Action: Publication of Divisions of Corporation Finance, Market Regulation and Investment Management ("Divisions")
Date: July 22, 1998
Summary: The Divisions remind public issuers,1 broker-dealers, investment advisers, and investment companies to consider their disclosure obligations in connection with the January 1, 1999 conversion by eleven member states of the European Union to a common currency, the "euro."2 These obligations may arise in connection with:
known trends or uncertainties related to the euro conversion that an issuer reasonably expects will have a material impact on revenues, expenses or income from continuing operations;
competitive implications of increased price transparency of European Union markets (including labor markets) resulting from adoption of a common currency and issuers' plans for pricing their own products and services in euro;
issuers' ability to make any required information technology updates on a timely basis, and costs associated with the conversion (including costs of dual currency operations through January 1, 2002);
currency exchange rate risk and derivatives exposure (including the disappearance of price sources, such as certain interest rate indices);
continuity of material contracts; and
potential tax consequences.
In addition, broker-dealers and other regulated entities3 are advised to refer to the Division of Market Regulation's Year 2000 Work Program in planning systems modifications responsive to the introduction of the euro.
Supplementary Information: This legal bulletin represents the Divisions' staff views. This bulletin is not a rule, regulation, or statement of the Securities and Exchange Commission. Further, the Commission has not approved or disapproved its content.
Contact Persons: For further information, please contact Paul Dudek regarding foreign issuers at (202) 942-2990, Anne M. Krauskopf regarding domestic public operating companies at (202) 942-2900, Craig C. Olinger regarding accounting issues at (202) 942-2960, Paul P. Andrews regarding broker-dealers at (202) 942-0799, and Paul T. Kraft regarding investment companies and investment advisers at (202) 942-0590.
I. The Euro Conversion
On January 1, 1999, eleven of the fifteen member countries of the European Union (the "participating countries")4 are scheduled to establish fixed conversion rates between their existing sovereign currencies (the "legacy currencies") and the euro.5 The participating countries have agreed to adopt the euro as their common legal currency on that date.6 The euro will then trade on currency exchanges and be available for non-cash transactions. The participating countries will issue sovereign debt exclusively in euro, and will redenominate outstanding sovereign debt.
As of January 1, 1999, the participating countries no longer will control their own monetary policies by directing independent interest rates for the legacy currencies. Instead, the authority to direct monetary policy, including money supply and official interest rates for the euro, will be exercised by the new European Central Bank.7
Following introduction of the euro, the legacy currencies are scheduled to remain legal tender in the participating countries as denominations of the euro between January 1, 1999 and January 1, 2002 (the "transition period"). During the transition period, public and private parties may pay for goods and services using either the euro or the participating country's legacy currency on a "no compulsion, no prohibition" basis. However, conversion rates no longer will be computed directly from one legacy currency to another. Instead, the following "triangulation" process will be applied:
An amount denominated in one legacy currency first will be converted into an amount denominated in euro.
The resultant euro-denominated amount then will be converted into the second legacy currency.
European Union regulations specify the number of decimal places and rounding conventions that will be used in these "triangulation" computations.8
Beginning January 1, 2002, the participating countries will issue new euro-denominated bills and coins for use in cash transactions. No later than July 1, 2002, the participating countries will withdraw all bills and coins denominated in the legacy currencies, so that the legacy currencies no longer will be legal tender for any transactions, making conversion to the euro complete.9
II. Disclosure Regarding the Euro Conversion
The effect of the euro conversion upon an issuer and its business will depend upon the nature of the business conducted and various other factors. For many entities, the euro conversion will create technical challenges to adapt information technology and other systems to accommodate euro-denominated transactions. The euro conversion also may affect market risk with respect to financial instruments.
For European issuers, and other entities with significant markets or operations in Europe (whether or not in the participating countries), the euro conversion may create strategic challenges as these entities adapt to a single transnational currency. The participating countries' adoption of a single currency will likely result in greater transparency of pricing, making Europe a more competitive environment. Issuers and other entities may need to respond by adjusting their business and financial strategies.
Issuers may be affected in different ways over time. An issuer should evaluate its disclosure obligations to investors and potential investors on an on-going basis during:
the period before the January 1, 1999 introduction of the euro;
the transition period;
the period after January 1, 2002, when the transition will be completed; and
when a non-participating country converts to the euro.
An issuer also should consider the effects of the euro conversion on each reportable industry segment, as well as each significant line of business (even if not an industry segment).
