In December 2003, the SEC issued an interpretative release giving guidance as to MD&A disclosure.1 The release makes clear that MD&A is a critical element of the public disclosure regime and that, going forward, the SEC will be carefully monitoring MD&A generally and adherence to the new guidance specifically. In particular, the SEC appears to be focused on disclosure as to company-level and industry-level drivers affecting financial condition and performance and strategies for taking advantage of or otherwise responding to those drivers.
Until the past two years, the SEC had not issued guidance as to MD&A disclosure since its seminal interpretative release in 1989.2 Since late 2001, the SEC has addressed MD&A disclosure a number of times, including in its final rules relating to MD&A disclosure of off-balance sheet arrangements,3 in a 2002 statement,4 and in its releases issuing cautionary advice regarding (and proposing rules relating to the application of) critical accounting policies.5 Although the SEC states in its most recent release that its newest guidance does not create new legal requirements, it is clear from the release that the bar for acceptable disclosure has been raised.
The purpose of MD&A is to provide readers with information necessary to an understanding of a company's results of operations, liquidity and capital resources. The SEC has stated on more than one occasion that compliance with MD&A requirements should:
provide a narrative explanation of a company's financial statements that enables investors to see the company through the eyes of management;
enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
provide information about the quality of (and potential variability of) a company's earnings and cash flow so that investors can ascertain the likelihood that past performance is indicative of future performance.
In the release, the SEC indicates that it has long sought through its rules, enforcement actions and interpretive processes to elicit MD&A that not only meets technical disclosure requirements but is also generally informative and provides enhanced transparency. The guidance in the release includes the following:
Presentation. In keeping with the SEC's plain English initiative, MD&A should be presented in clear and understandable language. In particular, companies should:
Introductory Section. Consider adding an introduction or overview that facilitates understanding and provides a balanced, executive-level discussion that identifies the most important themes that concern management when evaluating the company's financial condition and operating results.
Layering. Consider using a "layered" approach, presenting information in a manner that emphasizes (within the universe of material information that is disclosed) the facts and analyses that are most important, so as to assist readers to identify and understand the most critical take-aways.
Forward-Looking Information. Include prospective matters throughout the MD&A, including where there are known material trends and uncertainties (which are required to be disclosed) as well as where prospective information may not be required but is useful in assessing whether past performance is or is not indicative of future performance.
Avoid Boilerplate. Avoid using boilerplate disclosures or disclaimers and other generic language.
Key Indicators. Include key indicators of financial condition and operating performance (so as to give readers a view of the company "through the eyes of management," by providing both short and long-term analyses of the business), discussing both financial measures and non-financial information.
Tables and Headings. Consider whether a tabular presentation and additional or different headings could assist in understanding MD&A disclosure.
Overall, companies should focus on the most important information and analyses disclosed in MD&A, de-emphasizing (or, if appropriate, deleting) immaterial information that is not required and does not promote understanding (including unnecessary detail or duplicative disclosure that obscures material information) of past performance, current condition, or future prospects and risks.
Liquidity. In the liquidity section, companies should:
Cash Requirements. Focus on cash requirements, addressing (where material) the difficulties involved in assessing the effect of the amount and timing of uncertain events (such as loss contingencies) on liquidity.
Consider whether disclosure about routine and other matters that could nonetheless have a material impact on liquidity (such as funds necessary to maintain current operations, complete projects underway and achieve stated objectives; commitments for capital or other expenditures; and reasonably likely exposure to future cash requirements associated with known trends or uncertainties).
Sources and Uses. Focus on the primary drivers necessary to an understanding of cash flows, including how cash requirements identified in MD&A fit into an overall business plan (and resources available to satisfy those cash requirements).
Analyze external debt financing, use of off-balance sheet financing arrangements, issuance or purchase of derivative instruments linked to stock, use of stock as a form of liquidity and the potential impact of known or reasonably likely changes in credit ratings or ratings outlook (or inability to achieve changes), together with the types of financing that are (or that are reasonably likely to be) available (or the types of financing that a company would want to use but that are (or are reasonably likely to be) unavailable) and the impact on cash position and liquidity.
Debt Instruments. Discuss if there is (or is reasonably likely to be) a debt covenant breach.
Consider the impact of debt covenants on the ability to undertake additional debt or equity financing.
Consider discussing alternate sources of funding and the consequences of accessing them.
Cash Management. Disclose known material trends or uncertainties relating to determinations as to when and how to use cash resources to satisfy obligations and make capital expenditures.
Critical Accounting Estimates. If a company has made accounting estimates or assumptions as to material costs and contingencies, where the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, it should provide disclosure about those critical accounting estimates or assumptions in its MD&A. Such disclosure should supplement (not duplicate) the description of accounting policies that are already disclosed in the notes to the financial statements.
Based on the interpretative guidance set forth in the SEC release, companies may draw a number of conclusions.
