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New SEC Rules Affecting Disclosure of Off-Balance Sheet Agreements and Aggregate Contractual Obligations

By Gustavo J. Cruz, Jr.
[March 2003]

On January 22, 2003, the Securities and Exchange Commission ("SEC") adopted final rules under the Sarbanes-Oxley Act of 2002 to require disclosure of off-balance sheet arrangements, and to require registrants (other than small business issuers) to provide an overview of certain known contractual obligations in a tabular format. These provisions also apply to foreign private issuers.

The new off-balance sheet disclosures must be set forth in a separately captioned subsection of the "Management's Discussion and Analysis" (MD&A) section of periodic reports. The "off-balance sheet arrangements" that are to be disclosed include the following general categories of arrangements:

1. Any obligation under certain guarantee contracts;
   
   
2. A retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to the registrant for such assets;
   
   
3. Any obligation under certain derivative instruments; and
   
   
4. Any obligation arising under a material variable interest in an unconsolidated entity that conducts certain activities, such as providing financing, liquidity, market risk or credit risk support to the registrant, or engages in leasing, hedging or research and development services with the registrant.
   

Effective Date of Rules

The new rules will apply to all SEC filings required to include financial statements for fiscal years ending on or after June 15, 2003. Registrants, other than small business issuers, must also include a table of contractual obligations in registrations, annual reports, and proxy or information statements for fiscal years ending on or after Dec. 15, 2003. As a result, these rules do not apply to Forms 10-K filed by companies with calendar-year-end financial statements for the most recent year.

Disclosure Threshold

After consideration of several more stringent tests, the SEC adopted the "reasonably likely" disclosure threshold that is currently applied to other portions of the MD&A disclosure. Therefore, the registrant must disclose off-balance sheet arrangements that either have, or are reasonably likely to have, a material current or future effect on the registrant's financial condition. This material effect for investors might include items such as changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Nature of the Disclosure

The SEC has incorporated a "principles-based" approach to these new rules. As a result, the disclosure must include information "to the extent necessary to an understanding of such arrangements." The disclosure must include:

1. The nature and business purpose of the arrangement;
   
   
2. The importance of the arrangement with respect to liquidity, capital resources, market risk support, credit risk support, or other benefits to the registrant;
   
   
3. The magnitude of the arrangement, including information such as the amount of revenues, expenses and cash flow arising from such an arrangement; and
   
   
4. Any known event, demand, commitment, trend or uncertainty that will result in, or is reasonably likely to result in, the termination or material reduction in availability of the off-balance sheet arrangement and the course of action in response to any such circumstances.
   

Definition of "Off-Balance Sheet Arrangement"

The definition is intended to capture typical means by which companies structure off-balance sheet transactions, or otherwise incur risks of loss that are not fully transparent to investors. This is consistent with the "principles-based" approach adopted under the rules. As a result, the definition is relatively broad, and incorporates a variety of arrangements, including:

1. Guarantees;
   
   
2. A retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity, or market risk support to the registrant for such assets;
   
   
3. Any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument; and
   
   
4. Any obligation, including a contingent obligation, arising out of a variable interest in an unconsolidated entity.
   

The categories described above are further defined by cross-references to generally accepted accounting principles or "GAAP," as described in materials promulgated by the Financial Accounting Standards Board.

Safe Harbor for Forward Looking Statements

A statutory safe harbor for forward looking statements is included under the new rules. The disclosure must be identified as a forward looking statement, and must be accompanied by meaningful cautionary language, as is required under existing statutory safe harbor protections.

Tabular Disclosure of Contractual Obligations

The new rule also includes a requirement that companies disclose, in a tabular format, certain contractual obligations by aggregated category and specified time periods. Set forth below is the tabular format:

For these provisions, the categories of contractual obligations (other than "purchase obligations") also incorporate GAAP cross-references for definitional purposes. In addition to their ongoing reporting requirements, registrants must now implement systems to capture the appropriate information in categories according to the specified time periods. Registrants must provide footnotes as appropriate to further explain these items.

FOR FURTHER INFORMATION, PLEASE CONTACT THE AUTHOR:

Gustavo J. Cruz, Jr., (503) 778 5330, gustavocruz@dwt.com

This Corporate Finance Advisory Bulletin is a publication of the Business Transactions/Corporate Finance Group of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory Bulletin is to inform our clients and friends of developments in business, corporate finance and securities laws. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

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