SEC Proposes Rules to Implement Sarbanes-Oxley Act Reforms
FOR IMMEDIATE RELEASE
Commission also Proposes Exchange Act Bank Dealer Exceptions
Washington, D.C., October 30, 2002 — The Securities and Exchange Commission today voted to propose rules and amendments to implement provisions of the Sarbanes-Oxley Act and amend definitions of the term "dealer" in the Securities Exchange Act of 1934.
Use of Non-GAAP Financial Information
Background: Section 401(b) of the Sarbanes-Oxley Act of 2002 directs the Commission to issue final rules by Jan. 26, 2003, requiring that any public disclosure or release of "pro forma financial information" by a public company be presented in a manner that (1) does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the "pro forma financial information," in light of the circumstances under which it is presented, not misleading; and (2) reconciles the "pro forma financial information" presented with the financial condition and results of operations of the company under GAAP. The Commission proposed to meet the mandate of Section 401(b) by defining the category of financial information that is subject to that mandate and then taking a two-step approach to regulating the use of that financial information.
- The Commission proposed that the rules under Section 401(b) of the Sarbanes-Oxley Act apply to the public disclosure or release of material information that includes a "non-GAAP financial measure." For this purpose, a "non-GAAP financial measure" would be a numerical measure of a company's financial performance that: (1) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the issuer; or (2) includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable measure so calculated and presented. Statistical and operating measures would not be covered.
- The Commission proposed new Regulation G, which would apply whenever a company publicly discloses or releases material information that includes a non-GAAP financial measure. This regulation would prohibit material misstatements or omissions that would make the presentation of the material non-GAAP financial measure, under the circumstances in which it is made, misleading, and would require a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure presented and the comparable financial measure or measures calculated and presented in accordance with GAAP.
Regulation G would provide a limited exception for foreign private issuers where (1) the securities of the issuer are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States; (2) the non-GAAP financial measure and the most comparable GAAP financial measure are not calculated and presented in accordance with generally accepted accounting principles in the United States; and (3) the disclosure is made by or on behalf of the issuer outside the United States, or is included in a written communication that is released by or on behalf of the issuer only outside the United States.
- The Commission proposed to amend Item 10 of Regulation S-K and Item 10 of Regulation S-B to address specifically the use of non-GAAP financial measures in filings with the Commission. These proposed amendments would apply to the same categories of non-GAAP financial measures as are covered by proposed Regulation G, but contain more detailed requirements than proposed Regulation G. The Commission also proposed to amend Exchange Act Form 20-F to reference Item 10 of Regulation S-K.
Backround: Section 409 of the Sarbanes-Oxley Act added new Section 13(l) to the Exchange Act. New Section 13(l) obligates public companies to disclose "on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer . . . as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest."
- The Commission proposed to amend Form 8-K to require public companies to file with the Commission releases or announcements disclosing material non-public financial information about completed annual or quarterly fiscal periods. This proposal would not require the issuance of earnings releases or similar announcements. However, such releases and announcements would trigger the new proposed filing requirement. The proposed filing requirement would apply regardless of whether the release or announcement included disclosure of a non-GAAP financial measure.
- The Commission also proposed that public disclosure of financial information for a completed fiscal period in a presentation that is made orally, telephonically, by webcast, broadcast or similar means would not be required to be filed, if (1) the presentation occurs within 48 hours of a related release or announcement that is filed on Form 8-K; (2) the presentation is accessible to the public; and (3) the information in the webcast is posted on the company's website.
MD&A Disclosure about Off-balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments
- Section 401(a) of the Sarbanes-Oxley Act of 2002 amended Section 13 of the Securities Exchange Act of 1934 to include new sub-paragraphs (i) and (j). New Exchange Act Section 13(j) directs the Commission to issue final rules by Jan. 26, 2003, requiring an Exchange Act reporting company to disclose in its annual and quarterly financial reports all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the company 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 revenues or expenses.
- The Commission proposed to satisfy the Exchange Act Section 13(j) mandate by explicitly requiring a company to disclose these transactions and relationships in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A) section of the company's disclosure documents. While current MD&A rules already require a company to provide disclosure about its off-balance sheet arrangements to the extent necessary to an understanding of the company's financial condition, changes in financial condition and results of operations, the proposed rules will more specifically address the types of disclosure that companies must provide.
