What Constitutes a Material Contract?

The Securities and Exchange Commission's new Form 8-K rules, which became effective on August 23, 2004 (available at http://sec.gov/about/forms/form8-k.pdf), require that a Current Report on Form 8-K be filed within four business days after the entry into (or termination of) a material definitive contract which is not made in the ordinary course of business. See our Securities Update entitled "SEC Revises Form 8-K," dated April 5, 2004 (available at http://www.mayerbrownrowe.com/publications/article.asp?id=1323&nid=6), for a more comprehensive discussion of the complete changes required by the new Form 8-K rules. Because the time frame in which to report a material definitive agreement is now so short, it is important that the appropriate persons throughout a reporting company understand in advance what potentially constitutes a material contract so that they know to alert the persons responsible for public disclosure. Greater sensitivity within the organization as to the securities law parameters of contractual materiality will enhance a company's ability to comply with the new reporting requirements on a timely basis and help ensure the effectiveness of the company's disclosure controls and procedures as required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended.

Item 1.01 of Form 8-K requires the disclosure of the entry into or amendment of any material definitive agreement not made in the ordinary course of a company's business in which the company is a party or has a beneficial interest and which is to be performed at or following the date of disclosure. Material contracts may be contracts entered into by the public company or by a subsidiary. Item 1.01 defines a material definitive agreement as an agreement that provides for obligations enforceable against the company or rights enforceable by the company that are material, even if subject to conditions. It is important to recognize that the SEC's concept of "material contract" has not changed as a result of the new Form 8-K rules. If Item 601 of Regulation S-K requires a contract to be filed as an exhibit to periodic reports or registration statements as a material contract, the entry into (or termination of) that contract will trigger a Form 8-K filing obligation.

The instructions to Item 1.01 of Form 8-K reference Item 601 of Regulation S-K to identify contracts that are deemed not to be made in the ordinary course of business and that must be reported "unless immaterial in amount or significance," even if they are otherwise of the type that ordinarily accompanies the company's business. Item 601(b)(10)(ii)(A)-(D) of Regulation S-K specify four such situations:

• A contract with directors, officers, promoters, voting trustees, 5% or greater stockholders, or underwriters must be reported, unless it involves only the purchase or sale of current assets, having a determinable market price, where such assets are sold at such market price.

• If a reporting company's business is substantially dependent upon a contract, that contract will be considered material and must be reported. This would include any contract pursuant to which the reporting company sells the major part of its products or services or purchases the major part of its requirements of goods, services or raw materials. Similarly, reporting companies must report any franchise or license agreement involving a patent, formula, trade secret, process or trade name upon which the reporting company's business is dependent to a material extent.

• A contract for the acquisition or sale of any property, plant or equipment is a material contract if the consideration for the contract represents more than 15% of the reporting company's fixed assets on a consolidated basis as of the end of the most recent fiscal period.

• Any material lease relating to a property that is sufficiently important to be described in the company's Form 10-K or registration statement must be reported.

• The instructions to Item 1.01 of Form 8-K also reference Item 601(b)(10)(iii) of Regulation S-K to establish reporting requirements for contracts relating to employee benefit matters. For example, all management contracts and compensatory plans, contracts or arrangements that involve directors or the executive officers whose compensation is disclosed in the summary compensation table of the proxy statement are deemed material and must be reported. Contracts, compensatory plans and arrangements with any other executive officers, must also be reported unless they are immaterial in amount or significance.

• If a management contract or compensatory plan, contract or arrangement involves the issuance of equity to any employee, including options, warrants or rights, it will constitute a material contract if it was adopted without security holder approval unless it is immaterial in amount or significance.

