The Reality of Real-Time Reporting

New, superfast 8-K rules under the Sarbanes-Oxley Act could spawn problems with mergers, loan covenants, and share prices. Needed: a solid risk-management plan.

To report or not to report?

When finance executives must choose whether to pump out an 8-K or wait until the quarter’s end to reveal a possibly important business event, now might be a good time to err on the side of caution. That, at least, is the working philosophy of Mike Gersie, chief financial officer of Principal Financial Group, the huge 401(k) plan provider and life insurer.

Gersie has in mind the new reporting regime installed under Section 409 of the Sarbanes-Oxley Act — “Real-Time Issuer Disclosures” — and the recently enacted Securities and Exchange Commission rules that govern it. Even before the enactment of the SEC rules, he says, the company had been “turning over rocks” to bring potentially significant events to light, so the decision about whether to report them could be made promptly. A few times each month, for instance, the corporation’s finance team calls the CFOs and controllers of the company’s business units to ask about unexpected changes, both large and small. Principal is also formalizing the process for deciding which events should be reported on, as well as criteria for making those decisions.

To be sure, Principal has been aggressive about revealing unexpected events since it went public in October 2001. Barely a month later, the company issued an 8-K saying that it was reviewing its $171 million investment exposure in Enron, notes Gersie, even though those investments were a small part of Principal’s overall portfolio. In 2003, in response to investor queries about its investments in the beleaguered airline industry, the company reported on that exposure between quarters. While those efforts pre-date the new SEC rules, the company is stepping up its efforts to provide thorough disclosures in response to the requirements, adds the finance chief.

Indeed, taking pre-emptive action seems to make a whole lot of sense just now. Starting August 23, companies will have just four business days to report events that could have a “material effect” on their financial statements rather than the current deadlines of 5 business days or 15 calendar days, depending on the event. The new rules are the SEC’s response to the passage in Sarbox 409 that requires public companies to disclose the facts about financially significant events “on a rapid and current basis.”

Much more significant than the slightly tightened reporting period is the greatly expanded number of judgment calls that executives will have to make within it, now that the SEC has added eight new triggers for 8-K filings. Thanks to two triggers, which call for a company to report its unexpected entry into or exit from “a material definitive agreement,” a CFO might learn on Monday that a big sales contract on had been cancelled, then be required to report it to the SEC before the end of the work week. Within that time, the executive would likely have to call on accountants and lawyers to help define whether the event was indeed “material” and “definitive” — thorny definitional chores, at best.

The other new material events that should trigger filings are:

• The creation of a direct financial obligation, including long-term and short-term debt and capital-lease commitments, or an off-balance-sheet arrangement.

• The acceleration or increase of a direct financial obligation or an off-balance-sheet arrangement.

• Costs incurred during an exit from a business or disposal of an asset.

• Impairment of assets.

• Notice of a delisting.

• A decision that previously issued financial statements or audit reports can no longer be relied on.

The huge expansion of the kinds of events that must be revealed — and in a narrower timeframe, no less — signal the upwelling of a sea change in financial reporting, some feel. In its release accompanying the new rules, the SEC itself suggests that they’re part of a transition “towards a system emphasizing current reporting.” Former SEC chairman Harvey Pitt, now head of business consultancy Kalorama Partners, foresees a change from the current “backward looking” system of reporting. Pitt proposes a dual-level system that would include 10-Qs and 10-Ks as they exist today along with disclosure of current information, such as sales trends.

But the new real-time regime could boost a company’s risk exposures if its reporting goes awry, say attorneys and accountants. Among the potential perils: Temporarily breached loan covenants could suddenly be brought to light; promising mergers could fall by the wayside; and shareholders could sue if they learn, via an 8-K, that a company had previously been sluggish about reporting a previous mishap.

All those risks might well force a change in mindset among executives, according to Anne Swaller, practice director of Parson Consulting. Under Section 409, they might well find themselves looking at dozens of events every day, observes Swaller, and asking the same question again and again: “Is this a reportable condition?”

Is This Anything?

