Association for Investment Management and Research
Financial Accounting Policy Committee

31 December , 2002

Jonathan J. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re: Release Nos. 33-8144 and 34-46767; File No. S7-42-02; Proposed Rule: Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments

Dear Mr. Katz:

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR)¹ is pleased to comment on the Securities and Exchange Commission's Proposed Rule: Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments. The FAPC is a standing committee of AIMR charged both with maintaining liaison with standard setters who develop financial accounting standards and regulate financial statement disclosures and with responding to new regulatory initiatives. The FAPC also maintains contact with professional, academic, and other organizations interested in financial reporting.

General Comments

The FAPC strongly supports the Commission's proposal to

...Require disclosure of off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of an issuer with unconsolidated entities or other persons that have, or may have a material effect on financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Investors and other users of financial statements require complete, transparent, consistent, and comparable information about a company's commitments and other obligations in order to properly evaluate the firm's risks and future earning power. Such evaluations are critical to developing well-informed investment decisions. It is particularly important that users be able to evaluate the aggregate effect of the potential risk exposure on the company's operations.

The objective above is broad and encompassing as we believe it should be. Indeed, our reservations and concerns about the proposal arise from those provisions that restrict or limit the scope or reach of the definition. For example, the Proposed Rule states

...No obligation to make disclosure of an off-balance sheet arrangement shall arise until an unconditionally binding definitive agreement, subject only to customary closing conditions exists, or, if there is no such agreement, when settlement of the transaction occurs. [Emphasis added]

We are concerned that such a restriction may permit off-balance sheet transactions representing significant risks to the company to escape, or to be structured to escape, disclosure under this proposal. For example, these words may be read to exclude conditional binding executory contracts that may be sources of highly material risk exposure. Unless users of the statements are able to be confident that all risk exposures important to their investment decisions are fully disclosed, the objectives of this proposal are unlikely to be met. Indeed, such scope restrictions may undermine the intent of the proposal.

We do not agree that an objective of the definition of the term "off-balance sheet arrangement" should be to "filter out disclosure that is unimportant to investors." To the contrary, we believe that the definition should be sufficiently broad and encompassing to capture all off-balance sheet obligations that represent a material economic risk exposure to the company. The investor is in the best position to make the judgment about what is important to a particular investment decision.

Preparers' determinations of which off-balance sheet obligations must be disclosed will depend to a large extent on the definition of materiality that is applied. Consequently, we believe explicit reference should be made in the footnotes of the Rule to SAB 99 which makes clear that materiality decisions should be based upon whether the information may affect investors' decisions.

The FAPC agrees with the proposal to require MD&A disclosure in addition to footnote disclosure "when the possibility of loss is higher than remote." Indeed, we believe that the interests of investors and other users would best be served if this threshold were required in general for disclosure of off-balance sheet obligations, rather than the usual threshold "reasonably possible" or "reasonably likely". Otherwise, the ambiguity inherent in determining such probabilities provides opportunity for those companies that wish to escape the provisions to do so.

We believe that information about the entire distribution of risk exposures is important, rather than merely point estimates. In the past, too many items with material risk have escaped disclosure provisions.

We strongly support the proposed requirement that companies disclose:

• The amounts of revenues, expenses, and cash flows arising from the arrangements;

• The nature and total amount of any interests retained, securities issued and other indebtedness incurred; and

• The nature and amount of any other obligations or liabilities (including contingent obligations or liabilities) of the registrant arising from the arrangements that are, or may become, material and the triggering events or circumstances that could cause them.

However, the FAPC believes that for the information to be useful, the amounts must be presented gross, not net. That is, users must be able to evaluate separately the individual revenues as well as the expenses. If the numbers are netted, users are no longer able to properly evaluate the potential effects of the off-balance sheet obligations on the company's operations.

We support the provision to require tabular disclosure of off-balance sheet obligations in the MD&A. Tables can be both a highly efficient and an effective way of communicating large amounts of information. However, we are concerned that preparers may have a tendency to over-aggregate, significantly reducing the usefulness of the information provided, unless the proposal is clear on the amount of required detail in disclosure. We believe that this information will be most useful to investors and other users if maximum risk exposures are required to be disclosed.

Specific Comments

Off-balance Sheet Arrangements

The proposal defines off-balance sheet arrangements as

...Any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the registrant is a party, under which the registrant, whether or not a party to the arrangement, 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;

• Derivatives, to the extent that the fair value thereof 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 in the financial statements (excluding the footnotes thereto).

Question: Have we appropriately tailored the proposed definition of the term "off-balance sheet arrangement" and the proposed disclosure to filter out disclosure that is unimportant to investors? If not, how should we change the proposed definition or disclosure requirements?

