December 9, 2002
Jonathan G. Katz
Re: Release Nos. 33-8144, 34-46767; File No. S7-42-02 and
Dear Mr. Katz:
We appreciate the opportunity to comment on the proposed rules (the "Proposed Rules") implementing Sections 401(a) and (b) of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"). Our comments are based on our experience representing issuers, although the comments are solely our own and are not intended to represent the views of our clients.
We understand the Commission's and Congress's desire to improve the standards applicable to reporting issuers' use of non-GAAP financial measures and disclosures regarding off-balance sheet arrangements and other contingent liabilities. Our comments to the Proposed Rules aim to highlight provisions that could have the effect of working against the purported purpose, particularly those relevant to foreign private issuers. In each situation we have attempted to provide constructive comments that we believe would reinforce the goals of the Proposed Rules and the Sarbanes-Oxley Act.
Comments to Provisions Implementing Sarbanes-Oxley Act Section 401(a) - Disclosure About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments
In its 1989 Interpretive Release regarding the requirements of Item 303 of Regulation S-K (the "1989 Release"),1 the Commission set forth its views regarding several disclosure matters that should be considered by issuers in preparing their MD&A disclosure. In the 1989 Release, the Commission stated that the general purpose of the MD&A requirements was "to give investors the opportunity to look at the registrant through the eyes of the management by providing a historical and prospective analysis of the registrant's financial condition and results of operations, with particular emphasis on the registrant's prospects for the future."
In the 1989 Release, the Commission indicated that a "disclosure duty exists where a trend, demand, commitment or event uncertainty is both presently known to management and reasonably likely to have material effects on the registrant's financial condition or results of operations." (emphasis added). The Commission stated that if a known trend, demand, commitment or uncertainty is not reasonably likely to occur in the opinion of management, then no disclosure is required. If management cannot make a reasonable determination of the event's likelihood, then disclosure is required "unless management determines that a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur." (emphasis added).
In our view, the "reasonably likely" threshold for disclosure is of paramount importance in enabling investors to have the opportunity to look at an issuer through the eyes of management. A "reasonably likely" standard allows management to present to investors the items management considers important for investors. Since management has filtered the disclosure so that only the information most relevant for investors is presented, this allows investors to obtain the benefit of management's judgment on the possible impact of future events on the company. This approach was approved as recently as January of this year in the Commission statement regarding MD&A (the "January Release"),2 when the Commission reminded companies that "disclosure must be both useful and understandable, and that management should provide the most relevant information. . ." (emphasis added). In the January Release, the Commission specifically endorsed the "reasonably likely" disclosure threshold for requiring disclosure of off-balance sheet arrangements, and reminded issuers that this standard was lower than "more likely than not".
In contrast, the Proposed Rules would change the standard for disclosure regarding off-balance sheet arrangements by requiring disclosure if management believes the likelihood of a material event occurring, or the likelihood that if an event occurred, its effect on the results of operations and financial condition of the issuer would be material, is higher than remote. Such a standard would be exceedingly broad. Pursuant to guidelines adopted by the Financial Accounting Standards Board, if the likelihood of a future event is "remote", then "the chance of the future events or events occurring is slight."3
We believe that this disclosure threshold may lead issuers to disclose all off-balance sheet arrangements and their possible effects on the issuer, for fear that a decision not to disclose a liability that seemed remote at the time would later, based on hindsight, be presumptively viewed as a disclosure violation if the liability in fact materialized. This result would require investors to process voluminous disclosure without necessarily being provided adequate guidance as to which contingent liabilities management feels are reasonably likely to be material. Furthermore, there is a risk that faced with this volume of disclosure, an investor might become confused or make an improper judgment of what liabilities are more likely to occur, and actually suffer harm as a result of the increased disclosure.
