Staff Legal Bulletin No. 6 (CF/MR/IM)
Action: Publication of Divisions of Corporation Finance, Market Regulation and Investment Management ("Divisions")
Date: July 22, 1998
Summary: The Divisions remind public issuers,1 broker-dealers, investment advisers, and investment companies to consider their disclosure obligations in connection with the January 1, 1999 conversion by eleven member states of the European Union to a common currency, the "euro."2 These obligations may arise in connection with:
In addition, broker-dealers and other regulated entities3 are advised to refer to the Division of Market Regulation's Year 2000 Work Program in planning systems modifications responsive to the introduction of the euro.
Supplementary Information: This legal bulletin represents the Divisions' staff views. This bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission. Further, the Commission has not approved or disapproved its content.
Contact Persons: For further information, please contact Paul Dudek regarding foreign issuers at (202) 942-2990, Anne M. Krauskopf regarding domestic public operating companies at (202) 942-2900, Craig C. Olinger regarding accounting issues at (202) 942-2960, Paul P. Andrews regarding broker-dealers at (202) 942-0799, and Paul T. Kraft regarding investment companies and investment advisers at (202) 942-0590.
I. The Euro ConversionOn January 1, 1999, eleven of the fifteen member countries of the European Union (the "participating countries")4 are scheduled to establish fixed conversion rates between their existing sovereign currencies (the "legacy currencies") and the euro.5 The participating countries have agreed to adopt the euro as their common legal currency on that date.6 The euro will then trade on currency exchanges and be available for non-cash transactions. The participating countries will issue sovereign debt exclusively in euro, and will redenominate outstanding sovereign debt.
As of January 1, 1999, the participating countries no longer will control their own monetary policies by directing independent interest rates for the legacy currencies. Instead, the authority to direct monetary policy, including money supply and official interest rates for the euro, will be exercised by the new European Central Bank.7
Following introduction of the euro, the legacy currencies are scheduled to remain legal tender in the participating countries as denominations of the euro between January 1, 1999 and January 1, 2002 (the "transition period"). During the transition period, public and private parties may pay for goods and services using either the euro or the participating country's legacy currency on a "no compulsion, no prohibition" basis. However, conversion rates no longer will be computed directly from one legacy currency to another. Instead, the following "triangulation" process will be applied:
European Union regulations specify the number of decimal places and rounding conventions that will be used in these "triangulation" computations.8
Beginning January 1, 2002, the participating countries will issue new euro-denominated bills and coins for use in cash transactions. No later than July 1, 2002, the participating countries will withdraw all bills and coins denominated in the legacy currencies, so that the legacy currencies no longer will be legal tender for any transactions, making conversion to the euro complete.9
II. Disclosure Regarding the Euro Conversion
A. GeneralThe effect of the euro conversion upon an issuer and its business will depend upon the nature of the business conducted and various other factors. For many entities, the euro conversion will create technical challenges to adapt information technology and other systems to accommodate euro-denominated transactions. The euro conversion also may affect market risk with respect to financial instruments.
For European issuers, and other entities with significant markets or operations in Europe (whether or not in the participating countries), the euro conversion may create strategic challenges as these entities adapt to a single transnational currency. The participating countries' adoption of a single currency will likely result in greater transparency of pricing, making Europe a more competitive environment. Issuers and other entities may need to respond by adjusting their business and financial strategies.
Issuers may be affected in different ways over time. An issuer should evaluate its disclosure obligations to investors and potential investors on an on-going basis during:
An issuer also should consider the effects of the euro conversion on each reportable industry segment, as well as each significant line of business (even if not an industry segment).
B. Applicable Disclosure RequirementsIn this section, we summarize specific disclosure obligations under our rules that may require disclosure relating to the impact of the euro conversion. In section C, we describe specific aspects of the euro conversion for which disclosure may be required. We are providing guidance so that issuers can more readily focus on aspects of the euro conversion that may be material to them.
Issuers should consider each of the disclosure obligations below in evaluating whether a discussion of the euro conversion should be included in any particular section of a prospectus, annual or quarterly report or other document. We remind issuers that, in addition to these specific obligations, our rules require filed documents to include any additional material information necessary to make the required disclosure not misleading.10 We also remind issuers that disclosure must be issuer-specific to be meaningful to investors.