One big problem that executives encounter when they decide which items to report is figuring out what “material” means in the context of a given corporate event. In a staff bulletin on the subject the SEC issued in 1999, the commission spelled out the definition in purposefully broad terms: An event is material “if there is a substantial likelihood that a reasonable person would consider it important.”

Further, the SEC sharply curbed the use of “rules of thumb” — like 5 percent of net income or earnings per share — as gauges of how big a misstatement must be before reporting it is required. While such guidelines could be used as a first step in figuring out what to report, executives and auditors must “consider all the relevant circumstances” in evaluating what’s material, asserted the commission.

That leaves companies with a lot of latitude — and little guidance. Without clearly defined rules, joked Tom Manley, the CFO of software maker Cognos Inc., companies would do well to simply follow a “newspaper test.” To judge whether an event could have a material impact on corporate finances, he said, executives should ask themselves: “If it’s reported in the newspaper the next day, would you be embarrassed?”

To be fair, the SEC bulletin does supply a list of good reasons that a misstatement below 5 percent could be considered material — for instance, if it masks an earnings change, transforms a loss into a profit, brings the company into regulatory compliance, or boosts the bonus of top management.

Nevertheless, the abundance of criteria possible under the guidelines could breed widespread corporate confusion. “You can’t have 12 people with 12 different standards” of materiality in a given circumstance, says George Victor, director of accounting and auditing at Reminick, Aarons & Co. Even though rigid numeric cutoff points should be shunned, he advises, “you have to eliminate as much as possible so that everybody is reading off the same page.”

That means managers need to get on the horn with each other if a significant change of corporate fortunes could be in the cards. Even though larger companies tend to have greater technical support and wider expertise, notes Victor, executives who work for them might find it tough to cut through the bureaucracy and make a quick call on materiality. While small companies might have smaller resources, he adds, they’re more likely to be able to “turn on a dime.”

Definitely Maybe

Materiality, however, isn’t the only term in the new triggers that cries out for clarity. The word “definitive” in “material definitive agreement” also needs defining, contends Larry Spirgel, a former special counsel in the SEC’s Corporation Finance Division.

The commission hasn’t yet said if the term refers to a signed contract or a “binding agreement,” according to Spirgel, now a lawyer with Morrison and Foerster LLP. “‘Binding’ is not helpful because it’s vaguer and encompasses a lot more arrangements than companies are comfortable with [disclosing],” he says. One frequently undisclosed agreement is the “no shop” clause common in the early stages of mergers.

The distinction isn’t merely academic. How the term is eventually defined “could have a dramatic effect on how companies disclose mergers,” says Spirgel. What’s more, he thinks, it could change how companies structure merger negotiations. They might well avoid “definitive agreements” — and the need to disclose them in an 8-K.

Another attorney, Christopher Robertson of Seyfarth Shaw LLP, thinks that a misstep in timing the disclosure of a deal could create liability risks for companies. If a company’s stock moves downward as the result of a late disclosure of an arguably material deal, shareholders could sue on the basis that the deal should have been disclosed sooner.

To buy time rather than disclose a deal prematurely — which might trigger a drop in a company’s share price, followed by a lawsuit — Robertson suggests that companies might split deals into definitive and non-definitive parts. Even though strong commitments are better than non-binding ones, a split agreement might be a useful “if there’s a natural break in a contract because part of it is fixed and part of it is proposed,” according to Robertson. That might give a company some breathing room in disclosing the latter part of the deal — or even disclosing the deal at all, if it’s the second part that would make the entire arrangement material. But delays have their risks: If the non-fixed latter part of the deal falls through, resulting in the need to exit from a material arrangement, shareholders could argue in court that the company disclosed too late.

Apart from their potential for wreaking havoc on mergers, real-time reporting requirements could generate bad news about a corporation’s borrowing arrangements. Indeed, the violation of the terms of a significant loan covenant can be a reportable event under the new rules, notes Victor. Such a disclosure could hurt the company’s share price or harm investor confidence in management, he says.

Before the advent of Section 409, a company had elbowroom to be in temporary breach of the debt-to-equity ratio or similar requirements in a lending covenant. Although the company might be in technical violation of the loan, it had until the end of the quarter to buy a waiver from the lender. That would enable the borrower to maintain the loan rather than pay it off on an accelerated basis.

