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Lawsuit accounting: a quadruple threat for business defendants?

Major news afoot from the accounting world as written up in Law.com's The Recorder:

... changes proposed by the Financial Accounting Standards Board that would force public companies to disclose more about the risks of litigation have caused a howl of protest among general counsel and corporate and defense lawyers.

Under the revised rules for FASB Statement No. 5 (pdf), the threshold for reporting the potential loss from a lawsuit would be lowered from "probable" to anything but "remote." Public companies would also have to estimate just how much legal threats might cost and the likely outcome. They'd also have to disclose more details about the underlying litigation and the reasoning behind their predictions.

Businesses and their lawyers are worried about the possible abrogation of attorney-client privileges involved. Such a change could handicap business defendants and benefit the plaintiff's bar in at least four other distinct ways (there may be other ways I haven't noticed yet):

  • The shareholders' bar would be furnished with new grounds for suing companies over insufficiently disclosed litigation risks.

  • The plaintiff's bar generally would acquire an immensely valuable new road map to where companies are being sued and how seriously they take possible exposures. At present, companies often try to minimize public attention to emerging or speculative areas of litigation for fear of encouraging copycat or bandwagon suits. The new disclosures would soon become a tip sheet for exactly such filings.

  • In the poker-style negotiations over how much a lawsuit should settle for, plaintiffs may obtain through the accounting disclosures a look at their adversary's hole card, their evaluation of what the claim is "really" worth. Supposedly there'll be "an exemption from disclosing information that could hurt a party's position. But defense lawyers aren't sure that would protect them."

  • Defendants' assessments of litigation risk, especially if they are conservative (i.e., on the high side) to fend off shareholder lawyers, will tend to depress their stock and increase their cost of raising capital. In turn, companies will have a new reason to fold and pay a high settlement in order to get an even higher contingent liability off the books.

The story quotes veteran Northern California plaintiff's lawyer Joseph Cotchett as thinking the accounting change is a great idea, which is like having your picnic location endorsed by the ants.

More: Ted Frank, in email, proposes fifth, sixth and seventh ways defendants will lose out:

  • Attorneys can try to subpoena the third-party accountants who signed off on the litigation disclosure to obtain even more information about their opponents' internal evaluations of the case. And if courts deem this a waiver of attorney-client privilege, more cans of worms are opened...

  • Will attorneys be permitted to introduce liability evaluations at trial? One hopes not, because no matter what a defendant says, high, low, or fair, it would be used against them by a jury manipulated by a clever plaintiffs' attorney. ("They think they can get away with $100k/case. Send them a message.") ("They knew this would cost them $10M/case. Clearly you need to punish them more than that.") ("CEO, you signed this disclosure to shareholders saying this case could cost billions. Isn't that because you know that your company acted with reckless disregard of my client's safety?").

  • Companies worried about criminal or civil liability for failure to disclose litigation risks will have an incentive to exaggerate the possible liability, which will be a self-fulfilling prophecy because of the ability of opposing attorneys to use that data against them for the reasons stated above.

And (8:00 a.m.): Larry Ribstein titles his post about proposed FASB Standard 5, "The FASB plants a litigation bomb":

As PoL says, linking The Recorder, this would force disclosures of details and predictions concerning lawsuits that are non-remote, as compared with "probable" under the prior standard. But it's worse than that, since the rule would require disclosure even of remote contingencies that could have a "severe impact on the entity's financial position, cash flows, or results of operations." "Severe impact" is helpfully defined as one that has "a significant financially disruptive effect on the normal functioning of an entity," and "less than catastrophic." Here the rule goes even beyond international accounting standards....

...the standard significantly increases the strike value of litigation. As if that were not already enough of a problem.

Of course this gives firms a new reason to go private or elsewhere.

Aside from mumbling about improving disclosure, the FASB gives no hint that it took these costs of increased disclosure into account.

Wednesday a.m.: Kevin LaCroix at D&O Diary also comments. And for a flavor of the advocacy pushing the new proposal, the litigation lobby stalwarts at PIRG link to the Investor Environmental Health Network, which describes itself as "a collaborative partnership of investment managers, advised by nongovernmental organizations", which has issued an "Action Alert" backing the idea. More: CSR-News.net (interviewing IEHR's Sanford Lewis). The FASB comment period lasts through August 8.



Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.