Don’t Ask, Don’t Tell: A Poor Framework for Risk Analysis by Both Investors and Directors

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday November 15, 2009 at 1:16 pm
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(Editor’s Note: This post comes to us from Sanford J. Lewis, Counsel to the Investor Environmental Health Network.)

A clash is emerging between the needs and duties of directors and investors to manage risks, and attorneys who advise “don’t ask; don’t tell” to minimize corporate liability in any possible future litigation. The task of mitigating this clash falls on the shoulders of regulators at the Securities and Exchange Commission and the Financial Accounting Standards Board.

When the Financial Accounting Standards Board (FASB) took up the issue of contingent liability disclosures on behalf of investors in 2008, it appeared progress would be made. However, under pressure from the corporate legal community, which sought to block any requirements to require disclosure of potentially prejudicial information, the FASB may now be about to take a step backward unless the directors and investors can be mobilized.  The Securities and Exchange Commission is also in a position to act to make vital improvements in disclosure of information relevant to potential liabilities.

Will we have to wait for a flood of lawsuits, or will regulators act to establish clearer reporting rules that encourage better management of risks?

Progress depends on efforts by institutions and individuals, that need better accounting and disclosure so they can reduce their own risks, to press these agencies for better rules. The rules should be shaped by the general principle that not all potentially prejudicial information is off-limits. Instead, the regulators should follow the principled decision-making framework used in the courts, in which the potential for prejudice is balanced against the usefulness of information to the user. Categories of information that are “more probative than prejudicial” are appropriate targets for disclosure.

Existing regulations are too “flexible”

An example of how the weakness of contingent liability accounting affects disclosure can be seen in the environmental disclosure field.  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.

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, his 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.

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. Rogers says the logical course of action for companies in light of this flexibility may be to adopt a “don’t ask don’t tell” approach to reporting their environmental liabilities, but that director and officer duties might nevertheless require them to do more.

Directors and officers face liabilities

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 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. 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,” boards may be subject to liabilities for failure to establish sufficient mechanisms to ensure the company has information in place to monitor and manage its own liabilities.

Rogers also references section 302 requirements of the Sarbanes-Oxley Act requiring the CEO or CFO to certify 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.

The clash of duty and regulation

Scenario 1: A company has a lawsuit pending against it.  Consistent with the accounting rules (FAS 5 and FIN 47) management concludes 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.” Therefore, the financial statement may contain an accrual of the known minimums and little else beyond that.

Corporate oversight practices (investigation, estimation) are shaped by the regulations surrounding contingent liability disclosure. Maintaining a sense of uncertainty is encouraged, because it justifies minimal disclosure. This approach is nominally in compliance with the existing accounting rules and it sets the context for the management to argue in any future enforcement actions that it had no reason to know the financial statement doesn’t fairly present the company’s financial condition. The incentive for “practiced uncertainty” is high.

In contrast there is also the possibility, based on the Sarbanes Oxley and Caremark rules, that a court would find the CEO, Board, or company liable for failure to conduct extensive investigation beyond what is otherwise allowed under the accounting rules.

As board members and officers ponder whether flexible accounting standards or their more rigorous duties under Sarbanes Oxley and Caremark should drive their company’s estimate and disclosure policies, they are caught between a rock and a hard place.

Scenario 2: In completing the Management Discussion and Analysis (MD&A), a section of the Annual Report submitted to the SEC, a producer of nanotechnologies with potentially hazardous properties chooses to call the health risks “unknown,” neglecting to mention existing laboratory studies that find a correlation between certain carbon nanotubes and cancer (mesothelioma) precursors. The MD&A requirement grants flexibility to omit such critical information through a broad loophole, which allows the materiality and relevance of information to be determined “in the judgment of management.”  (see Bridging the Credibility Gap: Eight Corporate Liability Accounting Loopholes That Regulators Must Close written by the author for the Investor Environmental Health Network). So far, the “judgment of management” about potentially bad news that management would rather not discuss has too often trumped the obligation to “fairly present” information regarding these potential long-term liabilities.

The habits of avoiding investigation, estimation, and disclosure are entrenched in current accounting standards and corporate cultures. 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. The culture is unlikely to change without a clearer legal mandate, since those that report more accurately might arguably be at competitive disadvantage. SEC enforcement without further guidance could reduce investor confidence in already troubled markets.  Better accounting and disclosure guidance by both the FASB and the SEC offers the best way forward.

Prospects for improving financial accounting

The current system of don’t ask don’t tell is not optimal from the standpoint of encouraging effective management of corporations. It creates a decision-making environment of extreme uncertainty. Company executives and boards face an ongoing Catch-22, having to choose between the flexibility that accounting rules allow and the risks of liability for poor oversight or disclosure. In short, the current system is not preventive, not protective of investor interests in disclosure, complicates corporate decision-making, and in the end only encourages lawsuits.

Wouldn’t we all be better off with clear rules that allow officers, directors and auditors to know with less cost and reasonable certainty whether systems and disclosures are in compliance?

