Full Disclosure: Should Corporations Tell us Where it Hurts?

The United States’ Financial Accounting Standards Board (FASB) recently put forward a strange and controversial set of rules requiring firms to publish detailed information on their current and, more importantly, future and potential legal liabilities. The July draft proposal was actually an update to an initial July 2008 draft that revised the required disclosure of corporations’ loss contingencies under Topic 150. The Proposal would come into effect as of December 15, 2010, and its purpose is to address the concerns of investors who do not feel properly informed about the status of corporations that they may wish to invest in. Current and future legal liabilities obviously impact the chance, size and timing of any incoming or outgoing cash flows for corporations, and these new requirements increase transparency and information for current and potential investors.

While corporations being sued were already required to report any potential liabilities under existing laws, the new set of rules goes even further by requiring disclosure of any cash set aside for any ‘reasonably possible’ settlements in any particular area (but not in a particular case). This requirement is singularly problematic for companies as any change in this amount appears as a recognition of an increase in the corporation’s vulnerability. The new standards also demand that companies disclose the possibility – even if remote – of expensive litigation, and the amount of insurance bought to cover damages when lawsuits do arise. Expert testimony from trials on the quantity of damages faced by the company must also be reported.

These new rules are a giant step in the domain of corporate social responsibility and transparency. However, the rules are problematic, specifically in asking companies to estimate future liabilities that are usually either unknown or at best inaccurate estimates of damages. Furthermore, corporations expose themselves to a flight of capital or prevent possible incoming capital if they report a significantly high future liability.

The inaccuracy of estimating future liabilities is also controversial as companies may fear being sued for misleading investors if they underreport the potential liability. On the other hand, overestimating future liabilities might encourage opposition lawyers to press for the full amount and not settle if the corporation overstated their original estimate of future liabilities. Thus, an attempt by corporations to predict and calculate future liabilities can have a number of unintended consequences.

Companies reacted strongly and angrily to the proposal, but it remains to be seen whether the proposal becomes reality and if so whether it is properly implemented and respected.  The policy reasons behind this new step in corporate governance are evidently pro-investor, and the business community is correct in identifying the many problems that corporations would face in light of such standards. The question remains as to how best to balance the goal of corporate transparency for investors and the public without jeopardizing a company’s ability to attract capital while containing any legal liabilities that it may face.

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