• The following categories of management contracts or compensatory plans, contracts or arrangements do not have to be reported on a Form 8-K or filed as an exhibit to a periodic report or registration statement:

• ordinary purchase and sales agency agreements;

• agreements with managers of chain stores;

• contracts for labor, salespersons' bonuses or payments to a class of security holders in their capacity as security holders;

• broad-based plans, contracts or arrangements that by their terms are available to employees, officers or directors generally and that provide the same method for allocation of benefits to management and non-management participants;

• compensatory plans, contracts or arrangements of foreign private issuers that are permitted to furnish compensatory information on an aggregate basis; and

• compensatory plans, contracts or arrangements of companies that are wholly-owned subsidiaries registered under Section 12 or filing reports pursuant to Section 15(d) of the Securities Exchange Act of 1934, as amended.

As noted above, Item 601(b)(10) of Regulation S-K, referenced in the Form 8-K instructions, treats contracts for asset sales as material contracts if the consideration exceeds 15% of the fixed assets of the company on a consolidated basis. This is the only numeric test specifically referenced in the Form 8-K rules addressing the reporting of material contracts. However, there are other measures that may be relevant for materiality determinations. For example, Item 601(b)(4) of Regulation S-K, governing the filing as exhibits of instruments defining the rights of securities holders, permits the exclusion of any instrument with respect to long-term debt not being registered if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the company. Item 404(b) of Regulation S-K requires disclosure of specified related party transactions that exceed 5% of consolidated gross revenues of either party (although other related party transactions may be subject to disclosure under Item 404(a) of Regulation S-K if they exceed $60,000). In the requirements for the narrative description of business, Item 101 of Regulation S-K requires disclosure of products or services which account for 10% or more of consolidated revenue (or 15% or more of consolidated revenue, if total annual revenue does not exceed $50,000,000). Similarly, customers must be identified if they represent aggregate sales of 10% or more of the company's consolidated revenues and the loss of such customer would have a material adverse effect on the company and its subsidiaries taken as a whole. Item 103 of Regulation S-K requires disclosure of claims for damages only if they exceed 10% of the current assets of the company and its subsidiaries on a consolidated basis.

With the exception of the 15% of fixed assets test contained in Item 601(b)(10) of Regulation S-K with respect to asset transactions, exceeding any of these thresholds set forth in SEC regulations in other contexts will not necessarily mean a contract is material. However, these comparative measures may support the conclusion that a contract is not material where the amount under consideration falls below these levels. While these measures provide a useful backdrop to an analysis for what constitutes a material contract, it will be necessary for each reporting company to consider the particular circumstances applicable to it when determining whether a contract is material to it. This, by its nature, will be a fact-intensive inquiry and must take into account factors that may not be strictly numerical in nature.

The new Form 8-K rules also require a report of a material amendment to a material definitive agreement. Reporting of a material amendment may be required even if the underlying agreement has not been reported on Form 8-K. For example, the amendment itself may make the agreement material, or the underlying agreement may have been entered into before August 23, 2004, the effective date of the new Form 8-K rules.

• Many types of agreements have the potential to be characterized as material definitive agreements. Business combination agreements, agreements relating to the acquisition or disposition of substantial assets and agreements implementing extraordinary corporate actions are examples of the types of agreements that are likely to give rise to reporting obligations under the new Form 8-K rules. With respect to other types of agreements, fact-intensive analysis may be required to address whether an agreement outside the ordinary course of business is material or whether a reporting company is substantially dependent on a contract, regardless of whether it is otherwise of the type that ordinarily accompanies the company's business. Given the tight time frame for filing a Form 8-K and the lack of an objective materiality threshold in the rule, it would be useful for companies to identify in advance standards for contracts that should generally be reviewed to determine whether they are material for that company. For example, a company's officer contract authorization levels may serve as a helpful guideline to establishing such criteria. However, it is important to recognize that qualitative considerations specific to the impact of a particular agreement on the reporting company are also important to the materiality analysis. Any guidelines a company develops should be circulated throughout the organization, especially to persons involved in the negotiation of contracts.

