Corporate Disclosure Alert

Important New SEC Ruling Offers Diversified Shareholder Responses To Corporate Election Spending

2011-03-31T09:50:00.035-04:00

Sanford Lewis, Attorney

Shareholders have won the right to seek an annual proxy review and vote on a company's political spending, as a result of a new SEC decision. The SEC Staff, for the first time, allowed a shareholder resolution seeking shareholders' say on political spending (in a decision known as a “no action letter”). The proposal will appear on the Spring 2011 proxy of the Home Depot. The decision opens new options for shareholders seeking to take action in the aftermath of Citizens United, portending diversified approaches to shareholder interventions beyond the predominant approach of seeking better disclosure.

Corporate Spending In Elections: A Crisis Of Legitimacy

Citizens United v. Federal Election Commission, the controversial Supreme Court “corporate free speech” decision in January of 2010, opened the floodgates to additional corporate spending in the political process, including corporate funding of political advertising for and against candidates up to the day of an election. A baseline issue is the legitimacy of any corporate involvement and spending in the political process. The argument that giant corporations have essentially the same free speech rights in the political process as individuals, or even as groups of individuals, has met with enormous outrage and concern. A corporation is not a mere group of individuals but a legally created moneymaking machine, and as such will warp our political process to the extent it is allowed to be a player.

Compare this with a recent Supreme Court decision, ATT v. FCC, finding that corporations do not merit the same level of “privacy” protection as individuals, and the underlying notion of a corporation's participation in politics as if it were a "person" or "group of persons" is even more incongruous.

Potential Interventions by Shareholders

Although this author believes more extensive reforms are needed to undo the damage to our political system caused by Citizens United, it also seems possible that shareholders could help rein in the worst abuses of companies in the new post Citizens United political environment. The proposal cleared by SEC staff and filed by the Boston-based NorthStar Asset Management (hereafter NorthStar) asks the Board of Directors of Home Depot to annually include in its proxy statement the company’s policies on political contributions, a report on spending for the past year, and anticipated spending for the next year. Shareholders would then vote on whether they support those policies and plans. In addition, NorthStar recommended in its proposal that the proxy also analyze whether the spending is consistent with the company’s values and whether it poses risks to the company’s brand, reputation, or shareholder value.

In the aftermath of Citizens United, companies can put corporate money into ads supporting candidates, even if the company’s own shareholders might support different candidates. There is little accountability for this spending. One successful approach until now has been for shareholders to file resolutions seeking better disclosure of corporate political spending. This approach has been successfully advocated by numerous investors and the Center for Political Accountability.

However, now the specifics of spending on particular candidates and issues, issues regarding risks to the company's reputation, and congruency of that spending with the company's stated values are also also fair game for debate on the proxy, culminating in a shareholder vote on those policies. Home Depot had argued to the SEC that a vote on company spending would involve an impermissible intrusion of shareholders on the “ordinary business” of the Company.

The company’s Senior Counsel Stacey Ingram asserted “Decisions as to the appropriate future recipients of the Company's political contributions are ordinary business decisions made by management as part of its day-to-day operation of the Company…. The ability to make such decisions is fundamental to in spending ability to control the operations of the Company and, as such, is not appropriately delegated to shareholders.” However, under SEC and judicial precedents, shareholder proposals which present a “significant social policy issue” are not excludable even if they may otherwise intrude on ordinary business. In ruling in favor of allowing the proposal, the staff has essentially determined that after Citizens United, corporate political spending is a significant social policy issue and shareholders can seek to have input on management’s decisions. This contrasts with prior staff decisions finding that corporate charitable spending in general is excluded from shareholder oversight.

NorthStar has particular concerns about the failure of Home Depot’s political spending to live up to its policy against discrimination on account of sexual orientation. Home Depot's disclosed PAC contributions include donations to candidates whose actions and opinions seemed adverse to that policy. The financial and reputation risks associated with political spending were highlighted last year when the Target Company became the subject of a boycott campaign as a result of their support of anti-gay rights candidates.

Home Depot is cited on the Center for Political Accountability website as a "corporate leader" because the company discloses certain information and have adopted policies advocated by the Center.

With the SEC decision, the annual corporate meeting process can now become a battleground, not only on disclosure of spending, but also the financial risks to the company from that spending, the congruency of the spending with a company's stated values, and with investors' interests both as shareholders and as citizens. Ultimately, shareholders could vote on whether they support the management's practices.

The Opening for Diverse Approaches

The Home Depot proposal cleared by the SEC is only one possible approach to addressing congruency, risks and shareholder approval processes related to corporate electioneering. The significance of the decision is that it opens the way for many similar approaches to be explored by shareholders in future proposals.

The NorthStar resolution allowed by the SEC would give shareholders a nonbinding, advisory vote seeking approval of a majority of shareholders on the company’s spending. In contrast, legislation pending in Congress would make shareholders’ vote to approve corporate political spending binding on the company.

One serious limitation of seeking a shareholder vote is that a majority of institutional investors typically support whatever the management of a company thinks is appropriate. Simply establishing shareholder approval processes in the proxy may merely allow a rubberstamping of the management's political predilections. In contrast, citizen investors, and others who may represent only a minority of a corporation's investors may represent a dissenting view–not wanting to see their political preferences as citizens overridden by their investments–and yet be unable to block the spending. Harvard Law Professor Lucian Bebchuk has argued that to protect the rights of dissenting shareholders, requirements for a supermajority (e.g. 75% ) vote in favor of election spending could be appropriate.

May shareholder responses to corporate money in the political process go forth and multiply. In the aftermath of Citizens United, we need all the experimentation and engagement that's possible to staunch the bleeding.

---
Sanford Lewis is an Attorney who represented NorthStar Asset Management Funded Pension Plan before the SEC in defense of the Home Depot proposal.

Can Shareholders Benchmark “Safety Culture”? More Learning from the Gulf Coast Oil Disaster

2010-11-15T08:01:00.003-05:00

Sanford Lewis
Counsel
Investor Environmental Health Network

In its preliminary examination of the causes of the Gulf oil spill disaster, the Presidential Commission appointed to investigate has tentatively concluded that the underlying cause of the incident was not that the companies involved placed cost-cutting over safety, but rather that there was a lack of “safety culture” and, perhaps, safety competence.

From what we know about the incident so far, it is apparent that multiple things had to go wrong in order for the disaster to have been triggered. Decisions were made, sometimes in a hurry and overriding certain safety concerns. For instance:

1. The morning of the explosion, there was a dispute between the rig operator and BP over BP’s plan to replace heavy mud, used to keep the well's pressure down, with lighter seawater to help speed a process that was costing an estimated $750,000 a day and was already running five weeks late. BP overrode the rig operator’s objections.

2. The lack of safety culture was indicated by an employee survey conducted by Transocean (the rig operator) about a month before the disaster. The company found that rig employees had a fear of reprisal if they reported unsafe conditions. For instance, “only 46.3 percent of participants felt that, if their actions led to a potentially risky situation (e.g., forgetting to do something, damaging equipment, dropping an object from height), they could report it without any fear of reprisal," according to a CNN account of the report.

The focus on safety culture by the Presidential Commission raises a challenging, difficult question for shareholders: Can companies be benchmarked to determine which ones have an effective “safety culture” and which are at greatest risk of causing the next catastrophe?

Learning from the BP Experience
Some past shareholder initiatives have proven ineffectual at providing informed answers to this question. As I analyzed in greater depth in a recent blog post, the BP experience is notable in demonstrating how sustainability reporting failed to provide transparency on fundamental issues of risk-taking and risk management. In 2005, for example, BP Global Reporting Initiative Sustainability Report laid out some excellent company goals and values:

Responsible. We are committed to the safety and development of our people and the communities and societies in which we operate. We aim for no accidents, no harm to people and no damage to the environment.

These goals were stated in the same reporting year in which the company experienced a disastrous refinery explosion in Texas City. The company asserted in subsequent sustainability reports that it had learned from and was correcting the hazards identified as a result of Texas City. However, a 2009 reinspection by the Occupational Safety and Health Administration (OSHA) found 439 “willful” violations, many considered gravely serious, because the company had not addressed issues identified in the aftermath of the 2005 disaster. In particular, the agency noted the failure of the company to identify which instrumentation was critical to safety in its complex Texas City refinery. Despite these continuing problems, the 2009 sustainability report, issued after the OSHA allegations, continued to assert the notion of steady progress and commitment to safety at BP. Then, in 2010, OSHA fined the company $50 million for these continued violations -- by far the highest penalty ever assessed by the agency.

One cannot find sufficient information in BP sustainability reports to recognize that its safety culture has been seriously lacking, or to allow comparison with the culture of other companies. The GRI’s Guidance for preparing sustainability reports places a great deal of emphasis on the need for companies to “Describe the Management Approach.” This offers managers an opportunity to paint a flattering corporate self-portrait, setting forth their rendition of corporate goals, policies, and practices. It may encourage the development of two separate, disconnected cultures, a reporting culture that states some admirable goals, and a more true to life operational culture that may perpetuate the worst tendencies and lack of focus on safety.

Potential investor inquiries to probe a company’s safety culture.
In 2009, the SEC authorized investors to file resolutions seeking evaluations of risk to companies associated with significant policy issues. (Staff Legal Bulletin 14E.) Here are a few initial suggestions for how shareholders might use the “risk evaluation” opening provided by the SEC to probe “safety culture”at companies where safety concerns may be prominent:

1. Disclosure of ongoing regulatory enforcement allegations.
Existing SEC requirements for disclosure in the 10-K regarding regulatory enforcement proceedings provide too little information, too late. Even as weak as it is, the existing requirement to disclose anticipated environmental penalties in excess of $100,000 (Reg S-K, Item 103), has been poorly enforced by the agency. The recently enacted Financial Reform Act includes more stringent disclosures of regulatory allegations such as serious enforcement actions, orders and penalties -- but only for coal mining companies. This legislation could provide a model for investors to request safety risk reports, including disclosure and breakdowns of:
• The number of major violations once they are alleged by regulators in the past year;
• Orders to close facilities or withdraw products based on health and safety concerns;
• Suspensions of existing or new permitting for any period of time based on health and safety concerns; and
• Cumulative amounts of penalties paid.
The SEC staff should allow such resolutions since such reporting would help to flag and benchmark very significant risks related to big safety concerns at some companies; as such, it would be inappropriate for the staff to categorize such requests as excludable, even though legal compliance on routine matters can itself be seen by the SEC as excludable “ordinary business.”

2. Responses to emerging scientific literature findings regarding catastrophic risk.
Disclosure of catastrophic risks identified in scientific literature are inconsistent. Studies warned of the risks of deepwater drilling, such as technical problems and blowouts, warranting an industry task force. Shareholder requests for risk evaluation reports could include requests for a report that summarizes:

• peer-reviewed scientific studies indicative of potentially catastrophic risks of products or activities ( and to treat such studies in a precautionary manner, so that they are disclosed even where there may be some remaining scientific debate or uncertainty);

• profiles of the severity and scale of the potential problem; and

• measures being taken by the company to minimize adverse impacts or maximize business opportunities associated with the catastrophic risk issue.

3. Anonymous surveys or independent audits probing employee safety culture
In a recent conversation with Shelley Alpern of Trillium Asset Management, she asked whether shareholders could request reports from companies that lead to direct monitoring of the safety culture by surveying a company’s employees. As instructively conducted at Transocean, employee safety culture surveys ask employees to report on various attitudes and contingencies of safety culture. Any shareholder request for such surveys should emphasize the need for such employee surveys to be conducted with genuine assurance of anonymity, and also to evaluate whether employees believe they can report unsafe conditions, and even cause operations to stop, without fear of reprisal.

Learning from BP's "Sustainable" Self-Portraits: From "Integrated Spin" to Integrated Reporting

2010-10-26T11:57:00.012-04:00

Sanford Lewis, Counsel

Investor Environmental Health Network

ABSTRACT: Just as the paradigm of integrated corporate reporting begins to gain momentum, the BP oil spill highlighted significant shortcomings of current reporting standards and practice. Mere “integration” of current financial and sustainability disclosure standards could yield little more than “integrated spin,” neglecting substantial areas of risk.

