On September 17, 2010, the US Securities and Exchange Commission (the “SEC”) issued new guidance (the “New Guidance”) on liquidity and capital resources disclosures that form part of Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).1 In addition, the SEC proposed amendments to enhance disclosure about companies’ short-term borrowings (the “Proposed Rules”).2 The Proposed Rules, if adopted, will apply to all reporting companies, including foreign private issuers and smaller reporting companies, but with modifications for those categories.
The New Guidance and Proposed Rules are intended to provide investors with additional information concerning companies’ short-term liquidity and funding risks and address the shortcomings of the current reporting requirements which merely provide a snapshot of a company’s liquidity situation at the end of a quarter. The SEC is focused in particular on the increased frequency with which companies are using alternative short-term borrowing techniques, such as commercial paper, repurchase transactions and securitizations. Commentators have suggested that current reporting requirements allow companies to hide liquidity problems by adjusting their short-term borrowings at the end of a quarter and that the Proposed Rules could have provided investors with advanced warning of many of the liquidity issues which contributed to the recent financial crisis.
The Proposed Rules are subject to a 60-day public comment period following their publication in the Federal Register.
Guidance Regarding Liquidity and Capital Resources Disclosures
The New Guidance addresses three main areas: Liquidity Disclosure, Leverage Ratio Disclosures and Contractual Obligations Table Disclosures.
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 company’s liquidity increasing or decreasing in any material way. The SEC has previously highlighted a number of issues for management to consider when identifying such trends for disclosure in MD&A. The New Guidance provides additional suggestions for potential important trends which may require inclusion in MD&A, including:
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.
The New Guidance also provides a variety of suggestions to improve disclosure and comply with current requirements. The New Guidance notes that where a company’s financial statements do not adequately convey its short-term borrowing arrangements and their impact on liquidity, existing MD&A rules require additional narrative disclosure to enable investors to understand the company’s short-term borrowings. For example, if borrowings during the reporting period are materially different than the period-end amounts recorded in a company’s financial statements, disclosure about the intra-period variations is required to facilitate investor understanding of the company’s liquidity position.
A general trend of inadequate disclosure of certain repurchase agreements that are accounted for as sales, as well as other types of short-term financings that are otherwise not fully captured in a company’s balance sheet, is highlighted by the New Guidance. Companies are reminded that the disclosure requirements of Item 303(a)(1) continue to apply regardless of the fact that there are no specific references to off-balance sheet arrangements or contractual obligations to repurchase transactions that are accounted for as sales and the receipt of a “true sale” legal opinion does not eliminate the need for adequate disclosure. In evaluating whether disclosure in MD&A may be required in connection with a repurchase transaction, a securities lending transaction or any other transaction involving the transfer of financial assets with an obligation to repurchase that has been accounted for as a sale under applicable accounting standards, a company should consider whether the transaction is reasonably likely to result in the use of a material amount of cash or other liquid assets.
Further, the SEC suggests that companies should consider describing any cash management and risk management policies that are material to their financial condition. For example, banks should consider discussing their policies and procedures relating to meeting applicable banking agency guidance on funding and liquidity risk management or any policies and procedures that differ from such 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. This could include information about the nature of any limits or restrictions and their effect on the company’s ability to use or to access those assets to fund its business operations.
The New Guidance reemphasizes the SEC’s position that where financial treatment of a transaction or a company’s financial statements do not provide investors with a complete picture, the narrative discussion in MD&A should fill in the blanks.
Leverage Ratio Disclosures
The New Guidance discusses the inclusion of capital or leverage ratios in filings in the context of its position on disclosure relating to financial and nonfinancial measures in MD&A. The New Guidance provides a methodology for the company to analyze what disclosure is required with respect to a ratio. It states that:
A company must first determine whether the relevant ratio is a financial measure.