• Companies should include designated members of their legal and accounting departments who are responsible for preparing SEC filings as individuals who should be involved in the approval process for potentially material contracts so that those individuals will be in a position to generate, or respond to, inquiries about the Form 8-K contract reporting obligations. Ideally, at least one of the individuals notified should be on the disclosure committee. It is best to designate multiple individuals, each with appropriate experience and training, at the company to address Form 8-K issues arising from material contracts to reduce the risk of someone not being available to respond in sufficient time for timely compliance. Moreover, to ensure a consistent, informed response to any analyst or investor questions following the Form 8-K filing, investor relations personnel should be briefed on the subject matter and the timing of the filing.

• The disclosure committee, or some subset of that committee, should be brought up-to-speed on the new Form 8-K requirements, especially as these new rules impact on material contracts. Since there may not be time to convene a meeting of the full disclosure committee before the Form 8-K is due, a subset of the disclosure committee should be given the authority to file Form 8-K reports.

• Companies should consider providing instruction to those employees of the organization most likely to be directly involved in the negotiation of contracts that have the potential to be material so that they are aware of the new requirements and the need to report appropriate activity to a member of the disclosure committee. These individuals should be told to be overly inclusive in identifying contracts to the persons with disclosure responsibility. This training should encompass individuals who work in different areas of the company, such as human resources, legal, finance, accounting and treasury. Employees with contracting authority over a specified dollar level should be included.

• An agreement may be "definitive" for the purposes of this rule, even if it is not definite that the underlying transactions provided for in such agreement will occur. That is, a definitive agreement may be subject to significant closing conditions. Nevertheless, if the agreement is material it must be timely reported on a Form 8-K, even though the obligations may be contingent on conditions that may be outside the reporting company's control.

• Because the entry into material definitive agreements must be reported, even if conditional, when negotiating and documenting sensitive agreements, consideration should be given to the relationship between the time when the agreement is entered into and the types of conditions to which the agreement may be subject. For example, to avoid triggering a disclosure obligation at a stage that may be undesirable to the company, parties to contracts may find it desirable to limit conditions subsequent, such as board approval, by satisfying the subject matter of these conditions in advance of signing rather than making the contract contingent. Similarly, parties may prefer to complete all due diligence rather than making a contract subject to a due diligence closing condition in order to avoid a premature reporting obligation.

• Even a "nonbinding" letter of intent may be a material definitive agreement if some of its provisions are binding and such binding provisions are material to the company. However, if the binding provisions are not material, no Form 8-K disclosure would be required. In its adopting release for the new Form 8-K rules (SEC Release 33-8400, March 16, 2004, available at http://sec.gov/rules/final/33-8400.htm), the SEC indicated that confidentiality or no-shop provisions in a letter of intent ordinarily would not trigger a requirement to report an otherwise nonbinding letter of intent because those provisions are not material. On the other hand, if a letter of intent contains a material, binding provision, such as a significant break-up fee, disclosure may be required.

• Oral agreements, of course, can be binding. Accordingly, an agreement or an amendment does not necessarily have to be reduced to writing to be material. See, for instance, the provision of Item 601 (b)(10)(iii)(A) which requires the filing of a written description of any material compensatory plan, contract or arrangement that is not set forth in any formal agreement. Consideration should be given as to whether any oral agreement rises to the level of a material agreement or amendment to a material definitive agreement.

• If an agreement becomes material over the passage of time, without any formal amendment, there is no agreement to trigger the Form 8-K reporting requirement, but once the agreement has become material, it should be filed with the next Form 10-Q or Form 10-K.

• In addition to filing a Form 8-K to report entry into a material, definitive agreement, the new Form 8-K rules require disclosure of the termination of a material definitive agreement pursuant to Item 1.02. The Item 1.02 rules state that the expiration of a contract in accordance with its terms does not require a Form 8-K filing. An automatic renewal of an agreement pursuant to its terms, without any amended provisions, such as an agreement that is automatically renewed unless a termination notice is given a specified number of days prior to the expiration date, similarly should not be deemed to constitute the entry into a material definitive agreement. On the other hand, if a notice of termination is given with respect to an agreement that would otherwise renew automatically in accordance with its terms, a Form 8-K should be filed to report such termination.

