America's Community Bankers

December 9, 2002

Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments As Directed By Section 13(j) of the Securities Exchange Act of 1934, Added By Section 401(a) of the Sarbanes-Oxley Act of 2002
File No. S7-42-02; Vol. 67, No. 217 FR 68054 (November 8, 2002)

Dear Mr. Katz:

America's Community Bankers ("ACB")1 is pleased to comment on the proposed rule2 to implement section 401(a) of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley").3 Section 401(a) of Sarbanes-Oxley requires disclosure of off-balance sheet transactions, arrangements, obligations (including contingent obligations) and other relationships of an issuer4 with unconsolidated entities or other persons that have, or may have, a material effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

This comment letter addresses two issues on which the Securities and Exchange Commission ("Commission") requested comment. The first issue is the definition of off-balance sheet arrangements covered and required to be disclosed under the proposal. The second topic is the presentation of the balance-sheet information, including the Commission's proposed tabular format and placement of the off-balance disclosure within the Management's Discussion and Analysis ("MD&A").

ACB Position

Sarbanes-Oxley was enacted to strengthen public company corporate governance and financial disclosure in an effort to restore investor confidence in the public markets. Generally ACB agrees with the goal of improving the transparency of a company's off-balance sheet arrangements, including providing an overview of contractual obligations and contingent liabilities and commitments. Providing investors the necessary information and analysis to have a comprehensive understanding of the issuer's financial condition and operations is important in this process. ACB strongly supports the Commission's view that management is in the best position to provide the explanation and analysis to investors.

However, ACB believes that the threshold for determining which off-balance sheet items are to be disclosed is too low. We are concerned that the voluminous data that may be required may have the effect of confusing rather than enhancing an investor's understanding. We suggest that a more appropriate standard for disclosure should be the "reasonably likely" threshold applicable to other areas of the MD&A rather than the proposed lower "remote" threshold. A higher threshold would reduce the risk of the issuer presenting unimportant information. Consistent with the belief that management is in the best position to understand its off-balance sheet arrangements and their importance to the public company, we believe that the issuer should have the maximum flexibility of determining the placement of off-balance sheet disclosures within the MD&A.

Finally, ACB strongly urges the Commission to coordinate with the banking regulators and accounting standards setting bodies as these regulations are finalized.

Off-Balance Sheet Arrangement Definition and Disclosure

ACB supports the Commission's position that it is necessary to limit the definition of off-balance sheet arrangements to "filter out disclosure of insignificant details." We agree with the proposal to restrict the off-balance sheet definition to contractual obligations. The proposal requires disclosure of items only to the extent necessary to permit an understanding of the effect of the off-balance sheet arrangements, the registrant's financial management, changes in financial condition, revenues, expenses, results of operations liquidity, capital expenditures and capital resources. In drafting the proposal, the Commission acknowledges the need to deviate from the specific language of Section 401(a) of Sarbanes-Oxley "to aid companies in disclosing off-balance sheet arrangements that warrant more focused and precise disclosure. An overly broad definition could elicit unnecessarily voluminous and repetitive disclosure."5

"Reasonably Likely" Threshold Preferable to "Remoteness" Standard

The proposal includes a remoteness standard as a threshold for determining disclosures. The proposal would require "disclosure of off-balance sheet arrangements under circumstances where management concludes that the likelihood of occurrence of a future event is higher than remote."6 ACB believes that both the range of transactions included in the off-balance sheet arrangement definition and the "remoteness" threshold runs counter to the intent of "filter(ing) out disclosure of insignificant details". The basis for the Commission's proposed use of the "remoteness" standard lies in its interpretation of Section 401(a) of Sarbanes-Oxley.

ACB's view is that the term "may" should be interpreted to include those off-balance sheet arrangements, contingencies and commitments that have and are likely to have an effect on the financial condition, operation, and cash flows of the issuer based on management's assessment. We suggest the "reasonably likely test" currently used to determine whether disclosure is required in other parts of the MD&A is a more appropriate threshold standard than the broader proposed threshold of "remoteness".

The adoption of a lower standard will require the issuer to disclose and analyze a great deal of information. Such disclosures will place a disclosure burden particularly on financial companies without commensurate benefit to investors who also will have to wade through voluminous disclosures and distinguish which information is most useful to them. Financial companies engage on a regular basis in a large number of off-balance sheet transactions, many of which likely will not have a impact on the company's financial condition but potentially may be interpreted as having a greater than "remote" impact. For instance, a significant number of publicly traded issuer banks securitize mortgages and sell loan pools as a regular course of business. Many of these structured transactions may not be expected to have an effect but, arguably, it is possible that they may have more than a "remote" impact. Inclusion of all such transactions may add little to an investor's understanding of the bank but require investors to go through a wealth of information that is less critical to an understanding of the issuer.

