Update on the SEC's XBRL Proposal – Liability Considerations

The SEC recently proposed rules that would require companies reporting under U.S. GAAP or IFRS to provide their financial statements to the SEC in interactive data (XBRL) format. Our May 15, 2008 alert, which can be accessed at the following link, summarizes the principal provisions of the proposed rules as well as the applicable phase-in periods.

The full proposing release was published on May 30, 2008, and it provides additional detail on matters left unclear by the SEC staff’s brief description of the rule proposal at the open meeting on May 14. These include how the new XBRL exhibit will be treated for purposes of the liability provisions of the securities laws and the consequences of failure to file or post interactive data files when required.

I. Liability for XBRL Interactive Data

General

Under the proposed rules, a company would be required to prepare two versions of its financial statements. The first version, which the proposed rules call the “related official filing,” would consist of the financial statements formatted and filed on EDGAR as they are today, in ASCII or HTML format. The second version would be filed as an exhibit and posted on the issuer’s corporate website, and would consist of a machine-readable interactive data file that corresponds to the financial statements and financial data schedules in the related official filing. Proposed Rule 405 of Regulation S-T specifies the form and content of the interactive data file. Under proposed Rule 405, an electronic filer would be required to tag each data element in the interactive data file with an appropriate “tag” chosen from the official XBRL taxonomy specified in the EDGAR filer manual. Proposed Rule 405 would also require that the interactive data file reflect the same data as the financial statements and financial data schedules included in the related official filing, without any changes, deletions or summarization.

XBRL tags will allow individual data elements to be downloaded directly into spreadsheets and other applications and separately processed. If a data element is improperly tagged in the interactive data file, it could lead to potentially significant errors when the file is processed and viewed. Similarly, if there is a material inconsistency between the figures contained in the related official filing and those contained in the interactive data file, investors that rely primarily on the interactive data file when making investment decisions may suffer damages that would not have arisen had they relied on the traditional format financial statements set forth in the related official filing.

One approach the SEC might have taken in the proposed rules would have been to treat the interactive data file in the same manner as the financial statements included in the related official filing. Under that approach, a material misstatement or omission in the interactive data file would have been subject to the same liability as a material misstatement or omission in the traditional filing. Issuers and underwriters in a securities offering, for example, would have been subject to potential liability under Section 11 for the content of the interactive data file, and would be expected to carry out verification and due diligence procedures similar to those currently carried out with respect to the financial data in the related official filing. Similarly, the SEC could have required the annual financial information in the interactive data file to be audited by the company’s auditors, and it could have subjected the interactive data file to certification by the company’s CEO and CFO to the same extent as the financial information in the related official filing.

The SEC has not taken that approach, citing its goal of “rapid adoption and use of interactive data without imposing unnecessary cost and expense on filers.” Instead the SEC proposes that issuers, underwriters and others will be exempt from some of the liability provisions of the securities laws for information contained in the interactive data file. The interactive data file will also not be required to be audited or subject to certification by a company’s CEO or CFO.

The SEC proposes, however, that the “interactive data in viewable form” produced when the interactive data file is processed using the SEC’s viewing software would be subject to the same liability as the financial statements in the related official filing – but only to the extent such viewable information is displayed identically in all material respects to the corresponding information in the related official filing. This leaves open the question of how viewable information that is not displayed in substantially identical form will be treated, and we expect comment letters will seek clarification that the liability protections afforded for errors in the interactive data file extend equally to the viewable information produced when that file is processed.

Although the SEC will retain the ability to bring enforcement actions based on violations of its rules, the liability provisions set forth in the proposing release should reduce the risk of successful private litigation for good faith or inadvertent errors in the interactive data file. The proposed rules significantly narrow the causes of action available to a plaintiff bringing a private action against an issuer arising out of errors contained in the interactive data file that are not present in the related official filing. Issuers, underwriters and auditors would not be subject to liability for errors in the interactive data file under Section 11 or 12 of the Securities Act, and persons making or causing misstatements in the interactive data file would not be subject to liability under Section 18 of the Exchange Act. As a result, a plaintiff would be required to proceed under Rule 10b-5, which requires a showing of scienter.

