American Bar Association
File No. S7-42-02
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Section of Business Law (the "Committee")* in response to the request of the Securities and Exchange Commission in its November 4, 2002 Release No. 33-8144, entitled "Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments" (the "Proposing Release") for comments on proposals to implement new Section 13(j) to the Securities Exchange Act of 1934 (the Exchange Act"), 15 U.S.C. 78m(j), which was added by Section 401(a) of the Sarbanes-Oxley Act of 2002.
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.
The Commission has proposed to require that registrants provide in their "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") section of their disclosure documents filed with the Commission a comprehensive discussion of off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships with unconsolidated entities or other persons that have, or may have, a material effect on financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures or capital resources. The new disclosure would be presented in a separately captioned subsection of the MD&A. The proposals also would require that the registrants (other than small business issuers) provide an overview of their aggregate contractual obligations in a tabular format and to present in a tabular or textual format a description of their contingent liabilities and commitments. The proposals, while intended to implement the mandate of new Section 13(j) of the Exchange Act, also seek to codify certain portions of the Commission's interpretive statement on MD&A disclosure regarding off-balance sheet arrangements and contractual obligations and commitments provided in its January 22, 2002 Release No. 33-8056 (the "2002 Interpretive Release").
We generally support the Commission's goal to obtain improved disclosure of off-balance sheet transactions that previously had not been required to be disclosed or presented in a format that allowed the information to be readily evaluated by investors. Our concern is that the proposals are not sufficiently focused to achieve that result. Because of the unusual breadth of the proposed definition of off-balance sheet arrangements and the novel "higher than remote" disclosure threshold, the proposals will result in a significant amount of confusing and uninformative information at significant costs to public companies. The proposals would reach ordinary business transactions that are far removed from the specific concerns presented by off-balance sheet financing transactions. The proposed definition does not focus on the types of structured financings or special purpose entities that led to the enactment of Section 13(j) of the Exchange Act and that are indeed the subject of the Commission's own "Background" discussion in the proposing release. If the Commission actually intends to mandate disclosure of transactions beyond those typically associated with structured finance and special purpose vehicles, it should incorporate some limiting principles so registrants will not have to report as off-balance sheet arrangements ordinary course business activities that are the subject of executory contracts. This problem is further exacerbated by the detail of the disclosure mandated and the low or undefined disclosure thresholds incorporated into the proposals.
Our comments address the following issues:
II. The Appropriate Scope of the New MD&A Requirements
A. Definition of "Off-Balance Sheet Arrangement"
As proposed, the term "off balance sheet arrangement" includes any transaction, agreement or other contractual arrangement to which an 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:
This definition is extremely broad in that it is not limited to structured financings or the use of limited or special purpose entities. Instead, it would reach obligations with unaffiliated, independent third parties that are themselves operating companies. If that is the intended effect of these rules, it is much broader than what companies have considered to be their off-balance sheet arrangements and would encompass virtually all liabilities and contingent obligations of the registrant, so long as they are not currently required to be fully accrued (not just disclosed) under existing accounting principles.
The 2002 Interpretive Release, in contrast to the Proposing Release, principally focused on the need for additional disclosure of relationships with unconsolidated entities that are contractually limited to narrow activities that facilitate the registrant's transfer of or access to assets. These entities are often referred to as structured finance or special purpose entities. These entities may be in the form of corporations, partnerships or limited liability companies, or trusts.
Material sources of liquidity and financing, including off balance sheet arrangements and transactions with unconsolidated, limited purpose entities, should be discussed pursuant to Item 303(a).1
The Proposing Release, itself, in introducing the concept of off-balance sheet arrangements in its Background discussion, focuses on "off-balance sheet arrangements" used to provide financing, liquidity, market or credit risk support or to engage in leasing, hedging or research and development services. The entire Background discussion of the Proposing Release suggests that the scope of off-balance arrangements at issue are those used for financing or liquidity purposes, or to allocate risk.2
We do not believe the definition of off-balance sheet arrangements should include all potentially material arrangements with unconsolidated parties that have not been reflected fully on the registrant's financial statements. We understand that the Commission intended to obtain disclosure of potentially material arrangements with unconsolidated third parties even if the registrant was not a direct party to that arrangement, but nevertheless had a direct or indirect interest. However, without any reference to a special purpose or affiliated entity in the definition, the proposals would appear to require the MD&A to highlight many ordinary course business transactions that "may" (see discussion below) have a material effect on the registrant. For example:
Given the breadth of the definition and the absence of any narrowing principles or guidance as to the application, registrants and their advisers would be hard pressed to assess just what transactions are covered. For example, would contingencies like warranty reserves be deemed off-balance sheet arrangements? Would obligations subject to specific accounting standards such as pension liabilities or post-retirement benefits fall within the definition; are these obligations that the Commission views as fully valued on a company's balance sheet under current accounting standards?