Where the ratio is determined not to be a financial measure, the company should refer to the SEC’s guidance on disclosures relating to nonfinancial measures such as industry metrics or value metrics.3
Where the ratio is determined to be a non-GAAP financial measure, the company must follow the SEC’s rules and guidance governing the inclusion of non-GAAP financial measures.4
Any ratio or measure should be accompanied by a clear explanation of the calculation methodology and such explanation would need to clearly articulate the treatment of any inputs that are unusual, infrequent or nonrecurring, or that are otherwise adjusted so that the ratio is calculated differently from directly comparable measures.
■■ If a financial measure differs from other measures commonly used in the industry, a company must consider whether a discussion of those differences is necessary to make the disclosures not misleading. ■■ A company should consider disclosure stating why the measure is useful to an understanding of its financial condition. Contractual Obligations Table Disclosures Under current disclosure requirements, companies are required to include a contractual obligations table in their MD&A. The New Guidance does not provide new substantive guidance on what should be included in the contractual obligations table, but reminds companies of the purpose of the contractual obligations table. The primary purpose of the table is to present a meaningful snapshot of cash requirements arising from contractual payment obligations. In particular, the purpose of the table is to provide aggregated information about contractual obligations and contingent liabilities and commitments in a single location so as to improve transparency of a company’s short-term and long-term liquidity and capital resources needs and to provide context for investors to assess the relative role of off-balance sheet arrangements. The disclosure requirement is designed to allow flexibility so that the presentation can be tailored to a company’s business, however, the presentation method must be clear, understandable and appropriately reflect the categories of obligations that are meaningful in light of its capital structure and business. Proposed Rules Under the Proposed Rules, companies would be required to provide tabular disclosure and related narrative discussion in a separate section of their annual and quarterly MD&As of: ■■ The amount in each specified category of short-term borrowings (as described below) at the end of the reporting period and the weighted average interest rate on those borrowings. ■■ The average amount in each specified category of short-term borrowings for the reporting period and the weighted average interest rate on those borrowings. ■■ The maximum amount of each specified category of short-term borrowings during the reporting period. The above requirements substantially mirror those currently applicable to bank holding companies pursuant to Guide 3. Item VII (Short-Term Borrowings) of Guide 3 will be eliminated if the Proposed Rules are adopted. Definition of Short-Term Borrowings Under the Proposed Rules, “short-term borrowings” would mean amounts payable for short-term obligations that are: ■■ Federal funds purchased and securities sold under agreements to repurchase. ■■ Commercial paper. ■■ Borrowings from banks. ■■ Borrowings from factors or other financial institutions. ■■ Any other short-term borrowings reflected on the company’s balance sheet. Under the Proposed Rules, a company will be required to present each of the categories that is relevant to the types of short-term financing activities it conducts, even if that category is not required to be reported as a separate line item on its balance sheet under Regulation S-X. Unlike the current requirements under Guide 3, the Proposed Rules do not permit categories to be aggregated, even if immaterial. The SEC believes that this will enable comparability across companies and highlight the types of short-term borrowing arrangements likely to expose a company to liquidity risks. The Proposed Rules will require the disaggregation of amounts by currency or interest rate to the extent necessary to avoid misleading disclosure.
Financial Companies vs. Other Companies
The Proposed Rules establish different disclosure requirements for financial companies compared to other types of companies. For purposes of the Proposed Rules, a “financial company” means a company that, during the relevant reported period, is engaged to a significant extent in the business of lending, deposit-taking, insurance underwriting or providing investment advice, or is a broker or dealer as defined in Section 3 of the Exchange Act, and includes, without limitation, an entity that is, or is the holding company of, a bank, a savings association, an insurance company, a broker, a dealer, a business development company, an investment adviser, a futures commission merchant, a commodity trading advisor, a commodity pool operator or a mortgage real estate investment trust. Some companies that are engaged in both financial and nonfinancial businesses may meet the definition of “financial company”; for example, manufacturing companies that have a subsidiary that provides financing to its customers. The Proposed Rules would allow such a company to provide separate short-term borrowings disclosure for its financial and nonfinancial business operations.
Click here to see a table showing the differences in short-term financing disclosure requirements for financial companies and other companies: