ABA Urges FASB - U.S. Litigation Differs. Don't Amend SFAS 5

Wednesday, October 1, 2008 - 01:00

Editor: Bill, what was the role of the ABA Task Force that you chair in preparing the ABA's Comments on the Financial Accounting Standards Board (FASB) exposure draft titled "Disclosure of Certain Loss Contingencies: An Amendment of FASB Statements 5 and 141(R)" ("Exposure Draft or Amendment") and why was it involved?

Ide: The Task Force was given the task of coordinating the ABA's submission to the FASB with respect to the Exposure Draft. The Task Force utilized a drafting committee of me, Stanley Keller (Edwards Angell Palmer & Dodge LLP); Lewis H. Ferguson (Gibson, Dunn & Crutcher LLP), a former General Counsel of the Public Company Accounting Oversight Board, and Giovanni Prezioso (Cleary Gottlieb Steen & Hamilton LLP), a former General Counsel of the Securities and Exchange Commission. We received input from other members of the Task Force, ABA Sections and Committees, as well as a broad range of in-house and outside lawyers.

The Task Force was deeply involved because of our concern that the Exposure Draft would jeopardize the attorney-client privilege and work product rights (the"Privilege") of companies, by requiring them to speculate about litigation outcomes. This would provide plaintiffs with privileged information about a company's litigation vulnerabilities and defense strategies, thus hampering the ability of companies to mount a successful defense. Moreover, as adjudications are made, many speculations will prove to be incorrect, thereby exposing companies to claims that they made misleading disclosures.

Editor: Give us a little background with respect to current SFAS 5. Tell us about the treaty between the lawyers and accountants and how it is reflected in current SFAS 5.

Ide: Today, SFAS 5 operates well in assuring disclosure of facts as they become known in the litigation process. Accrual is required when a loss is probable of occurrence and can be reasonably estimated. Even if a litigation accrual is not required, a loss contingency must be disclosed if there is a reasonable possibility that a loss may be incurred. The disclosure must indicate the nature of the contingency and provide an estimate of the possible loss or range of loss or state that such an estimate cannot be made. Disclosure of a loss contingency puts investors on notice that the loss might be material. No disclosure is required for a loss contingency deemed to be remote.

The treaty ("Treaty") between the ABA and the American Institute of Certified Public Accountants (AICPA) complements this approach by providing rules for requests by auditors to clients that the client's law firms provide information concerning existing or potential litigation. At the requests of clients, lawyers will provide facts, but will not express judgments on outcomes except in the relatively few cases where an unfavorable outcome is either "probable" or "remote." This allows auditors to have guidance from outside counsel as to litigation that should be reviewed by them, while permitting clients to have the benefit of effective assistance of counsel by preserving the Privilege from claims of waiver. The Exposure Draft would undercut the Treaty, putting companies and their lawyers in the untenable position of purporting to estimate the magnitude of an ever-changing target of potential liability on a continuous basis.

Editor: What is the reason for the Amendment?

Ide: The Exposure Draft states that it responds to concerns that litigation disclosures under SFAS 5 do not provide adequate information to users of financial statements. No empirical data is referenced and the possibilities that any shortcomings could be from the failure of adherence to SFAS 5 best practices is not addressed.

Some believe that the Exposure Draft reflects an effort to bring about convergence between USGAAP and the International Financial Reporting Standards (IFRS) as promulgated by the International Accounting Standards Board (IASB). Fair value accounting is favored by the international standards under the theory that book or historic valuations are not as relevant to users of financial statements as market valuations. The Exposure Draft seeks to provide a more current loss contingency assessment of potential or existing litigation by using fair value accounting principles. In essence, the Exposure Draft seeks to "mark to market" existing or potential litigation.

Editor: What does the Exposure Draft require?

Ide: The Exposure Draft would require disclosures of all loss contingencies within its scope, except for those that are remote or unasserted claims that either will probably not be asserted or where, if asserted, the likelihood of loss is remote. The Exposure Draft would also require disclosure of even remote contingencies that are likely to be resolved in the next 12 months and could have a "severe impact," defined as significantly financially disruptive on the normal functioning of the entity. The requirement to disclose even remote contingencies in these circumstances is a change from present standards and goes further than the corresponding provision in International Accounting Standards No. 37, which only requires disclosure of contingencies that are more than remote.

