The legal community has raised the alarm about proposed changes to disclosure requirements for litigation and other contingencies in FASB’s Exposure Draft (ED): Disclosure of Certain Loss Contingencies-An Amendment of FAS 5 and Statement 141R (the FAS 5 ED.) The comment deadline to respond to FASB’s proposal is tomorrow (Aug. 8); see comments filed. (OpEd in today’s WSJ: “FASB’s Lawyer Bonanza”.)
The Association of Corporate Counsel’s (ACC) comment letter states: “The proposed amendments have generated a greater response from our membership, in a shorter period of time, than any other single issue within memory.” They add: “The proposed amendments dramatically alter the disclosure requirements of certain loss contingencies in current FASB 5 (“FAS 5”), including lawsuits…. In our view, and the view of our membership, the quality of the information that would result from the proposed amendments would not warrant the harm that they would inflict on companies and their shareholders.”
Here are some points from ACC’s letter:
Forcing the extensive and detailed disclosures mandated by the proposed amendments in a far broader range of cases than FAS 5 now requires will cause serious harm to the disclosing companies and their shareholders.
The proposed disclosures create a substantial risk of waiver of the attorney-client privilege and work-product immunity, with catastrophic consequences to the corporation.
Underestimating a large loss will be painted as a professional failure laid at the feet of lawyers who are forced to provide concrete estimates about remote and undeveloped matters. Bad numbers could also create new potential liability for the company whose stakeholders relied on mistaken estimates.
[U]nder the new rule, the financial statement consequences of a suit with huge potential losses, albeit a low likelihood of prevailing, will inflict immediate injury on the company and its shareholders. A sophisticated plaintiff may be able to exploit that problem by threatening a suit and then withdrawing it in exchange for an unjustified and extortionate settlement.
Because the proposed amendments would damage the companies ACC members represent, they necessarily injure those who have invested in these companies – a principal constituency that FASB seeks to protect.
Even if the disclosure of litigation-related loss contingencies were a serious systemic problem, it is extremely doubtful that compelling companies and their lawyers to quantify litigation risks would yield more accurate financial statements. As every trial lawyer knows, litigation anywhere in the world — but especially in American courts and before American juries— inherently is unpredictable. The reaction of a single juror or the impact of a single ruling can have a dramatic and unanticipated impact. Indeed, it is highly doubtful that any company or lawyer who ever lost a billion-dollar case expected that result -- they were presumably surprised by the extent of the negative outcome. Had they expected to lose or to lose so badly, they surely would have settled.
In this instance, requiring the losing lawyer or company to have produced a more precise description of the outcome would not have provided more accurate disclosure to investors.
Not only will these expanded disclosures compromise the litigation of existing claims, but they threaten to spark claims of their own. …by compelling the disclosure of significant detail regarding the circumstances of the claim, the factors that may affect the result, the most likely outcome, and the anticipated timing for resolution, the proposed revisions invite Monday morning quarterbacking. Parties who purport to have relied upon these litigation disclosures and predictions will use them as the basis for claims of their own.
The American Bar Association’s (ABA) comment letter states: “We have a number of serious concerns regarding the Exposure Draft’s approach to disclosure of non-financial liabilities, particularly those involving litigation.” They add, “We are particularly concerned with its requirements to provide current quantitative disclosures of estimates of possible losses and qualitative disclosures about the likely future course of events in pending claims without regard to whether a reasonable basis exists for making such estimates and predictions,” and conclude, “we urge the Board not to adopt the proposed amendment to FASB Statements 5 and 141(R).”
Here are some points from ABA’s letter:
- The quantitative and qualitative disclosures called for by the Exposure Draft would inevitably require reporting entities to turn to their lawyers for information if they are to act responsibly, but the kind of speculation and estimation contemplated by the Exposure Draft goes beyond what lawyers can do in a professionally responsible way even if they are willing to risk the possibility of privilege waivers by advising on the disclosure process. As a result, reporting entities often would be left to engage in their own speculation and estimating with the attendant uncertainties and potential exposure to additional liability… predictive information often will turn out to be incorrect because of the uncertainties inherent in litigation. This inevitably will increase the exposure of companies and their management to further litigation, including litigation of a type that Congress has sought to discourage in the Private Securities Litigation Reform Act as burdensome and abusive.
- The additional exception permitting omissions in “rare” circumstances when aggregation is not a solution does not adequately mitigate the prejudice because the minimum required disclosure will frequently still contain prejudicial information of the types described above. Moreover, the standard provides no guidance as to who will ultimately determine whether a particular case presents the “rare” circumstance justifying omission of the information, but concern about getting that judgment wrong and about the consequences of doing so will surely limit its use.
