In 2011, the staff of the Securities and Exchange Commission (“SEC”) zeroed in on public company disclosure surrounding litigation contingencies, most notably through staff comment letters issued in connection with the review of annual and quarterly reports filed with the SEC, as well as through staff statements made in speeches and at conferences. While its initial focus in this area was directed at large financial institutions, based on our review of over 250 SEC comment letters made public in 2011, it is now clear that the SEC has extended its focus to companies outside of the financial services sector.
Financial Accounting Standards Board (“FASB”) ASC 450-201 (formerly known as FAS 5) (ASC 450) requires companies to record an accrual of loss contingency amounts when a loss is deemed both “probable and estimable” and provide related disclosure. Where accrual is not required but a loss is “reasonably possible,” disclosure should indicate the nature of the contingency and provide “an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.” Similarly, even when an accrual is required, companies are required to disclose any “reasonably possible” loss in excess of the amount accrued. Most of the SEC’s recent focus has been to urge companies to provide estimates of “reasonably possible” losses or ranges of “reasonably possible” losses for litigation matters where no accrual has been recorded or for which there may be exposure beyond the recorded accrual, or either to disclose that such “reasonably possible” losses are not material or to explain why estimates of “reasonably possible” losses cannot be made. The objective of the disclosure is not necessarily to address what is accrued on the balance sheet but what is not accrued for which it is “reasonably possible” that there is a loss so as not to make the balance sheet potentially misleading. 2
SEC Hot Buttons
We reviewed over 250 SEC comment letters made public in 2011 in which the SEC staff issued a comment regarding a company’s litigation contingency disclosure. We also have reviewed speeches and presentations made in 2011 by senior staff members of the SEC’s Division of Corporation Finance. Based on this review, it is apparent that there are certain aspects of litigation contingency disclosure that have become hot buttons for the SEC staff and may result in a staff comment in connection with the SEC’s review of a company’s periodic reports filed with the SEC.
Silence May Result in Comment. When companies include disclosure relating to litigation matters, but do not address whether “reasonably possible” losses in excess of any accrual may exist, the SEC has been issuing a generic comment along the lines of the following:
- If there is at least a reasonable possibility that a loss exceeding amounts already recognized may have been incurred, you must either disclose an estimate of the additional loss or range of loss, or state that such an estimate cannot be made or, if true, state that the estimate is immaterial with respect to your financial statements as a whole.
If an Estimate Cannot be Made, the SEC May Ask Why.
In response to requests from the SEC staff to disclose an amount or a range of “reasonably possible” losses in connection with litigation contingencies, many companies have stated that they cannot estimate such an amount or range. While this disclosure is permitted under ASC 450, companies should be prepared to explain to the staff why such disclosure is appropriate under the circumstances. When a company states that it is not “reasonably possible” to estimate the possible loss or range of loss, the SEC has inquired about the procedures the company performs to attempt to provide an estimate with comments like the following:
For any matters for which you cannot estimate a range of reasonably possible losses, please supplementally provide the following:
- An explanation of the procedures you undertake on a quarterly basis to attempt to develop a range of reasonably possible loss for disclosure;
- Please explain, in sufficient detail for each specific matter, why you are unable to estimate a range; and
- The name of any case in which the plaintiff has requested in public filings a quantified amount of relief and the amount of such relief. For each of these filings, please explain why a range of reasonably possible loss cannot be determined.
The SEC staff may also request that companies describe the specific factors that limited their ability to reasonably estimate the loss or range of loss.
SEC May Allow You to Aggregate Estimates. In an effort to mitigate companies’ concerns that providing too much quantitative information may be detrimental to litigation efforts or settlement strategies, the SEC has indicated that separate disclosure for each individual matter is not necessarily required. The staff stated at the June 2010 Center for Audit Quality SEC Regulations Committee Joint Meeting with the SEC Staff that “disclosure can be aggregated in a logical manner vs. separate disclosure for each asserted claim.” The SEC has given the following comment in connection with a company’s ability to provide amounts in the aggregate:
- Please revise your disclosure to either provide the reasonably possible loss or range of possible losses, which may be aggregated for the matters in which estimation is possible, or provide explicit disclosure for each matter that you are unable to estimate the loss or range of possible loss and the reasons why you are unable to provide an estimate.
