Share Owners Win Public Policy Victory at SEC! Financial and environmental risks to be allowed in Resolutions

Today shareholders scored a major victory at the Securities and Exchange Commission, winning a reversal of the Bush administration policy that had allowed companies to exclude shareholder resolutions requesting information on the financial risks associated with environmental, human rights and other social issues facing companies. In Staff Legal Bulletin 14E issued today, the Division of Corporation Finance announced that from this point forward shareholder resolutions will be evaluated based on whether they raise a major social policy issue, not whether they inquire as to financial risks associated with such issues.

The issuance of the bulletin at this time means that many shareholder resolutions, most of which are filed in November, can now expressly inquire into the issues of greatest concern and interest to investors, namely the financial risks associated with an array of issues, from climate change, to subprime lending, to other major social and environmental issues.

The bulletin also states:

In addition, we note that there is widespread recognition that the board's role in the oversight of a company's management of risk is a significant policy matter regarding the governance of the corporation. In light of this recognition, a proposal that focuses on the board's role in the oversight of a company's management of risk may transcend the day-to-day business matters of a company and raise policy issues so significant that it would be appropriate for a shareholder vote.

Shareowners will still need to surmount various hurdles under other the existing shareholder resolution rules, including the sometimes vexing problem of demonstrating to SEC staff that the issue being raised is a large enough social policy issue to surpass "ordinary business". Investors will also need to ensure that resolutions are drafted to surpass various other hurdles in SEC rule 14a-8, such as micromanagement, duplication, and substantial implementation.

The policy in question was adopted informally early in the Bush administration in a series of staff decisions which excluded shareholder resolutions on environmental and social issues based on the theory that they asked the company to "evaluate risk." The policy was later formalized in staff legal bulletin 14 C, Jun. 28, 2005. Today's bulletin is viewed by investors as an override of the limitations of 14C. The change came after a concerted effort by shareowners to reverse this staff policy. In December 2008, a group of 60 investing organizations wrote to then President-Elect Obama urging him to make a priority of reversing the impediment to shareholder resolutions seeking disclosure of financial risks.On September 22, 2009 a group of investor representatives met with the new director of the Division of Corporation Finance, Meredith Cross, and asserted that this staff ruling deserves priority attention for reversal.

In a meeting with the staff of the SEC Division of Corporation Finance on September 22, an array of shareholder representatives from institutional, pension and socially responsible funds expressed dissatisfaction with aspects of the current SEC process. The meeting was chaired by Meredith Cross, the newly instated Director of the Division of Corporation Finance.

In preparation for the meeting, the author collaborated with several investor organizations including the Social Investment Forum, the Interfaith Center on Corporate Responsibility and Shareowners.org to conduct an internet survey of 40 shareholders, most of whom identified themselves as frequent filers of shareholder resolutions. 80% of respondents said they found the no action letter process to be frustrating or extremely frustrating. Strikingly, 85% of the respondents disagreed with the statement "the staff no action letter process is transparent and accountable" and 81% of the respondents disagreed with the statement "the staff provides sufficient information and justifications for individual decisions."

Principal among the shareowner objections to the current process was Staff Legal Bulletin 14C issued by the SEC staff during the Bush Administration declaring that the SEC would allow companies to exclude shareholder resolutions that ask companies to disclose financial risks associated with environmental issues. The same so-called risk evaluation exclusion has since then also been applied to human rights, public health, climate, and even subprime lending issues.

Most of the 15 or so investor representatives who participated in the September 22 meeting with SEC staff criticized this so-called risk evaluation exclusion. We referred to the letter from 60 investors sent December 11, 2008 to then President-elect Obama, hoping for change in this area. That letter noted:

The adoption of this new bar on resolutions requesting “risk evaluation” represented a significant departure -- disregarding the reasonable and principled approach that had governed at the SEC for decades, and replacing it with a radical interpretation of the rules. The result has been to limit shareholder resolutions to questions about the impact that companies are having on society in general, excluding vital questions about the impact that any of these issues may have on the company’s future finances. Institutional investors, especially those that hold long-term stakes in the marketplace, have expressed interest in being able to monitor the financial impacts that various issues pose on their portfolio holdings.

Notably, 90% of the respondents to the shareowner survey stated that they had been forced by staff rulings to write resolutions to avoid asking for disclosure of particular financial risks that they were concerned about. This is a vexing matter of censorship of investor inquiry for an agency that has been accused of botching its handling of Bernie Madoff and other recent disasters.

Contacts for media comment:
Sanford Lewis, Investor Environmental Health Network 413 549-7333
Jonas Kron, Trillium Asset Management 503-592-0864
Adam Kanzer, Domini Social Investments 212-217-1027
Tim Smith, Walden Asset Management 617-695-5177

Step Right Up! Part 3: Will SEC and FASB regulators leave improved liability accounting to the courts?