- In addition to fulfilling the statutory mandate, the proposed rules codify many of the views expressed in the Jan. 22, 2002, statement focusing on the need for improved MD&A disclosure (Release No. 33-8056; FR-61). The proposed rules would, however, lower the threshold that triggers disclosure relating to off-balance sheet transactions discussed in the January statement consistent with Congressional intent. While MD&A disclosure about an off-balance sheet transaction currently is required if the transaction is "reasonably likely" to have a material effect on the company, the proposed rules would require disclosure if the likelihood of the transaction having a material effect on the company is more than "remote."
- Although Exchange Act Section 13(j) directs the SEC to require the off-balance sheet arrangement disclosure only in a company's annual and quarterly reports, the Commission proposed to also require a company to include this disclosure in the MD&A section of its Securities Act registration statements.
- The proposals also would require a registrant, other than a small business issuer, to provide an overview of its aggregate contractual obligations in a tabular format and an overview of its contingent liabilities and commitments in either a textual or tabular format.
- The primary objectives of the proposed rules are to:
- provide investors with the information and analysis necessary to enable them to gain a more comprehensive understanding of the implications of a company's obligations and contingencies from off-balance sheet arrangements that cannot easily be understood from the company's financial statements alone; and
- better inform investors of the aggregate impact of short and long-term contractual obligations, contingent liabilities and commitments, from both on- and off-balance sheet activities, by presenting a total picture in a single location.
Restriction of Insider Trading During Pension Fund Blackout Periods
Background: Section 306(a) of the Sarbanes-Oxley Act of 2002 prohibits any director or executive officer of an issuer from, directly or indirectly, purchasing, selling or otherwise acquiring or transferring any equity security of the issuer during a pension plan blackout period that prevents plan participants and beneficiaries from engaging in transactions involving issuer equity securities held in their plan accounts, if the director or executive officer acquires the equity security in connection with his or her service or employment as a director or executive officer. Section 306(a) also requires an issuer to notify its directors and executive officers, as well as the Commission, of an impending blackout period on a timely basis. The statute takes effect on Jan. 26, 2003, 180 days after the date of enactment of the Sarbanes-Oxley Act. Section 306(a) further directs the Commission, in consultation with the Secretary of Labor, to issue rules that clarify the application of the statutory trading prohibition and that prevent evasion of the prohibition.
The Commission today proposed rules under the Securities Exchange Act of 1934 in response to this statutory directive. These proposals, which were developed in conjunction with the Department of Labor, would clarify the scope and operation of the statutory trading prohibition in a manner that is consistent with the objectives of Section 306(a) and Congressional intent.
Highlights of the Proposed Rules
Persons Subject to Trading Prohibition
Section 306(a) applies to the directors and executive officers of an issuer:
- with a class of securities registered under Section 12 of the Exchange Act;
- that is required to file reports under Section 15(d) of the Exchange Act; or
- that files or has filed a registration statement that has not yet become effective under the Securities Act and that has not been withdrawn.
The proposed rules would apply to the directors and executive officers of all reporting companies, including foreign private issuers, banks and savings associations and small business issuers.
Under the proposed rules, the term "director" would have the same meaning as under the general Exchange Act rules, and the term "executive officer" would have the same meaning as the term "officer" under the insider reporting requirements of Section 16(a) of the Exchange Act. This will both streamline compliance with the new statutory trading prohibition and enable security holders to monitor the trading activities of an issuer's directors and executive officers using the Section 16(a) reporting forms.
Securities Subject to Trading Prohibition
Generally, Section 306(a) of the Act applies to any equity security of an issuer. Under the proposed rules, this term would be defined to include both equity securities and derivative securities relating to an equity security, whether or not issued by the issuer. To promote consistency and streamline compliance, the term "derivative security" would have the same meaning as under the Section 16 rules.
Transactions Subject to Trading Prohibition
The statutory trading prohibition of Section 306(a) is limited to equity securities that a director or executive officer acquired in connection with his or her service or employment as a director or executive officer. The proposed rules would specify the instances where an acquisition of equity securities by a director or executive officer was "in connection" with his or her service to or employment with an issuer.
To prevent evasion of the statutory trading prohibition, the proposed rules would apply to indirect, as well as direct, acquisitions and dispositions of equity securities where a director or executive officer had a "pecuniary interest" in the transaction. To promote consistency and streamline compliance, the term "pecuniary interest" would have the same meaning as under the Section 16 rules. Accordingly, acquisitions or dispositions of equity securities by family members, partnerships, corporations, limited liability companies and trusts would be deemed acquisitions or dispositions by a director or executive officer if he or she had a pecuniary interest in the equity securities.