>B. Applicable Disclosure Requirements
In this section, we summarize specific disclosure obligations under our rules that may require disclosure relating to the impact of the euro conversion. In section C, we describe specific aspects of the euro conversion for which disclosure may be required. We are providing guidance so that issuers can more readily focus on aspects of the euro conversion that may be material to them.
Issuers should consider each of the disclosure obligations below in evaluating whether a discussion of the euro conversion should be included in any particular section of a prospectus, annual or quarterly report or other document. We remind issuers that, in addition to these specific obligations, our rules require filed documents to include any additional material information necessary to make the required disclosure not misleading.10 We also remind issuers that disclosure must be issuer-specific to be meaningful to investors.
An issuer should disclose the impact of the euro conversion if that impact is expected to be material to the issuer's business or financial condition.11 If an issuer suspects that its operations may be materially affected by the euro conversion, but is uncertain, the issuer should disclose this known uncertainty. In either case, the issuer should indicate whether it has initiated an internal analysis to plan for the conversion, and describe that analysis and/or plan.
If consequences of euro conversion issues may have a material effect on an issuer, without regard to the issuer's efforts to avoid those consequences, the issuer should disclose the nature and potential impact of those consequences as well as the issuer's efforts to avoid them.
We expect the conversion may be material to many European issuers,12 financial institutions, and domestic corporations with significant European operations, markets, investments, and/or contractual counterparties. These issuers may wish to consider the advisability of disclosure, even if the impact is not material.
1. Registration statements under the Securities Act of 1933 ("Securities Act") and annual and quarterly reports under the Securities Exchange Act of 1934 ("Exchange Act") must include:
a. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"). are required to discuss liquidity, capital resources, and other information necessary to understand their financial condition, changes in financial condition, and results of operations.13 Among other things, MD&A requires disclosure of known trends or uncertainties that the issuer reasonably expects will have a material impact on revenues, expenses or income from continuing operations.14
As described in Section C below, the euro conversion raises strategic as well as operational issues. As a result, issuers should include in MD&A disclosure concerning known trends and uncertainties related to the euro conversion that meet this materiality standard, such as:
longer-term competitive implications of the conversion (such as effects on product or service pricing due to increased transparency);
the issuer's costs in connection with the conversion and ability to pass these costs along to customers; and
the costs or consequences of incomplete or untimely resolution of any required systems modifications.
b. Description of Business. This item requires a description of the general development of the business of the issuer, its subsidiaries, and any predecessors.15 Among other things, this item requires a discussion of:
any material changes in the mode of conducting the business;
the principal markets for the issuer's products and services;
competitive conditions in the business; and
financial and narrative information about the issuer's industry segments.
c. Quantitative and Qualitative Disclosures About Market Risk ("Market Risk Disclosure"). Under existing rules, an issuer must describe the derivatives and other financial instruments it has entered into, their terms, how the issuer uses them, and how they are accounted for.16 Both quantitative and qualitative disclosure about market risks are required.17 Qualitative disclosure also is required regarding the context of primary market risk exposure, the strategies and objectives used to manage that exposure, and actual or expected changes in either that exposure or management techniques.
d. Legal Proceedings. An issuer must describe material pending legal proceedings in which the issuer or any of its subsidiaries is a party, or to which their property is subject.18 Generally, no information is required regarding claims for damages unless the amount involved exceeds ten percent of the current assets of the issuer and its subsidiaries on a consolidated basis. However, it may be necessary to describe routine litigation where the claim differs from the usual type of claim.19
e. Material Contracts. An issuer must file as an exhibit certain contracts that are considered material to its business.20 These contracts include contracts upon which the business is substantially dependent, such as contracts with principal customers and principal suppliers.
2. Registration statements under the Securities Act also must include , under the caption "Risk Factors" a discussion of the factors that make the offering speculative or risky.21 This discussion must be specific to the particular issuer and its operations, and should explain how the risk affects the issuer and/or the securities being offered. Generic or "boilerplate" discussions do not tell investors how the risk may affect their investment.
Form 8-K. The impact of the euro conversion may reach a level of importance that prompts an issuer to consider filing a Form 8-K under Item 5 of the form.22 In considering whether to file a Form 8-K, issuers should be particularly mindful of the accuracy and completeness of information in registration statements filed under the Securities Act that incorporate by reference Exchange Act reports, including Forms 8-K.23
>C. Specific Considerations
In applying these disclosure standards to the euro conversion, an issuer should specifically consider the factors listed below to the extent that such factors are material to the issuer's business, operations or financial condition. However, each issuer's situation may vary, and issuers should not construe the listed factors as exclusive.