In the first two segments of this three part series, we examined the article by C. Gregory Rogers, Attorney and CPA, describing the "flexibility" of existing environmental accounting rules, which grant enormous latitude to companies on whether and how to investigate, estimate and disclose many environmental liabilities. We then assessed whether the broad legal duties of directors and officers for fiduciary oversight and fraud avoidance may require some companies to estimate and disclose more. Our conclusion was that in certain circumstances those duties apply, but that the practices engendered by existing accounting rules make it unlikely that most companies will generally do the work needed to satisfy information needs of investors. Honest accounting still appears to be largely voluntary. Today, the final installment.

Endless litigation or workable accounting standards?
Based on the elements of future lawsuits set forth in the Rogers paper prepared for the American Bar Association, we can expect litigation in this area for many years to come. As some companies, boards and CEOs become targets of shareholder suits asserting poor disclosure, a tally of Board and CEO liability losses may ultimately yield fiduciary vigilance and better accounting. This process may take decades to work itself through -- decades of investor injury and recourse.

The system is also not optimal from the standpoint of managing corporations. It creates a decisionmaking environment of extreme uncertainty. Company executives and boards will face an ongoing Catch-22, having to choose between the flexibility that accounting rules allow and the risks of liability for poor oversight and disclosure. This is a distinct contrast from a situation in which the rules are clearly written and a company's officers and auditors can know with certainty whether systems and disclosures are in compliance.

In short, the current system is not preventive, not protective of investor interests in information on value, complicates corporate decisionmaking, and in the end, is possibly only good for coffers of the legal profession.

Shouldn't we ask, in this time of financial regulatory reform, whether there are fixes available for the Securities and Exchange Commission and the Financial Accounting Standards Board to adopt now to bring about orderly, broad compliance sooner, at less cost?

The Financial Accounting Standards Board actually proposed changes pointing in such a direction in 2008, when it published an exposure draft for revisions of the standards for contingent liability disclosures. This draft generated a great deal of opposition from the corporate and defense bars, with aggressive assertions that the proposal would require companies to disclose prejudicial information that could undermine companies' position in pending or future litigation. The corporate defense bar asserted, in essence, that the proposed FASB revisions would upset the delicate arrangement of the existing accounting rules, in which the goal of providing accurate disclosures of contingent liabilities for investors was balanced against the notion that investors do not want their companies to suffer additional litigation losses as a result of such disclosures.

In practice, the existing system has not proven very workable from the standpoint of investors, but has instead ensured enormous gaps in disclosure and estimation of liabilities. In many instances, such as asbestos cases and some environmental remedial liabilities, the amount of undisclosed liabilities have even surpassed everything else on the corporate ledger. In a time when restoring investor confidence in corporate disclosures is a priority, this is an issue that remains to be cleaned up.

Opposition to all "prediction" is inconsistent with judicial principles: "Prejudicial" concerns must be balanced against their "probative" potential
The position taken by the defense bar in opposition to the FASB proposal was not terribly nuanced. A plethora of lawyers essentially asserted that any requirements for new predictive disclosures would be prejudicial and should not be required by the FASB.

This is strikingly different approach from the principled approach taken to "prejudicial" information in the courts, where a balancing test is used to weigh how prejudicial and how useful information will be. Under federal and state rules, evidence which might be considered prejudicial will nevertheless be found to be admissible in evidence if it is "more probative than prejudicial."

A similar balancing test should be applied by accounting and securities rulemakers in considering the types of required disclosures to support the needs of investors.

At one extreme would be rules that would require disclosure of privileged information, such as disclosure of a lawyer's advice to his or her client. Requiring lawyer or client to waive attorney-client privilege is an extreme encroachment on that relationship. Arguably, this ought to be off-limits unless such a privilege is being abused by lawyer or client.

In contrast, there is an array of possible information which arguably might yield information for which the probative value for investors outweighs any concerns about prejudice. Existing accounting and investor disclosure rules already strike such a balance in some instances; the question is whether regulators will extend the logic to current needs and shortcomings of existing rules.

Below we will give examples of such information, first, in the realm of "narrative" disclosures, as found in the Management Discussion and Analysis, and second, in liability estimates as required under existing and proposed financial accounting standards.

The Management Discussion and Analysis: Potentially prejudicial, but required for its probative importance to investors
Already, existing Securities and Exchange Commission regulations require the management of a company to discuss and analyze pending issues that may affect the company's financial prospects. Regulation S-K item 303 requires disclosure of known trends or any known demands, commitments, events or uncertainties that are reasonably likely to affect liquidity, capital resources or results of operations. The SEC has also interpreted this to mean that if there is a reasonable likelihood but some uncertainty about the probabilities regarding such trends, demands, commitments, events or uncertainties, a reporting firm should err on the side of disclosure.

If one were to apply the logic of "prejudicial" concerns expressed by the defense bar even to the existing Management Discussion and Analysis regulation, we could easily see arguments being made that some of the information included in such an analysis could be used by plaintiffs suing the company over particular issues discussed in the MD&A. Indeed, these analyses are certainly referenced from time to time as evidence in lawsuits. But despite the potential for use of this information by plaintiffs, the judgment of regulators has been that this information is sufficiently "probative" (i.e., "useful") to investors, that it should be required to be disclosed regardless of the potential uses to plaintiffs.