In addition, the "reasonably likely" test is the threshold for inclusion in other sections of the MD&A. For consistency and enabling the investor to understand what are significant, consistent standards throughout the MD&A make sense. Therefore, ACB strongly urges the Commission to adopt a "reasonably likely" standard rather than the greater than "remote" proposed threshold. Additionally, we refer the Commission to the "reasonably likely" standard in FAS 5 as guide for an effective threshold. We urge the Commission to work with the FASB to ensure that the regulations do not conflict with guidance and standards promulgated by FASB and other standards setting organizations.

Finally, while ACB's view is that the lower "remoteness" standard threshold is not preferable and that it would be difficult to apply, if the Commission adopts it as part of the final rule, we strongly urge the Commission to develop guidance that will enable issuers to better understand the application of the standard to their own disclosures.

A More Precise Definition of Off-Balance Sheet Arrangements to Capture the Intent of Section 401(a): Capture an Issuer's Special Purpose Entity Exposure

We believe that with regard to off-balance sheet arrangements the Commission should apply a more specific and precise definition. The intent of Section 401(a) is to respond to Enron-type episodes in which the issuer did not disclose fully the relationship, including guarantees, with unconsolidated entities. The definition should focus on such special purpose entities ("SPE") exposures. Capturing such transactions is warranted and valuable information for investors. The preamble to the proposal describes some of the concerns with SPEs, including selling of financial assets through securitization structures.7 SPEs are often structured in ways that no one entity has a controlling interest. With the objectives of increasing liquidity, accessing funds and transferring risk, financial organizations will sell loans into a SPE.

Investors and the marketplace in general should have information of such SPEs. We believe, though, that the threshold for disclosures and definition are unnecessarily broad. ACB recommends that the Commission give careful consideration to the difficulty in certain situations of obtaining information about third-parties in off-balance sheet arrangements, especially in transactions in which the registrant is not a party in developing the disclosure requirements about reporting on third-parties in off-balance sheet arrangements.

ACB is also concerned about the possibility that the off-balance sheet definition could conceivably capture the routine transactions where exposure is minimal, for instance, customary reps and warrantees in loan sales, which may be interpreted as a form of guarantee.

Finally, we respectfully suggest that explicit language be included that the requirement be subject to the final FASB guidance on SPE consolidation. To the extent that the SPE will have to be consolidated into the financial statements of the issuer, such SPE exposures should not have to be included in the off-balance sheet discussions. This issue is alluded to in the preamble8 but the exclusion of consolidated SPEs should be made explicit in the final rule. Again, we urge the Commission to work with FASB in finalizing this rule to eliminate duplicative or conflicting requirements.


Materiality is the fundamental concept underlying disclosure under the securities laws. The proposal significantly alters the concept of materiality. The Commission's proposal would require disclosure of off-balance sheet arrangements if the disclosure is either material in the current period or may become material in the future, that is, the likelihood is greater than "remote". This definition of materiality, which expands the definition to include that of "prospective materiality" in essence broadens the definition and makes application of the materiality concept much more difficult. The definition appears to be inconsistent with current understanding and practice of materiality. At a minimum, the Commission must provide additional guidance, perhaps with some numerical or quantitative guidance of a materiality threshold.

Guidance for Aggregation

ACB requests additional guidance on the aggregation of off-balance sheet arrangements. There are situations in which aggregating certain arrangements may result in information that is not useful to investors. For instance, specific off-balance sheet transactions may not be individually material but, if aggregated, all such transactions may reach the materiality standard. Yet, such aggregated information may be meaningless to the investor. A bank may lease rather than purchase branches in the normal course of business. Each of these transactions is not material but taken together, they become material requiring the bank to provide the explanation of leasing rather than purchasing branches. Yet, the buy versus lease decision would not provide useful information for investors who wish to judge the off-balance sheet exposures that Section 401(a) was intended to address.

Current Banking Industry Reporting as Guidance for Off-Balance Sheet Disclosure

Depository institutions already provide a great deal of information as part of their balance sheet arrangements under the current MD&A reporting requirements. Bank filings include discussion and explanation of securitization activities and their impact on operations, condition, capital and earnings. Further, the use, notional amount of derivatives and swaps, and the effect on interest rate risk exposure management are required.