If the Commission intends to use the rubric of off-balance sheet transactions to change longstanding practices for reporting these ordinary business transactions, the Proposing Release should state that purpose clearly and explain the rationale. Instead, no explanation for departing from the more commonly understood concept of off-balance sheet arrangement is provided in the Proposing Release. Moreover, nothing in the legislative history to Section 13(j) would require such an open-ended disclosure obligation. Instead, Section 13(j) was adopted to address "the problems of Enron Corp. and its special purpose entities."4 Although Section 13(j) doesn't expressly limit its application to transactions and arrangements involving special purpose entities, the commonly understood meaning of the term "off-balance sheet arrangements" is limited by that concept. 5
The Commission should refocus the proposals on off-balance-sheet arrangements used as a financing, liquidity or risk sharing technique, including preferably by reference to the use of unconsolidated special purpose or affiliated entities. If the Commission goal is to mandate disclosure of arrangements outside the commonly understood meaning of the term off-balance sheet arrangement, it must develop much more specific definitional terms, examples and other types of guidance, including guidance as to what constitutes "similar arrangements." The Commission would also need to develop appropriately narrow disclosure thresholds and informational requirements so as not to defeat the Commission's stated goal of avoiding "unnecessarily voluminous and repetitive disclosure."
B. The Proposed Disclosure Threshold
The proposal to implement Section 13(j) of the Exchange Act also would differ from the 2002 Interpretive Release and existing MD&A requirements in its disclosure threshold. Disclosure of off-balance sheet arrangements would be required whenever there is a greater than a remote chance that the arrangement could have a current or future material effect on the registrant's financial condition, changes in financial condition, revenues or expenses, results in operations, liquidity, capital expenditures or capital resources. The 2002 Interpretive Release, on the other hand, applied the existing MD&A standard to require disclosure of off-balance sheet arrangements that are "reasonably likely" to have a material effect on the registrant. The Proposing Release points to Congress's use of the term "may" in Section 13(j), and concludes that, by excluding off-balance sheet arrangements that present only a remote risk of having a material effect on the issuer, the standard is consistent with that low statutory requirement without requiring overly broad disclosure. We do not believe that the statute's use of the term "may" requires a departure from current MD&A standard of "reasonably likely" particularly as construed by the Commission,6 and we are concerned that such a low standard will undermine the usefulness of the disclosure for investors while greatly increasing the cost of compliance.
First, the statute is expressly limited to "material" off-balance sheet arrangements. All off-balance sheet arrangements that merely "may" have a material effect on the registrant will not necessarily be material. The Commission should be equally concerned with implementing Congress's mandate to set an appropriately high disclosure threshold so as not to elicit immaterial information.
Further, we are troubled by the Commission's introduction of the concept of "prospectively material" information.7 The Proposing Release elsewhere refers to an arrangement that "is material in the current period or that may become material in the future."8 There is nothing in the legislative history of Section 13(j) that indicates that Congress intended to introduce an entirely new concept of materiality.9 Materiality of off-balance sheet arrangements should be assessed as of the time of the report, not some time in the future, based on whether the arrangement is reasonably likely to have a material effect on the issuer.
The introduction of a different standard within the MD&A requirements based upon "remoteness" would not only be unnecessary, it would be confusing by adding yet another threshold to those already specified in the MD&A requirements, Commission and staff guidance, and the accounting literature. The proposal would create a threshold that is higher than "remote",10 but apparently lower than "reasonable likelihood" used in MD&A or apparently even the "reasonable possibility" standard specified in SFAS No. 5, Accounting for Contingencies. 11 The proliferation of additional standards to be applied to contingencies is not helpful, particularly when the differing standards are to be applied within the same portion of the disclosure document based solely on whether the arrangement discussed is required by accounting standards to be fully reflected currently in the financial statements. A lower requirement is troublesome for the additional reason that it apparently would apply not only to contingent losses, but also to contingent gains arising from off-balance sheet arrangements.
