SEC Provides Interpretive Guidance to Improve Liquidity and Capital Resources Disclosures in MD&A and Proposed Rules for Disclosure of Short Term Borrowing
On September 17, 2010, the Securities and Exchange Commission (“SEC”) published interpretive guidance on disclosures in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) relating to liquidity, leverage ratios and contractual obligations. In conjunction with the release of the interpretive guidance, the SEC proposed measures to require registrants to disclose additional information to investors about their short term borrowing arrangements in a separately captioned subsection of the MD&A. The guidance became effective on September 28, 2010 and should be considered by all registrants for the next periodic reports.
Liquidity and Capital Resources Disclosure
As financing activities by registrants become more diverse and complex the SEC believes it is increasingly important that the discussion and analysis of liquidity and capital resources meets the objective of MD&A disclosure. The guidance reminds registrants that Item 303(a)(1) of Regulation S-K requires registrants to disclose known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in any material increase or decrease in the registrant’s liquidity. The guidance identifies the following trends and uncertainties relating to liquidity such as:
- Difficulties in accessing 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
If a registrant’s financial statements do not adequately convey financing arrangements during the reporting period, or the impact of those arrangements on liquidity, because of a known trend, demand, commitment, event or uncertainty, additional narrative disclosure should be considered and may be required to enable an understanding of the amounts in the financial statements. For example, if borrowings during the period are materially different than period-end amounts, disclosure about intra-period variations may be required to facilitate investor understanding of the registrant’s liquidity position.
To provide context for exposures identified in the MD&A, a registrant should consider describing cash management and risk management policies that are relevant to an assessment of its financial condition. Banks in particular should consider discussing their policies and practices in meeting applicable banking agency guidance on funding and liquidity risk management, or any policies and practices that differ from applicable agency guidance. A registrant that maintains or has access to a portfolio of cash and other investments that is material to its liquidity should consider providing information about the nature and composition of that portfolio, including a description of the assets held and any related market risk, settlement risk or other risk exposure. This could include, for example, information about the nature of any limits or restrictions and their effect on the registrant’s ability to use or access those assets to fund its operations.
Leverage Ratio Disclosures
The guidance reminds registrants whether disclosure of capital or leverage ratios complies with existing SEC guidance, including guidance relating to the disclosure of non-financial measures and of debt instruments, guarantees and related covenants and requirements relating to non-GAAP financial measures.
Both non-financial and financial measures included in a filing should be accompanied by a clear explanation of the calculation methodology. The explanation should highlight the treatment of any inputs that are unusual, infrequent or non-recurring or that are otherwise adjusted so that the ratio is calculated differently from directly comparable measures. The registrant should also include disclosures stating why the measure is useful to understanding the registrant’s financial condition.
Contractual Obligation Table Disclosures
Contractual obligations tabular presentation should be clear, understandable and appropriately reflects the registrant’s meaningful categories of obligations in light of its capital structure and business. The interpretive release addresses divergent practice with regards to the presentation of certain items under the contractual obligation requirement such as interest payments, repurchase agreements, tax liabilities, synthetic leases and obligations that arise under off-balance sheet arrangements. The interpretive release further emphasizes the purpose for the contractual table to provide aggregate information about contractual obligation and contingent liabilities and commitments in a single location so as to improve transparency of a registrant’s short term and long term liquidity and capital resources needs and provide context for investors to assess off-balance sheet arrangements.
Footnotes should be used to provide information necessary for an understanding of the timing and amount of the specified contractual obligations or a narrative discussion outside of the table should be considered where necessary to promote an understanding of the tabular data. Changes in presentation in the contractual obligations table should be highlighted so that investors can make period-to-period comparisons.
Proposed Rules for Disclosures of Short Term Borrowings
The SEC’s proposed rule is intended to enable investors to better understand whether short term borrowings at the end of a reporting period is consistent with amounts outstanding throughout the reporting period. The proposed rule, if adopted, would create a new section in MD&A requiring tabular disclosure of a company’s short-term borrowings related to liquidity and capital resources that would provide disclosure of each specified category of short-term borrowings at the end of the reporting period and the weighted-average interest rate on those borrowings. In addition, the Proposed Rule would require the following:
For each category of short term borrowings, the registrant is required to disclose:
- The amount of short-term borrowings outstanding at period end and the weighted average interest rate on those borrowings.
- The average amount of short-term borrowings outstanding during the period and the weighted average interest rate on those borrowings.
- The maximum month-end short-term borrowings outstanding during the period.
Registrants that are financial companies would also be required to include:
- The average amounts of short-term borrowings outstanding during the period computed on a daily average basis and the weighted average interest rate on those borrowings.
- The maximum daily amount of short-term borrowings outstanding during the period.
Under the proposed rule changes, registrants would also be required to provide a narrative analysis of short-term borrowing arrangements in the registrant’s MD&A section, including a discussion of:
- A general description of the short term borrowing arrangements included in each category and the business purposes and importance of the short-term borrowings.
- The importance of short-term borrowing arrangements to liquidity, capital resources, and market- and credit-risk support.
- The reason material difference between the maximum or average borrowings during the period and the same at the end of the period.
The proposed rule would apply to all SEC registrants including a new category of companies that meets the definition of a “financial company”. The purpose of the new definition is to scope in certain companies other than bank holding companies for which short term borrowings may be a significant source of liquidity.
The proposed rule defines a “financial company” as a company that 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 or an entity that is or in the holding company of, a bank, a savings association, an insurance company, a broker, a dealer, a business development company, an investment advisor, a futures commission merchant, a commodity trading advisor, a commodity pool operator and a mortgage real estate investment trust. The SEC’s list in the proposed rule is not exhaustive; however, the SEC has distinguished financial companies from non-financial companies based upon the assumption that non-financial companies’ cost in obtaining the additional information required of financial companies under the proposed rule would outweigh any potential benefit to investors. Companies that have financial and non-financial sectors or businesses would be able to provide separate disclosures for each, respectively.
Comments on the Proposed Rule are due by November 29, 2010.