Latham & Watkins Corporate Department

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1 Number 242 December 13, 2002 Client Alert Latham & Watkins Corporate Department The proposed rule is designed to force textual MD&A disclosures about off-balance sheet arrangements that have not been prominently disclosed in financial statements under GAAP. SEC s Proposed Rule on Disclosure of Off-Balance Sheet Arrangements Pursuant to Section 401(a) of the Sarbanes-Oxley Act of 2002 Background The Sarbanes-Oxley Act of 2002 was enacted on July 30, Section 401(a) of Sarbanes-Oxley added a new Section 13(j) to the Securities Exchange Act of That section requires the Securities and Exchange Commission (SEC) to adopt final rules by January 26, 2003 requiring each annual and quarterly financial report filed with the SEC to disclose information regarding offbalance sheet arrangements. Specifically, the Sarbanes-Oxley Act requires disclosure of all material off-balance sheet transactions, arrangements, obligations (including contingent obligations) and other relationships of the issuer with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenue or expenses. 1 To implement the statute, the SEC has issued Release No ; , which contains a proposed rule that would mandate additional disclosure in the Management s Discussion and Analysis (MD&A) section of a company s periodic reports. 3 The proposed rule would: lower the threshold that triggers required disclosure of off-balance sheet arrangements; require that the disclosure be set apart in a designated section of the MD&A; and require disclosure of aggregate contractual obligations and contingent liabilities and commitments. The proposed rule is designed to force textual MD&A disclosures about offbalance sheet arrangements that have not been prominently disclosed in financial statements under GAAP. It in no way calls in to question the propriety of traditional off-balance sheet financing strategies. Definition of Off-Balance Sheet Arrangement Off-balance sheet arrangements may be used to provide financing, liquidity or credit support, or to engage in leasing or hedging, among other things. They are also sometimes used in research and development. The most common form of off-balance sheet arrangement involves a special purpose vehicle set up to securitize accounts receivable by purchasing the receivables from the sponsoring or originating entity with cash proceeds received from issuing Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2003 Latham & Watkins. All Rights Reserved.

2 debt or equity securities, the repayment of which is dependent upon the cash flows from the receivables. Although these transactions are often structured so that the debt of the special purpose vehicle is not required to be reflected on the sponsoring company s balance sheet, in many cases the sponsoring company will have continuing financial liability to the special purpose vehicle, such as the obligation to buy back receivables in the event of a breach or the obligation to maintain minimum capital in the special purpose vehicle or minimum collateral balances. Congress and the SEC have determined that disclosures about these off-balance sheet arrangements are vital to investor understanding of a company that engages in off-balance sheet financing transactions and that the definition of off-balance sheet arrangements needs to be as broad as possible. The SEC s proposed rules define an off-balance sheet arrangement as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated 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 4 (GAAP currently requires disclosure of a guarantee, even if the possibility of loss may be remote; 5 the SEC s proposed rule would require MD&A disclosure when the risk of possibility of loss is higher than remote 6 ); a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement 7 (Disclosure regarding retained or contingent interests in transferred assets is required because such interest or credit enhancement could have a material effect on the company s operations or liquidity 8 ); derivatives, to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements ; 9 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). 10 The last of these is the broadest. 11 It would include obligations not classified as liabilities according to generally accepted accounting standards, contingent liabilities that are neither probable nor reasonably estimable and liabilities where reasonably possible maximum exposure is greater than the amount actually recognized in the financial statements. The effect of this definition is to capture an entire category of transactions that would not require disclosure on the face of financial statements under currently applicable accounting principles. For example, GAAP requires a company to accrue a loss if it is probable that the company has incurred the loss and can make a reasonable estimate of the loss. When the estimate involves selecting one amount from a range of estimated losses, GAAP requires a footnote if there is a reasonable probability that the loss will exceed the amount accrued. However, any transaction included in the SEC s proposed definition of an offbalance sheet arrangement would need to be reported in that MD&A, even if GAAP did not require that it be included on the face of the financial statements or in the footnotes. In contrast, if a transaction is reflected at fair value in the financial statements, it would not fall within the scope of the proposed definition because the company s maximum exposure would be fully reflected already. New Lower Threshold for Disclosure of Off-Balance Sheet Arrangements The proposed rule significantly lowers the standard for disclosing off-balance sheet arrangements. The proposed new threshold for disclosure of off-balance sheet arrangements is whether these arrangements may have a current or future material effect on the company s financial condition, changes in financial condition, results of operations, revenues or expenses, liquidity, capital 2 Number 242 December 13, 2002

