AMERICAN BAR ASSOCIATION
September 12, 2002
Via e-mail - email@example.com
Ladies and Gentlemen:
This letter is submitted in response to the request of the Securities and Exchange Commission for comments on its June 17, 2002 release entitled Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date (the "Release").
These comments have been prepared by members of the Committee on Federal Regulation of Securities, Section of Business Law of the American Bar Association. A draft of this letter was circulated for comment among other members of the Committee, including the Chairs and Vice-Chairs of Subcommittees and Task Forces of the Committee, the Officers of the Committee and the Advisory Committee of the Committee and the Officers of the Section. A substantial majority of those who have reviewed the letter in draft form have indicated their general agreement with the views expressed. However, this letter does not represent the official position of the American Bar Association, the Section, its officers, the Committee or the Subcommittees, nor does it necessarily reflect the views of all who reviewed it.
We support the concept of additional mandatory disclosure of specified material corporate events occurring between periodic reports. We agree with the Commission's approach to implementing this goal - i.e., by mandating additional specific items - as the means consistent with the structure and philosophy of the securities laws.1
Congress recently endorsed this approach in the Sarbanes-Oxley Act of 2002 by authorizing the Commission to issue rules prescribing disclosure of additional information on a "rapid and current basis" concerning material changes in the financial condition or operations of all public companies. 2
Although the objective of accelerated current reporting is commendable, we are concerned that its implementation as proposed by the Commission does not properly balance the benefits to investors of additional and accelerated disclosure with the burdens imposed on issuers, including harm to the business, added costs of compliance and exposure to liability.
Furthermore, we believe that this additional and accelerated disclosure will work under our securities regulatory system only if the criteria for disclosure are reasonably objective and there is protection from liability for judgments regarding the nature of an event, its materiality and the timing of disclosure. Specifically, we believe some of the specific requirements of the Commission's proposal raise practical concerns that, if left unaddressed, would likely result in reduced accuracy and quality of the information being elicited, a result which would not serve the interests of investors. The requirements should also accommodate the reality that premature disclosure of material business developments can in many instances cause severe economic harm to the enterprise and the investors that exceeds the benefits of immediate disclosure. The disclosure timing mandate should recognize and accommodate the legitimate interests of all company constituencies and allow for disclosure in a timely, yet orderly, fashion.
Both the practical and liability concerns described above arise from the Commission's use of the more judgmental materiality standard for many items (referred to in this letter as "subjective" standards), which contrasts with its previous approach of using more objective triggers for required 8-K disclosure. Accordingly, we propose a somewhat revised conceptual framework for identifying the new mandatory disclosures. Analyzing the Commission's proposed items against this framework, we recommend a number of changes. We suggest a narrowing of scope to more readily-identifiable items. The other, more subjective, items should be reportable quarterly in Forms 10-Q and 10-K. We also suggest a 5, rather than 2, business day deadline for event-driven reporting.
In the event the Commission decides not to narrow the scope of the new reportable items as we propose to avoid subjective disclosure triggers, we propose that they be the subject of bi-weekly reporting, rather than event-driven reporting, in recognition that these new items will require issuers to develop a cyclical, bottom-up approach to identify them.
We urge the Commission to adopt a broader liability safe harbor, like the one adopted for Regulation FD, protecting issuers from private liability based on alleged failure to make "required" disclosures. We also urge that late Form 8-K filings not result in 12-month disqualification from use of Form S-3.
We also urge that the Commission ease issuers' transition to the new system with an initially longer deadline of 10 business days for event-driven reporting. Finally, we respectfully urge the Commission to proceed cautiously before using its new authority under Section 409 of the Sarbanes-Oxley Act with respect to foreign issuers.
TABLE OF CONTENTS
Although proposed in the technical form of new 8-K reportable events, the Commission's proposal really involves the creation of an entirely new reporting regime based on a broad array of subjective triggers. As such, it comes very close to the continuous disclosure regime that we understand the Commission does not favor and that would be at odds with almost 80 years of successful experience under the federal securities laws.
In implementing the Commission's new regime, objectivity of identification, likelihood of senior management knowledge, reporting deadlines and liability issues are interrelated. The greater the objectivity of the triggers, obviousness of materiality and likelihood of the information being promptly known to senior management, the more feasible are relatively short event-driven reporting deadlines and less is the need for protection from second-guessing in the liability context. As the Commission itself recently stated in its release accelerating the filing deadlines for Form 10-K and 10-Q: "Increased quality and timeliness, with an appropriate balance between the two, assures that investors receive the full and reliable data they deserve at the speed in which they desire it." (emphasis supplied)3 We believe the Commission's proposal does not strike the appropriate balance, principally because of its overdependence on subjective triggers and extremely short deadlines. It also fails to recognize that there are situations where the risk of harm to the company (and indirectly to its investors) from premature disclosure (not non-disclosure) justifies deferred reporting in circumstances where the company is not selling new securities and insiders are not trading.
We believe the balance in our proposal is more appropriate and workable. To the extent the Commission declines to reduce the dependence on subjective triggers as we propose, the need for longer deadlines (such as the scheduled basis we propose as an alternative) and urgency for safe harbor protection from private liability for alleged failures of a duty to disclose become all the greater.
As noted, many of the Commission's proposed new 8-K items depart conceptually from past items in their use of the materiality standard. Where possible, a more objective test should be used. To the extent subjectivity remains, we believe the Commission should adopt appropriate safe harbors for issuers' determinations as to timing and materiality.
Accordingly, we suggest a revised analytical framework to take into account the inherent differences in various types of events and their significance. There are trade-offs among:
The attributes of the event to be disclosed are also relevant:
The foregoing factors lead to different conclusions about feasible disclosure deadlines for the items in the Commission's proposal. We suggest that the disclosure model the Commission should adopt, instead of the one it proposes, would:
To aid transition, we suggest that for a one-year phase-in period the event-driven deadline should be longer. We propose to allow 10 business days, rather than 5 business days, to file the event-driven 8-K items during the first year.
As noted, we propose that only objectively determinable items be subject to event-driven 8-K reporting, with the remaining items reportable quarterly in the Form 10-Q or 10-K. If the Commission declines to follow that approach, we propose a schedule-oriented 8-K deadline for these subjective items (other than financial Items 2.03-2.06, which we believe are suitable only for quarterly reporting). In large organizations, some types of events can only practically be identified and disclosure prepared through a scheduled deadline-oriented process. Business units know that by a certain date they must forward to more senior levels various categories of information, where it will be aggregated and analyzed from an enterprise-level perspective by persons having the appropriate understanding of securities law disclosure requirements. Some information not perceived to be material at the business unit level may be determined to be material when aggregated with similar information from other business units. Conversely, some information material to a business unit may not be material to the enterprise as a whole. Also, persons at the business unit level may not have the necessary securities law background or experience to recognize potential materiality. A scheduled, deadline-oriented bottom-up process is the only one that really works for many types of disclosures. While an ad hoc version of this deadline-oriented process can be implemented when an issuer is engaged in a securities offering, the process is still focused on a particular date - the date of the offering. It cannot be made to work on a general basis.
A bi-weekly 8-K for these more subjective items, while burdensome on issuers, would allow this deadline-oriented, cyclical management process to function. Information could be communicated up to senior management on a scheduled basis for disclosure analysis. We believe such a system would provide a more appropriate balance between providing investors information sooner and maximizing the accuracy of that information. Bi-weekly 8-K items would be due 10 days after the end of the two-week period in which the event occurred.
Finally, we believe that the shortened filing deadline for Form 8-K is simply not realistic for small business issuers that have limited staffs, have limited resources to engage outside securities counsel and are all too often stretched thin in meeting operating and regulatory demands.4 We urge that the Commission allow more liberal Form 8-K filing deadlines for small business issuers. For example, the proposed transition deadline described above could be retained permanently for small business issuers.
In the next part of this letter, we address each of the Commission's proposed new 8-K items in light of the above considerations. Set forth below is a summary of our suggestions.
Requiring Form 8-K reporting by a company when it enters into an agreement that is both material and not made in the ordinary course of business strikes an appropriate balance between the importance of prompt disclosure of material information and the practical burdens of complying with the obligation. In particular, we support Form 8-K reporting of binding agreements relating to matters that are unquestionably material, outside the ordinary course and likely to be the subject of substantial interest to investors, including definitive agreements relating to significant acquisitions or dispositions, material contracts with directors, named executive officers and 10% stockholders and compensatory or other arrangements with directors and named executive officers. If the disclosable events are limited in this fashion, we believe event-driven reporting is feasible under the extended deadline we propose - 10 business days for a one-year transitional period and 5 business days thereafter.
However, given the complexity of materiality judgments and formulation of related disclosure, we recommend continued reliance upon Form 10-K and Form 10-Q for mandatory disclosure of other material contracts, including commercial arrangements of the type that ordinarily accompany the kind of business conducted by a company.
Requiring disclosure of non-binding agreements would represent a dramatic and disruptive change in the law, particularly in the merger and acquisition context, and we strongly oppose this part of the Commission's proposal.