An issuer should disclose the impact of the euro conversion if that impact is expected to be material to the issuer's business or financial condition.11 If an issuer suspects that its operations may be materially affected by the euro conversion, but is uncertain, the issuer should disclose this known uncertainty. In either case, the issuer should indicate whether it has initiated an internal analysis to plan for the conversion, and describe that analysis and/or plan.
If consequences of euro conversion issues may have a material effect on an issuer, without regard to the issuer's efforts to avoid those consequences, the issuer should disclose the nature and potential impact of those consequences as well as the issuer's efforts to avoid them.
We expect the conversion may be material to many European issuers,12 financial institutions, and domestic corporations with significant European operations, markets, investments, and/or contractual counterparties. These issuers may wish to consider the advisability of disclosure, even if the impact is not material.
1. Registration statements under the Securities Act of 1933 ("Securities Act") and annual and quarterly reports under the Securities Exchange Act of 1934 ("Exchange Act") must include:
a. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"). are required to discuss liquidity, capital resources, and other information necessary to understand their financial condition, changes in financial condition, and results of operations.13 Among other things, MD&A requires disclosure of known trends or uncertainties that the issuer reasonably expects will have a material impact on revenues, expenses or income from continuing operations.14
As described in Section C below, the euro conversion raises strategic as well as operational issues. As a result, issuers should include in MD&A disclosure concerning known trends and uncertainties related to the euro conversion that meet this materiality standard, such as:
b. Description of Business. This item requires a description of the general development of the business of the issuer, its subsidiaries, and any predecessors.15 Among other things, this item requires a discussion of:
c. Quantitative and Qualitative Disclosures About Market Risk ("Market Risk Disclosure"). Under existing rules, an issuer must describe the derivatives and other financial instruments it has entered into, their terms, how the issuer uses them, and how they are accounted for.16 Both quantitative and qualitative disclosure about market risks are required.17 Qualitative disclosure also is required regarding the context of primary market risk exposure, the strategies and objectives used to manage that exposure, and actual or expected changes in either that exposure or management techniques.
d. Legal Proceedings. An issuer must describe material pending legal proceedings in which the issuer or any of its subsidiaries is a party, or to which their property is subject.18 Generally, no information is required regarding claims for damages unless the amount involved exceeds ten percent of the current assets of the issuer and its subsidiaries on a consolidated basis. However, it may be necessary to describe routine litigation where the claim differs from the usual type of claim.19
e. Material Contracts. An issuer must file as an exhibit certain contracts that are considered material to its business.20 These contracts include contracts upon which the business is substantially dependent, such as contracts with principal customers and principal suppliers.
2. Registration statements under the Securities Act also must include , under the caption "Risk Factors" a discussion of the factors that make the offering speculative or risky.21 This discussion must be specific to the particular issuer and its operations, and should explain how the risk affects the issuer and/or the securities being offered. Generic or "boilerplate" discussions do not tell investors how the risk may affect their investment.
Form 8-K. The impact of the euro conversion may reach a level of importance that prompts an issuer to consider filing a Form 8-K under Item 5 of the form.22 In considering whether to file a Form 8-K, issuers should be particularly mindful of the accuracy and completeness of information in registration statements filed under the Securities Act that incorporate by reference Exchange Act reports, including Forms 8-K.23
C. Specific Considerations
In applying these disclosure standards to the euro conversion, an issuer should specifically consider the factors listed below to the extent that such factors are material to the issuer's business, operations or financial condition. However, each issuer's situation may vary, and issuers should not construe the listed factors as exclusive.
1. Competitive Impact. The euro conversion is expected to stimulate cross-border competition by creating cross-border price transparency, which may make it more difficult for businesses to charge different prices for the same products on a country-by-country basis. Product lines may become more international and less local due to revised marketing strategies. Issuers may need to adjust product and service prices to remain competitive in a broader European market. Issuers may need to adapt to changing costs (including labor costs) due to competitive pricing adjustments by suppliers.
Other factors that may impact competition are:
2. Information Technology and Other Systems. Issuers will need to prepare for the transition period by modifying information systems software. Modifications will be necessary to:
Issuers also will need to modify fixed assets (such as keyboards, vending machines, and ATM machines) on a timely basis so that these assets will accommodate euro-denominated amounts. Financial institutions will require the technical capability to redenominate into euro accounts and transactions that are open on January 1, 1999.
