€ The Euro Audit Checklist
We refer to our Memorandum for Clients and Friends regarding the introduction of the "euro", which on January 1, 1999 completed its long gestation period and emerged as the single currency for the participating EU Member States, beginning a dual currency transition period leading to economic and monetary union, with the euro being the only legal tender, effectively by February 28, 2002.
This Euro Audit Checklist is a Supplement to our Memorandum and is intended to summarize the areas to be investigated by interested businesses in dealing with the euro's introduction.
In general, companies in the U.S. have been somewhat slower to react to the euro, and even slower to appreciate the more pronounced complications during the "Transition Period" (January 1, 1999 to effectively February 28,, 2002) which are estimated to exact an effective toll charge of up to 2% of sales through the costs and complications of dealing with two legal currencies simultaneously (despite the expected long-term savings). The euro is now here, and complex strategic decisions must be made and implemented by affected businesses.
Since the euro's impact will be felt in every area of affected companies' operations, prudent planning requires a multi-disciplinary Euro Committee being established so that an affected company can assess the full range of the euro's effects and the ramifications of decisions in each specific area on the Company's other operations.
The recommended Euro Committee should coordinate the many strategic decisions presented by the euro and also, just as urgently, take charge of the operational details attendant upon the new currency's introduction.
Broadly, the Euro Committee would plan, budget for, schedule, assess and resolve issues in the following primary areas:
- The effect of selling in one currency to 12 countries previously sold in separate currencies.
- IT requirements generated by the euro, and the Transition Period complications.
- Adjustments in currency risk management.
- Human resources issues across the entire workforce.
- Enforceability of contracts in place and proposed contracts.
- SEC or other disclosure of material aspects of the euro's impact on the Business.
The following Checklist highlights the principal areas for study and resolution.
Euro Audit Checklist
The extent and burden of an effective Euro Audit obviously will depend on the breadth and complexity of the Company's operations in (or affected by), the EU. If, for example, a U.S. Company does business there directly and also through joint venture and distribution channels, then decisions prompted by the advent of the euro will immediately be complicated by the necessity to involve others in the decision process.
Companies purchasing in the post-euro EU must also be well-informed consumers, and must be aware of the probabilities that suppliers may use the euro as an opportunity to raise prices effectively or to take sole advantage of transaction cost savings which might rather be shared with the Company as a consumer.
The price transparency presented by the euro prompts extremely important sales and marketing decisions, and the rounding most likely required (particularly by any seller of consumer products), will raise immediate pricing issues with instant opportunities for gain or loss, and difficulties in reestablishing "psychological" prices for retail products. Customers in the Member States will be able to compare disparate prices among the participating countries, and employees will be much more aware of wage and benefit differences.
To the extent that the Company hedges in the financial or other commodities markets, the euro raises distinct issues to be resolved with competent professional advice.
1. Sales and Operations: Increasingly One Market:
1.1 Broadly, consider all effects of increased competitiveness due to elimination of currency risk in intra-EMU transactions. Consider effects on joint venture and distributor relationships.
1.2 "Transparent" Price Issues:
- Disparate pricing among Member States will now be more obvious to customers and competitors alike.
- Prices are expected to gravitate down, not toward the average.
- Intra-EMU currency risk is now irrelevant to justifying price disparities.
- Issues of how to price, how to round and how to advertise all must be resolved.
- Dual pricing issues during Transition Period must be dealt with.
- EU Directives require Original Price and Unit Price, and also Promotion Price and Unit Price; so potentially 8 prices on each product; Rounding requires 6 significant figures and 3 decimal points.
- Very substantial labeling expenses are expected.
- Advertising and promotional expenses will initially increase.
- Central EU purchasing will increase on both buy and sell sides.
1.3 Costs and revenues "mismatch" for Companies outside the EU must be assessed.
1.4 EU Facilities: consider any indicated euro adjustments in required facilities payments and possible relocations based on euro-related revised manufacturing, marketing, or distribution plans.
- Schedule location and description of all affected facilities:
- manufacturing facilities
- distribution centers
- selling locations
- any inactive properties
- Summarize principal attributes of all facilities including:
- operating/capital lease
- customer analysis (dollar volumes)
- product mix (dollar volumes)
- Summarize all lease or ownership terms.
- rent (base plus percentages, if any)
- expiration dates
- renewal options
- renewal rental terms
- option purchase prices, if any
- equipment and automobile lease summaries
1.5 Review major customers and customer agreements and consider any indicated euro adjustments:
- by dollar volume.
