A new look at costs

On June 5, the Financial Accounting Standards Board (FASB) issued an exposure draft proposing amendments to Statement of Financial Accounting Standards Number 5 (FAS 5), Accounting for Contingencies, redefining disclosure requirements for contingencies including potential losses from pending and threatened litigation.

The amendments reflect the new principle that an entity will ‘provide disclosures to assist users of financial statements in assessing the likelihood, timing and amount of future cash flows associated with loss contingencies that are (or would be) recognized as liabilities in a statement of financial position.’ Said disclosures would inform on the risks that loss contingencies pose to the entity and their potential and actual effects on its financial position, cash flows and results of operations.

The proposed amendments implement this principle with a number of requirements, including increasing loss contingencies that are required to be disclosed, requiring the disclosure of specific quantitative and qualitative information about those loss contingencies and a tabular reconciliation of recognized loss contingencies to enhance financial statement transparency and provide an exemption from disclosing certain required information if disclosing that information would be prejudicial to an entity’s position in a dispute.

FASB states the amendments stem from a concern that disclosures about loss contingencies under existing standards do not provide adequate information to assist users of financial statements to assess future cash flows.

Reaction to the proposal, however, has been overwhelmingly negative. Over 90 percent of written responses received by FASB during a comment period that ended August 8 were critical. FASB plans to host an open forum on the proposed amendments at which those who have submitted comments may testify. Originally, FASB said the new disclosure standard would take effect for annual financial statements for fiscal years ending after December 15, 2008, but in September, extended the effective date by a year.

The status quo

FAS 5, combined with FASB 141-R (which applies to business combinations), establishes the accounting and reporting requirements for nearly all gain and loss contingencies. The rule defines a contingency as ‘an existing condition, situation or set of circumstances involving uncertainty about a possible gain or loss that will be resolved when one or more future events occur or fail to occur.’ Accrual of a loss contingency is now required if the loss is probable and reasonably estimable. Unasserted claims are accrued only if it is considered probable that a claim will be asserted.

The estimability requirement is intended to prevent accrual of amounts so uncertain they would impair the integrity of financial statements, which the proposed statement does not alter.

Measuring the unpredictable

Critics have several problems with the current regime: initial disclosure often does not occur until a material accrual is recognized; the disclosure threshold is too high, with losses that would be of interest to investors if undisclosed; estimating possible losses frequently is not possible; and amounts related to loss contingencies that are recognized in the financial statements are not transparent.

The many vocal skeptics of the new exposure draft believe proposed changes will increase problems. There are risks in disclosing risks and contingencies. ‘The frustrating truth is that litigation results are largely unpredictable,’ says David Greenwald, a partner with Jenner & Block. ‘FAS 5 requires auditors to consider three flavors of contingencies: those that are probable; those that are remote; and those that are ‘reasonably possible’, that is neither probable nor remote. Due to inherent uncertainties in litigation, lawyers are unable to predict outcomes that fall in the broad middle ground between probable, where a client’s success is extremely doubtful or slight, and remote, where a client’s not succeeding is extremely doubtful or slight. Lawyers simply should not be compelled to speculate about or quantify reasonably possible outcomes.’

According to a July press release from law firm Wilson Sonsini Goodrich & Rosati, when disclosure is required companies will have to disclose the nature of the litigation and an estimate of maximum exposure, material that is generally protected in adversarial proceedings. Plaintiffs could have an advantage in the discovery process and required disclosures could be admissible in evidence against the company in proceedings.

The firm posits that disclosures may encourage plaintiffs, as they indicate companies view litigation exposure to be both credible and serious: ‘disclosures also may serve to frustrate settlement negotiations and and/or result in higher settlement amounts or jury awards due to disclosed estimates of the maximum exposure,’ the release says. Additional disclosure threat could lead to frivolous litigation, being forced to settle to avoid disclosure.

The plaintiff’s bar would gain insight about companies facing litigation exposure and probably increase ‘me too’ lawsuits, the firm suggests.

Not enough leeway

The Wilson Sonsini release notes that the FASB proposal ‘recognizes that for certain loss contingencies – such as pending or threatened litigation – disclosure of certain information ... may be ‘prejudicial to the entity’s position’ in the litigation.’ If this is the situation, ‘the proposal provides that disclosures may be aggregated, or, in ‘rare instances’, omitted.’ In such cases, the company must disclose that information has not been disclosed and why. This proposed relief is a double-edged sword, the Wilson Sonsini analysis asserts, since FASB ‘expressly indicated that the relief is only available in ‘rare’ circumstances.’

