I. Executive Summary. January 7, 2003

Transcription

1 Legal Alert: SEC Proposes Rules Requiring Additional MD&A Disclosure of Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments January 7, 2003 I. Executive Summary On November 4, 2002, the Securities and Exchange Commission (the SEC ) proposed changes to the disclosures that public companies are required to make in the Management s Discussion and Analysis of Financial Condition and Results of Operations ( MD&A ) sections of their public filings. These proposals, intended to implement Section 401(a) of the Sarbanes- Oxley Act of 2002 ( Sarbanes-Oxley ), would specifically require a company to disclose in its annual and quarterly reports all off-balance sheet arrangements that may have a material effect on the current or future financial condition of the company. Additionally, the proposed rules would require (i) MD&A disclosure of aggregate contractual obligations in tabular format, and (ii) MD&A disclosure of contingent liabilities and commitments in tabular format or in text. The proposals would expand significantly the required disclosures relating to off-balance sheet arrangements, both by lowering the threshold for disclosing these arrangements and by mandating specific disclosures regarding these arrangements that must be presented in a separately captioned subsection of MD&A. The impact of the proposals relating to off-balance sheet arrangements largely depends on the extent to which companies employ these arrangements and the complexity of the arrangements. The proposals relating to contractual obligations and contingent liabilities and commitments, while not dramatically expanding the content of current disclosures, would require companies to categorize and quantify these items in greater detail and in a format not previously required. Public companies should consider evaluating their off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments in light of the fact that the rules will likely apply to Form 10-Ks filed for the fiscal year ending December 31, The proposing release is available at proposed/ htm. This article is for informational purposes and is not intended to constitute legal advise. 1

2 II. Off-Balance Sheet Arrangements A. What is an off-balance sheet arrangement? Off balance-sheet arrangements such as securitizations have been used, especially in recent years, to provide financing, liquidity, hedging protection, and other benefits to companies. These arrangements vary from complex structures such as special-purpose entities to more straightforward vehicles such as lease agreements. The SEC proposals define off-balance sheet arrangement broadly to encompass any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant, whether or not a party to the arrangement, has, or in the future may have:! Any obligation under a direct or indirect guarantee or similar arrangement;! A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;! Derivatives to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or! Any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto). Under the proposed rules, obligations and liabilities that are considered not fully reflected in the financial statements include:! Obligations not classified as a liability according to GAAP;! Contingent liabilities for which, as of the date of the financial statements, it is not probable that a loss has been incurred or, if probable, the amount of the loss cannot be reasonably estimated; and! Liabilities as to which the amount recognized in the financial statements is less than the reasonably possible maximum exposure to loss under the obligation as of the date of the financial statements. The SEC gives some examples to illustrate the application of the definition of off-balance sheet arrangement. For example, the SEC clarifies that the last bullet point above would require disclosure of contingent liabilities that are only partially accrued under GAAP on the financial statements, but would not require disclosure of contingent liabilities that are recorded at fair value as of the date of the financial statements, even if the maximum potential liability exceeds the fair value. The SEC also clarifies that no disclosure is required regarding an off-balance sheet arrangement until a definitive agreement that is unconditional or subject to only This article is for informational purposes and is not intended to constitute legal advise. 2

3 customary closing conditions exists or, if there is no such agreement, when settlement of the transaction occurs. Therefore, an off-balance sheet arrangement that is still being negotiated or subject to material closing conditions need not be disclosed under the proposed rules. B. What is the threshold for disclosing off-balance sheet arrangements? Perhaps the most significant aspect of the proposed rules is the lowered threshold for disclosure of off-balance sheet arrangements. Since 1989, the SEC has required that trends, demands, commitments, events or uncertainties known to management be disclosed in MD&A if they are reasonably likely to occur. The current proposals, however, would require disclosure of the potential effects of off-balance sheet arrangements if the likelihood of the occurrence of a future event and its material effect is higher than remote. Put another way, information regarding the potential impact of off-balance sheet arrangements would be required unless the occurrence of an event triggering a material impact is outside the realm of reasonable possibility. In order to comply with this lowered disclosure threshold, the SEC advises public companies to undertake a three-step review of their off-balance sheet arrangements, as follows:! Identify and review all direct or indirect guarantees, retained interests, equity-linked or -indexed derivatives and obligations (including contingent obligations) that are not fully reflected on the face of the company s financial statements;! Assess the likelihood that that a known trend, event, or uncertainty could require the company to perform under an obligation or recognize an impairment; and! If the assessed likelihood is greater than remote, evaluate objectively the consequences assuming that the event occurs. Disclosure would then be required unless the likelihood of a material effect on the company s financial condition or results of operations is remote. C. What must be disclosed regarding off-balance sheet arrangements? The SEC states that the goal of the proposed rules is to provide investors with sufficient information regarding off-balance sheet arrangements to enable them to understand the effect of the arrangements on a company s business activities, financial condition and financial results. In This article is for informational purposes and is not intended to constitute legal advise. 3