To be of value, integration must include concepts poorly handled under current sustainability and financial disclosure standards:

1) Require timely corporate disclosure of substantial enforcement notices, orders and allegations issued by regulators;

2) Require corporate disclosure of credible scientific reports and concerns indicative of potentially catastrophic risks of a company’s products and activities, regardless of scientific uncertainty as to the likelihood of such disaster scenarios.

3) Require corporate disclosure of any facts or circumstances that may be needed to ensure that the management’s self-portrait of its sustainability strategies, goals and progress is not materially misleading.

-----------------------------

After decades of work by NGOs and investors to develop globally applicable corporate sustainability reporting standards, 2010 was a watershed year. The formation of the International Integrated Reporting Committee in August 2010, with its distinguished membership from accounting, regulatory, and government sectors, evokes endorsement of the idea of integrating socially relevant data into corporate annual reports.

But in the same year, the Deepwater Horizon oil spill highlighted shortcomings of existing financial and sustainability disclosure standards and practice. Viewed in retrospect, it is apparent that both BP’s financial and sustainability reports veiled core weaknesses in how the company managed pivotal issues of maintenance and safety. Assertions of NGOs that BP’s sustainability claims were greenwash came through with a vengeance. As such, the Deepwater Horizon experience provides essential lessons for thinking about how to ensure effective integrated reporting, rather than “integrated spin.”

BP and its Sustainability Reporting: a Model Corporate Citizen?
The Global Reporting Initiative (GRI) is a network-based organization that has developed a framework for sustainability reporting. This standardized framework aims to assess organizational performance on multiple fronts, such as commitment to sustainable development and reducing greenhouse gas emissions.

BP is a prominent and touted GRI sustainability reporter. It has even received awards and recognition for its Global Reporting Initiative formatted reports. Some investors may have chosen to increase or sustain their investing in the company because its reporting made it “best in class.”

Although BP sustainability reports from 2005 through 2009 portrayed a company of high values and integrity, they omitted disclosure of available facts, opinions and metrics that would have contradicted this portrayal. Simple integration of BP’s flawed sustainability reports with its financial reports would not have yielded a useful “integrated report” from the standpoint of stakeholders. It would only have established “integrated spin.”

The Global Reporting Initiative’s Guidance for preparation of GRI sustainability reports (currently referred to as the G3, as in third-generation of guidance) emphasizes the need for a company to “Describe the Management Approach” to an issue – asking companies and their managers to offer their rendition of corporate goals, policies, and practices. Consistent with this guidance the BP sustainability report of 2005 , reported these excellent company goals and values:

Our values.

Performance driven. We deliver on our promises through continuous improvement and safe, reliable operations.

These values guide us in the conduct of our business. In all our business we expect our people to meet high ethical standards and to act in accordance with our code of conduct.

The 2005 sustainability report also contained nearly 1000 words explaining in detail the company’s risk management processes; the reader was given the impression that the company was doing much to manage risks to both its finances and its stakeholders. In retrospect, however, the following passage and the risk management section may seem particularly prescient:

Risks to our reputation could be created if it is perceived that our actions are not aligned to our high standards of corporate citizenship and our aspirations to contribute to a better quality of life through our products and services. For example, risks could arise from incidents of non-compliance with laws and regulation or ethical misconduct; or if it is perceived that we are not respecting or advancing the economic and social progress of the communities in which we operate.

The Jarring Reality of BP Safety Culture
In contrast to the shining image of a company working hard towards sustainability and safety presented in the company’s sustainability reports, in the aftermath of Deepwater Horizon numerous reviews suggest a company that was cutting corners on safety spending. Numerous press articles after the Deepwater Horizon disaster asserted that there was a persistent cultural problem, skimping on safety, at BP. For instance, an AP story that was typical, described the problem in numerous ways. Associated Press, “Documents: BP cut corners in days before blowout,” June 15, 2010.

“BP made a series of money-saving shortcuts and blunders that dramatically increased the danger of a destructive oil spill in a well that an engineer ominously described as a 'nightmare' just six days before the blowout.”

BP rejected the advice of Halliburton, Inc, a subcontractor, in preparing a cementing job to close up the well. Halliburton recommended using 21 centralizers to make sure the casing ran down the center of the well bore. Instead, BP used 6 centralizers. In an email on April 16th, a BP official in the centralizer decision said, “It will take 10 hours to install them, I do not like this.” Another official responded, recognizing the risks of proceeding with insufficient centralizers, but commented “Who cares, it's done, end of story, will probably be fine.” – Id.

Waxman and Stupak (Congressional Energy Subcomittee on oversight and investigations) state that “the common feature of these five decisions [questionable decisions BP made before the explosion], is that they posed a trade-off between cost and well safety.” – Id.

Oil industry expert and geophysicist Roger N. Anderson was interviewed by Columbia Magazine about the technical aspects of the Gulf of Mexico disaster. He noted that drilling mud is expensive. He is quoted in the magazine as saying:

“They were also rushing to finish the well, which had been fighting them the whole time, making them weeks behind schedule. The people on the rig called it the “Well from Hell.” On the morning of April 20, the crew from Transocean (the owner of the rig), over the strong objections of their own drilling superintendent, was ordered by BP to take the heavy drilling mud out of the drill pipe and replace it with seawater. That was the triggering event that allowed the gas and oil to blow out onto the Deepwater Horizon rig floor — then a random spark ignited a tremendous explosion. The rig sank, allowing the free release of the pressure and the energy of all that oil and gas into the ocean. The rest is history.” [emphasis added]

Examining Company Follow-up on the Texas City Refinery Disaster
It will take years for the courts to determine the degree to which BP was at fault in events leading to the Deepwater Horizon disaster.

However, examination of other aspects of the company’s record bear out the notion that an internal culture of cost cutting contrasted with its external disclosures of diligent attention to safety. See, for instance: Years of Internal BP Probes Warned That Neglect Could Lead to Accidents, Pro Publica, June 7, 2010.

Perhaps nowhere is the contrast between how the company portrayed itself in its sustainability reporting and its actual practices better illustrated than the record of disclosures and actions after the Texas City oil refinery disaster of 2005. BP was assessed $50 million in penalties for felony safety violations leading to the disaster. The company’s 2005 sustainability report expressed remorse for what happened in Texas City, where 15 employees were killed and 170 people were injured in the massive explosion. In the aftermath of the disaster, BP sustainability reports portrayed a company that was learning from experience and moving toward safer performance. The company sought to present an image in which unsafe operations were a thing of the past. In its 2005 Sustainability report BP noted:

“We responded to the industrial accident at the Texas city refinery with a thorough investigation and a fundamental review of systems and processes, leading to a range of new measures and investments being taken to maintain the safety of our people and the integrity of our plant”

Over the intervening years, the company reported various investigations and programs that to improve safety. For example in its 2009 BP Sustainability Report the company noted in its continuing follow-up on Texas City that:

“BP continued to make significant progress in delivering its programmes to strengthen process safety capability at all levels.”

“BP has taken a number of steps to strengthen its process safety culture, and its leaders support process safety positively and sincerely.”

We have taken action to close out our six-point plan, launched in 2006 to address immediate priorities for improving process safety and operational risk management at our operations worldwide, following the incident at Texas City in 2005 involving a fire, explosion, fatalities and injuries.

No doubt, the company must have improved safety in some areas of its operations. It abated about 500 of the 900 or so issues identified by Occupational Safety and Health Administration (OSHA) as needing abating after the Texas City disaster. OSHA also found hundreds of other instances in which the company had not done the needed abatement -- violations in instrumentation controls in the complicated Texas City refinery that were identified as lacking in 2005. The OSHA reinspection completed in October 2009 found 439 instances of “willful” violations, most or all of which were designated with gravity of 10 on a scale of 1 to 10. OSHA stated that:

“Our information indicates that for some identified hazards, BP either has not specified or allocated the specific layers of protection needed, and for other identified hazards where BP has specified the layers of protection it will use to control the hazards, the specified instrument controls have not been installed or are not operational.”

In September 2009, OSHA issued a warning that its audit had identified “systemic deviations from the industry standards” at the Texas City facility that had yet to be addressed. Specifically, areas of concern included a failure, four years after the blast, to complete a determination of which alarm functions in each unit were critical to process safety. “BP given new warning over Texas refinery,” Financial Times, (FT.com), September 23, 2009.

Despite notices of these violations and the availability of that information online on the OSHA website, neither the company’s 2009 annual report filed with the SEC nor its 2009 GRI sustainability report contained reference to this enormous volume of pending willful violations of the highest possible gravity. On August 12, 2010, OSHA reached an agreement with BP for it to pay a $50.6 million penalty for these failure to abate violations. OSHA reported this was by far the largest penalty ever paid.

It is worth emphasis here, that these were not violations leading to the Texas City disaster of 2005; they were violations occurring afterwards due to the failure of BP to follow through and implement the needed fixes. The Secretary of Labor stated, “the size of the penalty rightly reflects BP's disregard for workplace safety.” The Assistant Sec. of Labor added: “ It is perfectly within BP's financial means to make this facility safe and they've admitted they have the ability to make it safe.”

Little if anything was reported by the company on OSHA allegations during the 2009 reporting year. However, the company’s 2009 sustainability report Did contain the following cryptic statement regarding safety instrumented systems:

Safety Instrumented Systems (SIS) – US Refining developed a portfolio-wide plan to mitigate higher-level process risks through measures such as SIS by 2016. Lower-level risks will be mitigated on a site-by-site basis. More than 40 SISs are now in service at US refineries, but elements of the SIS life cycle management systems that are required by BP’s internal standards, including SIS documentation, training and auditing, remain to be implemented on these existing systems. US Refining is developing a plan to address these requirements.

Was this statement actually referring in part to the fact that the company was deferring instrumentation system fixes that were deemed grave violations by OSHA? Did the reference to higher-level “process risks” include the 439 instances identified in the Texas City plant that needed immediate remediation according to OSHA? If so, it would have been of interest to readers to know that this timetable of completion by 2016 was inconsistent with the timetable expected by regulators overseeing remedial solutions at Texas City.

Descriptions of the “Management Approach”: an Invitation to “Spin”?
As noted above, the guidance for GRI sustainability reports encourages companies to “Describe the Management Approach” to various issues. The expression “management approach” is used at least 26 times in the G3 Reporting Guidance, the currently operative guidelines for corporate sustainability reporting. Typically, the guidance asks the management to describe the relevant corporate goals, policies, and broadly speaking, their practices. It turns out that it is very easy for management to describe a strategy, policy or goal that may give stakeholders an impression that the company is “doing the right thing.” These statements of management approach can be relatively subjective; is not so easy to ascertain whether the reporting company is “walking its talk” or only presenting an idealized, marketing version of internal realities.

The undisclosed realities of internal corporate culture can easily trump a company’s self-portrait of strategy. As Marcy Murninghan of the Murninghan Post has noted in personal correspondence with the author, the strong pressure on companies to issue these reports can easily create two side-by-side cultures within BP and other firms – a culture of reporting and a culture of practice. While the reporting culture may focus on stating the kinds of values and goals that would be coherent and admirable when viewed by outside stakeholders, the culture of operational practice may nevertheless perpetuate the worst tendencies, focusing on short-term profitability and cost minimization. Current sustainability disclosure standards do not require disclosure of potentially contradictory evidence -- documenting when regulators or scientists find the company’s practices, implementation or behavior inconsistent with “management’s approach.”

Some observers have gone as far to state that in current practice the sustainability report should be understood as a corporate marketing tool rather than an effective means of holding companies accountable on sustainability issues.

Nevertheless, company reputations may be elevated, rightly or wrongly, by sustainability reporting that principally describes the management approach. Such reporting went a long way to seeing BP recognized for its efforts in sustainability. For instance,Fortune magazine ranked BP as the 9th out of 10 most accountable big companies in 2008. The Global Reporting Initiative (GRI) listed BP as a finalist for two categories in the Readers’ Choice Awards for sustainability reporting.