FASB pointed in this direction when it published an exposure draft to revise standards for contingent liability disclosures.  The FASB board announced in March 2008 that existing rules for reporting on contingent liabilities were inadequate from the standpoint of investors. Instead of including just the “known minimum” when reporting on impending liabilities and there is uncertainty about the  most likely outcome, the FASB proposed in the exposure draft that companies report a higher figure as well — either a worst-case liability estimate or, if a reporting company preferred, a probability-weighted estimate.

Corporate and defense bars aggressively asserted the proposal would require companies to disclose prejudicial information that could undermine company positions in pending or future litigation. In essence, they argued it is more important to hide potential liabilities that might increase the chance of litigation than it is to provide accurate disclosure of contingent liabilities to directors and investors.

As a result of this opposition, the board announced its intention to focus on disclosure of the “contentions of the parties rather than predictions of outcome.” Given that the current FAS 5 standard requires estimating liability, a shift away from “prediction” is a dramatic move away from improving information for investors.  If FASB continues its announced course, boards and investors will have even less information concerning liability risks than they do now.

In practice, the existing system has not proven very workable from the standpoint of investors, since it almost ensures an enormous gap between disclosure and actual liability.  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 worth resolving.

“Prejudicial” concerns must be balanced against their “probative” potential

The position taken by the corporate 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 from the principled approach taken to “prejudicial” information by 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.

In contrast, there is a large amount of information where its usefulness to directors and 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 disclosure requirements.

Below, I provide examples of such information, first, in the realm of “narrative” disclosures, as found in the MD&A, and second, in liability estimates, as required under existing and proposed financial accounting standards.

The MD&A: Potentially prejudicial, but required for its probative importance

Existing SEC regulations require management 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 corporate bar to the existing MD&A, we could easily see arguments that some of the information included could be used by plaintiffs suing the company. Indeed, these analyses are certainly referenced from time to time as evidence in lawsuits. 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 MD&A

In July 2009, a group of 80 funds, coordinated by the Social Investment Forum, wrote to the SEC recommending 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.

Investors framed their interpretive request in a manner that emphasizes the probative nature of the information needed from companies.  For example, the letter proposes guidance such as the following:

  • 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.

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 require 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 inform investors of relevant issues, while avoiding disclosure of confidentialities. In short, it is more probative than prejudicial.

Disclosing “severe” contingencies viewed by management as remote

While the above proposal asked the SEC to clarify requirements for the MD&A, the same principles also apply to elements of the pending FASB proposal regarding contingent liability disclosure. One of the categories of disclosure the FASB is examining is the obligation of companies to report on potentially “severe” contingencies for loss, even if they are considered by management to be only “remote” and “long-term.” Many of the losses experienced in the recent financial crisis, as well as in asbestos bankruptcies, would have been characterized in this way by the management for many years prior to final resolution at enormous toll. The Investor Environmental Health Network has proposed to the FASB that while it may be difficult to quantify such “severe, long-term, remote liabilities,” the narrative disclosure in the footnotes to financial statements should inform readers of these types of contingencies, and should track the kinds of disclosures described above for the MD&A.   In the absence of  such disclosures, financial statement readers may be misled with regard to the longer-term prospects of the company.

Doing the Numbers, Beyond the Known Minimum

While the above example relates principally to narrative disclosures, a second example relates to development and disclosure of quantitative estimates that would nevertheless be more probative than prejudicial, and therefore merit mandatory disclosure rules.

Existing guidance (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 leads to 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: shareholders lost billions.

In its exposure draft for revision of contingent liability reporting requirements, the FASB 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 examining the proposed requirement, because the options are not 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 place it on record. Such 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 is not prejudicial, since it is based on the simple application of mathematics to publicly available information.

Dow Chemical used such an analysis to disclose a previously unestimated $2.2 billion asbestos liability after it acquired Union Carbide. 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 benchmarks and other public information, without access to any privileged 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

Waiting for a flood of lawsuits to punish directors and officers to move beyond “don’t ask, don’t tell” is not a preventive solution.  It does not solve the problem of hidden liability risk that faces today’s directors and investors. Instead it offers the prospect that conflicting signals and costly litigation may improve corporate disclosures only over the course of decades.

Recent signals by FASB proposing to avoid “prediction” in future revisions to the contingent liability accounting standard, FAS 5, bode poorly for the prospect of sound management and disclosure of these issues. Directors will find themselves in court working out the fine points of issues they ignored because accounting regulators took a pass.  Investors will remain in the dark about the true value of companies. Investor and director organizations such as the Council of Institutional Investors, the National Association of Corporate Directors, the Social Investment Forum, the Investor Advisory Committee of the SEC and the Investors Technical Advisory Committee of FASB need to weigh in now to head off decades of muddy judicial pontification about the scope of corporate contingent liability accounting duties.

Sanford J. Lewis is an attorney specializing in corporate duties of disclosure of environmental and social issues in securities filings.

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