January 7, 2011

SEC Issues Interpretive Guidance on Liquidity and Capital Resources Disclosures and Proposes Rules Addressing Short-Term Borrowings Disclosure

Holland & Knight Alert
Patrick C. Emans

On September 17, 2010, the SEC issued interpretive guidance on liquidity and capital resources disclosures and proposed rules regarding short-term borrowing disclosures in Management’s Discussion and Analysis (the “MD&A”). Both the interpretive guidance and the proposed rules are designed to encourage companies to provide increased disclosure of short-term borrowings and funding risks. The interpretive guidance on liquidity and capital resources became effective on September 28, 2010. The comment period regarding short-term borrowing disclosures ended on November 29, 2010 and we are currently awaiting the SEC’s final rules.

Interpretive Guidance on Liquidity and Capital Resources Disclosure

In conjunction with the proposed rules regarding short-term borrowings disclosure, the SEC issued interpretive guidance that reviews current rules and provides new guidance addressing liquidity and capital resources disclosure in a company’s MD&A.

Liquidity Disclosure

In the interpretive guidance, the SEC reminds companies that Item 303(a)(1) of Regulation S-K requires companies to identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquidity. Additionally, the SEC noted that Item 303(a)(1) 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 a material way. To provide further guidance, the SEC emphasized that management should consider the following when identifying trends, demands, commitments, events and uncertainties that require disclosure in the MD&A:

  • 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
  • counterparty risk

Additionally, the interpretive guidance encourages companies to provide additional narrative disclosure to provide investors with an understanding of the amounts depicted in the company’s financial statements if the company’s financial statements do not adequately convey the company’s financing arrangements because of a known trend, demand, commitment, event or uncertainty. For example, if a company’s borrowings during the reporting period are materially different from the period-end amounts recorded in the company’s financial statements, then the current rules require the company to provide disclosure about the intra-period variations. This required disclosure will facilitate investor understanding of a company’s liquidity position. Moreover, the SEC noted that companies should consider whether a transaction is reasonably likely to result in the use of a material amount of cash or other liquid assets when determining whether the company should disclose certain off-balance sheet arrangements, repurchase transactions, securities lending transactions or other transactions involving the transfer of financial assets.

Lastly, the interpretive guidance suggests that companies should describe cash management and risk management polices relevant to an assessment of their financial condition. For example, a company that maintains or has access to a portfolio of cash and other investments should consider providing information about the nature and composition of the portfolio, including a description of the assets in that portfolio and any related market risk, settlement risk or other risks.

Leverage Ratio Disclosures

The interpretive guidance reminds companies to determine whether or not capital or leverage ratios are financial measures. If the ratios are not financial measures, then companies should refer to prior SEC guidance regarding non-financial measures, such as industry metrics or value metrics. However, if the ratios are financial measures, then companies should first determine whether the measures fall within the scope of the SEC’s requirements for non-GAAP financial measures, and if the measures are within the scope, companies would need to follow the SEC’s rules and guidance addressing inclusion of non-GAAP financial measures in SEC filings. In any case, any ratios or measures included in a company’s filings should be accompanied with a clear explanation of the calculation methodology that clearly explains the following:

  • the treatment of any inputs that are unusual, infrequent, non-recurring or that are otherwise adjusted so that the ratio is calculated differently from directly comparable measures
  • if the financial measure presented differs from other commonly used measures in the company’s industry, the company would need to consider whether a discussion of those differences or presentation of those measures is necessary to make the disclosure not misleading
  • the company’s reasons for presenting the particular financial measure
  • why the measure is useful to understanding the company’s financial condition

Contractual Obligations Table Disclosures

The interpretive guidance encourages companies to develop a presentation method that is clear, understandable and appropriately reflects the categories of obligations that are meaningful in light of the company’s capital structure and business. Moreover, the guidance reminds companies to prepare the tabular disclosure with the goal of presenting a meaningful snapshot of cash requirements arising from contractual payment obligations. Furthermore, companies should highlight any changes made in the presentation in order to help investors use the information to make comparisons from period to period.

The interpretive guidance notes that the SEC staff receives a variety of questions regarding purchase obligations; however, the SEC is not comfortable providing general guidance in response to the questions since the questions that arise tend to be fact-specific and closely related to a company’s particular business and circumstances. As a result, the SEC reminds companies that the purpose of the contractual obligations table is to provide aggregated information about contractual obligations and liabilities and commitments in a single location 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. Additionally, the SEC notes that footnotes or additional narrative discussion outside of the table should be used to help investors understand the tabular data.