Under the Exposure Draft, both quantitative and qualitative disclosures of contingent exposures would be required. Entities would be required to disclose the claim amount or, in the absence of a claim amount, an estimate of the maximum potential loss exposure. The reporting entity could also provide a supplemental disclosure of its best estimate of the possible range of loss if it believes that the claim or maximum exposure amount is not indicative of the actual exposure. In addition to the quantitative disclosure, the entity must disclose information to help the reader understand the facts surrounding the contingency and the risks it poses to the entity. Such disclosures would have to include, "at a minimum": (1) a description of how the claim arose; (2) its legal or contractual basis; (3) its current status; (4) the anticipated timing of its resolution; (5) a description of the factors that are likely to affect the ultimate outcome of the contingency, (6) the entity's qualitative assessment of the most likely outcome of the contingency, and (7) any assumptions made by the entity in estimating the amount of the most likely outcome. Finally, a qualitative and quantitative description of the terms of relevant insurance or indemnification arrangements covering the possible loss, including caps, limitations and deductibles, would be required.

For certain contingencies, such as pending or threatened litigation, where disclosure of certain information about the contingency required under the Exposure Draft would be prejudicial to an entity's position, disclosures could be aggregated at a higher level or, in "rare" circumstances, the reporting entity's qualitative assessment of the likely outcome of the contingency and its assumptions used to estimate that outcome could be omitted altogether. In such cases, the entity must disclose "the fact that, and the reason why, the information has not been disclosed."

The Exposure Draft goes beyond the basic disclosure threshold in SFAS 5, namely that a loss is reasonably possible (i.e., more than remote), and it greatly expands the content of the required disclosures. It also appears to eliminate the option for a reporting entity to conclude that the magnitude of the contingent loss, whatever its likelihood of occurrence, cannot be estimated during the applicable reporting period. In essence, compliance with the Exposure Draft will require entities to value all material (and sometimes remote) contingencies to provide the detailed information required.

Editor: What unique characteristics of the U.S. legal system make it difficult to achieve convergence with international standards and implement the other changes in the Exposure Draft without exposing companies to significant legal risks that can create harm to shareholders?

Ide: The U.S. litigation system is an adversarial system where each side advocates its own version of the facts and application of the law. Contrary to most legal systems, we have extensive discovery, use of juries and have expanded the risks of litigation through punitive damages, contingent fees (opposite of UK's "loser pays"), class actions and concepts of deterrence such as treble damages and have criminalized various compliance failures. Application of legal principles becomes clear over time as pleadings are filed and as rulings are made. Factual determinations of the allegations made by both sides are not usually determined until a judge or jury decides after discovery and a trial. See the Overview on this page.

SFAS 5 as now in effect does a good job of setting out principles that allow the parties to disclose what they know as rulings occur.

Editor: Why does the Exposure Draft's requirement that defendants provide their own estimate of maximum possible loss or an estimate of a likely range of losses seriously disadvantage defendants without providing offsetting benefits to the users of financial statements?

Ide: Under our litigation system, each side is empowered to pursue their respective versions of the truth through the advocacy process. It is not until you get a ruling by a judge or by a jury that you have any objective ascertainment of truth. So when you ask either party to give an estimate relating to the outcome of the litigation, they really do not have the information to make a meaningful estimate.

As pointed out in the Overview on this page, a party to a U.S. litigation does not have sufficient facts to provide a meaningful estimate until the other side has either stipulated to the facts or a third party has ruled on them. If one party provides such an estimate and give the assumptions behind that estimate, the other party will argue that such information constitutes an admission. As the litigation proceeds, as demonstrated by the cases described in the Overview, the party giving the estimation will have to change its estimate of the outcome again and again, which opens it up to claims of misleading disclosure. The Exposure Draft does not take into account the fluidity of the U.S. litigation system. Under fair value accounting, which is what is contemplated by the IFRS, a company would be marking litigation exposures to market quarterly. Unfortunately, this puts the U.S. defendant in the position of negotiating against itself with the plaintiff waiting and watching with keen delight as the defendant keeps updating its estimate and disclosing the basis for the update.

Editor: Why can the Exposure Draft's requirement for insurance and indemnity disclosure be prejudicial and unreliable?

Ide: Requiring disclosure of potential insurance and indemnity recoveries could be prejudicial to reporting entities and raise the cost of settlements. Such potential recoveries are excludable under the rules of evidence for the very reason that they can be prejudicial. They can, for example, raise the cost of resolution if a plaintiff believes that the defendant will not bear the full cost of the settlement or judgment. Moreover, insurance and indemnity rights can themselves be fraught with uncertainty, as insurers often reserve rights to deny coverage after the litigation is over. We believe it is better to allow reporting entities to decide on the appropriateness or need for disclosure of potential sources of recovery based upon prevailing materiality standards.

