IN THIS ISSUE
- DISCLOSURE OF YEAR 2000 ISSUES
- REGULATION 13D-G AMENDMENTS
- PLAIN ENGLISH TO BECOME MANDATORY ON OCTOBER 1, 1998
- MARKET RISK DISCLOSURE IN SEC FILINGS
- REGULATION S AMENDMENTS
DISCLOSURE OF YEAR 2000 ISSUES
The computer system at three major hospitals and 71 clinics in the Philadelphia area recently shut down when a nurse typed in an appointment for the year 2000. Similarly, all cash registers in a chain of stores in the Midwest shut down when a customer used a credit card with a year 2000 expiration date. The "Year 2000 problem" arises because most computer systems and programs were designed to handle only two-digit representations of years instead of the full four-digit representation. When the year 2000 begins, these computers may interpret "00" as the year 1900 and either stop processing date-related computations or process them incorrectly.
In response to a growing recognition of the substantial damage that may arise from this problem, the Securities and Exchange Commission has issued a Staff Legal Bulletin requiring that the Year 2000 issue be disclosed in the appropriate areas of public filings (e.g., risk factors, MD&A, etc.). Moreover, these disclosures apply to actual and potential problems, both within a company's organization as well as in outside organizations which could have consequences for the company. Public companies would be well advised to perform both an internal audit as to their own potential Year 2000 problems, and an external audit by which they coordinate with other entities with which they interact, including suppliers, customers, creditors, borrowers, and financial service organizations. Due to the material adverse consequences that can result from a Year 2000 issue, the SEC has stated that issuers must disclose in their SEC filings if the cost of addressing the Year 2000 issue is material or if the issuer's failure to timely address and resolve the Year 2000 issue would be reasonably expected to affect future financial results or cause reported financial information not to be indicative of future operating results or financial condition. Furthermore, the SEC views Year 2000 issues as material even if they are covered by insurance, and the SEC will require that costs related to correcting this problem be charged as an expense in the period incurred and not amortized.
Disclosure of the Year 2000 problem should include:
the issuer's general plans to address the Year 2000 issues relating to its business, its operations (including operating systems), and, if material, its relationships with customers, suppliers, and other constituents, and its timetable for carrying out those plans; and
the total dollar amount that the issuer estimates will be spent to remediate its Year 2000 issues, if such amount is expected to be material to the issuer's business, operations, or financial condition, and any material impact these expenditures are expected to have on the issuer's results of operations, liquidity, and capital resources.
As a result of these new rules, issuers are advised to perform Year 2000 audits as soon as possible so as to be able to disclose that such audits are complete, even if no problem or potential problem exists, and to correct problems that are discovered before they impact the issuer's operations.
REGULATION 13D-G AMENDMENTS
Effective February 17, 1998, the SEC instituted new rules relating to the reporting of beneficial ownership in publicly held companies under Regulation 13D-G. Under the prior rules, any investor who acquired more than 5% of the outstanding shares of a class of equity securities of a public company was required to file a Schedule 13D with the SEC and provide a substantial amount of information concerning its identity and background, sources of funds used to make the acquisition, the purpose of the acquisition, and any arrangements or understandings with respect to the securities acquired. The short-form Schedule 13G, which required minimal information, was available only to certain types of institutional investors which acquired securities in the ordinary course of their business and without intent to control the issuer ("Qualified Institutional Investors") and stockholders who acquired their shares prior to the issuer becoming a public company ("Exempt Investors").
The focus of the changes is to make short-form Schedule 13G available for reporting in a wider array of circumstances than the more burdensome Schedule 13D. The rule changes add a third class of eligible Schedule 13G filers -- persons acquiring more than 5% but less than 20% of a class of equity securities who did not acquire their holdings with the intent to change or influence control of the issuing company ("Passive Investors"). The rule changes also expand the class of Qualified Institutional Investors. As a result of the changes enacted, the SEC believes that Schedule 13G will be the primary means of reporting beneficial ownership, with Schedule 13D reserved for investors who acquire securities for the purpose or with the effect of changing or influencing control of the issuer.
