The Sarbanes-Oxley Act requires the Securities and Exchange Commission to issue by January 26, 2003 final rules relating to use of non-GAAP (pro forma) financial information in public company SEC reports and earnings releases and to MD&A disclosure of off-balance sheet arrangements, contractual commitments and contingent liabilities. In order to meet this deadline, the SEC has published formal rule proposals that would:

  • Require quantitative reconciliation of non-GAAP financial disclosures with comparable GAAP financial information, and prohibit material misstatements or omissions that result in non-GAAP disclosures being misleading. See SEC Release No. 33-8145 (November 5, 2002). These new disclosure requirements are consistent with the cautionary advice regarding pro forma earnings information issued to public companies by the SEC in December 2001 after Financial Executives International and the National Investor Relations Institute jointly published guidelines for press releases containing such information.

  • Require (i) specific MD&A disclosures on material off-balance sheet transactions, arrangements and obligations that may have a material effect on the company's financial condition, results of operations, liquidity, capital expenditures and resources or significant components of revenues and expenses and (ii) disclosure in the MD&A of a company's aggregate contractual commitments in a tabular format and a summary of its contingent liabilities in either a textual or tabular format. See SEC Release No. 33-8144 (November 4, 2002).

In addition, the rules proposed in Release No. 33-8145 would require U.S. domestic public companies to file earnings releases or similar announcements on Form 8-K, regardless of whether the release or announcement contains non-GAAP financial information. The comment periods for the proposed rules on non-GAAP financial information and MD&A disclosure will expire on December 13 and December 9, respectively.

These proposed rules will be adopted in final form in December or January. The rule proposals do not contain transition provisions, but the SEC staff has indicated that the rules will become effective on or shortly (within 30 to 60 days) after the date of final adoption. The rules will apply to all non-GAAP financial disclosures made, and all reports filed on Form 10-K, 10-Q, 20-F or 40-F, on or after the effective date. The new Form 8-K filing requirement will apply to any earnings releases or announcements made on or after such date.

Public companies considering use of pro forma financial information in year-end earnings releases and annual reports should begin developing reconciliation disclosures if they have not already done so in response to the SEC's cautionary advice. In addition, because detailed and complex disclosures will be required regarding off-balance sheet arrangements, contractual obligations and contingent liabilities, public companies should begin focusing on and preparing these disclosures as soon as possible.

Use of Non-GAAP Financial Information

The SEC has proposed a new Regulation G and amendments to Item 10 of Regulations S-K and S-B that would apply to disclosure of any material information that contains a "non-GAAP financial measure." Regulation G would be applicable to any public company that discloses a non-GAAP financial measure, whether the disclosure is made in a press release, analyst call, SEC filing or other communication. A company making such disclosure will be required to:

  • Present the most comparable financial measure calculated and presented in accordance with GAAP; and

  • Reconcile the differences between the non-GAAP financial measures presented and the comparable financial measure calculated and presented in accordance with GAAP.

In addition, Regulation G mandates that the non-GAAP financial measures, taken together with the accompanying information disclosed, may not misstate a material fact or omit to state a material fact necessary to make the presentation of the non-GAAP financial measures not misleading.

A non-GAAP financial measure is defined as any numerical measure of a company's financial performance that (i) excludes amounts that are included in the comparable measure determined and presented in accordance with GAAP in the income statement, balance sheet or statement of cash flows or (ii) includes amounts that are excluded from the comparable measure calculated and presented in accordance with GAAP. Non-GAAP measures are different from "pro forma" information as defined under Regulation S-X. Non-GAAP financial measures would not include statistical and operating information not contained in the base financial statements.

Regulation G will generally apply to disclosures made by foreign private issuers filing on Forms 20-F and 40-F. However, a foreign private issuer will not be required to make Regulation G disclosures, if (i) the securities of the company are listed outside of the United States, (ii) the non-GAAP financial information and the most comparable base financial information of the company are not determined and presented in accordance with GAAP as applied in the United States and (iii) the disclosure is made by the company outside the United States, or is included in a written communication that is released only outside the United States.

If a public company includes non-GAAP financial information in a filing with the SEC, proposed amendments to Item 10 of Regulation S-K and S-B would also require disclosure of:

  • The purposes for which its management uses the non-GAAP financial measures; and

  • The reasons why the company's management believes that such non-GAAP financial measures provide useful information to investors.

The proposed rules relating to non-GAAP information in SEC filings would also prohibit giving non-GAAP financial measures more prominence than GAAP measures, using confusingly similar names for non-GAAP and GAAP measures, and including non-GAAP measures in GAAP financial statements. They would also prohibit companies from misstating or omitting to state a material fact necessary to make the presentation of the non-GAAP financial measures not misleading.

The proposed rules on non-GAAP disclosures in SEC filings would apply to foreign issuers filing on Form 20-F, except to the extent the non-GAAP measure is expressly accepted in the foreign private issuer's home country and is included in its primary financial statements used in such country. The SEC has not proposed to amend Form 40-F, but Regulation G would apply to disclosures made on a Form 40-F report.