SEC Wants to See Proper Terminology. As discussed above, the standard for evaluating litigation contingency disclosure consists of “probable” and “reasonably possible.” The SEC has issued comments questioning the use of terms inconsistent with ASC 450, such as “possible losses,” and has given the following comment in response to the use of such terminology:
- Please revise your disclosures in future filings to refer to “probable” and/or “reasonably possible” losses instead of “possible losses” to be consistent with terminology of ASC 450. In this regard, please note that your use of the term “possible” is confusing as it appears to imply a fourth criteria in ASC 450 that does not exist in the range of probable, reasonably possible or remote.
Certainty is Not Required in Order to Provide an Estimate. When a company asserts that it cannot predict “with certainty,” “with confidence” or “with precision” the loss or range of loss related to litigation matters, the SEC has commented that this is not the required standard for disclosure:
- We note your disclosure on page [x] regarding your belief that the Company cannot predict “with certainty” the loss or range of loss, if any, related to the Company’s litigation matters. It appears your threshold for disclosure is whether you can estimate “with certainty” what the eventual outcome of the pending matters will be. We do not believe that this criteria is consistent with the guidance in ASC 450. ASC 450 indicates that if an unfavorable outcome is determined to be reasonably possible but not probable, or if the amount of loss cannot be reasonably estimated, accrual would be inappropriate, but disclosure must be made regarding the nature of the contingency and an estimate of the possible loss or range of possible loss or state that such an estimate cannot be made. Please revise your disclosures beginning in your Form 10-Q for the [x] quarter to include all of the disclosures required by paragraphs 3-5 of ASC 450-20-50. To the extent that you cannot estimate the possible loss or range of possible losses, please consider providing additional disclosure that could allow a reader to evaluate the potential magnitude of the claim.
SEC is Looking for Timely Litigation Disclosure Updates. The staff expects management to diligently review its litigation contingency disclosures in each reporting period and update such disclosures in response to changes in relevant facts and circumstances. Such changes could result in the accrual of a loss that is now probable, new disclosures in connection with a “reasonably possible” loss that could not be estimated in a prior period or revised disclosures about an estimated loss. The SEC has noted that disclosures should contain more quantitative information as a litigation contingency evolves over time and nears resolution. Disclosure of a material settlement of a case where prior disclosures gave no indication of “reasonably possible” losses may trigger a comment. For example, when a company’s disclosure indicated that it settled a lawsuit during the quarter, the SEC had the following comment:
- We note that you have settled a lawsuit on [date] and have accrued $[x] million related to the settlement. Please provide to us a chronological analysis supporting management’s compliance with ASC 450 regarding this lawsuit. Please ensure that you address each of the reporting periods affected, the timing of the accrual and the disclosure provided.
SEC Distinguishes S-K 103 Disclosure from ASC 450 Disclosure. The staff has pointed out the different disclosure requirements and objectives set forth in ASC 450 and Regulation S-K, Item 103. The staff stated at the September 2010 Center for Audit Quality SEC Regulations Committee Joint Meeting with the SEC Staff that “attempts to satisfy both objectives through an integrated set of disclosure often result in lengthy factual recitations rather than focusing on the underlying loss contingency, the related exposure and the likelihood of a loss.” Companies are reminded that Regulation S-K, Item 103 sets forth disclosure requirements outside of the financial statements which are related to legal proceedings.
The extent of SEC comments in this area suggest that companies should carefully assess their disclosures surrounding litigation matters on an ongoing basis to ensure compliance with ASC 450. When drafting and revising these disclosures, companies should be mindful of the areas of frequent SEC staff comment described above.