Section 306(a) permits the Commission to exempt appropriate transactions from the statutory trading prohibition, including purchases pursuant to an automatic dividend reinvestment program or purchases or sales made pursuant to an advance election. The proposed rules would exempt:
- acquisitions of equity securities under dividend or interest reinvestment plans;
- purchases or sales of equity securities that satisfy the affirmative defense conditions of Exchange Act Rule 10b5-1(c);
- purchases or sales of equity securities pursuant to certain employee benefit plans, other than discretionary transactions; and
- increases or decreases in equity securities holdings resulting from a stock split, stock dividend or pro rata rights distribution.
The statutory trading prohibition of Section 306(a) is triggered only if a blackout period lasts more than three consecutive business days and temporarily suspends the ability of at least 50% of the participants or beneficiaries under all individual account plans maintained by the issuer to purchase, sell or otherwise acquire or transfer an interest in issuer equity securities held in an account plan. The proposed rules would clarify application of the 50% test and describe how the two statutorily mandated exceptions to a blackout period would operate
A violation of the statutory trading prohibition of Section 306(a) by a director or executive officer is subject to possible enforcement action by the Commission. In addition, Section 306(a) provides that an issuer, or a security holder of behalf of the issuer, may bring an action to recover the profits realized by a director or executive officer from a prohibited transaction during a blackout period. The proposed rules would provide guidance on how the computation of profits would be made in a private action and solicit comment on alternative approaches.
The proposed rules would specify the content and timing of an issuer's required notice of a blackout period to directors and executive officers. The proposed rules also would require an issuer to notify the Commission of an impending blackout period by means of a Form 8-K filing.
Proposed Amendments to Exhange Act Bank Dealer Exceptions
The Commission proposed rules amending definitions of the term "dealer" in Section 3(a)(5) of the Securities Exchange Act of 1934, amending an exemption for banks from the definition of dealer for certain de minimis riskless principal transactions, and adding a new exemption from broker-dealer registration for certain bank securities lending transactions.
The Gramm-Leach-Bliley Act provides four exceptions to banks from the definition of "dealer" and eleven exceptions from the definition of "broker." The proposed rules would address certain of the exceptions from the definitions of "dealer" that were added under the Securities Exchange Act of 1934.
Proposed Definitions of Terms Used in Asset-Backed Exception to Dealer Registration:
The asset-backed dealer exception permits banks to issue and sell securities backed by obligations the bank and its affiliates originated, or other obligations that were originated by other banks and their affiliates in a syndicate.
The proposed rules would:
- Amend the definition of "originated" so that banks may use distribution channels such as automobile dealers, mortgage companies, and other banks, even though the bank does not "make and fund" the loan at the exact time that the loan is made.
- Retain the standard for "predominantly originated" at 85 percent.
- Replace the definition of "member of a syndicate of banks" with a definition of "member" as it relates to "syndicate of banks" to make clear that the individual banks originate the obligations, not the syndicate.
- Retain the requirement that when a syndicate of banks issues asset-backed securities through a grantor trust or other separate entity, each bank selling the securities, and thus, acting as a dealer in the transaction, must have originated at least 10% of the value of the pool of obligations backing the securities.
Proposed Exemption from the Definition of Dealer for Banks Engaged in "Riskless Principal" Transactions:
The proposed rules would change the de minimis exemption for riskless principal transactions so that both legs of a riskless principal transaction are counted as one transaction solely for purposes of the de minimis exemption.
Proposed Exemptions for Non-custodial Securities Lending from Dealer and Broker Registration and Custodial Lending from Dealer Registration:
The proposal would add a new exemption from the definition of broker and dealer for banks that engage in certain non-custodial securities lending transactions with "qualified investors" as defined in Section 3(a)(54) of the Exchange Act.
The current Commission exemption from the definition of "dealer" for banks, savings associations, and savings banks expires on Nov. 12, 2002. The Commission will extend the exemption from the definition of "dealer" until Feb. 10, 2003, to permit time for public comment, analysis of the comments received, and adoption of final rules.
The full text of detailed releases concerning each of these items will be posted to the SEC Web site as soon as possible. Comments will be accepted for 30 days following publication of the proposals in the Federal Register.