Our comments apply equally to the Commission's proposal to require 8-K reporting of amendments to material agreements.
The Scope of the New Form 8-K Requirement Should Generally Be a Subset of the Existing Item 601(b)(10) Material Contract Requirement
We submit that the new Form 8-K reporting requirement should be more closely based on the existing definition of material contracts contained in Item 601(b)(10) of Regulation S-K. Since companies and their advisors have already developed a working understanding of Item 601(b)(10), more directly tying the new Form 8-K requirement to the familiar provisions of Item 601(b)(10) will enhance compliance with the new requirement by reducing confusion associated with having to master two inconsistent sets of standards and by avoiding new interpretive issues.5
Item 601(b)(10) describes three categories of contracts required to be filed as exhibits. Paragraph (i) consists of contracts not made in the ordinary course of business that are material to the registrant. Paragraph (ii) requires the filing of four types of ordinary course contracts unless immaterial: (A) contracts with insiders and underwriters, (B) contracts upon which the business is substantially dependent, (C) contracts involving acquisition or sale of over 15% of the registrant's fixed assets and (D) material leases. Paragraph (iii) consists of management contracts and compensatory plans (A) in which a director or executive officer participates (unless involving a non-named executive officer and immaterial) or (B) that have not been approved by shareholders and involve issuance of equity.
In particular, we believe that:
Non-Ordinary Course Material Contracts Under Paragraph (i). We propose to limit the class of material contracts requiring mandatory 8-K disclosure to the subset that balance importance to investors with ease of identification and description. We believe these are definitive agreements for the acquisition or disposition of a business currently described in Item 2 (proposed Item 2.01) of Form 8-K.
Item 2 of Form 8-K currently requires disclosure upon consummation of an acquisition or disposition of a "significant" amount of assets, otherwise than in the ordinary course of business, by the registrant or a majority owned subsidiary. "Significant" is defined objectively as (i) equity in the net book value of the assets, or the amount paid or received, exceeding 10% of consolidated total assets or (ii) involving a business that is significant for purposes of Article 11 of Regulation S-X.
These agreements can generally be readily identified at the senior management level, without the need for a time-consuming bottom-up process. They typically already involve planned public announcements and input by inside and often outside disclosure advisors. Also, the quantified standard for disclosure in Item 2 is preferable to a general materiality standard. The quantified standard has been in place for years and has worked satisfactorily.
Other types of non-ordinary course material contracts are generally likely to present similar challenges as those described below for ordinary course material contracts, including the need to involve disclosure advisors who may not have been involved in the contract's negotiation, the uniqueness of the contract terms requiring customized disclosure, the need to analyze non-disclosure provisions in the contract and the possible need to seek confidential treatment. We believe these are best left for 10-Q and 10-K disclosures.
Ordinary Course Material Contracts Under Paragraph (ii). We believe that Form 8-K reporting should not be required with respect to contracts specified in subparagraph (A) of paragraph (ii) of Item 601(b)(10), other than with respect to contracts involving directors, named executive officers and 10% stockholders. We also believe Form 8-K reporting should not be required with respect to any contracts specified in subparagraphs (B), (C) or (D) of paragraph (ii).6
First, because the agreements specified in paragraph (ii) ordinarily accompany the kind of business conducted by the company, they represent the class of contracts where companies will experience the greatest difficulty in making materiality judgments. For example, it is not always apparent whether a particular licensing agreement or other commercial arrangement is one upon which the company's business is "substantially dependent" and the input of numerous people may be needed in order to make this determination. A two business day, five business day or even bi-weekly filing requirement does not provide enough time for the company's business, legal and financial personnel and advisors, many of whom may not have been actively involved in, or familiar with, all the details of the agreement, to be made aware of the agreement, to review the final signed agreement and to reach a reasoned judgment as to whether it must be filed.
Second, the agreements specified in paragraph (ii) are typically the most difficult to summarize because they often contain unique terms and because they often require a greater understanding of the business reasons underlying the agreement in order to accurately describe the material rights and obligations of each party. In this regard, such agreements may differ significantly from more standardized transactional documents (such as a merger agreement) and from compensatory agreements.
Third, material agreements are typically subject to non-disclosure provisions imposed by the counterparty, which must be analyzed and addressed. These invariably include provisions requiring both parties to co-ordinate disclosures, including public announcements, that may require longer than the 8-K reporting timeframe to negotiate after the agreement is signed.
Fourth, the Commission's proposal does not recognize the legitimate need of a company to defer disclosure when premature disclosure would prejudice the company's interests (and indirectly those of its shareholders and other investors). As long as the company is not issuing new securities, and its insiders are not trading in its securities, the company should be permitted to balance the harm to it of premature disclosure with the potential informational benefit to the public trading markets. Moving the disclosure to the 10-Q and 10-K for paragraph (ii) agreements would address this concern.
Fifth, these types of agreement often include sensitive business information for which the parties are entitled to receive confidential treatment. However, the process of reviewing an agreement to identify all confidential portions can be very time-consuming because it requires coordination between or among all parties to the agreement and often involves personnel at each company who were not involved in the negotiation of the agreement. It will often not be practical to address these issues during the course of negotiations. In addition, as discussed below in more detail, it would be very difficult to prepare a meaningful application supporting the confidential treatment request in the 8-K reporting timeframe. As a result, the need to file these agreements within a short period may result in premature disclosure of confidential business information that harms one or both companies and, indirectly, their investors.
Non-binding Agreements Should Not Be Subject to Mandatory Reporting
In contrast to reporting entry into a definitive agreement, imposing Form 8-K reporting obligations with respect to "any letter of intent or other non-binding agreement or any similar document" as proposed in the Release would create serious difficulties for companies and potential disruption in financial markets. Such a requirement would significantly change current law, forcing announcements of merely potential transactions (thereby fueling speculation) and jeopardizing stockholder value without in most cases improving the quality of disclosure.
In all contexts, we believe it is inappropriate to require disclosure of non-binding agreements, since such agreements, by their very nature, do not represent a legally enforceable obligation of any person and therefore are not ripe for mandatory disclosure. Moreover, the premature disclosure of such agreements could be misleading to investors, since there can be no certainty that a binding agreement will ever be reached, and could result in competitive harm to the parties. Rather, the disclosure of non-binding agreements should be left to the current system under which companies evaluate the benefits, burdens and need for disclosure.
Premature announcement of an M&A transaction, in particular, can be extremely damaging. A company viewed as "in play" may have difficulty conducting its business and retaining employees, customers, suppliers and lenders. Volatility in trading prices may be disruptive to negotiations. Mere knowledge of the existence of merger negotiations may be of limited value to investors. In cases where leaks have occurred, a number of companies have issued press releases announcing that they are holding merger discussions. However, the announcements typically do not disclose the range of possible terms of the transaction, including the amount and form of consideration, because, in the absence of a definitive agreement, such an announcement could be highly misleading. Letters of intent are used in many other contexts and raise the same concern. In the absence of an enforceable contract, disclosure could be premature, disruptive and misleading.
Most agreements that will be "material," especially merger and acquisition agreements, cannot be successfully negotiated in public. Moreover, many preliminary agreements fall apart; disclosure of such agreements that ultimately fail to be finalized would encourage even earlier investor speculation and arbitrage than normally follows announcements of definitive agreements and could disrupt orderly market trading.
In the Release, the Commission states that, in including non-binding documents in the definition of "agreements," it did "not intend to change current law" with respect to disclosure of acquisition negotiations. However, it is. Merger discussions and other business negotiations generally are not disclosed prior to reaching a definitive agreement because a determination is made that there is no duty to disclose, not because they are not material.7
Though recognizing that disclosure of preliminary discussions could adversely affect the companies and their stockholders, the Supreme Court found that "[a]rguments based on the premise that some disclosure would be `premature' in a sense are more properly considered under the rubric of an issuer's duty to disclose."8 We note that the proposal in the Release also runs counter to the Commission's own guidance on premature disclosure of merger negotiations in its 1989 MD&A interpretive release, codified as Section 501.06.d of the Commission's Codification of Financial Reporting Policies.9 Until definitive agreements are negotiated, non-binding agreements regarding business deals are merely a part of business negotiations.
As proposed in the Release, issuers would have a new affirmative duty to disclose certain non-binding agreements or documents. Public companies considering a significant acquisition, sale or other business transaction commonly enter into confidentiality agreements and other arrangements regulating the conduct of anticipated negotiations and due diligence. In many transactions, preliminary term sheets are prepared to expedite discussions and confirm basic common understandings. While providing no assurance that a binding contract will be entered into, such documents, as well as oral understandings and draft agreements, collectively, could well be viewed as material "non-binding agreements or documents" in view of the materiality of the related transaction.
While many of our concerns focus on preliminary and non-binding merger and acquisition agreements, they are in no way limited to such agreements. Significant commercial arrangements are likewise subject to the need for confidentiality until finalized in definitive form. If a vendor negotiating a letter of intent pertaining to a major contract with a customer were required to disclose that arrangement prior to completion of negotiations and execution of the binding contract, it is entirely possible that the early disclosure itself could jeopardize the completion of the transaction. For example, competitors could seek to make their own proposals to capture the business. Such a disclosure requirement could therefore be self-defeating. Furthermore, by increasing the circumstances in which announcements of positive developments, even though accompanied by cautionary statements, are followed by disappointing news, such a disclosure model could erode investor confidence in the integrity of our markets.