Rethink the MD&A's Focus. Companies may not be able to rely on their current MD&A disclosure as a guide for future disclosure. Companies should take a hard look at their current MD&A and, if it does not achieve the SEC's stated goals, should consider rewriting the section in its entirety. A company should approach redrafting MD&A disclosure with a view to giving a full and fair description of its "story."
Analyze, Not Merely Disclose. Companies must analyze the financial data which they present, and cannot simply restate the numbers or provide a superficial discussion. The SEC emphasized that the "analysis" portion of MD&A is critical and that companies must convey to investors the key "why's" of their financial position and performance. Companies also must balance the need to analyze generally with the need to sort through a myriad of information, so as to present investors with the most critical portions of their financial picture.
Balance Materiality with Detail. Companies should focus on material information and excise duplication, subject, of course, to their own needs to provide sufficient information to avoid material misstatements or omissions and to facilitate detailed discussions with analysts, institutional investors, and others without violating (or encountering frequent road blocks or close calls under) Regulation FD. The SEC release, while requesting such MD&A emphasis on material information, did not provide for any safe harbor against Rule 10b-5 or similar claims for companies that have deleted information in response to the SEC guidance. Thus, a company that is in doubt about whether to include or exclude certain disclosure should consider erring on the side of inclusion.
Consider Overriding Themes. Companies should focus on trends affecting them and their industry, and should analyze those trends and their responses thereto in the MD&A. This analysis should be emphasized through headings, tables and other highlighting techniques.
Review of Earnings Releases and Other Materials. Companies should review public disclosures (such as earnings releases, road shows and webcasts of analyst calls) for material disclosures (whether historical or forward-looking) that may need to be worked into the MD&A, in order to better capture the overriding themes and convey information that is relevant to MD&A disclosure. Companies also should consider reviewing internal materials such as Board packages, projections and slide shows. In the release, the SEC notes that it has brought numerous enforcement actions based on alleged violations of MD&A requirements and will continue to do so as appropriate. In fact, in the first such action,6 the SEC relied on Board materials as a key factor in its determination that a violation had occurred.
Involve Top Management. Companies should involve top management in the MD&A drafting process, to ensure presentation of the company's financial picture from management's point of view. This involvement should be integrated with the companies' disclosure controls and procedures and any disclosure committee process.
Independent Review. Companies should consider having persons who have not drafted or revised the MD&A, but who are familiar with the financial story, review the MD&A to ensure that there is clarity, consistency and thoroughness and that the overriding themes are accurately conveyed.
Risk Factors. Companies should consider adding a risk factors section in order to better and more concisely and completely convey known risks. Such a section would assist in complying with requirements to disclosure trends, establishing a "bespeaks caution" defense and complying with the cautionary language provisions applicable to the safe-harbor for forward-looking statements. It would also assist in the clear presentation of a company's "story" by enabling discussion of the "story" without further interruption for risk disclosure.
The Big Squeeze
Companies will have to balance the requirements of the accelerated reporting timetables with the need to be responsive to the SEC's guidance. In light of the new Sarbanes requirement that the SEC review companies' SEC filings at least once every three years, companies should prepare their MD&A disclosure with the expectation that it will be carefully parsed with the benefit of hindsight.1 The Release is entitled "Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations," Securities Act Release No. 33-8350 and Exchange Act Release No. 34-48960 (Dec. 19, 2003). For the full text, see http://www.sec.gov/rules/interp/33-8350.htm. 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures," Securities Act Release No. 33-6835 and Exchange Act Release No. 34-26831 (May 18, 1989), available at http://www.sec.gov/rules/interp/33-6835.htm.
3 "Final Rule: Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations," Securities Act Release No. 33-8182 and Exchange Act Release No. 34-47264 (Jan. 27, 2003), available at http://www.sec.gov/rules/final/33-8182.htm.
4 "Commission Statement about Management's Discussion and Analysis of Financial Condition and Results of Operations," Securities Act Release No. 33-8056 and Exchange Act Release No. 34-45321 (Jan. 22, 2002), available at http://www.sec.gov/rules/other/33-8056.htm.
5 "Cautionary Advice Regarding Disclosure About Critical Accounting Policies," Securities Act Release No. 33-8040 and Exchange Act Release No. 34-45149 (Dec. 12, 2001), at http://www.sec.gov/rules/other/33-8040.htm, and "Proposed Rule: Disclosure in Management's Discussion and Analysis of Financial Condition and Results of Operations about the Application of Critical Accounting Policies," Securities Act Release No. 33-8098 and Exchange Act Release No. 34-45907 (May 10, 2002), at http://www.sec.gov/rules/proposed/33-8098.htm.
6 In the Matter of Caterpillar Inc., SEC Release No. 34-30532 (Mar. 31, 1992), 1992 SEC LEXIS 786.
M. Ridgway Barker is Chair of the Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean G. Hedin is a Partner in the Securities Practice Group. Acknowledgement is given to Jeanne R. Solomon, an Associate at Kelley Drye & Warren LLP, for her efforts in the preparation of this article.