SEC Posts Release on Proposed Liquidity Disclosure

By Cydney Posner

The SEC has posted its proposed amendments intended to supplement current MD&A disclosure with enhanced disclosure regarding short-term borrowings.  Many of the failures in the financial crisis can be traced to liquidity constraints. Access to short-term borrowings for working capital and to fund operations are often a critical component of a company's liquidity and capital resources, and short-term financing techniques, such as commercial paper, repurchase transactions and securitizations, have become increasingly common among both financial institutions and industrial and commercial companies. When markets are illiquid, these types of arrangements may be especially vulnerable and, even when market conditions are stable, they can involve complex accounting and disclosure issues. Moreover, because a company's use of these arrangements can fluctuate materially during a reporting period, period-end amounts of short-term borrowings may not be indicative of that company's funding needs or activities. For example, for retailers that use short-term borrowings to finance inventory, the need to finance purchases may fluctuate based on the timing and volume of inventory sales. As a result, access to short-term borrowings may be critical to the company.

The proposed enhanced disclosure requirements are designed to provide additional transparency about a company's short-term borrowing practices, including its ability to obtain financing to conduct its business, and the costs of that financing. The proposed amendments would largely codify in Reg S-K the provisions in Industry Guide 3, Statistical Disclosure by Bank Holding Companies, for disclosure of short-term borrowings, but would expand the application to all companies that provide MD&A disclosure, not only to financial institutions, as well as to foreign private issuers.

MD&A Amendments

The proposal would add a new section to MD&A that would require tabular information about a company's short-term borrowings, as well as a discussion and analysis of those borrowings. Specifically, companies would be required to disclose the following:

• the amount outstanding in each specified category of short-term borrowings at the end of the reporting period and the weighted average interest rate on those borrowings;
• the average amount outstanding in each specified category of short-term borrowings for the reporting period and the weighted average interest rate on those borrowings (with an averaging period, for non-financial companies, not to exceed a month);
• for companies meeting the proposed definition of "financial company," the maximum daily amount of each specified category of short-term borrowings during the reporting period; and
• for all other companies, the maximum month-end amount of each specified category of short-term borrowings during the reporting period.

As proposed, "short-term borrowings" would mean amounts payable for short-term obligations in any of the following categories:

• federal funds purchased and securities sold under agreements to repurchase; <br>• commercial paper; 
•  borrowings from banks; <
• borrowings from factors or other financial institutions; and 
•  any other short-term borrowings reflected on the company's balance sheet.

Companies would be required to present each of the categories that is relevant to the types of short-term financing activities it conducts, even if that category is not required to be reported as a separate line item on its balance sheet under Reg S-X. Note that the proposal does not include a quantitative threshold for disaggregating amounts into the various categories. There is, however, a requirement to further disaggregate amounts by currency or interest rate to the extent necessary to promote understanding or to prevent aggregate amounts from being misleading (e.g., where foreign currency-denominated borrowings have a significantly higher interest rate than dollar-denominated borrowings), including footnote disclosure describing the method for disaggregation.

The proposal would define a "financial company," regardless of its nominal industry affiliation, organizational structure or primary regulator, as a "registrant that, during the relevant reported period, 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, and includes, without limitation, 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, or a mortgage real estate investment trust." Note that the definition is slightly different form the definitions used in the DFA. Companies engaged in both financial and non-financial businesses, such as manufacturing companies that have a subsidiary that provides financing to its customers to purchase its products, may constitute financial companies under the definition, but would be permitted to provide separate short-term borrowings disclosure for its financial and non-financial business operations, with an explanatory footnote explaining how the operations were grouped for purposes of the disclosure.

To provide context, the proposal would require a narrative discussion of short-term borrowing arrangements covering the following topics:

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

The narrative is intended to complement, but not repeat, other disclosures relating to liquidity and capital resources. In preparing the disclosure, companies would need to take into account their disclosures of cash requirements presented in the contractual obligations table, off-balance sheet arrangements and other liquidity and capital resources disclosures, disclosing the impact and implications of the items in an integrated discussion (e.g., using short-term financing to settle a purchase obligation in the table that would limit the company's ability to borrow for other purposes, such as making loans or financing inventory, which in turn can impact operations). In effect, companies should describe their "liquidity profiles," addressing overall liquidity and then short-term and long-term borrowings and liquidity needs.

The disclosure would be mandated on a quarterly and annual basis. For annual reports and registration statements, information would be presented for the three most recent fiscal years and for the fourth quarter (or other interim period in registration statements). For quarterly reports, information would be required with the same level of detail (i.e., not limited to material changes), but only for the relevant quarter (no comparative prior-year period). The requirements would be phased in over three years. MD&A should highlight material changes from the preceding period. Foreign private issuers would also be subject to the requirements, but would report only annually. For smaller reporting companies, only two years of information would be required, and quarterly disclosures would not be required unless material changes occurred during that interim period.

The SEC is not proposing to extend the special safe harbor in Item 303(c) of Reg S-K to include disclosures of forward-looking information made pursuant to the proposed rules. As a result, companies would need to treat forward-looking information disclosed under the proposed rules in the same manner as other MD&A disclosure for purposes of the statutory safe harbor.

Although leverage at banks is certainly a prime suspect as a cause for the global crisis, the SEC is also considering whether investors may benefit from additional transparency about the capitalization and leverage profile of non-financial companies, particularly for those companies that rely heavily on external financing and credit markets to fund their businesses and future growth. Accordingly, the SEC is considering whether to extend a leverage ratio disclosure requirement to companies that are not bank holding companies and is requesting comment on the scope of disclosure and ways to provide comparability of metrics used.

Other proposed changes

The proposal also involves conforming amendments to clause (4) of the definition of "direct financial obligations" in Items 2.03 and 2.04 of Form 8-K. The SEC is also taking this opportunity to conform references to U.S. GAAP in Item 303 of Reg S-K and Item 5 of Form 20-F to reflect the FASB Codification.

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