Corporate practice conceivably could conform to a highly formalistic interpretation of these terms - even prior to the Release many lawyers counseled against executing letters of intent or term sheets. However, such an approach of creating but not signing letters of intent or term sheets would drain the disclosure requirement of any real meaning, interfere with legitimate business dealings and simply create a trap for the unwary.
Reporting Deadline Should Be Longer Even for Narrowed Class
The same difficulties discussed in the previous subsections in identifying disclosable contracts and creating disclosure also create timing difficulties for reporting ordinary course material agreements and other material contracts outside the narrower categories of disclosable contracts we suggest. Issuers will likely continue to make timely event-driven disclosure of major material contracts regarding acquisitions and dispositions, as they do today. Adding a requirement to report them on Form 8-K within 5 (initially, 10) business days would be feasible. Similarly, material contracts with directors, named executive officers and 10% stockholders will be readily known at senior levels and are susceptible to event-driven reporting as long as the deadline is reasonable (which in our view 2 business days is not). The same is true for compensatory plans of the type we describe. Others, principally material contracts entered into in the ordinary course of business, will require internal analysis and judgment to identify and describe.
Accordingly, we believe the deadline for reporting our proposed narrower class of material contracts should be at least 5 business days. For a one-year transition period we recommend 10 business days. Other material contracts should be reportable on a scheduled basis through 10-Q and 10-K reports.
There are also many circumstances where premature disclosure may also harm companies because appropriate time cannot be taken to reassure other interested parties (e.g., affected employees, public officials, regulators, customers, suppliers, lenders) that are essential to the health, reputation and prosperity of the enterprise. Section 202.06 of the New York Stock Exchange Listed Company Manual acknowledges the need to delay certain public announcements temporarily. Our proposed deadline also accommodates this need.
Other Comments Relating to Proposed Item 1.01
Relationship to Regulation M-A Communication Rules. We support the proposal suggested in the Release to permit filers to avoid duplicative filings by indicating on the Form 8-K that the filing of the Form 8-K also satisfies its filing obligation under Rule 165, Rule 14d-2(b) and/or Rule 14a-12, as applicable.
Obligation to File Agreement as an Exhibit. As a practical matter, we believe most counsel will advise their clients to file a copy of the agreement as an exhibit to any Form 8-K filed under Item 1.01, whether or not doing so is an explicit requirement. In light of this, and given that the process of EDGARizing an agreement for filing with the 8-K is not generally difficult since the agreement typically already exists in electronic format, we believe that companies should, subject to resolution of the issues discussed in the next paragraph, be required to file a copy of any agreement which is the subject of a filing under Item 1.01.
We believe the greatest difficulty associated with filing the actual agreement as an exhibit within a short 8-K time period will arise when the agreement contains provisions for which the company wishes to seek confidential treatment. In general, the need for confidential treatment arises most often in the context of ordinary course material contracts of the type described in paragraph (ii) of Item 601(b)(10), since confidential treatment is not usually sought or available with respect to material merger and acquisition transactions or compensatory arrangements with directors and executive officers. Therefore, this issue will be largely minimized by excluding paragraph (ii) agreements from the Item 1.01 filing requirement as we propose. In any event, we believe the Commission should provide relief to companies by (1) allowing the confidential treatment application itself to be filed some number of days after the redacted exhibit is required to be filed on Form 8-K, (2) allowing entire sentences to be redacted, rather than the current requirement that only words and phrases be redacted, and (3) allowing Forms S-3 (other than for primary issuances) and S-8 to go effective while a company has pending confidential treatment applications.10
Item 1.02 Termination of a Material Agreement
Scope of Agreements Subject to this Requirement
As discussed above, we believe that it will be confusing to investors and companies if the reporting criteria of Form 8-K under Items 1.01 and 1.02 are different from those specified in Forms 10-K and 10-Q in accordance with Item 601(b)(10) of Regulation S-K. We recommend that the Item 1.01 and 1.02 requirements be more directly tied to the existing definitions contained in Item 601(b)(10). Accordingly, we believe that it would be appropriate to require a company to file a Form 8-K reporting the termination of an agreement that (1) has been identified by the company as a material contract in its most recent Form 10-K11 or in any subsequently filed Form 10-Q or (2) has been the subject of a Form 8-K filed in the current year under Item 1.01.12 As discussed below, we believe an event-driven reporting deadline is appropriate, provided the triggering event is actual termination and the deadline is reasonable (which we believe 2 business days is not).
The Standard for When Disclosure Is Required Should Always Be Tied to Actual Termination
Should Not Be Upon Receipt of Notice. Under the proposal, where the reporting company is not the terminating party, it would be required to file a Form 8-K under Item 1.02 if it receives a termination notice from the other party to the agreement, even though that termination will not become effective until a later date or is in fact ineffective. We believe that requiring the filing of an 8-K upon receipt of a termination notice is premature. For one thing, the termination notice could be a mistake or otherwise improper. Also, the parties could negotiate a revocation of the termination or renegotiate the underlying agreement. In either circumstance, investors would be poorly served by such a premature disclosure, since it would not tell the entire story. Such a filing requirement could also subject companies to significant harm by dramatically increasing the bargaining leverage of the other party, which will be able to use the mere threat of sending a revocable termination notice to exert undue influence during negotiations. This will be particularly detrimental to smaller public companies that have strategic relationships with larger companies. In such cases, the existing imbalance of bargaining power, which is already significant, will be meaningfully exacerbated. There will, of course, be situations where the materiality of the potential impending termination (as reflected in a termination notice that will become effective with the passage of time) will cause the reporting company to make public disclosure in any event. We do not, however, think it is appropriate to have a rule that always mandates disclosure in this context. Accordingly, we believe that the Item 1.02 obligation should only be triggered by the actual occurrence of an effective termination of a material agreement.
Should Not Be Upon Decision to Terminate. Where the reporting company is the terminating party, we believe the triggering event that requires disclosure under Item 1.02 should not be when the company "decides to terminate" the agreement because this standard is too subjective and may be difficult to determine. For example, assume the CEO decides on Monday that the company will terminate an agreement and that on Thursday of that same week at a meeting of the Company's Board of Directors, the Board votes to terminate the agreement. If the CEO had valid corporate authority to terminate the agreement without board action, it is possible under the Commission's proposal that the 8-K was due on Wednesday, the day before the Board met.
Use Actual Termination. To avoid issues such as these, we believe there should be a clear objective standard for when the filing obligation is triggered and that the Form 8-K requirement should only be triggered by the actual termination of a material agreement in the class of agreements we have identified.
Reporting Deadline Should Be Reasonable
In most cases a company can institute monitoring procedures with respect to the specific list of contracts we describe - the ones listed in the most recent 10-K and subsequent 10-Qs and Item 1.01 8-Ks (modified as we propose). Thus, event-driven reporting of actual termination appears feasible.
Nevertheless, the company will require a reasonable time to react to the termination identified by the procedures. The company may need time to address the internal consequences of termination. The company may need time to arrange for an agreement with another party to replace the terminated agreement, and premature disclosure of the terminated agreement would disadvantage it in negotiations for a new agreement with another party. Also, a host of other activities associated with the public announcement might take a number of days to firm up. Even after the termination is communicated to the other party to the agreement, there will be many circumstances where the ostensible benefits to investors of immediate disclosure would be overwhelmed by the harm to both corporations from disclosure at that time. Examples of activities that must be accommodated for one or both parties are notifications to lenders, assurances to employees, suppliers, customers, regulators and carefully drafted press releases that may need to be jointly negotiated with advice of counsel, auditors, etc. Public disclosures prior to such preparations could harm the economic interests of the parties and, indirectly, the interests of the investors the Commission seeks to protect.
Accordingly, we believe the minimum reasonable period is 5 business days, and that for a one-year transition period it should be 10 business days.
Should Not Apply to Agreements That Expire in Accordance with Their Terms (Not as a Result of an Early Termination)
We do believe no filing should be required under Item 1.02 when the termination of the agreement results from the expiration of a previously filed agreement in accordance with its terms. For example, if a company leases a material facility under a lease that provides for a lease term of January 1, 2002 through January 31, 2004, the company should not be required to file a Form 8-K after January 31, 2004 to report that the lease has expired in accordance with its terms. To the extent material, information about the company's plans following the expiration of its lease will already have been addressed in the company's periodic reports. Similarly, where an agreement provides optional renewal terms, we do not think the company should be required to file a Form 8-K indicating that it has or has not exercised a renewal option.