- by product line.
- copy of future marketing plans developed to date.
1.6 Review major suppliers and supply agreements and consider any indicated euro adjustments:
- by dollar volume.
- by product line.
- inventory on hand.
- annual purchases (last 3 years).
1.7 Revised risk management guidelines will be required with euro-induced elimination of intra-Member States currency risk.
1.8 Decide when to change over internal accounting and external reports to euro.
1.9 All normal Company operations must continue despite attention to euro conversion.
2. Financial Systems and Information:
2.1 Develop Business Plan for invoicing and payment in euros and in dual currencies during the Transition Period.
2.2 Understand the new payment systems developments and specific requirements of Systems chosen, and coordination with TARGET. Costs should decline. Understand individual Member States' ongoing requirements as well.
2.3 Consider consolidation of legacy currency accounts to save costs.
2.4 Review historical financial statements (annual, quarterly and monthly to the extent prepared by the Company) for the last three full fiscal years and since the end of the last fiscal year, and consider any indicated euro adjustments.
2.5 Review statements with detail of divisional/corporate overhead annually for each of the last three full fiscal years and consider legacy/euro adjustments.
2.6 Develop accounting procedures manual and requirements for euro translation procedures.
2.7 Review projected financial statements and their predicates; consider in view of legacy/euro adjustments and budgeted costs of euro adjustments.
2.8 Review inventory (by supplier and distribution center) and consider any indicated euro adjustments in carrying values or otherwise.
2.9 Review accounts receivable, accounts payable and accrual schedule and consider any indicated euro adjustments (such as opportunities for consolidation).
2.10 Review depreciation schedules and consider any indicated euro adjustments.
2.11 Review capital expenditure plans and consider any indicated euro adjustments:
- projected by major project
- committed by major project
2.12 Review detail with respect to any deferred taxes reflected on financial statements and consider any indicated euro adjustments.
3. Information Technology Systems:
3.1 Review existing IT systems and consider any indicated euro adjustments.
- Hardware and Software.
- Leased line costs and adequacy.
- Dual currency issues during the Transition Period.
- Issues of invoices and account statements matching specie of payment.
- "Euro Only" election avoids complications of dual currencies.
The U.K. Business and Accounting Software Developers Association has published an EMU Specification which describes minimum EMU requirements for application software, and this can be found at BASDA's website at www.basda.org.
3.2 IT Operating Plans
- description of all major projects and capital required.
- expensed versus capitalized costs.
3.3 All EU participants must modify IT, even if only marginal participation.
3.4 Modifications may be more complex than Y2K, since new work processes will likely be required, such as permitting system interfaces to permit review of transactions in both euro and legacy currencies. Possible shortage of qualified staff due to Y2K.
3.5 Since market conventions, regulatory reports, and tax return requirements not final yet (for example Germany may require dual filings), IT needs flexibility to accommodate possible changes in anticipated requirements.
3.6 IT must convert by "triangulation" to ensure consistency.
3.7 Rounding differences must be reconciled after conversions, and odd losses due to rounding differences must be written off or else they will accumulate.
3.8 Dual entry and display required during the Transition Period.
3.9 Systems must be compatible with customers' and suppliers' systems.
3.10 Sufficient system capacity will be required for Transition Period dual currencies plus conversion volumes.
3.11 Future system flexibility will be required for new EMU entrants and possible changes in market conventions.
3.12 The euro "glyph" may require a patch.
3.13 Systems must also convert certain historical data for regulatory filings and comparisons.
3.14 Controls in place must also accommodate the unexpected differences, such as decimals in securities prices.
3.15 For securities trading systems, new settlement conventions are also arriving, such as only 2 TARGET holidays.
3.16 Testing periods are very tight since time is short.
4. Human Resources and Indicated Euro Adjustments; Broad Review of Compensation and Benefits; Systems; Tax Planning for Individuals, Payroll; and Employee Communications:
4.1 Review EMU Organizational Structure
- detailed organizational charts and headcounts
- union contracts and other organizational activities
4.2 Review employee benefits and assess compensation and benefits "transparency" issues throughout international assignments and labor force generally, data systems and payroll systems.