Integrating EHS Personnel to Integrated Reporting: Beyond Sustainability Marketing
Issues of compliance and safety have been a poor stepchild of the forward-looking criteria of sustainability performance encouraged by the GRI reporting framework. The reduced emphasis on legal compliance issues is probably attributable to the outlook that “compliance” is a lagging indicator of companies’ forward-looking, innovative performance and planning – activities that go “beyond compliance.” But, in the aftermath of Deepwater Horizon as well as the Massey Energy coal mining disaster, we understand that knowing the status of a company’s current regulatory compliance challenges is a baseline for understanding risk.

Regulatory inspectors engage in some of the most detailed examination of facilities and products – the fact that they are finding and alleging problems can be some of the most important information for stakeholders to know when it comes to sustainability risk. Yet under current reporting frameworks, “sustainability” personnel work to portray the forward-looking vision of a company in addressing energy and resource management issues, while the environmental health and safety (EHS) staff of the same company may be wrestling with issues of prevention and compliance that are not necessarily reflected in the public sustainability reports. Effective “integration” may mean, among other things, recovering significant sources of intelligence regarding risk and management that current sustainability reporting frameworks fail to capture.

Bridging the Regulatory Disclosure Gap
While issues of legal and regulatory compliance may be a lagging indicator of sustainability innovation, we now understand they represent a baseline needed by investors, and can be leading indicators of sustainability risk.

The recently enacted Financial Reform Act in the US includes new disclosure requirements for mining companies regarding certain serious enforcement actions, orders and penalties issued to coal mining operations only. This set of disclosures goes much further, and with much more specificity, than what is otherwise required to be disclosed in SEC filings regarding ongoing litigation and enforcement actions. The new disclosure requirements can be an inspiration and model for new standards by sustainability and financial regulators –extending far beyond the coal mining sector, to provide an approach for all sectors where compliance issues may be a leading indicator of sustainability risk.

Going beyond the coal mining example, in the US and worldwide, most health or safety related regulators have categories of violations that are “severe,” or “health threatening.” Disclosure standards should include metrics that ensure disclosure and breakdowns of the number of such major violations once they are alleged by regulators. In addition, certain types of agency actions should be designated as per se material and trigger disclosure requirements:

Order to close facilities based on health and safety concerns.

Order to withdraw products based on health and safety concerns.

Suspension of existing or new permitting for any period of time based on health and safety concerns.

Cumulative amounts of penalties paid.

Disclosing Scientific Literature Findings Regarding Catastrophic Risk
Where, as with BP, the scientific literature is full of credible studies showing hazards of a company’s products or activities, disclosure of these risks is necessary, but not consistently disclosed in sustainability or financial reporting. What is needed is less the management’s assessment of such studies, but rather an objective trigger for disclosure when a company’s activities – e.g. a major product line or activity like deepwater drilling – are implicated by studies warning of catastrophic risks.

Although treated as news after the Deepwater Horizon disaster, the uncertainties and risks of Deepwater drilling were well documented in industry literature. As energy companies transitioned from shallow to deepwater oil drilling, experts identified several technical problems resulting from the more extreme conditions. Higher pressures, for instance, can cause seals to fail and choke and kill lines to collapse. Similarly, the lower water temperatures can affect the ability of seals to function. Other concerns include the formation of hydrates, which plug equipment.

Most importantly, many experts were concerned about the inability to control blowouts if they should occur—a prescient sentiment given the Deepwater Horizon spill. In a 1999 article Offshore: World Trends and Technology for Offshore Oil and Gas Operations, Paul Saulnier of Cudd Well Control admitted that well control companies had not been putting enough resources into developing methods to control deepwater drilling blowouts. In recognition of such concerns, the International Association of Drilling Contractors (IADC) and the Offshore Operators Committee (OOC) sponsored a task force to develop guidelines for deepwater drilling between 1997 and 1998. The report details many of the potential problems and solution of deepwater drilling, recognizing that “a serious deepwater incident could set deepwater exploration and development back many years.”

The US National Commission on the BP Deepwater Horizon oil spill and offshore drilling, convened after the spill, reiterates that these deep water drilling concerns were known within the industry, in its “Brief History of Offshore Oil Drilling”:

It was also recognized within the petroleum industry that deepwater conditions create special challenges for critical equipment, including the blowout preventer. In a 2007 article in Drilling Contractor, Melvyn Whitby of Cameron’s Drilling System Group described how blowout preventer (BOP) requirements got tougher as drilling went deeper. “Today,” he said, “a subsea BOP can be required to operate in water depths of greater than 10,000 ft, at pressures of up to 15,000 psi and even 25,000 psi, with internal wellbore fluid temperatures up to 400° F and external immersed temperatures coming close to freezing (34° F).” One possible enhancement he discussed involved taking advantage of advances in metallurgy to use higher-strength materials in ram connecting rods or ram-shafts in the BOP. He suggested that “some fundamental paradigm shifts” were needed across a broad range of BOP technologies to deal with deepwater conditions.

* * *

Perhaps the greatest risk factor was the very feature that made the deepwater boom so big in the first place. The prodigious flow rates in the deepwater help create “elephants,” industry slang for wells whose production is considered especially high by historic standards. Such fields have very high daily output and good overall economics. But in cases of an uncontrolled blowout, high flow rate becomes the enemy as great volumes of oil and gas are spewed into the environment. This special risk of the turbidite reservoirs was both obvious and largely ignored in public discussions before April 2010.

Were Public Information and BP’s Securities Filings Sufficient to Forewarn Investors?
Although most of the specifics discussed above were not in BP securities filings and financial reports, it is also true that some investors were able to read the handwriting on the wall about BP’s practices and risk-taking just based on some of the visible problems the company had, and reported in its Form 20-F (foreign company annual report ) filed with the Securities and Exchange Commission. For instance, the 2005 Texas City refinery disaster and its resulting felony charges, and the 2006 Prudhoe Bay Alaska oil spill resulting from corroded pipelines, were public knowledge and disclosed in the company’s filings. This information was sufficient warning to some investors to decide to disinvest from BP, despite the company’s artful sustainability presentations and branding.

The financial reports also reportedly revealed BP spending that was significantly lower than some other companies, which also could have been seen as a warning flag. However, assessing just how much this was effective frugality, and how much it involved cutting corners on necessary safety or maintenance, would be difficult to do without added disclosure.

Even though some information was available, the company’s state-of-the-art sustainability reporting and relative lack of public visibility of ongoing regulatory enforcement charges, especially in relation to Texas City, surely painted a confusing picture for other investors.

Going Forward Toward Truly Integrated Reporting
The new momentum for integrated reporting, combining financial and sustainability reporting in a single report, poses numerous challenges for those who have been laboring for these years to develop the idea of sustainability reporting. GRI Deputy Chief Executive Nelmara Arbex said that "the goal for refinement of GRI standards over the next few years is to develop a "standard ready" reporting framework, one that is ready for adoption by regulators, financial analysts, among other stakeholders."

Presumably, such standards would also be geared to preventing the kind of “spin” that was evident in the BP reporting experience.

From the standpoint of many investors and NGOs, and as amplified by the BP experience, the standards developed by GRI still have many gaps and shortcomings, and a need for inclusion of additional metrics to provide some of the most material information needed on corporate risk and performance related to sustainability. Yet there is also a cross current of concerns raised by the reporting community, seeking to reduce the volume of reporting and find those “fewer” metrics for sustainability that “really matter.”

Various scenarios exist to reconcile these two views. For instance, the new emphasis on integrated reporting could yield a global practice of issuing streamlined integrated reports, while disclosure of additional, standardized, periodic and real-time sustainability data and analysis exists on company websites for those who wish to drill down further.

Recommendations for Integrated Reporting
Whether integrated reporting reflects integration of sustainability reporting standards into financial annual report requirements, or a new set of standards that adopt some elements of sustainability reporting, to avoid “integrated spin” there is a need for inclusion of criteria currently neglected in both sustainability and financial reporting practice.

1. Disclosure standards should include metrics that ensure timely disclosure and breakdowns of the number of major violations once they are alleged by regulators. In addition, certain types of agency actions should be designated as per se material and trigger disclosure requirements:

Orders to close facilities based on health and safety concerns.

Orders to withdraw products based on health and safety concerns.

Suspension of existing or new permitting for any period of time based on health and safety concerns.

Cumulative amounts of penalties paid.

2. Standards should require disclosure of emerging scientific and technical issues that demonstrate the potential for catastrophic risks to humans, the environment or society.

• Disclosures should summarize credible scientific studies that may relate to public health or environmental risks associated with potentially catastrophic risks of 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 potential 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.

3. Require disclosure of any additional information needed to ensure that sustainability disclosures are not materially misleading.

The existing GRI guidance already contains general provisions requiring under many of the categories of disclosure that reporting companies provide additional relevant information required to understand organizational performance, such as:
• Key successes and shortcomings;
• Major organizational risks and opportunities;

• Major changes in the reporting period to systems or structures to improve performance.

This approach utilized by GRI still represents the process of self portraiture. Instead, analysis should be required from the standpoint of a reader -- asking whether they would be misled by what they are reading. Integrated reporting should adapt the principle applicable to all disclosures to investors under SEC rules – the standing obligation to disclose any additional information necessary to make what has been disclosed not materially misleading. SEC Rule 10b-5.

As integration brings disclosure of sustainability data into the context of legal credibility checks and enforcement, and further from the suspicion of being a mere marketing tool, such a generic requirement for disclosure of information necessary to not mislead the reader will be an important litmus test.

Conclusion
Robert G. Eccles, who convened the Harvard Business School Integrated Reporting conference, and who is coauthor with Mike P. Krzus of the seminal book on the topic, “One Report: Integrated Reporting for a Sustainable Strategy” says that he has been asked by various observers whether effective integrated reporting could have prevented the Deepwater Horizon oil spill.

Certainly that is a lot to ask of any disclosure standard. Nevertheless, it is possible that if a company like BP were more accountable for how it balances efficient business operations and the prevention of harm to society, it might make better, more precautionary decisions that would avoid some of these catastrophes. Certainly, “integrated reporting” will never replace regulatory controls or civil society; we can hope that it would synergize with other elements in the corporate internal and external environment to produce true corporate social responsibility.

The author wishes to thank Genevieve Byrne and intern Samantha Ostrowski for their research assistance on this paper and Adam Kanzer, Marcy Murninghan, Bill Baue, Richard Liroff and John Harrington for their helpful review and feedback. Any errors or omissions are my own.

Will corporate fear mongering deter reasonable action at the FASB?

2010-09-21T11:52:00.003-04:00

Yesterday, the comment period closed on the Financial Accounting Standards Board’s proposal to improve corporate disclosure of contingent liabilities in financial filings. The proposed standard is intended to allow investors to better comprehend the magnitude of liabilities facing companies they hold in their portfolios or are considering investing in.

The FASB has been bombarded with comments from companies and their lawyers, asserting that the new disclosures the guidance would require might allow plaintiffs to gain information enabling them to sue companies, or to increase their demands in settlements. The Wall Street Journal even weighed in to editorialize against the proposed standard.

The trouble is, from an investor standpoint, the disclosure standard currently in force barely works at all. Investors are blindsided, because existing disclosures in financial statements do not provide timely information regarding impending corporate liabilities. Consider the disclosures in the asbestos products liability cases, for example:

• Johns-Manville. Previously disclosed quarterly report liability estimate, $350 million; sudden new estimate upon filing for bankruptcy, $2 billion.

• Kaiser Aluminum. Previously disclosed liability estimate $160 million; but then liability at bankruptcy amounted to billions of dollars.

• Dow Chemical. Acquired Union Carbide without disclosure of $2.2 billion in asbestos liabilities, only estimated a year or two after the acquisition.

