August 27, 2008

No Love Potion for Proposed FASB Statement No. 5

It's not often you see a proposed change to a financial accounting standard causing a big stir in the legal profession.

For a little perspective, before practicing as an attorney and consultant, I was a tax accountant with one of the Big Four. The combination of my accounting, legal, and technology experience gives me a number of insights on the interplay of these fields and the intended and unintended consequences one has on the other.

I've been following some of the online news regarding the proposed amendment to FASB Statement No. 5, which could have a boatload of unintended consequences to disclosing companies, putting them in can't-win predicament in the interest of financial transparency. To recap, the proposed amendment would require companies to be more transparent in accounting for certain loss contingencies, including pending lawsuits, which on the face of it probably sounds like a good idea: Investors want to know if or when a company may take a significant financial hit from pending litigation.

For a much more detailed explanation of the issues, Wilson Sonsini has an excellent alert on the subject, as does K&L Gates. Mary Mack covered it on her blog, quoting and linking to a WSJ editorial piece which lays out the problems and increased risks such disclosures would bring to complying companies.

The comment period closed on Aug. 8th, and a number of companies have voiced their concerns. Basically, such disclosures, while attractive from a purely accounting and financial perspective, could severely hamper a company's ability to properly defend itself in ongoing litigation, investigations, and settlement negotiations. In other words, such new requirements, without being tempered in some meaningful way, would likely ignore the realities of the current business and legal landscape.

From my perspective, one of the goals of the FASB rules and statements is that the financial statements of a company materially reflect their financial condition. In other words, they need to be sufficiently accurate so that individuals and organizations can rely on them when making various decisions (e.g., investing, lending, etc.). The proposed amendments have been characterized as potentially requiring, in addition to existing disclosures, the disclosure of key elements of a company's litigation strategy, and the possible waiver of attorney-client privilege and attorney work-product protection.

Additional concerns are that the increased disclosure may itself be the source of additional litigation: Estimate the potential liability too high, and the plaintiffs bar can use that against the company in a number of ways, particularly in extracting higher settlements, which would also harm the very shareholders the financial disclosure rules are designed to protect. Estimate it too low and the company could get hit by shareholder suits questioning whether there was intent to mislead investors.

One can certainly understand the financial board's interest in protecting the investing public and others who rely upon a company's financial statements -- particularly after the past ten years have shown us the era's wildly inaccurate "pro forma basis" financial disclosures, the bust, Enron, MCI WorldCom, and the like. I suspect they have heard concerns from investors and are trying to do something, anything, to help increase investor confidence during a particularly turbulent economy. At the same time, the financial standards board should be fully informed as to both the intended and unintended consequences of its proposed changes. Transparency in financial disclosure is generally a good thing, but it needs to be weighed and tempered against the need to maintain the attorney-client privilege and attorney work product protection, which are generally prohibited against disclosure to the public and opposing litigants.

Thus I believe much of the criticism is well-earned at this point, and would expect strenuous opposition from both in-house and outside counsel, and conversely, support from the plaintiffs bar. While some may see this as a form of protectionism, a broader perspective recognizes there is definite merit in these challenges as they voice real-world concerns. While companies should not be allowed to hide wrong-doing from investors, there's a fine balance that needs to be kept to allow for good faith defense efforts, as not all suits have sufficient merit. I'm sure the financial news sites and various blogs will continue to provide updates, as this accounting development could have far-reaching consequences.

[I'll repeat the disclaimer that the posts and opinions expressed on this blog are solely my personal opinions and viewpoints. They do not represent or reflect (nor are they intended to represent or reflect) the positions, opinions, viewpoints, policies and/or statements of my employer or any other entity or person.]

Topic(s):   Other Musings
Posted by Jeff Beard