- summary of benefits in each Member State (salaried and hourly)
- stock option plans
- employee retirement plans and trusts
- savings and investment plans
- non-employee director plans
- management incentive plans
- other bonus programs by job function
- healthcare (active and retirees)
4.3 Benefit Booklets
- life and disability insurance coverage
- travel and accident insurance
- medical and dental benefits
4.4 Employment Policies and Procedures
- holiday and vacation
- sick leave and leave of absence
- company handbooks
4.5 Analyses of headcounts in light of possible euro-related movements.
4.6 analysis of other retirement benefits, funded and non-funded and consider any indicated euro adjustments
4.7 Copies of all commission agreements or evidence of commission arrangements with employees and sales agents.
4.8 Employees with euro-conversion responsibilities must be adequately trained and supervised.
5.1 Review all documents and agreements evidencing borrowings or available borrowings, whether secured or unsecured, and other financing arrangements by the Company, including loan and credit agreements, promissory notes and other evidences of indebtedness and consider any indicated euro Adjustments. Broadly, the issues are (i) Continuity; (ii) Interest Rate Calculation; (iii) Takedown Procedures; (iv) Payment Procedures (and "Business Day") Differences; and (v) Increased Expense of Compliance.
5.2 Consider euro Impact on price sources and market conventions.
5.3 Review all corporate or other guarantees of obligations and consider any indicated euro adjustments.
5.4 Review all documents and agreements evidencing other material financing arrangements including sale and lease-back arrangements, installment purchases, etc. and consider any indicated euro adjustments.
5.5 Review all correspondence with lenders for the last three years including all compliance reports submitted by the Company or its independent public accountants relevant to the Company and consider any indicated euro adjustments.
5.6 Internal investment and borrowing limits for investment of the Company's Internal and Pension Funds must be reassessed.
5.7 ISDA protocols for swaps and derivatives must be reviewed and understood.
5.8 Understand bankers' schedules for adopting euro; new price sources, and new market conventions and schedules for their introduction should be understood and agreed.
5.9 Consider adequacy of syndicate banks and other minor (and major) counterparties' readiness for the euro.
6. Currency Risk Management:
6.1 In conjunction with Financings Review, create alternative hedging theories with effective elimination of cross currencies (existing cross currency hedges in effect became annuities).
6.2 Review and understand ISDA conventions.
7.1 Review all letters in the past three years from the Company to the independent public accountants of the Company regarding representations requested by such independent public accountants in connection with their audit of the Company and consider any indicated euro adjustments.
7.2 Review all management reports from the auditors of the Company to the Company for the past three years and the responses to such reports from the Company and consider any indicated euro adjustments.
7.3 Assess additional audit complications and expenses during Transition Period and thereafter.
8.1 Consider euro-affected income taxes or equivalent information relevant to the Company:
- tax returns, domestic or foreign as applicable.
- copies of any IRS, or equivalent foreign governmental agency, determination letters for all periods for which the statute of limitations has not run.
- tax liens or deficiency notices.
- operating loss carry forwards (tax and book).
- analysis of income tax reserves.
- analysis of income tax timing differences.
- latest federal, state and foreign examination reports.
- any tax settlement documents and correspondence.
- any waivers or extensions of tax statutes of limitations.
- Review all tax planning materials relating to the Company and consider any indicated euro adjustments.
- Review sales, use, property and ad valorem tax returns for last 3 years and consider any indicated euro adjustments.
8.3 See KPMG, Overview of the Tax and Accounting Implications of the Euro, www.KPMG.com.
9.1 Prepare schedule of all suits, actions, litigations, administrative proceedings or other governmental investigations or inquiries, pending or threatened, relating to the businesses or operations of the Company, which may be affected by the introduction of the euro, including all material litigation involving payments in a legacy currency.
9.2 Review all consent decrees, judgments, other decrees or orders, settlement agreements and other agreements to which the Company is a party or is bound and consider any indicated euro adjustments.
9.3 Consider effect of euro introduction on contracts in force and any anticipated renegotiation or possible litigation which could result.
10.1 Review documents and filings relating to the Company's compliance with federal, state, local or other authorities' environmental laws, regulations or requirements applicable to the operations or products of the Company and consider any indicated euro adjustments, such as budget changes or changes in required payment terms.
10.2 Review any material documents relating to environmental matters, including any remedial action plan or any other documents relating to any administrative proceedings or other governmental investigations or inquiries pertaining to other significant environmental matters involving the Company and consider any indicated euro adjustments, such as budget changes or changes in required payment terms.