1. Competitive Impact. The euro conversion is expected to stimulate cross-border competition by creating cross-border price transparency, which may make it more difficult for businesses to charge different prices for the same products on a country-by-country basis. Product lines may become more international and less local due to revised marketing strategies. Issuers may need to adjust product and service prices to remain competitive in a broader European market. Issuers may need to adapt to changing costs (including labor costs) due to competitive pricing adjustments by suppliers.
Other factors that may impact competition are:
Customers may expect issuers in some businesses (and/or countries) to conduct transactions in euro sooner than other businesses;
Issuers may incur increased costs to conduct business in an additional currency during the transition period;
Issuers or their competitors may consolidate operations to pursue economies of scale by treating Europe as a single market; and
The participating countries' pursuit of a single monetary policy through the European Central Bank may affect the economies of significant markets.
2. Information Technology and Other Systems. Issuers will need to prepare for the transition period by modifying information systems software. Modifications will be necessary to:
Convert legacy currency amounts to euro;
Convert one legacy currency to another legacy currency through prescribed "triangulation" computations;
Perform prescribed rounding calculations (including corrections to the number of decimal places); and
Permit transactions to take place in both legacy currencies and the euro during the transition period.
Issuers also will need to modify fixed assets (such as keyboards, vending machines, and ATM machines) on a timely basis so that these assets will accommodate euro-denominated amounts. Financial institutions will require the technical capability to redenominate into euro accounts and transactions that are open on January 1, 1999.
Issuers should consider the costs, timeliness, and adequacy of their own modifications in evaluating their Risk Factor and MD&A disclosure obligations. Issuers also should consider the impact on their businesses of reliance on systems operated by others (such as customers, suppliers, banks, and other constituents) that require modification.24 An issuer that is affected should disclose:
the issuer's state of readiness;
remediation measures that have been proposed or implemented; and
the issuer's contingency plans.
3. Currency Risk. For many issuers, the conversion may result in reduced costs for currency exchange and eliminate currency exchange rate risk. However, this may not always be the case. Accordingly, issuers will need to evaluate their currency exchange costs and rate exposure with respect to the euro during and following the transition period. For example, U.S. and other issuers may use the euro more than they used the legacy currencies, thereby altering currency exchange cost and risk exposure. Issuers in the business of exchanging or trading currencies may lose significant business because the euro conversion will eliminate the legacy currencies.
The functional currency25 of one or more of an issuer's foreign operations (whose functional currency is currently a legacy currency or another currency) may change to the euro. Depending on the circumstances, this change may occur on January 1, 1999, during the transition period, or after January 1, 2002. Issuers should consider disclosing the nature and timing of the change in the functional currency, and the expected effects on financial condition and results of operations. Issuers that have invested or borrowed amounts in a currency different from their functional currency should discuss risk exposure if the impact of reasonably possible changes in exchange rates would be material.
4. Derivatives and Other Financial Instruments26 As a result of the euro conversion, the terms of certain derivatives and other financial instruments that are outstanding on January 1, 1999 may need to be modified. For example:
Foreign exchange options that have a different legacy currency on each side may either close out or function as annuities because both currencies will convert into euro;
Foreign exchange options with a legacy currency on one side may need to be redenominated in, or translated to euro;27
Interest-rate based instruments may require computations that occur on reset dates to be based on Euribor because the original legacy currency price source (such as Pibor28 ) may cease to exist; and
Equity-based derivatives may need to be redenominated or translated when the underlying equity securities begin to trade in euro.
Day count conventions29 and settlement conventions30 may require adjustment. Systems that monitor derivatives risk will require conversion so that historic performance data can be recalculated in synthetic euro terms.
New instruments are being designed to satisfy evolving market needs following introduction of the euro. For example, the euro conversion may result in the development of new standard categories of euro denominated instruments, such as swaps based on the spread between Euribor and euro Libor.31
Issuers should disclose the impact of the euro conversion on outstanding derivatives and other financial instruments if the anticipated impact is material. Issuers should consider the need to disclose the specific consequences to outstanding instruments of repricing, redenomination, replacement of price sources, and other modifications. Issuers also should consider the need to disclose the nature of any anticipated changes in how exposures to derivatives and other financial instruments will be managed following introduction of the euro.