Liability for Errors in the Interactive Data File

The proposed rules provide a mechanism for relief from liability in the event the interactive data file is improperly tagged or otherwise fails to comply with proposed Rule 405 despite a company’s good faith and reasonable attempt to do so, and address how interactive data will be handled for purposes of the liability provisions of the securities laws. The principal elements are as follows:

•   Ability to correct good faith errors. Under proposed Rule 406(c)(1) of Regulation S-T, the interactive data file will be deemed to comply with proposed Rule 405, even if the electronic filer makes an error in complying with proposed Rule 405’s tagging or content requirements, so long as the registrant made a good faith and reasonable attempt to comply and files an amended interactive data file correcting the error as soon as reasonably practicable after becoming aware of the error. By its terms, proposed Rule 406(c)(1) does not limit its scope to tagging errors; the rule also would appear to permit an electronic filer to correct failures to comply with proposed Rule 405’s content requirements. For example, the rule would appear to allow an electronic filer to correct numerical and other errors in the interactive data file that do not appear in the financial statements in the related official filing in order to bring the interactive data file into compliance with proposed Rule 405’s requirement that the data elements in the interactive data file correspond to the financial information contained in the related official filing.

•   Relief from liability for errors that are promptly corrected. Under proposed Rule 406(c)(2) of Regulation S-T, an interactive data file that complies with proposed Rule 405 or (pursuant to the correction mechanism described above) is “deemed” to comply with proposed Rule 405 “is not subject to liability … for failure to comply with Rule 405” under “any provision” of the Securities Act, the Exchange Act, the Trust Indenture Act, the Investment Company Act or the rules and regulations under those Acts. As proposed, therefore, proposed Rule 406(c)(2) suggests that an electronic filer would have no liability under the securities laws for improperly tagging a financial data element in the interactive data file or for errors that result in a mismatch between the data in the interactive data file and the data in the financial statements in the related official filing, so long as the error was made despite a good faith and reasonable effort to comply and is corrected as soon as reasonably practicable after discovery of the error by filing an amended interactive data file.

•   Exemption of the interactive data file from liability under Section 11 and 12 of the Securities Act and Section 18 of the Exchange Act. Proposed Rule 406(c)(3) of Regulation S-T provides that the interactive data file is not subject to liability under Section 11 or 12 of the Securities Act or Section 18 of the Exchange Act, and will not be deemed “filed” or “part of a registration statement or prospectus” for purposes of those sections. As proposed, therefore, an investor that invests based on a material misstatement or omission contained in the interactive data file that is not also present in the related official filing would have no cause of action under Section 11 or 12 of the Securities Act or Section 18 of the Exchange Act.

•   Continued liability for the substantive content of the interactive data file under other provisions of the securities laws. Although the interactive data file would be exempt from liability under the provisions of the securities laws described in the preceding bullet, an electronic filer would remain subject to liability under the remainder of the securities laws for the “substantive content” of the file, “as distinct from compliance with Rule 405,” to the same extent as the related official filing. The “substantive content” of the financial disclosure refers, for example, to the numerical values in the financial statements or footnotes and the statements in the footnotes. Thus, for example, an issuer would continue to be liable for the substantive content of the interactive data file under the antifraud provisions of the securities laws, including Exchange Act Rule 10b-5.

•   Exemption of the interactive data file from the scope of CEO/CFO certifications. The proposed rules would amend Exchange Act Rules 13a-14 and 15d-14 to exempt the interactive data file from the scope of the CEO/CFO certifications required under those rules.

Liability for Interactive Data in Viewable Form

Although the proposed rules exempt the machine-readable “interactive data file” from liability as described above, proposed Rule 406(b) of Regulation S-T provides that “interactive data in viewable form” will be subject to liability under the securities laws to the same extent as the related official filing. As proposed, “interactive data in viewable form” is defined as the financial statements and other information displayed when the interactive data file is converted to human-readable format using a viewer provided by the SEC in a manner that results in such information being displayed identically in all material respects to the corresponding financial information contained in the related official filing.

