It should come as no surprise to readers of our blog that public companies often expend significant resources each year on managing litigation matters.  As a result, perhaps it is natural that some companies might want to convey financial results that exclude (or adjust out) these litigation expenses from their GAAP results as they arguably do not relate to the core performance of the company’s business.

When considering whether to include an adjustment for litigation expenses in non-GAAP measures, companies should be mindful of how they identify and disclose such expenses (e.g., outside of the ordinary course of business (non-recurring)).  In monitoring recent Securities and Exchange Commission (SEC) comment letters, we found a letter exchange that we believe demonstrates the principal disclosure considerations at issue.

Background

As background, Item 10(e) of Regulation S-K provides that a registrant must not “adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years.” (Emphasis added.)

The SEC Staff provides the following additional guidance on this topic in C&DI 102.03:

“The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K.”

In other words, it is improper and misleading for a registrant to classify and disclose ordinary operating expenses as non-recurring expenses.  For example, the SEC brought its first enforcement action under Regulation G in 2009 against SafeNet, Inc. and certain of its former officers and employees for representing to investors that SafeNet’s non-GAAP earnings results excluded certain non-recurring expenses, when, according to the complaint, SafeNet had misclassified and excluded a significant amount of recurring, operating expenses from its non-GAAP earnings results, to meet or exceed quarterly EPS targets.

Peloton Comment Letter Exchange on Litigation Expense Adjustments

For ease of review, set forth below is the relevant SEC comment letter exchange, with hyperlinks to the initial correspondence letter here and to the second correspondence letter here.

Form 10-K for the Fiscal Year Ended June 30, 2020
Notes to Consolidated Financial Statements
Commitments and Contingencies
Legal Proceedings, page 77

1. 1. We note you recognized $60.1 million in litigation and settlement expenses for the fiscal year ended June 30, 2020 which was material to your net income. We also note that these expenses were adjustments in certain of your non-GAAP measures that you describe as consisting of legal settlements and related fees for specific proceedings, that arise outside of the ordinary course of your business. To help us better understand your disclosure, please quantify how much of the related expenses applied to the previously disclosed legal matters and how much of the expenses, if any, were related to matters not previously identified. Please further explain the nature of the expenses and how you determined that they are out of the ordinary.

The Company respectfully advises the Staff that of the $60.1 million in litigation and settlement expenses for the fiscal year ended June 30, 2020, approximately $[***] million relates to the confidential settlements and associated legal fees relating to two previously disclosed legal matters—“Downtown Music Publishing LLC et. al v. Peloton Interactive” and “Flywheel Sports, Inc.” Both matters were settled and disclosed in the Company’s quarterly report on Form 10-Q for its third quarter of fiscal 2020.  The nature of these expenses is primarily related to direct and incremental third-party legal expenses associated with, and amounts paid to settle, these outside the-ordinary-course copyright and patent litigation matters. The litigation and settlement expenses adjusted from the Company’s non-GAAP measure do not include content costs for past use. The remaining balance of extraordinary litigation matters of approximately $[***] million relates to the payment of legal fees with respect to individually immaterial matters that were also considered to be outside of the ordinary course of business.

The Company advises the Staff that when the Company calculates Adjusted EBITDA it adds back extraordinary litigation and settlement expenses to net income (loss) when such expenses relate to unique matters that are not attendant to the Company’s normal and continued business activity. The Company does not, however, add back litigation expenses that arise within the ordinary course of business in its calculations of Adjusted EBITDA. Unless the facts and circumstances with respect to a particular matter indicate otherwise, litigation expenses that the Company generally considers to be within the ordinary course of its business, include, but are not limited to, recurring fees relating to trademark, real estate and employee matters. Litigation expenses that are added back to net income (loss) to calculate Adjusted EBITDA due to their extraordinary nature consist of legal settlements and related fees for specific proceedings that are unrelated to the Company’s day-to-day business operations. The Company advises the Staff that the Downtown Music and Flywheel matters are examples of expenses related to extraordinary litigation that did not represent recurring expenses arising in the Company’s ordinary course of business, and that the Company believed it to be proper to add back such expenses when calculating Adjusted EBITDA as they are not indicative of the Company’s overall operating performance. The Company also advises the Staff that it reviews its litigation expenses periodically to ensure the nature of the costs being excluded from Adjusted EBITDA continue to be outside the ordinary course of business.

Second Comment Letter Exchange:

Form 10-K for the Fiscal Year Ended June 30, 2020
Response dated March 30, 2021, page 1

We note your response to comment one. Please clearly explain to us how you determine which copyright and patent litigation matters are considered to be “outside the-ordinary course” and therefore excluded from your non-GAAP measures. We note from disclosure in other parts of your annual report, that your success depends in large part on your proprietary technology and your patents, trade secrets, trademarks, and other intellectual property rights and that you spend significant resources to monitor and protect these rights. As such, it would be reasonable that related costs would be normal, recurring operating expenses. Please explain and tell us the other types of matters that you consider to be extraordinary in nature.

The Company respectfully advises the Staff that there are a number of actions that are ordinary course activities which the Company engages in to defend its proprietary technology and license content under copyright. These ordinary course actions include, among other things: patent and trademark renewal fees; application maintenance fees; copyright license fees; other costs of maintaining its patent and trademark portfolio, including oppositions in domestic and international trademark proceedings; and pre-litigation costs (such as sending cease and desist letters). The Company considers all expenses associated with these actions to be normal, recurring, cash operating expenses necessary to operate the Company’s business.

In contrast, and per our discussion with the Staff on April 19, 2021, the Company considers the following factors, among others, with respect to copyright and patent litigation matters in order to determine whether a matter, and the expenses associated with such matter, are “outside the-ordinary course of business,” and are therefore appropriate to exclude from the Company’s non-GAAP measures:

• • frequency of similar cases that have been brought to date, or are expected to be brought within two years;
  • complexity of the case (e.g., just intellectual property, or additional types of claims);
  • nature of the remedy(ies) sought, including size of any monetary damages sought;
  • offensive versus defensive posture of the Company;
  • counterparty involved;
  • the Company’s overall litigation strategy.

This illustrative list of factors continues to evolve as the Company has quickly scaled, in a technology-heavy industry that the Company has pioneered, and which increasingly has many new entrants. The Company’s Disclosure Committee regularly reviews the Company’s non-GAAP disclosure policy, including the adequacy of the reliance on the factors described above. Prior to the release of any non-GAAP metrics, the Company’s Disclosure Committee reviews and approves for release any proposed exclusions of expenses from its non-GAAP measures.

Further to its call with the Staff, the Company will continue to regularly assess charges associated with litigation matters that are excluded on a non-GAAP basis and provide specific disclosures about the nature of any such expense and why it is outside the ordinary course of business. Over time, and depending upon developments in its business and industry, the Company will also continue to assess whether certain types of litigation matters have become normal recurring costs of operating the business and therefore would not be appropriate to exclude from the Company’s non-GAAP measures.

Takeaway for Public Companies

The above comment letter exchange demonstrates that the SEC Staff continues to closely monitor non-GAAP compliance in connection with its routine Form 10-K reviews. The letter exchange also demonstrates the SEC Staff is laser-focused on how adjustments are classified and disclosed to investors. Another noteworthy takeaway for companies is Peloton’s disclosure about the active non-GAAP review process by its disclosure committee, and how it represents that the disclosure committee “reviews and approves for release any proposed exclusions of expenses from its non-GAAP measures.”

This serves as a reminder to companies to assess their internal disclosure committee process on non-GAAP adjustments and whether their committees have appropriate oversight over the adjustments in their non-GAAP financial measures.