No Surprises, Please: How an Outdated Regulation Shields the True Extent of Corporate Liabilities
Four years ago, Merck‘s blockbuster anti-anflammatory drug Vioxx came under intense scrutiny. The highly profitable medication was discovered to be closely linked to increased risk of heart attack and stroke, and a flood of litigation followed. The rise and fall of the product was of historic proportions, not only for the company, but for the drug market as well. When it was pulled from pharmacies in September of that year, it was one of the most widely used drugs ever to be withdrawn in the United States.
On November 1, 2007, during the height of the litigation, Merck filed its 2007 third quarter 10-Q with the Securities and Exchange Commission (SEC), declaring “the Company is unable to predict the outcome of these [Vioxx] matters, and at this time cannot reasonably estimate the possible loss or range of loss with respect to the Vioxx Lawsuits. The Company has not established any reserves for any potential liability relating to the Vioxx Lawsuits or the Vioxx Investigations.”
Eight days later, the company announced a global Vioxx agreement totaling $4.85 billion.
In just a week, Merck went from shrugging its shoulders to providing investors with a very specific and definitive number. Any observer could infer that settlement negotiations occurred in the week leading up to November 9. But the settlement announcement reflected no change in the underlying facts of the case; what frustrated investors ability to appreciate the magnitude of risk on November 1 were the existing accounting rules. Merck was complying with them, and therefore under no obligation to disclose even a general range of the aggregate product liability confronting it.
We, like many long-term investors, found this situation disquieting.
One of Many
The Vioxx case is one of many that point an accusing finger at existing disclosure requirements. Consider the litigation embroiling Chevron in Ecuador, where 30,000 residents of the Amazon rainforest are suing the company for pollution caused by Texaco decades before its 2001 acquisition by Chevron. The case has been brewing for well over a decade, but was never mentioned in Chevron (or Texaco’s) SEC filings until last spring, when Chevron could no longer put off telling investors that damages could go as high as $16 billion. Both cases beg the question, what and when should company tell investors about “loss contingencies” such as potential damages or government fines?
In 1975, the Financial Accounting Standards Board (“FASB”) answered this question with guidelines that have not been amended since. Under this rule (formally called FASB Statement No. 5 or FAS 5), companies have hidden or obfuscated their true loss contingency situations. Strangely enough, demands for disclosure have been minimal.
As socially responsible investors, we are interested in loss contingencies because lawsuits and government enforcement processes provide valuable information. Large loss contingencies can function as early warning signs that indicate weak social or environmental performance and as such, point to areas for potential improvement.
For example, if we were to learn that employment discrimination claims have been increasing against a nationwide retailer, that would be valuable information for us as investors who believe these issues are important for financial and social reasons. If we discovered that a body care products manufacturer was attracting product liability or consumer fraud suits targeting toxic chemicals in cosmetics, we would, similarly, find that information useful.
Many kinds of important loss contingencies can be obscured by companies: human rights violations surfacing in Alien Tort Claims Act suits; violations of the Clean Air and Water Acts; forestry and timber cutting violations; dam mismanagement resulting in fish kills; and Superfund site remediation. Civil rights claims at the local, state and federal level can be of great use in assessing social performance.
To take another example, we are concerned about the growing unregulated use of carbon nanotubes – impossibly small carbon fibers used in a variety of consumer products. A number of studies have pointed to the similarities between nanotubes and asbestos. As the long line of bankrupt companies attests, asbestos damage and litigation takes a heavy toll on life and company finances.
We also know that disclosure serves as a powerful motivation to put systems in place to avoid these anti-social and environmentally harmful actions. Companies often prefer to bury the bad news and if they are required to shed some more light on the risks they face, they may be more inclined to stop harmful behavior.
Opportunity for Improvement
Fortunately, FASB has recently acknowledged that FAS 5 is outdated and woefully inadequate. In doing so it affirms our belief that companies should be compelled to disclose more and disclose it sooner. It has also concluded that companies need to be more transparent.
As long term investors with an understanding of the impact of social and environmental issues on performance, transparency is key. Transparency also supports market efficiency and as long term investors we rely on the market being as efficient as possible. Better disclosure supports long term interests and helps to level sharp swings in the market.
Fortunately, FASB has proposed a new rule that would enhance disclosures about loss contingencies by expanding the population of potential liabilities that must be disclosed, requiring more specific information about those potential liabilities, and mandating clear and transparent disclosure formats. Trillium Asset Management Corporation (“Trillium”) has come out in support of these changes, which we believe will improve the overall quality of disclosures. We have also taken a leadership position in encouraging other members of the sustainable/socially responsible investing community, including the Social Investment Forum and Ceres, to speak out in support. (Our letter to FASB is available at www.trilliuminvest.com.)
While we are cautiously optimistic that these changes will be adopted, we are also suggesting to FASB that it go further to maximize the usefulness of the information and to close a potential loophole in the proposal.
Corporate lawyers are pulling out all the stops to prevent this proposed rule from going into effect. Letters from the American Bar Association and the Association of Corporate Counsel predict that the sun will fall from the sky if the rule is adopted. The reality is that it is a balanced and reasonable effort to bring an outdated rule into the 21st Century.
Finally, the FASB process offers us an opportunity to get at the heart of SEC reporting – the Management Discussion and Analysis (“MD&A”) found in companies’ annual 10-K filings. The MD&A is supposed to describe trends and uncertainties with material implications for a company’s future. It is a narrative discussion which is required to identify and analyze trends, demands, commitments, events and uncertainties that in the judgment of management are reasonably likely to materially impact a company’s liquidity, financial condition or operating results.
The Investor Network on Climate Risk (“INCR”), of which Trillium is a founding member, has petitioned the SEC to address the obligations of publicly-traded companies to assess and fully disclose the material economic opportunities and risks from climate change. INCR’s message is that climate-related opportunities and risks are material to shareholder investment decisions and must be disclosed under existing law. Furthermore, INCR stressed that climate related disclosures are critical for investors to make informed decisions and fundamental to the SEC’s core mission: “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” Truthful disclosures, however shocking they may seem at first, would go a long way toward fulfilling that promise.
We are witnessing in the FASB proposal and the INCR petition an opportunity to move the state of corporate disclosures of the truth a few steps forward. Accounting rules are a rather dry affair, but it is truly an exciting time ripe with the chance to improve the social and environmental performance of companies.