The traditional "reasonably likely" MD&A test was formulated to provide meaningful disclosure to investors regarding prospective information. Imposing a lower standard would give undue prominence to the off-balance sheet disclosures, create redundancy, and confuse investors.
C. The Required Disclosure
Once an off-balance sheet transaction has been identified and management cannot conclude that the a potential material impact is only remote, the proposal specifies detailed matters to be discussed, to the extent those matters are applicable and necessary to understand the arrangement and potential impact.
The breadth and detail of the required disclosure reinforce the conclusion that, notwithstanding the broad definition, the Commission truly is interested only in off-balance sheet arrangements with affiliated parties or special purpose entities that were sponsored by the registrant or its affiliates. Disclosures as to the purpose of many of the ordinary course executory contracts falling within the proposed definition as well as their material terms would serve little, if any, investor needs. In addition, the proposal would require the registrants to disclose information about the nature and amount of assets and of the total obligations and liabilities (including contingent liabilities) of unconsolidated entities with whom they have entered into disclosable arrangements. Unless limited to sponsored special purpose or affiliated entities, that requirement could result in registrants' having to disclose financial information concerning an unrelated third party who may not agree to that disclosure, e.g., in the case of a private company. If the company is a public company such disclosure should be unnecessary. In many cases falling within the broad definition of off-balance sheet arrangement, a registrant would not have a basis to know or obtain the required information; it is unlikely that transactions with an independent third party in the ordinary course of business would provide for a registrant to obtain and disclose such information. If the entity is a foreign entity, would the information have to be reconciled to GAAP? Who would perform that reconciliation?
In the case of sponsored special purpose or affiliated entities, on the other hand, registrants can be expected to retain the right to obtain sufficient information to monitor their risks.
III. Proposed Item 303(a)(5) of Regulation S-K
For all the above reasons we would not extend the "may" and "remote" standards proposed for off-balance sheet arrangements to existing MD&A disclosures. Nor would we apply it to the proposed requirements under Item 303(a)(5) for contractual commitments, contingent liabilities and obligations. The discussion in the Proposing Release of the appropriate disclosure threshold only addresses the new requirements pertaining to off-balance sheet arrangements in proposed S-K Item 303(a)(4). It is not clear what the disclosure threshold is for new Items 303(a)(5)(i) and (ii). Those proposed Items are not mandated by Section 401(a) of Sarbanes-Oxley and therefore presumably the Commission is not required to apply the same standard as that applicable to off-balance sheet arrangements. Unlike existing subparagraphs of Item 303(a) and proposed Item 303(a)(4), proposed Item 303(a)(5) does not specify a threshold for disclosure. Thus, we assume that the table required in proposed Item 303(a)(5)(i) would require an aggregation of all contractual obligations of the registrant, whether or not currently reflected on its balance sheet. But we seriously question the feasibility and utility of mandating that all ordinary course ongoing commitments be scheduled, including commitments under all purchase agreements, leases, employment contracts, licenses and franchise agreements. In our experience, registrants do not routinely collect that information today. The costs of collection and reporting would be substantial, and it is not clear what benefit would be provided to investors.
The proposed tabular or narrative summary of all contingent liabilities and commitments is equally troublesome. A summary of all contingent liabilities and commitments regardless of the probability of the contingent event occurring or the materiality of the event would be impracticable and confusing. Here, the Commission did not appear to intend to limit the categories of contingent liabilities or commitments to be included. Rather, any contingent obligation to any third party would be included and would be required regardless of whether the contingent liability is accrued on the balance sheet. Indeed, unlike proposed Items 303(a)(4) and (5)(i), under proposed Item 303(a)(5)(ii), the Commission does not propose to limit contingent liabilities to those related to a contractual commitment and could include a liability from pending or potential litigation, arbitration or government proceedings. The proposing release does not discuss why the Commission believes it necessary to override existing disclosure and accounting requirements to mandate disclosure regarding all possible contingent liabilities.12
We concur with the Commission's proposal to extend the existing exclusion from the MD&A requirements for preliminary negotiations to off-balance sheet transactions. In fact, that exclusion should not be limited to off-balance sheet transactions, as proposed; it should also exclude the disclosure that would be required by proposed Item 303(a)(5) of Regulation S-K.