Form 8-K Disclosure of Financial Results

Section 409 of the Sarbanes-Oxley Act added a new Section 13(l) to the Securities Exchange Act of 1934, which requires public companies to disclose "on a rapid and current basis such additional information concerning material changes in the financial condition of results of operations of the issuer . . . as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest." In response, the SEC has proposed requiring a company to file a Form 8-K report within two business days after any public announcement or release of material non-public information regarding a completed annual or quarterly fiscal period. Companies will need to anticipate or promptly identify any such announcement (whether oral or written) in order to make the required filing in a timely manner.

The new Form 8-K disclosure item applies only to material non-public information regarding a completed fiscal year or quarter. As a result, a new Form 8-K filing is not required each time a company refers to previously released financial information. Also, public disclosure of earnings estimates for current or future fiscal periods will not trigger a Form 8-K filing requirement.

The proposed Form 8-K item contains an exception for information presented orally, telephonically or by webcast, broadcast or similar means, if (i) the presentation occurs within 48 hours of a related release or announcement that is filed on Form 8-K, (ii) the presentation was announced by a widely disseminated press release and is accessible to the public and (iii) the information in any webcast is posted on the company's website.

The SEC has not proposed to amend Form 6-K, but foreign private issuers that report on Form 20-F or Form 40-F are already required to file all material press releases with the SEC on Form 6-K.

New MD&A Disclosure Requirements

The proposal would require public companies to disclose, in a separately captioned section of the MD&A, a comprehensive explanation of any off-balance sheet arrangement. The proposal would also require disclosure of aggregate contractual obligations in a tabular format and contingent liabilities and commitments in either a textual or tabular format.

These new MD&A disclosure requirements apply to foreign private issuers. The SEC has proposed amendments to Form 20-F and Form 40-F requiring new information to be included in the annual reports of all foreign issuers reporting on these forms. However, the SEC has not proposed to amend Form 6-K to require that the information be included in quarterly reports furnished to the SEC under cover of Form 6-K. The SEC has expressly requested comment on the extent to which Forms 20-F, 40-F and 6-K should be amended to require this information.

Off-Balance Sheet Arrangements.

Off-balance sheet disclosure requirements would cover any transactions or agreements of a public company with an unconsolidated entity under which the company has, or in the future may have:

  • Any obligation under a direct or indirect guarantee or similar arrangement;

  • A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement;

  • A derivative security, to the extent that the fair value of the derivative is not fully reflected as a liability or asset in the financial statements; or

  • Any obligation or liability (including a contingent obligation or liability), to the extent that it is not fully reflected on the face of the financial statements.

Disclosure would be required only if management determines that an off-balance sheet arrangement is material in the current period or may become material in the future. However, under this standard, disclosure must be made unless the occurrence of a future material event is "remote" or "outside the reach of reasonable possibility."

If a company is required to discuss an off-balance sheet arrangement, it must disclose:

  • The nature, business purpose and significant terms and conditions of the arrangement;

  • The nature and amount of the total assets, obligations and liabilities of the unconsolidated entity;

  • The amount of revenues, expenses and cash flows arising from the arrangement;

  • The nature and amount of any interest retained, securities issued, indebtedness incurred or other obligations arising from the arrangement, and the triggering events that could cause them to arise; and

  • Management's analysis of the material effects of the off-balance sheet arrangement on the company's financial condition, results of operations, liquidity and capital resources.

In addition, a company would be required to provide an analysis of its reliance on off-balance sheet arrangements for liquidity and capital resources, protection against market risk or credit risk and other benefits. The company would also be required to disclose the effects of a termination or material reduction in the benefits derived from the off-balance sheet arrangement. If there is a reasonable likelihood that an off-balance sheet arrangement will be terminated or have its benefits materially reduced, disclosure of the circumstances under which such termination or reduction may occur and the material effects of such a development would also be required.

Tabular Disclosure of Contractual Obligations.

The proposal would require disclosure in tabular format of the amounts of a company's contractual obligations. The table would aggregate contractual obligations by type, and cover total contractual obligations as well as contractual obligations during the following periods: less than one year, one to three years, three to five years and more than five years. This disclosure requirement would not apply to small business issuers reporting on Forms 10-KSB and 10-QSB.

Disclosure of Contingent Liabilities or Commitments.

The proposal would require disclosure, either in tabular form or in text, of information on contingent liabilities and commitments. These liabilities and commitments must be aggregated by type in a manner suitable for the company's business. Information regarding each type of contingent liability would include the amount, range of amounts or maximum amount of each type of contingent liability that is expected to expire during the following periods: less than one year; from one to three years; from three to five years; and more than five years. This disclosure requirement would not apply to companies reporting on Form 10-KSB and 10-QSB.

Conclusion

Like other SEC rules being adopted in the wake of Sarbanes-Oxley, the proposed rules on use of non-GAAP financial information and on MD&A disclosure of off-balance sheet arrangements, contractual commitments and contingent liabilities will place significant new disclosure burdens and time pressures on public companies. Whether such disclosure requirements will result in less frequent use of non-GAAP financial information or will discourage the utilization of off-balance sheet arrangements is unknown at this time. However, it is clear that public companies will need to build additional time and procedures into their timetables for SEC filings in order to obtain necessary information and properly make the new disclosures.

Please contact the Dorsey & Whitney attorney with whom you work if you have any questions regarding the proposed rules.

November 18, 2002