5. Continuity of Contract. The performance of a contract that requires payment in the currency of country A may be governed by the law of country B. However, the law of country A will determine what constitutes the lawful currency of country A. The substitution of a currency may result in a party claiming that performance of a contract is "frustrated," "impossible," or "impracticable."
The European Union has adopted regulations providing that the euro conversion should not enable one party unilaterally to break or change its contractual obligations, unless the parties have otherwise agreed.32 Legislation providing for similar results has been adopted in New York, Illinois and California,33 and has been introduced in other states.34 The International Swaps and Derivatives Association, Inc. ("ISDA") has published an EMU35 Protocol that parties to derivative contracts may use to amend their agreements to ensure continuity of contract.
Contracts governed by the law of a state or country that has not adopted a specific law relating to the continuity of contracts and the euro conversion will not necessarily become unenforceable as a result of the conversion. Issuers will need to review their contracts to determine whether amendments are necessary to ensure the parties' performance. Issuers should consider both:
the need to file amendments to Material Contracts; and
their disclosure obligations under Risk Factors, Market Risk, and Legal Proceedings.
6. Taxation. The Internal Revenue Service ("IRS") has issued Announcement 98-18 requesting comments on various tax issues raised by the euro conversion. The IRS asks whether conversion of a legacy currency to the euro creates a "realization event" for a financial instrument denominated in the legacy currency, and the appropriate time to recognize any gain or loss.36 Depending on how the IRS rules, the euro conversion may result in taxable gain or loss on legacy currency denominated instruments that have not been sold. The IRS expects to publish guidance on the issue soon.
7. Accounting. The staff of the FASB recently announced that costs associated with upgrading or replacing computer software and costs to make physical modifications to fixed assets to accommodate the euro should be accounted for in accordance with an issuer's existing accounting policies for similar costs.37
III. Investment Adviser and Investment Company Disclosure
Investment advisers and investment companies should determine whether the introduction of the euro will materially affect their business operations and whether disclosure is warranted. In making this evaluation, investment advisers and investment companies should consider the matters discussed above for other public issuers to the extent relevant. As mentioned above, disclosure, if required, must be issuer and situation specific to be meaningful. "Boilerplate" or generic disclosure should be avoided.
For investment advisers, the anti-fraud provisions of the Investment Advisers Act of 1940 generally impose on investment advisers an affirmative duty, consistent with their fiduciary obligations, to disclose to clients or prospective clients material facts concerning their advisory or proposed advisory relationship. If the failure to address the effect of the euro conversion could materially affect the advisory services provided to clients, an adviser that will not be able to or is uncertain about its ability to address euro conversion issues has an obligation to disclose that information to clients.
For investment companies, the Investment Company Act of 1940 provides that it is unlawful for investment companies to omit from registration statements and other public filings "any fact necessary in order to prevent the statements made therein, in light of the circumstances under which they were made, from being misleading."38 Investment companies generally rely on external service providers such as investment advisers, transfer agents, custodians, broker-dealers, fund administrators, and pricing services. Investment companies may need to disclose the effect that the euro conversion will have on their advisers' or other service providers' ability to provide the services described in their registration statements. For example, open-end management investment companies (mutual funds) are required by Item 6 of Form N-1A to describe the experience of their investment advisers and the services the advisers provide. In addition, investment company registrants may need to consider the effect of the euro conversion in discussing their investment objectives, investment strategies, and risks.39
IV. Implementation of Systems Changes by Broker-Dealers
and Other Regulated Entities
As noted above, the introduction of the euro may require market participants to make computer systems modifications to accommodate euro-denominated transactions. Broker-dealers, markets, clearing agencies, and transfer agents should assess their operations to determine the extent to which they will be impacted by the euro conversion and implement necessary measures. In this effort, they are advised to adopt guidelines similar to those developed in connection with the Year 2000 Work Program (available at http://www.sec.gov/news/y2k/mktwplan.htm).
In addition, to meet their fiduciary obligations to customers, broker-dealers are reminded that they have obligations to disclose to customers material information regarding their business operations and services. Broker-dealers should assess whether failure to adapt to the euro conversion will materially impact the services provided to their customers and, if so, make necessary disclosures to their existing and prospective customers.40 This is consistent with the Commission's long-standing position regarding a broker-dealer's disclosure obligations and imposes no new requirements upon broker-dealers. Other regulated entities also should be prepared to provide information to their members, participants, customers, or counterparties regarding the effect the euro conversion may have on their operations and the status of their efforts to prepare for the conversion.
