New York State Bar Association
One Elk Street
Albany, NY 12207
Business Law Section
Committee on Securities Regulation
December 13, 2002
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
E-mail address: email@example.com
Attention: Jonathan G. Katz, Secretary
Ladies and Gentlemen:
The Committee on Securities Regulation (the "Committee") of the Business Law Section of the New York State Bar Association appreciates the invitation in Release No. 33-8144 (the "Release") to comment on proposed disclosure requirements intended to implement Section 401(a) of the Sarbanes-Oxley Act of 2002 which requires rulemaking by the Commission. The Release also proposes other, additional disclosure requirements.
The Committee is composed of members of the New York Bar, a principal part of whose practice is in securities regulation. The Committee includes lawyers in private practice and in corporation law departments. A draft of this letter was reviewed at a meeting of the Committee, and the views expressed in this letter are generally consistent with those of the majority of members who reviewed and commented on the letter in draft form. The views set forth in this letter, however, are those of the Committee and do not necessarily reflect the views of the organizations with which its members are associated, the New York State Bar Association, or its Business Law Section.
A. Summary of Comments
The Committee supports the Commission's objectives to implement the corporate disclosure and financial reporting reforms of the Sarbanes-Oxley Act in a manner that will strengthen investor confidence. The present proposals are intended to improve investor understanding of a company's current and future financial position and sources of liquidity. We generally support the proposed new disclosures provided that certain important modifications recommended in this letter are made.
We urge the Commission to change the proposed "remoteness" disclosure threshold for off-balance sheet arrangements and transactions to the existing "reasonably likely" threshold applicable to other MD&A disclosures. Sarbanes-Oxley Section 401(a) does not use, and we do not believe it requires, a remoteness standard. In addition, we are not aware of any problem with the reasonably likely standard, and there has been no showing of any basis to justify a change in that standard. It would not be sound disclosure policy to introduce a different standard into MD&A, which could mislead investors. Finally, the lower threshold could result in information overload, and the additional disclosures would not provide investors with information management uses to manage the company.
In addition, we believe that the proposed specific items of information regarding off-balance sheet arrangements are sufficient and adequate for an understanding of the significance of off-balance sheet transactions, and should not be expanded. Also, we agree with the proposals to exclude preliminary negotiations and require disclosure only when there is a definitive agreement regarding off-balance sheet arrangements.
The final rules should expressly clarify that the proposed disclosure of "contractual obligations" and "contingent liabilities and commitments" under Item 303(a)(5) is limited to contractual commercial commitments. The caption "contingent liabilities and commitments," which may suggest otherwise, should be changed to "commercial commitments." These (a)(5) disclosures should also have the same express exclusions of preliminary negotiations and contingent liabilities arising out of litigation, arbitration or regulatory actions that are provided for off-balance sheet arrangements. In addition, disclosure should be required only for long-term obligations and commitments, and certain common commercial contractual provisions such as product warranties should be excluded as discussed below in this letter.
Finally, the proposed safe harbor protection should be expanded and made automatic, and should apply to Item 303(a)(5) disclosures regarding contractual obligations and commercial commitments as well as 303(a)(4) off-balance sheet disclosures.
B. Proposed Disclosure About Off-Balance Sheet Arrangements (Sarbanes-Oxley Section 401(a))
The proposed rules would require extensive, specified disclosures about off-balance sheet arrangements, as defined, in the management's discussion and analysis of financial condition and results of operations ("MD&A") section of annual reports on Form 10-K and quarterly reports on Form 10-Q (or comparable forms). The new disclosures would be added as Item 303(a)(4) of Regulation S-K (and corresponding requirements for other, comparable reporting forms) with a new Item 303(c) discussing the application of safe harbor provisions to the new disclosures.
The disclosures would be on a fiscal year basis in Forms 10-K under Item 303(a). The existing provisions of Item 303(b) would require a discussion of material changes for interim periods in Forms 10-Q. The proposed disclosures would be required to be presented in the MD&A section even where the disclosure may repeat and duplicate similar disclosures in the financial statement footnotes.
