Proposed Revisions To FAS 5 Standards For Disclosure Of Loss Contingencies Met With Sound Criticism

Wednesday, October 1, 2008 - 01:00

On June 5, 2008, the Financial Accounting Standards Board published an exposure draft entitled "Disclosure of Certain Loss Contingencies, an amendment of FASB Statements No. 5 and 141(R)" proposing amendments to the disclosure requirements for loss contingencies currently set forth in FASB Statement No. 5, Accounting for Contingencies .1The draft significantly expands the disclosure required for loss contingencies. A total of 236 comment letters were submitted, with an overwhelming majority expressing strong opposition to the proposal.

Current Requirements And The Proposed Amendments

Under existing FAS 5, a loss contingency must be disclosed if the loss is "reasonably possible."2The level of required disclosure varies depending upon whether or not the loss is both "probable" 3and its amount can be "reasonably estimated." If both elements are satisfied, the loss must be recognized and the nature and amount of the accrual must be disclosed.4If either or both of the elements are unsatisfied, no accrual is required; however, the nature of the loss contingency must nonetheless be disclosed along with an estimate of the amount of the loss or a statement supporting why such an estimate cannot be made.5

The exposure draft significantly expands the quantitative and qualitative disclosure required for both recognized and non-remote6unrecognized loss contingencies. In addition, it expands the class of loss contingencies for which disclosure would be required to include remote loss contingencies if such contingencies are expected to be resolved within one year and their resolution could have a "severe impact." 7The expanded information relating to all covered loss contingencies includes:

• the amount of the claim or assessment, or if none is asserted, a best estimate of the maximum loss exposure;

• a description of the loss contingency, how it arose, and its basis in law or contract;

• a description of factors likely to affect the ultimate outcome, an assessment of the most likely outcome of the contingency and the status and anticipated timing of its resolution;

• any significant assumptions made in estimating the exposure to loss or the probable outcome; and

• a description of insurance or indemnification arrangements that could lead to recovery of all or part of the possible loss.8

While the proposed revisions would not alter the standards mandating recognition of loss contingencies in financial statements, they would further expand disclosure relating to recognized loss contingencies to require not only the foregoing additional qualitative and quantitative disclosure applicable to all loss contingencies, but would also require tabular presentation in periodic reports of the total amount recognized for loss contingencies during each period, any increases and decreases to accruals for loss contingencies previously recognized, and reconciliations to contingency accruals during the period, in each case identifying the financial statement line items to which such loss contingencies relate, as well as the total amount of related insurance recoveries and indemnity arrangements recognized in each quarter.9

Objections To The Exposure Draft

Roughly 90 percent of the commentators expressed serious concern over the potential negative impact of the proposal. Their first and arguably weakest objection is that no "problem" with FAS 5 exists because current standards produce adequate disclosure when applied properly. The Board and many supportive commentators expressed frustration with companies' frequent reliance on their ability under current FAS 5 to state that no estimate of a potential loss can be made, claiming this leads to a lack of meaningful information in disclosure.10Many commentators responded that proper application rather than an overhaul of the requirements of existing disclosure standards would adequately respond to this concern. Second, commentators argued that the proposed amendments are ineffective to achieve the goal of transparency in disclosure. The proposed standard calls not only for enhanced disclosure of known or ascertainable facts, it also requires companies to make and disclose highly speculative predictions. This element of forward looking guesswork renders the Board's solution ineffective, muddying and confusing disclosure rather than clarifying it. Last, objecting commentators have almost uniformly asserted that the revised standard would result in serious harm to companies outweighing any potential benefits. They argue that the proposed additional disclosure of forward-looking litigation strategy, likely outcome and maximum potential exposure could unintentionally disadvantage defendants in litigation, jeopardize the attorney-client privilege and fuel additional litigation. This unified expression of the legitimate concern that companies would face serious harm if required to comply with the proposed amendments is compelling and should merit changes to or a withdrawal of the exposure draft.