As noted in the release, the new standards will put pressure on legal counsel who might have to provide more qualitative analysis and loss estimates to auditors. This could impact attorney-client privilege, which might be waived once the case analysis is disclosed. For Greenwald, ‘There has always been some tension between auditors and their clients. Auditors need enough information to provide unqualified opinions and their audit clients want to provide that information without waiving privileges. Even before FASB proposed changes to FAS 5, Sarbanes-Oxley’s admonition that auditors act as independent watchdogs for investors led to increased requests for disclosure of privileged material. The problem is that disclosure of otherwise privileged attorney-client communications to auditors may result in waiver of that privilege, undermining the client’s ability to defend itself in litigation.’

Mission impossible

Predicting a case’s potential outcome is obviously problematic, let alone trying to determine possible costs resulting from the action. But this rule adds further complexity as companies will need to predict the overall impact on share price. Trying to calculate the market’s reaction to a future verdict and what will happen to share price as a result is a virtual impossibility. Often, throughout the course of a multi-year action there will be a number of fluctuations as various announcements are made.

The rules would require disclosure of details and predictions of lawsuits considered ‘non-remote’ rather than those considered ‘probable’ under the current standard, a change that many feel will be a burden. ‘Also, the rule requires an ongoing evaluation process that will have to be updated every quarter,’ Greenwald notes.

FASB established the Investors Technical Advisory Committee as part of its efforts to ‘enhance participation of investors and other users of financial information in the standard-setting process.’ Proponents point out that investors include prospective investors, who don’t want to buy into uncertainty and get burned a week later on a wild-card litigation. Critics highlight that plaintiff’s attorneys are also users of financial information.

‘I’m not sure this was really called for,’ McDermott Will & Emery partner Andrew Kaizer says, citing a study, ‘2007 Securities Class Action Settlements’, by Joseph Grundfest, ex-SEC commissioner and current co-director of the Rock Center for Corporate Governance at Stanford University, and Laura Simmons of Cornerstone Research and the Mason School of Business at William & Mary. The study shows a public company’s share price doesn’t change materially after a settlement is announced. Share prices do change significantly, however, when a case goes to trial and a decision is announced. In the authors’ view, this may mean that the market is efficient in assessing settlements, so no further information is required. Yet the market is inefficient in assessing the outcome of litigation, because it is such an inherently uncertain venture. The authors offer their findings as ‘suggestive, not conclusive’ advising a broader study and that more time might strengthen analyses. Critics of the study claim that ad hoc information seeping into the market to allow efficient guesses on settlements would be improved by a more transparent and consistent disclosure requirement.

Not everyone is convinced the proposed amendments will be negative. Advocates of the amendments argue that changes are long overdue and the rule as it is does not provide sufficient reporting clarity. In addition, the new amendments to FAS 5 can aid corporations with their disclosure obligations from a more realistic and practical framework.

Michael Young, a partner with Willkie Farr & Gallagher, credits FASB’s awareness of – and concern for – corporate lawyers’ issues with the proposed rule. ‘One of the core concerns understandably raised by companies and their lawyers is that aspect of the exposure draft requiring a prediction on the potential outcome of litigation. If a company were to publicly say that it could lose $50 million, it can be assured a plaintiff will seek to have that admission introduced into evidence and the company may be assured the trial will be a short one.’ He thinks the answer may lie in effective qualitative disclosure, but understands the difficulty of predicting an outcome.

The exceptions

Although the amendments propose an answer to these problems, they would not be universally applicable. As indicated in an August alert by Investor Environmental Health Network (IEHN), the FASB proposal will not require reporting companies to disclose contingencies that could pose a ‘severe’ threat to the company. However, the alert states: ‘Companies are allowed to avoid disclosing such severe threats if they believe that a loss is only remotely likely, and that the issue would not be resolved during the coming year.’ This exception prevents investors from accessing information important to determining medium- and long-term investment health.

The IEHN outlines loopholes including the fact that ‘the proposed new rule on presumptive disclosure and quantification would apply only to legal liabilities, not to asset impairments. So it would cover pending lawsuits and product warranty claims,’ but not items such as flood risk to company property. Also, ‘a company would be allowed to avoid many disclosures by having its lawyers assert that the publication of information would be ‘prejudicial’. ... While the draft statement indicates use should be ‘rare’, it is too vague and does not provide clear and objective standards that could ensure that the exception does not get abused.’ These loopholes could be closed if FASB requires a narrative disclosure of ‘severe impact risks’.

While some sources view the proposed rule as an overreaction, others suggest it is a fair response to situations like Xerox blindsiding shareholders on a $600 million settlement. Proponents suggest minor modifications. One source following the issue closely mentions a remedy that could limit prejudicial disclosure concerns: have companies provide just some quantitative information relevant to a claim. This view assumes that actual, factual and non-predictive information would allow attorneys to avoid the quagmire of speculative predictions.