Item 1.03 Termination or Reduction of a Business Relationship with a Customer
Item 1.03 Should Not Be Adopted
For the reasons more fully discussed below, we have very serious reservations about termination or reduction in a business relationship as the trigger for a required 8-K disclosure. Such a termination or reduction will often be manifested over time as a trend, rather than as a single event or development that can be contemporaneously identified as an event giving rise to a current disclosure obligation. For that reason, we believe the disclosure would be more appropriately addressed under Management's Discussion and Analysis or otherwise, as appropriate, in Forms 10-Q and 10-K. Describing the potential consequences of the reduction in a customer business relationship can best be done in the context of a discussion of overall results, including applicable trend disclosure. We urge the Commission not to adopt this part of its proposal.
It will often be difficult for a registrant to determine whether a termination or reduction has in fact occurred and when that awareness triggers an 8-K filing requirement. The proposed Instruction states that no disclosure is required merely as a result of a reduction or termination of orders unless and until an executive officer becomes aware that a reduction or termination has occurred. However, absent an express notice or agreement to reduce or terminate the business relationship, the registrant's awareness would often be based solely on trend and other soft information suggesting a possible reduction or termination. Furthermore, there could be a gradual deterioration in the relationship that is not appropriately reportable, or even apparent, until the company-wide quarterly MD&A is being prepared. We believe this type of development does not lend itself to Form 8-K reporting, particularly under a short event-driven filing deadline. For example, if a customer starts submitting orders significantly below its historical amounts, or skips one or two months of orders, when does an executive officer become "aware" that a reduction in the business relationship has occurred, as opposed to a response to declining markets or the economy in general? We also note that a reduction may be threatened or used as leverage to exact better terms.
This proposed disclosure requirement is also another requirement that, if adopted, could cause severe economic harm to the company and its investors. In some cases, a termination of an existing relationship might be replaced with another, which may well not be sufficiently finalized to announce within a short time after the termination. Disclosure of the customer loss, standing in isolation, might cause significant loss in market capitalization, create volatility in the market for the company's securities, trigger defaults and funding freezes under agreements having material adverse change clauses, alarm suppliers, etc. Singling out the termination could distort the overall picture. Also, the 10% threshold is too mechanical - a series of under-10% customer losses may sometimes be important to disclose. Yet a simple materiality test would only exacerbate the problems of identification and disclosure described above.
Because we believe that the events addressed by proposed Item 1.03 are more appropriately addressed through MD&A, we believe that proposed Item 1.03 should not be adopted.
Suggestions If Item 1.03 Is Adopted
Deadline. If Item 1.03 is adopted, the same factors that lead us to urge non-adoption also support moving Item 1.03 to our proposed new category of events reportable on a bi-weekly, rather than an event-driven, basis. The significant judgment involved in responding to this Item warrants allowing registrants more time to assess the reportability of this information and use of a scheduled deadline-oriented management process.
Awareness vs. Occurrence. If the Commission determines to adopt proposed Item 1.03, it should clarify that the Item does not create any special duty of inquiry by the registrant in establishing an "awareness" of a termination or reduction in a business relationship.13 Evidence that a registrant should have been aware of such a termination or reduction should not provide a basis for a violation of the Form 8-K filing requirement. It would be very easy with 20/20 hindsight to claim that an officer should have been aware that a termination or reduction has occurred. For this additional reason, we believe that Form 8-K disclosure should be limited to express agreements or understandings among the parties to terminate or reduce the business relationship. We ask for confirmation of our interpretation of proposed Item 1.03.
Affiliated Customer Groups. We agree with the Commission's proposal to require that groups of customers that are under common control or that are affiliates of each other be regarded as a single customer for purposes of the 10% of revenue calculation. However, the Commission should clarify that the disclosure called for by proposed Item 1.03 would not require a listing of each separate entity within the group of entities. Upon reading a long list of affiliated customers that had terminated or reduced a business relationship, investors could easily be misled into thinking that a registrant had lost multiple customer accounts when, in reality, only one customer had made the decision to terminate or reduce its business relationship. Disclosure of only the controlling or "primary" customer would provide investors with the information necessary to make an informed decision about the status of the registrant's business relationships. We ask for confirmation that proposed Item 1.03 would only require disclosure of one entity (e.g., the parent or holding company).
Calculation of 10%. We ask that the Commission clarify the manner of calculating the 10% threshold. We interpret it as requiring the numerator to be the expected loss of revenues in the current fiscal year. However, utilizing current-year expected revenue in the numerator and prior year total revenue in the denominator could cause a customer termination to be reportable even when not particularly significant if current year revenue is otherwise growing significantly; conversely, it could cause a customer termination not to be reportable even if it is significant where current year revenue is otherwise declining significantly from the prior year. The impact of major acquisitions and dispositions on revenues will also distort results. These complexities are also further reasons not to adopt Item 1.03 at all.
Nowhere does the problem of subjectivity present itself more starkly than in the case of current disclosure of financial events. If the changes are adopted as proposed, registrants will be forced to make difficult materiality judgments in a very short time and to craft financial disclosure in isolation rather than in the context of an MD&A presentation. We believe that proposed new Items 2.03-2.06 are not appropriate for event-driven disclosure. We also believe that reporting on a scheduled basis generally would not be a feasible alternative for reporting these types of matters. Instead, we believe these items are appropriate only for MD&A disclosure in a 10-Q or 10-K and should therefore be withdrawn altogether from the 8-K proposal. The Commission's proposals in Items 2.03-2.06 would in effect require almost continuous financial reporting. We believe that if the Commission's goal is to increase the frequency of external financial reporting from the current quarterly requirement, a dramatic move that we believe is currently not feasible, that proposal should be made the subject of a separate rulemaking and be given the exposure and focus it deserves. It should not be part of event-driven 8-K reporting.
Item 2.03 Creation of a Direct or Contingent Financial Obligation That Is Material to the Registrant
This new Item would require disclosure whenever a registrant enters into, or becomes obligated on, a transaction or agreement that creates a material direct or contingent financial obligation. Many ordinary course purchase or sale transactions will require very large financial commitments and would be reportable under this new item. Unlike Item 601(b)(10) of Regulation S-K, which exempts (subject to specific exceptions) from filing material agreements that ordinarily accompany the kind of business the registrant conducts, this new requirement would subject even ordinary course obligations to a current disclosure requirement if material to the registrant. The Commission's question about whether to set specific objective thresholds for disclosure would in theory address the subjectivity that we find most troublesome. Setting objective thresholds, however, has its own set of problems. If a percentage of assets is used, it would disfavor companies that generate their sales on a small asset base, while favoring companies with substantial assets but that might not have the liquidity to satisfy significant financial obligations. Similar problems exist for equity, revenues and net income. The most sensible metric that occurs to us is cash flow from operations, but even that might vary among businesses in different industries. We are simply not sure there is a universal, objective standard that can be applied.
Besides creating identification difficulties associated with subjectivity, selecting "financial obligations" for disclosure is arbitrary. There are many important financial events of significance that may occur and are not captured by the Commission's proposed 8-K items - for example, large one-time expenses other than write-offs, significant gains from modest asset sales and reversals of reserves. All are best described in context through the quarterly or annual MD&A.
We suppose it would be feasible to require event-driven disclosure of direct indebtedness for money borrowed and guarantees of indebtedness, but we question the usefulness of such limited information to investors.
Contingent obligations raise the greatest subjectivity concerns. Existing financial reporting obligations already require booking of a liability for probable (and estimable) contingencies, and footnote disclosure for material possible contingencies (and probable but not non-estimable contingencies). For some, industries, such as property and casualty insurance, for which the entire business model involves a focus on managing contingent obligations, including those that are potentially quite large, we cannot see of how the Commission's proposal could work. In any event, a company's quarterly financial process is the proper one for developing this information. If supplemental disclosure of contingent obligations is to be required, it should be limited to the context of 10-Q and 10-K disclosure.
In addition to our concern about the subjectivity of this Item and the possibility for over-disclosure of ordinary course obligations, we have several additional concerns.
Suppose a registrant wishes to acquire a material amount of equipment. If the registrant enters into an agreement to purchase the equipment, where delivery and payment would occur at a future date, it presumably would have an obligation to make a filing under this new Item. This would be the case even if the registrant had cash sufficient to pay the purchase price at the time it entered into the agreement. However, if the registrant elected to make payment at the time it entered into the agreement, and delivered the cash as a prepayment for future delivery of the equipment, no disclosure would be required. It is not clear to us why those situations should be treated differently.
We also assume that simply entering into a loan agreement, where there is no immediate takedown of funds, would not give rise to a disclosure obligation under the new Item. Would each takedown need to be tested to see whether it is material, and only then the disclosure would be made? Such a system would be cumbersome. If required, entering into the loan agreement should be the triggering event for disclosure, and takedowns should not be required to be disclosed outside financial statement presentations in Forms 10-K and 10-Q.
The new Item would require "a description of events that may cause the obligations to arise, increase or become accelerated." We assume that a brief description of the events of default in a loan agreement, for example, would satisfy this requirement and that it would not be necessary to describe in detail each of the loan covenants and how a breach of the covenants may occur and how the breach, in turn, could result in an acceleration of the obligations. We assume that what is really sought here are unusual events, such as a default, or a significant interest rate increase based on a credit rating downgrade. It would be helpful if the Commission could clarify this reading of the Item in the Instructions that will appear in the Form.
