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Corporate counsel responsible for securities disclosure need to be familiar with new SEC guidance relating to the preparation of MD&A disclosures in periodic reports and prospectuses. In a post-Enron environment that features new SEC initiatives and congressional hearings on an almost weekly basis, it would be easy to lose track of this important SEC statement, which was issued in January. The new MD&A guidance, combined with other SEC actions late last year, indicates that the SEC will be scrutinizing MD&A disclosures much more closely. As a result, counsel and the disclosure team should reconsider their existing processes for preparing disclosure documents and the scope of the disclosures made. This will require deeper involvement by senior management, a thorough understanding of relevant financial information and trends, and a review of a wider range of documents for clues to needed disclosure. In January, the SEC provided guidance to issuers in preparing their Management’s Discussion and Analysis of Financial Condition and Results of Operations disclosures in periodic reports and prospectuses. [FOOTNOTE 1]Although triggered by the many apparent disclosure concerns exposed in connection with the collapse of Enron Corp., the SEC’s MD&A statement was issued in formal response to a Dec. 31, 2001, petition by the major accounting firms and the AICPA requesting an interpretive release to address areas where the petitioners believed “expanded disclosure is needed to improve the transparency of financial reporting.” [FOOTNOTE 2] The petition specifically identified three areas of concern about MD&A disclosure practices: � Disclosures concerning liquidity and capital resources, including off-balance sheet arrangements; � Disclosures about certain trading activities involving non-exchange-traded contracts accounted for at fair value; and � Disclosures about the effects of relationships and transactions between the registrant or its related parties and non-independent persons or entities. The petition requested that the SEC issue its guidance in the form of an interpretive release, which would be binding and potentially form the basis of future enforcement actions. The SEC chose to issue its guidance through a more informal “Commission Statement,” while stating that it intends to consider rule-making regarding these and other MD&A topics in the near future. COMMISSION STATEMENT The statement generally adopted the recommendations of the petition, although in certain respects the statement departed (sometimes significantly) from the phrasing requested in the petition. The SEC also took occasion in the statement to summarize important aspects of MD&A disclosure, with particular emphasis on certain disclosure requirements articulated in the SEC’s 1987 MD&A concept release [FOOTNOTE 3]and 1989 MD&A interpretive release. [FOOTNOTE 4] The statement specifically references the SEC’s Dec. 12, 2001, cautionary advice encouraging companies to include in MD&A plain English explanations of their “critical accounting policies, including the judgments and uncertainties affecting the application of those policies and the likelihood that materially different amounts would be reported under different conditions or using different assumptions.” [FOOTNOTE 5]The Dec. 12 advice noted that “[i]nvestors may lose confidence in a company’s management and financial statements if sudden changes in its financial conditions and results occur, but were not preceded by disclosures about the susceptibility of reported amounts to change, including rapid change.” The SEC also recommended in its Dec. 12 cautionary advice that companies’ audit committees “review the selection, application and disclosure of critical accounting policies.” DISCLOSURE OF KNOWN TRENDS AND UNCERTAINTIES One common element underlying each of the areas highlighted in the statement is the issue of proper disclosure of known trends and uncertainties, perhaps the most misunderstood aspect of MD&A disclosure. The statement begins with a reminder that companies are subject to an obligation to “provide such other information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations.” Central to that obligation, according to the statement, is “management’s identification and evaluation of what information, including the potential effects of known trends, commitments, events and uncertainties, is important to providing investors and others an accurate understanding of the company’s current and prospective financial position and operating results.” The statement reminds issuers of the guidance in the 1989 interpretive release that where a trend, demand, commitment, event or uncertainty is known, management must make two assessments: � Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required. � If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the company’s financial condition or results of operations is not reasonably likely to occur. [FOOTNOTE 6] The SEC acknowledged in its 1989 interpretive release that its “reasonably likely to have a material effect” standard for MD&A disclosure differs significantly from the probability/ magnitude test for materiality that was adopted by the U.S. Supreme Court in Basic Inc v. Levinson, 485 U.S. 224, 238 (1987), where the Supreme Court stated that materiality “will depend at any given time on a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company’s activity.” In MD&A, the probability component is considered first, and separately from the magnitude component. Further, in assessing probability, the statement takes the position that “identification of circumstances that could materially affect liquidity is necessary if they are �reasonably likely’ to occur. This disclosure threshold is lower than �more likely than not.’” DISCLOSURES CONCERNING LIQUIDITY AND CAPITAL RESOURCES The statement emphasizes the importance of MD&A discussion of liquidity and capital resources. The SEC reminded issuers that general statements regarding the sufficiency of short- and long-term funding and waivers of loan covenant defaults are not satisfactory. [FOOTNOTE 7]Registrants are advised to describe in detail the sources of liquidity, material risks and “matters that could affect the extent of funds required within management’s short- and long-term planning horizons.” The SEC highlighted several specific disclosure items that management may want to consider: � Provisions in financial guarantees or commitments to third parties, [FOOTNOTE 8]debt or lease agreements or other arrangements that could trigger requirements for early payment, additional collateral support, changes in terms or the creation of additional financial obligations; � Circumstances such as the inability to maintain a specified investment grade credit rating, level of earnings, earnings per share, financial ratios or collateral that could impair the company’s ability to continue to engage in transactions that have been integral to historical operations or are financially or operationally essential, or that could render an activity commercially impracticable; � Factors specific to the company and the markets in which it operates that the company expects to be given significant weight in the determination of its credit rating or otherwise affect the company’s ability to raise short- and long-term financing; and � Written options on nonfinancial assets, such as real estate puts. The statement also reminded registrants to consider the need for MD&A disclosure regarding transactions, arrangements and other relationships with unconsolidated entities or third parties, including structured finance and other special-purpose entities, that are reasonably likely to affect liquidity or capital resources. Companies should describe material sources of liquidity and financing from off-balance sheet arrangements and transactions, including the extent of the company’s reliance on those arrangements, particularly where the other parties provide financing, liquidity, market- or credit-risk support, or research and development services, engage in leasing or hedging activities, or otherwise expose the company to liabilities that are not reflected in its financial statements. In addition, “[w]here contingencies inherent in the arrangements are reasonably likely to affect the continued availability of a material historical source of liquidity and financing, registrants must disclose those uncertainties and their effects.” Among the disclosures recommended for these identified off-balance sheet arrangements are: � The business purposes and activities of the arrangements and their “economic substance”; � Key terms and conditions of commitments; � Initial and ongoing relationships with the company and its affiliates; and � Potential risk exposures resulting from contractual or other commitments. Where a company may be economically or legally required or is otherwise reasonably likely to fund losses of an off-balance sheet entity or to provide it with additional funding or otherwise be financially affected of the performance or nonperformance by the other party, the company may need to include information about the arrangements and exposures. Other disclosures the company should consider include: � Total amount of assets and obligations of each off-balance sheet entity, with a description of the nature of those assets and obligations, and identification of the class and amount of any debt or equity securities issued by the registrant; � The effects of the entity’s termination, if it has a finite life or it is reasonably likely that the company’s arrangement with the entity may be discontinued in the foreseeable future; � Amounts receivable or payable, and revenues, expenses and cash flow resulting from the arrangements; � Extended payment terms of receivables, loans and debt securities resulting from the arrangements, and any uncertainties as to realization, including repayment that is contingent upon future operations or performance; � The amounts, key terms and conditions of purchase and sale agreements between the registrant and other parties; and � The amounts of any guarantees, lines of credit, standby letters of credit or commitments, take or pay contracts, through-put contracts or other similar arrangements, including tolling, capacity or leasing arrangements, that could require the company to fund any obligations under the arrangements, including repayment or value guarantees and make-whole agreements. The statement emphasized that although certain of these disclosures may be appropriately aggregated, care