about the covenant
is material to an investor’s understanding of the company’s
financial condition and/or liquidity, then the company may
be required to disclose the measure as calculated by the
debt covenant as part of its MD&A. In disclosing the
non-GAAP financial measure in this situation, a company
should consider also disclosing the following:
-
the material terms of the credit agreement including the covenant;
-
the amount or limit required for compliance with the covenant; and
-
the actual or reasonably likely effects of compliance or non-compliance with the covenant on the company’s financial condition and liquidity. [Jan. 11, 2010]
At the 2024 AICPA Conference, the SEC staff noted that a registrant might disclose a
measure that is calculated in accordance with a debt covenant in the liquidity and
capital resources section of MD&A on the basis of its belief that it must do so
to comply with Regulation S-K, Item 303. The staff indicated that it would not
object to the disclosure of such a measure and that the measure would not be subject
to the SEC’s non-GAAP rules and regulations related to potentially misleading
adjustments because registrants are already required to disclose such measures in
MD&A under SEC rules.13 However, the staff clarified that it would object to the measure if it (1)
included an adjustment that rendered it misleading or (2) was disclosed as a
performance measure.
As indicated in C&DI Question 102.09, a registrant must disclose
in its MD&A material items affecting its financial condition or liquidity. The
C&DI emphasizes that a registrant should disclose a measure that is calculated
in accordance with a credit agreement when (1) the credit agreement is a material
agreement, (2) the covenant is a material term of the credit agreement, and (3)
information about the covenant is “material to an investor’s understanding of [its]
financial condition and/or liquidity” (e.g., when the registrant is at risk of
violating the covenant). Disclosure of the measure may be required even if the
measure would otherwise be prohibited under Item 10(e) (see Section 4.1).
When providing the disclosures required by Item 10(e) related to non-GAAP measures
associated with debt covenants, registrants should carefully consider the context of
such information. If the primary purpose of the disclosures is to describe
compliance with the covenant as of the most recent balance sheet date, registrants
should consider whether it would be appropriate to discuss the measures associated
with the covenant by comparing them to measures for prior reporting periods.
Disclosing such measures on a comparative basis may be indicative that the measures
are used to evaluate performance rather than liquidity. Similarly, registrants
should consider whether it is appropriate to disclose covenant-related non-GAAP
measures within an earnings release since such a release generally focuses on a
company’s performance.
The SEC staff frequently reminds registrants that in addition to
providing the non-GAAP disclosures required by Item 10(e), they should consider
disclosing the following other details described in C&DI Question 102.09: (1)
“the material terms of the credit agreement including the covenant,” (2) “the amount
or limit required for compliance with the covenant,” and (3) “the actual or
reasonably likely effects of compliance or non-compliance with the covenant on the
company’s financial condition and liquidity.”
Footnotes
13
Section IV.C of the 2003 MD&A interpretive release states, in part:
“There are at least two scenarios in which companies
should consider whether discussion and analysis of material covenants
related to their outstanding debt . . . may be required.
First, companies that are, or are reasonably likely to
be, in breach of such covenants must disclose material information about
that breach and analyze the impact on the company if material. . . .
Second, companies should consider the
impact of debt covenants on their ability to undertake additional debt or
equity financing.” [Footnotes omitted]