As I wrote in the Investor Environmental Health Network’s comments to the Board, we believe the new proposal, which avoids requiring disclosure of legally privileged information, but instead only requires modest disclosures of largely public and nonprivileged information available to companies, is a reasonable solution to the problem. The Proposal that has drawn so much ire requires, for instance, that companies disclose average settlements on claims so far, whether their contingent liabilities are insured, and provide tabular disclosures that break down the various types of cases. The board also agreed with our prior comment, that when there are issues emerging in peer-reviewed scientific literature that demonstrate hazards of corporate products or activities, this can be a trigger for disclosure.

Objections that investor disclosures may provide information to potential plaintiffs have been raised as long as there have been securities laws and accounting principles. Incidental disclosure of some information that may be relevant and useful to a diverse array of stakeholders, including consumers and their lawyers for instance, is a price that we pay for relying largely on disclosure, rather than government micromanagement, for protection of investor interests.

The original standard for contingent liability disclosure promulgated in 1975 was greeted with similar objections, as were proposals for various elements of the SEC’s securities regulations -- especially disclosure of “risk factors” and publication of the Management Discussion and Analysis. The legal sky did not fall with the establishment of those requirements; nor would the set of disclosures proposed by the exposure draft significantly alter the shape of the current litigation environment.

The current proposal is also consistent with a balanced approach taken by the judiciary regarding the use of potentially prejudicial information in the courts. The courts take the view that often potentially prejudicial information which is “more probative than prejudicial” should be allowed into evidence. In the current proposed standard, the information disclosures required are also “more probative than prejudicial” from the standpoint of investor interest, as contrasted with the relatively minor potential prejudicial impact on litigation.

So, the approach taken by the Board in the latest draft presents an appropriate compromise. It preserves legally privileged information, but requires disclosure of information, the concealment of which could essentially encourages companies to issue intentionally misleading financial statements. The accounting rules should not countenance such a scenario.

It is unfortunate to see the Chamber of Commerce and corporate bar once again whip up a frenzy of fear and concern among companies about this very modest proposal. One can only hope that common sense will prevail at the FASB, the imbalanced corporate opposition to modest reforms, lacking in a problem-solving approach, will be rejected by the board, and their reasonable new standard will be upheld and implemented.

----
You can read our comments to the FASB here, and an investor sign-on letter urging the FASB to continue to support investor interest on this issue here.

Want info on pending corporate liabilities?

2010-08-10T08:05:00.002-04:00

Investors must weigh in with FASB by August 20

Endorse our investor sign-on letter by sending an e-mail with your name, title and organization to Sanfordlewis@gmail.com.

Sanford Lewis

When investors are unaware of impending financial pain at the companies in their portfolios, they often face expensive surprises. Financial accounting rules are supposed to arm investors with information to avoid these shocks, but the failures are many and notorious - the collapse of Enron and WorldCom, subprime lending, and massive bankruptcies from asbestos product liabilities.

Guidance for disclosure of pending liabilities in financial statements is provided by the Financial Accounting Standards Board (FASB). After a proposal for reform in 2008 met stiff opposition from corporate lawyers, the board has issued a new draft in July 2010, this time with a proposal that would avoid disclosure of legally privileged or prejudicial information.

At issue: corporate financial statement disclosures on liabilities
Financial statements are required to disclose potential future losses, known to accountants as "loss contingencies." The FASB concluded in 2008 that its current contingent liability reporting standards failed to provide investors and analysts with sufficient information regarding the likelihood, timing, and amount of liabilities.

This is a tricky policy arena to negotiate. On the one hand, investors need good information; on the other hand, investors and companies do not want to arm plaintiffs with information to win higher recoveries as a result of providing better information to investors. Therefore, legal and auditing professions have carefully tiptoed around one another on disclosure related to ongoing litigation. Through their professional organizations they established a so-called "treaty," limiting the degree to which lawyers would disclose liability projections to auditors and companies for purposes of investor disclosure.

But in 2008 the FASB issued draft reforms that would have upset that delicate arrangement. Most notably, the draft would have required companies to disclose their attorneys' worst-case liability projections. FASB was flooded with letters from corporate lawyers urging them not to go forward with the plan.

So FASB went back to the drawing board. On July 20, it issued a proposal (Comments due by August 20) that eliminates the "worst-case projection" proposal, but does require companies to disclose more nonprivileged information, such as providing links to company pleadings and disclosure of expert witnesses' liability estimates.

More About The Revised FASB Draft
Contrary to the 2008 proposal, companies would be allowed to continue the controversial practice of disclosing only their estimate of the "known minimum" of liabilities where there is uncertainty as to the most likely outcome. Such an estimate is unreliable for investors -- the final liability in lawsuits is often dramatically larger than this figure -- but it protects corporate positions in litigation.

Instead, the proposal seeks to require disclosure only of non-privileged information, and places the responsibility with investors to use that information to develop their own estimates of the potential magnitude of liabilities. As guidance to companies it includes the logical principle that more information should be disclosed and made available as a case proceeds. This makes sense, since more is known later, but without specific operational guidelines about precisely what information must be disclosed when it will be hard for companies to act on this requirement.

The new proposal could provide better guidance. For instance it could clarify that disclosed information should include the amount of settlements or judgments issued in similar cases at other companies. The need for such benchmarking could be explicitly specified.

Scientific Literature Disclosure but Not for Longer Term Liability Risks
The July 2010 proposal adds a new requirement that disclosure may be triggered by new science that indicates "potential significant hazards related to the entity's products or operations." However, it may have only limited impact, because it focuses on whether those studies lead to a requirement to accrue liability amounts, rather than also triggering aqualitative disclosures relevant to longer term risks.

Remote but severe liabilities
Liabilities judged by a company to be "remote" would only be require disclosure if they have potential for severe impact and are either "asserted" claims (lawsuits filed) or relate to other potential claims that the management has concluded are both likely to be filed and resolved unfavorably to the company. In practice, this means that even the most severe long-term issues will seldom be disclosed.

This perpetuates the tendency of companies to underestimate the likelihood of longer-term, severe financial threats. Enron, the subprime lending crisis, and asbestos liabilities are three examples of longer-term liabilities that were not disclosed until it was too late. Such large issues loom undisclosed for many years, with eventual catastrophic consequences for investors. Yet under the proposed FASB standard, companies are allowed to avoid disclosing such severe long-term threats if they characterize the claims filed in litigation as "frivolous" or if there are as yet no asserted claims.

HOW TO COMMENT TO FASB
Endorse our investor sign-on letter by sending an e-mail with your name, title and organization to Sanfordlewis@gmail.com.

You can also submit your own comment letter to FASB by August 20, 2010 by emailing director@fasb.org, File Reference No. 1840-100. Those without email may send their comments to the Technical Director - File Reference No. 1840-100 Financial Accounting Standards Board, Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, Connecticut 06856-5116. Contact Sanford Lewis at 413 549-7333 or sanfordlewis@gmail.com if you have questions.

Note that the FASB has received requests to extend the commenting deadline, but will not decide on an extension until August 18, 2010. We will notify the investing community if we learn that the deadline is extended.

The Investor Environmental Health Network (IEHN) is a coalition of investors concerned with risks and opportunities associated with toxic chemicals in corporate products and operations. IEHN has previously participated in revisions of the contingent liability disclosure standard with comments on the 2008 exposure draft, outreach to investors for additional shareholder engagement, and by participating in the FASB stakeholders' roundtable on this topic in March 2009. Our report, Bridging the Credibility Gap: Eight Corporate Liability Disclosure Loopholes That Regulators Must Close (2009) raised many of the issues relevant to need for reform of the FASB contingent liability closure standard, as well as reforms needed in Securities and Exchange Commission disclosure requirements.

--

SEC staff says shareholder proposals process should lag behind emerging issues

2010-07-15T08:41:00.002-04:00

Should shareholder proposals be early warnings for emerging issues and retail challenges? SEC Staff says no.

The socially responsible investment community views the shareholder resolution process as a vehicle for allowing investors to raise and debate issues that may eventually impinge on the corporate bottom line. However, a recent meeting with the staff of the Securities and Exchange Commission indicated that such a view is not necessarily shared by the SEC staff.

First, some legal background. Shareholders that hold over $2000 of shares in a company for over a year are entitled under SEC rules to submit proposals for the company to publish on the proxy statement it issues before its annual meeting. However, the SEC staff also oversees a process of assessing whether particular proposals can be excluded from the proxy based on various SEC rules allowing certain proposals to be excluded. One of the exclusion rules most commonly asserted by companies is that a resolution impinges on the company’s “ordinary business” — addressing issues so mundane that they are not considered appropriate for shareholder deliberations. There are several wrinkles in the staff definition of ordinary business that can determine whether an issue will be kept off the proxy.

Risk evaluation. Prior to 2009, resolutions asking for a company to disclose the financial risks associated with their activities were deemed by the SEC to be excludable as “risk evaluation”. On this basis, in 2008 proposals at Washington Mutual, Bear Stearns, and Lehman Brothers asking for a report on subprime lending practices and risks were kept off the proxy by the SEC. Needless to say, keeping this information out of the proxy did not work out well for investors in these companies. In 2009, after the subprime lending crisis hit, the SEC issued Staff Legal Bulletin 14 E. which changed its policy on risk evaluation. The new policy is to allow shareholders to submit proposals on risk evaluation, but only if the core issue of the proposal addresses what the staff considers to be a “significant policy issue.”

But other staff decisions relating to “significant policy issue” were controversial. For example, this year the staff found proposed issues not “significant” included:

• Net neutrality (a free and open internet) filed at internet providers, even though President Obama had himself publicly declared it an important issue.

• Bottled water quality and labeling, even though this issue is garnering high visibility media and decisions of numerous state and local governments to avoid buying bottled water.

Members of the SEC staff noted in a meeting with stakeholders (including investors and companies) on July 12, 2010 that they view their job as determining whether an issue may have the staying power or whether it could be just a fad. In their view, only firmly engrained issues are appropriate to go to the proxy. The Director of the Division of Corporation Finance, Meredith Cross, stated that the staff decision-making process may lag behind some shareholders’ expectations. She stated that the staff should not, for instance, treat as “significant” this year an issue that they think might yet become significant next year.

Significant policy issue. The SEC staff deliberates on a case-by-case basis as to whether a proposal addresses a “significant policy issue” such that it will not be considered ordinary business. This year, the staff concluded that even though it might seem “ordinary business” for a poultry farm to decide what kind of additives to put in chicken feed, a proposal seeking a phaseout of certain antibiotics in chicken feed presented a significant social policy issue that could appear on the Tyson Foods proxy. What apparently made the issue significant to the staff was that the practice is being banned in Europe.    Similarly, even though environmental management of facilities generally could be ordinary business, environmental impacts and financial risks associated with the natural gas extraction process known as hydraulic fracturing were deemed a “significant policy issue” due to the level of environmental concern facing these practices.

Retail product selection.   While allowing proposals filed at manufacturing companies addressing the products that they sell, the SEC staff routinely excludes proposals that ask retailers to take some responsibility on their end for potential impacts of products that they sell. For instance, the staff has allowed exclusion of numerous proposals asking retailers to avoid selling toxic cosmetics, toys or nanomaterials.   Similarly, in the past year, the staff blocked proposals at two banks that proposed altering bank lending practices to ban loans to companies engaged in coal mining through mountaintop removal.

Opportunities for Shareholder Response

1. The current process places proposals on emerging issues at the mercy of the SEC staff to assess whether they are “significant enough” this year to appear on the proxy, even though many issues and risks of great concern to investors evolve quickly. Witness the staff decision, in the midst of the subprime lending crisis, to rethink prior exclusions of “risk disclosure” proposals.   The SEC policies for disallowing proposals on emerging issues and retail products are not mandated by court decisions or regulatory language, but rather are products of SEC staff deliberation. As such, these policies could be overturned by the Commissioners.

2. Comments of Corporation Finance Director Cross implied that the staff may declare some new issues to be “significant” prior to each proxy season. Therefore, it may be appropriate for shareholders to notify the Division of Corporation Finance prior to the coming proxy season (no later than September) of any specific issues that they believe   to be “significant social policy issues,” and to seek a staff declaration that those issues are appropriate for resolutions in the upcoming season.