Question: Is the proposed definition too narrow? If so, how should we change it to include other off-balance sheet arrangements that are significant to investors?

The FAPC believes that the spirit and intent of the Sarbanes-Oxley definition, "any obligation, including a contingent obligation, that is not fully reflected in the financial statements," is to protect the interests of investors and other users of financial statements. By requiring that any obligation be disclosed, contingent or otherwise, that represents significant risk exposure to the company, and that could affect the decisions of investors and other users, we believe the Sarbanes-Oxley Act intends that such disclosure should depend upon the economic substance of the risk exposure rather than the legal form that the exposure takes. Consequently, we would prefer to see the emphasis in the definition shifted to the fourth (bullet) point above, which is broader and more encompassing, by placing it first. The remaining points may serve as examples of such arrangements.

We do not agree that an objective of the definition of the term "off-balance sheet arrangement" should be to "filter out disclosure that is unimportant to investors." To the contrary, we believe that the definition should be sufficiently broad and encompassing to capture all off-balance sheet obligations that represent a material risk exposure to the company. The investor is in the best position to make the judgment about what is important to a particular investment decision.

Question: Is the proposed definition of an "off-balance sheet arrangement" sufficiently clear to enable registrants to determine which derivative instruments are included in the proposed disclosure requirements and which are not?

We believe that the definition is clear. However, we believe it important that reference be made in the footnotes to SAB 99 which provides guidance that will be essential in determining which obligations are material.

Question: Is it appropriate to apply our existing policy of excluding preliminary negotiations from MD&A disclosure to off-balance sheet arrangements?

We believe that the disclosure should not depend upon the stage of negotiations, but upon any economic risk exposure the company may have incurred as a result of the negotiations. For example, one party may agree to make payments to the other party should the first party decide to end the negotiations. Such a circumstance may occur when multiple bidders are available and interested in merging with or acquiring the second company. The nature of the conditional expenses should be described, providing quantitative information, and should explain what conditions trigger the payments.

Question: Is the proposed "remote" disclosure threshold appropriate and consistent with the language in Section 401(a) of the Sarbanes-Oxley Act? If not, how should we change it?

Question: Would it be appropriate under the language in Section 401(a) of the Sarbanes-Oxley Act to apply the "reasonably likely" disclosure threshold applicable elsewhere in MD&A to disclosure about off-balance sheet arrangements? If so, should we adopt the "reasonably likely" standard for disclosure of off-balance sheet arrangements?

Question: Would the application of the disparate disclosure threshold proposed to apply to disclosure of off-balance arrangements, in comparison to the "reasonably likely" standard used elsewhere in MD&A, attribute undue prominence to information about off-balance sheet arrangements in relation to other significant information?

Question: Should we consider amending current MD&A rules to lower the existing "reasonably likely" disclosure threshold to be consistent with the threshold in the proposals?

Question: Would the proposed disclosure threshold for prospectively material information related to off-balance sheet arrangements yield comparable disclosures among registrants?

The FAPC agrees with the proposal to require MD&A disclosure in addition to footnote disclosure "when the possibility of loss is higher than remote." Indeed, we believe that the interests of investors and other users would best be served if the "remote" threshold were required in general for disclosure of off-balance sheet obligations, rather than the usual threshold "reasonably possible" or "reasonably likely". Otherwise, the ambiguity inherent in determining such probabilities provides opportunity for those companies that wish to escape the provisions to do so. We believe that this threshold is much more likely to produce consistent and comparable disclosures than the existing threshold.

In recent years, off-balance sheet arrangements have represented increasingly large portions of many companies' operations, and, as we have seen, highly material risk exposure to the companies and their investors. Therefore, it is critical that investors understand the nature and extent of these exposures.

Question: Is there any basic information not required by the proposals that would be necessary to understand a registrant's off-balance sheet arrangements? If so, what additional disclosure should be required?

Question: Do the proposals provide enough flexibility to companies to fully and clearly describe their off-balance sheet arrangements? Would a more flexible approach, such as the current MD&A requirements for liquidity and capital resources, result in better disclosure?

Question: Would a registrant be able to monitor and provide disclosure about arrangements to which it is not a party, yet that may create direct or contingent liabilities or obligations for the registrant?

Question: Is there any management analysis not required by the proposals that would be necessary for an investor to gain an understanding of the magnitude and proximity of risk exposures and financial impact of a registrant's off-balance sheet arrangements? If so, what additional disclosure should be required?

Regarding the disclosure of the specific effects of the off-balance sheet obligations on the company's revenues, expenses, and cash flows, the FAPC believes that for the information to be useful, the amounts must be presented gross, not net. That is, users must be able to evaluate separately the individual revenues as well as the expenses. If the numbers are netted, users are no longer able to assess the potential effects of the off-balance sheet obligations on the company's operations. The basic presumption should be that this information is of importance to investors and should be disclosed.

