United States: Disclosure Of Off-Balance Sheet Arrangements

"Transparency" and "accountability" have been two of the primary goals of the Sarbanes-Oxley Act of 2002, the federal legislation enacted last summer in response to the corporate finance and accounting scandals that began with Enron, Tyco and WorldCom. Much of the law and the SEC initiatives that followed have addressed who is accountable for ensuring the integrity of public company financial reporting and oversight. Rules are now in place for officer certification of financial statements, board and audit committee responsibilities, and standards of conduct for the professionals involved in the securities law compliance process.

Other rules have focused on the transparency side of the equation, with new requirements that expand and accelerate reporting of insider trading and material corporate events. The SEC is adding to the transparency requirements with new rules on disclosure of off-balance sheet arrangements in public company SEC filings. These rules are directed at previously undisclosed off-balance sheet arrangements that expose a company to continuing risks or contingent liabilities. The new rules will apply to annual reports, registration statements and proxy statements that include financial statements starting June 15, 2003.

The new SEC rules require that public companies provide investors with a clear understanding of their material offbalance sheet arrangements. The disclosures now called for include:

• the business purpose of the off-balance sheet arrangements and their importance to a company’s liquidity, capital resources and market or credit risk supports
• the overall magnitude of off-balance sheet activities
• the events that trigger contingent obligations or liabilities and the resulting financial impact
• termination or reduction events for arrangements that provide material benefits

Central to the new rules is the SEC definition of "offbalance sheet arrangements," which includes:

• obligations under certain guarantees
• retained or contingent interests in assets transferred to an unconsolidated entity that serve as credit, liquidity or market-risk support for the entity
• obligations under certain derivative instruments
• obligations arising out of a variable interest held in an unconsolidated entity that provides financial support to the public company or engages in leasing, hedging or R&D services with the public company

Guarantees. Corporate guarantees that fall within the definition of off-balance sheet arrangements include:

• contracts that require payments based on changes to a specified rate, security or commodity price, foreign exchange rate or index of prices or rates (an "underlying") that relate to an asset, liability or equity security of the guaranteed party
• performance guarantees
• indemnification agreements that require payments based on changes to an underlying
• keepwell and other agreements where a public company agrees to provide funds to another entity upon the occurrence of specified events

Guarantees targeted by the definition are meant to correspond to U.S. GAAP.

Retained or Contingent Interests. Off-balance sheet arrangements include retained or contingent interests in assets transferred to an unconsolidated subsidiary where the retained interest serves as credit, liquidity or marketrisk support for that entity.

Derivative Instruments. Obligations under derivative instruments constitute off-balance sheet arrangements if indexed to the public company’s stock and classified as stockholders’ equity.

Variable Interests. Any material contractual, ownership or other pecuniary interest in an entity that changes with changes in that entity’s net asset value falls within the definition of offbalance sheet arrangements. Included in this category are investments or other interests that absorb a portion of an entity’s expected losses or that can earn residual returns.

Disclosure of off-balance sheet arrangements is required where the arrangements have or are likely to have a current or future material impact on a public company’s financial situation. To determine whether to disclose offbalance sheet arrangements, management must make the following analysis:

• identify all off-balance sheet arrangements
• assess the likelihood of any trend, commitment, event or uncertainty that could impact an offbalance sheet arrangement
• if the trend, commitment, event or uncertainty is not reasonably likely, no disclosure is necessary
• if management cannot conclude that the trend, commitment, event or uncertainty is not reasonably likely, it must evaluate the impact assuming the trend, commitment, event or uncertainty occurs
• disclosure is required unless management concludes that a material effect on the public company is not reasonably likely to occur

The SEC also will require that public companies centralize and aggregate information on contracts that require future payments. This information must cover long-term debt, capital lease obligations, operating leases, purchase contracts and other long-term liabilities. A tabular presentation of these types of commitments over several time periods will be required. The requirements take effect on December 15, 2003 and will not apply to small business issuers.

Off-balance sheet disclosures will likely contain a variety of estimates and projections, particularly statements estimating potential payouts under off-balance sheet arrangements or identifying event risk. Information of this kind will be protected by the statutory safe harbor for forward-looking statements. The safe harbor is expected to encourage better disclosure practices for off-balance sheet information by shielding public companies from liabilities that might otherwise result when attempting to comply with the rules.