In the Aftermath of the Deepwater Horizon Oil Disaster: Can we install Precaution in the Corporate Operating System?

2010-05-10T14:36:00.003-04:00

In the Aftermath of the Deepwater Horizon Oil Disaster: Can we install Precaution in the Corporate Operating System?

Should BP and other corporations follow the “precautionary principle”?

By Sanford Lewis

We don’t yet know the full toll on regional and global ecosystems and economies from the unprecedented BP Deepwater Horizon oil catastrophe in the Gulf Coast. But it is not too soon to draw one lesson — the need for a dramatically different decision-making principle to operate whenever a corporation threatens what is most valued by humanity. Now is a good moment to ask whether there is more we can do to install such a principle in the corporate “operating system.”

For over a decade, there has been a mostly quiet and scholarly discussion about the Precautionary Principle. This is essentially a common sense notion that when an activity may pose the potential for severe or irreversible damage to the things we hold dear, businesses and governments must take all reasonable precautionary measures to avoid the damage. The principle demands action even in the face of uncertainties, such as how likely it might be for such severe damage to occur, or whether the acting entity may be held legally accountable for the resulting damage.

Despite its common sense, the Principle does not drive relevant decisions in most corporations today. In the case of the Gulf Coast disaster, BP reportedly saved $500,000 by omitting a remote acoustical emergency valve. The company had fought regulations in the US, similar to those already effect in Norway and Brazil, which require such a valve. And while other companies voluntarily install the valves even where not legally required, BP and its contractors did not do so. We will probably never know whether the valve would have stopped the current disaster. But the uncommon sense of the Precautionary Principle would dictate that the valve should have been in place.

This raises the question of whether it is possible to install this principle in corporate “operating systems” in a way that would lead companies to make more precautionary decisions.

Here are a few ideas for reader input. Do these ideas strike you as worth pursuing as part of corporate social responsibility and socially responsible investment initiatives?

Integrate the Precautionary Principle to Enterprise Risk Management?

Enterprise Risk Management (ERM) is a widely used process by which a company reviews and manages its “risk profile.” See Enterprise Risk Management Framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO) (2004). Financial and reputational risks are typical drivers of decisions under ERM. In contrast, integrating the Precautionary Principle to ERM would mean requiring action when the environment or other core social values such as human rights are seriously threatened, regardless of projections of whether the related costs will be internalized to the corporate bottom line. Some forward-looking companies such as Dell, Samsung and Bristol-Myers Squibb have already adopted the Precautionary Principle. One wonders whether and how those companies are already integrating the Principle to ERM. Where else are there opportunities to advance Precaution as a decision-making principle within ERM?

The Precautionary Principle and human rights? The Deepwater Horizon disaster is not just an environmental catastrophe. Because it threatens the right to livelihood of many coastal people who rely on the ocean for fishing, and the right to a healthy environment, it also is a human rights disaster. The Precautionary Principle is relevant to protection of human rights as well as to the environment. Shouldn’t society require that businesses operationalize the idea that if their actions may trample fundamental human rights, even if there is some uncertainty, they must consider and apply measures to avoid such harms? The opportunity to instill such a principle may exist now. Professor John Ruggie, the Special Representative of the UN Secretary-General on Business and Human Rights, has proposed a framework that would, among other things, encourage corporations to “respect” human rights by exercising “due diligence.” (The framework is due to be refined and finalized by June 2011.) At a recent gathering to discuss the framework, lawyers asserted that getting their corporate clients to engage in “due diligence” is difficult because “human rights” are so amorphous. How can they know with certainty when such rights are about to be violated? Could integrating the Precautionary Principle, or something like it, into the UN framework help to ensure that corporations respect human rights even in the face of uncertainty?

Integrate the precautionary principle to corporate charters, perhaps beginning with emerging “green” and “sustainable” corporate models?

The deepest place to install the Precautionary Principle would be in the “DNA” of the corporation, the corporate charter. At least theoretically, efforts could be undertaken to amend corporate charters to require the application of the Precautionary Principle. But an easier place to begin may be through the new efforts to provide mechanisms to incorporate and certify companies as “green” or “sustainable.” For instance, on April 14, 2010, the state of Maryland established a new law allowing companies to incorporate as “Benefit Corporations,” integrating societal benefit goals to their charters and missions, and backing this up with review and certification by respected third-party certifiers (much like Underwriters’ Laboratory reviews safety). Other states are also considering such laws. The incorporation and certification programs that are emerging are an attempt to overcome widespread greenwash, as a result of companies like BP attempting to self-certify or brand themselves as green. Could a litmus test be whether the new “green” corporations have adopted and operationalized the Precautionary Principle?

There are many other potential opportunities and strategies for integrating the Precautionary Principle to corporate decision-making, such as shareholder resolutions, legislation, and directors’ fiduciary duties. In the aftermath of Deepwater Horizon, the time is ripe to begin the work of integrating the common sense of precaution to corporate decision-making systems. Which of these opportunities do you find most promising, and why?

Will Integrated Financial And Sustainability Reporting Become A Legal Mandate?

2010-04-25T15:42:00.004-04:00

Much of what we think of as corporate sustainability reporting is currently done on a voluntary basis. But most observers believe it is only a matter of time until sustainability disclosure will be a legal requirement just as financial disclosure is today.

The Securities and Exchange Commission recently took an important and celebrated step toward mandating sustainability disclosure with a guidance on climate related risks. The guidance clarified duties of companies to disclose certain kinds of climate data and analysis in SEC filings. The guidance was based on existing legal requirements, such as the duties to report on litigation and liabilities and on emerging trends, events and uncertainties.

Since these requirements are already on the books, why the need for guidance? NGO and investor reviews of SEC filings show that, in the absence of SEC guidance, environmental and social issues disclosure in SEC filings is sparse, inconsistent, and typically omits large issues facing the reporting company.

For instance, there is growing concern by investors on how potential environmental impacts from natural gas extraction including drilling and related processes may affect energy companies. An estimated 60-80% of natural gas wells drilled in the next decade will require a process known as “hydraulic fracturing” (“fraccing”) in which huge volumes of water, chemicals and particles are injected underground to release natural gas. Public concerns regarding toxicity and water impacts are already having an effect.

For instance, Chesapeake Energy, recently withdrew several natural gas-related development plans after public and government expressions of concern on potential environmental hazards. These included plans to drill in the New York City watershed, to dispose of waste water in an abandoned well near a water supply in upstate New York, and to withdraw water for fracturing from the Delaware River basin. Yet, the company did not mention these problems in its latest annual 10-K report filed with the SEC.

Another company, Cabot Oil & Gas, was hit with numerous environmental enforcement actions in 2009 around its operations in Pennsylvania due to toxic spills, and to methane entering nearby private drinking wells. Enforcement included a temporary shutdown order and a consent agreement containing a civil penalty of $120,000. Again, these did not appear in the Company’s SEC filings.
The lack of disclosure of the $120,000 penalty might seem notable in light of an SEC regulation requiring disclosure of pending or likely environmental enforcement actions where the penalty is expected to exceed $100,000. But a recent study found that 73% of all companies are not disclosing environmental enforcement actions with penalties in excess of $100,000. It seems either the rule’s applicability to specific cases is considered by companies to be equivocal, or the absence of SEC enforcement is not inspiring broad compliance.

For Cabot, the $120,000 penalty was not the end of the matter. On April 15, 2010, the state modified the consent agreement with a fine of $240,000, and a continuing penalty of $30,000 per month until Cabot rectifies identified environmental problems. The new order also bans the company from drilling new wells in the area for a year. In response, the company issued a news release (but so far, not an SEC disclosure) noting that “This modified order does not impact the number of wells scheduled to be drilled under Cabot’s 2010 drilling effort, nor will it impact our production guidance.”
Shareholders monitoring the gas companies remain concerned about poor disclosure. New York State Comptroller Thomas DiNapoli, Green Century Funds and numerous other investors are attempting to fill the natural gas sector’s disclosure gap through a series of shareholder resolutions requesting reports on this issue by energy companies. Beyond the disclosure gaps on this specific issue, it is obvious that additional SEC guidance and enforcement could enhance disclosure of an array of issues in SEC filings.

On the other hand, better enforcement or single issue approaches like the climate guidance, are not the end-all and be-all of sustainability disclosure. Arguably, fully integrating current financial reporting to the SEC with data associated with impacts of the corporation on society could be far more useful. The Social Investment Forum submitted a proposal to the SEC last summer calling for movement in the direction of an integrated disclosure requirement, such as that suggested by Harvard business professor Robert G. Eccles and Michael P. Krzus of Grant Thornton LLP in their new book, One Report: Integrated Reporting for a Sustainable Strategy.

The SIF proposal had two elements. First it requested that the SEC require issuers to report annually on a comprehensive, uniform set of sustainability indicators. The letter suggested that the Global Reporting Initiative (GRI) reporting guidelines would be a reasonable starting point. Secondly, it asked that the SEC issue a guidance to ensure disclosure of short- and long-term sustainability risks in the Management Discussion and Analysis section of the 10-K (MD&A). The latter proposal would reduce the subjectivity of a company’s decisions to disclose by providing more objective thresholds to trigger disclosure obligations, such as disclosing the emergence of peer-reviewed studies indicating potential hazards of a company’s products or activities.

Such changes would go much further in ensuring that investors and other stakeholders have ready access to the information needed for an integrated examination of where and how finances and sustainability converge.

Do Directors have a fiduciary duty on sustainability?

2010-04-05T10:05:00.003-04:00

I'm a guest blogger today on CSRwire Talkback on "Legal frontiers of Sustainability." As investor's counsel, I explain why/how we asked Intel's Board to address CSR/Sustainability as fiduciaries.

According to a recent CERES report, aligning economic prosperity and environmental sustainability will demand new strategies in the board room and executive suite. First among the strategies identified by CERES is a need for every corporate board of directors to assign a board committee to oversee sustainability. A number of US companies have already taken this step. There is a sound business case for doing so. Companies that are attentive to sustainability in many sectors have done better than average financially during the financial slowdown. Also, many companies are finding that they can use a sustainability focus to drive their leadership as innovators.

Notably, just a week after CERES issued its report, Intel’s Board of Directors decided to modify a committee charter to better integrate sustainability and corporate social responsibility. Moreover, the company acknowledged that the change makes these issues part of committee members’ fiduciary duties.

These changes to the committee charter happened after my legal client, Harrington Investments, Inc. (HII) http://harringtoninvestments.com had filed a shareholder resolution, for the second year in a row, to amend Intel’s bylaws to create a Board Committee on Sustainability. Intel initially opposed the resolution at the Securities and Exchange Commission. But a subsequent dialogue with HII yielded an agreement (in exchange for withdrawal of the resolution) to propose changing the governance and nominating committee charter to require the committee to:

“review(s) and report(s) to the Board on a periodic basis with regards to matters of corporate responsibility and sustainability performance, including potential long and short term trends and impacts to our business of environmental, social and governance issues, including the company’s public reporting on these topics.”

As part of the dialogue, Intel also had its outside legal counsel Gibson, Dunn & Crutcher LLP ink an opinion clarifying that pursuant to Delaware law, the committee’s charter generates a fiduciary obligation. The legal memo cites the notion of a “charter imposed duty” as clarified by In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 53-54 (Del. 2006).

Although the case cited, Walt Disney involved a finding by the Delaware Supreme Court that a $130 million severance payment to Michael Ovitz did not entail a breach of the directors’ duties, the case is widely cited for the notion that directors have a fiduciary duty to “act in the face of a known duty to act.” Thus by integrating sustainability and corporate social responsibility into a committee charter, committee members gain a fiduciary duty to attend to those issues.

As HII’s lawyer in this process, I find the inevitable legal questions flowing out of this analysis particularly interesting. First of all, do all directors already have a fiduciary obligation regarding sustainability and corporate social responsibility? The answer is that within certain relatively uncharted boundaries they do. For instance, when it comes to oversight of environmental compliance, or social issues that may affect a company’s reputation, the duty of care attendant to directorship clearly extends such issues interwoven with the company’s prospects. An excellent aw review article, “Is There An Emerging Fiduciary Duty To Consider Human Rights?” by law professor Cynthia Williams details this obligation, for instance, in the arena of human rights.