Damage to Litigation Strategy

The proposal would require disclosure of the stated amount, or if none is asserted, an estimate of the maximum exposure of every covered loss contingency. In addition, the amendments would require companies to assess the most likely outcome and timing of every claim asserted against them. Many jurisdictions prevent claimants from specifying claim amounts until late in the litigation process, thus these required of estimations at the onset of claims would effectively force defendants to establish settlement floors via their disclosed estimates. Thus, a company's estimate for potential loss would dictate in part the ultimate outcome of the claim, even where the estimation is made at a time when neither party is able to make accurate assessments. Further, the proposed qualitative disclosure would provide a roadmap of the disclosing company's litigation plan by requiring disclosure of proposed strategies, key issues and weaknesses in a company's own position as well as those of its opponent identified by it. Not only would such disclosure compromise litigation strategy, but sophisticated opponents could also use this requirement to extract quick and favorable settlements from companies that are unwilling to publicly disclose large loss estimates even for weak, baseless claims for fear of negative shareholder reactions. The Board acknowledged this issue and as a result the exposure draft permits aggregation of the required disclosure "at a level higher than by the nature of the loss contingency such that disclosure of the information is not prejudicial."11And, in "rare instances," a company might omit disclosure of prejudicial information altogether, but in no case could it "forgo disclosing the amount of the claim or assessment against the entity" and additional qualitative information.12Opponents to the amendments universally agree that these exemptions fail to alleviate the harms posed by the proposal. Commentators assert that the disclosure of prejudicial information would be the norm, rather than a "rare instance." Given the sophistication of the legal community, it is naïve to assert that the proposal's allowance of aggregation of disclosure meaningfully mitigates these concerns. Aggregation cannot mask the strategic information called for under the revised standard. Moreover, sophisticated analysis would enable litigants to extrapolate meaningful information from aggregated quantitative disclosure regarding individual cases in many instances. Aggregating data would not solve the problem of disclosing prejudicial information if a single claim constituted a disproportionate part of a company's total exposure, in which case aggregation would not provide a meaningful shield. In addition, aggregation would not shield a company from prejudicial information related to a new large claim if investors could simply compare reported amounts between quarters. Ultimately the goal of transparency in disclosure must be balanced against the adversarial nature of our established system of justice. Forced disclosure of predictive information in the litigation context upsets this balance, and consequently carries too high a cost.Attorney-Client Privilege At Risk

The proposed amendments' requirement to disclose various elements of litigation strategy threatens attorney-client privilege and the work product protection doctrine. By necessity, a company would likely derive this type of information from confidential discussions with its counsel. Providing this disclosure to third parties, such as independent auditors, risks the waiver of attorney-client privilege and the work product protection doctrine.13Moreover, even if privilege is not compromised in every case, as pointed out by the American Bar Association, at the very least, disclosure under the proposed amendments likely would result in two unintended consequences: first, an increase in litigation over privilege matters; and second, a chilling of open communication about these disclosures between a company and its counsel for fear that such communication could lose the protection of the privilege.14Once again, the Board's proposal conflicts with a cornerstone of our judicial system:

the attorney-client privilege.

Increased Risk of Litigation

Many commentators raised the additional concern that the requirement to disclose speculative information would increase the risk of disclosure-based litigation. The amendments would require companies to estimate losses and predict outcomes for litigation before they have completed or, in many instances, even begun discovery. Commentators persuasively assert that these estimations would entail groundless guesswork. Similarly, many of the required qualitative disclosures would require speculation due to the inherently unpredictable nature of the U.S. litigation system. Too many factors figure into the ultimate outcome of litigation for companies to accurately disclose the predictive qualitative information proposed to be required. These inevitably inaccurate disclosures would expose companies to litigation from third parties claiming to have relied on them. Thus, the proposal essentially guarantees an increased risk of additional litigation for companies.


As proposed, the amendments are ineffective and their cost far outweighs their potential benefits. While there is some room for argument as to whether expanded disclosure requirements are warranted, the current proposal goes too far. If the Board concludes that some reform is needed, then the elimination of the speculative elements of the proposed qualitative and quantitative disclosure would go a long way towards addressing many commentators' concerns. Not all of the expanded disclosure called for in the exposure draft gives rise to "serious harm" concerns. The portion of paragraph 7(b) that calls for expanded disclosure of known or ascertainable facts does not pose the same threat of serious harm and therefore might serve to expand disclosure without unduly burdening disclosing companies. Moreover, this approach would be consistent with some companies' current application of Regulation S-K Item 103 and the existing FAS 5 standard ( i . e . some companies already provide this kind of information). As drafted, however, the potential for serious harm to companies under the current proposal outweighs the purported benefits.

Tracy Kimmel is a Partner in King & Spalding's Corporate Practice Group, practicing in the firm's New York office. Ms. Kimmel's practice includes a broad range of corporate finance transactions, securities matters and liability management transactions. Vanessa Witt is an Associate in the New York office of King & Spalding. Her work focuses on mergers, acquisitions and corporate finance. Please visit our website at for the footnotes to this article.

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