On Friday, August 26, the Canadian Securities Administrators (CSA) issued Staff Notice 41-304 - Income trusts: prospectus disclosure of distributable cash. The Notice is intended to provide additional guidance on the CSA's expectations about the nature and extent of estimated distributable cash disclosure in prospectuses.
Most income trust issuers present information about estimated distributable cash (or distributable income) in their prospectuses, as this often forms the basis upon which an income trust is valued in connection with its initial public offering. These estimates are usually based on trailing 12-month net income, adjusted for interest expenses, taxes, depreciation and amortization (EBITDA). EBITDA is usually further adjusted for certain additional items, ranging from non-recurring historical items to normalizing the effect of a recent or prospective acquisition, in order to arrive at distributable cash. The specific adjustments, as well as the level of explanatory disclosure provided in prospectuses concerning these various adjustments, generally vary from issuer to issuer.
Staff Notice 41-304 reflects the CSA's prospectus disclosure expectations in response to their concern that prospective income fund investors are not always being provided with adequate disclosure of the significant estimates and assumptions underlying the reconciling distributable cash or income adjustments. The Notice also addresses Staff's concerns about adjustments that are based on the expected economic effect of anticipated future events.
Adjusted EBITDA - A Forward-Looking Perspective
Staff Notice 41-304 makes clear Staff's view that any reconciling adjustment based on the expected economic effects of anticipated future events provides a "forward-looking perspective," and therefore raises many of the same issues that have concerned Staff with other forms of future-oriented financial information (FOFI). The Staff Notice seems to implicitly recognize a distinction, however, between a "forward-looking perspective" and FOFI; the former requiring enhanced disclosure in the prospectus from what has heretofore generally been provided, and the latter necessitating the inclusion of a forecast in accordance with National Policy 48 - Future-oriented financial information.
With Staff Notice 41-304, the CSA's aim is to provide prospective investors with sufficient disclosure to allow them to determine whether the adjustments used by management in arriving at estimated distributable cash represent a balanced and complete assessment of all factors affecting estimated distributable cash. To this end, the CSA expects the presentation of estimated distributable cash to include a discussion of (among other things):
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the work that was done by the issuer to ensure the completeness and reasonableness of the estimated distributable cash information;
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the nature of the adjustments, including a description of the underlying assumptions used in preparing each element of the forward-looking information as well as the forward-looking information as a whole, including how those assumptions are supported; and
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the specific risks and uncertainties that may affect each individual assumption and that may cause actual results to differ materially from the estimated distributable cash figure; general cautionary language accompanying the estimated distributable cash presentation, that "actual results may vary materially from the amounts presented", will be considered insufficient.
While we have noticed a trend over the past year towards requiring such enhanced disclosure, it is our expectation that in the future the CSA will require far greater disclosure of the underlying assumptions, how they are supported and the particular risks affecting them, than in most recent filings. Staff has noted that it expects objective corroboration of the assumptions used in the distributable cash presentation. In many circumstances, providing such a level of disclosure should not be problematic; however, in other circumstances it may require specificity at a level that raises concerns over disclosure of competitively sensitive strategies, programs, contractual terms, and pricing and cost structures.
When FOFI Requires a Forecast
If (A) the estimated distributable cash information includes forward-looking adjustments that are based on "significant assumptions," and (B) those adjustments materially affect estimated distributable cash, then Staff expects that a forecast be prepared in accordance with CICA Handbook Section 4250 - Future-oriented financial information and included in the income trust's prospectus.
According to Section 4250, an assumption would usually be considered significant when:
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it reflects an expectation of economic conditions significantly different from those currently prevailing;
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there is a relatively high probability of a sizeable variation; or
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a small change in the assumption would have a significant impact on the forward-looking information.
The above definition, which is imported into the Staff Notice by reference, arguably sets a fairly high bar that, when combined with the second test (i.e., that the particular significant assumption materially affect estimated distributable cash), will likely provide most issuers with a safe harbour from the requirement to prepare a Section 4250 Forecast.
Aside from the time and expense involved in the preparation of a Section 4250 Forecast, and the attendant future disclosure obligations that result from providing one, most issuers and their professional advisors are reluctant to include a Section 4250 Forecast in a prospectus due to a general perception that it creates greater potential for liability. Moreover, because many accounting firms have recently been interpreting the audit guidelines relating to the preparation of financial forecasts (examination of a financial forecast or projection included in a prospectus or other public offering documents) conservatively, issuers may find it difficult to engage a professional auditing firm to examine the required financial forecast.
Compendium
CSA Staff Notice 41-304 makes it clear that, at the very least, significantly enhanced and detailed disclosure of the adjustments used to arrive at estimated distributable cash will be required in prospectuses. Although in certain circumstances such disclosure may necessitate the preparation of a Section 4250 Forecast, even where a forecast is not required, the specificity and objective corroboration required by such enhanced disclosure may require issuers to disclose competitively sensitive strategies, programs, contractual terms, pricing and cost structures.
In situations where issuers anticipate making reconciling adjustments to estimated distributable cash that may necessitate a Section 4250 Forecast, issuers will need to work closely with their professional advisors in order to determine if such a forecast can be prepared. We would expect that issuers may find it increasingly difficult to include Section 4250 Forecasts in their prospectuses, and as a result creative alternative structures (e.g., "earn-ins" or "reverse grinds") will likely be employed to deliver to issuers and their sponsors the appropriate level of value.
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