Clarifying the Management Discussion and Analysis
A group of investors recently asserted that the information contained in the Management Discussion and Analysis should be updated with an interpretive guidance that ensures that relevant environmental and social information is integrated. In July 2009, a group of 80 funds, coordinated by the Social Investment Forum, wrote to the Securities and Exchange Commission recommending the issuance of an interpretive guidance clarifying that issuers must disclose short and long-term sustainability risks as part of the MD&A.

The concern of the investors is that even though the existing MD&A requirements arguably include such information as among the "trends, events and uncertainties", in practice they are not well disclosed and discussed by many reporting companies, especially if they are emerging concerns (e.g., public-health risks of nanomaterials). Clearer guidance regarding the materiality of such trends is needed to ensure proper disclosure.

To be sure, the types of disclosures that these investors seek are also among those issues with respect to which companies will sometimes become defendants, such as "any significant developments at a company that might negatively affect public health or the environment, involve ethical lapses or labor human rights abuses, be harmful to the company's brand or reputation, result in legal liabilities are otherwise detract from shareholder value."

The investors have framed their interpretive request in a manner that emphasizes the probative nature of the information needed from companies. The letter goes on to state some criteria that could require companies to disclose more, regardless of the management's predilections to conceal. These include:

* Discuss the relevant trends or developments such as trends or significant developments in scientific studies that may relate to public health or environmental risks associated with products or activities. The disclosure of these significant developments should be required even if there is scientific debate or uncertainty, such as some studies finding a lack of such impacts.

* Describe the severity and scale of the problem, such as the percentage of the company's expected sales volume that a potentially problematic product comprises, the potential extent of workplace exposures where materials are used in the fabrication of goods, or overall potential human health effects and to the greatest extent possible qualitatively or quantitatively describe the magnitude of potential liabilities or opportunities associated with the issue.

* Review measures being taken to minimize adverse impacts or maximize business opportunities associated with the issue. Examples could include consumer education, research, materials modification or substitution, development of new products or services, exposure reduction, public policy efforts, fieldwork, third-party auditing, adoption of new codes, insurance, employee training or other actions.

This is all information of great importance to many investors because it can allow them to assess risks, value and prospects, and ultimately to decide whether a stock belongs in their portfolio. Each of these items is reasonably objective; rather than requiring "admissions" of liability, they seek disclosure of facts that are germane to understanding the magnitude of financial risks associated with the conditions in which the company is functioning. None of these disclosure items requires the company to tip its hand with regard to trade secrets, privileged information, or internal business strategy. Instead, information that is owing to investors can be expressed at a level of generality that allows the company to both inform the investors of the relevant issues while avoiding disclosure of confidentialities. In short, it is more probative than prejudicial.

In our report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close, we essentially applied the criteria of the proposed MD&A interpretive guidance to emerging health and financial risks associated with nanomaterials, and demonstrated how such a set of disclosure requirements would lead to more robust disclosures than are currently provided by nano producers.

Doing the Numbers, Beyond the Known Minimum
While the above example relates principally to narrative disclosures, our second example relates to development and disclosure of quantitative estimates that would nevertheless be more probative than prejudicial, and therefore merit mandatory disclosure rules.

The existing guidance from the Financial Accounting Standards Board (FASB Interpretation 14) requires companies to estimate the range of their potential liabilities associated with a claim, but if no single amount within that range is considered more probable than any other amount within the range, it instructs them to record the low end of the range ( the "known minimum)." This is a widely used and abused practice, which results in companies commonly disclosing only the lowest possible projection of liability - often orders of magnitude lower than the eventual end liability. In Bridging the Credibility Gap, we depicted how Johns- Manville and Kaiser Aluminum delayed a realistic estimate until the moment they declared bankruptcy, and shareholders lost billions.

In its exposure draft for revision of contingent liability reporting requirements, the FASB has proposed requiring companies to disclose either a worst-case liability range, or if the company prefers, a probability weighted estimate of the liabilities. This is one of the issues that the defense bar vigorously objected to. However, it is worth breaking down the different elements of such a proposed disclosure requirement, because not all options and elements are equally "prejudicial."

The most prejudicial aspect of the proposal is the prospect (optional under the FASB proposal) of disclosing a probability-based estimate of the total amount of liability. The likelihood of success in litigation is best known by the attorney handling the case. This would take strategic information - from the mind of an attorney representing the company in litigation, and highly relevant to negotiations -- and could require that it be placed on the record. Such a requirement for disclosure of an attorney's mental impressions could indeed violate the fundamental integrity of the judicial system.

In contrast, information on the range of potential liabilities, severed from the question of the likelihood of specific outcomes, can in many instances be disclosed in a manner that is less prejudicial.

