Management's Discussion and Analysis of Financial Condition and Results of Operations or "MD&A"

The recent scandals involving Enron, Global Crossing and Worldcom, together with various well-publicized investigations into the accounting policies and disclosure practices of a number of other prominent companies, have triggered an unprecedented scrutiny of corporate disclosure. The SEC has promised that it will review more Form 10-Ks than it ever has before. During the last recession, the SEC brought numerous enforcement actions against public companies and their chief executive and financial officers for allegedly failing to properly fulfill their MD&A disclosure requirements. As such, in this environment, companies need to carefully review their procedures for preparing MD&A. What you did last year may not be enough.

Prior to drafting this year's MD&A, we encourage you to reassess your company's MD&A disclosure in light of the current climate. To assist you in this process, this memorandum discusses the basic rules and principles underlying MD&A, describes recent SEC initiatives to improve MD&A and outlines a suggested process for preparing and drafting MD&A.

The Disclosure Requirements of MD&A

As the SEC has repeatedly stated, MD&A is the "heart and soul" of a company's disclosure requirements under the Securities Exchange Act of 1934 and a crucial component in increasing the transparency of a company's financial performance and providing investors with the ability to evaluate the company on an informed basis. In a recent release, the SEC articulated three interrelated purposes of the MD&A disclosure requirements:

• To provide a narrative explanation of a company's financial statements that enables investors to see the company through the eyes of management;
  
  
• To improve overall financial disclosure and provide the context within which financial statements should be analyzed; and
  
  
• To provide information about the quality, and potential variability, of a company's earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
  
  

The Basic Rule. In MD&A, companies must provide a narrative explanation of their financial statements and accompanying footnotes. In their annual reports, companies must discuss their liquidity, resources for capital expenditures, and results of operations. For quarterly reports, companies must include a discussion and analysis of their financial condition and results of operations sufficient to enable the reader to assess material changes since the end of the preceding fiscal year and, as appropriate, from the corresponding period in the preceding fiscal year.

General Principles. A company's MD&A should cover its business as a whole (on a consolidated basis with its subsidiaries), and should include a discussion of various segments or other subdivisions of the business to the extent that management deems such disclosure to be appropriate to an understanding of the company's entire operations. Management must also disclose such other information that it "believes to be necessary to an understanding of the registrant's financial condition, changes in financial condition and results of operations." When drafting this year's MD&A, it is essential to remember that each company is unique and "one size does not fit all." Disclosure needs to be reassessed and revised from period to period to reflect the changing business environment and each company's particular circumstances. Finally, in a recent release, the SEC emphasized that disclosure should be both useful - that is, it should include the most relevant information - and understandable - that is, it should use language and formats that investors can easily understand.

Recent Developments. In response to some recent corporate scandals, the SEC has focused on the application of the MD&A requirements to specific areas it believes have historically not been adequately addressed. The SEC recently adopted amendments requiring separate sections describing a company's off-balance sheet arrangements, contractual liabilities and contingent liabilities or commitments, which can be found on the SEC Website at www.sec.gov/rules/proposed/33-8144.htm. These rules apply to Form 10-Ks filed by December 31 year-end companies for fiscal year 2002. In addition, the SEC had previously issued interpretive guidance in January 2002 providing its views on the application of the existing MD&A rules to the same topics, as well as emphasizing the need to include in MD&A a discussion of related party transactions and trading activities involving non-exchange traded contracts accounted for at fair value. This guidance can be found on the SEC Website at www.sec.gov/rules/other/33-8056.htm.

The SEC has also focused on public companies' "critical accounting policies" as an important component of MD&A disclosure. In December 2001, the SEC issued a cautionary statement providing its views on the application of the existing MD&A rules in this area, which can be found on the SEC Website at www.sec.gov/rules/other/33-8040.htm, and, in May 2002, the SEC proposed specific new disclosure requirements that would require extensive disclosure of critical accounting policies and the effects of any changes in the underlying assumptions. The proposed rules can be found on the SEC Website at www.sec.gov/rules/proposed/33-8098.htm. At present, it appears unlikely that these proposed rules will be effective for the 2002 year-end reporting process, though companies should comply with the guidance in the December 2001 cautionary statement.

