Project: Corporate Counsel Part I (Unintended Consequences) - Law Firms Environmental Disclosure In The Post Sarbanes-Oxley World

Friday, July 1, 2005 - 00:00

The past few years have been a bumpy ride for the investing community. The breath-taking gains of the Bull Market of the 1990's crashed in equally spectacular fashion on the shoals of recalibrated performance expectations. At the same time, high profile corporate scandals began to dominate the news. The detritus of wrecked companies continues to wash through the market place. These events shook investor confidence to its very core and spurred Congress to adopt the Sarbanes-Oxley Act in 2002 in an effort to restore the faith of the investing community in the quality of information being reported by publicly-traded companies and to eliminate identified abuses of disclosure requirements.

In the three years since the Sarbanes-Oxley Act took effect, it is debatable whether either of these objectives have been met. It is clear, however, that the Act has fundamentally changed the process by which information must be digested and reported to the investing community and has made senior executives directly accountable for that process as well as the content of the financial reports for their companies. These systemic changes are evident in many different arenas, including the thorny subject of environmental disclosure where the Sarbanes-Oxley Act places a premium on the use of interdisciplinary teams of skilled professionals to handle the multi-faceted issues posed by environmental disclosure. This article examines this evolving phenomenon.

The basic framework governing financial disclosure obligations of publicly-traded companies has been in place since the 1930's. In response to the stock market crash of 1929 and the financial turmoil of the Great Depression that followed, Congress enacted the Securities Act of 1933 ("Securities Act"), and the Securities Exchange Act of 1934 ("Exchange Act"). These two statutes cover the registration of securities offered for sale to the public and the periodic disclosure of information by regulated companies to the investment community.

Long after the Securities Act and the Exchange Act became law, state and federal programs designed to protect the environment began to proliferate. Since 1971, the Securities and Exchange Commission ("SEC") has wrestled with the manner in which disclosure of environmental liabilities and compliance costs should be handled within the framework created by the Securities Act and the Exchange Act. The SEC's early efforts reflected the notion that environmental issues were primarily of social rather than financial importance and lacked direct and immediate economic significance. The SEC's perspective changed dramatically as the costs associated with meeting environmental requirements increased substantially, particularly in the late 1980's with the explosion of liability for remediation of so-called "Superfund" sites. Nevertheless, the SEC sought to address the disclosure of environmental liabilities and compliance costs through existing tools rather than by fundamentally altering the requirements applicable to financial disclosure. The SEC continues to use this approach today, incorporating requirements relating to environmental disclosure within the complex body of regulations governing the disclosure of information by companies under its jurisdiction. These regulations, briefly summarized below, cover the content of financial statements and narrative disclosures.

Regulation S-X, 17 C.F.R. Part 210, governs the SEC accounting rules and requirements pertinent to financial statements. By contrast, Regulation S-K, 17 C.F.R. Part 229, contains requirements applicable to the non-financial statement portions of a broad range of documents including registration statements under the Securities Act, and documents and reports required pursuant to the Exchange Act such as registration statements, annual or other reports (including Form 10-Q (quarterly), Form 10-K (annual) and Form 8-K (episodic)), going private transaction statements, tender offer statements, and proxy and information statements.

Three areas under Regulation S-K are most likely to involve the potential for narrative disclosure of information related to environmental compliance and environmental liabilities - Item 101 (Description of Business), 17 C.F.R. § 229.101; Item 103 (Legal Proceedings), 17 C.F.R. § 229.103; and Item 303 (Management's Discussion and Analysis of Financial Condition and Results of Operations), 17 C.F.R. § 229.303.

Item 101 includes a requirement that as part of a narrative description of the business, the registrant discuss the material impacts of environmental compliance on the business, as follows:

Appropriate disclosure also shall be made as to the material effects that compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries. The registrant shall disclose any material estimated capital expenditures for environmental control facilities for the remainder of its current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem materials [sic]. 17 C.F.R. § 229.101 (c)(1)(xii).

Item 103 requires registrants to "[d]escribe briefly any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party or of which any of their property is the subject." 17 C.F.R. § 229.103. The instructions to Item 103 amplify on these requirements as they apply to environmental proceedings, making clear that an environmental proceeding is not to be deemed "ordinary routine litigation incidental to the business" and must be described if the proceeding (1) is material to the business or financial condition of the registrant; (2) involves primarily a claim for damages or involves potential monetary sanctions, capital expenditures, deferred charges or charges to income and the amount involved, exclusive of interest and costs, exceeds 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis; or (3) a governmental authority is a party to the proceeding and the proceeding involves potential monetary sanctions, unless the registrant reasonably believes that the proceeding will result in monetary sanctions, exclusive of interest and costs, of less than $100,000.