Extensive Commission and FASB guidance for disclosures of off-balance sheet arrangements and related matters already exists. In addition, the accounting profession and others are considering what other disclosures would be appropriate for these arrangements. For example, the Financial Accounting Standards Board (FASB) has an exposure draft outstanding that would make significant changes in the rules for consolidation of other entities. The proposed changes would require complicated and difficult analyses and could result in companies being required to consolidate many entities that are presently unconsolidated special purpose entities engaged in off-balance sheet transactions. If those entities ultimately are required to be consolidated, the transactions would no longer be off-balance sheet. Thus, the entities and arrangements that would be subject to disclosure under the Commission's proposed rules could be changing as the new rules go into effect.
Although it would be better to wait until after the FASB action -- FASB has stated that it intends to take final action by the end of 2002 -- Section 401(a) of Sarbanes-Oxley requires the Commission to adopt additional rules now (by January 26, 2003), although the Act does not enumerate what the specific items of disclosure should be or mandate when the new disclosures should go into effect.
The most recent Commission pronouncement was the statement about the MD&A section, dated January 22, 2002 (hereafter the "2002 Statement").1The 2002 Statement sets forth the Commission's views of matters regarding liquidity and capital resources including off-balance sheet arrangements that should be considered for disclosure under existing Commission rules and interpretations. The following is a general summary of several of the items to be considered for disclosure about off-balance sheet transactions enumerated in the Statement.
- Off-balance sheet financing arrangements that are material sources of liquidity and financing
- Factors reasonably likely to affect ability to continue using off-balance sheet arrangements
- Extent of reliance on the arrangements for financing, liquidity, and market or credit risk support or for providing leasing, hedging or research and development services for the company; and exposure of the company to liability
- Business purposes and activities
- Economic substance
- Key terms and conditions
- Relationships of the company with off-balance sheet entities
- Potential risk exposures
- Total amount of assets and obligations of any special purpose entity ("SPE")
- Effects of early termination
- Amounts receivable or payable, and revenues, expenses and cash flows to the company
- Amounts of guarantees, lines of credit, standby letters of credit or commitments or take or pay contracts, throughput contracts or similar arrangements that could require the company to provide funding including guarantees, make whole agreements or value guarantees.
2. The proposed rules would generally codify the specific off-balance sheet arrangements disclosures in the Commission's 2002 Statement with one exception.
There is essentially no change in the specific types of information that would be required to be disclosed by proposed new Item 303(a)(4) of Regulation S-K from the disclosures in the 2002 Statement, summarized above, with one exception. Of course, the proposed rules would explicitly require the specific, detailed disclosures which the Commission in the 2002 Statement only asserted should be considered for disclosure under more general MD&A requirements related to liquidity and capital resources.
Fashioning a disclosure rule for off-balance sheet arrangements presents two issues -- first, identifying the transactions to be disclosed and described, and second, specifying the information to be provided about the identified transactions. The major difference in the proposed rules from the 2002 Statement is the use of a much lower threshold of disclosure -- "remoteness" --to identify arrangement to be disclosed than the "reasonably likely" standard in the 2002 Statement and other existing MD&A requirements.
3. The "remoteness" disclosure threshold proposed for off-balance sheet arrangements and transactions should be changed to the existing "reasonably likely" standard of MD&A.
Proposed Item 303(a)(4) would require disclosure of certain off-balance sheet arrangements in a separately captioned section of MD&A. However, proposed 303(a)(4) does not require disclosure of all significant off-balance sheet arrangements, but only where they could result in the company having to perform guarantees or other obligations or recognize impairments that are material. For example, the Release recognizes that some off-balance sheet arrangements may be required to be disclosed under other MD&A provisions, but not under 303(a)(4).2 As a result, the identification of arrangements to be disclosed under the proposed rules focuses on the contingent triggering events of material guarantees or other obligations or of impairments.
Remoteness is one of several measures of the probability of a contingency that could be used depending on the level of probability desired. The current MD&A requirements and the 2002 Statement use a "reasonably likely" standard under which disclosure is required if the event or effect is reasonably likely to occur. The proposed rules use a "remoteness" standard under which disclosure would be required unless the likelihood of the event or effect is remote.