In addition, off-balance sheet arrangements and transactions are part of the determination of compliance with the regulatory risk-weighted capital requirements. For purposes of determining capital adequacy, banks report certain off-balance sheet arrangements. As reference, the capital requirements require the reporting of letters of credit, bankers acceptances, securities lent, loans with limited recourse, derivatives and interest rate and foreign exchange contracts. An example of such reporting requirements is found in Appendix A of Section 325 of the rules and regulations issued by the Federal Deposit Insurance Corporation.9

Investors have access to this information and are accustomed to looking at such data in evaluating the financial situation of publicly held banks. Because banks already report the information and investors regularly are able to analyze that data, the information serves as a sound model for determining the types of arrangements that should be reported by banking institutions.

A different off-balance sheet definition, as outlined in the proposal, adds reporting complexity and burden to the public bank that will have to continue to report data to the federal banking agencies. We question the benefit of having two sets of off-balance sheet criteria or definitions. Applying comparable reporting requirements would both ease the compliance burden and be useful to investors who are accustomed to analyzing such balance sheet exposures in evaluating the capital resources of banking institutions. We strongly urge the Commission to work with the federal banking agencies to adopt useful but not duplicative disclosure requirements for banks.


In addition to the disclosures of transactions, entities and structures, the Commission also requested comments on the presentation. In brief, the Commission is proposing to require public companies to report separately in the MD&A in a single location and also aggregate the off-balance sheet information and report contractual obligations in tabular form and disclosure of contingent liabilities or commitments in either tabular or textual form.

Public Companies Should Have Flexibility in Placement of the Off-Balance Disclosures Within the MD&A

The proposal requires a separate section within the MD&A for disclosing the off-balance sheet arrangements. ACB believes that the public company should have maximum flexibility in the placement of the information, which reflects its understanding of how off-balance sheet transactions fit into the company's strategy, structure and operation. Companies will enter into off-balance sheet transactions for specific reasons such as reducing cost of capital, increasing liquidity and spreading risk. Under such circumstances, the management's discussion of the off-balance sheet arrangements may appropriately fit under discussion of capital or liquidity resources. Regardless of where management decides to insert the off-balance sheet arrangement discussion, the registrant should not be obligated to repeat the analysis in both the general MD&A discussion and in a separately designated section for off-balance sheet arrangements in the MD&A.

Proposed Tabular and Textual Presentation Would Be Helpful to Public Companies

The proposed required tabular and textual format for presenting the off-balance sheet information would appear to help public companies report information and thus facilitate investor understanding and analysis of the impact of off-balance sheet arrangements. ACB believes that instructions for completing the disclosures would be useful, keeping in mind that there should remain some flexibility for public companies to reflect their unique facts and circumstances. The critical issue remains, as we have commented, in arriving at a practical definition of what off-balance sheet information should be reported by the public company in tables and text.


In summary, ACB agrees with the goals of improving the transparency of a company's off-balance sheet arrangements and providing investors the necessary information and analysis to have a comprehensive understanding of the public company's financial condition and operations. ACB supports the Commission's view that management is in the best position to provide the explanation and analysis to investors. ACB though, believes that the definition of the required off-balance sheet disclosures, as proposed, is excessively broad. Specifically, ACB considers the appropriate standard for disclosure to be the "reasonably likely" threshold applicable to other parts of the MD&A rather than the proposed "remote" threshold proposed. Adoption of the "reasonably likely" threshold would reduce the risk that the issuer would present unimportant information. In addition, ACB is requesting a more precise guidance on the definition of off-balance sheet arrangements.

ACB appreciates the opportunity to comment on these important matters and would be happy to provide you with any additional information you would like regarding the laws and regulations that govern banking organizations. If you have any questions, please contact the undersigned at (202) 857-3121 or via e-mail at, or Steve Davidson at (202) 857-3158 or via e-mail at


Charlotte M. Bahin
Director of Regulatory Affairs
Senior Regulatory Counsel

1 ACB represents the nation's community banks of all charter types and sizes. ACB members, whose aggregate assets exceed $1 trillion, pursue progressive, entrepreneurial and service-oriented strategies in providing financial services to benefit their customers and communities.
2 67 Fed. Reg. 68054 (Nov.8, 2002).
3 Pub. L. 107-204 (2002).
4 For purposes of this comment letter, the terms "issuer", "public company" and "registrant" will be used to refer to filers of periodic financial reports (that include MD&A disclosures) to the Commission and considered to be synonymous terms.
5 67 Fed. Reg. 68058.
6 Id. at 68060.
7 Id. at 68057.
8 Id. at 68057.
9 12 CFR Part 325.