We respectfully do not believe that the Sarbanes-Oxley Act mandates a lower disclosure threshold than "reasonably likely" and feel that the lower disclosure threshold runs contrary to investors' interests. The Sarbanes-Oxley Act requires the Commission to enact rules providing that annual and quarterly reports filed with the Commission disclose all material off-balance sheet transactions that may have a material current or future effect on the financial condition of the issuer. In Basic v. Levinson,4 the Supreme Court, in approving the materiality standard adopted in the proxy-solicitation context in TSC Industries, Inc. v. Northway, Inc.5 as the standard for materiality in §10(b) and Rule 10b-5 contexts, stated the following: ". . .the court was careful not to set too low a standard for materiality; it was concerned that a minimal standard might bring an overabundance of information within its reach, and lead management `simply to bury the shareholders in an avalanche of trivial information - a result that is hardly conducive to informed decision making.'"6
We understand that a definition of "off-balance sheet arrangements" must address a wide variety of arrangements. However, we would suggest the following text edits to the definition of off-balance sheet arrangements found in the Proposed Rules so that it reads more clearly:
"The term off-balance sheet arrangement means:
(i) any transaction, agreement or other contractual arrangement to which any entity unconsolidated with the registrant is a party, under which the registrant, whether or not a party to the arrangement, has, or in the future may have (A) any obligation under a direct or indirect or similar guarantee or arrangement or (B) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;
(ii) derivatives to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements; or
(iii) any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto)."
Comments to Provisions Implementing Sarbanes-Oxley Act Section 401(b) - Use of Non-GAAP Financial Measures
The Proposed Rules for Regulation G contain a limited exemption for foreign private issuers. The proposed Regulation G states that Regulation G shall not apply to disclosure of a non-GAAP financial measure that is made by or on behalf of a registrant that is a foreign private issuer if the following conditions are satisfied:
(1) the securities of the registrant are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States;
(2) the non-GAAP financial measure and the most comparable GAAP financial measure are not calculated and presented in accordance with generally accepted accounting principles in the United States; and
(3) the disclosure is made by or on behalf of the registrant outside the United States, or is included in a written communication that is released by or on behalf of the registrant only outside of the United States.
The rationale given for this exemption is to balance the interests of U.S. investors with the interests of foreign private issuers in communicating in their home markets. However, we believe the requirement that a written communication be released only outside of the United States will in practice greatly reduce the attractiveness of the exemption for foreign private issuers, is contrary to the disclosure regime in place for foreign private issuers and could also harm the interests of U.S. investors.
First, many foreign private issuers are large multi-national corporations. It is common practice for such companies to issue worldwide earnings releases. The narrow exemption to Regulation G offered to foreign private issuers contained in the Proposed Rules will be unavailable to companies that issue worldwide earnings releases.
Second, the proposed rules are contrary to the approach the Commission has taken with foreign private issuers in the past. Historically, the Commission has not applied specific disclosure requirements to communications by foreign private issuers other than disclosure contained in their annual reports on Form 20-F. By applying Regulation G to foreign private issuers with only the limited exemption contained in the Proposed Rules, the Commission will be interfering with an issuer's ability to communicate according to the customary practices in its home market.
Third, if foreign private issuers do modify their current behavior in response to Regulation G, U.S. investors will in fact suffer as a result. Since the limited exemption in the proposed rules only applies to written materials released outside the United States, foreign private issuers may modify their current practice so that some data is not released in the United States. The effect may be that U.S. investors obtain less information concerning the results of operations of a foreign private issuer than would otherwise be available.
In order for the exemption to provide a meaningful balance between the interests of U.S. investors and the interests of foreign private issuers, we believe the third prong of the test should be modified. Under this third prong as revised, Regulation G would not apply as long as:
(a) the information is not communicated exclusively to, or targeted at, persons located in the United States; and
(b) following disclosure or release of information on a worldwide basis, the information is included in a submission to the Commission made under cover of a form 6-K.
We believe that as long as the foreign private issuer satisfies the two first two prongs of the exemption in the Proposed Rules, together with the third prong modified as we propose, U.S. investors' interests under the Sarbanes-Oxley Act will be sufficiently protected, but U.S. investors, should they so choose, will be able to continue to avail themselves of the maximum information available.
Proposed Regulation G draws a distinction between written communications and oral communications. Under the Proposed Rules, if an issuer (either a domestic issuer or a foreign private issuer) utilizes a non-GAAP financial measure in a written communication, the issuer is required to provide the following information as part of any such communication:
(the "Required Information"). Conversely, if a non-GAAP financial measure is released orally, telephonically, in a webcast or broadcast or by similar means, proposed Regulation G would permit an issuer to provide the Required Information by posting it on the issuer's website, and the issuer would be required to disclose the location and availability of the Required Information during its presentation.