• If a renewal of a material contract involves new terms, then an analysis should be performed to determine if the renewal constitutes a material amendment. (If a renewal involves entering into a new replacement agreement, even on substantially the same terms, other than a new expiration date, as the prior agreement, the renewal will be treated as the simultaneous entry and termination of contracts, which should be analyzed for materiality). Also, a renewal is a good time to assess whether an agreement that had previously not been material to the company has become material. If it has, it would be prudent to file a Form 8-K to report the renewed agreement rather than waiting until the next Form 10-Q or Form 10-K filing.

• Questions have arisen as to whether option or restricted stock awards granted to directors and executive officers require Form 8-K disclosure by virtue of being a management contract or compensatory plan, contract or arrangement. Based on informal advice from the staff of the SEC, the answer depends on whether the terms of the grant or award are substantially set forth in the plan itself, or the plan together with the form of an agreement that is on file with the SEC. Accordingly, reporting companies should verify that they have not only filed the plans pursuant to which these awards are made, but also have filed the ancillary documents, such as option agreements or restricted stock agreements for awards made under their plans, if such forms are necessary to understand, among other things, the terms of the awards, other than the identity of the recipient, the number of securities covered and the price. If these forms of agreement are necessary to understand the terms of the awards and are not already on file, reporting companies should file them as exhibits before their next awards to executive officers or directors. For many companies, it will be sufficient to file these exhibits with their next Form 10-Q or Form 10-K. If a key term found in such a form of agreement is materially modified in conjunction with an award, the amended or new form of agreement should be filed before awards are made to avoid a need for specific Form 8-K disclosure of the award (which in any event would merely duplicate information already in the marketplace as a result of a Section 16(a) filing, usually a Form 4.)

• An employment agreement with an executive officer included in the summary compensation table in the proxy statement is by definition considered material, while an employment agreement with a non-named executive officer must be analyzed to determine if it is immaterial in amount or significance. Clearly, entering into an employment agreement or a severance agreement with a named executive officer will trigger a Form 8-K filing requirement, as will a material amendment to an existing agreement with a named executive officer. However, the identity of the named executive officers may vary from year to year. Therefore, a question arises as to the need to report an agreement with an executive officer who was not named in the most recent proxy statement, but who may be so named in the upcoming proxy statement. If the person in question is a new chief executive officer, it would probably be necessary to report the terms of the agreement on a Form 8-K. In this circumstance, disclosure would also be required under Item 5.02, which requires disclosure of the appointment of new principal officers. A more common question may be reporting obligations with respect to an employment agreement with an existing officer who is likely to become one of the named executive officers in the next proxy statement. It seems appropriate not to file a Form 8-K to report the agreement if it is immaterial in amount and significance, although if it is quite likely that the contract will eventually have to be filed because the officer will be in the summary compensation table in the next proxy statement. The company may want to report or file it when it is first entered into even if not yet required.

• It may be necessary to determine if a payment to an executive officer is pursuant to a compensatory plan, contract or arrangement. If an employment agreement with a named executive officer is amended to provide for a salary increase, a Form 8-K should clearly be filed. However, if an executive officer receives an annual raise or a discretionary cash bonus, the circumstances will need to be analyzed to determine whether such action constitutes a reportable compensatory plan. It seems likely that discretionary compensation decisions made in the ordinary course of business, such as annual salary determinations and cash bonuses that are not part of a plan with established targets, would not be viewed as compensatory plans triggering Form 8-K reporting requirements. However, this point has not been settled. Hopefully there will be additional guidance from the SEC on this matter.