How then does the insertion of specific language into a committee charter alter the scope of directors’ fiduciary duty on these issues? Contrary to the vagaries of evolving fiduciary obligations, with little delineation of the scope of a director’s obligation, the committee charter is very specific. It asks for the members to examine, for instance, “potential long and short-term trends and impacts to our business of environmental, social and governance issues.” It gives much clearer guidance as to the range of issues under committee scrutiny, including “long term” trends, and “potential” issues.
Finally, under what circumstances might the resulting fiduciary duty be deemed enforceable by the courts?

In general, the deliberations of directors are shielded by the “business judgment rule” which“ presumes that ‘in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.’ ” Aronson v. Lewis, 473 A.2d 805, 812 (Del.1984). So, it takes more than just a mistake by board members to face any liability exposure. In general, the kinds of failures in their duties of care and good faith that would trigger liability would involve intentional dereliction, a conscious disregard for one’s responsibilities, an actual intent to do harm, or gross negligence.

I believe the most immediate legal implication may be the enhanced duty of the directors to inquire and to oversee. Specifically, when potential sustainability or corporate social responsibility issue present significant risks or opportunities to the company, the committee members have a duty to ensure that they are reasonably well informed. Secondly, they must ensure that the management is on top of the details, with sufficient internal controls in place, such as enterprise risk management systems.

Given the fiduciary duties that accompany this expanded committee role, it seems well worthwhile to encourage more boards of directors to ensure that sustainability and corporate social responsibility are well- delineated in committee charters.

Risky Business: 10 Questions on Risk Management for the New Decade

2010-01-07T10:26:00.001-05:00

For the last decade, risk governance and risk management have been on the ascendancy. Early in the decade, Enron and its ilk helped to propel a sense of urgency and crisis, driving the completion of the Enterprise Risk Management framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO) (2004). But the recent financial crisis, compounded by snowballing sustainability issues such as climate change and product toxicity, made it clear that risk management is a work in progress. Far more must be done to turn the patchwork of risk management approaches into viable public policy and corporate governance solutions.

From my perspective as counsel to investors who are typically concerned with both the financial and societal risks associated with their portfolio companies, here I will offer my perspective on 10 key questions on risk management likely to be answered over the next decade:

1. Will the major environmental and social risk disclosure loopholes be closed by the SEC and FASB?

Numerous organizations and investors have communicated to the Securities and Exchange Commission the need for clearer guidance on disclosure to investors of environmental and social risks, including climate risk, human rights, labor impacts, and other so-called ESG performance issues. See, for instance, communications to the SEC by the Investor Network on Climate Risk and the Social Investment Forum.

In addition, as we wrote last year in our report for the Investor Environmental Health Network, Bridging The Credibility Gap: Eight Corporate Liability Disclosure Loopholes That Regulators Must Close, the system of disclosure to investors regarding potential and pending corporate liabilities overseen by the SEC and the Financial Accounting Standards Board is seriously broken. It remains to be seen whether either agency will have the backbone needed to repair the flaws. Practically speaking, action by those agencies depends on whether the affected constituencies, especially investors, make their voices heard on these issues.

2. Will “sustainability risk” become an operative principle of corporate decision-making?

As demonstrated in the Chartered Accountants of Canada 2009 report on Sustainability, Risk and Opportunity, the word sustainability has at least two meanings: it can mean the ability of a business to continue to “sustain” itself financially, or it can mean essentially an environmental evaluation- whether a particular activity undermines or supports the needs of future generations living on our planet. The new term “sustainability risk” attempts to embody both concepts, but may in the end prove confusing. Other terms, such as “climate risk” or even “long-term risk” may prove clearer in framing disclosure and risk management discussions and policies.

3. Will compensation structures be linked to long-term views of risk and performance?

Compensation watchdogs, such as Nell Minow of The Corporate Library and Prof. Lucian Bebchuk of Harvard Law School, have asserted that as long as the corporate insiders who hold major quantities of stock can benefit by temporarily pumping up a firm’s short-term financial performance, incentives will be skewed towards short-term over longer-term performance and risk.

A resolution filed by Harrington Investments at Goldman Sachs for the 2010 shareholder meeting would require the top five executives to hold 75% of their future stock bonuses until three years after their retirement, effectively creating an incentive to maintain the long view.

4. Will board risk governance committees catch on?

Senator Charles Schumer’s “Shareholder Bill of Rights Act of 2009” would require all public companies to establish risk committees of their boards, to “be responsible for the establishment and evaluation of the risk management practices of the issuer.” Some expert observers and commentators regarding corporate governance assert that such a uniform requirement for board risk committees is ill-advised. They assert that risk management oversight is a core responsibility of the entire board, and not a role that can be delegated to a subgroup of board members through a committee.

Yet, there are so many issues involved in ensuring the integrity of a firm’s overall risk management framework, that the greater focus brought by a separate committee does seem appropriate, at least in reviewing the integrity of the risk management systems that are put in place, and identifying risk issues which should be given priority attention by the board in its entirety.

Shareholders concerned with risk governance at their portfolio companies have begun to follow the lead of the Schumer bill in resolutions filed for the upcoming season. For example, a resolution filed by Northstar Asset Management at Western Union requests that the company form a risk governance committee independent of the existing audit and finance committee. Similarly, a resolution filed at ConocoPhillips asks the company to disclose the board’s risk governance practices, and to explore whether a separate board risk governance committee is needed.

5. Will directors face liabilities for poor risk oversight?

So far, it is unclear whether boards of directors will be held liable for poor risk oversight. The recent Delaware Chancery Court decision in In Re Citigroup Inc. Shareholder Derivative Litigation, 964 A. 2d 106 (Del. Ch. Feb. 24, 2009) (see good discussion here) demonstrates that the courts may be willing to grant a wide berth around board discretion in risk decision-making, based on the business judgment rule which protects board members from liability in exercising ordinary business judgment. Shareholders had filed a derivative action on behalf of Citigroup alleging that the company’s officers and directors had breached their fiduciary duties by, among other things, failing to monitor and manage the risks associated with subprime lending. The Court noted, “Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.”

Nevertheless, there are cracks in the wall that may eventually lead to board liability. For instance, in discussing the Securities and Exchange Commission’s recently established requirements for disclosure of risk management credentials of board members, Arthur C. Delibert of the law firm of K&L Gates LLP recently cautioned against too aggressively stating a board member’s qualifications to avoid expanding his or her liability.

…registrants should bear in mind that individuals with expertise in relevant areas may be subject to heightened standards of liability under federal and state securities laws. When the Commission in 2003 adopted the requirement that registrants disclose whether their audit committees include at least one “audit committee financial expert,” it also provided relief from some forms of potential liability to which such “experts” might otherwise be subject. The new disclosure requirements provide no such relief, despite comments from several organizations having raised concerns about such liability. Accordingly, registrants may wish to be circumspect in their descriptions of director qualifications, while honoring the requirement that disclosure be complete in all material respects.

The potential liability of board members for poor risk oversight remains a contested territory, and will no doubt be an interesting topic of litigation during the new decade.

6. Will Enterprise Risk Management protect investors and society, or merely insulate management and boards from potential liabilities?

Enterprise Risk Management involves determining how much uncertainty is acceptable within an organization, and then identifying a strategy consistent with that risk appetite. As an article published by the accounting firm of Grant Thornton recently noted, by adopting ERM,

a company gains the ability to align its risk “appetite” and tolerance with business strategy. As a result, management can better manage risk “opportunistically”–they can identify events that could have an adverse effect, determine whether the benefits outweigh the risks and develop an action plan to manage them. In other words, proper risk management allows organizations to examine and evaluate opportunities and create value by taking risks carefully.

It remains to be seen however whether the existence of ERM programs will result in better choices about risk, or principally provide an evidential baseline for asserting that officers and directors had not neglected their fiduciary duties to manage risk.

7. Will corporate risk managers apply the precautionary principle to potentially catastrophic risks to society?

In a dialogue at The Conference Board that I participated in during the summer of 2009, several board members of major corporations stated unequivocally that when it comes to sustainability and a company’s risks to society, the bottom line for them is simply whether the way the company handles an issue helps to maximize profitability. This approach is consistent with the COSO guidelines for Enterprise Risk Management, under which risk management means of choice among various strategies. Although a baseline of legal compliance may be inferred, taking other voluntary action to reduce risks to society posed by the firms activities is weighed against other approaches to the risk, including buying insurance or choosing to simply shoulder the risk.

In contrast to that view, some companies do appear to take the position that any potentially catastrophic risks to society posed by corporate activities are to be minimized or avoided, regardless of the potential returns or availability of insurance. For instance, forward-looking companies such as Dell, Samsung and Bristol-Myers Squibb which have adopted the Precautionary Principle, which would require them to minimize certain risks with potentially severe implications for society. Taking action to reduce the risks is the priority, and not coequal with other risk management options such as insurance.

The issue of risks to society has been amplified by recognition of systemic risks – errors repeated across companies and sectors – where only strong government oversight seems sufficient to the task of controlling the broader implications of many individual corporate risk decisions.

8. Will the attention to "Black Swan" risks -- those considered largely unpredictable -- lead to disempowerment, or action to avoid and plan for the worst consequences?

The financial crisis has brought a great deal of attention to the concept of the “Black Swan” event, the improbable event that defined calculation of probabilities. In a recent article in the Harvard Business Review, the author of the book The Black Swan: The Impact of the Highly Improbable cowrote an article in which the number one mistake made by executives in risk management is to fail to shift the focus from predicting when the severe incidents might happen to preparing for the eventualities.

There is a danger in the present environment that risk managers will be disempowered by the notion of risks that they cannot predict, and pay too little attention to reducing the potential consequences for the firm and society. For example, even though it is difficult to calculate the odds of health impacts, we already know enough about some nanotechnology hazards to public health to suggest that greater attention, prevention and disclosure is prudent.

9. Will Web 2.0 bring radical transparency to corporate risks?

Web 2.0 technologies such as Reframeit have already made it possible for corporate annual reports to be annotated by any member of the public. It is only a matter of time until such tools are applied in a manner that brings much more information into the hands of the investing public. Websites that emerged in 2009 like MoxyVote.com and Shareowners.org are a promising vanguard of such an approach, and new requirements of the Securities and Exchange Commission for companies to uniformly encode their annual reports (in XBRL) may help to enable this trend.

10. Will shareholders use their growing powers to ensure transparency and accountability on risk?

In 2009, it became clear that shareholder rights are on the ascendancy. There is momentum for shareholders to win stronger rights to nominate and elect directors of their companies. In addition, the SEC restored the right to file shareholder resolutions seeking disclosure of hidden financial and sustainability risks. Already, dozens of resolutions have been filed for 2010 asserting those restored rights.

Nevertheless, it remains to be seen whether the broader community of all shareholders will effectively assert those rights to secure better risk management in the coming decade.

The author is a legal advisor to investors focused on financial and societal risks associated with portfolio company issues such as sustainability, public health, and human rights. He is counsel to the Investor Environmental Health Network as well as many of the funds and investors mentioned in this blog post.

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

2009-10-27T06:21:00.004-04:00

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?

2009-10-15T14:46:00.003-04:00

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?

2009-10-09T08:25:00.001-04:00

.
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?

2009-10-05T09:25:00.000-04:00

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?

2009-10-01T16:03:00.001-04:00

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.

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 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.

Receptive NYC Audiences Ponder Closing the “Eight Corporate Liability Accounting Loopholes”

2009-07-02T10:12:00.000-04:00

On June 16, the Investor Environmental Health Network (IEHN) issued a new report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close. The report describes how companies are encouraged, and arguably even required, by current accounting rules to keep hundreds of billions of dollars of impending liabilities off of their financial statements and out of securities filings. While the report examines case studies of asbestos and nanotechnology company disclosures, the findings apply to a wide array of impending and potential liabilities that companies should be disclosing and estimating in their financial statements.