If foreign private issuers are to be subject to Regulation G for press releases, such as earnings releases, that are disseminated on a worldwide basis, we believe that foreign private issuers should be able to comply with Regulation G in all cases by posting the Required Information on their website and indicating in the release where the information is available. Forcing foreign private issuers to include the Required Information in an earnings release that is released worldwide would constitute an interference with the issuer's ability to communicate according to the customary practice in its home market.
The Proposed Rules would disadvantage foreign private issuers by requiring those issuers to include the Required Information in their earnings releases, while such information would not be contained in the earnings releases of other issuers in their home market. Applying Regulation G to foreign private issuers already represents a departure from the Commission's historical policy of regulating only the disclosure of foreign private issuers contained in their annual reports filed on Form 20-F. We believe that requiring foreign private issuers to make information available contemporaneously on their website offers sufficient protection for U.S. investors, balanced against the added burden to foreign private issuers.
Under the proposed amendments to Regulation S-K and Form 20-F, foreign private issuers would be subject to the more stringent requirements of the proposed amendments to Regulation S-K with regard to the use of non-GAAP financial measures in filings with the Commission. In addition to the additional disclosure required, this would include a prohibition against using certain non-GAAP financial measures in Commission filings. As with domestic issuers, foreign private issuers would be prohibited from presenting non-GAAP per share measures or presenting non-GAAP financial measures on the face of the issuer's financial statements prepared in accordance with GAAP or the accompanying notes. The Proposed Rules contain an exemption to the rules prohibiting certain non-GAAP financial measures if the measure is expressly permitted under the generally accepted accounting principles used in preparing the issuer's primary financial statements and was included in the issuer's annual report or financial statements used in its home jurisdiction or market. This exception will not be of much practical use to foreign private issuers because use of non-GAAP financial measures is unlikely to be expressly permitted.
As a result, U.S. investors who review a foreign private issuer's Form 20-F could be denied information that was released in the foreign private issuer's home market and was considered by management to be material information. We believe that subjecting foreign private issuers to the positive disclosure requirements under Regulation G will offer sufficient protection for U.S. investors, and that prohibiting certain non-GAAP financial measures could work to the detriment of U.S. investors. Accordingly, we believe foreign private issuers should be able to include any non-GAAP financial measures that are included in the issuer's annual report or financial statements used in its home jurisdiction or market.
Impact of Rules on Canadian Issuers Entitled to Use Form 40-F
The Commission has proposed to subject Canadian issuers eligible to use Form 40-F under the Multi-Jurisdictional Disclosure System ("MJDS") to the rules concerning disclosure regarding off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments. The philosophy of MJDS is that Canadian disclosure requirements should dictate required disclosure in filings with the Commission for filers entitled to use Form 40-F. In general, other than requirements related to English translations, a consent to service of process and, if applicable, a reconciliation of financial statements, the MJDS disclosure is based on use of the registrant's home jurisdiction documents in their entirety.
In the adopting release for MJDS, the Commission stated: "The Commission finds that permitting certain Canadian issuers to register under the MJDS using their home jurisdiction disclosure documents instead of using disclosure documents prepared in accordance with the Securities Act specifications is in the public interest and fully adequate for the protection of U.S. investors."7 We continue to believe that allowing MJDS filers to use their home jurisdiction disclosure documents is in the public interests of U.S. investors and do not see any reason to make a change in the philosophy of MJDS at this time. In order to prevent the erosion of MJDS, MJDS filers who file annual reports on Form 40-F should continue to be able to prepare their home jurisdiction disclosure documents in accordance with Canadian requirements.
The Proposed Rules treat Canadian issuers unevenly with respect to the rules regarding non-GAAP financial measures. Consistent with the philosophy of MJDS, the Proposed Rules do not propose to subject Canadian filers eligible to use Form 40-F to the additional requirements contained in the amendments to Regulation S-K. However, the Proposed Rules would subject such issuers to Regulation G with respect to all public disclosures in the United States, including disclosure on Form 40-F. For similar reasons as contained in the previous comment, we do not believe Canadian issuers eligible to use Form 40-F should be subject to the requirements of Regulation G. Canadian disclosure requirements should dictate required disclosure for filers entitled to use Form 40-F. To retain consistency with the philosophy of MJDS, Canadian issuers entitled to use Form 40-F should not be subject to Regulation G.
We appreciate your consideration of our comments. Please call Timothy E. Peterson at 011 44 20 7972 9676 or Kenneth R. Blackman at (212) 859 8280 of our Firm if you have any questions about or require clarification of our comments.