Issuers should consider the costs, timeliness, and adequacy of their own modifications in evaluating their Risk Factor and MD&A disclosure obligations. Issuers also should consider the impact on their businesses of reliance on systems operated by others (such as customers, suppliers, banks, and other constituents) that require modification.24 An issuer that is affected should disclose:
3. Currency Risk. For many issuers, the conversion may result in reduced costs for currency exchange and eliminate currency exchange rate risk. However, this may not always be the case. Accordingly, issuers will need to evaluate their currency exchange costs and rate exposure with respect to the euro during and following the transition period. For example, U.S. and other issuers may use the euro more than they used the legacy currencies, thereby altering currency exchange cost and risk exposure. Issuers in the business of exchanging or trading currencies may lose significant business because the euro conversion will eliminate the legacy currencies.
The functional currency25 of one or more of an issuer's foreign operations (whose functional currency is currently a legacy currency or another currency) may change to the euro. Depending on the circumstances, this change may occur on January 1, 1999, during the transition period, or after January 1, 2002. Issuers should consider disclosing the nature and timing of the change in the functional currency, and the expected effects on financial condition and results of operations. Issuers that have invested or borrowed amounts in a currency different from their functional currency should discuss risk exposure if the impact of reasonably possible changes in exchange rates would be material.
4. Derivatives and Other Financial Instruments26 As a result of the euro conversion, the terms of certain derivatives and other financial instruments that are outstanding on January 1, 1999 may need to be modified. For example:
Day count conventions29 and settlement conventions30 may require adjustment. Systems that monitor derivatives risk will require conversion so that historic performance data can be recalculated in synthetic euro terms.
New instruments are being designed to satisfy evolving market needs following introduction of the euro. For example, the euro conversion may result in the development of new standard categories of euro denominated instruments, such as swaps based on the spread between Euribor and euro Libor.31
Issuers should disclose the impact of the euro conversion on outstanding derivatives and other financial instruments if the anticipated impact is material. Issuers should consider the need to disclose the specific consequences to outstanding instruments of repricing, redenomination, replacement of price sources, and other modifications. Issuers also should consider the need to disclose the nature of any anticipated changes in how exposures to derivatives and other financial instruments will be managed following introduction of the euro.
5. Continuity of Contract. The performance of a contract that requires payment in the currency of country A may be governed by the law of country B. However, the law of country A will determine what constitutes the lawful currency of country A. The substitution of a currency may result in a party claiming that performance of a contract is "frustrated," "impossible," or "impracticable."
The European Union has adopted regulations providing that the euro conversion should not enable one party unilaterally to break or change its contractual obligations, unless the parties have otherwise agreed.32 Legislation providing for similar results has been adopted in New York, Illinois and California,33 and has been introduced in other states.34 The International Swaps and Derivatives Association, Inc. ("ISDA") has published an EMU35 Protocol that parties to derivative contracts may use to amend their agreements to ensure continuity of contract.
Contracts governed by the law of a state or country that has not adopted a specific law relating to the continuity of contracts and the euro conversion will not necessarily become unenforceable as a result of the conversion. Issuers will need to review their contracts to determine whether amendments are necessary to ensure the parties' performance. Issuers should consider both:
6. Taxation. The Internal Revenue Service ("IRS") has issued Announcement 98-18 requesting comments on various tax issues raised by the euro conversion. The IRS asks whether conversion of a legacy currency to the euro creates a "realization event" for a financial instrument denominated in the legacy currency, and the appropriate time to recognize any gain or loss.36 Depending on how the IRS rules, the euro conversion may result in taxable gain or loss on legacy currency denominated instruments that have not been sold. The IRS expects to publish guidance on the issue soon.
7. Accounting. The staff of the FASB recently announced that costs associated with upgrading or replacing computer software and costs to make physical modifications to fixed assets to accommodate the euro should be accounted for in accordance with an issuer's existing accounting policies for similar costs.37
III. Investment Adviser and Investment Company DisclosureInvestment advisers and investment companies should determine whether the introduction of the euro will materially affect their business operations and whether disclosure is warranted. In making this evaluation, investment advisers and investment companies should consider the matters discussed above for other public issuers to the extent relevant. As mentioned above, disclosure, if required, must be issuer and situation specific to be meaningful. "Boilerplate" or generic disclosure should be avoided.