We believe that these disclosures, together with those required elsewhere in the Proposal, and including disclosures we suggest below, will provide sufficient information about companies' off-balance sheet obligations to enable investors and other users to properly evaluate the potential effects that such obligations may have on the companies' operations.

The FAPC believes that if a registrant has obligations, arrangements, or other commitments to "which it is not a party, yet that may create direct or contingent liabilities or obligations for the registrant" and that it is not able to monitor or provide disclosure about them, then this should be a matter of particular concern to investors. For example, investors would want clear and explicit explanations to be provided about how the company incurred material obligations for which it is unable to obtain sufficient information to meet the requirements of the Rule.

Contractual Obligations and Contingent Liabilities and Commitments

The Proposed Rule states

...We believe that aggregated information about contractual obligations and contingent liabilities and commitments in a single location would improve transparency of a registrant's short- and long-term liquidity and capital resource needs and demands. It also would provide appropriate context for investors to assess the relative role of off-balance sheet arrangements with respect to liquidity and capital resources. We therefore propose to require certain registrants to include tabular disclosure about contractual obligations, and either tabular or textual disclosure about contingent liabilities and commitments in the MD&A section. The disclosure would include information about a registrant's known contractual obligations and contingent liabilities and commitments, encompassing both on- and off-balance sheet arrangements as of the latest balance sheet date.

...A registrant would have to disclose, either in tabular format or in text, the expected amount, range of amounts or maximum amount of contingent liabilities or commitments that are expected to expire in less than one year, from one to three years, from three to five years, more than five years...The contingent liabilities or commitments must be aggregated by type in a manner that is suitable for the registrant's business.

We support the provision to require tabular disclosure of off-balance sheet obligations in the MD&A. Tables can be both a highly efficient and an effective way of communicating large amounts of information. We believe that tabular disclosure should be required for contingent obligations as well. That is, the same consistent and comparable disclosure should be required regardless of the legal provisions or other complexities of the arrangements.

We are concerned that preparers may have a tendency to over-aggregate and thus significantly reduce the usefulness of the information provided unless the proposal is clear on the amount of detail required to be disclosed. Thus, we agree that additional detail should be provided to preparers about the specific types or classes of obligations that should be disclosed.

We believe that this information will be most useful to investors and other users if maximum risk exposures are required to be disclosed. Investors need such information in order to properly evaluate the potential risk exposure. In addition to the maximum amounts, disclosure of the distribution or range of such exposures will provide balanced information to investors and will help them to assess the probabilities and the potential effects of the obligations on the company's operations.

As we have stated above, we believe that investors are in the best position to decide what is important to their investment decisions. Consequently, the disclosures should provide full information regarding the potential effects of off-balance obligations and other arrangements on the financial statements of the registrant.

Question: Should we require the proposed table to be accompanied by additional narrative disclosure regarding liquidity and capital resources above and beyond that which already exists in MD&A?

We believe that continuous disclosure of the information, particularly with regard to changes in the obligations and related liquidity and capital resources would best serve the interests of investors.  Sufficient narrative disclosure should be provided for investors and other users to be able to understand the disclosures and their implications for the company's profitability and risks.

Question: Should we adopt definitions of "contractual obligations" and "contingent liabilities or commitments"? If so, what should they be?

See our comments in the first section. 

Question: To avoid potential abuses and to promote comparable disclosure among companies, should we include an instruction to the table that would limit the extent to which a registrant may adapt the table to its particular circumstances? If so, what limits should we impose?

We agree that such a limitation would enhance consistency and comparability of the disclosures, and, thus, improve their usefulness to investors. For example, we are concerned that preparers may tend toward over-aggregation, thereby significantly reducing the usefulness of the disclosures to users of the statements. Moreover, to the extent that companies may develop idiosyncratic disclosures, including minimal disclosure, the objectives of the Proposal Rule will not be achieved.

Question: Should the proposed rules state that no disclosure is required with respect to the issuance of notes, drafts, acceptances, bills of exchange or other commercial instruments with a maturity of one year or less issued in the ordinary course of the registrant's business?

The FAPC believes that any existing or known obligations not currently reflected in the registrant's financial statements should be included in this disclosure, and we believe that is the intent of the Sarbanes-Oxley Act. The objective of the Proposed Rule, as we understand it, is to provide users with information about all obligations and potential risk exposures not currently reflected in the financial statements. It is not clear what the "ordinary course of the registrant's business" might mean and the definition is likely to differ significantly across companies and industries.

Presentation of Proposed Disclosure

Question: Should we require the proposed disclosure to be presented in a separate MD&A section or should it be integrated into other closely related MD&A discussions of financial condition, changes in financial condition, results of operations and liquidity and capital resources?

