Edwards Angell Palmer & Dodge

Guidelines for Preparing the New MD&A

1. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is a dynamic disclosure vehicle that adapts to meet changing regulatory concepts and internal and external developments affecting a company. This is illustrated by the SEC’s recent MD&A interpretive guidance. Release No. 33-8350 (Dec. 19, 2003). MD&A has gained equal status with the financial statements as the most important sources of disclosure regarding the company and its financial position. In that connection, it is integral to an understanding of the company’s financial statements.

2. MD&A dates from 1980 and its requirements are found in Item 303 of Regulation S-K (and the comparable item of Regulation S-B) applicable to Securities Exchange Act periodic reports on Form 10-K and Form 10-Q (and other comparable forms) and certain Securities Act registration statements.

3. Sources of SEC guidance on MD&A are found, among other places, in:
   • 1987 interpretive release on MD&A

   • 1988 interpretive release on defense contract disclosure, but relevant more generally on disclosure of contingencies

   • 1989 comprehensive interpretive release on MD&A

   • December 2001 cautionary advice regarding critical accounting policies

   • January 2002 statement regarding certain MD&A topics

   • May 2002 rulemaking proposal regarding disclosure of critical accounting estimates

   • January 2003 rulemaking regarding disclosure of off-balance sheet arrangements and contractual obligations

   • February 2003 Fortune 500 review summary

   • December 2003 interpretive release providing MD&A guidance

   • SEC enforcement actions relating to MD&A, including most prominently Caterpillar, Inc.; Bank of Boston Corp.; Gibson Greetings, Inc.; Sony Corporation; and Edison Schools, Inc.

4. The purpose of MD&A is to provide investors in a clear and straightforward manner with an informative discussion and transparent information necessary to an understanding of the company’s financial condition, changes in financial condition and results of operations, with three principal objectives:
   • Provide a narrative explanation of the company’s financial statements that enables investors to see the company through the eyes of management (e.g., analysis of the reasons for material changes and identification of key risks).

   • Enhance overall financial disclosure and provide the context for analyzing the financial statements (e.g., critical accounting estimates; off-balance sheet arrangements).

   • Provide information about the quality and potential variability of the company’s earnings and cash flow so that investors can ascertain the likelihood that past performance is indicative of future performance (e.g., known trends and uncertainties that are reasonably likely to affect future results).

5. The process for preparing MD&A should involve combining both an overall perspective (the “1,000-foot view”) with greater detail necessary for an understanding of material information (the “100-foot view”). This can be accomplished through a layering of information that conveys the most important information and a roadmap of more detailed disclosure, for example, through the use of an overview and introductory paragraphs to particular sections. Expanded use of tables can also help the presentation of MD&A information.
   • What is apparent is that effective MD&A is not a process of marking up the last one.

   • It also requires top-down guidance from senior executives in its formulation and active involvement of the company’s disclosure committee. MD&A is part of an ongoing process that involves telling the company’s story through earnings releases, investor calls and webpostings, investor presentations, annual reports and board reviews. Each of these sources should be consulted to tell a consistent, cohesive and complete story.

6. MD&A is best understood by examining its component parts. At the same time, the importance of disaggregating information down to segments and even lower subdivisions where material needs to be kept in mind.
   • Any well written MD&A will emphasize the material, focus on analysis (the “A” in MD&A), avoid mere narrative recitation of what is apparent from the financial statements and eschew redundancies and irrelevancies.

7. The components of MD&A can be viewed as the following:
   • An overview that discusses what the company is about, how it makes money, what are the trends and drivers of the business, what are the principal risks and challenges that face it, and what are the strategies and opportunities for growth and the uncertainties associated with carrying them out.

   • A discussion of results of operations focusing on the reasons for the historic results and period-to-period changes and the extent to which these past results are indicative of future results. This involves addressing known trends and uncertainties that can affect future results, applying the MD&A two-part materiality test. That test requires disclosure unless the matter is both unlikely and not material. It is also an opportunity to provide the company’s forecasts and the risks associated with those forecasts. A proper analysis may involve non-GAAP financial information to the extent meaningful, as well as non-financial factors relevant to the business (which may be macro-economic, industry-based or company specific). Segment and below segment information may be most important here.

   • Discussion of liquidity, cash flow and capital resources has taken on increased importance. It requires addressing the company’s cash needs, both short-term and long-term, for operations, capital expenditures, debt repayments and distributions. It then requires addressing how the company expects to meet those needs, such as from internally generated funds and external sources (with requisite specificity), and risks associated with obtaining the necessary funds. This could require discussion of covenants that affect the ability to raise funds, as well as when there is an existing or possible default. Changes in cash flow also should be discussed with identification of the specific elements that affected cash flow.

   • Closely related for an understanding of cash needs, as well as the company’s balance sheet and financial position, is a compilation of contractual commitments and a discussion of off-balance sheet obligations (as affected by FIN 45 regarding guarantees and indemnities and FIN 46R regarding variable interest entities). Although not required by the MD&A rules recently adopted, contingent liabilities may need discussion to give an accurate picture of the company’s cash needs and financial position.

   • If the company engages in trading activities, non-exchange traded obligations would have to be discussed as set forth in the January 2002 statement.

   • Similarly, related and near-related party transactions would require discussion if their terms mean that past performance is not necessarily indicative of the future.

   • Critical accounting estimates (formerly policies) requires special attention in order to provide a context for understanding the financial statements and the variability of certain items that could be material. This should not be a repetition of the note describing accounting policies but rather an analysis of those policies that involve estimates and assumptions that are highly subjective and judgmental and whose variability could have a material impact on the financial statements.

   • Sometimes, the MD&A is used as the vehicle for setting forth risk factors, often called “investment considerations.” These serve to qualify disclosures by identifying risks and uncertainties and to provide a basis for using the forward-looking information safe harbor.

8. The MD&A in the Form 10-K sets the baseline as the complete discussion, prepared annually. The Form 10-Q MD&A is an update that describes the results for the quarter and material changes from the Form 10-K MD&A. The reader is presumed to be familiar with the Form 10-K, and therefore repetition from it can be avoided in the Form 10-Q.

9. With the introduction of expanded and accelerated Form 8-K current disclosure, the nature of MD&A as the core of periodic reporting is likely to evolve. It will have to reflect and amplify upon the current reports during the period. In connection with preparing the periodic MD&A, consideration should be given to whether all required Form 8-Ks have been filed inasmuch as the safe harbor from Rule 10b-5 liability for failure to file a Form 8-K applies only until the next periodic report.

The content of this update is general in nature and is not intended as legal advice related to individual situations. Counsel should be consulted for specific legal planning and advice.