We question how relevant the disclosure is of the name of any underwriter or placement agent that assisted in the transaction giving rise to the obligation and the amount of any fee paid to that person. The Release does not articulate why this information is necessary to accomplish the objectives of the proposal. It does not appear to us to be necessary and, given the amount of disclosure already required, we believe it should be deleted from the new Item.
The new Item calls for management's analysis of the effect of the obligation. Here again, it is not clear what the Commission is asking for, or how this will elicit something different from the description of the nature and amount of the obligation required under paragraph (b) of the new Item. This type of "instant analysis" is unlikely to generate any useful disclosure, and we believe that simple disclosure of the existence of the obligations appropriately addresses the market's need for information. The quarterly MD&A is the appropriate location for any further analysis.
Item 2.04 Events Triggering a Direct or Contingent Financial Obligation That Is Material to the Registrant
This new Item would require disclosure of "triggering events" as defined in the text of the new Item. The new Item is intended to take the place of Item 3, Defaults under Senior Securities, under Part II of Form 10-Q.
This new Item raises the same concerns that we expressed in our comments on Item 2.03 above, but to an even greater degree. For those reasons, we also strongly urge that the disclosures required by this Item be required only in Forms 10-Q and 10-K.
Disclosing "triggering events" would involve even more subjectivity and be more problematic than disclosure of contingent obligations. An unambiguous declaration by a bond trustee of an acceleration following payment default, or even the occurrence of the payment default itself, would be relatively straightforward to disclose. It likely would be promptly disclosed in any event. However, where any variety of "events" may have occurred under joint venture agreements, purchase contracts or any of the myriad other contracts, some very important, that accompany the conduct of every business, requiring disclosure, particularly where only contingent financial obligations may arise, comes close to a continuous disclosure regime.
We believe that "triggering events," unless limited to payment defaults under indebtedness for borrowed money,14 are not susceptible to the type of event-driven 8-K disclosure contemplated by the Commission. In industries such as property and casualty insurance, where the occurrence of "triggering events" is inherent in the business, such a requirement effectively would result in continuous financial reporting.
Would a decision to close a manufacturing plant, resulting in payment obligations under a union contract, be a triggering event? Would the discovery of environmental problems requiring remediation expenditures and reimbursement obligations under an agreement pursuant to which the affected property had been sold, be a triggering event? If so, why should disclosure of that obligation be required immediately, when the same discovery on currently owned property, requiring the same expenditures, would not appear to require disclosure under the Commission's proposal because no agreement is involved? If the Commission does intend to require disclosure in such a situation, the Item 2.04 requirement is in effect a requirement to make event-driven disclosure of all contingent financial obligations. We submit that such a proposal would be completely infeasible.
We also have additional comments related specifically to this Item.
The new Item would require a description of the agreement under which the triggering event occurred. We note that Item 2.03 requires a "brief" description of the agreement, whereas the requirement to include a description of an agreement related to a reportable triggering event required by Item 2.04 is not modified by "brief." The standard should be the same, and it should be the "brief" standard. In addition, no description should be required of an agreement that has been previously described in a Form 8-K, 10-Q or 10-K.
The proposal asks registrants to discuss management's analysis of the effect on the company of the triggering event. In many instances the company is trying desperately to address the business issues surrounding the triggering event. There may be precious little time for the type of thoughtful analysis that the proposal contemplates. In any event there are likely to be too many uncertainties to present a balanced picture outside the context of complete quarterly or annual results. Investors will be aware of the event; waiting for the analysis until the next Form 10-Q is filed will not put them at a substantial disadvantage.
The same concerns are present in this Item as in Item 2.03 with respect to the need for an objective financial measure for disclosure. Choosing a "one size fits all" standard does not recognize the substantial differences that exist among registrants. Although objectivity is a desirable standard, we are concerned that it is simply not achievable here.
Delaying disclosure while a registrant is negotiating a waiver or amendment to the triggering event seems to us to be a sensible provision. As the Commission noted in asking for comment, premature disclosure would frustrate the purpose of the negotiations and unduly harm the interests of the registrant and, ultimately, the investors.
If, despite our strong view against its adoption, Item 2.04 is adopted substantially as proposed, we believe that Item 3 of Part II of Forms 10-Q and 10-QSB would not be necessary and should be deleted.
Item 2.05 Exit Activities Including Material Write-Offs and Restructuring Charges
This new Item would require disclosure when the board of directors or management definitively commits to an action that will result in a material write-off or restructuring charge under generally accepted accounting principles. We are concerned that this requirement is in most cases impossible to disclose outside the context of a complete quarterly or annual financial presentation in MD&A. Singling out write-offs and restructuring charges (proposed Item 2.05) and impairments (proposed Item 2.06) appears to us to be selecting arbitrary income statement events. Why should they be inherently more significant than any other financial event having a material effect on income or expense? We believe the premise behind requiring this type of disclosure is flawed, and that no 8-K reporting of these types of financial items should be required.
The adoption of this new Item could lead boards of directors to delay making decisions to close down lines of business, for example, until the necessary analysis is done and a draft of the Form 8-K prepared or until the next 10-Q or 10-K. The company might also be negotiating for the sale of assets or some other related transaction that premature mandated disclosure could jeopardize.15 Disclosure requirements should never force businesses to make or delay making decisions that are otherwise appropriate for the proper operation of the business. Currently, registrants would include an analysis of decisions to exit businesses in a Form 10-Q or Form 10-K, which permits the type of careful analysis that these activities warrant. We believe that is all that should be required. If the Commission nevertheless believes this Item should be retained, we strongly recommend that it be moved to the new bi-weekly category we propose and be triggered only by resolution of all material pending issues.
Because we believe that these disclosures are not appropriate for accelerated disclosure, we also believe that updates to estimates should not be required to be disclosed. Such a requirement would also present timing issues, because it would be difficult to determine precisely when the change occurred.
Item 2.06 Material Impairments
Our comments on write-offs apply to this new Item as well. The analysis and disclosure of impairments should be made only in the context of an MD&A discussion of overall quarterly or annual results.
Furthermore, the extensive and often sophisticated valuation analyses required to support an impairment decision may require even greater judgment than required for events covered by proposed Item 2.05. Given that these valuations are often performed only at the time financial statements will be published, we believe requiring 8-K reporting will not produce sufficient acceleration of information into the marketplace to justify the problems it will create for registrants in the few instances it may apply.
Item 3.01 Rating Agency Decisions
Item 3.01 Should Not Be Adopted
As a general matter, we believe that a company should not be required to file reports with the Commission as a means of improving the dissemination of third-party information about the company. Third parties publish a wide range of information that investors may find newsworthy, including not only rating agency decisions, but also research reports of securities analysts, reports published by industry analysts and newspaper articles. This information is available to investors from various sources, including free Internet-based services that automatically collect and consolidate information on a company-by-company basis. Given the existing availability of information and the legitimate desire of companies to avoid becoming "entangled" with this information from a liability perspective, we believe that the marginal additional benefit to investors of mandatory Form 8-K filing of information published by third parties and widely available to investors does not justify the risks and burdens to companies.
We believe this general principle is certainly applicable in the case of rating agency decisions. First, as noted in the Release, rating agencies typically issue press releases announcing rating changes. As a result, information about rating changes is already readily and promptly available to investors. In fact, the market usually knows that a company's ratings are under review or a stated negative outlook. In these circumstances, the company's securities may trade down in anticipation of the expected downgrade. In any event, the impact of the rating change or expected rating change will be reflected in the prices of the company's securities, providing, along with other information available to the marketplace, some measure of protection to actual and potential investors from their own lack of knowledge about the rating if they trade. Accordingly, we believe proposed Item 3.01 is not necessary or useful and should not be adopted.
Suggestions If Item 3.01 Is Adopted
If the Commission nevertheless decides to proceed with a requirement that some rating agency decisions be disclosed on Form 8-K, we recommend the following changes to proposed Item 3.01:
Item 3.02 Notice of Delisting or Failure to Satisfy Listing Standings; Transfer of Listing
We believe that it is appropriate to require prompt reporting on Form 8-K of (1) a company's receipt of any written notice from its principal trading market to the effect that the company does not meet the market's listing requirements and (2) the actual delisting of a company's securities. In almost all cases, the underlying reason for a company's receipt of an initial deficiency notice is the failure to meet a quantitative listing requirement that is readily and objectively determined by reviewing the company's trading price or its most recent financial statements. The company should be aware of this development well in advance and have time to prepare for the consequences, including a required 8-K filing. In light of this, we believe companies would not be unreasonably harmed by promptly disclosing the receipt of an initial deficiency notice.
We do, however, believe there is little or no benefit to filing the actual notice received from the national securities exchange or national securities dealers association, since the material information contained in the notice can be summarized in the text of the Form 8-K.
Since we understand it is the practice of the national securities exchanges and national securities dealers association to provide notices of listing deficiencies in writing, we believe that the Form 8-K filing obligation should only be triggered by receipt of a written notice.