• Entering into a material definitive agreement may require a response to more than one item of revised Form 8-K. For example, if a material definitive agreement reportable under Item 1.01 involves the disposal of a long-lived asset for which material charges will be incurred, disclosure will also be required under Item 2.05. Similarly, a material definitive agreement may relate to a private placement of equity securities requiring disclosure under Item 3.02. Also, in the case of a replacement agreement, it may be necessary to report both the entry into a material definitive agreement pursuant to Item 1.01 and the contemporaneous termination of a prior agreement pursuant to Item 1.02. In circumstances in which Form 8-K disclosure is required pursuant to more than one item, the disclosure may be contained in one of the applicable items in a single Form 8-K that identifies, and responds to, all required disclosure items and includes a cross-reference to other applicable items.

• Be aware that entering into an agreement for an acquisition or disposition may trigger a Form 8-K reporting requirement even if it does not require the preparation of pro forma financial statements. Contracts relating to acquisitions or dispositions of property, plant or equipment are deemed material if the consideration represents more than 15% of the reporting company's consolidated fixed assets, while the pro forma financial rules contained in Article 11 of Regulation S-X use a number of 20% tests to determine whether an acquisition or disposition of assets is significant. Note that Item 2.01 of Form 8-K requires a report on Form 8-K following the completion of the acquisition or disposition of assets in which the net book value of the assets or the amount paid or received exceeded 10% of the total assets of the company.

• While material definitive agreements must be reported within four business days of the date of entry into the agreement, the actual agreements in most circumstances do not have to be filed until the Form 10-Q or Form 10-K for the period during which the contract was entered into is required to be filed. Despite the fact that the agreement is not required to be filed as an exhibit to the Form 8-K, it may be advantageous to do so where time permits so that the full agreement is available to amplify the summarized narrative disclosure.

• Because material contracts do not have to be filed as exhibits to the Form 8-K reporting the entry into the agreements, there is time to prepare confidentiality requests before the due date for filing the agreement. If a reporting company expects to file for confidential treatment, it must be careful not to undermine its request by disclosure contained in the narrative description of the agreement contained in the Form 8-K. Rather, the description itself could reference areas for which confidential treatment is being sought. Note that a confidential treatment request should not be overbroad. The request must contain an analysis of why confidential treatment is appropriate to prevent competitive harm to the company. It generally should not encompass a matter that is subject to a specific SEC disclosure requirement, information that is material to investors or information that already is publicly disclosed. See Division of Corporate Finance, Staff Legal Bulletin No. 1 (with Addendum), February 28, 1997 (Addendum included: July 11, 2001). The request must be filed by the date the next Form 10-Q or Form 10-K is filed (or the Form 8-K if the contract is being filed with the Form 8-K). The portions of the contract for which confidential treatment is requested must be redacted in the exhibit to the applicable report. If the confidentiality request is ultimately denied by the SEC, the applicable agreement will need to be refiled as an exhibit, including the formerly redacted portions of the agreement for which confidential treatment was not obtained.

• From a contract drafting perspective, careful review of the confidentiality provisions is necessary to ensure that the terms of the contract can be reported and that the contract may be filed as an exhibit as necessary to comply with applicable securities law requirements without breach of contract. Also, in light of the requirement to report the termination of a material agreement resulting from an event other than the expiration of the agreement in accordance with its terms or the completion of all obligations under the agreement, it is necessary to review the performance requirements and cure and termination mechanics to avoid a counterparty's issuance of a notice of termination prior to expiration of all applicable cure periods.

• A reporting company will not lose Form S-2 or Form S-3 eligibility as a result of a late filing of a Form 8-K reporting a material contract. However, all required Form 8-K reports must be filed before a company files a registration statement on Form S-2 or Form S-3.

• There is a safe harbor from Rule 10b-5 liability for failure to timely file a Form 8-K reporting a material contract. The safe harbor only applies to failure to file a Form 8-K. Material misstatements or omissions in a Form 8-K filing would still be subject to Rule 10b-5 liability. As part of the preparation of the Form 10-Q and Form 10-K, special emphasis should be placed on identifying any material contracts for which a Form 8-K was required, because the Rule 10b-5 safe harbor only applies if the missed disclosure was included in the next Form 10-Q or Form 10-K. 

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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