Monday, September 15, 2008

A win-win solution for liability disclosure?

In August, the Financial Accounting Standards Board received an outpouring of comments for and against its proposals to expand liability disclosure requirements under its FAS 5 exposure draft. Long term investors, socially responsible investors and organizations managing, or representing beneficiaries of, trillions of dollars of marketplace investments submitted letters urging FASB to improve its 33 year old disclosure rules, which are sorely out of date given growing needs and demands for transparency and accountability.

However, many of the companies that would be required to comply with any new disclosure rules opposed FASB's for proposals strengthened disclosure. Many commenters argued that is too difficult to predict liabilities until lawsuits are either settled or judgment is rendered, and that disclosing worst case liabilities would unduly distort stock values downwardly. Some legal commenters asserted that requiring additional disclosure could undermine corporate positions in pending trials and settlement negotiations.

As a legal commenter in the investors' camp, I strongly believe that it could be possible for FASB to fashion rules that would better balance the underlying interests. One idea that could provide a win-win is our proposal to require narrative disclosure of long term, "remotely probable-severe impact" liability scenarios.

Readers may recall that the FASB draft proposed a new requirement for disclosure of "severe" impact financial loss scenarios, even if viewed as remotely probable by a company's management, but only if the underlying issue is expected to resolve in the near term, i.e. within a year.

My comments as counsel to the Investor Environmental Health Network urged that reporting entities must be required to disclose all loss contingencies that could have a severe impact even if viewed by the company as "remotely probable," and regardless of the timing of the resolution of the issue.

We proposed a compromise approach -- that for disclosures of remote, severe losses, at least those that may take more than a year to resolve, the disclosure duty could entail a narrative description of the severe impact contingency, without quantification.

I believe this could be a win-win solution because:

• Investors would be empowered by the disclosures to consider longer term issues, and gain the opportunity to inquire further where any potentially severe issues are flagged. It would make it possible for SRI investors to enhance their screens, by avoiding companies that are taking undesirable kinds of longer term "remote" risks.

• Reporting entities would not need to estimate the "remote" issues precisely but only provide a simpler "order of magnitude" characterization of the issues as "severe." They would have ample opportunity to minimize shareholder concern by explaining their judgment calls about the remoteness of risks, while still maintaining reasonable transparency. They would also face less risk of legal prejudice, because their characterization of issues as "remote" would shield against anyone reading too much into a disclosure for litigation purposes.

The history of subprime lending and the asbestos bankruptcies places one harsh lesson in bright light – reasonable investors must look closely at "severe impact" threats even if the management characterizes them as only "remote." Without an accounting rule to embody this lesson, the investing public is at the mercy of those whose judgment about the severe threats is skewed toward "improbability" and nondisclosure.

Read Investor Environmental Health Network comments to FASB