For investment advisers, the anti-fraud provisions of the Investment Advisers Act of 1940 generally impose on investment advisers an affirmative duty, consistent with their fiduciary obligations, to disclose to clients or prospective clients material facts concerning their advisory or proposed advisory relationship. If the failure to address the effect of the euro conversion could materially affect the advisory services provided to clients, an adviser that will not be able to or is uncertain about its ability to address euro conversion issues has an obligation to disclose that information to clients.
For investment companies, the Investment Company Act of 1940 provides that it is unlawful for investment companies to omit from registration statements and other public filings "any fact necessary in order to prevent the statements made therein, in light of the circumstances under which they were made, from being misleading."38 Investment companies generally rely on external service providers such as investment advisers, transfer agents, custodians, broker-dealers, fund administrators, and pricing services. Investment companies may need to disclose the effect that the euro conversion will have on their advisers' or other service providers' ability to provide the services described in their registration statements. For example, open-end management investment companies (mutual funds) are required by Item 6 of Form N-1A to describe the experience of their investment advisers and the services the advisers provide. In addition, investment company registrants may need to consider the effect of the euro conversion in discussing their investment objectives, investment strategies, and risks.39
IV. Implementation of Systems Changes by Broker-Dealers
As noted above, the introduction of the euro may require market participants to make computer systems modifications to accommodate euro-denominated transactions. Broker-dealers, markets, clearing agencies, and transfer agents should assess their operations to determine the extent to which they will be impacted by the euro conversion and implement necessary measures. In this effort, they are advised to adopt guidelines similar to those developed in connection with the Year 2000 Work Program (available at http://www.sec.gov/news/y2k/mktwplan.htm).
|1||Although investment companies, investment advisers, and broker-dealers may be public issuers, for purposes of this Staff Legal Bulletin, "issuers" generally refers to corporate public issuers other than investment companies. Considerations applicable to investment advisers and investment companies, and broker-dealers and other regulated entities are addressed in Sections III and IV, respectively.|
|2||As used in this Staff Legal Bulletin, "euro" includes both single and plural references to the new currency.|
|3||These entities include markets, clearing agencies, and transfer agents.|
|4||The participating countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.|
|5||Denmark, Greece, the United Kingdom and Sweden (the "non-participating countries"), which also are members of the European Union, may convert to the euro at later dates.|
|6||On January 1, 1999, the euro also will replace the ECU basket of currencies on a one-to-one rate. The currencies that comprise the ECU basket are not in all instances the currencies of the participating countries. For example, the British pound is included in the ECU basket, but the Austrian schilling is not.|
|7||The national governments of the participating countries will retain authority to set tax and spending policies and public debt levels|
|8||Council Regulation (EC) No. 1103/97 (June 19, 1997) (the "Article 235 Regulation").|
|9||You may obtain more complete information about the euro conversion at the European Union's euro website - http://europa.eu.int/euro/.|
|10||See,e.g., Securities Act Rule 408, Exchange Act Rule 12b-20, and Exchange Act Rule 14a-9. Issuers also should consider the anti-fraud provisions of Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Exchange Act Rule 10b-5. The anti-fraud provisions apply to statements and omissions both in Commission filings and outside of Commission filings. Issuers also should consider potential civil liability under Securities Act Sections 11 and 12(a)(2) and Exchange Act Section 18.|
|11||Forward-looking statements concerning the euro conversion may be covered by the safe harbor provisions under Sections 27A of the Securities Act and 21E of the Securities Exchange Act . The safe harbor requires issuers to include meaningful cautionary language to identify important factors that could cause actual results to differ materially from those in the forward-looking statement.|
|12||For this purpose, a "European issuer" means any issuer that is domiciled in a European country, whether or not that country is a member of the European Union.|
|13||Item 303 of Regulations S-K and S-B, and Item 9 of Form 20-F.|