Finally, we believe it would be helpful in the adopting release to specifically identify the forms of notices currently being used by the major markets, the receipt of which would trigger a filing obligation under Item 3.02. In the case of Nasdaq, our understanding is that Nasdaq refers to its initial communication as a "Deficiency Notice," which is then followed by a "Staff Determination Letter" and, in the case of a company that requests a hearing before the Nasdaq panel prior to delisting, by a "Listing Qualifications Panel Decision." In the case of the New York Stock Exchange, our understanding is that the NYSE refers to its initial communication as a "Below Compliance Letter," which is then followed by a "Suspension and Delisting Notice." In the case of the American Stock Exchange, our understanding is that the AMEX refers to its initial communication as a "Deficiency Notice," which is then followed by a "Delisting Confirmation."
Item 3.03 Unregistered Sales of Equity Securities
We believe that it is appropriate to require event-driven reporting on Form 8-K of material sales of equity securities that are not registered under the Securities Act. However, we recommend that proposed Item 3.03 be modified as follows in order to minimize the potential burden to companies of being required to file frequent Form 8-Ks reporting immaterial transactions:
The Commission should state in an instruction to Item 3.03 that disclosure made in a good faith attempt to comply with Item 3.03 will not constitute a general solicitation or offer for Securities Act Section 4(2), Rule 144A or Regulation D purposes or constitute directed selling efforts for Regulation S purposes.
While we believe it is not necessary for the Commission to define the word "sale" as used in Item 3.03, we believe it would be helpful to repeat in an instruction to Item 3.03 the current second sentence of Item 701 of Regulation S-K, which reads as follows: "Include sales of reacquired securities, as well as new issues, securities issued in exchange for property, services, or other securities, and new securities resulting from the modification of outstanding securities."
Finally, we believe there is no value to re-reporting on the next Form 10-Q or 10-K unregistered sales of equity securities that have already been reported under Item 3.03.
Item 3.04 Material Modifications to Rights of Security Holders
We believe that it is appropriate to require prompt reporting on Form 8-K of material modifications of rights of security holders.
Item 4.02 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report
We agree that withdrawal of previously issued financial statements or a previous audit report should trigger Form 8-K reporting.
Given the sensitivity of this type of disclosure, and the extent of analysis that may be required to produce the relevant disclosure, including possible quantification of the effect of the triggering event on the financial statements, we believe it is especially important that the deadline afford registrants sufficient time. Accordingly, we suggest at least 5 business days (10 business days during the proposed one-year transition period). The additional time would also permit the disclosure to be reviewed, and possibly revised, by the independent auditor before it is filed, thereby avoiding the two-step disclosure contemplated by the proposal, which creates the potential for market uncertainty for an indefinite period between the registrant's disclosure and the possible filing of the auditor's response.
Non-Reliance on Financial Statements. Given the relatively short deadline (i.e., the 5 business days we propose, 10 business days initially), we recommend that the Commission clarify the precise events that will trigger this requirement in respect of non-reliance on financial statements. The standard proposed ("should no longer be relied upon") is not sufficiently clear with respect to financial statements. Does this mean there has occurred an event that under generally accepted accounting principles would require restatement? While we understand that correction of a material error should be the type of such restatement event warranting 8-K disclosure, that should not be the case for a stock split, which also requires a restatement under GAAP but will undoubtedly have already been promptly disclosed pursuant to stock exchange requirements and does not undermine the usefulness of prior financial statements. Therefore, we doubt that GAAP restatement was the Commission's intended standard. In any event, we urge the Commission to clarify the trigger event and base it on a more objective standard.
We infer from one of the Commission's questions in the Release that the "financial statements" subject to proposed Item 4.02 are limited to annual financial statements, and would not include unaudited condensed or interim financial statements of the type included in Form 10-Q. We agree that the required disclosure should be so limited and request that the Commission clarify that.
Non-Reliance on Audit Report. We believe the proposed standard for triggering disclosure about withdrawal of an audit report is sufficiently clear. However, to provide certainty we urge the Commission to clarify that the notice must be in writing and delivered to the registrant's principal financial or accounting officer.
Item 5.01 Changes in Control of Registrant
We support the proposed changes to current Item 1 of Form 8-K, including the revised source of funds disclosure. We also concur with the Instruction permitting the registrant to satisfy the proposed Item 5.01 requirements by reference to a prior report.
The Commission may want to consider taking this opportunity to clarify the scope of the current Form 8-K Item 1 disclosure requirement in proposed Item 5.01. Although the heading of Item 1 refers to changes of control of the registrant, the scope of the Item is in fact broader, because of Item 1(b)'s reference to Item 403(c) of Regulation S-K. Item 403(c) requires disclosure of any "arrangements" that may "at a subsequent date result in a change of control." Accordingly, the Item is triggered not only by an actual change in control, but by any arrangement that may result in a change in control (for example, a merger agreement). We suggest that the Commission change the heading of this Section to reflect potential changes in control. In addition or alternatively, the Commission may also wish to restate the requirements of Item 403(c) of Regulation S-K in the text of proposed Item 5.01(b), rather than simply providing an internal reference.
Item 5.02 Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers
We support the proposals to expand the event-driven Form 8-K disclosure requirements regarding resignations and appointment of directors and principal officers. Current Item 6 is too narrow in requiring disclosure only in those instances where a director resigns or declines to stand for reelection due to a disagreement with management and provides a letter to management describing that disagreement. We believe, however, that the two-step process envisioned by proposed Item 502(a) can be streamlined. We believe that most (if not all) registrants would prefer that the director review the Form 8-K prior to its initial filing and thus avoid the possibility of a second, corrective filing.
Indeed, rather than require the registrant to characterize the director's reason for the resignation in the first instance and apply the Item 5.02(a) procedure only when the registrant has concluded that the resignation resulted from a disagreement, the registrant in all instances should have an obligation to advise a departing director of his or her opportunity to submit a letter explaining the reason for the resignation or decision not to stand for reelection. If the departing director provides a letter describing a disagreement within a stated timeframe (for example, two business days), then the registrant would have to follow the proposed Rule 5.02(a) procedures. If not, the registrant would follow the Item 5.02(b) procedures.
We believe a reasonable filing deadline would be at least 5 business days (10 business days during the one-year transition period). In most cases, this would also provide registrants with sufficient time to prepare and file the full and correct description of the reasons for a departing director's decision in the first (and hopefully only) Form 8-K filed with regard to such matters, rather than, as we believe would be the case, providing information that would often need to be amended shortly after the initial Form 8-K is filed.
The announcement of officer changes must also be carefully timed for legitimate reasons to provide a smooth transition, such as co-ordination with past or new employers, private introductions to or discussions with internal working groups and outside interests. The deadline suggested above would accommodate those needs.
We believe that it is unnecessary and in some cases inadvisable to disclose the reasons for officer changes. If the company wishes to provide the disclosure, it can. However, there are many situations where disclosure would be undesirable. To minimize exposure to litigation (e.g., defamation or reputational damage to the individual), companies may wish to understate the real reason for the change, but could then be subject to potential liability for misleading disclosure. Companies should not be forced into such a conundrum.
We believe that the proposal to require disclosure of officer changes covers too many positions. While the officers listed are undoubtedly the most important ones, we believe the suggested disclosure should cover only the principal executive officer, the principal financial officer and, if different, the principal accounting officer. Those are the persons most in control of business, financial and accounting policy and practices and whose departure (or change) would be of most interest to investors.
Some reporting companies have no publicly traded or listed equity securities, yet are required (or elect) to report under Section 15(d) because they engage in their own separate debt finance activities through registered offerings. In such controlled and/or joint venture arrangements, "parent companies" provide the directors of the reporting companies to ensure such companies follow the policies dictated by the parents. The top officers of such companies likewise are indirectly controlled by the parents. In such circumstances, changes in directors or officers are usually for the convenience of the parents or reflect succession planning at the parent level and would not likely be of any interest to the company's investors or signify any change in policy or direction of the company. Accordingly, we urge the Commission not to apply Item 5.02 reporting to companies having no publicly traded equity securities.
Finally, we concur, for the reason provided, with the Commission's conclusion that the proposed Item 5.02(a) procedure should apply only to directors.
Item 5.03 Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year
We support the proposal to require event-driven disclosure of an amendment to the registrant's articles of incorporation or by-laws. We note that the Commission has not proposed to amend Item 601 of Regulation S-K to require that the registrant's amended articles of incorporation or bylaws be attached as an exhibit to the Form 8-K. Accordingly, the proposal calls for disclosure of the amendment itself in a Form 8-K, but would not require filing of the amended document or documents until the registrant's next Form 10-Q or Form 10-K filing. If the Commission determines that this is not its intended approach, Item 601 should be amended not only to require the filing of the amendment with the Form 8-K, but also to provide relief from the requirement of Item 601(b)(3) that "a complete copy of the [articles or by-laws] as amended shall be filed." At a minimum, the Commission should confirm that Item 601(b)(3) does not require that the registrant prepare a restated version of the articles and by-laws solely for filing purposes.