The use of a "remoteness" threshold for disclosure is troublesome for many reasons, as highlighted by the fact that 5 of the 13 questions for which comments are requested in the Release on 303(a)(4) involve the remoteness issue. However, we are not aware of any problem with the reasonably likely disclosure threshold, which is the existing standard for MD&A requirements and is the standard in the Commission's 2002 Statement for these very same off-balance sheet arrangements disclosures. Furthermore, there has been no showing of any basis to justify a change in that standard. In addition, Sarbanes-Oxley Section 401(a) does not use and does not require a remoteness standard.
In calling for disclosure of off-balance sheet arrangements, Section 401(a) of Sarbanes-Oxley refers to disclosing an event that "may have" a material effect. The Commission believes that remoteness would aid companies in applying the rule and is used even though the exclusion of events or effects that are remote is not in the statute (see footnote 63). This suggests remoteness is a higher threshold and would exclude some disclosures that would be required under the "may have" a material effect language in Section 401(a). The Release and proposed rules apparently treat "may" as a possibility standard without regard to how likely or probable the possibility is. However, it is not clear that such an interpretation is correct as it appears contrary to the plain, dictionary meaning of the word "may." If the statute intended possibility, it would have used the word "could" which indicates possibility, in the place of "may" which is "[u]sed to indicate a certain measure of likelihood or possibility." 3 Thus, we believe that the Commission in effect is actually proposing using a lower threshold of disclosure than the statute.
In addition, it is not a good policy choice for creating understandable disclosures that are not overwhelming for investors to introduce a different standard into the MD&A disclosures. We doubt that many investors reading MD&A disclosures are going to understand or even be aware of the refinements of disclosure thresholds that would be introduced by use of the remoteness standard here.
There should be one standard for everything in MD&A, as is presently the case. Investors should be able to expect the same standard of disclosure in order to be able to weigh the various matters being disclosed. Introducing a new, lower threshold can only mislead investors who over the years have come to expect the same standard for disclosure throughout the MD&A with the same level of significance and likelihood of occurrence.
In addition, going to a remoteness standard would create a real risk of information overload. Expanding the scope of disclosure to include matters of much lower probability would be counterproductive. It can be expected to generate a large increase in the amount of information being disclosed which, together with the several other new and pending disclosures, could defeat the purpose and usefulness of MD&A.
Furthermore, as the Release notes, one of the principal purposes of MD&A is to enable investors to see the company through the eyes of management. The type of information being proposed for MD&A is not likely to be what management is looking at to manage the company. This would be especially true in the case of the lower probability disclosures under a remoteness standard.
The troublesome disparity between remoteness and the "reasonably likely" standard used elsewhere in the existing MD&A guidance has led the Commission to request in the Release for comment on whether it should consider amending the other current MD&A rules to lower the existing disclosure threshold. The Commission should not change the existing "reasonably likely" threshold. Instead, the off-balance sheet disclosure threshold should be changed to "reasonably likely."
4. The proposed specific items of information are sufficient and adequate for an understanding of the significance of the arrangements identified for disclosure.
Our impression is that companies have been disclosing the existence of significant off-balance sheet arrangements so that the major impact of the proposed rules would be to require disclosure of much more specific, detailed information about the arrangements.
Recognizing that the Enron meltdown was a significant impetus to requiring off-balance sheet disclosure in Sarbanes-Oxley 401(a), it is instructive to note that the principal problems with the Enron transactions were allegations of improper accounting and inadequate disclosure. Of course, accounting treatment and rules are not at issue here. With respect to disclosure, the Enron Board's Powers Report found that Enron failed to disclose facts that were important for an understanding of the substance of the transactions, and never clearly disclosed the purposes behind the transactions or the complete financial statement effect of the arrangements.
We believe that the specific, detailed disclosures that would be required under the proposed rules are extensive, would provide the information necessary to an understanding of off-balance sheet transactions, and would provide the type of information allegedly missing from the Enron disclosure. Of course, because off-balance sheet transactions can be quite complex, the disclosure cannot be oversimplified and a complete understanding may be difficult. However, this might be due to the inherently complex nature of some of these transactions and not because of any lack of information.
5. It is appropriate to exclude preliminary negotiations and require disclosure only when there is a definitive agreement regarding off-balance sheet arrangements.
