On September 17, 2010, the SEC published for public comment proposed rules that would require public companies to disclose detailed quantitative and qualitative information regarding their short-term borrowing arrangements in a separately captioned subsection of Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”). The proposed disclosure rules would be applicable to both annual and interim periods and annual and quarterly reports, proxy or information statements that include financial statements and registration statements filed under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). Short-Term Borrowings Disclosure Release Nos. 33-9143; 34-62932 (September 17, 2010).

The proposing release containing the proposed short-term borrowing disclosure rules is a companion release to the SEC’s interpretive guidance regarding liquidity and capital resources disclosures in MD&A. Andrews Kurth’s e-alert outlining the interpretive guidance can be found here.

This e-alert briefly summarizes the key components of the proposed disclosure rules as well as action items for public companies to consider in light of the proposed disclosure rules.

Background

In the past, the SEC has, from time to time, adopted new disclosure requirements and issued interpretive guidance aimed at enhancing the information disclosed in MD&A regarding public companies’ funding and liquidity risk. These enhancements have resulted from the SEC’s conviction that MD&A disclosure regarding liquidity and capital resources is essential to an investor’s evaluation of a public company’s future prospects and likelihood of survival. The proposed rules reflect the SEC’s belief that short-term borrowings are an essential component of a company’s liquidity and capital resources and that investors could benefit from increased disclosure regarding short-term borrowings.

The concern that prompted the SEC to propose the enhanced short-term borrowing disclosures is that the currently prevailing approach of disclosing in MD&A period-end short-term borrowing balances may not accurately depict a registrant’s funding needs during the reporting period or in the future since the registrant’s short-term borrowings may fluctuate significantly within a reporting period. The SEC is convinced that disclosure shortfalls identified as a result of the recent recession and resulting liquidity crises necessitate additional, more specific intra-period short-term borrowing disclosures to enable investors to better understand companies’ funding needs and liquidity risks.

Proposed Short-Term Borrowing Disclosure Rules

The proposed disclosure rules would apply to all public companies that provide MD&A disclosure, including foreign private issuers (except those that file reports pursuant to the U.S.-Canadian Multijurisdictional Disclosure System (“MJDS”)). Registrants would be obligated to include the required short-term borrowing disclosures in annual and quarterly reports, proxy or information statements that include financial statements and registration statements filed under the Securities Act and the Exchange Act.

As discussed below, the proposed rules would require different disclosures for those registrants that constitute a “financial company.” As proposed, a “financial company” would be defined 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 as defined in Section 3 of the Exchange Act. The SEC did not propose a specific threshold or definition of “significant” in connection with the proposed definition. Therefore, unless a threshold is included in the final rules, an issuer will be required to determine whether it is involved to a “significant extent” in the designated activities. The proposed definition of “financial company” includes a non-exclusive list of companies that would be deemed a financial company, including an entity that is, or is the holding company of, a bank, a savings association, an insurance company, a broker, a dealer, a business development company, an investment adviser, a futures commission merchant, a commodity trading advisor, a commodity pool operator and a mortgage real estate investment trust.

Quantitative Disclosures. The proposed quantitative disclosure rules are similar to existing annual short-term borrowing disclosure rules applicable to bank holding companies that are contained in Industry Guide 3, Statistical Disclosure by Bank Holding Companies (“Guide 3”). Unlike the rules in Guide 3, however, the proposed quantitative disclosure rules do not contain a quantitative threshold for separate disclosure of short-term borrowings by category. The proposed rules would require registrants to provide in a separately captioned subsection of MD&A the following information in tabular format:

• the average amount of short-term borrowings outstanding during the reporting period and the weighted average interest rates on the borrowings for each of the following short-term borrowing categories included in the proposed definition of “short-term borrowings”:
  • federal funds purchased and securities sold under agreements to repurchase;
  • commercial paper;
  • borrowings from banks;
  • borrowings from factors or other financial institutions; and
  • any other short-term borrowings reflected on the balance sheet;
• the period-end outstanding amount of short-term borrowings and the weighted average interest rates on the borrowings for each of the short-term borrowing categories mentioned above;
• for registrants that constitute a “financial company,” the maximum daily amount of short-term borrowings outstanding during the reporting period (i.e., the largest amount outstanding at the end of any day during the reporting period) for each of the short-term borrowing categories mentioned above; and
• for registrants that do not constitute a “financial company,” the maximum month-end amount of short-term borrowings outstanding during the reporting period (i.e., the largest amount outstanding at the end of the last day of any month during the reporting period) for each of the short-term borrowing categories mentioned above.

Each registrant that is a “financial company” would be required to compute the average amounts required by the proposed rules on a daily average basis, which means the outstanding amount at each day’s end averaged over the reporting period. All other registrants have discretion to determine how to compute the average amounts so long as the averaging period does not exceed one month and they disclose the basis for computing the averages.

The proposed rules would require registrants to disaggregate amounts within each short-term borrowing category by currency, interest rate or other relevant category if necessary to enhance investor understanding or to prevent the disclosure from being misleading. In addition, registrants would be required to provide footnote disclosure describing the disaggregation method used and any additional relevant data relating to the calculation of the amounts included in the table.

The proposed short-term borrowing categories were derived from existing categories set forth in Regulation S-X and Guide 3. As a result, a registrant may be required to provide tabular disclosure in MD&A of a short-term borrowing category even though the category is not required by Regulation S-X to be included as a separately reported line item on its balance sheet.

