October 15, 2008
As the most recent fiscal quarter has come to a close, public companies are preparing their periodic reports in the midst of turmoil in the general economy and upheaval in credit markets. These developments create special challenges for the disclosures required in periodic reports filed with the securities and exchange commission and warrant a discussion of current issues and approaches.
The current financial market disruptions and developments have resulted in a range of issues that companies need to consider as they prepare their periodic reports. Among these events are:
Existing SEC Disclosure Requirements
These developments may implicate disclosure requirements under SEC rules that require specific discussions about liquidity issues, trends and uncertainties. Specifically:
Recent Trends in Disclosures
Many companies have started to file Forms 8-K that address some of these disclosure considerations. For example, a number of companies with significant financial businesses have recently released current reports with attached updated risk factors that address the proposed Troubled Asset Relief Program, the current market turmoil in general, levels of market volatility in general, and the soundness of other financial institutions. These current reports have often been issued in connection with proposed acquisitions or capital infusions, but in some instances, they have been issued to address more general concerns in the marketplace. Examples include recent filings by Capital One Financial Corp., JP Morgan Chase & Co., Citigroup Inc., Bank of America Corp. and MetLife, Inc. More recently, two companies outside of the financial sector have released current reports updating risk factors (Penn National Gaming, Inc. and Thornburg Mortgage, Inc.) and others have released current reports reaffirming their liquidity positions (American Express Co., Behringer Harvard REIT I, Inc. and First Energy Corp.). Maui Land & Pineapple Company, Inc. also issued a current report explicitly acknowledging the failure of a Lehman Brothers entity to honor its portion of a lending commitment.
SEC Guidance on Disclosure Considerations
The SEC has issued three interpretive releases addressing MD&A disclosure requirements, each of which address liquidity disclosures. These releases were issued
in 1989 (http://www.sec.gov/rules/interp/33-6835.htm),
in 2002 (http://www.sec.gov/rules/other/33-8056.htm), and
in 2003 (http://www.sec.gov/rules/interp/33-8350.htm). The 1989 release, issued at the time of the previous savings and loan crisis, also specifically discusses disclosure considerations on the effects of federal financial assistance upon companies’ operations.
In the 2003 MD&A interpretive release, the SEC stated that a company is required to include in its MD&A liquidity discussion the following information, to the extent material:
If these items were not material when a company prepared its Form 10-K containing MD&A disclosures, it should consider whether subsequent events now make it appropriate to address these matters. Also, material changes in previously reported information should be discussed. For example, the SEC has stated that, when companies are discussing liquidity, companies should include an analysis of any material variations in the underlying sources of cash flows even where reported amounts of cash provided and used by operations, investing activities or financing have been consistent.
As discussed above, MD&A requires forward-looking information in some circumstances. Specifically, where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:
In making this assessment, the SEC has stated that the "reasonably likely" standard establishes a disclosure threshold that is lower than "more likely than not." In other words, discussion may be required even when the likelihood of an event is less than 50/50. In making this assessment, companies should take into account all information available to them, including events and trends that have manifested themselves after the close of the quarter.
In the 2003 MD&A release, the SEC stated that if there are any known material trends or uncertainties related to cash flow, capital resources, capital requirements, or liquidity, a statement that a company has adequate resources to meet its short-term and/or long-term cash requirements may be insufficient if more detailed or nuanced information regarding the source, availability or cost of such financing is material. Even in the absence of known trends or uncertainties, in light of widespread investor concerns, many companies will find it useful to provide voluntary additional disclosures discussing resources available to satisfy their cash requirements.
Finally, in assessing future events, companies should be mindful of the need to assess reserves for financial statement reporting purposes, an area that was the subject of a number of SEC enforcement cases during the economic slowdown in the late 1980s. For example, in SEC v. Bank of New England, SEC Litigation Release No. 12743 (Dec. 21, 1990), the SEC alleged that the Bank knowingly and recklessly understated the allowance for loan and lease losses and related provision for loan and lease losses, because the Bank allegedly failed to identify and quantify accurately the probable loss in individual loans within its portfolio and failed to give adequate consideration to existing negative trends, including deterioration in the Bank’s asset quality and in the New England real estate market.
What Companies Should Do Now
MD&A disclosure of trends and uncertainties is particularly difficult during periods of economic distress due to the requirements to provide forward looking information in the circumstances discussed above. Those challenges are compounded by the increased scrutiny of periodic filings that occurs during periods of economic difficulty and by the heightened after-the-fact examination that the MD&A receives by both the SEC and at times in private litigation. Indeed, both the recession in 1989 and the collapse of Enron Corporation precipitated renewed SEC inspection of, and emphasis on, MD&A disclosure, including issuance of the interpretive releases discussed above.
In light of this SEC guidance on liquidity disclosures, the developments in the financial markets and their concomitant effects on liquidity, companies should carefully evaluate and consider revising their liquidity and cash flow disclosures as they prepare their quarterly filings. This evaluation should not be limited only to the direct effects of tightened credit, such as a company’s own commercial paper borrowings, but also the secondary effects on the company’s liquidity that result from the company’s customers and lenders dealing with the tightening credit markets.
When companies determine that forward-looking statements are required in their MD&A under the standards discussed above, companies may also wish to revise, restate or supplement their risk factor discussions to address those known trends or uncertainties. Likewise, given investor and market concerns, when companies have determined that known trends or uncertainties are not reasonably likely to have a material effect on their future liquidity, companies should evaluate addressing the basis for those determinations, and may wish to include voluntary forward-looking disclosures in either their MD&A and/or alert investors to the variables affecting those determinations in either the MD&A or their risk factor disclosures.
In addition to considering the guidance set forth in the SEC releases discussed above and some of the specific examples that are set forth in those releases, companies should examine each of the following categories of disclosures:
Does the company reasonably expect undiminished access to the commercial paper market?
If the commercial paper market is closed or restricted for the company, does the company have alternative sources of liquidity such as bank lines of credit or readily salable current assets?
If the company is not able to access the commercial paper market, will the company face higher interest expense as a result of accessing bank loans instead?
Is the company considering any capital infusions as an alternative to borrowing?
Is the company reliant on a single or small group of banks for financing?
Are any of the company’s lenders in especially precarious positions such that the company’s ability to draw down on lines of credit is jeopardized?
Is the company in danger of being out of compliance with any conditions to its ability to draw funds down under its existing credit agreements?
Are ratings changes likely and will they trigger collateral calls, defaults, or rate increases on any lending arrangements?
Are the company’s customers likely to be affected by the credit market turmoil in a way that makes the company’s future cash flows less certain?
Has the company reassessed its receivables and determined if reserves need to be increased?
Does the company depend on securitization and resale or factoring of its receivables for part of its liquidity?
If so, what arrangements are available to the company if those sources become closed or restricted?
Is it possible that the company may not be able to access or liquidate investments held in money market funds?
Finally, for further consideration, Gibson Dunn recently released a related client alert addressing new guidance on fair value accounting under FASB No. 157 and related MD&A disclosures.
Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above. Please contact
John Olson (202-955-8522, email@example.com),
Brian Lane (202-887-3646, firstname.lastname@example.org),
Ron Mueller (202-955-8671, email@example.com),
Amy Goodman, (202-955-8653, firstname.lastname@example.org),
Michael Scanlon (202-887-3668, email@example.com),
Gillian McPhee (202-955-8230, firstname.lastname@example.org),
Beth Ising (202-955-8287, email@example.com) or
Robert Lindsey (214-698-3157, firstname.lastname@example.org)
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