Editor: In requiring the disclosure and discussion of remote contingencies (whether asserted or probable of assertion) that are likely to be resolved in the near term and having a severe financial impact, does the Exposure Draft circumscribe significantly the reporting entity's judgment in assessing "materiality" under the Supreme Court standard ?

Ide: Many reporting entities and securities practitioners have long believed that if an event is remote, even if it could have a major impact, it would not be material to a reasonable shareholder. This view finds support in the Supreme Court's decision in Basic v. Levinson , in which the Court described "materiality" as involving a two-fold test of likelihood of an event's occurrence and its significance if it did occur. We are concerned that the Exposure Draft's requirement to disclose certain remote contingencies changes the accepted principles of materiality under Basic v. Levinson and TSC Industries, Inc. v. Northway and will provoke a flood of frivolous cases.

Editor: Are the concerns you mentioned about the disclosure of prejudicial information addressed specifically in the Exposure Draft, which permits the company to disclose an estimate or range of possible loss, to aggregate disclosures or, "in rare instances," to omit the disclosures altogether?

Ide: Providing an estimate or range of possible loss involves the release of confidential information. Lumping all the claims together is also not workable. For example, when a class action or other major litigation is filed it is such a big part of the lump that it would be very easy for a plaintiff to winnow it out of the lump and know exactly what the defendant is saying about a particular class action or punitive damage action. With respect to omitting the disclosures altogether, it is unclear how "rare" the instances would have to be and who would make the determination.

Editor: Why would the Exposure Draft erode the protections of the attorney-client privilege and work product doctrine?

Ide: There is mixed case law about whether or not giving information to your client's auditor is a waiver. The better view is that there is a "common interest" waiver protection, but unfortunately there is enough bad case law out there that you have to assume that, if the lawyer gives Privileged information to the auditor, either directly or through the client, then there is a risk of waiver. Waiver will also be claimed for furnishing investors, through disclosures in the financial statements, estimates and evaluations required by the Exposure Draft (the underlying basis having been obtained from counsel). That will give the plaintiff access to information that would otherwise be unavailable and reduce the likelihood that the defendant will be able to mount a successful defense. It also chills the ability of the client to fully confide in the lawyer who is handling the matter.

Editor: The deadline for filing comments on the Exposure Draft was August 8. What further steps are contemplated before the Exposure Draft becomes final?

Ide: The FASB has been very receptive to hearing from all interested parties - not only investors but also from companies, their lawyers and from business and professional organizations. In the first quarter of 2009, the FASB plans to hold one or more public roundtable meetings on the Exposure Draft. The purpose of roundtable meetings is to listen to the views of, and obtain information from, interested constituents about the Amendment. Apparently, the FASB will first field test with some major public companies, on a confidential basis, the provisions of the Amendment in comparison to existing FAS 5 and a straw model that is halfway between the Amendment and existing practices. The purpose of the field tests is to assess the workability of the Amendment and evaluate the cost and benefits of the proposed change.

In working on matters relating to the attorney-client privilege, such as the recent DOJ revision of the McNulty Memo, we have found that bringing clients and lawyers together in a coalition is the most effective way to deal with policy matters. Lawyers have their duties to the courts in the adversarial system and to protect clients under the code of professional responsibility, but it's the clients that have the highest credibility as the actual users of the system. Therefore, with respect to our concerns about the Exposure Draft, we are seeking to hold hands with the Chamber of Commerce, with the Business Roundtable and many different business groups, all working together to present the facts, because we believe the facts are so compelling.

Your readers and Internet viewers can help. They can supply our Task Force with anecdotal evidence and their views. We would urge your readers to keep this issue high on their radar screens.

SFAS 141(R) has been adopted by FASB and becomes effective for fiscal years ending after December 15, 2008 and provides in the context of business combinations that the resultant entity's loss contingencies be disclosed pursuant to the disclosure principles proposed in the Exposure Draft. We are asking FASB to postpone the effective date of SFAS 141(R) until a final determination is made on the Amendment.

An immediate challenge is the effective date of SFAS 141(R) and that if the Amendment were adopted now, it becomes effective for fiscal years ending after December 15, 2008, and interim and annual periods in subsequent fiscal years. Given the complexities of compliance, the large number of comments submitted and the many problems they have identified, the need to analyze the input that will be received from the roundtables and field testing, we are urging that action not be taken on the Amendment and that the effective date of SFAS 141(R) be postponed.