Step Right Up! Will voluntary disclosure of corporate liabilities meet investors' needs?

A Three Part Series

Part 1: American Bar Association “Best Paper” Documents Legal “Flexibility” For Disclosure of Environmental Liabilities

Sanford Lewis, Counsel
Investor Environmental Health Network

At an American Bar Association meeting in Baltimore in late September, Attorney C. Gregory Rogers published a paper on corporate environmental financial disclosures. Rogers, who is both an environmental lawyer and a Certified Public Accountant, is uniquely qualified to write on this subject, as well as to Chair the ABA Environmental Disclosure Committee. The premise of his paper, which won the “best paper” award at the recent ABA Fall Environmental Summit, is that even though current accounting regulations are “flexible” (in plain English, “weak”) companies should consider going beyond the minimum in their disclosure of environmental liabilities.

In my opinion, the paper does a better job of describing how much flexibility companies have than it may do in persuading companies to nevertheless step right up and disclose information needed by investors. In today’s first of three parts, we’ll review the “flexibility” Rogers identifies for corporate accounting. In the second part, we’ll discuss the arguments Rogers makes for going beyond the minimum, and then in the final part of this series we’ll look at the prospects and possibilities for legal reforms to elevate the minimum.

Three Layers of Flexibility
It is worthwhile to read his whole paper, but to summarize briefly, he states that existing accounting requirements provide latitude for management of companies to exercise discretion in 1. Investigation of existing circumstances; 2. Speculation about future outcomes; and 3. Transparency of disclosure.

On the duty of investigation, the paper notes:

Management often has discretion to attempt to identify and fully assess all pre-existing pollution conditions or to investigate only those matters subject to pending enforcement or litigation.

With regard to speculation about future outcomes, the paper states concisely and accurately:

Under applicable US GAAP and relevant voluntary standards, management has broad discretion to measure the loss at its known minimum value, most likely value, expected value, or quoted price (fair value). No speculation about future outcomes is required to determine a known minimum value. In contrast, speculation about future outcomes generally is required to develop an expected value or fair value.

Notably, the American Bar Association is among those who have recently lobbied heavily to keep in place this enormous flexibility regarding “speculation.” The ABA has formally argued to the Financial Accounting Standards Board that requiring disclosure of liability estimates above the “known minimum” could be prejudicial - aiding plaintiffs in any pending litigation, to the detriment of companies as well as their shareholders. We will discuss and deconstruct this argument in the third part of this series, and examine options and prospects for legal reform.

Finally, with regard to the leeway in disclosure rules, the Rogers paper states:

Disclosure standards for environmental liabilities include subjective language such as “to the extent material,” “when necessary for the financial statements not to be misleading,” and “encouraged but not required.”

The broad flexibility on investigation, estimation and the duty of disclosure strikes three blows against detailed disclosure of corporate environmental liabilities.

How Flexibility Affects Options for Action
Rogers goes on to describe the three options, given all this flexibility, that a typical company’s management faces regarding disclosure of environmental liabilities. The first option he says is "don't ask don't tell." In other words, don't investigate:

The don’t ask don’t tell policy is effective at limiting the collection and dissemination of prejudicial information. The downside of the don’t ask don’t tell policy is that it limits the information available to inform sound decision-making by management, the board, and investors. Its informational value is low.

He calls the second option the “crystal ball option,” which would, he says, provide high informational value to inform decision-making by management, the board and investors through estimates and projections of liability:

The downside of the crystal ball policy is that it produces and disseminates prejudicial information. Such information could lead to unknown, but potentially severe losses. Another downside of the crystal ball policy is that debt and equity markets may mistakenly punish the entity for appearing to have greater exposure to environmental losses than its nontransparent peers.

Finally he says that the third option is “double booking” -- to keep two sets of books so that the amount of publicly disclosed information would be minimized while providing information needed to inform decision-making by management and the board.

The downside of the double-booking policy is that it conceals important information from financial statement users and thereby exposes the entity to accusations of accounting and securities fraud.

He concludes dryly, based on the above analysis and options, that "the selection of the don't ask don't tell policy seems reasonably defensible, if not obligatory."

The Results of Don't Ask Don't Tell
We documented the outcome of the "reasonably defensible, if not obligatory" nondisclosure approach to broad flexibility in our recent report, Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close. Examples of liability disclosure shortcomings resulting from the current accounting “flexibilities” included:

-- Numerous asbestos companies that concealed a realistic prediction of the amount of their liability until the day they finally provided the realistic estimate, and promptly filed for bankruptcy.
-- Companies that could have accurately projected the magnitude of their liabilities for investors if they had simply benchmarked them against other companies facing similar forms of lawsuits.
-- Companies that do not estimate their liabilities in SEC filings (or state the known minimum), but nevertheless provide large, long term liability estimates for their insurers.
-- Companies are producing innovative nanomaterials which may have been found in laboratory testing to cause precursors to mesothelioma, but are reporting to their investors only that the health effects of their products are "unknown".

In addition, Rogers himself has conducted a study of the amounts reserved for environmental liabilities by various companies, and has developed an algorithm for evaluating the adequacy of those reserves. See the recent article in 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?

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.

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 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 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.

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.