For example, one possible scenario for a company to identify and disclose the range of possible liabilities may be derived by benchmarking the number of cases pending at a company against similar suits that have been resolved at other companies. This allows a prediction of the possible range of liabilities, and is not prejudicial because it is based on a simple application of mathematics to publicly available information. Dow Chemical performed such an analysis to disclose a previously unestimated $2.2 billion asbestos liability at Union Carbide, a company it had acquired a few years earlier; many other companies can and should have offered similar information to investors to fairly inform them regarding pending liabilities. But in the absence of rules requiring it, many hold back and resort to the "known minimum." Requiring such disclosures and projections would clearly be more probative than prejudicial.

Another scenario would involve calculation of the range of liabilities through the use of external consultants, who produce their estimates using public information and without access to any privileged information. Such estimates can build upon benchmarks and other publicly available information. Again, even though plaintiffs might point to such figures, the probative value of such data to investors (and the potential to avoid costly duplicative consulting work of this kind across the investing economy) would exceed any prejudicial impacts.


Conclusion
While fixes are being applied in some areas of financial regulation, the Rogers article documented well that when it comes to accounting and disclosure of environmental liabilities, the system is still fundamentally flawed. Waiting for a flood of lawsuits to punish directors and officers into doing the right thing is not a preventive solution; it does not solve the problem of hidden liability risk that faces today's investors; it only offers the prospect that conflicting signals and costly litigation may improve corporate disclosures over the course of decades.

By contrast, the opportunity exists today for the regulators at the Securities and Exchange Commission and the Financial Accounting Standards Board to apply the reforming spirit to this policy area, protecting investors now.

Update
Following up on this blog post, I wrote to the FASB Board members on October 22, 2009 on behalf of the Investor Environmental Health Network. Contingent liability predictions should be "more probative than prejudicial"; they should not avoid prediction entirely. http://tr.im/CEAy



References and Links

Part 1 of the Series

Part 2 of the Series

Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes that Regulators Must Close, Investor Environmental Health Network

C. Gregory Rogers paper on Corporate Environmental Disclosure Policy

July 2009 Letter on Sustainability Disclosure to SEC from 80 Investor Groups

FASB Exposure Draft on Loss Contingencies

FASB Loss Contingencies updates page

Step Right Up! Part 2: Will emerging duties of directors and officers lead to honest environmental accounting?

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Part one of this series examined the paper by Attorney C. Gregory Rogers which describes the "flexibility" of existing environmental accounting rules that allows companies to avoid investigation, liability estimation and disclosure. Rogers has written that in light of the amount of flexibility offered by current accounting rules, "a don't ask don't tell policy seems reasonably defensible, if not obligatory." Today, we address the reasons why Rogers nevertheless asserts that some companies must assess and disclose additional liabilities. This, he says, has to do with "advances in environmental risk transfer, accounting principles and financial analysis."

Distilling Rogers’ arguments, there are essentially two reasons why he asserts that companies might have to do more estimation and disclosure than the “flexible” minimum. First, there are certain circumstances in which accounting regulations are becoming less flexible. Second, broad principles of common law and statutory law require companies and directors to engage in oversight, estimation and disclosure of liabilities where necessary for effective business management or to ensure that disclosures are not misleading.

Standards call for more specific disclosures, but lax enforcement environment leaves some rules a paper tiger
On the first point, Rogers identifies some instances in which the accounting rules are becoming less flexible. “Fair value” measurement of liabilities, rather than disclosure of the “known minimum,” is applicable in some instances where companies are subject to international accounting rules (IFRS) and also to US companies for environmental liabilities associated with the retirement of tangible long-lived assets (property, plant and equipment), FAS 143 (Asset Retirement Obligations). For certain US sites where remediation will be part of the expected closure process, the company must go beyond the “known minimum” to identify how the market might value the cleanup cost. So far, this is hard to disagree with.

Rogers also notes another disclosure requirement contained in SEC rules, which he says is widely violated, a requirement to:

disclose annual environmental remediation expenditures (as required by SAB 92) or annual accruals for environmental remediation liabilities (as encouraged by SOP 96-1).

On this requirement, it is apparent that if the SEC is not taking enforcement action, nobody feels compelled to comply. The exception under the rule is where those annual accruals are not seen by management to be material. This seems to be sufficient to preclude widespread enforcement of the requirement by the SEC, which likely assumes that if companies are not reporting those accruals annually then they must not be viewed as material.

