– “A Christmas Carol” by Charles Dickens
Most lawyers can relate to Ebenezer Scrooge’s concern. Is there a possible legal risk, or a definite liability? Unfortunately, lawyers don’t have a Ghost of Christmas Yet to Come to show them the potential losses that may be incurred in the future, so they have to address potential future litigation events themselves. While they can’t change the future, the Ghosts of Legal Past and Legal Present can at least give lawyers the information needed to deal with the Ghost of Legal Future.
Reserve Setting as a Competitive Advantage
The process for identifying, setting, and updating reserves is driven almost exclusively by the preparation and filing of financial statements. As a result, the timeliness and accuracy of reserves lives by the quarter.
But while financial reporting is focused on the end of each quarter, strategic decisions must be based on up-to-date information. This enables businesses to appropriately adapt and respond to market conditions and competitors. Most executives would find it unacceptable to make key decisions based on months-old data, yet that is precisely what happens when it comes to the financial, political, and reputational risks that businesses face due to possible legal claims.
Last week, we provided an overview of how and when to accrue for or disclose loss contingencies. In this week’s post, it’s time to explain why you should track legal reserves and understand loss contingencies.
There is an important relationship between setting reserves and making key business decisions. To highlight this, we review the recent trends in SEC enforcement activity through the eyes of executive management, law departments, and outside counsel. Our goal over the upcoming weeks is to emphasize that processes relating to legal reserve setting are not solely a function of compliance, but are also a competitive advantage that can aid strategic decision-making.
Trends in SEC Loss Contingency Examination
In recent years, the SEC has increased its focus on two key issues:
- (a) the timeliness of disclosures and reserves, and
- (b) appropriate updates to these as new information becomes available
Notably, the SEC has emphasized that its guidance also applies to reserves or disclosures that have been omitted or not adequately updated. Companies that fail to identify, record, and update loss contingencies due to inadequate or lacking processes and procedures have poor internal controls. When these companies base decisions on this insufficiently identified or reported information, they risk setting themselves up for failure. Internally, they may make misinformed decisions. Externally, they are at risk of governmental investigation or shareholder action (e.g., class action lawsuit).
A large part of your job as CEO focuses on developing and implementing your company’s vision. Disclosures of and accruals for contingent losses may change how outside investors, potential business partners, and even the board views the risk of investing in or working with your company.
Having accurate legal reserves and contingent loss information will allow you to assess various risks to your company and manage these appropriately. If the tone at the top emphasizes the importance of managing risk through proper development and tracking of legal reserves, other individuals within your company will likely adopt a similar attitude. This atmosphere will allow your company to improve viability and more easily capture information related to possible losses.
Internal controls relating to the accuracy and timeliness of loss contingency tracking, legal reserve setting, and financial reporting processes are critical to maintaining an appropriate risk information system. Although some degree of internal control is externally-mandated, developing a positive tone at the top related to these procedures and systems will drive company performance while decreasing regulatory and reputational risk.
The SEC examines intercompany trends in reserve accruals and disclosures over multiple filing periods to establish whether changes in the disclosures or accruals for loss contingencies were reported in a timely manner.
Your focus as CFO is on providing accurate, timely numbers that can be justified. Failure to accrue, or making an accrual that understates a potential loss, may result in a material misrepresentation of the financial statements. If financial statements must be restated, the market value of your company could take a hit. Overstatement of liabilities, on the other hand, may also negatively impact your metrics (e.g., EPS). Tracking potential and in-progress litigation also provides you with insight that you can use to manage risk, such as by financing or insuring a case.
The SEC Doesn’t Want Your Excuses – or, Why You Need to Track Legal Reserves
When a company fails to disclose or accrue for a possible loss as required, the SEC will frequently bring enforcement action against the company. The SEC also takes action in a number of related circumstances:
- When insufficient internal controls surrounding the identification and reporting of contingent losses results in missed disclosures or accruals
- When early-warning disclosures are not present for matters that are accrued or recognized in later financial statements.
Similarly, the SEC has pushed back on generic statements or assertions by companies that the amount or range of reasonably possible losses cannot be estimated. In these cases, companies are required to provide an explanation as to why they cannot do this.
For an example, look at this recent SEC response letter to a quarterly filing in which the company was unable to estimate the amount of a loss:
“In regards to this matter […], please supplementally tell us
(a) the procedures you undertake […] to attempt to develop a range of reasonably possible loss for disclosure and
(b) the specific factors that are causing your inability to estimate and when you expect those factors to be alleviated for each matter.
[… A]n effort should be made to develop estimates for purposes of disclosure, including determining which of the potential outcomes are reasonably possible and what the reasonably possible range of losses would be for those reasonably possible outcomes.”
Ultimately, in evaluating companies on the adequacy of their internal controls for purposes of ASC 450, the SEC adopts an approach that utilizes guidance from their joint publication with the DOJ: A Resource Guide to the U.S. Foreign Corrupt Practices Act. They assess whether internal controls are adequate and whether companies appropriately attempted to determine estimates (e.g., estimates for contingent losses).
The Legal Crystal Ball: Setting Reserves
Predicting outcomes is a fundamental aspect of the provision of legal services (as our data science teams know well). Attorneys tend to be risk averse and are trained to spot legal issues, risks, and areas of uncertainty. While lawyers may shy away from concrete, objectively measurable predictions about what the future may hold, ABA rules of professional conduct suggest that a lawyer should inform clients of “prospects of success” during litigation. Although ASC 450 does not require certainty, it does require lawyers to provide some degree of quantitative prediction about matters.
Your company’s auditors (either internal or external) will likely come to you for assessments of various matters to determine whether they need to be disclosed or accrued for. Whether privilege applies or not, you are best suited to make these assessments, as you are likely the most well-informed on these matters. (We will dedicate a future post to the interplay between privilege and legal reserves.)
Outside counsel are often involved in pending or threatened litigation, and so it is also important to consult them when assessing the likelihood and amount of possible losses.
While legal costs are not accrued under ASC 450 and you are not directly responsible for this type of reporting, your clients may still contact you for estimates so that they can properly accrue for or disclose litigation and other legal matters that you handle. Your clients may use your predictions as a benchmark against which they measure the actual outcome. Furthermore, an increasing amount of your work is likely based on fixed fees or other alternative fee arrangements (AFAs). Originating new work may depend on your early case assessment or AFA bids, which require you to make predictions about cases. Consequently, in order to win and keep business, it may be in your firm’s best interest to estimate outcomes as accurately as possible.
This week we visited the Ghost of Legal Future and saw why it’s important to track legal reserves and update them and other loss contingencies. In our upcoming posts, we’ll discuss how to actually set initial estimates (hint: the Ghosts of Legal Past and Present are helpful here!). We’ll cover different risk models, assessment methods, and best practices for setting legal reserves. Our next post will discuss the importance of properly capturing and assessing legal risk, as this is the first step in the reserve setting process.
Ebenezer Scrooge image credit: http://www.victorianweb.org/art/illustration/carol/7.html, scanned by Philip V. Allingham.