Ernst & Young LLP
December 9, 2002
Mr. Jonathan Katz
Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments
Dear Mr. Katz:
We are pleased to comment on the proposed rules under Section 13(j) of the Securities Exchange Act of 1934, added by Section 401(a) of the Sarbanes-Oxley Act of 2002 (the "Act"). On December 31, 2001, Ernst & Young and the other major accounting firms, with the endorsement of the AICPA, petitioned the SEC to issue an interpretive release about MD&A disclosures in specific areas, including off-balance sheet arrangements. In response to that petition, the SEC issued FR-61, which we believe has improved disclosures in these areas. Accordingly, we support the SEC's proposal to amend its MD&A rules to codify certain of the interpretive recommendations of FR-61. However, we are concerned about certain aspects of the proposed amendments that go beyond the requirements of the Act and the recommendations in FR-61.
Off-Balance Sheet Arrangements
Proposed Disclosure Threshold
With respect to the requirements for MD&A disclosures about matters based on their likelihood of a material future effect, the proposed amendments have a lower threshold for off-balance sheet arrangements (i.e., more than remote) than the threshold for all other matters under current MD&A rules (i.e., reasonably likely). We believe that the SEC should adopt the existing "reasonably likely" disclosure threshold for off-balance sheet arrangements as well.
We do not agree that Section 13(j) of the Exchange Act necessarily mandates a disclosure threshold lower than "reasonably likely." Section 13(j) directs the SEC to adopt rules requiring disclosures about off-balance sheet arrangements that "may" have a material future effect. In our view, "reasonably likely" is a more appropriate interpretation of "may" than is "not remote" as the SEC has proposed. We note that FR-61 states that "reasonably likely" is a lower disclosure threshold than "more likely than not." In contrast, FASB Statement No. 5, Accounting for Contingencies (FAS 5), defines "remote" as a chance of future occurrence that is "slight." We are not aware of any legislative history under the Act that suggests "may" should be interpreted to mean having "other than a slight chance." We believe that a "reasonably likely" disclosure threshold for off-balance sheet arrangements would provide an appropriate balance of disclosures within MD&A and would result in more consistent interpretation and application.
Definition and Scope
The proposed amendments define off-balance sheet arrangements more broadly than FR-61, which focuses on transactions with unconsolidated entities such as structured finance and special purpose entities ("SPEs") that may be in the form of corporations, partnerships or limited liability companies, or trusts. For example, the proposed definition would include (a) derivatives that are indexed to the registrant's own stock and accounted for as equity instruments, and (b) contingent liabilities, that (i) have not been recognized in the financial statements because the loss is either not probable or probable but not reasonably estimable, or (ii) have been recognized in the financial statements because the loss is probable, but additional losses beyond the amount accrued are reasonably possible. While we agree that such items might require disclosure under existing MD&A rules, we question whether the scope of the proposed disclosures should include such items.
Section 13(j) directs the SEC to adopt rules requiring disclosures about "all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons." In our view, the legislative history of the Act suggests the principal concern, and thus the intent of Section 401(a), involved off-balance sheet transactions with SPEs, such as those at Enron. Accordingly, we do not believe that equity derivatives and contingent liabilities (other than those involving unconsolidated SPEs) should be characterized as "off-balance sheet arrangements" and segregated in a separate section of MD&A that discusses off-balance sheet arrangements involving SPEs.
Equity derivatives may be classified as equity instruments under EITF No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock, if they (a) require physical settlement or net-share settlement, or (b) give the company a choice of net-cash settlement or settlement in its own shares (physical settlement or net-share settlement), assuming that specific criteria also are met. The accounting for such equity derivatives is premised on the expectation that a company can avoid any demands on its liquidity. As equity instruments, the resolution of such equity derivatives will not affect future operating results. To the extent such equity derivatives are reasonably likely to materially affect liquidity (presumably based on the company's intent to potentially settle on a net-cash basis), a company would be required to provide disclosures under existing MD&A rules. However, we do not believe that any such discussions of the potential effects of equity derivatives should be set out within a section of MD&A titled "Off-Balance Sheet Arrangements." (Also, we note that at its March, 2002 meeting, the Emerging Issues Task Force revised Issue No. 00-19 to require additional financial statement footnote disclosures. These disclosures would appear sufficient to address the potential dilution from physical or net-share settlement of equity derivatives classified as equity instruments.)
Similar to equity derivatives, contingent liabilities are not commonly thought to be "off-balance sheet arrangements." While the proposed definition of off-balance sheet arrangements would exclude contingent liabilities arising from "litigation, arbitration or regulatory actions," existing MD&A rules would require disclosure to the extent any contingent liabilities are reasonably likely to materially affect liquidity. However, we do not believe that the MD&A discussion of contingent liabilities should be set out within a section titled "Off-Balance Sheet Arrangements." Instead, we recommend that the final amendments limit the disclosures about contingent liabilities in this section to those involving unconsolidated SPEs.
