The SEC's new proposal for derivatives disclosure goes beyond FAS 119. The question is: does it go too far?

By John Goff

Michael Sutton must know how Nero felt. In his role as chief accountant for the Securities and Exchange Commission (SEC), Sutton recently issued the agency's long-awaited proposed amendments for derivatives disclosure. But in the year-and-a-half run-up to Sutton's issuance of the proposal, critics blasted the SEC, charging that Sutton and his staff were fiddling around while investors got burned by undisclosed corporate use of derivatives.

No one's accusing Sutton or the SEC of Punic faith anymore. At the end of December, the chief accountant issued the commission's long awaited-and much-ballyhooed-proposals on derivatives disclosure. Already the 120-plus page document has touched off a minor backlash among accountants, derivatives experts and industry associations. "The practicality of some of these suggestions needs to be thought through," says one Big Six accountant. "Frankly, the SEC may have gone too far this time."

The SEC may have had little choice. Amid a procession of front-page derivatives deals gone bad, the SEC has been unfairly pilloried in the press of late for staying on the sideline. Says Mark Bachmann, a manager at Standard & Poor's, "There's been so much public attention on derivatives that the SEC had a lot of pressure to come out with something."

Apparently, Sutton and his staff were hoping that Standard 119 of the Financial Accounting Standards Board (FASB) would bring derivatives disclosure up to snuff-thus scotching the need for the Commission to officially step in. But as corporate reports rolled in during 1994 and 1995, it became clear to Sutton and his staff that companies were still less than forthright in their disclosure of derivatives activities. In the new proposal the SEC notes that, although FAS 119 has improved derivatives reporting, "Footnote disclosures of accounting policies for derivatives often are too general to convey adequately the diversity in accounting that exists for derivatives." Indeed, some industry observers say that the SEC fast came to the conclusion that FAS 119, while well-meaning, lacked teeth. Says Michael Joseph, a partner at Ernst & Young, "The new SEC proposal is really the implementation of 119."

And then some. The new proposal goes way beyond 119. For starters, the SEC's proposal, which will amend Regulations S-X and S-K, and forms including 20-F, will require companies to lay bare any commodities hedging that cannot be settled in kind. What's more, the proposed amendments prescribe a quantitative analysis of the risk of any market-sensitive instrument-including such instruments as mortgage-backed securities and Treasury bonds. Risk, it seems, is not just for derivatives anymore. "The SEC is saying that market risk exists in conventional instruments as well as derivatives," says one Big Six accountant. "Their intention is good." But a rival sees problems with the approach. "The intention of the SEC is not the issue. The amount of reporting is the issue."

Lots of Work

Indeed, some industry observers say, when it comes to the proposal, the devil is squarely in the details. "This is so extensive," one financial consultant complains. "There are dozens of disclosure requirements." Unlike FAS 119, the SEC's proposal requires registrants to reveal any multipliers, or leverage, built in to their derivatives. In addition, the proposed amendments require companies to differentiate between their trading and nontrading derivatives activities. Under existing SEC rules, any derivative deemed to be speculative must be marked to market, a requirement that can lead to some embarrassing consequences-something officials at Procter & Gamble know only too well.

But by far the most controversial aspect of the SEC proposal-and the one that clearly sets it apart from FAS 119-is the commission's insistence that registrants quantify their exposure to risk-sensitive instruments. Companies can chose one of three methods for quantifying this risk. (See Derivatives Strategy, December/January 1996.) The first, a table of derivatives listed by maturity buckets, seems the least onerous. "This involves a lot of detail, but it's not beyond the mechanics in place," says one accountant. Several financial consultants says it appears likely that most of their corporate clients will go this route.

The second quantitative method, a sensitivity analysis, shows how hypothetical market changes in the next reporting period would tilt the value of a company's risk-sensitive instruments. A registrant, for instance, would show how a fluctuation in the dollar/yen exchange rate would effect the value of the company's currency-linked derivatives. While this kind of test gives investors and analysts a detailed look at how much risk a company is carrying in its portfolio, it also requires a fair amount of modeling. According to Joseph, sensitivity analysis seems best suited to banks. "They already regularly calculate the effects of interest rate changes," he says.

Similarly, most investment banks already run their operations on a worst-case scenario basis. Not surprisingly, observers say these investment houses will likely choose the SEC's third quantitative method: a value-at-risk assessment of derivatives risk. In the value-at-risk method-the most complicated of the three-a registrant shows how a severe market downturn over a specified period would affect a company's derivatives portfolio. Due to its complexity, accountants say most corporates will shy away from this method.