should be taken to ensure that important distinctions are not lost. The SEC also emphasized that while legal opinions regarding “true sale” and issues relating to contingent, residual or other liabilities “can play an important role in transactions involving such entities, they do not obviate the need for the registrant to consider whether disclosure is required.” DISCLOSURES ABOUT CERTAIN TRADING ACTIVITIES The statement expresses concern about the possible “lack of transparency and clarity with respect to the disclosure of trading activities involving commodity contracts that are accounted for at fair value or for which a lack of market price quotations necessitates the use of fair value estimation techniques.” The statement recommends that companies engaging to a material extent in these types of trading activities consider providing supplemental statistical and other disclosures in MD&A beyond those required in financial statements. Among other things, the statement recommends that companies consider providing information that: � Disaggregates realized and unrealized changes in fair value; � Identifies changes in fair value attributable to changes in valuation techniques; � Disaggregates estimated fair values at the latest balance sheet date based on whether fair values are determined directly from quoted market prices or are estimated; � Indicates the maturities of contracts at the latest balance sheet date; � Discloses the fair value of net claims against counterparties that are reported as assets at the most recent balance sheet date, based on the credit quality of the counterparty; and � Describes the company’s risk management policies and practices related to these activities. DISCLOSURES ABOUT EFFECTS OF TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES In addition to disclosure requirements under general accepted accounting principles, the statement recommends that companies consider disclosing: � Descriptions of material transactions involving related person and entities; � The business purpose of the related-party arrangements; � Identification of the related parties (in this regard, the SEC rejected language proposed in the petition that contemplated disclosure of “persons who have both significant influence relative to the registrant” and financial interests in the other entity and “the extent of the registrant’s influence or control over the transactions or entities”); � How transaction prices were determined by the parties; � If the disclosure includes a representation that the transaction has been evaluated for fairness, a description of how the evaluation was made; and � Ongoing contractual and other commitments as a result of the arrangement. In addition, registrants were advised to consider the need for disclosure about parties that do not fall within the traditional definition of “related parties,” but with whom the company or its related parties have relationships that may enable the parties to negotiate terms of transactions that may not be available from independent parties on an arm’s-length basis. Specific examples given include entities established and operated by individuals who were former senior management of, or have some other current or former relationship with, the company. PRACTICAL CONSIDERATIONS IN APPROACHING MD&A DISCLOSURES The process of preparing MD&A disclosures and the resulting disclosures themselves must be customized for each company’s internal organization and reporting structures and will vary considerably from company to company. The SEC’s published guidance about MD&A disclosure, recent guidance on disclosure of critical accounting policies and pro forma earnings [FOOTNOTE 9]and lessons learned from past SEC MD&A enforcement actions do, however, highlight some common elements that companies should consider as they prepare MD&A disclosures. � The SEC has emphasized the importance of senior management’s involvement in the process of preparing MD&A disclosures. This means that senior officials should be knowledgeable about MD&A and the SEC’s interpretation of the disclosure requirements, actively involved in the disclosure preparation process, and have available to them and the team charged with preparing MD&A disclosures information from all levels of the company. � The disclosure team should review board minutes and records of the deliberations of senior management (including materials supplied to the board and to senior management for review), to identify both important trends and uncertainties and possible components of the company’s business that should be highlighted in MD&A. � The disclosure team should understand the company’s internal projections, interim financial results, long-range forecasts and other financial data. Included in this analysis should be a review of the company’s credit agreements and related payment schedules. Variations from budgeted or projected results can be a valuable clue to disclosure issues. � The disclosure team should review press releases and informal disclosures (such as website materials, transcripts of investor conference calls, and statements made in analyst conferences or in newspaper interviews of senior management), both to identify important events that should be highlighted in MD&A and to ensure consistency of MD&A disclosure with prior