Because the definition only applies to viewable financial information that is in fact displayed identically in all material respects to the financial information in the traditional filing, proposed Rule 406(b) by its terms appears to stand for the unremarkable proposition that viewable financial data that is substantially identical to the financial data in the traditional format filing will be subject to same liability. Surprisingly, the proposed rules do not expressly address the liability that would attach to viewable information that is not displayed identically in all material respects to the data in the related official filing. We expect comment letters on the proposed rules will seek a clear statement from the SEC that the liability protection afforded by proposed Rule 406(c) extends not only to the interactive data file but also to the viewable information resulting from processing that file, whether that information is processed using the SEC’s viewing software or otherwise. Absent such an interpretation, the protections afforded to the interactive data file would be illusory, because a plaintiff would simply base its cause of action on the viewable information created by processing the interactive data file.

II. Consequences of Failure to File or Post an Interactive Data Exhibit

The proposing release also provides further detail on the consequences of failure to file or post an interactive data file when required by the proposed rules.

•   Eligibility for Short-Form Registration. The proposed rules would amend the instructions to Form S-3, Form F-3 and Form S-8 to provide that a registrant is not eligible to use such forms unless it has submitted to the SEC and posted on its corporate website, if any, all interactive data files required to be submitted and posted under the SEC’s rules during the 12 calendar months and any portion of a month immediately preceding the filing of the registration statement. Because the eligibility provisions would not turn upon whether the registrant had “timely” filed or posted the interactive data files, a registrant could cure prior failures to post or file by bringing its file up-to-date prior to filing a registration statement.

•   Current Public Information for Purposes of Rule 144. Rule 144 under the Securities Act conditions certain resales under that rule upon the availability of “current public information” concerning the issuer of the securities. Under the proposed rules, current public information would not be available for an issuer unless it had submitted to the SEC and posted on its corporate website, if any, all interactive data files required to be submitted and posted under the SEC’s rules during the 12 months preceding the Rule 144 resale.

•  WKSI Eligibility. The proposing release does not expressly address the impact of the above provisions on an issuer’s status as a well-known seasoned issuer, or WKSI. However, because the WKSI definition requires an issuer to meet the registrant requirements for short-form registration under Form S-3 or F-3, an issuer that loses its S-3 or F-3 eligibility due to failure to file an interactive data exhibit will also lose its status as a WKSI if it has not filed all required interactive data exhibits as of the “determination date” for WKSI eligibility specified in Rule 405 under the Securities Act.

Under the WKSI definition, an issuer determines its WKSI status on a determination date that is the latest of: (i) the time of filing of its most recent shelf registration statement; (ii) the time of its most recent amendment to an outstanding shelf registration statement for purposes of complying with Section 10(a)(3) of the Securities Act; or (iii) if the issuer has not filed a shelf registration statement or a Section 10(a)(3) amendment for 16 months, the time of the issuer’s most recent annual report on Form 10-K or Form 20-F.

As a result, a WKSI that has an effective shelf registration statement will lose its WKSI eligibility on the date it files its Form 10-K or Form 20-F unless, at such time, it has filed and posted all interactive data files required to be posted during the preceding 12 calendar months. Although the rules permit an issuer to reestablish eligibility once the required interactive data files have been filed and posted, a WKSI that brings its file up to date by filing and posting the required information will not necessarily immediately regain WKSI status, because WKSI eligibility is tested only on specified determination dates. An issuer that does not wish to wait until the date of filing its next annual report to reestablish WKSI status would need to file a shelf registration statement to trigger a new determination date.

•   Impact on Issuers with Effective Shelf Registration Statements. Under the SEC staff’s existing telephone interpretations, when an issuer with an effective shelf registration statement loses its eligibility to file on Form S-3 or Form F-3, the issuer generally can continue to use the registration statement until it files its next Form 10-K or Form 20-F. If the issuer is still not eligible at the time it files its Form 10-K or Form 20-F, the issuer must file a post-effective amendment to its shelf registration statement on a form it is then entitled to use.

Although the matter is not addressed in the proposing release, under this guidance, an issuer with an effective shelf registration statement that ceases to be eligible to file on Form S-3 or F-3 during the course of its fiscal year due to failure to file or post a required interactive data file should remain eligible to use its shelf until the time it files its Form 10-K or Form 20-F. If the interactive data files have not been filed and posted as required at that time, a post-effective amendment to the shelf would need to be filed.

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Click here for copies of the proposing release.

The 60-day comment period for comments on the proposing release ends August 1, 2008.

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Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under the “Capital Markets” section of this website if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP