Risk & Compliance

Short-Term Debt Rule Sheds Light on SEC, Too

Unanimous vote shows a get-tough approach to abuses that made the financial crisis worse.
Roy HarrisSeptember 23, 2010

When the Securities and Exchange Commission proposed last week to make company reporting of short-term borrowings more transparent, the action reflected more than the seriousness of the economic damage caused by debt patterns being hidden from scrutiny. It also said something about the commission itself.

The SEC proposal passed by a 5-0 vote, with the two Republican commissioners sounding very positive about the measures — although both said they would weigh their potential costs and burdens as the approval process continues.

In part, that unanimous support could stem from the “restorative” nature of the change. As the commissioners’ discussion noted, more-detailed reporting requirements were eliminated in 1994. And some have said that the resulting lack of transparency led to the practice of “window dressing” by certain financial companies, Lehman Brothers among them.

That approach allowed companies to hide liquidity issues by keeping private their average and maximum short-term borrowings during a quarter, and instead reporting only the short-term-borrowing situation at the end of the quarter. Since many financial institutions and other companies fund their operations through short-term instruments such as commercial paper, repurchase agreements, letters of credit, and promissory notes, their practices are of great interest to investors, the SEC noted.

Under the proposed rules, companies would be required to increase their disclosures in the Management’s Discussion and Analysis section of quarterly and annual reports. An “interpretive release” from the SEC was issued last week to provide guidance on how to prepare the MD&A.

While the commissioners didn’t specifically mention Lehman, it was on their mind. The bankruptcy report on Lehman exposed massive misuse of short-term borrowing that was masked by Lehman’s quarter-end statements.

SEC chairman Mary Schapiro noted in her statement last week that when the new reporting proposal takes effect, “investors would have better information about a company’s financing activities during the course of a reporting period — not just a period-end snapshot.”

While fellow Democratic SEC appointees Elisse Walter and Luis Aguilar concurred, the majority was joined by strong support from both Republican appointees, Troy Paredes and Kathleen Casey. The measures are “designed to provide investors with better information and thus are expected to subject corporate decision making to enhanced investor oversight,” wrote Paredes. He added that he is particularly interested in comments about the compliance steps that will be required, and “the extent to which non-financial companies should be subject to the expanded MD&A requirements.”

Casey’s supporting comment said that the new rules would “expand and enhance the quantitative data about short-term borrowings” and “enable investors to assess a company’s ability to weather a disruption in access to these sources of liquidity.”

The unanimity on the issue — from a commission that has three Democratic and two Republican members — “is a positive sign and should give people confidence that some part of the system is working on their behalf in the wake of the meltdown,” says Nell Minow, co-founder of The Corporate Library, which encourages activist shareholders.

Still, said Casey in her statement, while last week’s step is “a good starting point” for improving disclosures, she has “extensive questions on both the value of these additional disclosures to investors and the costs and burdens of providing them.”

A memo issued this week by law firm Davis Polk and Wardwell LLP said the commission action had been “informed by the responses to the ‘Dear CFO’ letters that the SEC staff sent to many major financial institutions earlier this year.” Davis Polk noted that the MD&A guidance about how to report the intraperiod borrowing activity “is effective immediately and should be considered by U.S. public companies as they prepare their third quarter Form 10-Qs.”

The actual amendments to the rules, however, are subject to a comment period that ends 60 days after publication in the Federal Register.