Disclosure of Forward-Looking Information

While the SEC generally does not require a company to disclose projections or other "forward-looking" information concerning its business or financial condition, the MD&A rules do expressly require disclosure of certain forward-looking information. Under the rules, a company must disclose in its MD&A any known trend, event or uncertainty that is reasonably likely to have a material effect on the company's results of operations, financial condition, or liquidity. Conversely, with one exception, the MD&A rules do not require a company to disclose a less likely trend, event or uncertainty or one that will not have a material effect on the company.trend, demand, commitment, event or uncertainty" was known at the time but not discussed as required by the MD&A rules If forward-looking information is included, management must remember that such information may be deemed to be "alive" and the company may have a duty to update the disclosure as circumstances change.³

The SEC has developed a two-part "double negative" test to aid companies in determining whether known trends, events or uncertainties must be disclosed in the MD&A:

As a result of this "double-negative" test doubts about the likelihood that an event or uncertainty will occur, or will be material, should be resolved in favor of disclosure. Remember that any review of a decision not to disclose a contingency will be made with the benefit of hindsight; when a material change in a company's financial condition or results of operations has occurred and the likelihood of such a change occurring was not discussed in prior reports, the SEC will inquire as to the circumstances existing at the time of the earlier filings to determine whether the "trend, demand, commitment, event or uncertainty" was known at the time but not discussed as required by the MD&A rules.⁵ Keep in mind that these disclosures are not limited to financial information, but include the whole range of risks, trends and uncertainties that could affect your business.

Guidelines for Drafting MD&A

Although the standards for what constitutes adequate MD&A disclosure are inherently flexible, companies can attempt to minimize their exposure in this area by following a number of guidelines. The guidelines are grouped under two general topics: (i) organizing the disclosure process and collecting information and (ii) drafting and reviewing the MD&A disclosure.

Organizing the Disclosure Process and Collecting Information.

Successful MD&A disclosure begins with the adoption and implementation of an organized, proactive process for gathering information that is periodically re-evaluated and, when appropriate, revised. While it has always been necessary to have some process for collecting and assessing information relevant to the preparation of SEC disclosure, under rules adopted in the wake of the Sarbanes-Oxley Act of 2002, public companies are now expressly required to institute and maintain "disclosure controls and procedures" - a set of procedures "designed to ensure that information required to be disclosed . . . [in SEC documents] . . . is recorded, processed, summarized and reported, within the time periods specified."⁶ In addition, CEOs and CFOs must now personally certify to the effectiveness of their company's procedures on a quarterly basis. Accordingly, it is more important than ever that companies focus on the process they employ in preparing their MD&As.

No single set of procedures will fit all companies' needs perfectly; disclosure controls and procedures must be custom-tailored for each company's particular circumstances. The following is a list of suggestions for companies to consider in developing and assessing their process:

• Form a disclosure team. Generally, such a team should be broad-based and include a company's senior officers and financial personnel, the heads of various operating functions and the company's counsel. The SEC's only specific suggestion for disclosure controls and procedures was that companies consider establishing a formal disclosure committee. While a formal committee with explicitly designated responsibilities may or may not be appropriate at a particular company, it is clear that identifying the individuals who should play a role in the process and clearly communicating their responsibilities is a crucial aspect of ensuring that adequate procedures are in place.
  
  
• Develop a procedure for identifying topics and trends and collecting information. At a minimum, members of the disclosure team should:
  
  
  • Review existing controls and procedures for preparing MD&A and attempt to identify any areas for improvement.
    
    
  • Review the company's most recent Form 10-K and 10-Q, and any press releases issued during the preceding quarter. As a general rule, the team should consider each matter covered in a press release to determine whether it is material and, if it is, disclose it in the MD&A.
    
    
  • Question key operating people from each significant division within the business to identify issues that are of concern to operating personnel, and document the fact that such interviews occurred. In determining which operations are significant, it is important to consider, among other things, product line, geographic location, competitive and regulatory environments, volatility of operating results, and past effect on economic performance. In this regard, the disclosure team should make an effort to educate the key operating personnel as to the disclosure requirements.
    