Dirty Laundry

Indeed, the entire SEC proposal has not exactly been met by thunderous applause out in end-user land. One treasurer of a prominent computer company reportedly complained vociferously that stringent disclosure requirements would force him to divulge corporate secrets. Worse, some critics contend too much disclosure is, well, too much disclosure. Says Timothy Lucas, director of research and technical analysis at the FASB, "You could bury someone in the volume of disclosure."

Still others dispute the SEC's entire premise for joining the fray. "The SEC says investors and analysts need this info," says one commercial banker. "I challenge that contention." But analysts seem to be coming down on the side of the SEC. "It's hard to tell how useful these amendments will be until we see how preparers deal with them," says S&P's Bachmann. "But generally, the more disclosure the better."

But the biggest complaint coming from corporates so far is that the SEC assumes registrants can easily gather all of the information needed to meet the quantitative requirements. That may not be a problem for "companies that have already been doing value-at-risk analysis and have this information in a central location," as Joseph notes, but many don't.

Burdensome or not, there is no doubt that the overall regulatory climate greatly improved for derivatives last month. FASB made an unexpected about-face on a key accounting proposal. When last heard of, the four-year effort by the Financial Accounting Standards Board had arrived at a recommendation backing their purest possible mark to market of derivatives -gains and losses to appear in earnings or against shareholder equity on the balance sheet. No accruals were to be permitted, and no offsetting hedges recognized. Collective corporate howls of protest apparently did their work in recent months. For now the FASB says that a draft of its proposals, due out by June 30th, will sanction offsetting hedges. While the International Swaps & Derivatives Association was delighted, dissenting FASB board members said readers would be unable to get a clear picture of a firm's risk profile. Whether many end-users care enough, however, will only be clear in the public comment period this summer.

The comment period on the SEC proposals will run for the coming four months. But it appears the regulators might not be waiting for the reviews to come in. Says an accountant at a Big Six firm, "A couple of my clients have gotten word that the SEC would like to see this type of disclosure in their 1995 financials." Adds the accountant, "When officials at the SEC say they'd like to see something, they end up seeing it."

What the SEC wants...

While derivatives disclosure in financial statements has gotten noticeably better under FASB Standard 119, officials at the SEC obviously felt there was plenty of room for improvement. Following are the highlights of the 120-or-so pages the SEC lyrically calls "Proposed Amendments to Regulation S-X and S-K, and Various Forms, Including Form 20-F":

• Requires a quantitative disclosure of information about market risk of derivatives. Registrants have the choice between three methods of assessment: tabular listing of expected future cash-flow amounts and related contract terms categorized by maturity dates; sensitivity analysis; or value-at-risk assessment.
• Requires disclosure of leveraged derivatives if the leverage is not adequately captured in the quantitative analysis.
• Requires a breakdown of traded and non traded derivatives.
• Includes commodity-traded derivatives, not just financial derivatives instruments.
• Includes all market-risk-sensitive instruments, including mortgage-backed securities and debt obligations (if the risk could materially affect the company).
• Attempts, but does not totally succeed, to define "materiality."

Recognizing the complexity of the issues involved, the SEC upped the period for comments from 60 to 120 days. If its amendments are adopted, the SEC will review the new rules after five years. It may take people that long just to get through the proposal. -J.G.

FASB on FASB

One of the driving forces behind a new standard for derivatives disclosure is the relative toothlessness of the old standard for derivatives disclosure. Standard 119, a piecemeal document issued by the FASB in October 1994, came on the heels of several unexpected-and highly publicized-corporate losses from derivatives. In essence Standard 119 was a well-intentioned attempt to get companies to be more forthcoming about their derivatives activities.

But judging by a special report just put out by the FASB, US corporates lived up to the letter-but not nearly the spirit-of Standard 119. One problem: 119 encourages, but does not require, quantitative analysis of exposure to market risk. Not surprisingly, 30 out of 35 companies randomly selected by the FASB did not provide disclosure of the hypothetical effects of possible changes in market prices. Apparently companies had their reasons for not confessing in full. Says Timothy Lucas, the FASB's director of research and technical, "They didn't have to do it, and it's a lot of hard work. Moreover, just using the word 'derivatives' is a risk."

Here, then, are some of the FASB's more telling discoveries:

• Excluding dealers, not a single company in the study provided information on leverage features.
• 93 percent of the companies did not include a discussion of potential exposure in their discussions of credit risk.
• Only eleven out of 51 selections (excluding dealers) provided information about the cash requirements of their derivative financial instruments.
• A mere 16 percent of the selections noted if derivatives were held for trading purposes. Those that did were all commercial banks.
• Over half of the companies (excluding dealers) did not disclose information about hedges of anticipated transactions.

The long-term effects of the study? The FASB is reportedly studying more stringent guidelines on disclosure, including, in some cases, marking derivatives to market.