Tuesday, March 10, 2009

Report Back from FASB Roundtable on Contingent Liability Disclosure

Abstract: Report from Financial Accounting Standards Board 3/6/09 Roundtable on Contingent Liability Disclosure (FAS 5) • Convergence of opinion on several points, such as needs to avoid requiring “prejudicial” disclosures, and the need to mandate disclosure of severe risks even if viewed by management as “remote” and “long term.” • Questions for investors: How much of a priority is it for FASB to: (a) Require companies to seek and disclose third party liability estimates in lieu of disclosure of their attorneys' projections? When should this be required? (b) Require disclosure of severe “remote” risks, such as science showing nanotech hazards that could amount to the "next asbestos"?

On Friday March 6, 2009, the Financial Accounting Standards Board held a Roundtable panel to hear ideas from an array of stakeholders about how to move forward on the board’s proposals for improving disclosure of contingent liabilities in financial statements. The Roundtable was a follow up from last year’s “exposure draft which proposed expanding the duty to disclose more information in financial statements about potential and pending liabilities – including estimations of either a filer’s best projection of liabilities, or if that is not possible, then at least worst case liability scenarios.

In attendance were representatives of financial statement users, individual companies, the Chamber of Commerce, the American Bar Association, and the defense bar. Also in attendance were all of the members of the Financial Accounting Standards Board, as well as representatives from the Securities and Exchange Commission, the Public Companies Accounting Oversight Board (PCAOB), and the International Accounting Standards Board. I was on the panel both in the morning and the afternoon representing the Investor Environmental Health Network. (Our liveblog from the event, which contains more detailed notes, is available here. The audio feeds from both sessions are available here: morning and afternoon.)

Some ideas seemed to draw support:

Existing disclosures are inadequate to sufficiently inform investors. (Generally agreed to by financial statement users, but not necessarily agreed to by representatives of the filers or defense bar.)

There was general agreement from financial statement users with the idea that if a liability is viewed by a company as “remote” but the consequences could be severe, then disclosure should be required regardless of the timeline on which the liability would be resolved. Furthermore, it was also the general sense that the more remote a liability is viewed, and the longer time it may take to resolve, the less detailed the disclosure obligation might be. (The issue of reporting of potentially severe long-term liabilities even if viewed as remote by the management had been a major issue raised by the Investor Environmental Health Network, and it was gratifying to hear something of a consensus forming among investors on the need to address this.)

In improving contingent liability disclosures, the FASB will need to strike a balance between providing better information to investors, while not requiring disclosure of information that would prejudice cases being defended by companies, and therefore might actually lead to an increase in the costs of those liabilities. Examples of problematic disclosures could include (a) predictions of total liability or probability of success as determined by a company’s own lawyers, especially when disclosed separately on the individual case (b) settlement offers and projections of the timing for a settlement.

Examples of information that would not fall into this “prejudicial” category might include: (a) descriptions of the contentions made in a case; (b) public documents such as public court filings that show in more detail the contentions in the case; (c) Links to those public documents. The financial statement filers and defense bar representatives at the meeting suggested that the best solution is to provide shareholders with access to those contentions and public documents, and for investors to then do their own assessment as to the level of potential liability. It was suggested that the largest investors would be able to do their own assessment of the liability using those public documents. I raised the question about where that leaves smaller investors, and the added cost and inefficiencies posed to the broader investing community if everybody has to do their own assessments of the magnitude of these liabilities.

The take-away about estimating existing liability claims
I suggested that there are different categories of liabilities that are more or less difficult to estimate without prejudicing a company's case. For example, environmental remediation cases, and backlogs of asbestos related claims are examples of where it is possible for third parties to make a projection simply based on the public record regarding existing claims or sites, and a comparison with results in comparable cases elsewhere. The failure of existing financial regulations to require that companies provide such assessments based on comparable cases has in many instances resulted in companies severely underreporting their liabilities (e.g. accruing a small fraction of the likely liability), only to go bankrupt later. Needless to say, this is an unfair result for investors. So, I asserted, this is an important example of areas where estimates can and should be required.

Some of these disclosure shortcomings were well-documented in our 2004 report for the Rose Foundation, Fooling Investors, Fooling Themselves: How Aggressive Corporate Accounting And Asset Management Tactics Can Lead to EnvironmentalAccounting Fraud. We wrote there about examples such as:


Dow Chemical did not report any asbestos liabilities when it acquired Union Carbide in 2001. But two years later, Dow reported a $2.2 billion asbestos liability associated with the acquisition, a figure arrived at by finally looking at comparable lawsuit outcomes at other companies.

Kaiser Aluminum, a subsidiary of Maxxam Corporation, underestimated its asbestos liabilities in the mid-1990’s. A few years later Kaiser was driven into bankruptcy, in part because the spiraling asbestos litigation costs finally caught up with them.