The report, which I prepared under contract to the IEHN, provides practical recommendations for regulatory reforms that the Financial Accounting Standards Board and Securities and Exchange Commission can adopt in order to close these loopholes.

Field testing our ideas
During the week of June 22, I had the opportunity to test out the ideas in the report on audiences at two conferences in New York City. First, I attended and spoke at a meeting of a Working Group on Sustainability and Governance of the Conference Board. The Conference Board is a research organization which “creates and disseminates knowledge about management and the marketplace to help businesses strengthen their performance and better serve society.” Later in the week I spoke at a larger conference on Mainstreaming Environmental, Social and Governance Issues (ESG), cosponsored by Responsible Investor and the Social Investment Forum.

Contingent Liabilities and Sustainability in The Corporate Boardroom
The Conference Board working group meeting was an interesting and frank exchange of views among corporate board members and institutional and mainstream investors. We had an opportunity to hear some high-level corporate board members think out loud about the challenges of integrating sustainability to board decisions. The most important take-home lesson was that Board members are having a difficult time with this process of integration, in part because they don’t know how to define or measure sustainability when compared with concrete measurables such as Return on Investment.

Into that context, I injected the idea from our report that current contingent liability disclosure rules (FAS 5 and Fin 14) are substantial contributors to the shortfall of information on sustainability for board members. Even though there may be very large impending liabilities such as on environmental or social issues, the current rules encourage disclosure of the “known minimum,” and allow the legal privileging of information about the potential range of liabilities facing a company. Because privileges could be waived if lawyers' work products are shared with board members, the current rules leave board members in the dark about the magnitude of issues that are facing their own companies.

This dilemma has been especially well expressed by Greg Rogers, CPA, JD, the chair of the American Bar Association Committee on Environmental Financial Disclosure. Rogers has recently launched a new product that demonstrates how inconsistently companies accrue their liabilities based on the current rules. He points out that the current accounting rules leave companies with few good choices when it comes to producing and using realistic estimates of contingent liabilities; in the absence of effective rules creating a level playing field, companies that voluntarily provide better disclosure may suffer a competitive disadvantage in the investing marketplace. By sticking with the known minimum, Boards and managers are flying blind as to the real magnitude of liabilities facing companies. And if companies should choose to keep a second set of books for internal use indicating what the projected level of liabilities may be, they could be accused of accounting fraud.

I believe there was resonance among the participants at the Conference Board meeting with the core idea from our report that the existing, decades old contingent liability disclosure rules rely too heavily for disclosure on litigators, who are ethically bound to the opposite of disclosure, i.e., to secrecy and privilege. Our report proposes that when there are potentially material liabilities on which the range of potential losses has not been disclosed, the preparers of financial statements should be required by revised FASB and SEC rules to contract with independent consultants to develop nonprivileged, public estimates of the potential range of liabilities - numbers that would be usable by investors as well as board members.

Mainstreaming Environmental, Social and Governance Issues In Investment
At the second meeting, regarding mainstreaming ESG, various institutional investors and analysts presented their strategies for integrating data and analyses regarding environmental, social and governance issues in their investing strategies. Again, I found a responsive audience among investors, who are well aware that financial statements currently contain poor disclosure of many contingent liabilities, including both “bankruptcy booby-traps” and long-term product liability hazards that are not being disclosed by nanotechnology innovators and other companies.

For institutional investors looking to better integrate environmental and social risks and opportunities facing companies into their investment decision-making, the poor disclosure of contingent liabilities is an enormous stumbling block. In many instances the undisclosed contingent liabilities will eventually swamp the levels of value that are reported in the financial statements. Better disclosure and estimation of these contingent liabilities is a must for any investors that hope to integrate financially relevant data about environmental and social issues.

At the Responsible Investor conference numerous investors and analysts asked me to keep them informed as to how this issue is developing. I left both meetings with the sense that if given a fair hearing in the “marketplace of ideas,” the practical solutions offered in our report could prevail on their merits.

In the Meantime, Rule-making is Stalled
The Financial Accounting Standards Board was set to begin redeliberation of its 2008 exposure draft regarding (FAS 5) contingent liability reforms since the beginning of this year. However, given the many other issues of regulatory reform that are surfacing in this arena, and the controversy that the draft faced, it is not surprising that the Board has not yet taken action on redeliberation.

In a letter to the Financial Accounting Standards Board sent along with the report, I noted to Board Chairman Robert Herz and the Board members that:

“The members of the Investor Environmental Health Network recognize that the Board is under intensive pressure from the corporate defense bar and the Chamber of Commerce, among others, not to pursue your proposed actions to improve the contingent liability disclosure rules.

However, our report demonstrates that the arguments advanced by the corporate community in opposition to your exposure draft are misdirected. It is not necessary to subject the companies we invest in to additional liability, nor require waiver of their legal privileges, in order to improve the quality and quantity of information available to investors on contingent liabilities. We believe our new report offers a way forward for the Board that will lead to a more balanced and effective disclosure framework for contingent liabilities.

Walking the path between preserving the integrity of the litigation system and insuring the credibility of the financial statement is a mazelike task for the Financial Accounting Standards Board. It is not surprising that the 2008 exposure draft failed to accomplish this goal without hitting some sharp corners. We hope that our report will contribute to effective action on this issue by the Board.”

There will surely be opportunities in the weeks and months ahead for investors and other concerned stakeholders to advance these issues. Readers are urged to contact us at disclosure@iehn.org to stay informed on opportunities to help advance these issues. The issues raised in our report are certainly among those that regulators must address to restore the credibility of financial statements for investors.

.

Video Preview: Eight Liability Disclosure Loopholes that Regulators Must Close

2009-06-10T09:12:00.000-04:00

.

Excerpt (1:44) from an interview with me conducted by Bill Baue of Seachange Media, previewing our forthcoming report, Bridging the Credibility Gap: Eight Corporate Liability Disclosure Loopholes that Regulators Must Close. The report will be published soon by the Investor Environmental Health Network.

Request more info on the report via email

Website

Twitter

Goldman Sachs: Governing US Economy from Within or Without?

2009-05-07T07:21:00.000-04:00

.

Goldman Sachs has so many former employees in high places within the Obama Administration that several articles have asked whether the company now runs our government. Are there too many people within the government looking out for the interests of Goldman Sachs? (See, for instance, here and here .) In contrast, few are asking an equally important question: Is Goldman Sachs looking out for economic the interests of the US, since it has received a $10 billion taxpayer bailout?

A bylaw amendment pending at the company’s annual shareholder meeting, on Friday, May 8, would help ensure that people in high places within Goldman Sachs give priority to thinking about the company’s impact on the US . The amendment, placed on the proxy by Harrington Investments Inc. (HII), would establish a Board level committee on US economic security.

“This resolution will be the first in the country to call upon the owners of a major financial institution that has received taxpayer bailout funds to create a board committee to pledge support for U.S. economic security,” said John Harrington, President and CEO of HII, “Goldman Sachs has received a $10 billion bailout, $22 billion in bond guarantees, FDIC insurance, and is eligible for cheap money from the Federal Reserve, and all the while denying any responsibility to safeguard our country’s economic future.”

Among other concerns, John Harrington, a life-long human rights advocate, is concerned that Goldman’s $2.6b investment in the Chinese government’s Industrial and Commercial Bank of China (ICBC) will be used to undermine U.S. national security interests. The Chinese communist government’s banks fund weapons and telecommunications research, and China has a history of utilizing its technology to “hack” into U.S. defense and Pentagon computers as well as breach U.S. Department of Defense weapons contractor’s computer systems to collect data and information that may compromise national security.

The same amendment was also filed at Bank of America and Citigroup, but those companies applied for and received permission from the Securities and Exchange Commission to exclude the proposal from the proxy.

Read more

Disclosure note: The author represented HII in the development and defense of the bylaw amendment.

Report Back from FASB Roundtable on Contingent Liability Disclosure

2009-03-10T13:35:00.000-04:00

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 “DISCOVERS” $2.2 BILLION IN ASBESTOS LIABILITIES

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.

MAXXAM/KAISER IGNORES JOHNS MANSVILLE’S EXPERIENCE
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

Counsel

Investor Environmental Health Network

FASB to Resume Deliberations on Liability Disclosure

2009-02-09T14:26:00.000-05:00

FASB needs more investor commentators.
FASB seeks companies to model good financial statement disclosure.

You may recall that last summer, when Wall Street was only just beginning its current meltdown, the Financial Accounting Standards Board solicited comments on a new proposal to expand its liability disclosure standards. The proposal would require companies to report more about known and potential liabilities in their financial statements.

FASB received dozens of letters from investors and advisors urging the Board to go forward with disclosure improvements. But it also received letters from hundreds of companies and their lawyers opposing the proposal -- asserting that disclosure of future liabilities is too speculative and that it would would undermine attorney client privilege.

Originally slated for implementation in December 2008, FASB postponed the effective date until at least December 2009. The Board asked FASB staff to conduct “field experiments” to demonstrate models of possible disclosure:

"The staff will develop an alternative model for disclosure requirements that will attempt to address concerns raised by certain constituents about the proposed requirements in the Exposure Draft. The staff will then conduct field testing of both the model in the Exposure Draft and the alternative model. Field testing is expected to take place in November and December 2008…

After field testing is completed, the FASB will hold public roundtable discussions. Those discussions are expected to take place in the first quarter of 2009."

According to FASB staffer David Elsbree, only three companies came forward to volunteer to field test options for disclosure. The companies agreed to actually prepare financial statements consistent with the original proposal, as well as an alternative model based more on factual disclosure and less on speculative judgment calls about potential liability. The theory is that the alternative model might avoid most of the problems that corporate lawyers asserted would breach attorney-client privilege or work product. The alternative model could involve disclosure of factual information sufficient to allow third parties to begin to develop informed estimates of potential liability exposures, without requiring the companies to advance speculative estimations of liability themselves. Apparently there are only a few limited examples of this approach in the model suggested to the field testing companies.

The staff at the FASB is still awaiting results from the three volunteer companies, who are conducting the field trial on a confidential basis.

On March 6, FASB plans to hold a roundtable to discuss the results of the field tests, and seek constructive dialogue among stakeholders as to how to refine the prior proposal into something more workable for all concerned.

As I noted in my prior blog post I believe there is room for refining the prior proposal to better meet investors’ information needs while protecting privileged information.

Action Steps for Interested Investors:

• The participants in the pending FASB roundtable have not yet been selected . There are far more representatives of corporate law firms and corporate filers who have volunteered to be in the roundtable than users of financial statements. ( Full disclosure: I am on the short list of potential roundtable participants from the investors’ perspective.) Interested investors can contact FASB within the next few days and request to be added to the list of possible March 6 roundtable participants. (Or contact me to discuss this further.)

• FASB needs to find additional companies who could model ( either on a public or confidential basis) what a good model of disclosure would look like. Do any candidates come to mind among the companies in your portfolio?

Largest TARP Banks Oppose Board Accountability for Effects on US Economy

2009-01-21T11:24:00.000-05:00

In his inaugural address President Barack Obama stated that:

"And those of us who manage the public's dollars will be held to account, to spend wisely, reform bad habits, and do our business in the light of day, because only then can we restore the vital trust between a people and their government.

***

[t]his crisis has reminded us that without a watchful eye, the market can spin out of control. "

The new era of accountability and responsibility heralded by the inauguration of our new leader flags outstanding questions about the ongoing bank bailouts. An enormous amount of taxpayer money is currently being managed by private companies. The two companies that received the most money from the Troubled Assets Relief Program (TARP) are Bank of America and Citigroup. Together they have received nearly $100 billion in taxpayer assistance. With so few strings attached by the outgoing Bush administration, the responsibility for holding those who are managing these public funds accountable seems to have fallen by default upon the board of directors of those companies or their shareholders.