Item 303 requires prospective information to be discussed through the eyes of management to the extent that the information relates to issues such as liquidity, capital resources, and results of operations. 17 C.F.R. § 229.303(a). Item 303 also requires the registrant to discuss such other information that the registrant believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations. Instruction 2 to Item 303 clarifies that the "purpose of the discussion and analysis shall be to provide to investors and other users information relevant to an assessment of the financial condition and results of operations of the registrant as determined by evaluating the amounts and certainty of cash flows from operations and from outside sources.

Rule 10b-5, the SEC's general anti-fraud rule, may also mandate disclosure of environmentally-related information in certain instances. Under Rule 10b-5, it is unlawful to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, in connection with the purchase or sale of any security. 17 C.F.R. § 240.10b-5.

While the Sarbanes-Oxley Act did nothing to change the substantive environmental rules that corporate America must live by nor did it alter the SEC's environmental disclosure requirements, it provides a major impetus for more thorough evaluation of environmental liabilities in connection with the disclosure process and substantially increases the stakes for failing to make appropriate disclosures, including environmental disclosures. A brief review of those changes underscores the new emphasis placed by the Act on "process" and the penalties for failing to satisfy such "process" oriented requirements.

Of central importance are the top level management certification requirements that apply to companies filing periodic reports with the SEC. First, under section 302 of the Sarbanes-Oxley Act, the chief executive officer ("CEO") and chief financial officer ("CFO") of a registrant must certify that they have reviewed annual and quarterly reports filed with the SEC, and that, based on their knowledge, the reports do not contain any untrue statement of a material fact or omit any material fact, and fairly present, in all material respects, the financial condition and results of the company. Second, these officers must certify that they are responsible for establishing and maintaining internal controls, that they have designed the controls to ensure that material information is made known to the officers and others within the company, and that they have evaluated the adequacy of the controls within ninety days of the date of the report.

Finally, these officers must certify that they have disclosed to the company's auditors and the Board of Director's audit committee all significant deficiencies in the design or operation of the company's internal controls which could adversely affect the company's ability to record, process, summarize and report financial data and (to the auditors) any material weaknesses in internal controls. They must also certify that they have indicated in the report whether there were any significant changes in internal controls or other factors that could significantly affect internal controls subsequent to the date of their evaluation, including corrective actions regarding significant deficiencies and material weaknesses.

Of equal importance are the enforcement consequences of failing to comply with the certification requirements. For example, under Section 906 of the Sarbanes-Oxley Act, any person who willfully certifies a report knowing that the report does not comport with the requirements of the Act is subject to penalties of up to $5 million and 20 years imprisonment. In addition, the Act contains new criminal penalties for defrauding shareholders (Section 807) and a new requirement (Section 304) that, in the event that the company must prepare a restatement due to material non-compliance with reporting requirements as a result of misconduct, the CEO and CFO must reimburse the company for any incentive or equity based compensation and profits from the sale of securities during the 12 months following a public issuance or filing with the SEC.

While what is material for environmental disclosure purposes continues to be governed by the prexisting SEC requirements discussed above, the CEO and CFO certification requirements under the Sarbanes-Oxley Act impose what amounts to a new standard of care on those officers to ensure that the company's environmental disclosures are correct and that the company's internal reporting requirements concerning environmental information are sufficient to record, process, summarize and report financially significant environmental information. Thus, not only must the company's environmental management system be up to the task of recording, processing and summarizing relevant environmental information, the new standard implicitly assumes that the company will employ the necessary expertise to develop that information in the first place.

Given the substantial adverse consequences of making inaccurate certifications, the Sarbanes-Oxley Act provides a significant incentive to err on the side of careful evaluation and accurate disclosure of environmental liabilities. Outside environmental counsel who are able to bring both a breadth and depth of expertise to identifying environmental liabilities can play a key role in providing the expertise necessary to ensure that the company has undertaken a broad and in depth evaluation of its current and future environmental exposures. Indeed, such an approach may be critical to satisfying the new standard of care in making the necessary certifications under the Sarbanes-Oxley Act.

Bruce S. Katcher and Michael M. Meloy are Partners at Manko, Gold, Katcher & Fox, LLP, an environmental law firm in Bala Cynwyd, Pennsylvania.

Please email the authors at bkatcher@mgkflaw.com or mmeloy@mgkflaw.com with questions about this article.