Sarbanes-Oxley Act of 2002: Disclosure of Material Outsourcing Contract Contingencies
Posted October 9, 2009 by Bierce & Kenerson, P.C. · 
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Summary:
Under Section 401(a) of the Sarbanes-Oxley Act of 2002, issuers and registered investment companies reporting to the Securities and Exchange Commission must disclose “off-balance sheet” transactions that may be material. On January 22, 2003, the SEC issued a rule defining the rules governing such disclosures for each annual and quarterly financial report required to be filed with the Commission. This commentary outlines the rule as it applies to both outsourcing service providers and their customers.
Sarbanes-Oxley Act of 2002.
Section 401(a) requires the SEC to issue regulations relating to Section 13(j) of the Securities and Exchange Act of 1934 governing the disclosure of “all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.”
SEC Regulations of January 2003.
The SEC adopted regulations that require a registrant to provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of the “Management’s Discussion and Analysis” (MD&A) section in its disclosure documents. The regulations will require registrants (other than small business issuers) to provide an overview of certain known contractual obligations in a tabular format.
Definition of “Off-Balance Sheet Transactions.”
The regulations include a definition of “off-balance sheet arrangements” that primarily targets the means through which companies typically structure off-balance sheet transactions or otherwise incur risks of loss that are not fully transparent to investors. The SEC advised that its definition of “off-balance sheet arrangements” will employ concepts in accounting literature in order to define the categories of arrangements with precision. Generally, the definition will include the following categories of contractual arrangements:
- certain guarantee contracts;
- retained or contingent interests in assets transferred to an unconsolidated entity;
- derivative instruments that are classified as equity; or
- material variable interests in unconsolidated entities that conduct certain activities.
Materiality.
In order not to leave anything to doubt, the Commission adopted a very broad concept of when the disclosures might be material, and therefore to require disclosure. Consistent with the existing MD&A requirements, the amendments will contain a principles-based requirement that a registrant provide such other information that it believes is necessary for an understanding of its off-balance sheet arrangements and their specified material effects.
Contingency Quantiflication in Table Format.
In addition, the SEC amendments include a requirement for registrants to disclose, in a tabular format, the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligation, for specified time periods. The categories of contractual obligations to be included in the table are defined by reference to the applicable accounting literature.
Impact on Outsourcing.
Outsourcing contracts have been used for a variety of purposes. The complexity of design in the typical outsourcing relationship could generate material contingences. The new SEC regulations affect not only transactions being negotiated, but also existing arrangements.
Effective Date:
This rule applies for all Commission filings that are required tonclude financial statements for the fiscal years ending on or after June 15, 2003. Registrants will be required to comply with the disclosure requirements for the table of contractual obligations in Commission filings that are required to include financial statements for the fiscal years ending on or after Dec. 15, 2003. The SEC asks registrants to voluntarily comply with the new disclosure requirements before the mandatory compliance dates.