I would add here that there are other environmental financial disclosure obligations that are known to be widely violated even though detection of the violations is far easier. Regulation S-K, Item 103, requires SEC registrants to disclose material pending administrative or judicial legal proceedings known to be contemplated by governmental authorities, and on environmental matters should include any which are likely to result in monetary sanctions of $100,000 or more. In 1998, the United States Environmental Protection Agency’s Office of Enforcement and Compliance Assurance conducted a study which determined 74 percent of corporations failed to report such proceedings. Ten years later in 2008, a fresh study conducted at the University of Arkansas found the noncompliance rate to be 72%. The researcher concluded that the compliance rate did not improve over the intervening decade because enforcement of the rule by the Securities and Exchange Commission remained lax. The researcher also found that when companies disclosed their environmental enforcement proceedings, there was on average a 1% drop in stock price. This 1% “punishment by the marketplace” occurred because these companies strictly followed legal disclosure guidelines. One can extrapolate that this means stock prices may be at least 1% inflated on the other 70+% of the noncompliant companies. A lack of enforcement means a lack of effective motivators for compliance contrasted with potential market punishment of those who comply.

In short, in the absence of enforcement action by the Securities and Exchange Commission to bring companies into compliance with these duties, there has been little improvement in compliance. Merely publicizing the existence of violations as was done in 1998, in the University of Arkansas study, and even in the Rogers paper, seems to do little to compel companies to comply. The market incentives for nondisclosure exceed the incentives of an a potential but seldom seen SEC enforcement action.


Common law and statutory duties of directors and officers call for better environmental accounting
Rogers also describes the growing specter of board member liability for failure to adequately manage and oversee their companies. Suits against directors for insufficient accounting oversight are possible as a result of Caremark International, Inc., a 1996 Delaware decision in a derivative suit involving a Board of Directors that was alleged to have failed to adequately oversee activities of employees that led to breaches of federal and state laws and regulations. Although in general, the very protective "business judgment" rule shields directors against liability for legal failures of the company, the court articulated a new rule that directors must satisfy their duty of care to be reasonably informed including "assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance."

Since, according to Rogers, many companies have unrecognized environmental liabilities that are material to the financial condition of the entity as a whole, and their don't ask don't tell policy means that they are "deliberately flying blind", the boards may be subject to liabilities for failure to establish sufficient mechanisms for ensuring that the company has information in place to monitor and manage its own liabilities.

Rogers also references the section 302 requirements of the Sarbanes-Oxley Act for the CEO or CFO of a company to certify that the financial statement "fairly presents" the company’s financial condition, regardless of whether the financial statement is technically in compliance with generally accepted accounting principles. So when a company reports only the "known minimum” of its liabilities even though there may be some information to suggest that impending liabilities might overwhelm currently reported value, the question of “fair presentation” may be implicated.

As evidence that the pieces could fall into place to expose directors to liability, Rogers highlights the recent case of Tronox Inc., an Oklahoma City chemical company spun off from Kerr-McGee in 2005. Tronox filed for Chapter 11 bankruptcy protection in January 2009. The company’s Form 8-K filed May 4, 2009 stated:

[T]he Company’s [financial statements filed with the SEC] should no longer be relied upon because the Company failed to establish adequate reserves as required by applicable accounting pronouncements. … The amount of any increase to its reserves that may need to be taken is not known at this time. However, the adjustments will be material.

Rogers says:

A financial analysis of Tronox’s environmental loss reserves shows that the company had material unrecognized environmental liabilities … at every point up to its bankruptcy filing in January 2009. Yet, Tronox’s directors authorized a public offering of securities and its CEO and CFO certified the fairness of the corporation’s financial statements and the adequacy of its internal control over financial reporting. These circumstances indicate that Tronox’s directors and senior management lacked the information and reporting systems needed to make informed judgments concerning the corporation’s compliance with accounting standards and securities laws.

He acknowledges that Tronox is an extreme example. But he says his research shows that many other publicly-traded U.S. corporations have unrecognized environmental liabilities that are material to the financial condition of the entity as a whole and that might therefore raise issues of fair presentation by the CEO and CFO and Board oversight of liabilities.


Director and officer duties are counterbalanced by entrenched practices, poor standards, lack of enforcement
Rogers, whose practice focuses on Boards of Directors, has done his best to persuade his clients to do the right thing. But in my opinion, the balance of incentives still leans heavily toward companies disclosing very little. In order to see why, let's explore some typical nondisclosure scenarios.

In one typical scenario, a company has a lawsuit pending against it, or perhaps a series of lawsuits, and consistent with the accounting rules (FAS 5 and FIN 47) it has concluded that in light of the uncertainties, no particular outcome of the potential liabilities is known to them to be more probable than the "known minimum". In such a context, their financial statement contains an accrual of the known minimum, and little else is disclosed beyond that. (An exception would be for remedial liabilities on the site of an operation, where the new retirement obligation rules would now require a “fair value” report of the liabilities.) The corporate oversight practices (investigation, estimation) associated with these minimally disclosed liabilities have been shaped by the regulations surrounding contigent liability disclosure -- basically, maintaining a sense of uncertainty is encouraged, because it allows the company to justify its minimal disclosures. This approach is nominally in compliance with the existing accounting rules, and sets the context for the management to argue in future enforcement actions, if they happen, that it had no reason to know that the financial statement doesn't fairly present the company’s financial condition.