    
  • Review Board minutes and materials sent to the Board and any committees of the Board during the relevant period to determine what issues have been considered at the Board level, in particular by the Audit Committee. These materials may provide early warnings of risks that may need to be disclosed to the public. Any matter that has been seriously considered by the Board or the Audit Committee and management may warrant disclosure in the MD&A. Moreover, the SEC may view communications to the Board concerning different areas of the business to be evidence of the existence of segments requiring segment reporting.
    
    
  • Review questions asked at recent investor meetings and conference calls as well as discussions contained in analysts' reports. These may provide insight into how informed investors view a company and its financial performance. By providing appropriate disclosure in MD&A, a company will also be able to have more detailed discussions of these topics with investors without violating the SEC's Regulation FD prohibitions.
    
    
  • Review the MD&A disclosures of competitors (including risk factors) to identify disclosure issues common to members of the company's industry and to see how other companies are handling their disclosures.
    
    
• Involve the Audit Committee. Management should ensure the Audit Committee understands the disclosure controls and procedures being implemented and, as required by SEC rules, is notified as to any important changes in the procedures.
  
  
• Be particularly sensitive to factors that, if present, indicate that specific disclosure in the MD&A may be required. These factors include
  
  
  • the company's financial covenants in debt documents and its ability to be in compliance with these covenants in the year ahead (if projections show the possibility of noncompliance, this may raise a serious disclosure issue);
    
    
  • the company's cash requirements and, if applicable, the necessity to obtain financing to fund ongoing operations;
    
    
  • a change in the regulatory environment, including an unfavorable interpretation by an official concerning some aspect of the company's business;
    
    
  • troubled relations with competitors, customers, suppliers or employees;
    
    
  • an adverse market event that affects operations;
    
    
  • the disproportionate contribution of a product or segment;
    
    
  • extraordinary or unusual financial results; and
    
    
  • significant changes from prior periods in revenue, profits, losses or other financial indicators.
    
    

  In addition, the disclosure team should be sensitive to the SEC's "hot button" issues, such as non-GAAP financial measures, goodwill impairment and revenue recognition policies.

• Building a Record. Throughout the information-gathering process, the disclosure team should be on the alert for contradictory internal analyses (for example, projections that show a breach of a loan covenant), and, in an effort to build a record of good faith, take care to consider the views expressed in such analyses and document the resolution of contested issues.
  
  

  With respect to documentation in general, the disclosure team must be aware of the importance of creating an accurate and complete record of the assumptions underlying all conclusions and the basis for all forward-looking statements, and should educate management at all levels in this practice. In a number of enforcement actions centering on the sufficiency of a company's MD&A disclosure, the SEC relied on internal documentation as evidence that an undisclosed contingency (which later came to fruition) was "known" and considered at the time a particular disclosure was drafted. In particular, communications to the Board of Directors and senior management should be carefully drafted so as not to imply that the fact that the Board or senior officers are being advised of a risk means that there has been a determination that such risk is likely to occur or is likely to have a material effect on the company. Companies should consider whether to document any determination that a particular contingency is not disclosable, including a description of the reasoning underlying that determination.

  Drafting and Reviewing the MD&A Disclosure.

  Only after the preliminary analyses are complete should the drafters begin to prepare a first version of the MD&A.

• When the initial draft of the MD&A is complete, it should be reviewed by the members of the disclosure team (including the company's financial staff and legal counsel), other key operating people and the company's outside accountants. Reviewers should be particularly alert to possible omissions; at this point, significant deficiencies in an MD&A will most likely involve something that is not there, rather than something that is.
  
  
• To qualify for the Private Securities Litigation Reform Act's safe harbor, forward-looking statements should be labeled as such, and should be accompanied by "meaningful cautionary statements identifying factors that could cause actual results to differ materially" from those predicted. Existing case law makes clear that boilerplate warnings will not suffice; rather, the cautionary statements "must convey substantive information about factors that realistically could cause results to differ materially from those projected . . . such as, for example, information about the issuer's business." In other words, to obtain the benefit of the safe harbor, the cautionary statement must identify specific factors which could affect the matter addressed in the forward-looking statement. As a result, more and more companies are including disclosures in their MD&A that resemble the risk factor disclosures in an IPO prospectus.
  
