On September 17, 2010, the Securities and Exchange Commission (the SEC) voted unanimously to propose new rules that would require additional disclosures about short-term borrowing arrangements. At the same time, the SEC staff also issued guidance for existing disclosure requirements regarding liquidity and funding. The goal of the proposed rules and the current guidance is to enable investors to better understand whether amounts of short-term borrowings reported at the end of reporting periods are consistent with amounts that were outstanding during the reporting periods.
In order to fund operations, more and more companies engage in short-term borrowing, which involves financing arrangements that generally mature in a year or less. Currently, SEC rules require most companies to disclose short-term borrowings only as they exist at the end of the applicable reporting period. Because short-term borrowing can fluctuate significantly during a reporting period, the amounts existing at the end of the period may not be indicative of a company’s funding needs or activities throughout the period. Investors who currently lack such information may not fully appreciate a company’s liquidity, leverage position and funding risks. The SEC also indicated that some companies may be using the current disclosure requirement to intentionally mask their actual liquidity and leverage position by incurring significant short-term borrowings during reporting periods and reducing those amounts just before period-end to show less leverage in reported amounts.
Short-Term Borrowings Defined
Under the proposed rules, “short-term borrowings” would include commercial paper, borrowings from banks, borrowings from other financial institutions and any other short-term borrowings reflected on the company balance sheet. Additionally, while there are exceptions, most repurchase arrangements would be covered under the definition of short-term borrowings.
Under the proposed rules, a company would be required to provide quantitative information in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of quarterly and annual reports, as well as registration statements under the Securities Act of 1933, for each type of short-term borrowings the company uses, that includes:
- the amount outstanding at the end of the reporting period;
- the weighted average interest rate on those borrowings;
- the average amount outstanding during the period;
- the weighted average interest rate on those borrowings; and
- the maximum amount outstanding during the period.
Additionally, the company would provide a narrative description of each type of short-term borrowing and its business purpose. The narrative discussion would also describe the relative importance to the company of its short-term borrowings arrangements to its liquidity, capital resources, market-risk support, credit-risk support or other benefits; the reasons for the maximum reported level for the reporting period; and the reasons for any material differences between the average outstanding amount and the period-end outstanding amount of short-term borrowings.
Smaller reporting companies (those with a public float of less than $75 million, measured as of the last business day of its most recently completed second fiscal quarter) would not be required to provide the tabular disclosure in its quarterly reports. Instead, they would be required to discuss material changes from the end of the prior fiscal year and, if included in the filing, from the corresponding interim balance sheet date of the prior year.
Special Requirements for “Financial Companies”
Under the proposed rules, “financial companies”, which is defined below, would be subject to certain enhanced disclosure requirements. "Financial companies" would be required to provide averages calculated on a daily average basis (which is consistent with existing guidance included in the SEC's bank holding company disclosure guide known as Guide 3), and to disclose the maximum amount outstanding on any day in the period. All other companies would be permitted to calculate averages using an averaging period not to exceed a month and to disclose the maximum month-end amount during the period. However, a company that is engaged in both financial and non-financial businesses would be permitted to present the short-term borrowings information for its financial and non-financial businesses separately.
The concept of “financial company” is expansive and includes any company that is (i) engaged to a significant extent in the business of lending, deposit-taking, insurance underwriting or providing investment advice; (ii) a broker or dealer as defined in Section 3 of the Securities Exchange Act of 1934; or (iii) 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.
Interpretive Release for Existing MD&A Requirements
In conjunction with the proposed rules, the SEC staff issued interpretive guidance for existing MD&A requirements that will be relevant to management’s discussion of short-term borrowings.  The guidance is effective immediately upon publication of the interpretive release in the Federal Register, which is expected shortly. The interpretive release elaborates upon the existing requirement that companies “identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquidity.” Its stated goal is for such MD&A disclosure to keep pace with the increasingly diverse and complex financing alternatives available in the financial marketplace.
The release emphasizes the importance of MD&A disclosure regarding important trends and uncertainties relating to a company’s liquidity, 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, and counterparty risk.
The release also addresses the need for disclosure in situations in which a company’s financial statements do not adequately convey the company’s financing arrangements during the subject reporting period, or the impact of those arrangements on liquidity, because of a known trend, demand, commitment, event or uncertainty. The release provides examples of such situations that resonate with the substantive focus of the proposed rules – e.g., when a company’s borrowings during the reporting period are materially different than the period-end amounts recorded in the financial statements, or when certain repurchase agreements are not fully captured in period-end balance sheets.
Ultimately, the release makes clear the staff’s positions that:
- a company cannot use financing structures designed to mask the company's reported financial condition;
- leverage ratios and other financial measures included in filings with the SEC must be calculated and presented in a way that does not obscure the company's leverage profile or reported results; and
- regardless of divergent practices that have arisen in the context of tabular disclosure of contractual obligations, companies should focus on providing informative and meaningful disclosure about their future payment obligations.