Prospect Capital Wins Surprise Concession From SEC

Updated from 10:33 a.m. with new share price and quotes from KBW analyst Mason in paragraphs 3, 5 and 6.

NEW YORK (TheStreet) -- Prospect Capital  (PSEC) will not be required to restate past earnings as the Securities and Exchange Commission had requested, surprising many analysts who follow the stock and sending shares higher in morning trading Wednesday.

The business development company (BDC) will be required to restate future earnings, however, starting next month and KBW analyst Greg Mason stated in a report late Tuesday that he cannot quantify the earnings impact until the company provides further guidance. The restatements will lower GAAP operating earnings but will not impact net income, Mason wrote, basing this assumption on previous guidance from Prospect's management.

"It's on one hand a clear positive that they don't have to restate, but on the other hand its not like a ringing endorsement of their accounting policies," Mason said in an interview Wednesday.

Prospect shares dropped 5% to $10.20 May 7, after the company disclosed the dispute with the SEC in its 2014 fiscal third-quarter earnings filing. They had fallen further since then with the announcement of various class action lawsuits from shareholders, which cited the SEC dispute in arguing Prospect Capital management breached its fiduciary duties. Those suits will become more difficult to win since the SEC has partially backed down from its position that Prospect's accounting was flawed.

In Wednesday's interview, KBW's Mason argued the lawsuits wouldn't have been a threat even if the SEC had stuck to its original firmer decision that past results needed to be restated.

"It's just a bunch of ambulance chasers that were trying to get their name on the door in case something material happened," Mason said.

Shares were up 5% to $10.31 shortly early Wednesday afternoon.

"The possibility of a restatement raised questions regarding the company's accounting practices and quality of earnings and resulted in significant downward pressure on the stock. Given that the issue was resolved in a relatively short period of time (roughly 5 weeks), we believe some of the uncertainty regarding the company's financial reporting practices has been mitigated," wrote National Securities analyst Andrew Kerai in a report published Wednesday.

Prospect is the highest yielding stock in a space referred to as business development companies, publicly traded lenders that target small to mid-sized companies, pay few if any taxes and distribute large dividends to investors.

The dispute draws attention to a questionable accounting maneuver by Prospect Capital's management that appears to line its own pockets at the expense of shareholders.

Prospect drew the SEC's attention for treating equity investments in seven of the companies in its portfolio as debt. Thus, when it receives a distribution from those companies, Prospect classifies the distribution as interest income. If the investment is classified as equity, as the SEC believes it should be, the distribution would be considered dividend income only if the portfolio company earns enough to cover the dividend. If earnings are insufficient, it must be classified as a return of capital.

If the distribution is a return of capital rather than an outgrowth of earnings, Prospect's net investment income would decline, which would require the BDC's management to return incentive fees it gets based on that metric.

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