Under the prior format, persons acquiring more than 5% of a class of equity securities that did not qualify either as Qualified Institutional Investors or Exempt Investors were subject to the rigorous disclosure requirements of Schedule 13D, even where they had no intent to change or influence control of the issuer. The new rules allow such Passive Investors to report on the less burdensome Schedule 13G until the 20% threshold has been reached. Upon reaching the 20% threshold, Passive Investors will be required to file a Schedule 13D because of the inherent control implications corresponding to such ownership positions held by persons who do not purchase securities in the ordinary course of business. In addition, upon reaching the 20% threshold, Passive Investors must observe a "cooling off" period as discussed below.
Since the determination of whether an investor qualifies as a Passive Investor is largely subjective, reflecting the state of mind of the investor (i.e., whether or not the investor's intent is to control), the SEC has asserted that the 20% limitation is a necessary safeguard against potential abuse of the system permitting less disclosure. Based on the same rationale, Passive Investors must file their initial Schedule 13G within ten days after acquiring beneficial ownership of more than 5% of the class of securities. By contrast, Qualified Institutional Investors are not required to file until 45 days after the end of the calendar year in which the investor holds more than 5% as of year-end or within ten days after the first month in which the investor's beneficial ownership exceeds 10% as of the end of the month. In addition, Passive Investors must file an amendment on Schedule 13G "promptly" after their beneficial ownership exceeds 10% of the class, and thereafter promptly after their position increases or decreases by more than 5% of the class, as well as within 45 days after the end of the calendar year to reflect any changes in the information reported. This compares with the requirement that Qualified Institutional Investors file such amendments within ten days after the end of the month in which the ownership change takes place. The SEC has expressed the opinion that the more stringent requirements are necessary to provide more timely notice to the market of the existence of voting blocks that have the potential of influencing control.
As a result of the rule changes, investors who have been filing on Schedule 13D, own less than 20%, and do not have intent to control are now eligible to switch to the short-form Schedule 13G. In this regard, the SEC has taken the position that a Schedule 13G must be filed prior to any change in ownership that would trigger an amendment to the investor's current Schedule 13D. Otherwise, the investor will have to file an amendment on the longer, burdensome Schedule 13D before being able to switch its filings to Schedule 13G. If an investor chooses to file a Schedule 13G prior to the change in ownership, no action needs to be taken to terminate the prior Schedule 13D.
If a Qualified Institutional or Passive Investor determines that it is no longer holding without intent to control, the investor must file a Schedule 13D within ten calendar days. To prevent any abuse in the use of Schedule 13G by investors who have an intent to control the issuer, the SEC has adopted a "cooling-off" period upon a change in investment purpose. The same cooling-off period will apply to Passive Investors reaching the 20% threshold. The cooling-off period begins with the change in investment purpose (or reaching the 20% threshold, in the case of Passive Investors) and expires ten days after the filing of a Schedule 13D. During that time, the investor is prohibited from voting the securities subject to reporting or acquiring additional beneficial ownership of any equity securities of the issuer or any entity controlling the issuer. The SEC believes the cooling-off period is necessary to encourage the prompt filing of a Schedule 13D and to give the market the opportunity to react to the information contained in the filing.
Re-Establishing Schedule 13G Eligibility
The amended rules specifically allow investors who have lost their Schedule 13G filing eligibility to re-establish it and once again file using the short-form. An investor's eligibility is re-established when it can make the required certification regarding its investment intent and/or when its ownership interest drops below 20% or it regains "Qualified Institutional Investor" status, as applicable. No formal amendment to a filed Schedule 13D will be required; the investor will simply file a new Schedule 13G (not an amendment to a prior "disqualified" filing), which will serve to amend the Schedule 13D. The SEC believes that allowing investors to re-establish Schedule 13G eligibility will result in clearer market signals because Schedule 13D filings should thereby be limited to investors with a disqualifying purpose or effect or who hold more than 20% of a class.
As a result of the new rules, we would advise investors to review their filing status, noting particularly that, under the new structure, the SEC perceives Schedule 13D filings as a market signal indicating intent to control. We would anticipate that many investors who own less than 20% of the equity securities of a public company who currently file on Schedule 13D will be eligible to convert to Schedule 13G.
