In late January 2003, the SEC adopted final rules implementing Section 401(a) of the Sarbanes-Oxley Act of 2002 regarding disclosure of off-balance sheet arrangements and aggregate contractual obligations. The rules are intended to increase the transparency of financial disclosures. Specifically, the new rules require, in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") portion of a registrant's disclosure documents:
- Disclosure of off-balance sheet arrangements, which must be in a separately designated section of the MD&A; and
- Tabular disclosure of contractual obligations.
Off-Balance Sheet Arrangements
The new rules define the term "off-balance sheet arrangement" as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the registrant is a party, under which the registrant has:
- Any obligation under certain guarantee contracts;
- A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets;
- Any obligation (including contingent obligations) under certain derivative instruments; or
- Any obligation (including contingent obligations) under a material variable interest held by the registrant in an unconsolidated entity where the entity provides financing, liquidity, market risk or credit risk support to the registrant or engages in leasing, hedging or research and development services with the registrant.
No obligation to make disclosure of an off-balance sheet arrangement arises until a binding definitive agreement, subject only to customary closing conditions, exists or, in the absence of such an agreement, when the transaction closes.
Registrants will be required to include in their quarterly and annual reports a separately designated section of their MD&A that fully describes any material off-balance sheet arrangements. The new rules require disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
This threshold is similar to that presented in the SEC's 1989 Interpretive Release on MD&A disclosure, but should be contrasted with the disclosure threshold contained in the proposing release, namely that disclosure is required if management concludes that the likelihood of the occurrence of a future event and its material effect is higher than "remote." The SEC rejected that "remote" standard in an effort to simplify disclosure by maintaining consistency with the current MD&A disclosure scheme.
The statutory safe-harbor protections (Sections 27A of the Securities Act of 1933 and 21E of the Securities Exchange Act of 1934) are explicitly applied to forward-looking information provided by a registrant pursuant to the new rules.
Aggregate Contractual Obligations
The Sarbanes-Oxley Act and the new rules attempt to increase the transparency of a registrant's short- and long-term liquidity and capital resources needs, and to provide a context in which shareholders can more effectively evaluate the impact of off-balance sheet arrangements with respect to liquidity and capital resources. To that end, the new rules require registrants to present certain information regarding contractual obligations in tabular format within the registrant's MD&A. The table should present amounts of payments due under specified contractual obligations, aggregated by type of contractual obligation, for specified time periods.
Although the release suggests a format for the table, a registrant may disaggregate the specified categories by using other categories suitable to its business. However, the table must include all of the obligations that fall within the specified categories, namely: long-term debt obligations; capital lease obligations; operating lease obligations; purchase obligations; and other long-term liabilities reflected on the registrant's balance sheet under GAAP.
This required tabular disclosure of contractual obligations must be presented in an appropriate section of an issuer's MD&A, although not necessarily under a separate caption. The final rules did not adopt the proposed requirement that the registrant disclose certain information regarding contingent liabilities and commitments in tabular or textual format.
The new rules regarding the disclosure of off-balance sheet arrangements and aggregate contractual obligations apply to domestic registrants in annual and quarterly reports and Securities Act registration statements. They apply equally to reports filed on Forms 20-F and 40-F by foreign private issuers, as well as registration statements filed on Forms F-1, F-2, F-3 and F-4. The new rules do not, however, apply to quarterly reports on Form 6-K filed by foreign private issuers.
The new rules will take effect April 7, 2003. Registrants must comply with the new rules pertaining to off-balance sheet arrangements in registration statements, annual reports and proxy or information statements that are required to include financial statements for their fiscal years ending on or after June 15, 2003, and must include the table of contractual obligations in these filings for their fiscal years ending on or after December 15, 2003.
Quarles & Brady Comment
These new rules continue the series of actions which the SEC is taking as required by the Sarbanes-Oxley Act of 2002. The SEC provided interpretations in a January 2002 release "suggesting" further MD&A disclosure of these types of financial obligations. However, the new rules provide further definition and clarity, and make mandatory, the SEC's expectations.
Most companies have been making a good faith attempt to provide the additional information which the SEC had suggested in its January 2002 interpretive release. As a result of the specificity and mandatory nature of the new rules, though, registrants will want to carefully review their prior disclosures to assure continuing compliance in their MD&A presentations.
We encourage you to contact your Quarles & Brady attorney to discuss any concerns you have relating to the new rules. The SEC's final rules release (Release No. 33-8182; 34-47264) is available on the SEC's website at http://www.sec.gov/rules/final/33-8182.htm. Please let us know if you would like a copy of the release.