SEC Proposes Disclosure of Off-Balance Sheet Arrangements

The SEC recently proposed rules to implement Section 401(a) of the Sarbanes-Oxley Act of 2002 which would require public companies to disclose their off-balance sheet arrangements and their contractual obligations and contingent liabilities and commitments in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of their filings with the SEC. A summary of the proposal follows:

Proposed Disclosure Requirements
The Act requires the SEC to issue final rules, not later than January 26, 2003 requiring companies to disclose in their annual and quarterly reports all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the company with unconsolidated entities or other persons, that “may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.” The SEC proposal would require:

• A discussion of off-balance sheet arrangements in a separately captioned subsection of the MD&A. The proposal would not limit this disclosure to annual and quarterly reports, but would require it everywhere an MD&A is required.
• Disclosure of a company’s aggregate contractual obligations in tabular format in the MD&A. This information would only need to be updated in quarterly reports to reflect material changes.
• Disclosure of the expected amount, range of amounts or maximum amount of contingent liabilities or commitments, either in a table or text. This information would only need to be updated in quarterly reports to reflect material changes.

Off-Balance Sheet Arrangements
The proposal defines the term “off-balance sheet arrangement” as any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the company is a party, under which the company, whether or not a party to the arrangement, has, or in the future may have:

• Any obligation under a direct or indirect guarantee or similar arrangement;
• A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;
• Derivatives, to the extent that the fair value is not fully reflected as a liability or asset in the financial statements; or
• Any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes).

“Other than Remote” Disclosure Threshold
Currently, a company is required to disclose an off-balance sheet transaction in the MD&A if it is “reasonably likely” to have a material effect on the company. The Act contains a lower standard for this disclosure – “may have a material . . . effect.” The SEC proposal would require disclosure of off-balance sheet arrangements if the likelihood of the occurrence of a future event and its material effect on the company is higher than remote. Stated another way, “unless management determines that the occurrence of an event and the materiality of its effect is outside the realm of reasonable possibility,” disclosure is required. This language is thus broad enough to sweep in arrangements that currently would not be required to be disclosed.

Required Disclosure
The proposal would require a company to disclose, to the extent necessary to an understanding of the effect of the off-balance sheet arrangements on the registrant’s financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures and capital resources:

• The nature and business purpose of its off-balance sheet arrangements.
• The significant terms and conditions of the arrangements.
• The nature and amount of the total assets and total obligations and liabilities (including contingent obligations and liabilities) of an entity in which off-balance sheet activities arc conducted.
• The amounts of revenues, expenses and cash flows arising from the arrangements and the nature and amounts of any interests retained, securities issued and other indebtedness incurred by the company and any other contingent obligations or liabilities of the company arising out of the arrangement that are or may become material and the events that could cause them to arise.
• An analysis of the material effects of any of the items discussed above and an analysis of the degree to which the company relies on off-balance sheet arrangements for its liquidity and capital resources or market or credit risk support or other benefits.
• The circumstances under which any off-balance sheet arrangement that materially benefits the company will or is reasonably likely to be terminated or reduced as a result of a contractual provision or any known event, demand, commitment, trend or uncertainty, and any material effects of such termination or reduction.

The disclosure would have to appear in a separately captioned section of the MD&A.

Contractual Obligations

• The proposal would also require companies (other than small business issuers) to include tabular disclosure in the MD&A about contractual obligations (which would include both on and off-balance sheet obligations) as of the latest balance sheet date. The tabular presentation must cover at least the periods described in the table below. Similar types of contractual obligations should be aggregated using the categories below or other categories appropriate to the company. The table should be accompanied by footnotes to describe pertinent data.
    

Contingent Liabilities and Commitments
The proposal would also require companies (other than small business issuers) to disclose, either in tabular or textual form, the expected amount, range of amounts or maximum amount of contingent liabilities or commitments that are expected to expire in less than one year, from one to three years, from three to five years, and more than five years. Examples of contingent liabilities or commitments that would be covered under the proposal are lines of credit, standby lenders of credit, guarantees, and standby repurchase obligations.

Safe Harbor for Forward-Looking Statements
Information about the effect of off-balance sheet arrangements may require the disclosure of forward-looking information. The proposal would apply the safe harbor for forward-looking statements under the Private Securities Litigation Reform Act (“PSLRA”) to forward-looking information that would be required to be disclosed under the proposed rules.

• It appears that the forward-looking statement would not need to be identified as such, but that it would need to be accompanied by meaningful cautionary statements that identify important factors that could cause actual results to differ materially from those in the forward-looking statement.
• Application of the safe harbor will permit its use in IPOs and tender offers, where by the terms of the PSLRA it does not apply.

The statutory safe harbor covers statements by reporting companies, persons acting on their behalf, outside reviewers retained by them, and their underwriters (when using information from, or derived from, the companies).

January 2002 Statement
The proposal is similar to guidance the SEC provided in January 2002 in Release 34‑45321. In the proposing release, the SEC stated that it is only codifying the guidance in the January 2002 release as it relates to off-balance sheet arrangements, but that the guidance remains relevant to issuers preparing MD&A.

Application to Foreign Private Issuers
The Act and the SEC proposal apply to foreign private issuers. Because foreign private issuers are not required to file quarterly reports (unless they file a registration statement during the year), they would not be required to update the disclosure more frequently than annually.

Contact Information
If you have any questions or would like to learn more about the proposed rules, please contact the lawyer who normally represents you.