In our view, the proposed amendments define "off-balance sheet arrangements" too broadly. As discussed above, we recommend that the final definition remove equity derivatives and contingent liabilities (other than those involving unconsolidated SPEs) from its scope. In addition, we recommend that the final definition be revised to make clear that its scope excludes other items that would appear to fall within the proposed definition, such as pension and postretirement benefit arrangements, as well as investments accounted for under the equity method (including joint ventures).
Disclosures under generally accepting accounting principles about off-balance sheet arrangements continue to evolve. We note that FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140), now requires extensive disclosures about retained interests in securitized financial assets. For example, under FAS 140 companies must provide a sensitivity analysis or stress test showing the hypothetical effect on the fair value of retained interests from unfavorable variations in key valuation assumptions. Also, FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others (FIN 45), will require extensive new disclosures in both annual and interim periods about guarantees. Further, we note that as part of its redeliberation of the expected interpretation on consolidation, the FASB has concluded to require additional financial statement footnote disclosures by holders of significant variable interests in unconsolidated entities. Those disclosures would include the activities and purpose of the unconsolidated entities and the potential risks and rewards from variable interests held.
Some of the disclosures under the proposed MD&A amendments appear to duplicate the disclosure requirements of FAS 140, FIN 45 and the FASB's proposed consolidation interpretation. In addition, other proposed MD&A disclosures could be subsumed by future accounting standards. In order to avoid redundant disclosures in MD&A and the financial statements, we recommend that the final SEC rule only require the specified MD&A disclosures to the extent not already provided in the financial statements.
We concur with the proposed amendments that would codify, other than for small business issuers, the tabular summary of contractual obligations that was suggested in FR-61. We suggest that the final rule clarify that obligations to be summarized in the table are those where the cash flows are fixed or reliably determinable. This would make clear that the table should exclude contractual arrangements where the amount and timing of cash flows are subject to market risk, such as derivative financial instruments, certain other financial instruments and certain derivative commodity instruments that fall under the disclosure requirements of Item 305 of Regulation S-X, Quantitative and Qualitative Disclosures About Market Risk. In addition, we suggest that the final rule allow, but not require, issuers to include supplemental line items to the table for contractual cash inflows, such as sublease rentals, notes receivable and forward sales contracts.
Contingent Liabilities and Commitments
Under the proposed rule, registrants (other than small business issuers) would be required to provide MD&A disclosure about the potential demands on liquidity from "contingent liabilities or commitments." We recommend that the Commission instead use the term "commercial commitments," define that term, and provide specific examples of commercial commitments that would fall within the scope of the final rule.
We believe that the term "contingent liabilities and commitments" generally is understood to include loss contingencies accounted for under FAS 5. We believe that loss contingencies would not lend themselves to the type of summarized disclosures that would be required under the proposed rules, because by their nature loss contingencies do not have an objectively determinable maturity or expiration. Under existing MD&A rules, issuers are required to discuss such loss contingencies to the extent they represent uncertainties that could materially affect liquidity.
In FR-61, the Commission recommended that issuers provide summarized disclosures about "commercial commitments," which "are intended to include lines of credit, guarantees, and other potential cash outflows resulting from a contingent event that requires registrant performance pursuant to a funding commitment." FR-61 suggested by illustration that commercial commitments would include lines of credit, standby letters of credit, guarantees and standby repurchase obligations. Such commitments are identical to the specific examples cited in the proposing release that would fall within the scope of the proposed MD&A disclosure. Accordingly, we recommend that the Commission use the term "commercial commitments" in the final rule and define that term as "potential cash outflows resulting from a contingent event that requires registrant performance pursuant to a funding commitment, such as lines of credit, standby letters of credit, guarantees and standby repurchase obligations." In addition, the Commission should consider providing a more comprehensive listing of the types of commercial commitments that should be included in the summarized MD&A disclosures. Such a listing would assist issuers in identifying whether or not the required disclosures include, among other things, residual value guarantees in leasing arrangements, contingent lease rentals, contingent purchase consideration, and contractual performance bonds.
Section 21E of the Exchange Act provides a safe harbor for forward-looking information provided that the forward-looking statement (a) is accompanied by meaningful cautionary statements, (b) was made without knowledge that the information was false or misleading, or (c) was not material. The proposed amendments would explicitly extend the statutory safe harbor for forward-looking information to information provided in MD&A about off-balance sheet arrangements, other than historical facts. We concur with the proposal and would encourage the Commission to expand the proposed safe harbor to all MD&A disclosures.
The proposed amendments essentially would codify the disclosures recommended in FR-61 related to off-balance sheet arrangements, contractual obligations and commercial commitments. However, the proposal would not codify other aspects of FR-61, including (1) interpretive guidance on discussions about liquidity; (2) transactions with related and certain other parties, and (3) trading activities involving non-exchange traded commodity contracts accounted for at fair value. In connection with the final rules, we recommend that the SEC rescind any superceded portions of FR-61 in order to avoid potential confusion from duplicative or inconsistent guidance.
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We would be pleased to discuss our comments with the Commission or its staff at your convenience.