11. Intellectual Property:
11.1 Review schedule of all confidentiality or proprietary information agreements, patents, trademarks, service marks, trade names, brands, copyrights and all pending applications of the Company which relate to the operations or name of the Company, whether or not registered, created or used by or on behalf of the Company and a copy of any applications and agreements pertaining thereto and consider any indicated euro adjustments to any legacy payment terms.
11.2 Review all material legacy currency royalty and licensing agreements to which the Company is a party and consider any indicated euro adjustments.
12. Other Material Agreements:
12.1 Consider basic issue of continued enforceability of any legacy currency contract.
12.2 Review all agreements relating to the ownership of, or voting rights pertaining to, the capital stock of the Company, including all agreements under which any person has registration or preemptive rights for shares of common stock of the Company and consider any indicated euro adjustments.
12.2 Review all stockholder and capitalization records (including outstanding options, warrants and convertible securities) and consider any indicated euro adjustments.
12.3 Review all contracts relating to securities of the Company, including stock option plans, forms of stock option agreements and any agreements pursuant to which the Company has agreed to issue securities or to register securities under the Securities Act of 1933 or other National laws and consider any indicated euro adjustments.
12.4 Review all significant documents relating to any major acquisitions or dispositions by the Company or currently proposed acquisitions or dispositions.
12.5 Review all material agreements encumbering real or personal property, including mortgages, deeds of trust and security agreements.
12.6 Review all significant leases of real property and all leases of any substantial amount of personal property to which the Company is a party, either as lessor or lessee.
12.7 Review any title insurance policies for material properties owned or leased by the Company.
12.8 As noted above, review all material supply or requirements contracts to which the Company is a party, and standard forms of all supply, distribution or similar agreements.
12.9 Review forms of all material rental, warranty and service agreements of the Company.
12.10 Schedule all relevant insurance coverage of the Company or its employees, including but not limited to general liability, workers' compensation, property and product liability, business automobile policies, etc., and consider any indicated euro adjustments.
12.11 Review all material franchises, distribution agreements, commission or agency agreements, sales representative agreements and conditional sales contracts to which the Company is a party.
12.12 Review all relevant material collective bargaining agreements, employment agreements and material consulting agreements to which the Company is a party.
12.13 As noted above in connection with Human Resources, review all documents representing any bonus, retirement, profit sharing, incentive compensation, pension, change in control agreements and other employee benefit plans or agreements of the Company, and consider any indicated euro adjustments.
12.14 Review all material joint venture and partnership agreements to which the Company is a party and consider any indicated euro adjustments.
13. Corporate Records Review for Legacy Currency References and Possible Adjustment to Euro References:
13.1 Review charter documents (and also the by-laws) of the Company to determine whether any references (e.g., par value) should be adjusted to euro; consider authorization procedures, including any shareholder approval requirements.
13.2 Review stock books of the Company.
13.3 Review form of stock certificates of the Company.
13.4 Prepare schedule of the names and background of current executive officers, directors and key employees of the Company for euro notices, etc.
13.5 Review all quarterly and annual reports and any other communications to shareholders of the Company over the last three years to consider appropriate euro disclosure issues.
14. Government Filings and Regulations:
14.1 Prepare schedule of each jurisdiction in which the Company is qualified to do business, and schedule periodic reporting obligations which may have to change to euro.
14.2 Review all proxy materials of the Company during the last three years, and consider possible adjustment to any legacy currency references.
14.3 Review applications for permits filed with agencies having "blue sky" jurisdiction over the issuance of securities of the Company including all permits, qualifications and substantive correspondence in respect thereof, if any, and consider legacy currency/euro adjustments.
14.4 Review correspondence with, reports of or to, filings with or other material information with respect to any other (federal, state or foreign) regulatory bodies that regulate a material portion of the Company or its business (for example, the Federal Trade Commission, FDA, OSHA, the Department of Justice, the Internal Revenue Service, etc.) and consider any necessary euro adjustments.
14.5 Review material government permits, licenses, approvals, grants, etc. of the Company and consider any indicated euro adjustments.
14.6 Review documentation with respect to safety and other compliance issues (including any correspondence with regulatory authorities) and consider any indicated euro adjustments.
