After Enron, SEC Recommends:

First published on February 1, 2002

Enhanced MD&A Disclosure for Liquidity & Capital Resources Including Off-Balance Sheet Arrangements; Non-Exchange Traded Contracts Accounted for at Fair Value; & Effects of Transactions with Related & Certain Other Parties

After Enron, SEC Recommends: Enhanced MD&A Disclosure for Liquidity and Capital Resources including Off-Balance Sheet Arrangements; Non-Exchange Traded Contracts Accounted for at Fair Value; and Effects of Transactions with Related and Certain Other Parties In response to a petition by the "Big 5" accounting firms, the U.S. Securities and Exchange Commission ("SEC") on January 22, 2002 issued a statement (SEC Release Nos. 33-8056; 34-45321) suggesting that companies improve their disclosures in the Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") with respect to financial information for the fiscal year ended 2001 and periods ending thereafter. This will impact, among others, Annual Reports on Form 10-K and 20-F (annual reports for foreign private issuers), Quarterly Reports on Form 10-Q and Registration Statements under the Securities Act of 1933.

In recent weeks, the markets have reportedly traded down the values of securities issued by a broad range of energy companies, banks and conglomerates whose public disclosures in this area are not viewed as clear and thorough, and therefore troubling in a post-Enron era. Some companies have delayed certain off-balance sheet or financial structured products transactions until these enhanced disclosure requirements are digested. Although the SEC emphasized that the Release does not create new requirements or rules¹ , but rather provides further guidance as to the existing MD&A disclosure requirements, the SEC expressed the view that generally the quality of disclosure should be improved. The SEC identifies three broad areas that need enhanced disclosure in MD&A: liquidity and capital resources, including off-balance sheet arrangements; trading activities involving derivatives and non-exchange traded contracts; and related-party relationships and transactions. This Memorandum discusses the increased disclosure guidance, and then notes a number of practical considerations for publicly traded companies.

In considering whether to discuss issues in a Liquidity and Capital Resources section of MD&A, companies must discuss trends, demands, commitments, events or uncertainties that are "reasonably likely" to materially impact either liquidity or capital resources. This standard is a more demanding threshold, resulting in greater disclosure, as compared to a "more likely than not" standard that guides disclosures in other parts of the MD&A or materiality-driven disclosure generally. In the past few years, moreover, the SEC has arguably lowered the threshold of materiality-based financial disclosures by twice admonishing companies not to view the materiality thresholds by old "rules of thumb", but rather more demanding quantitative and qualitative standards. See SEC Staff Accounting Bulletin No. 99 and SEC Release No. 33-7811.

The Release provides companies with examples of circumstances that should be considered in drafting these disclosures:

• Provisions in financial guarantees or commitments, debt or lease agreements or other arrangements that could trigger a requirement for an early payment, additional collateral support, changes in terms, acceleration of maturity, or the creation of an additional financial obligation upon the occurrence of certain events, such as adverse changes in the companies’ credit rating, financial ratios, earnings, cash flows, or stock price, or changes in the value of underlying, linked or indexed assets. (Such provisions may appear in a variety of loans and debt financings, as well as lease financings and structured finance products that are either on- or off-balance sheet. For example, it is common for transactions (on- or off-balance sheet) to provide for defaults or termination events if the debt rating of a borrower or issuer falls below investment grade. Similarly, many swaps and other derivatives require a party to provide additional collateral if downgraded. A sudden downgrade, as happened to Enron, can lead to repayment, amortization or collateralization requirements which overwhelm the company’s cash resources or severely curtail its cash flow.)
• Circumstances that could impair the company's ability to continue to engage in transactions that have been integral to historical operations or are financially or operationally essential, or that could render that activity commercially impracticable, such as, the inability to maintain a specified investment grade credit rating, level of earnings, earnings per share, financial ratios, or collateral. (For example, if a company were dependent on continuous asset sales through securitization programs as a means of financing transactions, but such sales were conditioned on maintenance of financial ratios or ratings levels, failure to maintain the ratios or ratings could lead to a sudden erosion of the company’s liquidity or earnings. Additionally, although in securitizations with ongoing commitments the termination events primarily relate to performance of the underlying financial assets, downgrades or other significant credit events relating to the transferor company may also be termination events if the transferor is servicer or provides significant indemnities or other enhancements.)
• Factors specific to the company and its markets that the company expects to be given significant weight in the determination of the company’s credit rating or will otherwise affect the company’s ability to raise short-term and long-term financing.
• Guarantees of debt or other commitments to third parties; and
• Written options on non-financial assets, such as real estate puts.

The SEC recommends that more specific disclosure regarding off-balance sheet financing arrangements and relationships with unconsolidated entities be provided. The SEC emphasizes that if a company’s liquidity is dependent on the use of off-balance sheet financing arrangements, such as securitization of receivables or obtaining access to assets through special purpose entities, the registrant should consider disclosure of the factors

that are reasonably likely to affect its ability to continue using those off-balance sheet financing arrangements. The disclosure should include such items as the business purpose of the arrangement, its economic sub-stance, the key terms and conditions, the initial and ongoing relationships with the registrant and the registrant’s potential risk exposure resulting from the arrangement.