IV. The Treatment of Foreign Issuers
Proposed Item 303(a)(4)(i) applies to off-balance sheet arrangements with "unconsolidated" entities. In the case of foreign private issuers, because home country standards for consolidation for financial reporting may differ from U.S. GAAP, it is possible that the reconciliation required for foreign private issuers would consolidate an entity with the registrant that is not consolidated in the registrant's primary financial statements. The Commission should make clear that in this instance the entity would be deemed consolidated for the purpose of proposed Item 303(a)(4)(i). Otherwise, foreign private issuers would be required to "double count" the commitments and obligations represented by the off-balance sheet arrangements with these entities.
By requiring Form 40-F filers to add the new off-balance sheet arrangement disclosure to their Canadian reports, the Commission is effecting a de facto repeal of the Multijurisdictional Disclosure System. In the past the Commission has adopted significant disclosure reforms without incorporating those reforms into the Form 40-F. For example, the MJDS documents are not subject to the plain English requirements of Item 501 of Regulation S-K or the market risk disclosure requirements of Item 305 of Regulation S-K. Starting with the addition of certification requirements under Sections 302 and 906 of the Sarbanes-Oxley Act of 2002, including the addition to the annual report of the certifying officers' conclusions as to the effectiveness of the registrant's disclosure controls and procedures, the Commission has been eroding the usefulness of the MJDS system by adding substantive disclosure requirements to the Canadian documents. Before the Commission adds disclosure requirements as extensive as the proposed for off-balance sheet arrangements, we suggest that the Commission consult with the Canadian securities regulators concerning their willingness to adopt similar requirements. We note that the Commission has not proposed to add the new disclosure requirements to MD&A disclosure contained in Canadian prospectuses. To the extent the Commission believes that Sarbanes-Oxley requires that the Form 40-F include the off-balance sheet disclosure when filed as an annual report, the Commission should not require that disclosure in initial Exchange Act registration statements filed on Form 40-F, which are not subject to the Section 13(j) requirements. Nor should the Commission impose the disclosure requirements relating to contractual obligations, contingent liabilities and commitments on even the annual report on Form 40-F, since those requirements are not covered by Section 13(j).
Similarly, the international disclosure standards embodied in Form 20-F were derived from a process of consultation and negotiation with securities regulators from all the major markets. There is nothing in the legislative history of Section 13(j) that suggests the goals and benefits of that process have not been realized or need be sacrificed to meet the goals of the current initiatives. Any Congressional mandate must be read within the context of the complex and varied regulatory scheme in which Congress was writing and the Commission should not presume that Congress intended to undo a myriad of unrelated policy initiatives and determinations when directing the Commission to address a targeted issue.
We concur with the Commission's determination not to require the new MD&A disclosure in Forms 6-K filed by foreign private issuers even if the Form 6-K contains interim financial statements, for the reasons provided in the Proposing Release.
V. The Safe Harbor Proposal
We agree with the Commission's proposal to clarify that the statutory safe harbor for forward-looking statements would be available for the disclosure made pursuant to proposed Item 303(a)(4). The Commission is defining the term "forward-looking information" to include the disclosure of off-balance sheet arrangements provided in proposed Item 303(a)(4), but leaving all other requirements and limitations of the statutory safe harbor in place. The safe harbor should be extended to apply to proposed Item 303(a)(5)(ii) as well, because of the inherent predictive nature of disclosures of contingent liabilities and commitments and we are concerned that the failure to include that provision would lead to a negative inference that such disclosure is not covered by the safe harbor. In adopting the market risk disclosure rules, the Commission provided in Item 305(d)(2)(ii) of Regulation S-K that the mandated disclosure would also satisfy the cautionary language requirements of the statutory safe harbor. The Commission should likewise provide that a registrant providing the required information about off-balance sheet arrangements, obligations, contingent liabilities and commitments would also be deemed to have provided adequate cautionary language. In addition, the safe harbor rule should affirmatively state that the exclusions from the statutory safe harbor for initial public offerings, tender offers, direct participation offerings and other specified exclusions do not apply to disclosure called for by proposed Items 303(a)(4) and (a)(5) of Regulation S-K. Otherwise, the Commission would not achieve its goal of encouraging registrants in these excluded transactions to draft their MD&A disclosure with the safe harbor in mind. Finally, the Commission should consider whether separate relief under Securities Act Rule 175 and Exchange Act Rule 3b-6 is also appropriate.