The outcome would differ if the accounting rules were changed (as was proposed by the FASB in 2008) to generally require, even in the face of uncertainty, disclosure of the range of potential liabilities, rather than the known minimum. But without such a change, the incentive for "practiced uncertainty" is too great to be overcome by the possibility, which currently only looks hypothetical, that a court would find that the CEO, Board or company liable for failure to conduct extensive investigations and estimations beyond what is otherwise allowed under the accounting rules.

As board members ponder whether to allow the existing standards of accounting to drive their companies estimation and disclosure policies, or whether to go beyond those standards, the reality is that no board members have yet been held liable for failure to ensure that their companies disclose liabilities beyond the known minimum. It is all too easy for companies under the current rule to simply frame an issue as to "uncertain" or even in Greg Rogers' own terms to require a "crystal ball" to project where the issue may come out. The amount of uncertainty that is found to exist in order to justify reporting the known minimum, may be substantially greater than the amount of uncertainty that would exist with full investigation. But it is a convenience of the current accounting rules that is hard to get away from.

A second example relates to emerging risks facing a company that could portend future lawsuits, negative consumer reactions or restrictive regulations. One place for such disclosures should be in a company’s Management Discussion and Analysis (MD&A), a section of the Annual Report submitted to the SEC. In our report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close, we profiled the poor disclosure by nanotechnology producers of potentially hazardous properties of certain forms of carbon nanotubes. None of the incentives that Rogers has described would alter the calculus by companies that have chosen to call the health risks of carbon nanotubes "unknown," neglecting to even mention existing laboratory studies finding a correlation between certain carbon nanotubes and mesothelioma precursors. The language of the MD&A requirement grants flexibility to omit critical information through the widely encompassing loophole for regarding materiality and relevance of information to be determined “in the judgment of management.”

In fact, the new mandate to "fairly present" the company’s financial results under Sarbox Section 302 is not terribly different from the long-standing requirements to disclose more in order to make the information disclosed "not misleading" under the antifraud provisions of the Securities Acts, Rule 10(b)-5. Section 302 of Sarbox may put the CEO or CFO on the line, but the haze of uncertainty created and encouraged by the accounting rules may or may not prove enough to shield the executives from prosecution when their companies’ liabilities turn out to be quite a bit more than they had anticipated.

To summarize, the habits of avoiding investigation, estimation and disclosure are entrenched in the current accounting scheme, and there is little in the way of action by the SEC or the FASB to suggest that companies cannot maintain a convenient "inability" to speculate as to pending litigation or future liability risks. Unless and until we see an outbreak of shareholder suits or SEC enforcement that stings a group of CEOs or directors, or an improvement in the accounting rules, honest accounting will be perceived as a voluntary matter, and it is most unlikely that better disclosures of environmental and other liabilities will sweep 10-Ks and financial statements clean.


Next…
In this time of financial regulatory reform, why wouldn’t accounting regulators actually set forth rules for companies to estimate and disclose the needed information for investors? A short answer is that securities and accounting regulators have struck a precarious balance, attempting to provide shareholders with information about a firm’s liabilities, while not mandating disclosures that might undermine the firm’s position in pending or future litigation. The goal of providing accurate information relevant to valuation has been balanced against the recognition that most investors do not want to see their companies suffer additional litigation losses as a result of mandated disclosures. The trouble is, this balance has never proven particularly workable. Instead it has ensured enormous gaps in disclosure and estimation of liabilities – issues that for many companies may be severe enough to overshadow the other numbers that do appear on the corporate ledgers. In our final post of this series, we will suggest practical solutions for regulators—to bring more relevant information to the markets without undermining companies’ positions in litigation.

Step Right Up! Will voluntary disclosure of corporate liabilities meet investors' needs?

A Three Part Series

Part 1: American Bar Association “Best Paper” Documents Legal “Flexibility” For Disclosure of Environmental Liabilities

Sanford Lewis, Counsel
Investor Environmental Health Network

At an American Bar Association meeting in Baltimore in late September, Attorney C. Gregory Rogers published a paper on corporate environmental financial disclosures. Rogers, who is both an environmental lawyer and a Certified Public Accountant, is uniquely qualified to write on this subject, as well as to Chair the ABA Environmental Disclosure Committee. The premise of his paper, which won the “best paper” award at the recent ABA Fall Environmental Summit, is that even though current accounting regulations are “flexible” (in plain English, “weak”) companies should consider going beyond the minimum in their disclosure of environmental liabilities.

In my opinion, the paper does a better job of describing how much flexibility companies have than it may do in persuading companies to nevertheless step right up and disclose information needed by investors. In today’s first of three parts, we’ll review the “flexibility” Rogers identifies for corporate accounting. In the second part, we’ll discuss the arguments Rogers makes for going beyond the minimum, and then in the final part of this series we’ll look at the prospects and possibilities for legal reforms to elevate the minimum.

Three Layers of Flexibility
It is worthwhile to read his whole paper, but to summarize briefly, he states that existing accounting requirements provide latitude for management of companies to exercise discretion in 1. Investigation of existing circumstances; 2. Speculation about future outcomes; and 3. Transparency of disclosure.

