Friday, October 9, 2009

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

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.

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.

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