We submit that changes to an issuer's articles of incorporation and bylaws are generally irrelevant to Section 15(d)-reporting companies, which have no publicly traded equity securities. If there are changes that impact the rights of such companies' debt investors, those would be required to be reported on an event-driven basis pursuant to Item 3.04 and, in any event, in the next 10-Q or 10-K. We urge that Item 5.03 not apply to companies having no equity securities registered under Section 12.
Item 5.04 Material Events Regarding the Registrant's Employee Benefit, Retirement and Stock Ownership Plans
We believe that proposed Item 5.04 has been rendered moot by the Sarbanes-Oxley Act of 2002 and should be withdrawn. Section 306(b) of the Act mandates that the plan trustee or issuer provide affected plan participants 30 days' advance notice of "blackout periods." We note that proposed Item 5.04 would be somewhat broader in that it would require disclosure about any event "materially" limiting participants from effecting transactions in plan holdings. Nevertheless, we believe that the Commission should respect the Congressional intent implicit in Section 306(b) that other restrictions need not be disclosed. Also, ERISA already requires that plan sponsors give notice to participants regarding the timing of black-out periods as well as other material events relating to the plans.
Even if the Commission wishes to expand the notice requirements of Section 306(b) of Sarbanes-Oxley, we believe that Form 8-K is not the appropriate means to disseminate information to employees concerning a material limitation or restriction on their ability to conduct transactions in their employee benefit plans. Form 8-K should be reserved for highlighting information material to market participants. As proposed, Item 5.04 would have exactly the opposite function because it would excuse filing when the restriction or limitation results from the actual or potential possession of material non-public information that may be material to market participants. The Commission should craft an alternative mechanism for ensuring that participants are alerted to administrative restrictions or limitations on plan transactions. For example, the Commission could propose an amendment to Rule 428 to require that the Form S-8 prospectus be supplemented to reflect any such restrictions or limitations on plan transactions.
A. Loss of S-3 Eligibility
Timely filing of all Forms 8-K within the previous 12 months is currently a requirement for eligibility to use Form S-3 (and short-form disclosure in Form S-4). The significant increase in the number of new reportable events, the difficulty in determining whether and when materiality thresholds have been passed and the difficulty registrants might have in preparing the necessary disclosure within short timeframes make it imperative that this requirement be changed to one requiring that all required 8-K filings have been made (as for Form S-8), but not necessarily that they have been timely filed. If the Commission wishes to retain the requirement that all periodic reports (i.e., Form 10-Q and Form 10-K) have been timely filed during the previous 12 months, we would have no objection. There are probably few excuses for an issuer not filing a 10-Q or 10-K report on time, especially given the relief afforded by Rule 12b-25, and a failure to file on a timely basis may suggest some difficulty for which a 12-month Form S-3 ban might be appropriate. For the new Form 8-K items, however, there may be many legitimate reasons why a registrant would have difficulty making a timely filing, and as discussed below, there is no practical relief afforded by Rule 12b-25. So long as all required Form 8-Ks are filed before the issuer files on Form S-3, the use of the Form should be permitted.
The Commission has asked whether currentness should be a condition to shelf takedowns. There is no such requirement now, and we believe that there is no need to impose additional impediments in the capital-raising process. The requirements of Section 11 and Section 12(a)(2) under the Securities Act provide sufficient incentives for issuers to make sure that information that is required in the registration statement or prospectus, or that is necessary to make the information included not misleading, will be included at the time of a shelf takedown.
B. Liability Issues - Additional Safe Harbor Proposals
Issuer Safe Harbor
The expanded list of items triggering an 8-K filing requirement will place an extraordinary burden on issuers. Even if the Commission adopts many of the suggestions in this letter, there will still be numerous instances in which issuers will have difficulty determining whether and when an event is one that is required to be disclosed. This difficulty will arise first because the accelerated filing requirement will in many instances deny the issuer the time required to fully assemble and review related facts that bear upon the materiality of an event or the 8-K-required disclosure. In addition, counsel and other advisers will similarly often be denied sufficient time to understand the full relevant factual background and therefore to offer management adequate advice. Issuers will be subject to second-guessing as to whether a lower-level employee's awareness of an event (or the employee's view of its materiality) should be attributed to senior management and as to whether management's judgment about a disclosable matter and its materiality is correct.
Issuers will inevitably adopt procedures designed to mitigate these difficulties, as contemplated by the limited safe harbors proposed by the Commission and recently adopted Rules 13a-15 and 15d-15.16 Given the novelty of the challenges mentioned above, however, such procedures will not be developed overnight. Under these circumstances, it would be manifestly unfair to expose issuers to the threat of civil litigation for failures to comply with the new 8-K requirements.
The Commission states that "Form 8-K items ... historically have been subject to liability under all relevant sections of the Exchange Act." This is true but does not tell the full story. A requirement to file Form 8-K has historically been triggered only by the occurrence of a relatively small number of concrete, tangible events. In our experience, there have been relatively few - perhaps no - situations where anyone has been in doubt about whether a Form 8-K had to be filed with the Commission. Obviously, this is about to change.
The safe harbors should not be limited to protection from Commission enforcement action for non-disclosure, but should also extend to private liability. In this connection, the Commission should follow a path similar to the one it followed two years ago when it imposed an equally novel reporting requirement on issuers in Regulation FD. There, the Commission provided simply and directly that failures to make disclosures required solely by Regulation FD would not be deemed to be violations of Rule 10b-5. The disclosures themselves, when made, were of course fully subject to potential Rule 10b-5 liability.
In the absence of such a safe harbor, issuers can be legitimately concerned about potential private Rule 10b-5 liability based on allegations that a failure to file an 8-K or a late filing breached a "duty to disclose." The Commission confirmed this concern by stating in its 2000 adopting release regarding Regulation FD that "other [non-FD] reporting requirements under Section 13(a) or 15(d) ... do create a duty to disclose for purposes of Rule-10b-5."17 The safe harbor we propose would merely clarify that the new 8-K regime proposed by the Commission, like the Regulation FD regime, does not by itself create a duty to disclose as to which a breach could result in private Rule 10b-5 liability. The Commission would remain free to bring enforcement action for failure to file an 8-K or for late filing. Of course, it is important to note that once an issuer has made an 8-K disclosure, it would have full responsibility for the disclosure, including Rule 10b-5 civil liability if the disclosure is materially false or misleading.
The situation faced by issuers in light of the Commission's proposal to expand 8-K reporting is strikingly similar to the situation when Regulation FD was proposed. Although the 8-K proposal is technically in the form of an amendment to existing requirements, in substance it represents the creation of an entirely new reporting regime. For the first time, Commission rules will require ad hoc disclosure of a broad range of highly subjective and soft "events." Previously, such subjective disclosures were required only on a quarterly basis or under issuer-controlled circumstances such as in the context of a disclosure document used for capital-raising or to the extent necessary to prevent a voluntary public disclosure from being materially misleading. Mandatory 8-K events were limited in number and objectively determinable. The new requirements are so different as to be a new regime with the potential for expanded exposure to private lawsuits based on a failure to disclose required information and to do so timely.
Under these circumstances, it seems entirely appropriate, as the Commission did in connection with the adoption of Regulation FD, to protect issuers from private Rule 10b-5 liability based solely on the failure to file an 8-K.
If such a safe harbor were adopted, we believe it would not be necessary to extend the safe harbor to include false or misleading disclosures in a filed Form 8-K. Assuming that an event has come to the issuer's attention and triggered a filing, it is not too much to ask that the disclosure be accurate and not misleading in a Rule 10b-5 sense. It should be possible to describe any ambiguities regarding the event in the Form 8-K.
Nor do we believe that it would be necessary for the Commission to extend such a safe harbor to Section 11 of the Securities Act, at least insofar as issuers are concerned. It is true that the expanded list of items triggering a Form 8-K will increase the number of "material facts required to be stated" in the registration statement, thus expanding potential liability for omitted statements beyond the otherwise-applicable standard of whether or not the omission rendered misleading other statements contained in the registration statement. On the other hand, an issuer that is about to sell securities registered under the Securities Act should be focusing on whether its Exchange Act disclosure record, as incorporated by reference into its Securities Act registration statement, is complete and accurate.
In considering our safe harbor proposal, we have deliberately not suggested that availability be conditioned on good faith of the issuer or compliance with the conditions of proposed Rules 13a-11 and 15d-11 - in other words, maintenance of procedures satisfying those rules and absence of executive officer knowledge. We did so because such a more limited safe harbor from private liability would be far less effective in preventing undesirable litigation. This is because the viability of the private claim may turn on questions of fact about issuer procedures and executive officer knowledge, thereby precluding adjudication on a motion to dismiss or other early stage and subjecting issuers to the very discovery and similar litigation burdens that a safe harbor should be designed to prevent. As a result, a safe harbor with such conditions will be of significantly less assistance to issuers in avoiding non-meritorious class actions.18
Underwriter Safe Harbor
The same Section 11 burden cannot and should not be placed on underwriters. We have suggested before to the Commission that registered public offerings of reporting companies, particularly takedowns from a shelf registration statement, often are executed under conditions of such extreme time pressure that underwriters in these transactions should be entitled to a safe harbor from Section 11 liability. It should be apparent that it will be impossible for underwriters of such offerings to do more than rely on an issuer's assurances that it has made all required Form 8-K filings.