3 expenditures or capital resources (emphasis added). 12 Disclosure would be required if management determines either that an off-balance sheet arrangement is material in the current period or that it may become material in the future. The existing MD&A disclosure threshold is whether a trend, event, demand, commitment or uncertainty is both presently known to management and reasonably likely to have future material effects on the registrant s financial condition or results of operations. 13 The SEC has interpreted the Sarbanes- Oxley Act to require disclosure of offbalance sheet arrangements if the likelihood that they will have a material effect in the future is higher than remote. Disclosure under the proposed rules would not be required for off-balance sheet arrangements where management believes that the likelihood of either the occurrence of an event or the materiality of its effect is remote under an objective reasonableness standard. In other words, if an off-balance sheet arrangement may have a current or future material effect, disclosure will be required, unless management determines that the occurrence of an event and the materiality of its effect is outside of the realm of reasonable possibility. 14 Application of the new disclosure rules would be similar to management s current analysis, except that the threshold for disclosure of a financial liability is now may or higher than remote rather than reasonably likely. Disclosure Requirements Under the Proposed Rule The proposed rule is intended to advance the MD&A s purpose of disclosing the facts and circumstances necessary to provide investors with a clear understanding of the registrant s business activities. According to the SEC s release, companies would be required to disclose: the nature and purpose of off-balance sheet arrangements, describing why and how the company engaged in the arrangements; 15 the significant terms and conditions of the arrangements, particularly those that implicate a company s preexisting guarantees, keep well agreements or other similar arrangements; 16 the nature and amount of the total assets and total obligations and liabilities (including contingent liabilities) of an entity through which off-balance sheet activities are conducted; 17 the amounts of revenues, expenses and cash flows arising from the arrangements; 18 the nature and total amount of any interests retained, securities issued and other indebted-ness incurred; 19 and the nature and amount of any other obligations or liabilities (including contingent liabilities) arising from the arrangements that are, or may become, material and the triggering events or circumstances that could cause them to arise. 20 Management would also have to provide: an analysis of the material effects of the off-balance sheet arrangements, the effects of gains or losses from asset sales and changes from prior periods, changes in third party, at-risk equity and the consequences, the amount and source of the assets required to be maintained and how that will affect ongoing operations; 21 an analysis or discussion of the impact and proximity of the potential risks that may arise from the offbalance sheet arrangements, the impact of triggering events and their aggregate effect on the company; 22 an analysis of the degree to which the registrant relies on off-balance sheet arrangements for its liquidity and capital resources or market risk or credit risk support or other benefits; 23 and a discussion of the effects of a termination or material reduction in the benefits of the off-balance sheet arrangements. 24 The proposed rule would require companies to disclose the aggregate effects of all their off-balance sheet 3 Number 242 December 13, 2002

4 arrangements to the extent that aggregation increases understanding. Each registrant would also be required to disclose the off-balance sheet arrangements in a separate section of the MD&A. 25 Disclosure of Contractual Obligations and Contingent Liabilities and Commitment The proposed rule would require certain registrants to use a table (shown below) to disclose contractual obligations. 26 In addition, in either another table, or through a textual disclosure, companies would be required to disclose contingent liabilities and commitments, for example, lines of credit, standby letters of credit, guarantees and standby repurchase obligations. This information, which is currently dispersed throughout a company s filings, would be aggregated in a single location to expand understanding. These disclosures, whether in tabular or textual format, would not have to be set apart in a different section of the MD&A; they may be placed in any MD&A section management deems appropriate. In addition, this section would not apply to small business issuers who file under Regulation S-B. Foreign Private Issuers The proposed rules would require expanded disclosure of off-balance sheet arrangements on Forms 20-F and 40-F for foreign private issuers. Sarbanes-Oxley does not distinguish between foreign private issuers and domestic companies. The current MD&A requirements in Form 20-F already mirror the MD&A disclosure requirements for domestic companies, and investors would benefit from the disclosure information for both Form 20- F and Form 40-F filers. However, because these proposed rules only apply to quarterly and annual reports, 27 they would not apply to Form 6-K reports for foreign entities reporting home jurisdiction disclosures. Consequently, unless a foreign private issuer files a Securities Act registration statement that must include interim period financial statements and related MD&A disclosure, it would not be required to update the proposed MD&A disclosure more than annually. 28 Safe Harbor Provisions The proposed rules specifically provide that the statutory safe harbor for forward-looking information provided in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Act of 1934 will apply to information disclosed pursuant to the proposed rules in the same manner and with the same criteria that currently applies to other disclosed information. 29 The proposed rules further clarify that information provided in response to certain of the new requirements particularly management s analysis of the effects of off-balance sheet arrangements and of the circumstances leading to, and effects of, a termination or reduction in these Contractual Obligations Payments due by period TOTAL <1 year 1-3 years 3-5 years >5 years [Long-Term Debt] [Capital Lease Obligations] [Operating Leases] [Unconditional Purchase Obligations [Other Long-Term Obligations] [Total Contractual Obligations] 4 Number 242 December 13, 2002