One effort to bring some accountability has been initiated by shareholder John Harrington of Harrington Investments. He has filed shareholder resolutions at both companies that would amend the corporate bylaws to establish a board level committee on US economic security. The role of such a committee would be to identify whether the company’s policies adequately support US economic interests, especially in light of the receipt of these billions of dollars in taxpayer funds.

Having received the funds with so few strings attached, the companies apparently do not want to start accounting for the return on American taxpayers' investment now. So the companies have filed massive No Action letter request with the Securities and Exchange Commission, asking the SEC to allow these companies to exclude the bylaw amendments from their 2009 proxy statements. (Company requests: Citigroup letter; Bank of America letter) As counsel to Harrington Investments I filed rebuttals to these letters on Monday of this week. (Proponent replies: Citigroup letter; Bank of America letter)

The companies make some remarkable assertions in their attempt to block these bylaw amendments from appearing on the corporate proxy. For instance, Bank of America, attempting to cast the resolution as “ordinary business” asserts audaciously that “a review of the corporation’s policies to determine their impact in the US Economic Security do not raise any significant policy issues to be contemplated by 14a-8(7).” While shareholders normally have the capacity to raise major policy issues with the Board of Directors through the shareholder resolution process, the company is essentially asserting that it is none of the shareholders’ business or interest whether the company’s expenditures of the TARP funds benefit the US economy. This is a remarkable assertion, given the impact of the company’s decision-making regarding the well-being of the US economy, whether it be the extent of mortgage foreclosures in the US, the impact on wages of US workers and other questions of investment in the US economy.

Both companies also assert in essence that Delaware law prohibits shareholders from amending the bylaws of the corporation to create a committee on a specific topic, because to do so would limiting the discretion of the Board of Directors to decide whether or not that is an appropriate topic for the board to address. This is an amazing and unprecedented suggestion for a limitation on the shareholders’ franchise. Neither company could cite any legal precedents that would bind the courts to find in favor of the companies on this point. As we argued in our letter, this is clearly an unsettled question of Delaware law, and as such, the companies have not met the burden of proof that would be needed for exclusion of the resolutions from the proxy statements.

Bank of America attempts to take the plain language of the resolution and imposes an aura of vagueness as another grounds for excluding the bylaw amendment. This stuff almost looks like it was written with tongue planted firmly in cheek but somehow it winds up in their opposition letter:

The Proposal does not define "economy of the US." Does economy refer to an economic measure, such a gross domestic product or inflation? Should the Corporation be analyzing the Proposal in terms of macro or micro-economic indicators? Should regional or global economies be factored into the analysis? Do the stock markets or the Corporation's stock price factor into the economic analysis? Should the Corporation's policies impact" the long term health of the economy of Corporation focus on the trade deficit or measures that may balance the federal budget? The proposal leaves numerous unanswered questions for the proposed Board Committee, the Corporation and its stockholders.
The Proposal's definition of "US Economic Security" also requires the proposed Board Committee to consider the "economic well-being of US citizens, as reflected in indicators such as levels of employment, wages, consumer installment debt and home ownership." While the proposed Board Committee can review these macro-economic items, it is unclear what the actions they are expected to take to shape corporate policy to support these economic indicators.

The question of the “vague and indefinite” exclusion is whether the shareholders would have enough of an idea about what they are voting on to make an informed choice to vote for or against the resolution. The resolution is quite clear that shareholders would know that they would be creating a committee on US economic security to examine policy issues relative to the impact of the company on the US economy; that the chairman of the board would appoint the members; and that the committee would have a fair amount of flexibility in defining the scope of its activities, but would also have some guidance in terms of the set of suggested issues to consider the possible inclusion. We argue that this is ample guidance for shareholders to know whether they want to vote in favor of the bylaw or not.

Here's hoping that the Securities and Exchange Commission staff, under its new leadership, recognizes the importance of this new day in America, and will support the shareholders' role in bringing accountability to US Economic Security for those in the private sector who are now "managing public funds".

- Sanford Lewis

[You can also listen to audio commentary on this topic by Investor John Harrington at Sea Change radio]

Investors Write President-Elect Obama to Restore Shareholder Resolutions on Risk

2008-12-11T11:00:00.000-05:00

.

MORE THAN 60 INVESTORS, GROUPS URGE OBAMA TO IMPROVE FINANCIAL RISK DISCLOSURE BY U.S. CORPORATIONS

President-Elect Encouraged to Work in First 100 Days to Reverse Recent SEC Roadblocks to Shareholder Proxy Resolutions Inquiring About Risks

Full text of the joint letter and complete list of signatories.

NEW: Click here for **Questions and Answers**

Coverage: Pensions & Investments

WASHINGTON, D.C. – December 11, 2008 – President-elect Barack Obama can help to avoid future market disruptions and also pave the way for a sustainable economy if he protects and strengthens investors' rights to use the shareholder resolution process to highlight corporate risk factors and press for needed remedies, according to a joint letter submitted today by 60 leading institutional investors, investment firms and investor groups.

The letter asks the help of President-Elect Obama to act within the first 100 days of his administration to reverse a five-year “pattern” at the SEC blocking shareholders from using proxy resolutions to request better disclosure of identified financial risks to a company. These risks may include marketplace, social, or environmental concerns.

The letter to Obama was signed by a diverse group that includes, among others, the Office of the Comptroller of the City of New York; noted shareholder advocates Robert A.G. Monks and Amy L. Domini; Calvert Group, Domini Social Investments, Trillium Asset Management Corporation, Boston Common Asset Management, and Catholic Healthcare West.

Leading organizations of investors also endorsed the letter, including: the Investor Network on Climate Risk (INCR), a network of 75 institutional investors and financial institutions with over $5 trillion in assets; the Investor Environmental Health Network (IEHN), whose shareholder members are concerned with financial and health impacts of product toxicity hazards, with $30 billion in assets; and the Interfaith Center on Corporate Responsibility (ICCR), representing nearly 300 faith-based investors with $100 billion in assets.

The joint letter reads, in part: “All investors need better tools to assess corporate risks and more effectively participate in corporate governance and we look to your administration and the Securities and Exchange Commission (SEC) to facilitate such reforms. From the creation of the SEC in 1934, investors have been in a unique position to monitor the companies in their portfolios, and to guard against certain risks to stock price, and to society, by encouraging responsible decision-making by management.”

The letter continues: “In particular, we believe restoring the ability of institutional investors to use the shareholder resolution process to probe companies on certain areas of investment risk is an important initial step. These include the kind of credit risks associated with the mortgage crisis, as well as an array of environmental and social issues which we believe may have large financial implications e.g., climate change and product toxicity … it is our belief that shareholders are in a very good position to help companies evaluate risk.”

However, the letter notes: “For the last five years, the SEC has gradually been closing the door to important shareholder concerns. Shareholder proxy requests that had been allowed in previous years asking for better disclosure of financial risks to companies have been stymied.”

Cheryl Smith, co-CEO at Trillium Asset Management Corporation, said: “The current financial and economic crisis demonstrates the extent to which all sectors and all participants in the market, whether companies, investors, employees, or communities, are interrelated and deeply affected by the actions of any one participant. Protecting and enhancing the rights of investors to seek and receive information from their companies about company activities improves the stability of the financial system as a whole.”

As the letter explains: “We recognize that in the early days of your administration you will be focused on shoring up the economy and helping to restore consumer confidence. As part of your strategy we urge that you help us to correct decisions that have undermined our ability to use the shareholder resolution process to probe these issues on a company by company basis.”

Calvert Senior Vice President for Social Research and Policy Bennett Freeman said: "The President-elect has made it clear that addressing climate change will be a top priority. With our record of encouraging companies to assess and manage the business risks associated with climate change, investors stand ready to work with policy-makers and corporations to tackle this monumental challenge. A change in SEC rules on risk evaluation will make us even more effective partners in this effort."

“We view shareholder resolutions as an essential part of our tool kit as a fiduciary. The SEC’s withdrawal of our right to use resolutions to probe risks that concern us has hampered our ability to monitor and enhance corporate performance and responsibility,” said Lauren Compere, director of shareholder advocacy at Boston Common Asset Management.

Sanford Lewis, counsel to the Investor Environmental Health Network noted:
"With recent product toxicity issues, such as lead in toys, many companies knew about the potent financial risks posed by chemicals in their product lines. Even though they omitted these disclosures in their financial reports, shareholder resolutions to seek better disclosure of these risks through the proxy process were also being obstructed by the SEC.”

Full text of the joint letter and complete list of signatories.

CONTACT: Patrick Mitchell, (703) 276-3266 or pmitchell@hastingsgroup.com

A win-win solution for liability disclosure?

2008-09-15T11:00:00.000-04:00

In August, the Financial Accounting Standards Board received an outpouring of comments for and against its proposals to expand liability disclosure requirements under its FAS 5 exposure draft. Long term investors, socially responsible investors and organizations managing, or representing beneficiaries of, trillions of dollars of marketplace investments submitted letters urging FASB to improve its 33 year old disclosure rules, which are sorely out of date given growing needs and demands for transparency and accountability.

However, many of the companies that would be required to comply with any new disclosure rules opposed FASB's for proposals strengthened disclosure. Many commenters argued that is too difficult to predict liabilities until lawsuits are either settled or judgment is rendered, and that disclosing worst case liabilities would unduly distort stock values downwardly. Some legal commenters asserted that requiring additional disclosure could undermine corporate positions in pending trials and settlement negotiations.

As a legal commenter in the investors' camp, I strongly believe that it could be possible for FASB to fashion rules that would better balance the underlying interests. One idea that could provide a win-win is our proposal to require narrative disclosure of long term, "remotely probable-severe impact" liability scenarios.

Readers may recall that the FASB draft proposed a new requirement for disclosure of "severe" impact financial loss scenarios, even if viewed as remotely probable by a company's management, but only if the underlying issue is expected to resolve in the near term, i.e. within a year.

My comments as counsel to the Investor Environmental Health Network urged that reporting entities must be required to disclose all loss contingencies that could have a severe impact even if viewed by the company as "remotely probable," and regardless of the timing of the resolution of the issue.

We proposed a compromise approach -- that for disclosures of remote, severe losses, at least those that may take more than a year to resolve, the disclosure duty could entail a narrative description of the severe impact contingency, without quantification.

I believe this could be a win-win solution because:

• Investors would be empowered by the disclosures to consider longer term issues, and gain the opportunity to inquire further where any potentially severe issues are flagged. It would make it possible for SRI investors to enhance their screens, by avoiding companies that are taking undesirable kinds of longer term "remote" risks.

• Reporting entities would not need to estimate the "remote" issues precisely but only provide a simpler "order of magnitude" characterization of the issues as "severe." They would have ample opportunity to minimize shareholder concern by explaining their judgment calls about the remoteness of risks, while still maintaining reasonable transparency. They would also face less risk of legal prejudice, because their characterization of issues as "remote" would shield against anyone reading too much into a disclosure for litigation purposes.

The history of subprime lending and the asbestos bankruptcies places one harsh lesson in bright light – reasonable investors must look closely at "severe impact" threats even if the management characterizes them as only "remote." Without an accounting rule to embody this lesson, the investing public is at the mercy of those whose judgment about the severe threats is skewed toward "improbability" and nondisclosure.

Read Investor Environmental Health Network comments to FASB

FASB Proposes Improved Disclosure of Liabilities

2008-07-23T10:15:00.000-04:00

Sanford Lewis, Counsel to the Investor Environmental Health Network discusses the proposal of FASB to modify financial statement liability disclosure obligations of corporations. He notes that FASB is missing an essential opportunity to require disclosure of issues that may SEVERELY impact a company in the long term (e.g. asbestos, Enron, subprime lending) but on which the management views such impacts as only "remotely probable". Given the tendency of companies to misjudge how unlikely an admittedly severe issue could be, IEHN is urging investors to join in asking FASB to ensure disclosure of these issues. (3:35)

Video in quicktime format

IEHN Action Alert regarding the FASB Proposal

News coverage at SocialFunds.com

FASB Exposure Draft on Accounting for Contingencies

FASB Accounting for Contingencies webpage

Investor Environmental Health Network