In its 10-K report for 1995, Kaiser estimated that future cash payments in connection with asbestos litigation would be …an aggregate of approximately $78 million thereafter through 2008. The company noted there was no reasonable basis for estimating such costs beyond 2008. One could have predicted much greater asbestos liability, however, by comparing the amount per case that Kaiser was using to calculate its liabilities against the much greater amounts that were being paid out per case by other comparable companies in the course of their asbestos settlements. For example, asbestos cases against the Johns Manville trust had, by 1990, paid an average of$43,500 each on the first 24,000 claims. Maxxam, by contrast, had accrued only $160 million for 59.7 thousand cases pending in its 1995 10-K. If Kaiser had multiplied the 60,000 cases by the average Johns Mansville settlement figure of $43,500, they would have calculated a total potential loss of $2.5 billion... By 2002 … Kaiser and 24 subsidiaries filed for bankruptcy [ citing mounting asbestos liabilities among other issues ].

The harder cases involve innovative litigation “one offs” where there is no comparable record to draw upon. I suggested that in instances where the individual case is substantial enough, financial regulators could require that there be a third-party assessment, akin to what insurance companies do. Instead of requiring every individual investor to conduct their own assessment, why not require the company to pay for and disclose a third-party assessment of the range of potential costs, akin to what an insurance company would do? This can be based on the public record so that it does not jeopardize attorney-client privileges. I suggested that this would not be appropriate in every instance it, but could be a good solution in large cases -- those cases where the results could have a material impact on the company.

The take-away about prospects for disclosure of severe, long-term liability risks
Another issue is the need for requiring disclosure of the kinds of long-term remote issues that we have flagged, which involve risks of severe claims mounting over the long term. These may seem only hypothetical unasserted claims at the present time, but investors should have better access to information about the long-term risks that companies are taking on these issues. There was some discussion about what constitutes a severe risk, and there was some agreement that a severe risk would at least involve the kind of issue where the management is essentially “betting the company” on the risk not coming to fruition.

I strongly argued that improving disclosure of “remote” liabilities could help to overcome the tendency of corporations to stay in “denial” about some severe contingencies. I pointed out that to the extent that companies simply trust their own staff scientists’ rendition of the level of hazard associated with particular products or activities, they may view the likelihood of liability as too remote to even mention. This is what happened with asbestos. In the early days, in which science was flagging the health hazards, financial reports were silent on these issues. Then, in the later days as claims began to mount, many companies underestimated their liabilities. In both the early and the later days investors were under-informed about the level of risk exposure. Both investors' finances and public health suffered as a result.

I gave the current example of the production of carbon nanotubes, which have already been found in the laboratory to produce mesothelioma-like illness in rats. Yet, many of the producers of these products are not disclosing to investors that they are essentially “betting the company” that they will not end up on the receiving end of lawsuits paralleling the bankrupting liabilities of asbestos.

This issue was documented in last year’s IEHN report, The Toxic Stock Syndrome: How Corporate Financial Reports Fail to Apprise Investors of the Risks of Product Recalls and Toxic Liabilities. For example, we wrote in that report:

Despite early warnings about the effects of asbestos on health, it took 100 years to introduce internationally accepted asbestos standards. The chronic danger of exposure to nanoparticles could similarly take time before it manifests itself. Multiple laboratories have already independently reported that carbon nanotubes cause progressive, irreversible lung damage in test rodents. As noted above, this may be because carbon nanotubes are similar in form and size to asbestos fibers. Product liability may also arise from other similarities between nanotechnology and asbestos, such as their worldwide dissemination and wide range of uses. Carbon nanotubes already have a variety of uses, from tennis rackets and bicycles, to displays and TV screens, and a variety of resins used by aerospace, defense, health care, and electronics companies.

* * *

In the absence of long-term toxicological studies, it is difficult to determine the degree of risk posed by the presence of nanoparticles in the body or environment. However, risk assessors are focusing on these questions, and recognize the extreme complexity of the problem. According to [a report by reinsurer] Swiss Re: …an inattention to nano-specific risk research puts more than consumers and the environment in danger. It sets up a scenario in which the future promise of nanotechnology in such fields as robotics, medical technology, and computer science could suffer serious setbacks, when predictable and preventable problems emerge as market-jarring surprises. It is very likely that a cause and effect relationship will be established between nanoparticles and human health effects, because these particles have historically unprecedented access to the human body. Swiss Re also points out that ”these artificially manufactured nanoparticles will be traceable back to the manufacturer, which makes the establishment of liability easier than in the case of substances that are universally present, such as ultrafine particles from diesel exhaust fumes.”

The FASB plans to resume deliberations on this issue later this month or early April.

Thanks to the many people who provided input to help me prepare for the Roundtable. Now I am looking for further input from the shareowner and financial statement user community. In particular, I am soliciting your opinions regarding the relative priority the investing community wants to give toward:

(a) Encouraging the FASB to require companies to undertake and disclose estimates of liabilities through third parties (so that a company’s own lawyers’ opinions remain privileged)? If so, under what circumstances should such estimates be mandatory?

(b) Ensuring FASB requirements for disclosure of remote long-term potentially severe issues such as unasserted claims regarding nanotechnology liability risks?

Looking forward to our continuing discussion of these timely and important questions.

Sanford Lewis