PLAIN ENGLISH TO BECOME MANDATORY ON OCTOBER 1, 1998
The SEC recently adopted the final "Plain English" Rule which applies to prospectuses prepared by operating companies and mutual funds in connection with their public offerings. While compliance with the rule will be mandatory beginning on October 1, 1998, the SEC encourages issuers to prepare their filings in Plain English sooner, including not only prospectuses for securities offerings, but also annual meeting proxy statements, merger proxy statements, spin-off proxy statements, Forms 10-K, and others. The SEC has been giving expedited reviews to Plain English IPOs, merger proxy/prospectuses, and other filings which undergo full review, and they have indicated that they will attempt to continue to expedite their review of Plain English filings for as long as feasible. Pepper Hamilton recently prepared and filed with the SEC a Plain English proxy statement relating to a merger of a public company, which the SEC did not review.
The new rule requires issuers to use "Plain English" in the organization, language, and design of the cover page, summary, and risk factor sections of their prospectuses. The language must, at a minimum, substantially comply with each of the following principles:
- the active voice;
- short sentences;
- definite, concrete, everyday words;
- tabular presentation or "bullet" lists for complex material;
- no legal jargon or highly technical business terms; and
- no multiple negatives.
The amendment does not limit the length of the summary, limit the number of risk factors, or require the prioritization of risk factors as was proposed. Although the rule currently applies only to prospectuses, it is anticipated that the rule will eventually be extended to apply to all filings.
MARKET RISK DISCLOSURE IN SEC FILINGS
The use of derivative and similar financial instruments (including interest rate swaps, options, and structured notes) to manage exposures to market risk has increased substantially in recent years. However, in using market risk sensitive instruments, some companies have experienced significant losses resulting from unexpected changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. In light of those losses and the substantial growth in the use of market risk sensitive instruments, the SEC has adopted new rules that require issuers to disclose certain quantitative and qualitative information about market risk exposure.
For banks, thrifts, and issuers with market capitalizations in excess of $2.5 billion, Item 305 of Regulation S-K requires disclosure about market risk exposure in filings with the SEC that include annual financial statements for fiscal years ending after June 15, 1997 (e.g., a Form 10-K for 1997). For other issuers, disclosure concerning market risk exposure is required in filings with the SEC that include annual financial statements for fiscal years ending after June 15, 1998 (e.g., a Form 10-K for 1998). All issuers must furnish the disclosure about derivative accounting policies specified by the rule in filings that include financial statements for either an annual or interim fiscal period ending after June 15, 1997.
A primary objective of the quantitative disclosure requirements is to provide investors with forward looking information about an issuer's potential exposures to market risk. The SEC anticipates that the quantitative disclosures will help investors better understand specific market risk exposures of an issuer and allow them to better manage market risks in their investment portfolios. Those disclosures should provide the issuer with a mechanism to disclose, where applicable, that its use of derivatives represents risk management rather than speculation. Though a central focus of the disclosure is market risk resulting from the use of derivatives, an issuer that does not use derivatives may have material exposures to market risks from non-derivative financial instruments that must be disclosed under the new rule. For example, an issuer that borrows money in a foreign currency may have a material market risk exposure requiring disclosure from changes in exchange rates or interest rates.
To determine if the quantitative and qualitative disclosures must be furnished, an issuer must (1) categorize its market risk sensitive instruments into two portfolios (instruments entered into for trading purposes and all other instruments), (2) further categorize instruments within the two portfolios by type of market risk exposure category (interest rate risk, foreign currency exchange rate risk, etc.), and (3) assess the materiality of the market risk exposure for each category within each portfolio. Both the materiality of the fair values of the instruments and the materiality of potential, near-term losses in future earnings, fair values, and cash flows must be evaluated. If either is material, the issuer must disclose the quantitative and qualitative information for that particular market risk exposure. An issuer may not net favorable and unfavorable fair values in making its determination, except where allowed under generally accepted accounting principles.
If an issuer determines that disclosure about market risk is required in its filings, the quantitative information about market risk sensitive instruments may be presented in one or more of the following alternatives:
- tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates;
- sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices; or
- value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period of time and with a selected likelihood of occurrence.
In providing the quantitative disclosure, the issuer must discuss any "limitations" that may cause the required disclosure about market risk not to reflect fully the net market risk exposures. For example, if an issuer utilizes futures contracts to hedge certain risks relating to its inventory, disclosure about the market risk inherent in the futures contract would not adequately address the market risk inherent in maintaining the inventory. In addition, if an instrument has a feature (e.g., leverage) that is affected by changes in market rates or prices outside those reflected in the value at risk and sensitivity analysis disclosures, the issuer should include a summary of the features and a discussion of the limitations created by these features.
