Getting Companies to Come Clean About Risks

July 24th, 2008 by Phil Mattera

In 1982 building materials producer Johns-Manville filed for bankruptcy, overwhelmed by a rising tide of lawsuits brought by workers crippled from exposure to the company’s most infamous product: asbestos insulation. The Manville litigation and Chapter 11 filing caught many investors off guard because the company, despite knowing the risks of asbestos for decades, did not disclose the potential consequences to shareholders. The episode is one of the most egregious cases of corporate irresponsibility in U.S. history.

Unfortunately, Corporate America did not learn the lesson of the asbestos debacle. Many companies—from cigarette manufacturers to investment banks involved with subprime mortgages—have failed to fully inform investors of potential liabilities. They have been able to do so, in large part, because of lax accounting rules.

That could now change. The entity that sets the rules—the Financial Accounting Standards Board—is currently working on the first modifications since 1975 to its disclosure guidelines, known as FAS Statement No. 5, regarding “loss contingencies.” The problem is that FASB is considering revisions that some advocacy groups consider too weak.

The Investor Environmental Health Network (IEHN), “a collaborative project of investment managers that tracks product toxicity issues,” has just issued an appeal for interested parties to submit comments urging FASB to adopt stricter standards for Statement No.5. The comments are due by August 8.

Specifically, the IEHN is concerned that the revision of Statement No. 5, while requiring companies to report maximum possible loss, has three significant loopholes. These would allow companies to skirt the new rules if the company claims that the risks are only remotely likely and would not be resolved within the next year, or if it claims that the disclosure would be “prejudicial.” Also, the new rules would apply only to legal liabilities, not asset impairments (such as the risk that a company’s property might be destroyed by flooding related to climate change).

As Sanford Lewis, who serves as counsel for IEHN, puts it in an e-mail message to me: “For Enron, subprime lending and asbestos, the unifying theme is that management treated these severe-impact issues as only ‘remotely likely’ to hurt their companies. Now FASB wants to make some of these ‘remotely likely’ issues discloseable, but only if the issue is expected to be resolved within a year. Yet issues such as these typically take many years, if not decades, to be resolved. Investors need to know about them now, not right before the financial catastrophe hits.” (See his video on the issue here.)

Stricter accounting rules might not prevent risky behavior on the part of corporate executives, but they would increase the odds that investors would know about those risks before it was too late to bail out—or pressure management to clean up its act.

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