Monday, January 09, 2012

Corporation Finance Division Guides on Financial Statement Disclosure around European Sovereign Debt Exposure

Noting current uncertainties in connection with European sovereign debt exposures, and the lack of transparent, comparable information, the SEC Division of Corporation Finance issued guidance out of concern about the adequacy of financial statement disclosures for investors. Under the circumstances, the staff believes that principles-based item requirements may call for more detailed disclosure on this topic. In determining which countries are covered by the guidance, companies should focus on those experiencing significant economic, fiscal and/or political strains such that the likelihood of default would be higher than would be anticipated when such factors do not exist.

The staff expects that the countries covered by this analysis would vary and thus the disclosures should be sufficiently flexible to capture those risks as they change over time. Corp Fin encourages companies to disclose the basis used for identifying the countries included in this disclosure.

The staff said that disclosures should be provided separately by country, segregated between sovereign and non-sovereign exposures, and by financial statement category, to arrive at gross funded exposure. Companies should also consider separately providing disclosure of the gross unfunded commitments made. The staff suggests that companies provide information regarding hedges in order to present an amount of net funded exposure. In deciding what disclosure is relevant and appropriate for the particular facts of each company, the staff urges companies to consider a number of factors, including gross funded exposure, unfunded exposure, and total gross exposure, as well as the effects of credit default protection to arrive at net exposure and other risk management disclosures.

With regard to gross funded exposure, companies should consider the basis for the countries selected for disclosure and the basis for determining the domicile of the exposure, as well as the separate categories of exposure to sovereign and non-sovereign counterparties. Companies should also consider categories of financial instruments, including loans and leases, held-to-maturity securities, available-for-sale securities, trading securities, and derivatives to arrive at a gross funded exposure. For held-to-maturity securities, the amortized cost basis and the fair value should be considered. Similarly, for available-for-sale securities, the fair value, and if material, the amortized cost basis should be considered.

For trading securities, only the fair value need be considered. For derivative assets, the fair value should be considered, except that amount could be offset by the amount of cash collateral applied if separate footnote disclosure quantifying the amount of the offset is provided.

Regarding unfunded exposure, the company should consider the amount of unfunded commitments by type of counterparty and by country, and the key terms and any potential limitations of the counterparty being able to draw down on the facilities.

According to the SEC staff, the effect of gross funded exposure and total unfunded exposure should be subtotaled to arrive at total gross exposure as of the balance sheet date, separated between type of counterparty and by country. Appropriate footnote disclosure may be provided highlighting additional key details, such as maturity information for the exposures.

The effects of credit default protection purchased separately by counterparty and country should also be disclosed, along with the fair value and notional value of the purchased credit protection. In addition, the nature of payout or trigger events under the purchased credit protection contracts should be disclosed, noted the staff, and the types of counterparties that the credit protection was purchased from and an indication of the counterparty’s credit quality. The company should also reveal whether credit protection purchased has a shorter maturity date than the bonds or other exposure against which the protection was purchased. If so, there should be clarifying disclosure about this fact and the risks presented by the mismatch of maturity.

The other risk management disclosures include how management is monitoring and mitigating exposures to the selected countries, including any stress testing performed and the effects of indirect exposure in the analysis of risk. Disclosure should explain how the companies identify their indirect exposures, examples of the identified indirect exposures, along with the level of the indirect exposures.
It is also incumbent on management to disclose current developments, such as rating downgrades, financial relief plans for impacted countries and widening credit spreads of the identified countries, and how those developments, or changes to them, could impact the company’s financial condition, results of operations, liquidity or capital resources.