4 particular, the following disclosures regarding off-balance sheet arrangements would be required to be made in a separately captioned subsection of MD&A:! the nature and business purpose of the arrangements;! the significant terms and conditions of the arrangements;! the nature and amount of the total assets and liabilities (including contingent liabilities) of any entities in which the arrangements are conducted; and! other information that would provide investors with insight into the importance of, and risks of, the arrangements, including: o o o the amounts of revenues, expenses, and cash flows arising from the arrangements; the nature and total amount of any interest retained, securities issued, and other indebtedness incurred; and the nature and amount of any other obligations or liabilities arising from the arrangements that are or may become material, and the triggering events that could cause them to arise. Additionally, the rules would require disclosure of management s analysis regarding the material effects of the arrangements (and the resulting obligations or liabilities) on the company. This disclosure would need to describe the likelihood and impact of the risks associated with the arrangements, as well as the extent to which the company relies on these arrangements for liquidity and capital resources and other purposes. Finally, if a company employs an off-balance sheet arrangement that is reasonably likely to be terminated or materially reduced, the rules would require disclosure of the events that would trigger the termination or reduction and any material consequences. The SEC urges companies to present the information in a level of detail most conducive to an understanding of the impact of, and dependence on, these arrangements. The SEC also warns that boilerplate disclosures that do not address a company s particular circumstances will not satisfy the proposed rules. Finally, the SEC instructs companies not to include disclosures that only financial experts can understand, and encourages companies to aggregate similar arrangements to the extent practicable. This article is for informational purposes and is not intended to constitute legal advise. 4

5 III. Contractual Obligations and Contingent Liabilities and Commitments In addition to the proposed rules regarding off-balance sheet arrangements, which are mandated by Section 401(a) of Sarbanes-Oxley, the SEC release includes additional rule proposals addressing contractual obligations and contingent liabilities and commitments which go beyond the requirements of Sarbanes-Oxley. A. Contractual Obligations The proposed rules would require tabular disclosure of contractual obligations (both onand off-balance sheet) as of the date of the latest balance sheet. The disclosure would be aggregated by type of obligation as shown in the following table: Contractual Obligations [Long-Term Debt] [Capital Lease [Operating Leases] [Unconditional Purchase [Other Long-Term [Total Contractual Payments due by period Total Less than 1 year 1-3 years 3-5 years More than 5 years The SEC encourages companies to replace the above categories with categories most suitable for its business. The table should also include footnotes as needed to describe contractual provisions that could create, increase, or accelerate obligations, or to describe any other important information regarding the obligations. This article is for informational purposes and is not intended to constitute legal advise. 5

6 This table would not be required in quarterly reports on Form 10-Q. However, quarterly reports on Form 10-Q must include disclosure of any material changes to the information in the table. B. Contingent Liabilities and Commitments The rules would require similar disclosure regarding the expected amount of contingent liabilities and commitments (both on- and off- balance sheet). As with the disclosure regarding contractual obligations, this disclosure would be aggregated by type of liability or commitment, and should indicate the amount of liabilities or commitments that are expected to expire in less than one year, in one to three years, in three to five years, and in more than five years. The disclosure may be in either tabular format or in text. Quarterly reports on Form 10-Q would only need to describe any material changes to such information. IV. Safe Harbor for Forward-Looking Information Because the proposed rules would require companies to disclose forward-looking information, the rules explicitly expand the current statutory safe harbor for forward-looking statements to the information called for by the proposed rules. V. Application of Proposals to Investment Companies, Small Business Issuers and Foreign Private Issuers Registered investment companies would be exempt from the proposed rules; however, business development companies would be subject to the proposed rules. Small business issuers would be subject to the disclosures regarding off-balance sheet arrangements, but would not be required to provide the disclosures regarding contractual obligations and contingent liabilities and commitments. Foreign private issuers that file annual reports on Forms 20-F or 40-F would be subject to the rules; however, the rules would not apply to any disclosures on Form 6-K. Therefore, foreign private issuers would generally only need to update these disclosures on an annual basis. VI. Compliance Date Under Sarbanes-Oxley, the SEC is required to adopt final rules by January 26, As the proposals do not contemplate a phase-in period, we expect that the proposals will become effective soon after adoption. This article is for informational purposes and is not intended to constitute legal advise. 6

7 VI. Further Information This publication has been prepared solely for informational purposes and is not intended as legal advice. For more information about the matters discussed in this Legal Alert, please contact the Sutherland Asbill & Brennan LLP attorney with whom you work, or any of the attorneys listed below. B. Knox Dobbins Wade H. Stribling Patrick J. Whelchel This article is for informational purposes and is not intended to constitute legal advise. 7