  
• Following its preparation by management, the company should consider providing the members of the Audit Committee with a draft of the Form 10-K, including MD&A with year to year comparisons, for their review and comment in advance of the time that the Form 10-K is presented to the directors for their signatures. This review period should coincide with the Audit Committee's review and approval of the company's financial statements to give members of the Audit Committee the benefit of the process in conducting this review. Some companies follow a similar procedure prior to filing the Form 10-Q, even though this document is not signed by members of the Board.
  
  

  Conclusion

  According to a former director of the SEC's Division of Corporation Finance, there are four basic reasons that companies get into trouble with the MD&A requirements. First, some companies take a checklist approach to MD&A (going through each item and marking up the prior year's disclosure), forgetting that MD&A disclosure is as dynamic as the company's business. Second, companies can run into trouble if they fail to realize that the MD&A requirements are in part an attempt by the SEC to require information about the various components of a company's business. If a company has a business activity that accounts for a significant part of reported results, the company should strongly consider whether that business activity should be discussed in its MD&A. A third reason that companies encounter difficulty in the MD&A area is that they fail to focus on the requirement to disclose forward-looking information to the extent required by the "double negative" test. Finally, in order to satisfy the MD&A requirements, a company must be willing to talk about negative trends and problems in its business, a discussion which many companies shy away from.

  While drafting a legally sufficient MD&A disclosure is a time consuming and painstaking process, the result can be well worth the effort in terms of both legal protection and investor relations. Apart from the obvious benefits of complying with the SEC's rules, a company's disclosure of significant trends and uncertainties concerning its business enhances the ability of the company's shareholders and others to evaluate the company's future prospects. This is particularly important where potential investors will rely on the disclosures in connection with raising capital, whether by incorporation by reference or otherwise. To the extent that MD&A disclosure provides an accurate, dynamic picture of the company's business, unanticipated developments should occur with less frequency, and, as a result, the incidence of stock price volatility and SEC enforcement actions and shareholder lawsuits charging improper disclosure may be minimized.

  This document is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. ã 2003 Goodwin Procter LLP. All rights reserved.

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  Footnotes

  1. If adopted in its current form, the SEC's proposed new critical accounting policy disclosure rules would require companies to identify and discuss any estimate they make for accounting purposes that is based on assumptions as to "highly uncertain" matters and that relates to matters that would materially affect the company's financial statements if a different estimate could reasonably have been used or if changes in the estimate are reasonably likely to occur from period to period. The required disclosure would be extensive, including (a) basic information necessary to understand the estimate (e.g., methodology and assumptions as well as impact on financial statements) (b) presentations of quantitative sensitivity analyses to illustrate the impact of reasonably possible changes in the underlying assumptions, and (c) whether management has discussed these estimates with the audit committee. The proposed rules also require specific discussion of any accounting policy initially adopted during the past year that had a material effect on the company's financial condition, changes in financial condition or results of operations. SEC staff members have publicly stated they expect most companies to have between three and five critical accounting estimates requiring disclosure, with the disclosure averaging approximately six pages.

  2. Under the proposed rules, off-balance sheet arrangements must be disclosed unless the probability that a trend, event or uncertainty including the arrangement will occur and have a material effect of the company is "remote," which the SEC has interpreted as meaning that the chance of the future event or events occurring is slight.

  3. A number of safe harbors exist that may protect a company from liability in the event that actual results differ from the company's forward-looking disclosure, which are discussed in more detail below under "Guidelines for Drafting MD&A¾Drafting and Reviewing the MD&A Disclosure."

  4. The SEC has stated that "reasonably likely" is a lower disclosure standard than "more likely than not." In public appearances, former SEC officials have indicated that the "reasonably likely" part of the test can be met even if a particular event is less than 51% likely to occur.

  5. With respect to the disclosure of preliminary merger negotiations, however, the SEC has stated that where disclosure of such negotiations is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of such negotiations where, in the company's view, inclusion of such information would jeopardize completion of the transaction.

  6. The SEC also has proposed requirements to maintain internal controls and procedures for financial reporting that focus on controlling the process by which a company records and processes financial information. The two sets of controls and procedures overlap significantly.