On the duty of investigation, the paper notes:

Management often has discretion to attempt to identify and fully assess all pre-existing pollution conditions or to investigate only those matters subject to pending enforcement or litigation.

With regard to speculation about future outcomes, the paper states concisely and accurately:

Under applicable US GAAP and relevant voluntary standards, management has broad discretion to measure the loss at its known minimum value, most likely value, expected value, or quoted price (fair value). No speculation about future outcomes is required to determine a known minimum value. In contrast, speculation about future outcomes generally is required to develop an expected value or fair value.

Notably, the American Bar Association is among those who have recently lobbied heavily to keep in place this enormous flexibility regarding “speculation.” The ABA has formally argued to the Financial Accounting Standards Board that requiring disclosure of liability estimates above the “known minimum” could be prejudicial - aiding plaintiffs in any pending litigation, to the detriment of companies as well as their shareholders. We will discuss and deconstruct this argument in the third part of this series, and examine options and prospects for legal reform.

Finally, with regard to the leeway in disclosure rules, the Rogers paper states:

Disclosure standards for environmental liabilities include subjective language such as “to the extent material,” “when necessary for the financial statements not to be misleading,” and “encouraged but not required.”

The broad flexibility on investigation, estimation and the duty of disclosure strikes three blows against detailed disclosure of corporate environmental liabilities.

How Flexibility Affects Options for Action
Rogers goes on to describe the three options, given all this flexibility, that a typical company’s management faces regarding disclosure of environmental liabilities. The first option he says is "don't ask don't tell." In other words, don't investigate:

The don’t ask don’t tell policy is effective at limiting the collection and dissemination of prejudicial information. The downside of the don’t ask don’t tell policy is that it limits the information available to inform sound decision-making by management, the board, and investors. Its informational value is low.

He calls the second option the “crystal ball option,” which would, he says, provide high informational value to inform decision-making by management, the board and investors through estimates and projections of liability:

The downside of the crystal ball policy is that it produces and disseminates prejudicial information. Such information could lead to unknown, but potentially severe losses. Another downside of the crystal ball policy is that debt and equity markets may mistakenly punish the entity for appearing to have greater exposure to environmental losses than its nontransparent peers.

Finally he says that the third option is “double booking” -- to keep two sets of books so that the amount of publicly disclosed information would be minimized while providing information needed to inform decision-making by management and the board.

The downside of the double-booking policy is that it conceals important information from financial statement users and thereby exposes the entity to accusations of accounting and securities fraud.

He concludes dryly, based on the above analysis and options, that "the selection of the don't ask don't tell policy seems reasonably defensible, if not obligatory."

The Results of Don't Ask Don't Tell
We documented the outcome of the "reasonably defensible, if not obligatory" nondisclosure approach to broad flexibility in our recent report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close. Examples of liability disclosure shortcomings resulting from the current accounting “flexibilities” included:

-- Numerous asbestos companies that concealed a realistic prediction of the amount of their liability until the day they finally provided the realistic estimate, and promptly filed for bankruptcy.
-- Companies that could have accurately projected the magnitude of their liabilities for investors if they had simply benchmarked them against other companies facing similar forms of lawsuits.
-- Companies that do not estimate their liabilities in SEC filings (or state the known minimum), but nevertheless provide large, long term liability estimates for their insurers.
-- Companies are producing innovative nanomaterials which may have been found in laboratory testing to cause precursors to mesothelioma, but are reporting to their investors only that the health effects of their products are "unknown".

In addition, Rogers himself has conducted a study of the amounts reserved for environmental liabilities by various companies, and has developed an algorithm for evaluating the adequacy of those reserves. See the recent article in CFO.com detailing his findings. He found that companies vary widely on the amount of reserves they are setting aside for their liabilities, demonstrating that the flexibility associated with current accounting methods makes liability disclosures particularly opaque, and difficult for shareholders to assess.

Next...
In the second half of his paper, Rogers goes on to set forth reasons why companies might nevertheless consider disclosing more. We’ll examine those arguments in the second part of this series.

Shareholders Query SEC on No Action Letter Process: Why disempower share owners from seeking information on financial and environmental risks?

The process by which the Securities and Exchange Commission decides whether it will allow companies to exclude a shareholder’s proposal from the annual meeting proxy is coming under increasing scrutiny of the investing community. Many share owners believe the SEC’s process is disempowering investors from seeking information on risks at the very time when empowerment is most needed.

In a meeting with the staff of the SEC Division of Corporation Finance on September 22, an array of shareholder representatives from institutional, pension and socially responsible funds(1) expressed dissatisfaction with aspects of the current SEC process. The meeting was chaired by Meredith Cross, the newly instated Director of the Division of Corporation Finance.