In addition, the extent of a company’s reliance on off-balance sheet entities, such as limited special purpose vehicles, should be described fully and clearly where those entities provide financing, liquidity, or market or credit risk support for the registrant; engage in leasing,

hedging, research and development service with the registrant; or expose the registrant to liability that is not reflected on the face of the financial statements. Where contingencies inherent in the arrangements are reasonably likely to affect the continued availability of a material historical source of liquidity and finance, companies must disclose those uncertainties and their effects. For example, a company may be economically or legally required or reasonably likely to fund losses of an unconsolidated, limited purpose entity, provide it with additional funding, issue securities pursuant to a call option held by that entity, purchase the entity’s capital stock or assets, or the company otherwise may be financially affected by the performance or non-performance of an entity or counterparty to a transaction or arrangement.

With respect to these types of arrangements, additional factors that explain the effects and risks of off-balance sheet arrangements should be discussed in the MD&A. Such factors include:

• Total amount of assets and obligations of the off-balance sheet entity, with a description of the nature of its assets and obligations, and identification of the class and amount of any debt or equity securities issued by the company;
• The effects of the entity’s termination if it has a finite life or it is reasonably likely that the company’s arrangements with the entity may be discontinued in the foreseeable future;
• Amounts receivable or payable, and revenues, expenses and cash flows resulting from the arrangements;
• Extended payment terms of receivables, loans, and debt securities resulting from the arrangements, and any uncertainties as to realization, including repayment that is contingent upon the future operations or performance of any party;
• The amounts and key terms and conditions of purchase and sale agreements between the registrant and the counterparties in any such arrangements; and
• The amounts of any guarantees, lines of credit, standby letters of credit or commitments or take or pay contracts, throughput contracts or other similar types of arrangements, including tolling, capacity, or leasing arrangements, that could require the registrant to provide funding of any obligations under the arrangements, including guarantees of repayment of obligors of parties to the arrangements, make whole agreements, or value guarantees.

The SEC explicitly stated that off-balance sheet arrangements which involve "true sale" opinions relating to contingent, residual or other liabilities of the company do not preclude disclosure of such matters by the company, based upon any automatic conclusion that the company is no longer at any risk. Companies still must consider disclosure of residual risks associated with such true sale transactions. (For example, if a company wished to take the assets and liabilities of a business segment off its consolidated balance sheet by transferring them into a non-consolidated partnership or other special purpose entity, but remained at risk through performance guaranties, make-whole agreements or other contingent arrangements, the company might be required to disclose these contingencies even though the actual assets and liabilities had been effectively transferred for accounting purposes.) The SEC recommends that disclosure of these matters should be clear and individually tailored to describe the risks to the company, and should not consist merely of recitation of the transactions’ legal terms or the relationships between the parties or other boilerplate language.

Disclosure of contracts and commitments all in the MD&A

Accounting standards already require registrants to disclose obligations and commitments to make future payments under contracts, such as debt and lease agreements, and under contingent commitments, such as debt guarantees. The SEC, however, believes that the financial consequences of these contractual obligations and commercial commitments should be provided in the MD&A so that a total picture of obligations and their effects would be readily available in one location. As a means to provide the required information in a manner that is comprehensible and thorough, the SEC suggests that registrants include detailed tables of contractual obligations and commercial commitments which would relate to a company’s discussion of liquidity and capital resources and the role of on- and off-balance sheet arrangements. See attached SEC Disclosure Example A.

The Release also reflects the SEC’s concerns with respect to the disclosure of trading activities involving certain commodity contracts not traded on exchanges. The lack of market prices dictates the use of fair value estimates for financial reporting purposes. These contracts generally are indexed to weather conditions, commodities prices, or service capacity (such as energy storage and bandwidth capacity contracts). The SEC recommends that companies involved in trading these contracts to a material extent provide additional statistical and other information in their MD&A about these business activities and transactions, beyond what is currently required by applicable accounting standards, to provide investors with a better understanding of the potential effects of these transactions on the company and to provide accounting transparency.

Companies in this situation should consider the need to furnish information, quantified to the extent practicable, that does the following:

• disaggregates realized and unrealized changes in fair value;
• identifies changes in fair value attributable to changes in valuation techniques;
• disaggregates estimated fair values at the latest balance sheet date based on whether fair values are determined directly from quoted market prices or are estimated;
• indicates the maturities of contracts at the latest balance sheet date (e.g., within one year, within years one through three, within years four and five, and after five years); and
• indicates the fair value of net claims against counter-parties that are reported as assets at the most recent balance sheet date, based on the credit quality of the counterparty (e.g., investment grade; noninvestment grade; and no external ratings).

Such disclosures, if presented, would reflect significantly more detail about the components of derivative con-tracts, and their values and terms, as compared to current public reporting. See attached SEC Disclosure Example B.

