Should Companies Disclose More Information To Investors About the Liabilities They Face?
by Sanford Lewis, Counsel, Investor Environmental Health Network
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
You can also submit your own comment letter to FASB by August 20, 2010 by emailing email@example.com, 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.
Post republished on CorpGov.net with permission: 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.
I had the pleasure of providing editorial and substantive advice to Sanford Lewis on his paper Don’t Ask, Don’t Tell: A Poor Framework for Risk Analysis by Both Investors and Directors (HLSCG&FR, 11/15/09). Lewis describes a growing clash between the needs and duties of directors and investors to manage risks, and attorneys who advise “don’t ask; don’t tell,” in order to minimize corporate liability in any possible future litigation. He warns that a strategy based on culpable deniability serves no one well.