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Recent Events Require Heightened Attention
to Securities Exchange Act Reporting
By Marcus Williams
[Feb. 2002]
I had the privilege recently to attend the National Securities
Regulation Institute in San Diego, sponsored annually by Northwestern
University School of Law and widely reputed to be the best course
in the country on securities law and regulation. A number of senior
Securities and Exchange Commission officials spoke at the Institute,
including newly appointed Chairman Harvey Pitt, Chief Accountant
Robert Herdman, Director of Enforcement Stephen Cutler, and Director
of Corporation Finance Alan Beller.
I wanted to take this opportunity to bring to your attention a
number of important issues that were discussed at the conference.
These issues are of particular importance to companies required
to file periodic reports under the Securities Exchange Act, as well
as to individuals who serve on public company boards of directors
and -- particularly -- those who serve on audit committees. These
issues relate primarily to your company's reporting under the Securities
Exchange Act, but by analogy you should consider a number of specific
issues as you continue to improve your communications with shareholders.
SEC Reporting
As one might expect in light of the unfolding Enron debacle, each
of the SEC representatives at the Securities Regulation Institute
concentrated on the importance of accurate, adequate Securities
Exchange Act reporting. Chairman Pitt and Directors Herdman and
Beller noted that Enron, while perhaps egregious in terms of the
magnitude of losses and the alleged conduct of some persons involved,
may not be unique as having used "opaque" accounting and reporting
techniques. All three officials suggested strongly that companies
focus much more detailed attention to their Exchange Act reports
in the coming months, and Herdman and Beller pointedly noted that
the SEC Staff would significantly intensify their review of public
company filings.
Obviously, not all companies have engaged in the types of accounting
misstatements and Exchange Act reporting irregularities of which
Enron is accused; however, the Staff's emphasis will be "across-the-board"
targeting a more thorough review of all public company reports.
We are providing this guidance to our public company clients in
the hopes that they may be able to use current events as a catalyst
to improve their reporting in a way that will provide clear, meaningful,
and materially accurate disclosure to investors. These improvements
can help mitigate the potential for specific SEC scrutiny that might
otherwise result in a diversion of management's attention from day
to day affairs, as well as increases in legal and accounting expenses
associated with responding to specific inquiries. While it would
be impossible to detail all of the aspects on which a particular
client might need to focus, we believe that in particular, registrants
should pay careful attention to the following issues.
Management's Discussion & Analysis
In light of the SEC's heightened scrutiny and its growing emphasis
on clear, meaningful and materially accurate disclosure, quality
expectations about MD&A will be much higher this year than in years
past. In light of this emphasis, Chief Accountant Herdman noted
that "this would be a good year to start drafting your MD&A afresh
on a clean sheet of paper." Chairman Pitt echoed this concern and
suggested that vague, over-simplified "boilerplate" statements carried
over from years of previous reporting experience would no longer
be acceptable as a means of satisfying one's Exchange Act reporting
requirements. In furtherance of that advice, on January 22, 2002
the Commission issued Exchange Act Release 34-45321 entitled "Commission
Statement About Managment's Discussion and Analysis of Financial
Condition and Results of Operations." A copy of this release is
attached below, or you may retrieve it at the SEC's website, http://www.sec.gov.
In the MD&A release the Commission reemphasized the importance of
MD&A, noting that it is "intended to give the investor an opportunity
to look at the company through the eyes of management by providing
both a short and a long-term analysis" of the company's business.
In doing so, "disclosure must be both useful and understandable
[meaning that] management should provide the most relevant information
and provide it using language and formats that investors can be
expected to understand." In the January MD&A release, the Commission
"reminded" companies of specific MD&A requirements relating to (1)
liquidity and capital resources; (2) trading activities involving
certain types of derivative contracts; and (3) related party transactions.
While relatively few of our clients derive significant revenues
or expenses from trading in derivative contracts, all of them should
refocus their attention on disclosure and discussion of liquidity
and related party transactions.