|14||In Securities Act Release No. 6835 (May 18, 1989), the Commission provided interpretive guidance regarding the disclosure required by Item 303. The MD&A disclosure requirements also are described in In the Matter of Caterpillar Inc., Exchange Act Release No. 30532 (March 31, 1992), a case involving failure to disclose known trends regarding currency translation gains.|
|15||Item 101 of Regulation S-K, and Item 1 of Form 10-K. Item 101 of Regulation S-B and Item 1 of Form 20-F require similar disclosure.|
|16||Item 305 of Regulation S-K, Item 7A of Form 10-K, and Item 9A of Form 20-F. This disclosure requirement was adopted in Securities Act Release 7386 (January 31, 1997). Banks, savings and loans, and registrants with market capitalization over $2.5 billion are required to make this disclosure in filings that include audited financial statements for years ending after June 15, 1997. Other registrants will be required to make this disclosure in filings that include audited financial statements for years ending after June 15, 1998. Small businesses are not required to make this disclosure, whether or not they file on small business forms. The staffs of the Office of Chief Accountant and the Division of Corporation Finance have published a booklet, "Questions and Answers About the New Market Risk' Disclosure Rules" (July 31, 1997), that explains this disclosure requirement.|
|17||This information must be provided in one place other than the financial statements, and may be set forth in MD&A.|
|18||Item 103 of Regulations S-K and S-B, and Item 3 of Form 20-F.|
|19||Instruction 1 to Item 103 of Regulation S-K, and Item 3 of Form 20-F.|
|20||Item 601(b)(10) of Regulations S-K and S-B, and Item 19 of Form 20-F.|
|21||Item 503(c) of Regulations S-K and S-B. This item was amended in Securities Act Release No. 7497 (January 28, 1998) to require issuers to describe risk factors in plain English.|
|22||Item 5 may be used by an issuer to report on Form 8-K any events, for which information is not otherwise called for by the form, that the issuer deems of importance to security holders.|
|23||General Instruction B.4 of Form 8-K.|
|24||Regarding third party risks, issuers may consult revised Staff Legal Bulletin No. 5 (January 12, 1998) and future Commission and staff guidance concerning Year 2000 issues.|
|25||Statement No. 52 of the Financial Accounting Standards Board ("FASB") defines functional currency as "the currency of the primary economic environment in which the foreign entity operates; normally that is the currency of the environment in which an entity primarily generates and expends cash."|
|26||On June 15, 1998, the FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement No. 133 establishes accounting and reporting standards for derivative instruments, including certain instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair value. It also specifies the accounting for changes in the fair value of a derivative instrument depending on the intended use of the instrument and whether (and how) it is designated as a hedge. Statement No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999.|
|27||A redenomination would result in both recordkeeping and payment in euro. In contrast, if an instrument is translated, recordkeeping would be in euro but payment would continue in the legacy currency.|
|28||The Paris Inter-Bank Offered Rate.|
|29||A day count convention is the method for determining the number of days used to calculate the accrual of interest on an instrument.|
|30||Settlement conventions, such as T+1 or T+0, designate the number of days following the trade date by which settlement must take place.|
|31||Euribor will be a measure of the cost of euro funds quoted by banks within the participating countries. In contrast, euro Libor will be a measure of the cost of euro funds based on the offer rates quoted by certain London banks.|
|32||The Article 235 Regulation, and Council Regulation (EC) No. 974/98 (May 3, 1998) (the "Article 109l(4) Regulation").|
|33||"New York Continuity Law" (Article 5, Title 16 of the N.Y. General Obligations Law); "Illinois Euro Conversion Act" (Ill. Stat. Ch. 815, Section 617); and Cal. Civ. Code Section 1663.|
|34||Michigan House Bill 5835 ("Euro Conversion Act"); and Pennsylvania House Bill 2193 ("European Union Currency Equivalency Law").|
|35||European Economic and Monetary Union.|
|36||1998-10 I.R.B. (March 9, 1998). Announcement 98-18 also asks whether a qualified business unit with a legacy currency as its functional currency will have changed its functional currency as a result of the euro conversion and, if so, the tax implications of that change.|
|37||Topic D-71 of the minutes of the May 21, 1998 Emerging Issues Task Force (EITF) meeting. The accounting profession currently is considering whether additional guidance is necessary concerning other matters related to the euro conversion.|
|38||Section 34(b) of the Investment Company Act.|
|39||See, e.g., Item 4 of Form N-1A, and Item 8 of Form N-2.|
|40||SeeExchange Act Release No. 8363 (July 29, 1968)|
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