In preparation for the meeting, the author collaborated with several investor organizations including the Social Investment Forum, the Interfaith Center on Corporate Responsibility and Shareowners.org to conduct an internet survey of 40 shareholders, most of whom identified themselves as frequent filers of shareholder resolutions. 80% of respondents said they found the no action letter process to be frustrating or extremely frustrating. Strikingly, 85% of the respondents disagreed with the statement "the staff no action letter process is transparent and accountable" and 81% of the respondents disagreed with the statement "the staff provides sufficient information and justifications for individual decisions."

Principal among the shareowner objections to the current process is a legal bulletin issued by the SEC staff during the Bush Administration declaring that the SEC would allow companies to exclude shareholder resolutions that ask companies to disclose financial risks associated with environmental issues. The same so-called risk evaluation exclusion has since then also been applied to human rights, public health, climate, and even subprime lending issues.

Most of the 15 or so investor representatives who participated in the September 22 meeting with SEC staff criticized this so-called risk evaluation exclusion. We referred to a letter from 60 investors sent December 11, 2008 to then President-elect Obama, hoping for change in this area. That letter noted:

The adoption of this new bar on resolutions requesting “risk evaluation” represented a significant departure -- disregarding the reasonable and principled approach that had governed at the SEC for decades, and replacing it with a radical interpretation of the rules. The result has been to limit shareholder resolutions to questions about the impact that companies are having on society in general, excluding vital questions about the impact that any of these issues may have on the company’s future finances. Institutional investors, especially those that hold long-term stakes in the marketplace, have expressed interest in being able to monitor the financial impacts that various issues pose on their portfolio holdings.

Notably, 90% of the respondents to the shareowner survey stated that they had been forced by staff rulings to write resolutions to avoid asking for disclosure of particular financial risks that they were concerned about. This is a vexing matter of censorship of investor inquiry for an agency that has been accused of botching its handling of Bernie Madoff and other recent disasters.

The new Division Director, Meredith Cross, noted that it “sounds pointy-headed to say that risk is not a big issue or one that shareholders should not be concerned about.” Since coming to the SEC as an Obama appointee in June 2009, Cross has been asking her staff to clarify why this risk evaluation exclusion makes sense. This observer had the sense that she has not yet gotten satisfactory responses to her questions so far; no rationale for the exclusion was offered in the meeting. It remains to be seen whether and how Cross will reverse this misguided policy.

In the meeting it also became apparent that the staff of the SEC works very hard on its review of each resolution challenged by a company. However, some of the review criteria utilized by the staff, and described in the meeting, raised many an eyebrow. For example, it appears that in determining whether a resolution addresses a “social policy issue” that would render the resolution permissible, staff ponders whether the issue is "big" enough in terms of the level of public, legislative and media attention that it is getting to merit “significance.” It seems that a wide array of resolutions – including the issue of consumer privacy and freedom of expression on the internet, disclosure of water sources by bottling companies, and asking a company to develop a policy for reinvestment in the communities it does business, have been excluded because the SEC staff did not view those policy issues as “big.”

Many lawyers in the meeting, representing corporations as well as investors, seemed surprised at these staff determinations of what is a sufficiently “big” issue. What special expertise and political mandate does the staff have to pick and choose among the many corporate social responsibility issues?

The staff also is making some interesting calls about whether an issue is sufficiently relevant to a company receiving a resolution. As an example, the staff has allowed various large retailers, including Wal-Mart, to exclude resolutions asking what they were doing to reduce the toxicity of products they sell. The staff apparently allowed these resolutions to be excluded as “ordinary business” because of their opinion that these issues of toxicity were inadequately related to the retailers’ businesses.

Although no immediate changes were proffered by Cross or her staff on these contentious issues, the staff does seem to be poised to make some modest modifications of the no action letter process in the coming season. This includes providing an additional sentence or two in no action letters to clarify why a resolution was found to be excludable as "ordinary business." The staff may also modify the standard, but confusing, language in their response letters stating that a company had provided “some basis” for finding an exclusion to be applicable; they may replace that language with a clearer statement that the company had met its burden of proof.

These changes may alleviate a bit of the investors’ frustration regarding transparency of the process. However, there was no indication from the SEC staff, or from Meredith Cross, that the risk evaluation exclusion or the other issues of concern in the decisionmaking framework would be addressed before the coming season.

The mood among the investors attending the meeting was restless, to say the least. The coming shareholder resolution season should be an interesting one, as investors continue to assert their rights to place key issues on the proxy and before annual meetings.

- Sanford Lewis

(1) Among those attending the meeting were Paul Neuhauser, Tim Smith of Walden Asset Management, Adam Kanzer of Domini Social Investments, Jonas Kron of Trillium Asset Management, Sanford Lewis (the author of this post), representing the Investor Environmental Health Network and other investor clients, Damon Silvers of the AFL-CIO, Richard Simons of New York City Public Employees Retirement funds, Richard Metcalf of LIUNA, Ann Yerger of the Council of Institutional Investors, Rich Ferlauto of AFSCME, and several others. Also present were some of the leading attorneys representing companies in the no action letter process.