public statements by the company. [FOOTNOTE 10] � The team should consider reviewing reports of analysts who follow the company and others in the company’s industry, as well as relevant industry trade publications. Probing questions from analysts and financial reporters about particular elements of the company’s business may be useful in identifying issues that should be discussed. It may be helpful for the team to review the MD&A disclosures of competitors that confront disclosure issues similar to those of the company. � Restatement announcements from competitors and reports critical of the accounting practices of competitors may be indicative of an industrywide issue that should be considered. As noted previously, the SEC recently has cautioned issuers to consider enhanced disclosure of “critical accounting policies” as part of MD&A. � Once the disclosure team completes its initial drafts, the MD&A should be reviewed by senior officials and outside advisers who may have knowledge of other events or factors that should be reflected in MD&A. As numerous SEC enforcement actions warn, cursory review by top management is not sufficient. The draft MD&A (at least for annual reports) also must be reviewed by the independent accountants under applicable accounting standards and may be reviewed by outside counsel. The SEC has suggested that companies also have their audit committee review MD&A disclosures. Although the SEC was careful to emphasize that the statement was not intended to create new legal requirements or to modify existing legal requirements, the statement represents the SEC’s most significant general statement on MD&A disclosure in over a decade. Even before the statement was issued, the SEC’s Division of Corporation Finance disclosed that its staff would “monitor the annual reports filed by all Fortune 500 companies that file period reports with the Commission” for disclosures that are inconsistent with SEC rules, generally accepted accounting principles, or “materially deficient in explanation or clarity.” [FOOTNOTE 11]The statement should be required reading for those preparing MD&A disclosures. David E. Brown Jr. is a partner in the Washington, D.C., office of Alston & Bird, www.alston.com/index.cfm?fuseaction=main. E-mail: [email protected]; telephone: (202) 756-3345. ::::FOOTNOTES:::: FN1Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Opera-tions, Securities Act Rel. No. 33-8056, Ex-change Act Rel. No. 34-45321, Financial Reporting Rel. No. FR-61, www.sec.gov/ rules/other/33-8056.htm (Jan. 22, 2002). FN2Petition of Arthur Andersen LLP, Deloitte and Touche LLP, Ernst & Young LLP, KPMG LLP, PricewaterhouseCoopers LLP and American Institute of Certified Public Accountants for Issuance of Inter-pretive Release, www.secgov/rules/petitions/ petndiscl-12312002.htm (Dec. 31, 2001). FN3Concept Release on Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Rel. No. 33-6711, Exchange Act Rel. No. 34-24356, 38 SEC Docket (CCH) 138 (April 17, 1987). FN4Management’s Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures, Securities Act Rel. No. 33-67835, Exchange Act Rel. No. 34-26831, Investment Company Act Rel. No. IC-16961, Financial Reporting Rel. No. FR-36, www.sec.gov/rules/ interp/33-6835.htm (May 18, 1989). FN5Cautionary Advice Regarding Disclo-sure About Critical Accounting Policies, Securities Act Rel. No. 33-8040, Exchange Act Rel. No. 34-45149, Financial Reporting Rel. No. FR-60, www.sec.gov/rules/other/ 33-8040.htm (Dec. 12, 2001). FN6Item 303(a)(3)(ii) of Regulation S-K requires that MD&A identify any “known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations….” Similarly, Item 303(a)(1) requires disclosure of “any 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.” The instructions to Item 303 add that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” FN7See, e.g., In the Matter of America West Airlines Inc., Exchange Act Rel. No. 34-34047, Accounting & Auditing Enforce-ment Rel. No. AE-562, 56 SEC Docket (CCH) 1787 (May 12, 1994); In the Matter of Salant Corp., Exchange Act Rel. No. 34-34045, Accounting & Auditing Enforcement Rel. No. AE-561, 56 SEC Docket (CCH) 1779 (May 12, 1994) (failure to describe uncertainties about liquidity and plans to remedy liquidity concerns). FN8The SEC has previously taken enforcement action against issuers that failed to disclose the effects of contingent obligations. See., e.g., In the Matter of Kahler Corp., Exchange Act Rel. No. 34-32916, Accounting & Auditing Enforce-ment Rel. No. AE-481, 55 SEC Docket (CCH) 27 (Sep. 17, 1993) (failure to disclose uncertainties associated with minority investment in partnership, in-cluding effects of guarantee of partnership debt and practice of funding partnership debt payments). FN9See Alston & Bird LLP Securities Law Advisory, “SEC �Pro Forma’ Earnings Enforcement Action,” www.alston.com/ docs/Advisories/199709/ SEC Pro Forma.pdf (January 2002). FN10See, e.g., In the Matter of Shared Medical Systems Corp., Exchange Act Rel. No. 34-33632, 56 SEC Docket (CCH) 199 (Feb. 17, 1994) (failure to include in MD&A disclosures about anticipated reduction in sales growth contained in earlier press release). FN11See SEC News Digest, www.secgov/ news/digest/12-21.txt (Dec. 21, 2001).

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