A registrant that constitutes a “financial company,” but also has non-financial business operations, would be permitted to provide separate short-term borrowings disclosure for its financial and non-financial operations. In preparing the disclosure, the registrant may comply with the non-financial company disclosure requirements for its non-financial operations disclosure, but it must comply with the financial company disclosure requirements for its financial operations disclosure. Under these circumstances, additional footnote disclosure should be provided describing how the company’s operations were grouped for purposes of the disclosure.

Qualitative Disclosures. In addition to the proposed quantitative disclosure rules, the SEC proposed that companies include in the separate subsection of MD&A a narrative discussion and analysis of their short-term borrowing arrangements. The narrative discussion would include disclosure addressing the following:

• a general description of the short-term borrowing arrangements included in each short-term borrowing category (including any key metrics or other factors that could reduce or impair the issuer’s ability to borrow and whether collateral posting requirements are included);
• a general description of the business purpose of the short-term borrowing arrangements;
• the importance of the short-term borrowing arrangements to the company’s liquidity, capital resources, market-risk support, credit-risk support or other benefits;
• the reasons for any material differences between average short-term borrowings for the reporting period and period-end short-term borrowings; and
• the reasons for the maximum outstanding amount during each reporting period, including any non-recurring transactions or events, use of proceeds or other contextual information.

The proposed narrative discussion and analysis is intended to highlight short-term borrowing activities and complement, but not be repetitive of, other MD&A liquidity and capital resources disclosures. The SEC indicated that registrants should consider how to integrate the various MD&A disclosure requirements, including the proposed narrative, into a coherent and comprehensive liquidity discussion. As mentioned by the SEC in the proposing release, a registrant could organize its liquidity discussion to address overall liquidity followed by short-term and long-term borrowings and liquidity needs.

Reporting Periods. The disclosures must be provided for the following time periods:

• for annual reports, the three most recent fiscal years and, only for annual reports on Form 10-K, the fourth fiscal quarter;
• for quarterly reports, the relevant quarter without comparative period data; and
• for registration statements with audited full-year financial statements, the three most recent fiscal years and any relevant interim periods.

As proposed, registrants that are not bank holding companies or otherwise subject to Guide 3 would be permitted to phase-in the comparative annual data requirements. Thus, in the first year only disclosure for the most recent fiscal year would be required, in the second year only disclosure for the two most recent fiscal years would be required and in the third year and thereafter disclosure for all three fiscal years would be required.

The disclosure in quarterly reports and interim period disclosure in registration statements would be required to include the same level of detail as provided for annual periods (i.e., full presentation of quantitative and qualitative disclosures for short-term borrowings during the interim period). In addition, with respect to interim periods companies would be required to discuss material changes from prior reporting periods.

Foreign Private Issuer Disclosures

Foreign private issuers that are not MJDS filers would be required to include substantially similar short-term borrowing disclosures as that required of domestic companies. However, the proposed rules would permit foreign private issuers that do not prepare financial statements under U.S. GAAP to identify the short-term borrowing categories required by the new disclosures based on the short-term borrowing classifications employed under the accounting principles used to prepare their primary financial statements. Under these circumstances, the disclosure would be required to provide the same level of detail required by the specified quantitative disclosures.

Foreign private issuers would not be required to comply with the proposed quarterly reporting disclosure requirements unless filing a Securities Act registration statement that must include interim financial statements. However, if foreign private issuers are furnishing short-term borrowing information pursuant to Form 6-K, the SEC encourages, but would not require, the inclusion of an update to the annual short-term borrowing disclosures included in the annual report on Form 40-F.

Smaller Reporting Company Scaled Disclosures

Smaller reporting companies would only be required to disclose short-term borrowing information for two fiscal years rather than three in the annual report if they provide two years of financial information as permitted by existing smaller reporting company disclosure requirements and may omit disclosure for the fourth fiscal quarter of the most recent fiscal year in annual reports on Form 10-K. Further, smaller reporting companies would not be required to provide quarterly short-term borrowing disclosures unless material changes occurred since the end of the preceding fiscal year.

Conforming Form 8-K Amendment

The SEC also proposed revisions to the definition of “direct financial obligation” used in Items 2.03 and 2.04 of Form 8-K in order to conform to the proposed definition of “short-term borrowings” used in the proposed short-term obligations disclosure. The proposed revised definition of “direct financial obligation” would retain the existing exception for obligations that arise in the ordinary course of business.

Action Items

Although the proposed rules will likely change prior to adoption, registrants should review the proposed rules and begin to evaluate how they will be impacted if the rules are adopted. For example, some registrants may not currently have the data gathering systems and disclosure controls and procedures necessary to collect and report the required short-term borrowing information. Those registrants should consider reviewing existing data gathering systems and disclosure controls and procedures to determine how to modify and update those systems and controls in order to comply with the proposed rules. Other registrants that already have existing data gathering systems and disclosure controls and procedures that collect and report short-term borrowing information, such as bank holding companies and other financial institutions, should also consider reviewing existing systems and controls to determine whether they need to be modified or updated in order to comply with the proposed rules. In addition, registrants should evaluate their existing disclosures regarding short-term borrowings and liquidity needs to determine if they should be enhanced even before the rules are finalized (particularly in view of the companion release referenced above).

In addition, registrants should consider whether they want to comment on the proposed rules by responding to the SEC’s numerous general and specific questions contained in the proposing release. Comments must be received by the SEC on or before November 29, 2010.

Proposing Release

The SEC’s proposing release containing the proposed rules can be found here.

Andrews Kurth advises numerous public companies, including publicly traded partnerships, in a variety of industries and will continue to follow developments related to the topic of this e-alert and other SEC rulemaking and guidance.

If you would like more information about the subject of this e-alert and other securities law developments, please contact your Andrews Kurth representative in the Corporate Securities Practice Section.