The Release requests comments on whether the Commission's existing policy of excluding preliminary negotiations should apply to off-balance sheet arrangements. The proposed rules properly exclude preliminary negotiations and only require disclosure if there is a definitive agreement. Because these are contractual arrangements, disclosure could be harmful to a company in negotiation. Furthermore, the specific types of proposed disclosures could be harmful even if the fact of negotiations is otherwise known. For example, specific terms being considered and negotiated may change at any time. Thus, requiring disclosure of preliminary terms and provisions could end up misleading investors. In addition, public disclosure of terms being considered could disrupt negotiations and make it more difficult to reach final agreement or achieve the most favorable terms, to the detriment of the company and its investors.
C. Proposed Disclosure About Contractual Obligations and Contingent Liabilities and Commitments
The proposed rules would also require a summary of contractual obligations and contingent liabilities and commitments in the MD&A section of annual reports on Form 10-K and quarterly reports on Form 10-Q (or comparable forms). These are essentially cash obligations. A tabular presentation would be required for contractual obligations, but companies would have the option of textual or tabular disclosure for contingent liabilities and commitments. The new disclosures would be added as Item 303(a)(5) of Regulation S-K.
The disclosures would be on a fiscal year basis in Forms 10-K under Item 303(a). The existing provisions of Item 303(b) would require a discussion of material changes for interim periods in Forms 10-Q, provided that the tabular presentations would not be required for interim periods; instead, material changes could be disclosed by textual discussion. As in the case of off-balance sheet arrangements, the proposed disclosures are required to be presented in the MD&A section even where the disclosure may repeat and duplicate similar disclosures in the financial statement footnotes.
Unlike the off-balance sheet disclosures, these proposed rules regarding contractual obligations and contingent liabilities and commitments are not required by Sarbanes-Oxley. In addition, the summary of obligations would include any applicable amounts under off-balance sheet arrangements discussed above.
The broad scope of obligations that would be required to be summarized include many that are disclosed in the financial statement footnotes, or even on the face of the financial statements such as amounts of indebtedness. The Release recognizes that disclosure of the obligations that would be summarized already "is dispersed throughout various parts of a registrant's filings." The rationale for the proposed additional disclosures is that they would aggregate the information in a single location which the Commission believes would improve transparency of liquidity and capital resource needs and demands, and also "provide appropriate context for investors to assess the relative role of off-balance sheet arrangements with respect to liquidity and capital resources."
The Commission's 2002 Statement included tabular presentation of "Total Contractual Cash Obligations" and "Total Commercial Commitments" as set forth below, among the items to be considered for disclosure in connection with liquidity and capital resources:
Capital Lease Obligation
Unconditional Purchase Obligations
Other Long-Term Obligations
Total Contractual Cash Obligations
| Other Commercial Commitments
Lines of Credit
Standby Letters of Credit
Standby Repurchase Obligations
Other Commercial Commitments
Total Commercial Commitments
2. The proposed rules would codify the specific Contractual Obligations and Commercial Commitments disclosure in the Commission's 2002 Statement with two exceptions.
The proposed rules would now expressly require the disclosure of summaries of various contractual obligations and obligations that basically include what the Commission urged in the 2002 Statement, although companies would have the option of using either a tabular or a textual presentation for certain obligations and commitments. The first type of obligation -- contractual obligations -- are described in the same manner in the proposed rules and in the 2002 Statement. However, the proposed rules make a change in terminology in referring to the second type of obligations and a change in what amounts should be provided for those obligations. Those changes could be very troublesome depending on whether the Commission intended a substantive change by the change in wording.
Specifically, the Release and proposed rules substitute the phrase "contingent liabilities and commitments" for the phrase "commercial commitments" that is used in the 2002 Statement. In addition, the 2002 Statement suggested a table giving "Total Amounts Committed" whereas the proposed rule calls for the expected range of amounts or the expected amount or maximum amount of contingent liabilities and commitments, indicating if amounts disclosed are expected or maximum amounts.
Although the changed terminology is often used in connection with describing and disclosing the broad scope of contingencies covered by Statement of Financial Accounting Standards No. 5 (SFAS 5), the Release gives the same types of commercial commitments specified in the 2002 Statement and listed above as examples of contingent liabilities and commitments.4 This suggests that a change from contractual commercial commitments to contingencies generally was not intended, but it is not perfectly clear.
