Suppose at the end of every fiscal year, clients wrote a letter to their outside counsel as follows:
Please prepare a letter about the large cases you are defending for our company, honestly and completely explaining:
- What are our risks in cases where we re being sued? Do you think we are going to win or lose? If we lose, how bad is it likely to be?
- When do you think you will settle the case?
- Include an evaluation of any cases where you are sure we will win and not owe anything, but if you're wrong and the wheels fall off, the verdict will have a "severe impact" on our company. And then write about any cases where you're sure we're going to win, but defending the case is going to be really expensive and disruptive -- we want your evaluation of those cases, too.
An when you're done writing all this down, we're going to put it up on the internet where the other side can read all of your thoughts about these cases.
After you've shown all your cards, good luck defending the cases. Don't let us get into trouble. And have a nice day.
Pretty wacky hypothetical, huh? Pretty far out? But in effect, that's what the Financial Accounting Standards Board of the Financial Accounting Foundation may be getting ready to require with its "Proposed Accounting Standards Update, Disclosure of Certain Loss Contingencies."
This is going to be a longer and more arcane post than the usual CBL musing. So for those readers who don't have time to read all of this because, for example, they have jobs, here are the key points:
- The FASB issued its unfortunate "Exposure Draft" on July 20, with a comment period of less than thirty days. The comment period ends August 20. Comments need to be sent to the Financial Accounting Standard Board's director at email@example.com, File Reference No. 1840-100. Comments -- lots of them -- would be a very good idea.
- The new standard, if adopted, will supplant the 35-year-old Statement of Financial Accounting Standards No. 5 in governing requests for audit information to lawyers. More importantly, it may supplant the 1975 "Treaty" between the American Bar Association and the American Institute of Certified Public Accountants, more formally known as the "Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information." The "Treaty" helped to ensure that lawyers' responses to audit requests did not result in a waiver of the attorney-client privilege and work product doctrine.
- The new standard contains none of the protections of the Treaty, and requires companies to ask lawyers to provide information to non-clients -- independent accounting firms -- that in many instances cannot be provided without breaching the attorney-client and work-product privileges.
- Under California law, and the law of many states, a voluntary disclosure of privileged matters constitutes a waiver of the privilege, exposing the previously protected matters to discovery by an adverse party.
- The proposal's requirements related to "maximum exposure" and plaintiff's demands will require the disclosure of misleading information and/or result in no useful information for investors or other users of financial statements.
- Similarly, the requirement that contingencies be disclosed without regard to insurance coverage will also result in misleading information in those instances where the availability of liability insurance mitigates the impact of otherwise large exposures.
- The aggregation provisions help prevent prejudice in some cases, but they do nothing about the wavier problem and are of not help to a small company with a big lawsuit.
Those are the essentials. For readers who want to get deeper in the weeds, there's much more after the jump.
Why Is Cal Biz Lit Posting On This Subject, Anyway?
Regular readers know that Cal Biz Lit usually provides a slightly irreverent and sometimes snarky view on product liability, Proposition 65, consumer law and other litigation subjects with a decidedly California-centric slant.The idea is to provide anyone interested some useful and easily digested information about the unique litigation environment that is California.
Once in awhile, however, a national issue comes up that may be so impactful on any lawyer defending companies anywhere that CBL feels the need to bring it to everyone's attention. And so it is with today's subject: the latest proposal to amend FASB Topic 450 (the renumbered version of what is still widely known as Statement of Financial Accounting Standards No. 5). CBL believes the proposal endangers the attorney-client privilege and work product doctrine for companies in litigation all over the United States, but particularly in California. So CBL encourages companies, attorneys and other interested persons to submit comments to the FASB, telling the Board the revision is a bad idea.
Most in-house counsel are familiar with the FASB and SFAS No. 5 (officially changed to "Topic 450" last fall). Most outside counsel are also familiar with SFAS No. 5 because of the wave of letters they receive every year from their clients, asking them to provide the clients' accounting firms with information about "contingent risk" that may be "material."