Liquidity and Capital Resources
With respect to liquidity and capital resources, for example, reporting
companies have customarily used statements such as, "we believe
that our sources of liquidity, including funds from operations,
funds from sales of assets, and sources of short- and long-term
borrowings, will be sufficient to meet our liquidity needs and to
fund our anticipated capital expenditures in the foreseeable future."
Beller, the Director of Corporation Finance, specifically noted
that companies should engage in a meaningful and in-depth discussion
of each aspect of liquidity and capital resources based on the registrant's
actual current situation. The Exchange Act Release mentioned above
notes that "registrants should consider describing the sources of
short-term funding and the circumstances that are reasonably likely
to affect those sources of liquidity. For example, a registrant
that identifies its principal source of liquidity as operating cash
flows may need also to disclose the extent of the risk that a decrease
in the demand for the company's products would reduce the availability
of funds." This type of information must be disclosed in meaningful
language in light of the reporting company's actual current situation
and not simply a boilerplate statement to be carried forward from
period to period. Similarly, where a company expects to rely on
short-term or long-term debt financing to fund operations or capital
needs, the company should discuss any limitations on its borrowing
capability such as events that might reasonably be expected to cause
a breach of an operating covenant or an event of default. This type
of discussion needs to occur if circumstances are "reasonably likely"
to affect liquidity; this standard is a lower disclosure threshold
than the "more likely than not" situation and requires disclosure
unless management determines that a material effect on the registrant's
operating results or financial condition is not reasonably likely
to occur. Finally, where a modification of a credit arrangement
or a breach of a loan covenant results in a need to reclassify a
long-term debt obligation as a current liability, reporting companies
will be expected to state their financial condition accordingly
and to provide in MD&A both an explanation of the event and a discussion
of the resulting impact on operations and financial condition.
Registrants should bear in mind that disclosures must be made in
light of management's assessments, but that management's perspective
must be objectively reasonable when the determination is made. Several
specific events and uncertainties might be expected to affect our
reporting company clients. First, where adverse impacts on earnings
or financial condition would affect one's ability to borrow under
an existing credit arrangement (or where those events would materially
increase the applicable interest rate or repayment terms), the registrant
should discuss both the potential events and the likely results
if one or more of those events occurs. Second, where potential events
may cause an adverse change in historical activities, such as cancellation
or reduction in historical volumes under existing contracts or the
effects of one-time charges or credits, those events and the anticipated
or potential changes must be clearly and concisely described.
Related Party Transactions
As with MD&A, management should consider whether they should improve
their disclosures of related party transactions. Item 404 of Regulation
S-K requires disclosure of certain transactions with management
or directors, or entities controlled by a registrant's management
or directors, where the value of the transaction exceeds $60,000
or if the relationship involves certain products or services. Recent
Staff guidance suggests that registrants provide specific disclosures
where those discussions would provide investors with meaningful
assistance in understanding the registrant's financial statements
or if the arrangements involve terms that would differ materially
from those that might be negotiated with independent parties. Without
limiting the generality of these admonishments, the Staff suggested
that registrants disclosing these transactions discuss the party
and their relationship to the registrant, the purpose of the arrangement,
the process by which the related party was selected, any evaluation
the registrant conducted of the fairness of the transaction, and
any ongoing contractual commitments.
The Staff also suggested that a "related party" for purposes of
this discussion may be construed more broadly than those parties
specifically identified in Item 404 of Regulation S-K, where those
parties might have negotiated terms that would not be available
to clearly independent third parties. Again, as with MD&A, reporting
companies should focus their presentation on a clear, accurate and
meaningful discussion of the realities underlying their operations
and financial condition.
Pro Forma Financial Information Used in Earnings
Releases
Many, and perhaps most, public companies use "pro forma" financial
information in addition to GAAP data to provide investors a better
understanding of their financial condition and operating results.