- description of special health and safety matters
- inspections (federal, state, local and foreign)
- compliance orders
15. SEC DISCLOSURE ISSUES
15.1 On July 22, 1998 the SEC's Divisions of Corporation Finance, Market Regulation and Investment Management (the "Divisions") published Staff Legal Bulletin No. 6 (CF/MR/IM)(the "Bulletin") to remind public issuers, broker-dealers, investment advisers and investment companies to consider their euro disclosure obligations.
15.2 In addition, broker-dealers and other regulated entities 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.
15.3 Contact Persons at the SEC are 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.
An issuer should evaluate its disclosure obligations to investors and potential investors on an on-going basis during:
- 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.
Companies 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).
15.4 Companies 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. The Bulletin reminds issuers that, in addition to these specific obligations, SEC rules require filed documents to include any additional material information necessary to make the required disclosure not misleading and 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. 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 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.
15.5 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"). The MD&A is required to discuss liquidity, capital resources, and other information necessary to understand financial condition, changes in financial condition, and results of operations (Item 303 of Regulations S-K and S-B, and Item 9 of Form 20-F). 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. (In Securities Act Release No. 6835 (May 18, 1989), the SEC 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).
As described below, the euro conversion raises strategic as well as operational issues. As a result, an issuer should include in MD&A disclosure concerning known trends and uncertainties related to the euro conversion that meet the 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. 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. (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). Both quantitative and qualitative disclosure about market risks are required. This information must be provided in one place other than the financial statements, and may be set forth in MD&A.
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. 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, and euro-related litigation could fall within this category.
e. Material Contracts. An issuer must file as an exhibit certain contracts that are considered material to its business. These include contracts upon which the business is substantially dependent, such as contracts with principal customers and principal suppliers.
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. 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.
15.6 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. In considering whether to file a Form 8-K, the SEC Staff believes that 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.
15.7 Specific Disclosure Considerations. The Bulletin states that 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.
15.7(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 (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.
15.7(2). Information Technology and Other Systems. The Bulletin reminds issuers 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 the 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 Factors 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.
The Bulletin states that an affected issuer should disclose:
- the issuer's state of readiness;
- remediation measures that have been proposed or implemented; and
- the issuer's contingency plans.
15.7(3). Currency Risk. The Bulletin notes that 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 has eliminated the legacy currencies.
The functional currency 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 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.
15.7(4). Derivatives and Other Financial Instruments 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.
As a result of the euro conversion, the terms of certain derivatives and other financial instruments 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 converted into euro;
- Foreign exchange options with a legacy currency on one side may need to be redenominated in, or translated to euro;
- 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 Pibor) 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 conventions and settlement conventions 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.
The Bulletin states that 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.
15.7(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."
As discussed in detail in the Carter, Ledyard Memorandum for Clients and Friends, the EU 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. Legislation providing for similar results has been adopted in New York and several other states. ISDA has published an EMU 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.
15.7(6). Taxation. Status of the euro conversion under U.S. tax law was largely settled July 28, 1998 with the publication of IRS Temp. Reg. Section 1.985-8T. Conversion to the euro will not be a U.S.-taxable event under Code Section 1001, and no IRS consent is needed for the change in functional currency resulting from the conversion for a qualified business unit under Code Section 985. However, there are aspects of the euro conversion which could lead to taxable events, such as an unscheduled fractional principal payment on a debt instrument in order to facilitate a rounding convention. The regulations do not address issues not unique to the euro conversion, such as the deductibility of the actual costs of conversion, and practitioners are still looking for guidance in this area and others. The IRS expects to publish guidance on the issue soon, but apparently will not issue specific guidance on items not unique to euro conversion.
15.7(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.
15.8 Investment Adviser and Investment Company Disclosure
According to the Bulletin, 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." 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.
15.9 Implementation of Systems Changes by Broker-Dealers and Other Regulated Entities
According to the Bulletin, 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, the Bulletin reminds broker-dealers 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. This is consistent with the SEC'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 counter parties regarding the effect the euro conversion may have on their operations and the status of their efforts to deal with the conversion.
16. MAINTAIN CONSTANT COMMUNICATION WITH CUSTOMERS, SUPPLIERS AND EMPLOYEES.
17. CONDUCT CONSTANT ONGOING ANALYSIS OF THE APPROACH OF CUSTOMERS, SUPPLIERS, AND THE COMPETITION TO THE EURO ISSUES AND THE EFFECT ON THE COMPANY'S COMPETITIVE POSITION.
Questions regarding this advisory or "euro audits" may be directed to Robert A. McTamaney (firstname.lastname@example.org) of our New York Office
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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