SFAS No. 5 requires two categories of reporting. The first requires to accrue (i.e., show on the balance sheet) a contingent loss if "it is probable that an asset had been impaired or a liability had been incurred" and if the "amount of loss can be reasonably estimated."
The second reporting requirement occurs when "there is at least a reasonable possibility" that a loss has been incurred. Under these circumstances, the company must disclose "the nature of the contingency" and "give an estimate of the possible loss or range of loss or state that such an estimate cannot be made."
Even with these limited disclosures, it is very hard for a company to provide this kind of evaluation without getting into work attorney work product and attorney-client privileged information. Thus, there has been a thirty-five year balancing act involving auditors, who presumably want to maximize the availability of information for shareholders and other stakeholders, and lawyers, who want to safeguard privileges as to pending or anticipated litigation. The tension was at least partly resolved by a 1975 "Treaty" between the American Bar Association and the American Institute of Certified Public Accountants. The Treaty, more formally known as the Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information, provided, among other things, that:
- "The public interest in protecting the confidentiality of lawyer-client communications is fundamental;"
- There are "strict statutory and ethical obligations of the lawyer to preserve the confidences and secrets of the client;"
- Lawyers may provide information requested by an auditor "unless such information discloses a confidence or a secret or requires an evaluation of a claim;"
- An adverse party "may assert that an evaluation of potential liability is an admission;"
- The lawyer should refrain from expressing judgments as to outcome "except in those relatively few clear cases where it appears to the lawyer that an unfavorable outcome is either 'probable' or 'remote.'"
So, for thirty-five years, the accountants and the lawyers continued their uneasy dance, with the lawyers generally not giving the accountants explicit evaluative opinions and the accountants relying on somewhat limited information to determine what accruals to make and for how much.
Proposed Amendments, Round One
And then, for whatever reason -- Sarbanes-Oxley, the new empowerment of the Public Company Accounting Oversight Board, or a sense that Generally Accepted Accounting Practices should be closer to the European International Accounting Standard 37 -- the FASB decided more disclosure was required. After some committee meetings, hearings and other bureaucratic machinations, the FASB issued its 2008 proposal to amend Standard No. 5, which included the following:
- The disclosure requirement for non-accrual contingencies was broadened. Instead of requiring disclosure of contingencies that were "reasonably possible," the proposal required disclosure unless the likelihood of loss was remote;
- Regardless of the likelihood of loss, companies would be required to disclose any loss contingency -- even a remote one -- that was expected to be resolved in the year after the financial statement, if the contingency "could" have a "severe impact" on financial position, cash flows, or results of operations;
- The proposed amendments would require disclosures in footnotes of:
- The company's "best estimate of the maximum exposure to loss" of any contingent claims (compared to the current rules, which allow either a range estimate or a statement that such an estimate cannot be made);
- Qualitative information about the contingency, including how it arose, its legal or contractual basis, its current status, the anticipated timing of the resolution, a description of the factors likely to affect the ultimate outcome of the contingency, the entity's assessment of the most likely outcome, and the significant assumptions made by the company in forming these judgments.
The proposal included an exception for prejudicial information that allowed aggregation of data, or, in "rare" circumstances, allowed the company to forgo disclosure.
The FASB received more than 200 comments. CBL hasn't read them all, but in our experience, such comments are rarely along the lines of "hey, great job." More likely, they would have made one or more of the points in the pharmaceutical industry's very-well articulated comment, here. And so, the FASB went back to the drawing board.
Proposed Amendments, Round Two
The new proposal, issued July 20,2010, kept most of the problematic changes from the first proposal and added some new ones. While the FASB states in its comments that it has eliminated the need to disclose resolution timing and maximum exposure, the text of the draft does not support this statement. The new draft includes these provisions:
An entity shall disclose qualitative and quantitative information about loss contingencies to enable financial statement users to understand all of
a. The nature of the loss contingencies
b. Their potential magnitude
c. Their potential timing (if known).
(Emphasis supplied, but important.)
In furtherance of all that,
During early stages of a loss contingency’s life cycle, an entity shall disclose information that is available to enable users to understand the loss contingency’s nature, potential magnitude, and potential timing (if known). Available information may be limited and, therefore, disclosure may be less extensive in early stages of a loss contingency. In subsequent reporting periods, disclosure shall be more extensive as additional information about a potential unfavorable outcome becomes available.
And the company must disclose any contingent claim other than a remote one.
An entity shall disclose information about a [contingent claim] if there is at least a reasonable possibility (that is, more than remote possibility) that a loss may have been incurred regardless of whether the entity has accrued for such a loss (or any portion of that loss).
Among the items to be disclosed are: (1) "[Q]ualitative information to understand the loss contingency's nature and risks;" (2) The contentions of the parties, basis of claim and amount of damages claimed by plaintiff at early stages of litigation, and more extensive information as the case progresses; (3) Sufficient information to allow financial statement users to go to the courthouse and look up more information about the case; (4) If it can be estimated, the possible loss or range of loss; (5) If it can't be estimated, the reasons why not.
The new draft added a provision that whether or not contingencies were discloseable should be determined without reference to insurance:
When assessing the materiality of loss contingencies to determine whether disclosure is required, an entity shall not consider the possibility of recoveries from insurance or other indemnification arrangements.
The only acknowledgment of the attorney-client privilege is in two catch-all provisions providing that reporting entities should include "other non-privileged" information.
What's Wrong With This Picture?
So what's the big deal, anyway? Well, for starters, most companies are going to have an awfully hard time responding to items 1, 4 and 5 above without resorting to attorney-client communications and evaluations: just the kind of information that attorneys were advised under the Treaty that they should not provide. And under California law, and the law in many other jurisdictions, waiver of the privilege is a slippery slope. First, voluntary disclosure of privileged matter to a third party -- such as an accountant-- constitutes a waiver of the privilege. Second, the waiver may well go beyond the specific communication disclosed and become a waiver of an entire subject matter.
And in any event, the new proposal contemplates that all this disclosure will end up available for review by anyone -- certainly including the other side -- in the company's annual report.
By requiring disclosure of Plaintiff's demand in the early stages of litigation, FSAB gives companies a Hobson's choice: it can present the meaningless, enormous demands that typically accompany new claims. Or if the company wants to give a more balanced view -- explaining, for example, that the cases are likely to resolve for orders of magnitude less than the initial demands -- it must resort to attorney evaluation and legal advice in order to do so. Thus, the company must choose between (a) reporting without comment the plaintiffs' initial, preposterous demands or (b) waiving privileges in order to provide a more realistic view.
The "ignore the insurance" provision can also result in misleading disclosures. The proposal requires that remote contingencies likely to resolve in the following year be disclosed if they could have a severe impact on financial position, cash flows or results of operations. Other contingencies should be disclosed if there is a "reasonable possibility" of a loss. But apparently, these assessments are to be undertaken without regard to insurance purchased and maintained for the purpose of avoiding such losses and impacts.The proposal allows aggregation of some data in order to mitigate the potential prejudice of giving the other side granular information about individual cases. Sometimes this may help avoid giving useful information to the company's adversaries. It likely does nothing to address the privilege problem. And how useful it is to tell shareholders when a company is involved in mass litigation that the plaintiff's have 3000 cases against us, they are demanding $10 million in each case, so the maximum demand, or maximum exposure, or maximum something is thirty billion dollars?
Further, the aggregation device does nothing to help the small company with one large case against it. That company has nothing it can aggregate, and no other way to hide its evaluation and strategy from its adversary.
So Now What Happens?
One way to avoid a bunch of pesky negative comments about a proposal is to throw the proposal out there with a thirty day comment deadline during the time of year when many in-house and outside counsel take their vacations. While CBL has no reason to question anyone's motives, that is, in effect, what the FASB has done here. As mentioned above, the deadline for comments is August 20. Although there has been one request for an extension, CBL hasn't seen a response from the FASB.
Page 7 and 8 of the Exposure Draft contains eight questions the FSAB is asking commenters to address. CBL's law firm will be submitting a comment responding to the questions and urging the FASB to return to the drawing board. CBL urges all defense counsel and in-house counsel to do the same.