Thursday, July 2, 2009

Receptive NYC Audiences Ponder Closing the “Eight Corporate Liability Accounting Loopholes”

On June 16, the Investor Environmental Health Network (IEHN) issued a new report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close. The report describes how companies are encouraged, and arguably even required, by current accounting rules to keep hundreds of billions of dollars of impending liabilities off of their financial statements and out of securities filings. While the report examines case studies of asbestos and nanotechnology company disclosures, the findings apply to a wide array of impending and potential liabilities that companies should be disclosing and estimating in their financial statements.

The report, which I prepared under contract to the IEHN, provides practical recommendations for regulatory reforms that the Financial Accounting Standards Board and Securities and Exchange Commission can adopt in order to close these loopholes.

Field testing our ideas
During the week of June 22, I had the opportunity to test out the ideas in the report on audiences at two conferences in New York City. First, I attended and spoke at a meeting of a Working Group on Sustainability and Governance of the Conference Board. The Conference Board is a research organization which “creates and disseminates knowledge about management and the marketplace to help businesses strengthen their performance and better serve society.” Later in the week I spoke at a larger conference on Mainstreaming Environmental, Social and Governance Issues (ESG), cosponsored by Responsible Investor and the Social Investment Forum.

Contingent Liabilities and Sustainability in The Corporate Boardroom
The Conference Board working group meeting was an interesting and frank exchange of views among corporate board members and institutional and mainstream investors. We had an opportunity to hear some high-level corporate board members think out loud about the challenges of integrating sustainability to board decisions. The most important take-home lesson was that Board members are having a difficult time with this process of integration, in part because they don’t know how to define or measure sustainability when compared with concrete measurables such as Return on Investment.

Into that context, I injected the idea from our report that current contingent liability disclosure rules (FAS 5 and Fin 14) are substantial contributors to the shortfall of information on sustainability for board members. Even though there may be very large impending liabilities such as on environmental or social issues, the current rules encourage disclosure of the “known minimum,” and allow the legal privileging of information about the potential range of liabilities facing a company. Because privileges could be waived if lawyers' work products are shared with board members, the current rules leave board members in the dark about the magnitude of issues that are facing their own companies.

This dilemma has been especially well expressed by Greg Rogers, CPA, JD, the chair of the American Bar Association Committee on Environmental Financial Disclosure. Rogers has recently launched a new product that demonstrates how inconsistently companies accrue their liabilities based on the current rules. He points out that the current accounting rules leave companies with few good choices when it comes to producing and using realistic estimates of contingent liabilities; in the absence of effective rules creating a level playing field, companies that voluntarily provide better disclosure may suffer a competitive disadvantage in the investing marketplace. By sticking with the known minimum, Boards and managers are flying blind as to the real magnitude of liabilities facing companies. And if companies should choose to keep a second set of books for internal use indicating what the projected level of liabilities may be, they could be accused of accounting fraud.

I believe there was resonance among the participants at the Conference Board meeting with the core idea from our report that the existing, decades old contingent liability disclosure rules rely too heavily for disclosure on litigators, who are ethically bound to the opposite of disclosure, i.e., to secrecy and privilege. Our report proposes that when there are potentially material liabilities on which the range of potential losses has not been disclosed, the preparers of financial statements should be required by revised FASB and SEC rules to contract with independent consultants to develop nonprivileged, public estimates of the potential range of liabilities - numbers that would be usable by investors as well as board members.

Mainstreaming Environmental, Social and Governance Issues In Investment
At the second meeting, regarding mainstreaming ESG, various institutional investors and analysts presented their strategies for integrating data and analyses regarding environmental, social and governance issues in their investing strategies. Again, I found a responsive audience among investors, who are well aware that financial statements currently contain poor disclosure of many contingent liabilities, including both “bankruptcy booby-traps” and long-term product liability hazards that are not being disclosed by nanotechnology innovators and other companies.

For institutional investors looking to better integrate environmental and social risks and opportunities facing companies into their investment decision-making, the poor disclosure of contingent liabilities is an enormous stumbling block. In many instances the undisclosed contingent liabilities will eventually swamp the levels of value that are reported in the financial statements. Better disclosure and estimation of these contingent liabilities is a must for any investors that hope to integrate financially relevant data about environmental and social issues.

At the Responsible Investor conference numerous investors and analysts asked me to keep them informed as to how this issue is developing. I left both meetings with the sense that if given a fair hearing in the “marketplace of ideas,” the practical solutions offered in our report could prevail on their merits.

In the Meantime, Rule-making is Stalled
The Financial Accounting Standards Board was set to begin redeliberation of its 2008 exposure draft regarding (FAS 5) contingent liability reforms since the beginning of this year. However, given the many other issues of regulatory reform that are surfacing in this arena, and the controversy that the draft faced, it is not surprising that the Board has not yet taken action on redeliberation.

In a letter to the Financial Accounting Standards Board sent along with the report, I noted to Board Chairman Robert Herz and the Board members that:

  • “The members of the Investor Environmental Health Network recognize that the Board is under intensive pressure from the corporate defense bar and the Chamber of Commerce, among others, not to pursue your proposed actions to improve the contingent liability disclosure rules.

    However, our report demonstrates that the arguments advanced by the corporate community in opposition to your exposure draft are misdirected. It is not necessary to subject the companies we invest in to additional liability, nor require waiver of their legal privileges, in order to improve the quality and quantity of information available to investors on contingent liabilities. We believe our new report offers a way forward for the Board that will lead to a more balanced and effective disclosure framework for contingent liabilities.

    Walking the path between preserving the integrity of the litigation system and insuring the credibility of the financial statement is a mazelike task for the Financial Accounting Standards Board. It is not surprising that the 2008 exposure draft failed to accomplish this goal without hitting some sharp corners. We hope that our report will contribute to effective action on this issue by the Board.”
There will surely be opportunities in the weeks and months ahead for investors and other concerned stakeholders to advance these issues. Readers are urged to contact us at to stay informed on opportunities to help advance these issues. The issues raised in our report are certainly among those that regulators must address to restore the credibility of financial statements for investors.