On September 17, 2010, the SEC issued an Interpretive Release intended to improve discussion of liquidity and capital resources in MD&A in order to facilitate the understanding by investors of the liquidity and funding risks facing companies.1 In particular, the Interpretive Release provides guidance on the presentation of liquidity, leverage ratio and contractual obligations table disclosures within MD&A. The Interpretive Release is the latest in a series of SEC releases on improving the quality of specific aspects of MD&A.2 Concurrently, the SEC also issued proposed amendments which would require both financial and non-financial companies to disclose additional information in registration statements and periodic reports about intra-period short-term borrowings as a supplement to disclosure about period-end amounts.3 The proposed rule changes contained in this Companion Release would require a registrant to provide, in a separate MD&A subheading, a comprehensive explanation of its short-term borrowings, including both quantitative and qualitative information for short-term borrowings during the interim period, instead of simply disclosing material changes since the previous balance sheet date.4  

Liquidity  

In the Interpretive Release, the SEC acknowledges that companies have undertaken increasingly diverse and complex types of financing activities, and have expanded the kinds of funding methods and cash management tools they use. Accordingly, the Interpretive Release not only revisits prior guidance and rulemaking initiatives that the SEC has issued in the past with respect to MD&A – such as the importance of discussing trends and analyzing the business from management’s perspective – but also provides new guidance with respect to the following areas of liquidity disclosure within MD&A:

  • trends and uncertainties relating to liquidity;
  • intra-period variations in liquidity;
  • repurchase agreements that are accounted for as sales;
  • and cash management and risk management policies.  

Although this guidance has not been codified per se within SEC rules, it is nevertheless important for companies as they prepare MD&A because it highlights certain SEC concerns. As many of our clients know from their SEC comment letters, liquidity has been a key focus of the SEC comment process in the past several years.  

Trends and Uncertainties Relating to Liquidity. The SEC once again emphasized the importance of focusing on the discussion of trends in the context of liquidity, stating that Item 303(a)(1) of Regulation S-K requires disclosure of “known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”5 The SEC then suggests that some additional important trends that should be discussed may include difficulties accessing the debt markets, reliance on commercial paper or other short-term financing arrangements, maturity mismatches between borrowing sources and the assets funded by those sources, changes in terms requested by counterparties, changes in the valuation of collateral and counterparty risk. Companies are being encouraged by the SEC to update their disclosure about risks, uncertainties, trends and commitments, particularly as circumstances change with time. In light of this, the company’s finance and treasury teams should revisit their disclosure and consider the impact of these factors set forth by the SEC.  

Intra-Period Variations in Liquidity. If the registrant’s financial statements do not adequately convey its financing arrangements during the accounting period covered by the filing, or the impact of those arrangements on intra-period liquidity, additional narrative disclosure should be considered. For example, depending on the registrant’s circumstances, if borrowings on specific dates during the reporting period are materially different than the period-end amounts recorded in the financial statements, disclosure about the intra-period variations is required to facilitate investor understanding of the registrant’s liquidity position. This is an area where many companies may need to supplement their existing liquidity disclosure in response to this new guidance. In fact, the amendments proposed by the Companion Release would require registrants to provide tabular information about their intra-period short-term borrowings,6 as well as a narrative discussion about those short-term borrowings.  

Repurchase Agreements that are Accounted for as Sales. The Release focuses on certain repurchase agreements that are accounted for as sales, as well as other types of short-term financings not otherwise fully captured in period-end balance sheets, such as securities lending transactions, off-balance sheet arrangements or certain transfers of financial assets. Where a transaction is reasonably likely to result in the use of a material amount of cash or other liquid assets, disclosure in MD&A may be required in connection with a repurchase transaction, particularly if the registrant does not otherwise include such information in its off-balance sheet arrangements or its contractual obligations table.  

Cash Management and Risk Management Policies. The SEC believes that companies should consider describing cash management and risk management policies that are relevant to an assessment of their financial condition. Banks, in particular, should consider discussing their policies and practices in meeting applicable banking agency guidance on funding and liquidity risk management, or any policies and practices that differ from applicable agency guidance. In addition, a company that maintains or has access to a portfolio of cash and other investments that is a material source of liquidity should consider providing information about the nature and composition of that portfolio, including a description of the assets held, and any related market risk, settlement risk or other risk exposure.  

Leverage Ratio

In the Interpretive Release, the SEC stresses the importance of including a clear explanation of the calculation methodology behind any ratio (such as a capital or leverage ratio) or other measure included in SEC filings when there are no regulatory requirements prescribing the calculation of that ratio, or where such ratios are calculated using a methodology that is modified from its prescribed form.7 In particular, the SEC suggests disclosure regarding:

  • the treatment of any inputs that are unusual, infrequent or non-recurring;
  • if applicable, how the financial measure differs from other measures commonly used in the registrant’s industry;
  • the registrant’s reasons for presenting the particular financial measure; and
  • why the measure is useful to understanding the registrant’s financial condition.  

In addition, although no formal rules have been proposed yet, the SEC is soliciting comments in the Companion Release on whether to extend leverage ratio disclosure requirements to companies that are not bank holding companies, and the scope of any such potential disclosure requirement.  

Contractual Obligations Table

In the Interpretive Release, the SEC notes that since adopting rules for the contractual obligations table in 2003, divergent practices have emerged in connection with the preparation of this tabular disclosure. However, the SEC states that the rules, in fact, permit the flexibility to tailor the presentation to suit the company’s business, and the SEC encourages registrants to develop a presentation method that is clear, understandable and appropriately reflects the categories of obligations that are meaningful in light of the registrant’s capital structure and business. The SEC is reluctant to provide guidance on addressing specific questions that have been asked of them regarding the contractual obligation requirement, as these tend to be fact-specific and closely related to a particular registrant’s business and circumstances. Instead, registrants should prepare the disclosure consistent with the objective of providing aggregated information about contractual obligations and contingent liabilities and commitments in a single location, so as to improve transparency of a registrant’s short-term and long-term liquidity and capital resources needs, and of providing context for investors to assess the relative role of off-balance sheet arrangements. Footnotes to the table, as well as additional narrative disclosure outside of the table, are encouraged to provide more information to help investors understand the tabular data presented.