Companies are also required to disclose qualitative information about market risk. The qualitative disclosure includes a discussion of (1) an issuer's primary market risk exposures at the end of the current reporting period, (2) how the registrant manages those exposures, and (3) changes in either the issuer's primary market risk exposures or how those exposures are managed, when compared to the most recent reporting period and what is known or expected in future periods.
The forward looking disclosure required by the new regulation falls generally within the statutory safe harbor under the federal securities laws. To satisfy the safe harbor requirement for "meaningful cautionary statements," the issuer should disclose all material assumptions and limitations of the disclosures and consider what additional information is necessary to alert investors to important factors that could cause actual results to differ materially from the information given in the forward looking statements.
On February 17, 1998, the SEC adopted a release which affects long-anticipated amendments to Regulation S, the safe harbor regulation that exempts offshore sales of securities to non-U.S. persons from the registration requirements of the Securities Act of 1933 ("Securities Act"). The amendments provide additional and more stringent requirements applicable to Regulation S offerings. The rule changes went into effect on April 26, 1998 and apply to all securities sold under Regulation S on or after that date. A summary of the material amendments is set forth below.
Extension of Restricted Period for Public Companies. The restricted period for U.S. reporting issuers (i.e., public companies) has been extended from 40 days to one year and has been renamed the "distribution compliance period." This is the period after the offshore placement under Regulation S during which resales in the U.S. markets are not permitted. This change, of all of the changes, will likely have the greatest impact on U.S. public companies, and will generally minimize the usefulness of Regulation S for such issuers to obtain equity financing in situations where traditional private placement financing is not available. This change should also substantially reduce the number of abuses which have taken place under Regulation S, typically by smaller capitalization U.S. reporting issuers, in order to evade the registration requirements of the Securities Act. These abuses typically involve the sale of securities pursuant to a "sham" Regulation S transaction, followed by a resale in the U.S. markets after 40 days, under circumstances where the purchasers are either foreign entities which are secretly controlled or owned by U.S. persons or where the risks of ownership never rest with a foreign purchaser.
Regulation S Securities Classified as "Restricted Securities". Shares sold pursuant to Regulation S are classified as "restricted securities" for purposes of Rule 144. Accordingly, unless another exemption from registration is available, resales in the U.S. markets of shares of U.S. reporting companies initially sold pursuant to Regulation S will have to be made subject to the volume and other limitations of Rule 144. This will apply only to securities sold pursuant to Regulation S on or after April 26, 1998. Securities of U.S. reporting issuers sold pursuant to Regulation S prior to that date may be resold in the United States after 40 days, provided that the seller is not an affiliate of the issuer and is not otherwise an "underwriter" within the meaning of the Securities Act.
Additional Legending Requirements. Share certificates of U.S. reporting issuers will be required to be legended, and the legend required to be included in the offering materials used in the Regulation S offering has been amended. Purchasers in the Regulation S offering are required to provide a certification relating to certain matters, including that the purchaser will not engage in any hedging transactions with regard to the Regulation S securities (such as short sales and purchases and sales of put and call options) except in compliance with the Securities Act. In addition, the issuer is required to impose stop transfer restrictions on securities sold pursuant to Regulation S during the distribution compliance period.
Additional Requirements for Promissory Notes as Consideration. As provided in Rule 144, the use of promissory notes to pay for securities in a Regulation S offering will result in a tolling of the Rule 144 holding period unless certain conditions are satisfied. This eliminates an abuse previously seen in some Regulation S offerings, where the securities were paid for with non-recourse promissory notes which were repaid with the proceeds of the resale of the shares in the U.S. markets 40 days later.
Changes in Reporting Requirements. The requirement that U.S. reporting issuers disclose Regulation S offerings on a Form 8-K filed within 15 days after completion of the transaction has been eliminated, effective January 1, 1999. Instead, issuers will be required to disclose Regulation S offerings in their next Form 10-Q or 10-K, as they are required to do with other sales of securities which are exempt from registration under the Securities Act.