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Legal Reserves: What Are They, and Why Do We Care?

Hello, I am suing you - legal reserves

Mondays are rough. Imagine you are the general counsel of a publicly-traded company, and you have to walk into the CFO’s office for a Monday morning meeting. Your news? Your biggest competitor is suing you for patent infringement related to your best-selling product. You deliver the news as the CFO sits down in her chair, a concerned look on her face. She doesn’t hesitate to ask her first question: “What legal reserves do we need?” As GC, your focus is on defending the company. But as the CFO, her concern is the business’s financial well-being, and the impact this case may have on the financial statements. Have you also considered the financial implications of a possible loss?

Overview

Loss contingencies represent the loss or impairment of an asset due to future events that may or may not occur. One specific subset of loss contingencies are legal reserves, which relate to potential future litigation events.

During the upcoming weeks, we’ll be publishing a series of posts covering legal reserves. We’ll discuss adequate reporting systems, delving into disclosures and reporting within financial statements, and the business case for accurate reserves. We will focus this series through the lens of loss contingencies for legal risks under ASC 450.

Our post today provides an introduction to legal reserves that we’ll build upon throughout the series. One important distinction to make before we begin concerns the difference between setting accruals or reserves for loss contingencies, and the actual reserving, or earmarking, of certain assets for a specific purpose. Throughout the series, our use of the term “reserve” refers to an accounting accrual.

Authority

Who provides guidance on how loss contingencies are treated for financial statement purposes?

Sarbanes-Oxley Act: Sections 302, 906, and 404Sarbanes-Oxley Act of 2002

Section 302 of Sarbanes-Oxley (SOX) mandates the establishment and maintenance of internal procedures designed to ensure accurate financial disclosures, including certification by company officers. Section 906 attaches potential criminal liability to “knowingly” or “willfully” falsified disclosures and management certifications. Section 404 requires management and external auditors to report on the adequacy of a company’s internal control on financial reporting (ICFR).

Sections 302, 906, and 404 rules are prescribed pursuant to the Exchange Act. Section 13(b)(2)(B) of the Exchange Act “requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles (GAAP).

Accounting Standards Codification 450

The Accounting Standards Codification (ASC) is the primary authoritative source of GAAP. Loss contingencies are codified under ASC 450-20 (previously included under FASB Pronouncement FAS 5). ASC 450 applies to any public or private company that follows GAAP, regardless of whether the company is subject to SEC disclosure or NYSE listing requirements. This section covers the accounting for and disclosure of loss contingencies as required under US GAAP.

While this blog series will focus on ASC 450-20, we may briefly touch on related SEC regulations to the extent that they interact with this section:

  • SK 103 (Legal Proceedings)
  • SK 303 (MD&A)
  • SK 503(c) (Risk Factors)
What is a Loss Contingency?

In ASC 450-10-20, FASB defines a contingency as “[a]n existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur.” (Gain contingencies are discussed in a separate ASC section, but we will not explore them as part of our series.)

Why Do We Care?

Legal Requirements and Objectives

ASC 450-20 is at the heart of various regulations that require companies to provide accurate financial statements and maintain adequate reporting systems. Part of SOX’s job is to protect investors from inaccurate or misleading financial statements. SOX requires companies to maintain books and records that are detailed, accurate, and fairly reflect a company’s financial condition.

SOX supplements long-standing legislation that prohibits directors from making materially false or misleading statements in connection with the preparation or filing of a required disclosure, such as financial statements. In particular, SOX requires companies to “devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances” necessary to prepare financial statements in accordance with GAAP. If a company’s officers fail to implement these requirements and controls, they may be personally liable.

Executive in handcuffsDuring the 2015 and 2016 fiscal years, the SEC brought more than 200 financial reporting and disclosure actions, charging more than 245 individuals. This represents a doubling in the number of cases brought during the 2012 and 2013 fiscal years.

The SEC continues to bring more and more actions under the record-keeping provisions of the Foreign Corrupt Practices Act (FCPA). The SEC relies heavily on whistleblowers to bring these actions. In 2016, for example, the SEC issued a $22 million reward to a whistleblower for exposing alleged financial reporting and disclosure fraud at Monsanto.

The SEC Enforcement Division’s Financial Reporting and Audit (FRAud) Group employs data analytics and technology-based tools to strengthen the SEC’s enforcement efforts and capabilities. The FRAud unit has proven invaluable to the SEC. Their work has led to numerous matters, including inquiries, investigations, and enforcement actions. Given the increase in FCPA claims, willingness to bring charges against individuals, whistleblower trends, and the FRAud group’s ability to focus on financial reporting and disclosures using new techniques and methods, corporate officers are facing more risk than ever with no signs of this trend slowing.

For many businesses, legal and regulatory risks can create significant headaches both internally and externally. Therefore, in addition to potentially being held personally liable, officers have a compelling business reason to ensure that adequate controls and systems are implemented to track and value legal reserves. Compliance with ASC 450-20 and SOX requires two core competencies. First, companies must know when and how to estimate liability. Second, companies need to know how to establish an adequate system to do so. This blog series will explore ASC 450-20 and related SOX legislation with the goals of increasing compliance and developing the capabilities to establish industry-leading practices for managing legal uncertainty.

Business Decisions Based on Reliable Information

Accurate Liability Estimates

Exchange Act amendments resulting from SOX were largely adopted to protect investors. ASC 450-20 provides guidance on how to accurately account for contingent liabilities under an accrual method of accounting. It is designed to provide both shareholders and management with reliable information necessary to make informed decisions. SOX and ASC 450-20 are not designed to require companies to overestimate potential liabilities and entirely avoid the risk of potentially underestimating a loss. Rather, ASC 450-20 provides guidance on how to properly assess potential liabilities so that the financial statements are free of material misrepresentation.

While GAAP generally favors conservative approaches, overestimating liabilities can cause just as many problems. Executives and managers must remember that business decisions should be based on the best available models and information, not just what regulations require. Overestimated liabilities can result in understated net income and earnings per share. This can impact the business in a number of negative ways. Poor quarterly results due to legal reserves can lead to stock price decreases, which can affect investor sentiment, cost of capital, and employee retention and satisfaction. Even worse, investors forced to sell in an acquisition scenario may receive less than fair value for the business overall.

Timely Liability Estimates

The more time that passes after the initial discovery or assessment of a contingent liability, the more information becomes available. This may change either the estimated liability, or the ability to reliably estimate in the first place. There are three fundamental moments when an estimated contingent liability should be updated to provide a reliable and accurate estimate:

  1. When the company becomes aware of the liability or potential liability
  2. After the completion of updated financial statements
  3. When the liability is resolved, settled, or no longer exists

An update may also be necessary if new information warrants an adjustment that would have a material impact on the financial statements, or in order to avoid making the financial statements materially misleading.

Accruing Estimated Legal Costs

Legal costs should not be accrued as part of contingent liabilities. While FASB has not issued specific guidance on legal costs, they appear to defer to the SEC’s Staff Announcement. The Staff Announcement states that companies should treat legal costs in a manner consistent with their stated material accounting policies.

What’s Next?

Our next posts will delve further into the details of legal reserves. We’ll discuss when to accrue, and when to disclose. We’ll also discuss how to set initial estimates and update them over time, and how to develop appropriate reporting systems.

In addition to the “accounting” side of legal reserves, we’ll also look at the importance of building and maintaining estimation capabilities as a means of developing a competitive advantage.  Lastly, we’ll connect the dots between legal reserves, litigation insurance, and litigation finance, helping you understand how organizations can holistically manage and transfer legal risks.