Now, however, a company might not be able to get a waiver quickly enough to avoid disclosing the covenant breach in an 8-K, according to Victor. To avoid such perils, he advises, executives need to keep a sharp, continuous eye out for breaches of the ratios in their loan agreements.

Better Late Than Inaccurate?

On a more personal level, the pressures imposed by real-time reporting can add to the legal liabilities of finance chiefs and their bosses. As part of the Section 302 certification of financials by CFOs and CEOs, the executives must attest that they’ve installed adequate disclosure controls. But if the company files an 8-K late, “is that a sign that their disclosure controls are ineffective?” asks Spirgel. Tardiness might make investors question a company’s competence in getting material information up to the C-suite swiftly enough, he explains — and lawsuits against officers and directors as well as the company itself might follow.

Yet while the risks of Section 409 could be formidable, few companies are up to snuff in managing them, say compliance experts. The main reason for the lag is that their compliance focus has been on Section 404, which compels CFOs and CEOs to sign off on the adequacy of internal finance controls. Further, companies are in the midst of phasing in speeded-up periodic reporting strictures: By the end of 2005, companies will have only 60 days beyond the end of their fiscal year to file their 10-K, compared with 90 days in 2002. “Most organizations right now are concentrating on 404,” says Swaller, “so there’s been a little neglect, quite frankly, of 409 and accelerated reporting dates.”

What can executives do to manage the risk of being caught by surprise by one of 409′s “material” events? The most obvious step might simply be to file late and take the time to make the needed adjustments. While late filing might spur doubts about a company’ disclosure controls, the downside of filing an inaccurate 8-K could be much worse, according to Spirgel.

Under a safe-harbor provision in the new rules, in fact, the SEC gives late filers a bye until the end of their current reporting period. In an earlier commission proposal, seasoned issuers of stocks and bonds would have had to file an S-1 form — a long form normally used by first-time issuers — if they came in with a late 8-K. “If you used an S-1 every time you had material information, you would have to stop selling and amend the registration,” adds Spirgel. “It would have made trading in public markets very difficult.” Under the new rules, a late filing won’t cost a company its eligibility to file an S-2 or S-3 short form when it raises capital. In contrast, there’s no protection for incorrect reporting.

To avoid problems with real-time reporting, some executives are taking a longer-range approach. Scanning data generated by their operating units, they hope to uncover brewing material problems early in the game. Each morning at Cognos, for example, Manley pores over “a rich array of report cards,” including current information about software deals that have been closed or changed in the last 24 hours or ones that have been pushed to a later quarter. The finance chief feels that the data provides him with an excellent resource for tackling 409-related risks. “If I had several large deals fall out of a quarter, that could create a potential material event,” he says.

But such internal transparency will likely be hard to come by at most companies. “CFOs are going to have a huge challenge on their hands to comply with 409,” says Richard Roth, chief research officer at The Hackett Group. “Even at the best companies, it’s a tremendous task to find and reconcile data and get it back to the business unit” for confirmation. Finance executives at companies with many operating units, each with differing data standards, will find it particularly tough sledding, he adds.

At the same time, some executives feel that investments in technology can go a long way toward helping their companies comply with the dictates of current financial reporting. Even as it attempts to emerge from bankruptcy, Owens Corning will be installing a business-performance-management system over the next few years, according to corporate finance director Kent Wegener. A data-warehouse system (with software provided by Kalido) has already been installed, although providers for the data-forecasting and data-presentation functions have yet to be chosen.

Until the system is in place, the company plans to comply with Section 409 through a “manual, brute-force kind of effort,” says Wegener. But once it’s up and running, he expects Owens Corning’s finance executives to have a much clearer and more current view of the company’s risks. “Today, if we have an operating issue in a business, it would go through several layers of management and analytical cycles before it reached the top layer of the company. But because of technology, it would be available at the same time at the top level as lower management,” he says. “It would compress that cycle dramatically.”

David M. Katz is the deputy editor of CFO.com.

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