Monday, October 5, 2009

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 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.

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.

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