- Even if disclosures can be crafted that preserve the privileges in most cases, two consequences of the Exposure Draft are foreseeable: (i) there will be a substantial increase in litigation over privilege matters and communications between reporting entities and their counsel relating to these disclosures and (ii) reporting entities may feel inhibited in their ability to communicate freely with counsel about these disclosures fearing that such communication may lead to loss of privilege. Neither of these would be a desirable result.
- Because of the numerous subjective factors that go into an assessment of a lawsuit, as well as the possibility of critical factors that are not presently known, auditing quantitative disclosures about litigation will be very challenging. To the extent that the reporting entity’s judgments and estimates are based on privileged communications between a disclosing entity and its counsel, auditors may feel obliged to seek privileged information from counsel or the company in order to test the disclosures. Even where the reporting entity has not relied on its counsel for the estimates, counsel representing the entity in the matter is likely to be a useful source of information to test those assertions. In either case, disclosure of privileged information to an independent auditor could lead to loss of the privilege. At the least, the need for the auditor to audit the information is likely to put strains on the “Treaty” between the American Bar Association and the AICPA that has governed lawyers’ responses to auditors’ inquiries since the 1970s. … As the United States Supreme Court said in Upjohn Co. v. United States 449 U.S. 383, 393 (1981) “an uncertain privilege…… is little better than no privilege at all”. The loss of the protections of the attorney-client privilege and work product doctrine for this type of detailed analysis will often be extraordinarily detrimental. Once the privilege is lost, the subject of the once privileged communication becomes fair game for discovery in the litigation. The reporting entity’s adversaries will be given a potential roadmap to victory since the privileged information will reveal counsel’s assessment of the strengths and weaknesses of the reporting entity’s litigation position
- This is one of those unusual situations where the potential harm to reporting entities and their shareholders from the required disclosures outweighs the potential benefits to investors and other users of financial reports.
- The Exposure Draft fails to take into account certain basic aspects of the adversarial system of justice in the United States and threatens to put reporting entities at a serious disadvantage in that process.
The FAS 5 Changes and the "Preeminence" of Investors
The last two points raised in ABA's comment letter, cited above, speak to the need for FASB to balance the many sometimes divergent interests in the system to achieve a state of fairness.
Similar points were made in Willkie Farr attorney Michael Young's comment letter. Young is highly regarded for being an expert on securities law and recently rotated off FASB's Advisory Committee, FASAC. Young states [we format with bullets for emphasis]:
“At the risk of stating the obvious, what is really going on here - at least insofar as the exposure draft is applicable to loss contingencies arising from litigation - is a fundamental difference between two cultures.
- One is the culture of financial reporting and its commendable commitment to transparency.
- The other is the culture of our adversary system of justice which necessarily balances the objective of transparency against prejudice to litigants seeking to have their day in court."
Young continues, "It should not be surprising, therefore, that commentators on this exposure draft can offer such differing, but wellintentioned and genuinely held, views.”He adds, “I believe that the two cultures may be reconcilable for purpose of FAS 5,” and states, “if improvement is warranted, I would suggest that the Board seek a middle ground that both seeks to accommodate the objectives of users while preserving the ability of preparers to have their day in court without undue prejudice." See his comment letter for his detailed recommendations on how FASB can achieve this balance.
On the subject of balance, Professor Tom Selling, in his Accounting Onion blog, discussed his views on investor 'preeminence' as that term is used in the final report of the SEC Advisory Committee on Improvements to Financial Reporting (CIFiR). (He cites our earlier post which noted footnote 15, one of the last additions to CIFIR's final report, amplified that ''preeminence' as that term is used is not necessarily that investors' views 'trump' all other interests, but that investors views should be given 'greater weight." )
Personally, I believe the footnote is an attempt to reflect the necessary balancing of all interests - a balancing recognized as fundamental to standard-setting going back to FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information (CON 2), which included cost-benefit among the necessary characteristics to consider, noting in para. 140:
"The burden of the costs and the incidence of benefits fall quite unevenly throughout the economy, and it has been rightly observed that “ . . . the matter of establishing disclosure requirements becomes not only a matter of judgment but also a complex balancing of many factors so that all costs and benefits receive the consideration they merit. For example, a simple rule that any information useful in making investment decisions should be disclosed fails as completely as a rule that says disclosure should not be required if competitive disadvantage results.” The problem is to know how to accomplish that “complex balancing.”
The FAS 5 proposal, on which comments are due tomorrow, will surely be an opportunity for FASB to exercise the "complex balancing" referenced in CON 2 above. Willkie Farr's Young noted in his letter: "I have every confidence that the Board will rise to the challenge.”
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