5 arrangements will be considered forward-looking information to the extent such information does not present historical facts. Companies preparing the required disclosure should take care to meet the requirements of the statutory safe harbor. Conclusions The proposed rule would use textual disclosure in the MD&A to cure what the SEC perceives as failures in financial statements prepared in accordance with GAAP. Although the rules were clearly drafted as a response to the Enron debacle, they cast a wide net that will capture perfectly standard financing strategies such as accounts receivable securitizations. Equally questionable is the proposed lowering of the traditional materiality standard for disclosure in favor of the new not remote standard discussed above. In the end, however, we do not expect these disclosure requirements to impede traditional and legitimate off-balance sheet arrangements. Additional Information The SEC is accepting comments to this proposed rule until December 9. It is unclear what changes, if any, the SEC will make to the rule before adopting a final version. The full text of the SEC release discusses the definition of offbalance sheet arrangements and certain disclosures in greater detail than this Client Alert. For more information, please contact Doug Tansey at , Laura DeFelice at , any of the attorneys listed at the end of this Client Alert or the Latham & Watkins attorney whom you normally consult. Endnotes 1 See Sarbanes-Oxley Act, Pub. L , 116 Stat. 745, 401(a) [15 U.S.C. 78m(j)] (2002). 2 Proposed Rule: Disclosure in Management s Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments, Exchange Act Release Nos ; , File No. S (Nov. 4, 2002), available at (hereinafter, Proposed Rule ). 3 The current MD&A rules require disclosure of certain off-balance sheet arrangements. While only one item in the current MD&A rules mentions off-balance sheet arrangements specifically, other items require disclosure of off-balance sheet arrangements if necessary to an understanding of a registrant s financial condition, changes in financial conditions and results of operations. Specifically, Item 303(a)(2)(ii) of Regulation S-K, 17 C.F.R (a)(2)(ii), requires disclosure of any known material trends, favorable or unfavorable, in the registrant s capital resources, including any expected material changes in the mix and relative cost of capital resources, considering changes between debt, equity and any off-balance sheet financing arrangements. This proposed rule, adding Item 303(a)(4) and (5), seeks to increase the transparency of specifically off-balance sheet arrangements. 4 See Proposed Rule, proposed Item 303(c)(3)(i) of Regulation S-B[17 C.F.R (c)(3)(i)]; proposed Item 303(a)(4)(iii) of Regulation S-K [17 C.F.R (a)(4)(iii)]; proposed Item 5.E.3 of Form 20-F [17 C.F.R f]; and General Instruction 7(iii) of Form 40-F [17 C.F.R f]. 5 See Proposed Rule text at FN See Proposed Rule text at FN 48 and Section II.B.3. 7 See proposed Item 303(c)(3)(ii) of Regulation 8 See Proposed Rule text at FN See proposed Item 303(c)(3)(iii) of Regulation S-B, and corresponding proposed sections of 10 See proposed Item 303(c)(3)(iv) of Regulation 11 See Proposed Rule text at FN Emphasis added. See proposed Item 303(c)(1) of Regulation S-B and corresponding proposed sections of Regulation S-K and Forms 20-F and 40-F. 13 See Proposed Rule text at FN See Proposed Rule text at FN See proposed Item 303(c)(1)(i) of Regulation See proposed Item 303(c)(1)(ii) of Regulation 18 See proposed Item 303(c)(1)(iii) of Regulation 5 Number 242 December 13, 2002

6 See proposed Item 303(c)(1)(iv) of Regulation See proposed Item 303(c)(2) of Regulation S-B and corresponding proposed sections of 25 See proposed Item 303(c)(1) of Regulation S-B and corresponding proposed sections of 26 See proposed Item 303(a)(5) of Regulation S-K and corresponding proposed sections of Forms 20-F and 40-F; but not Regulation S-B for small businesses. 27 Sarbanes-Oxley Act 401(a) 28 See Proposed Rule text at FN 111, See proposed Item 303(d) of Regulation S-B, and corresponding proposed section of Regulation S-K, and Forms 20-F and 40-F. Office locations: Boston Brussels Chicago Frankfurt Hamburg Hong Kong London Los Angeles Milan Moscow New Jersey New York Northern Virginia Orange County Paris San Diego San Francisco Silicon Valley Singapore Tokyo Washington, D.C. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you have any questions about this Client Alert, please contact Laura DeFelice or Doug Tansey in our New York office, or any of the following attorneys. Boston David A. Gordon Brussels John P. Lynch +32 (0) Chicago Nancy Schimmel Ellen Marks Frankfurt John D. Watson, Jr Hamburg Joachim von Falkenhausen Hong Kong Andrew D. Hutton London James Chesterman Lene Malthasen Los Angeles Vicki Marmorstein Dominic Yoong Milan Lucantonio N. Salvi Moscow Anya Goldin New Jersey James E. Tyrrell, Jr New York Kevin Blauch Kirk Davenport Laura DeFelice Kevin Fingeret Northern Virginia Scott C. Herlihy Orange County Patrick T. Seaver Scott Shean Paris Etienne Gentil +33 (0) San Diego Robert E. Burwell San Francisco Ken Blohm Silicon Valley Robert A. Koenig Singapore Michael W. Sturrock Tokyo Michael J. Yoshii Washington, D.C. John J. Huber Number 242 December 13, 2002