VI. Transition Issues
We understand that the Commission is under a Congressional mandate to have final rules in place by January 26, 2003. We suggest that the Commission adopt a set of rules targeted to meet the mandate. First, the Commission should limit the off-balance sheet arrangement disclosure requirements to arrangements involving affiliated or special purpose entities in transactions of the type discussed in the Background section of the Proposing Release and in the 2002 Interpretive Release. If the Commission believes that MD&A disclosure of transactions beyond such off-balance sheet arrangements is warranted, the Commission could then reconsider and repropose a broader version of the MD&A rules that provide clearer guidance as to their intended scope and the reasons MD&A disclosure of such arrangements is warranted. Finally, the Commission should not adopt proposed Item 303(a)(5) at this time.
Because the proposals would mandate disclosure of information that currently is not gathered on an ongoing basis, it is critical that the Commission not apply those standards to reports for current fiscal year. Instead, at the earliest, the standards as proposed should only be applied to fiscal years ending on or after December 15, 2003. The current fiscal year's Form 10-K, of course, would be subject to the guidance of the 2002 Interpretive Release. Even if the Commission adopts our suggestion to narrow the proposals to require only the type of off-balance sheet arrangements that were the focus of the 2002 Interpretive Release, it would not be reasonable to expect full compliance for fiscal years ending earlier than on or after September 15, 2003. Instead, the Commission could urge registrants to begin to look to the new standards for guidance in updating their MD&A disclosure for interim periods ending on and after March 15, 2003.
* * *
We appreciate the opportunity to submit comments. We are available to meet with the Commission or the Staff and to respond to any questions.
David A. Sirignano
Linda C. Quinn
Catherine T. Dixon
Linda L. Griggs
Hon. Harvey L. Pitt
|* Reference to "we" and "our" mean the Committee.|
|1||Likewise, the current MD&A disclosure requirement only refers to "off-balance sheet financing" activities. Item 303(a)(2)(ii)(emphasis added).|
|2||See also Testimony Concerning Transparent Reporting for Structured Finance Transactions, submitted by Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Before the Senate Permanent Subcommittee on Investigations, Committee on Governmental Affairs (December 11, 2002)(describing SEC concerns and initiatives regarding structured financing transactions); In re The PNC Financial Services Group, Inc., Securities Act Release No. 8112, Administrative Proceeding File No. 3-10838 (July 18, 2002)(special purpose entities in which registrant retained significant interest).|
|3||Proposing Release, text at n. 56.|
|4||See, e.g., Report of the Committee on Banking, Housing, and Urban Affairs of the United States Senate to accompany S.2673, S.Rep. No. 205, 107th Cong., 2d Sess., at Title IV.B (July 3, 2002).|
|5||Section 401(a) of Sarbanes-Oxley, like the Proposing Release, uses the term "unconsolidated entity," but Congress elsewhere in Section 401 referred to special purpose entities and financing arrangements. If the Commission believes that the term "unconsolidated entity" has a limiting connotation that would exclude unrelated, independent operating companies, Item 303(a)(4) should be revised to define unconsolidated entities as entities sponsored by or affiliated with the registrant or its affiliates or special purpose vehicles that are not required to be consolidated with the registrant under GAAP.|
|6||The formulation of the "reasonably likely" disclosure threshold in the 1989 and 2002 Interpretive Releases requires that unless management can affirmatively conclude that the contingent event is not reasonably likely to occur, management must evaluate whether the event, assuming it will occur, will have a material effect. Unless it can make the affirmative determination that it would not, disclosure is required. By placing the burden on management to determine that a contingent event is not reasonably likely to have a material effect, the current MD&A standard of probability already provides an appropriate standard of probability for disclosure.|
|7||See, e.g., Proposing Release, text at n. 71. We ran a Lexis search of "prospectively material" or "prospective materiality" in the Commission's release file and received one hit - the Proposing Release.|
|8||Proposing Release, text at n. 62.|
|9||See Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, H. Rep. No. 414, 107th Cong., 2d Sess. 40 (April 22, 2002)(SEC to adopt rules requiring disclosure of off-balance sheet transactions "that are not otherwise reported at fair value and are reasonably likely to materially affect the registrant's liquidity..." (emphasis supplied).|
|10||Under FASB SFAS No. 5 (March 1975), except in the case of guaranties, loss contingencies need not be disclosed unless there is a reasonable possibility that a loss may have been occurred. Guaranties must be disclosed even if "remote," which SFAS No. 5 defines to mean that "the chance of the future event or events occurring is slight."|
|11||Id. (the chance of the future event or events occurring is more than remote but less than likely).|
|12||We recommend that the Commission consider whether the additional disclosure about guarantees required for the FASB's recent Interpretation No. 45 avoids the need for at least some of the proposed disclosures about guarantees in the MD&A.|