However, misuse of this type of presentation can also be misleading
and can subject a registrant to both civil liability and SEC enforcement
action. On December 4, 2001 the SEC issued Exchange Act Release
No. 34-45124, "Cautionary Advice Regarding the Use of 'Pro Forma'
Financial Information in Earnings Releases." The Chief Accountant's
Staff issued the release to "sound a warning" about the "potential
dangers" of using such information. The Staff noted in the release
that pro forma information is sometimes helpful, such as to provide
a meaningful comparison of one period's results to those of a comparable
previous period. The Staff specifically noted that "there is no
prohibition preventing public companies from publishing interpretations
of their [operating] results," and noted that "with appropriate
disclosures about their limitations accurate interpretations of
results and summaries of GAAP financial statements taken as a whole
can be quite useful to investors."
However, when using pro forma financial data, management must explain
the principles underlying its presentation so that investors can
use the data to reconcile that information to GAAP earnings and
financial condition. Moreover, the Staff noted that over-reliance
or manipulation of pro forma information can be misleading to investors.
For example, a presentation of results that focuses inordinately
on one aspect of a registrant's operating results, such as EBITDA
or earnings excluding one-time charges, can mislead investors to
believe that the items excluded from the calculation do not have
a meaningful impact on the company's financial results or condition.
Where a reporting company uses these types of presentation, financial
management should take care to ensure that a meaningful, plain-English
reconciliation to GAAP should be included prominently with those
statements. Additionally, registrants should be aware that statements
that are literally true but that omit material information are nonetheless
misleading and thus can subject the company both to enforcement
action and private liability. "For example, investors are likely
to be deceived if a company uses a 'pro forma' presentation to recast
a loss as if it were a profit, or to obscure a material result of
GAAP financial statements, without clear and comprehensible explanations
of the nature and size of the omissions."
So long as issuers take care to use pro forma earnings information
in a way that is meaningful to investors and that does not obfuscate
GAAP results, and so long as that information is accompanied by
a meaningful verbal reconciliation of the proforma information to
materially accurate GAAP data, there is little worry that investors
will be misled. However, given the recent re-emphasis on this issue
by the SEC Accounting Staff, we would encourage our clients to discuss
these types of statements with securities counsel and with their
audit firms, paying careful attention to the need to provide clear,
accurate disclosures in a way that is most meaningful to shareholders
and the investing public.
A Final Note
Although perhaps intensified because of recent events surrounding
Enron, Global Crossing and others, the Commission's recent statements
are more appropriately viewed as consistent with the SEC's and Congress'
actions during the past few years. The Private Securities Litigation
Reform Act, Regulation FD and the "Plain English" initiative have
all been directed toward the goal of providing meaningful, comprehensible
disclosures to all investors. Accordingly, issuers should make thorough,
meaningful disclosures to the investing public in language investors
can understand. These disclosures should include a thorough discussion
of historical events and their effects on the registrant's current
operating results and financial condition, as well as a reasonable
and meaningful discussion of anticipated events and uncertainties
for the future. As SEC Chief Accountant Robert Herdman suggested,
we are advising our clients to take this year as an opportunity
to start afresh in drafting your MD&A and your other Securities
Exchange Act reports, keeping in mind these goals and recent guidance.
The extra effort expended during this reporting season will prove
critical during this period of heightened scrutiny and may provide
reporting companies with a much-improved basis for future reporting
cycles.
Below are links to each of the SEC's releases discussed above,
and I would urge management and directors to review these materials
in preparation for the upcoming reporting season. Please feel free
to contact me or your regular DWT attorney if we can be of assistance.
The Commission Statement About Management's Discussion and Analysis
of Financial Condition and Results of Operations, Exchange Act Release
No. 34-45321, is located at http://www.sec.gov/rules/other/33-8056.htm.
The Cautionary Advice Regarding the Use of "Pro Forma" Financial
Information in Earnings Releases, Exchange Act Release No. 34-45124,
is located at http://www.sec.gov/rules/other/33-8039.htm.
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