3. The final rules adopted should expressly clarify that Item 303(a)(5)(ii) is limited to contractual commercial commitments.
The final rules should expressly provide that Item 303(a)(5)(ii) is limited to contractual commercial commitments. Specifically, the category should be "commercial commitments" (or "other commercial commitments" in relation to the contractual obligations of Item 303(a)(5)(i)), instead of "contingent liabilities and commitments" throughout the adopting release and the new rules. The phrase "commercial commitments" is used in this letter to mean the category referred to as "contingent liabilities and commitments" in the Release and proposed rules.
The final rules also should specify that disclosure is only required for obligations and commitments that are non-cancelable or irrevocable, or that are subject to significant penalties or special charges for cancellation or modification. A company should be permitted to identify those obligations and commitments required to be disclosed that can be cancelled or modified provided that the applicable penalties and special charges are also disclosed.
In addition, a new Instruction 14 should be added to Item 303(a) providing that no disclosure of contractual obligations or commercial commitments is required under paragraph (a)(5) until a definitive agreement that is unconditional or subject only to customary closing conditions exists or, if there is no such agreement, when settlement of the transaction occurs. This is the same as the treatment of off-balance sheet arrangements in proposed Instruction 13, which we believe should be equally applicable to the (a)(5) obligations.
Finally, Item 303(a)(5) should expressly provide that contingent liabilities arising out of litigation, arbitration or regulatory actions are not contractual obligations or commercial commitments covered by paragraph (a)(5). Again, this is the same treatment provided for off-balance sheet arrangements, which we believe should also be provided for (a)(5) obligations.
While we do not believe that the Commission intends (a)(5) to cover contingent liabilities other than contractual commitments, that should be made clear by the changes suggested in this subsection 3. Including general contingent liabilities would present the same types of serious issues raised in two previous SEC proposals referred to below. If the Commission does intend (a)(5) to extend beyond contractual commitments, that should be expressly stated and interested parties given the opportunity to comment.
The Commission's pending proposal on disclosure of the application of critical accounting policies in MD&A would require companies to provide quantitative information with respect to loss accruals for FAS 5 contingent liabilities such as reserves for litigation, contingent tax liabilities, environmental remediation costs, and product liability claims.5 Prior to that proposal, the Commission solicited public comment on quantitative disclosure of contingent liabilities as part of its proposals for specific disclosure with respect to loss accrual accounts in January 2000.6 The 2000 Proposal was not adopted.
The comments filed on those two proposals, including our letters dated April 19, 2000 and July 30, 2002, showed how the proposed disclosures could cause loss of the attorney-client privilege and could constitute admissions against interest. The comments also showed the economic damage to companies that would result from adversely affecting the ability to negotiate favorable settlements in litigation and tax and other disputes. The concerns raised in our letters and other commenters' letters should be considered if proposed Item 303(a)(5) is intended to cover non-contractual liabilities.
The Release requests comment on whether disclosure of notes, drafts, acceptances, bills of exchange or other commercial instruments with a maturity of one year or less issued in the ordinary course of business should be required. Disclosure of these money market instruments should not be required. More generally, and for avoidance of doubt, the final rules should expressly provide that disclosure is required only for long term obligations or commitments (obligations or commitments initially extending out for more than one year).
The rationale for these disclosures is to show what commitments the company has made over a longer time frame which raise the risk of a mismatch over time because of possible changes in circumstances such as economic or product changes. Including current obligations and commitments do not present the same types of risk, do not have the same significance, and would tend to obscure the more critical information. In addition, it would be very burdensome, or possibly not feasible, to collect and aggregate all obligations and commitments being entered into to meet current needs in order to disclose all obligations and commitments due within one year.
5. The final rules should expressly exclude product warranties and guarantees, performance guarantees and contractual indemnifications.
