Shareholders in Merck & Co. Inc. were in for a surprise in the fall of 2007.
The drug maker said in its quarterly report that it could not "reasonably estimate the possible loss or range of loss" from class-action lawsuits over its arthritis drug Vioxx, which had been linked to heart attacks and strokes. As a consequence, it hadn't set aside a dime to pay for them.
Eight days later, it settled the suits – for $4.85-billion (U.S.).
The Merck disclosure – or lack of it – was only the most egregious of several instances of U.S. companies failing to provide shareholders with adequate information on what are called "litigation contingencies." Attempts to toughen the accounting rules to fix the problem, however, have failed, and it seems the U.S. Securities and Exchange Commission will have to step up to be the last line of defence for investors.
U.S. generally accepted accounting principles call on companies to record an expense for lawsuits when a loss in litigation is "probable," and when the amount of loss can be "reasonably estimated." If one or both of the criteria is not met, but a loss is "reasonably possible," the company is supposed to disclose an estimate of the possible loss, or at least say that it can't make an estimate.
As it happens, U.S. companies seemed to interpret "probable" as "certain," and rarely gave shareholders the information. (Under Canadian GAAP, the standard for recording an expense was if the loss was "likely." Now that Canadian public companies are moving to International Financial Reporting Standards, the hurdle is being lowered to the much more disclosure-friendly "more likely than not," says Rebecca Villmann, a principal with the Canadian Accounting Standards Board.)
In the wake of Merck, and several other companies who sprang legal settlements in the hundreds of millions of dollars on their shareholders, a group of investor advocates asked the U.S. Financial Accounting Standards Board, or FASB, to beef up the contingencies rules, originally written in the 1970s.
Alas, the FASB did its job too well: The resulting draft rules provided tough disclosure requirements, including a rule that said companies needed to reveal an exact amount accrued for lawsuits that hadn't yet been settled. The FASB got hit with an avalanche of negative comments from companies, accountants and defence lawyers.
"You'd be telling the world at large that you expect to lose and how much you expect to lose, and the world at large includes plaintiffs, so all they have to do is read your financial statements, and you've immediately established a floor in settlement discussions," says Michael Young of Willkie Farr & Gallagher in New York. Worse than that, he says, the plaintiffs might even introduce the financial statements into evidence. "That's going to be a short trial."
The FASB retreated on that point, but even a subsequent, less-stringent draft has run into opposition. At its November meeting, the FASB abandoned attempts to implement any new rules and directed its staff to work with the SEC. It will "begin re-deliberations" in the second half of this year.
Will the SEC pick up the slack? Mr. Young believes so. In a note to clients last week, he said the chief accountant of the commission's Division of Corporation Finance, Wayne Carnall, warned lawyers at an American Bar Association meeting that companies could not rely on attorney-client privilege in violating GAAP on disclosure of legal liabilities. "He's said, pretty much every chance he gets, that his division is going to be looking hard at litigation disclosures this year." (An SEC spokesman noted that Mr. Carnall's comments are his own and don't necessarily reflect the views of the SEC or its staff.)
Lynn Turner, former chief accountant for the SEC, was a member of the committee advising the FASB to toughen the rule. He's sympathetic to the concerns about providing too much information to plaintiffs, but notes that companies aren't even disclosing the amounts claimed in publicly available lawsuits. Merck, he says, also had multiple tax claims against it by the Internal Revenue Service and failed to reveal the amounts the IRS was seeking.
"Now that the FASB appears to have punted the ball, the SEC is the last hope for requiring companies to disclose contingencies to investors," Mr. Turner says. "However, given the current 'kindler, gentler' approach this administration has taken toward business, that is a hope that may go nowhere."
Special to The Globe and Mail
David Milstead