Proposed Rules on Short-Term Borrowings Disclosure

Current rules regarding the MD&A require discussion and analysis of a company’s liquidity and capital resources. However, aside from the discussion of liquidity and capital resources under Item 303(a)(1) and (2) of Regulation S-K, companies are not required to provide specific data regarding short-term borrowing amounts unless the company is a Bank Holding Company subject to Industry Guide 3, Statistical Disclosure by Bank Holding Companies (“Guide 3”).

In order to increase disclosure of short-term-borrowing amounts, the SEC is proposing rules that would codify Guide 3 in Regulation S-K and would expand the Guide 3 disclosure to apply to all companies that provide MD&A disclosure, not just financial institutions.. These proposed rules would be applicable to annual and quarterly reports, proxy or information statements that include financial statements, registration statements under either the Securities Act of 1933 (the “Securities Act”) or the Securities and Exchange Act of 1934 (the “Exchange Act”).

The proposed rules would require companies to disclose the following in their MD&A:

  • the amount in each specified category of short-term borrowings 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
  • financial companies must disclose the maximum daily amount of each specified category of short-term borrowings during the reporting period
  • non-financial companies must disclose the maximum month-end amount of each specified category of short-term borrowings outstanding during the period

Definition of Short-Term Borrowings

The proposed rules define short-term borrowings to include:

  • 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

Requirements for Financial Companies and Non-Financial Companies

Additionally, the proposed rules distinguish between financial companies and non-financial companies. Financial companies would be required to disclose the maximum daily amounts outstanding (the largest amount outstanding at any day over the course of the reporting period) and the average amounts outstanding during the reporting period computed on a daily basis. Non-financial companies would only be required to report the maximum month-end amounts outstanding (the largest amount outstanding at the end of the last day of any month during the reporting period) and would be required to disclose the basis used by the company to calculate the average amounts reported.

The proposed rules define a financial company as a company that, during the relevant 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. The definition of “financial company” includes:

  • 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
  • a mortgage real estate investment trust

Some companies that are engaged in both financial and non-financial businesses may meet the definition of “financial company,” such as manufacturing companies with a subsidiary that provides financing to its customers. For those companies, the proposed rules allow for the company to provide a separate short-term borrowing disclosure for its financial and non-financial operations.

Narrative Discussion of Short-Term Borrowings

Additionally, the proposed rules require companies to provide a narrative discussion of short-term borrowing arrangements, which would include the following topics:

  • a general description of the short-term borrowing arrangements included in each category (including any key metrics or other factors that could reduce or impair the company’s ability to borrow under the arrangements and whether there are any collateral posting arrangements) and the business purpose of those arrangements
  • the importance to the company of its short-term borrowing arrangements to its liquidity, capital resources, market-risk support, credit risk support or other benefits
  • the reasons for the maximum amount for the reporting period, including any non-recurring transactions or events, use of proceeds or other information that provides context for the maximum amount
  • the reasons for any material differences between average short-term borrowings for the reporting period and period-end short-term borrowings

This proposed short-term borrowing disclosure is designed to complement, but not repeat, the other MD&A requirements relating to liquidity and capital resources.

Reporting Periods

These proposed rules would be applicable to annual and quarterly reports, proxy or information statements that include financial statements, and registration statements under either the Securities Act or the Exchange Act. For annual reports, information would be presented for the three most recent fiscal years and for the fourth quarter. Registrants preparing registration statements with audited full-year financial statements would be required to include short-term borrowing disclosure for the three most recent fiscal years and interim information for any subsequent interim periods. For quarterly reports, information would be presented for the relevant quarter, without a requirement for comparative data.

Treatment of Foreign Private Issuers and Smaller Reporting Companies

The proposed rules would apply to most foreign private issuers. These companies would provide short-term borrowing disclosures on their Form 20-F, which is the annual report filing for foreign private issuers. The proposed rules would not require foreign private issuers to provide the short-term borrowing disclosure more than annually since foreign private issuers are not required to file quarterly reports with the SEC.

Additionally, the proposed rules would apply to smaller reporting companies, except that quarterly disclosures would not be required unless material changes have occurred during the interim period and information for the fourth fiscal quarter would not be required in annual reports. In addition, the smaller reporting companies would be required to provide only two years of short-term borrowing information.

Leverage Ratio Disclosure Issues

Currently, the SEC is considering whether or not it should extend a leverage ratio disclosure requirement to companies that are not bank holding companies. The SEC noted that there does not seem to be a uniform leverage ratio used by companies or investors. As a result, the SEC sought comments as to whether it should require leverage ratio disclosure and whether such a requirement would take into account the differences among metrics and industries while still providing comparability.

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