If an issuer determines that the euro conversion may be material to its business or financial condition, it should provide clear and specific disclosure to investors. If an issuer suspects that its operations may be materially affected by the euro conversion, but is uncertain, the issuer should disclose this known uncertainty. In either case, the issuer also should indicate whether it has initiated an internal analysis to plan for the conversion, and describe that analysis and/or plan. This disclosure should be particular to the entity and its operations, rather than a boilerplate recitation of general concerns.
If the issuer or other entity's anticipated costs in connection with the euro conversion are expected to be material, the issuer or other entity should disclose these costs to the extent they are known. If these costs are not known, this known uncertainty should be disclosed.
In addition, the staff urges investment advisers, investment companies, broker-dealers, and other regulated entities to implement necessary measures to prepare for the euro conversion by September 30, 1998, to permit sufficient time for systems testing. Investment advisers and broker-dealers also are reminded to make appropriate disclosures to their customers regarding potential adverse consequences stemming from inadequate resolution of the euro conversion issue.
Although investment companies, investment advisers, and broker-dealers may be public issuers, for purposes of this Staff Legal Bulletin, "issuers" generally refers to corporate public issuers other than investment companies. Considerations applicable to investment advisers and investment companies, and broker-dealers and other regulated entities are addressed in Sections III and IV, respectively.
On January 1, 1999, the euro also will replace the ECU basket of currencies on a one-to-one rate. The currencies that comprise the ECU basket are not in all instances the currencies of the participating countries. For example, the British pound is included in the ECU basket, but the Austrian schilling is not.
See,e.g., Securities Act Rule 408, Exchange Act Rule 12b-20, and Exchange Act Rule 14a-9. Issuers also should consider the anti-fraud provisions of Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Exchange Act Rule 10b-5. The anti-fraud provisions apply to statements and omissions both in Commission filings and outside of Commission filings. Issuers also should consider potential civil liability under Securities Act Sections 11 and 12(a)(2) and Exchange Act Section 18.
Forward-looking statements concerning the euro conversion may be covered by the safe harbor provisions under Sections 27A of the Securities Act and 21E of the Securities Exchange Act . The safe harbor requires issuers to include meaningful cautionary language to identify important factors that could cause actual results to differ materially from those in the forward-looking statement.
In Securities Act Release No. 6835 (May 18, 1989), the Commission provided interpretive guidance regarding the disclosure required by Item 303. The MD&A disclosure requirements also are described in In the Matter of Caterpillar Inc., Exchange Act Release No. 30532 (March 31, 1992), a case involving failure to disclose known trends regarding currency translation gains.
Item 305 of Regulation S-K, Item 7A of Form 10-K, and Item 9A of Form 20-F. This disclosure requirement was adopted in Securities Act Release 7386 (January 31, 1997). Banks, savings and loans, and registrants with market capitalization over $2.5 billion are required to make this disclosure in filings that include audited financial statements for years ending after June 15, 1997. Other registrants will be required to make this disclosure in filings that include audited financial statements for years ending after June 15, 1998. Small businesses are not required to make this disclosure, whether or not they file on small business forms. The staffs of the Office of Chief Accountant and the Division of Corporation Finance have published a booklet, "Questions and Answers About the New Market Risk' Disclosure Rules" (July 31, 1997), that explains this disclosure requirement.
Statement No. 52 of the Financial Accounting Standards Board ("FASB") defines functional currency as "the currency of the primary economic environment in which the foreign entity operates; normally that is the currency of the environment in which an entity primarily generates and expends cash."
On June 15, 1998, the FASB issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." Statement No. 133 establishes accounting and reporting standards for derivative instruments, including certain instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair value. It also specifies the accounting for changes in the fair value of a derivative instrument depending on the intended use of the instrument and whether (and how) it is designated as a hedge. Statement No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
Euribor will be a measure of the cost of euro funds quoted by banks within the participating countries. In contrast, euro Libor will be a measure of the cost of euro funds based on the offer rates quoted by certain London banks.
1998-10 I.R.B. (March 9, 1998). Announcement 98-18 also asks whether a qualified business unit with a legacy currency as its functional currency will have changed its functional currency as a result of the euro conversion and, if so, the tax implications of that change.
Topic D-71 of the minutes of the May 21, 1998 Emerging Issues Task Force (EITF) meeting. The accounting profession currently is considering whether additional guidance is necessary concerning other matters related to the euro conversion.