Question: To facilitate the layering of MD&A, should we amend the MD&A rules to require separate captions for the required discussions of results of operations, liquidity and capital resources?

The FAPC agrees that the information should be "set apart in a designated section of MD&A". We agree that "...a distinct presentation of the information would highlight it for readers of MD&A and enable investors to more easily compare disclosure of different companies."  We also agree that the information will be more useful and meaningful if it is disclosed in a single location rather than being fragmented throughout the MD&A.

We agree that separate captions should be provided.

Other MD&A Disclosure

Question: Should we further amend the MD&A rules to require more specific disclosure about liquidity and capital resources? If so, what specific disclosure items should we include?

Question: Should we further amend the MD&A rules to require more specific disclosure about relationships and transactions with persons or entities that derive benefits from their non-independent relationships with the registrant or the registrant's related parties? If so, what specific disclosure items should we include?

The FAPC believes that any information needed by investors and other users to properly evaluate the company's off-balance sheet risk exposures and liquidity and capital resources should be provided. This should include clear and complete discussion of the nature of the arrangements and the potential effects on the company's operations. 

Question: Should we codify the factors that we identified in our January 2002 Commission statement for management's consideration in identifying the trends, demands, commitments, events and uncertainties that require disclosure with respect to liquidity and capital resources? Are there other factors that should be included in such a codification?

Such information is especially important in that it sheds light on potential risk exposures and their possible effects on the company's operations. Consequently, we would strongly support this suggested codification.

Application of the Proposals to Foreign Private Issuers

Question: Should we apply the proposed rules to foreign private issuers' annual reports on Form 20-F or 40-F, as proposed? Or should we exempt these foreign private issuer annual reports from the scope of the proposed rules? If so, why?  

Question: Should we exempt Form 40-F, the MJDS annual report filed by qualified Canadian issuers, from the scope of the proposed rules? If so, why?  

Question: If we should require foreign private issuers to provide some expanded disclosure regarding off-balance sheet transactions and other similar items in their annual reports, should we adopt rules that apply different standards for foreign private issuers compared to the standards adopted for domestic issuers but that would be consistent with the Sarbanes-Oxley Act? If so, what standards would you substitute for the proposed rules?

Question: Should we exempt Form 6-K reports from the scope of the proposed rules, as proposed? Or should we apply the proposed rules to Form 6-K reports that include quarterly financial statements?

The FAPC has long held that all registrants should be subject to the same financial reporting and disclosure requirements. The reason is that investors need consistent and comparable information in order to be able to make well-informed investment decisions. However, we understand that such a requirement may present implementation difficulties because the information upon which the disclosures are based may not be of comparable quality or prepared according to U.S. GAAP.

Proposed Safe Harbor for Forward-Looking Information

Question: Should the proposed safe harbor be expanded to apply to all forward-looking information in MD&A, regardless of whether the information relates to off-balance sheet arrangements?  

Question: Is there any need for the proposed safe harbor, or would the statutory safe harbors afford sufficient protection to encourage the type of information and analysis necessary for investors to understand the impact of off-balance sheet arrangements?

The FAPC has historically supported the statutory safe harbor provisions as applied to certain forward-looking information in the belief that they would encourage the disclosure of the more relevant, useful and complete information needed by investors and other users. Consequently, we would support the extension of the existing statutory provisions to this disclosure. However, we do so cautiously out of concern that some registrants may provide less than adequate information knowing that they can take refuge in the safe harbor should the events, commitments, and contingencies have material adverse effects on the company's operations.

Concluding Remarks

The Financial Accounting Policy Committee appreciates the opportunity to express its views on the Commission's Proposed Rule: Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments. If the Commission or staff have questions or seek amplification of our views, please contact Rebecca McEnally at 1-434-951-5319 or at rebecca.mcenally@aimr.org. We would be pleased to answer any questions or provide additional information you might request.

Respectfully yours,

/s/ Jane Adams __________________________ Jane Adams Chair, Financial Accounting Policy Committee

/s/ Rebecca Todd McEnally __________________________ Rebecca McEnally, Ph.D., CFA Vice-President, Advocacy, AIMR

cc: AIMR Advocacy Distribution List
Patricia Doran Walters, Senior Vice-President
Professional Standards & Advocacy

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With headquarters in Charlottesville, VA, and regional offices in Hong Kong and London, the Association for Investment Management and Research® is a non-profit professional organization of 61,000 financial analysts, portfolio managers, and other investment professionals in 113 countries of which 48,800 are holders of the Chartered Financial Analyst® (CFA®) designation. AIMR's membership also includes 118 affiliated societies and chapters in 29 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program, which had more than 100,000 candidates from 143 nations enrolled for the June 2002 exam.