Text of Proposed Safe Harbors
Accordingly, we would suggest that the Commission adopt the following safe harbors as, when and if it adopts the expanded list of events triggering a Form 8-K filing requirement. It should be noted that the safe harbors proposed below would apply only to private actions and not to Commission enforcement proceedings.
Effect on Antifraud and Securities Act Liabilities
C. Specific Comments on Proposed Safe Harbor and Amendments to Rule 12b-25
Commission's Proposed Safe Harbor
We believe that the safe harbor from private liability described above would be of far greater assistance to issuers than the Commission's safe harbor in proposed Rules 13a-11 and 15d-11. Nevertheless, we believe the Commission's proposed rules are generally appropriate and should be retained. However, the reference to "absence of knowledge by any officer, employee or agent" is so broad that it almost completely eliminates the relief. An employee somewhere within the enterprise will almost certainly have been aware of underlying facts and could be alleged to have had some responsibility for knowing that an 8-K may have been required. The reference to agents could pick up outside agents, who may have only partial knowledge of the necessary facts or have no reason to believe the issuer is not making a required filing and thus no reason to take steps to press the issuer to file. Accordingly, we urge that the phrase be changed to refer to knowledge only of executive officers, or at least knowledge only of officers.
Proposed Rule 12b-25 Amendments
A Rule 12b-25 cure for a delinquent Form 8-K filing is not an appropriate approach. Without disclosure of the subject matter of the tardy filing, the market will over-react and drive market value from the company's capitalization. It will be difficult for a company to provide a partial description of the subject matter of the upcoming report without causing market turmoil. Investors would not be protected or served by partial disclosure of a material, reportable matter. This is particularly true where developing events or analysis might render the report unnecessary, such as where a default might be waived or otherwise avoided.
Furthermore, the qualifying standard for use of the rule, "not able to file in a timely manner without unreasonable effort or expense," may be inapplicable in some cases. The company may not be certain a triggering event has occurred or what the exact ramifications are or it may conclude that disclosure when required is premature or otherwise not in the best interests of the company and investors. These reasons would not qualify under the Commission's proposed standard.
For these reasons, while we do not object to the proposed Rule 12b-25 amendments, we believe that in practice they will almost never provide issuers relief, and the Commission should not assume that this Rule will ameliorate the consequences of issuers' inability to meet the proposed 2-business day filing deadlines.
Even if all of our suggestions are reflected in the Commission's final rule, the extent of the impact of the new mandatory 8-K disclosures will be far greater than we can foresee today. Most of the new disclosures will require issuers to engage additional staff and develop entirely new internal procedures to identify disclosable events and prepare disclosures. Disclosure of many of these events will for the first time be triggered by subjective matters. Accordingly, we strongly urge the Commission to allow a transition period.
First, the new requirements should have a deferred effective date. We believe the new requirements should not become applicable while issuers are preoccupied with responding to new disclosure procedure requirements driven by Section 302 of the Sarbanes-Oxley Act, or while issuers are in the midst of preparing their annual financial statements and annual report on Form 10-K. Accordingly, we suggest an effective date of the later of 6 months from adoption or 30 days after the filing of the issuer's next Form 10-K.
Second, the new requirements should have more lenient deadlines during their first year of operation. During this transition year, the "bi-weekly" 8-K items should cover one-month periods and be due 30 days after the end of each month. The date for event-driven items should be 10 business days, rather than the 5 business days we propose. The extended time for filing would allow issuers to adjust their internal staffing and processes to meet the new deadlines. Experience may also demonstrate that some amendments by the Commission to the deadlines or the substance of the requirements may be needed. A transition period would allow experience to be gained without placing undue burdens or risk on issuers.
Finally, we recommend that the above "transition" deadlines be retained permanently for small business issuers. We believe that filing deadlines for Form 8-K appropriate for larger companies are simply not realistic for small business issuers that have limited staffs, limited resources to engage outside securities counsel and are all too often stretched thin in meeting operating and regulatory demands. We urge that the Commission retain the proposed transition Form 8-K filing deadlines as the permanent deadlines for small business issuers.
Section 409 of the recently enacted Sarbanes-Oxley Act of 2002 amends Section 13 of the Exchange Act to require all reporting issuers to disclose publicly, on a "rapid and current basis," such additional information as the Commission by rule may require. We believe the practical effect of this provision is Congressional endorsement of the concept behind the Commission's 8-K proposals, and reinforcement of the Commission's authority to require the new 8-K events proposed. We believe it does not require any change in the Commission's proposal and does not affect the appropriateness of our comments in this letter on that proposal. We also believe that "rapid and current" does not mean two days or five days or any particular number of days and can indeed mean any timeframe that calls for disclosure in an expeditious manner, giving all due accommodation to the need to take into account the inherent harm to investors than can come from premature disclosure.
In particular, we respectfully urge the Commission to continue its approach of mandating disclosure of particular events, consistent with the historical philosophy and approach of the securities laws.
Finally, we note that Section 409 specifically states that the disclosures it contemplates may include trend disclosure. We believe this provides further support for future efforts by the Commission to enhance the requirements for disclosure in MD&As. Given both the importance of good MD&A disclosure and the challenge of drafting appropriate MD&A disclosure, we believe any such effort should allow for a substantial public comment period.
B. Foreign Issuers
We concur in the Commission's proposed continued exemption of foreign private issuers from the Form 8-K current reporting mandate, continuing the Commission's reliance on foreign private issuers' home country disclosures to provide interim disclosure to investors. This long-standing Commission policy recognizes the need to accommodate the widely varying corporate laws and business structures, corporate governance policies and practices and disclosure and financial reporting regimes governing foreign private issuers.
Throughout its history, the Commission has sought to assure that U.S. investors receive sufficient information from foreign private registrants while at the same time providing accommodations to those registrants' home country laws and practices so as not unduly to deter foreign companies from participating in the U.S. public capital markets. U.S. investors have been well served by the Commission's approach, which has encouraged hundreds of foreign private issuers from around the world to register their securities with the Commission and provide American investors the opportunity to trade foreign securities in the U.S. market subject to direct Commission oversight. Great care needs to be taken that any change to the regulatory regime applicable to foreign private issuers does not disrupt this balance between the interests of U.S. investors' need for information and accommodations to registrants' home country laws and practices, and cause foreign private issuers to avoid the U.S. public market. Such a consequence would relegate U.S. investors who want to invest in these companies to the offshore or private markets, beyond the active oversight of the Commission. With the increasing integration of the European capital markets, the Eurozone is an increasingly strong competitor to the U.S. capital markets.
Any proposal to change the Commission's policy of reliance on home market disclosure for interim reporting would represent a fundamental change in the regulatory regime that existing foreign registrants believed they had agreed to in entering the U.S. market. Before initiating any such change, we strongly urge the Commission to undertake a considered and extensive review of the potential implications of such a change in policy, in consultation with the foreign private issuer community as well as investors, financial intermediaries and other affected constituencies. The full ramifications of such a change in policy should be explored in the context of a discrete, defined initiative focused on the specific issues of interim reporting of foreign private issuers, and not simply as a "tag on" to rulemaking principally focused on reporting obligations of domestic issuers.
Therefore, in response to the Commission's specific inquiries, we strongly recommend that the Commission not amend Form 6-K either to mandate specific current disclosures or to add to the illustrative list of matters that may be material. Many in the foreign private registrant community are already highly concerned about implications for them of the Sarbanes-Oxley Act, which they perceive to have been passed with little consideration for the particular needs and concerns of foreign private issuers. We believe the Commission could go a long way in helping to address these concerns by providing the foreign private registrant community the opportunity to have a meaningful dialogue with the Commission on the appropriate regulatory regime for these companies before any changes are made to their reporting mandates. Moreover, we think it would be ill-advised to begin a reconsideration of the reliance on home country disclosure for interim reports on a piecemeal basis starting with the Form 8-K.
Proposed 8-K Reporting of Insider Transactions. In the Commission's recent release on the Section 16(a) rule amendments mandated by the Sarbanes-Oxley Act, the Commission noted that it was still considering its proposal to require 8-K reporting of Rule 10b5-1 plans and certain loans to insiders.19 We have previously commented on those proposals and believe they should not be adopted. If the Commission nevertheless decides to require some form of reporting by issuers of that information, we urge that a new report form be created, which would not be incorporated by reference into Securities Act filings or considered a "periodic report" for currentness purposes of Securities Act rules and forms.
Proposed 8-K Reporting of Codes of Ethics. We note that Section 406(b) of the Sarbanes-Oxley Act requires the Commission in a future rulemaking to mandate 8-K disclosure of changes in or waivers to codes of ethics for senior financial officers. We expect to offer comments on those proposed rules when published for comment by October 28, 2002, as required by the Act.
We appreciate the opportunity to submit comments. We are available to meet with the Commission or the Staff and to respond to any questions.