Thursday, October 15, 2009

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.

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.

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.

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

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