Of particular interest to companies in the energy, paper, mining and airline industries is the SEC’s reminder that accounting standards require disclosures in financial statements of material trading and risk management activities. The SEC recommends that information about these trading activities, contracts and modeling methodologies, assumptions, variables and inputs be included in management’s discussion of how the activities affect reported results for the relevant period and how financial position is affected as of the latest balance sheet date. Explanations of the different outcomes reasonably likely under different circumstances or measurement methods should also be included.

The Release also provides guidance on MD&A disclosure of related-party transactions. The SEC suggests that registrants include descriptions of all material transactions involving related persons or entities, with clear discussion of arrangements that may involve transaction terms or other aspects that differ from those which would likely be negotiated with clearly independent parties.

Discussion of the following may be necessary:

• the business purpose of the arrangement;
• identification of the related parties;
• how transaction prices were determined;
• if disclosures represent that transactions have been evaluated for fairness, a description of how the evaluation was made; and
• any ongoing contractual or other commitments as a result of the arrangement.

The SEC suggests that disclosure of related-party transactions extend beyond transactions with specific parties currently identified as "related parties" in Item 404 of Regulation S-K and Financial Accounting Standards No. 57. For example, disclosures may not have been made regarding transactions between a company and an entity established and operated by individuals that are employees, but not executives of the company, or by individuals who were former senior management of, or have some other current or former relationship with, a company other than being executives. The SEC recommends that companies disclose transactions with parties with whom the registrant or its related parties have a relationship that enable the parties to negotiate terms of material transactions that may not be available from other, more clearly independent, parties on an arm’s-length basis.

In view of this new guidance on MD&A disclosures, we suggest that public companies consider promptly the following:

• Review all Structured Products, Derivatives and Financings. Review all debt, lease, securitization, derivative and structured product financings, taking special note of the specific disclosures recommended by the SEC. This review requires specific familiarity with these complex financing structures and related documentation, especially with their various covenants, default and amortization mechanisms. These disclosures may go far beyond the GAAP or materiality driven disclosures followed by companies previously in disclosing these financings.
• Review Market Considerations. Carefully evaluate the financial market conditions that might effect the maintenance or continuation of the company’s financings.
• Specific Disclosures. Disclose the financings and their terms, potential defaults and market ramifications specifically in SEC filings and avoid boiler-plate. These disclosures could significantly extend the length and detail of MD&A disclosures.
• Outside Review. The company’s auditors should review the new MD&A disclosures, presumably as part of their reports to the company’s audit committee.
• Consider Tax, Capital and Regulatory Characterizations. Sometimes structured products and derivative transactions are characterized for tax, regulatory and capital purposes, and companies should be careful, when making expanded disclosures in the MD&A, to maintain consistency with these characterizations in their public SEC filings.
• Consider Competitive Consequences. Although SEC disclosure requirements supersede company disclosure concerns about confidentiality and competitive disadvantage, companies should nevertheless consider and plan for any competitive market-place consequences arising from competitors obtaining through publicly available SEC filings more detailed information about the company’s previously non-public financings and financial risks.
• Securities Offerings. Companies considering public offerings, especially using existing shelf registrations, or private 144A offerings, should consider whether their MD&A disclosure in these areas is adequate prior to any offering, and should also consider any delays that could arise due to further diligence, comfort letter or other assurances that may arise in this area.
• Reform Act. To the extent more forward-looking information is presented in the MD&A, companies should be mindful of proper disclaimers and specific risk disclosures applicable to SEC-filed documents as contemplated by the Private Securities Litigation Reform Act and the "bespeaks caution" doctrine.
• Further Questions. Be prepared for increased scrutiny and questioning of the heightened disclosures in the post-Enron era by auditors reviewing the disclosures, members of the Board of Directors, especially the audit committee, rating agencies, analysts, shareholders and the SEC.
• Avoiding Updating Duties, and Complying with Regulation FD. In responding to inquiries by analysts, shareholders, and other market participants regarding these heightened disclosures in the post-Enron era, companies should be mindful of avoiding the creation of "updating duties" for the company, be careful with presenting forward-looking disclosures along with proper qualifications applicable to oral statements as contemplated by the Private Securities Litigation Reform Act, and avoid selective disclosures and comply with the Regulation FD public disclosure requirements.

In the post-Enron era, disclosures, particularly financial disclosures, will be closely scrutinized by the SEC, analysts and investors. The failure to provide complete and comprehensible disclosures will run the risk of not only SEC comment but could also negatively affect the trading in a company’s securities. Companies are well advised to expand the circle of those reviewing MD&A disclosures to include the business people, lawyers and accountants involved in complex transactions that are, or should be, disclosed. Mayer, Brown, Rowe & Maw has substantial experience in securities law matters, as well as the complex securitization, lease, derivative and other structured finance products covered by the Release.

SEC Disclosure Examples A for Contracts & Other Commitments

Payments Due by Period

If you have any questions regarding this alert, we would be pleased to provide additional details or advice about specific situations. For more information, please contact any member of our corporate and securities practice group.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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