Product warranties and guarantees, performance guarantees, and indemnifications covering damages and personal injury commonly appear in most commercial contracts. However, they do not reflect the same types of business judgments and strategies of management or provide the same types of risks, as the types of contractual obligations and commercial commitments specifically referred to the in Release and the proposed rules. We do not believe that these typical contractual provisions were intended to be covered by the proposed rules. Inclusion of these provisions would be very burdensome and, more importantly, would obscure the disclosure of the more significant obligations and commitments. Accordingly, we urge the Commission to expressly exclude these types of contractual provisions in the final rules.
D. Safe Harbor Protection Should be Automatic and Should Also Apply to Contractual Obligations and Commercial Commitments as Well as the Proposed Application to Off-Balance Sheet Arrangements
Limited safe harbor protection would be provided in proposed Item 303(c) of Regulation S-K for disclosures under proposed 303(a)(4) regarding off-balance sheet arrangements. Specifically, the statutory safe harbor provisions of Section 27A of the Securities Act and 21E of the Exchange Act would apply to 303(a)(4), and certain of the (a)(4) information would be deemed a "forward looking statement." However, the protection would not apply to all filings and transactions (e.g., IPOs would be excluded) or to all types of issuers. Also, the safe harbor defense would be subject to claims in litigation about whether the company provided sufficiently "meaningful cautionary statements," thus significantly diminishing the protection. Finally, the Item 303 (a) (5) disclosures are not included in the protection even though they clearly call for forward-looking statements such as the expected amounts or range of amounts or maximum amounts of contingent commitments.
1. The final rule should provide automatic safe harbor protection under the Private Securities Litigation Reform Act; protection should apply to all transaction and filings and all types of issuers
The Commission should provide in the final rule that all information under new Items 303(a)(4) and (a)(5) of Regulation S-K, except for historical facts, is deemed "forward-looking statements" and to be accompanied by meaningful cautionary statements, meeting the requirements and entitled to the full protection of the safe harbor provisions of Section 27A of the Securities Act and Section 21E of the Exchange Act. This would be similar to the protection the Commission provided in Item 305(d) of Regulation S-K adopted in 1997 requiring quantitative and qualitative disclosures about market risk.
Subsections (g) of both Section 21E and Section 27A grant the Commission authority to provide exemptions with respect to liability "that is based on a statement or that is based on projections or other forward-looking information," if consistent with the public interest and the protection of investors, as determined by the Commission. We believe that the findings made by the Commission in the Release about the value and benefit to investors, and the risks faced by companies in being required to disclose forward-looking information provide conclusive support for such determination in this case.
2. The final rule should provide safe harbor protection for proposed Item 303(a)(5) disclosures regarding contractual obligations and commercial commitments.
The disclosures mandated by proposed Item 303(a)(5) involve forward-looking statements by definition. For example, commercial commitments would include contingent commitments such as debt guarantees or standby letters of credit, which can be substantial. Disclosure would be required of the "expected amount, range of amounts or maximum amount " aggregated by type that are expected to expire over various time periods. Accordingly, (a)(5) should be provided the same safe harbor protection as (a)(4) off-balance sheet disclosures.
We hope the Commission finds these comments helpful. We would be happy to meet with the Staff to discuss these comments further.
COMMITTEE ON SECURITIES REGULATION
By___ Gerald S. Backman
GERALD S. BACKMAN
CHAIRMAN OF THE COMMITTEE
Michael J. Holliday, Chair
Richard E. Gutman
The Honorable Harvey L. Pitt, Chairman
The Honorable Paul S. Atkins, Commissioner
The Honorable Roel C. Campos, Commissioner
The Honorable Cynthia A. Glassman, Commissioner
The Honorable Harvey J. Goldschmid, Commissioner
Alan L. Beller, Esq., Director of Division of Corporation Finance
Jackson M. Day, Acting Chief Accountant
|1|| Release Nos. 33-8056; 34-45321; FR-61.
|2|| In such a case, a company may choose whether or not to provide the disclosure in the separately-captioned 303(a)(4) section of MD&A.
|3|| The American Heritage College Dictionary, Third Edition, 1997.
|4|| Both the 2002 Statement and the Release refer to Lines of Credit, Standby Letters of Credit, Guarantees, and Standby Repurchase Obligations.
|5|| Release Nos. 33-8098; 34-45907; International Series Release No. 1258, May 10, 2002.
|6|| Release Nos. 33-7793, 34-42354, January 21, 2000.