Ethical Issues in Setting Litigation Reserves

Clay James, Partner at Hogan Lovells

Annie Kao, Senior Litigation Counsel at Vail Resorts

December 8, 2010

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What is a Litigation Reserve or Accrual: FAS 5

• A reserve or accrual is, essentially, an adjustment to a company’s earnings numbers that attempts to account for the possibility of a financial loss

• A reserve may be required when there is a “loss contingency”– Loss: the impairment of an asset or incurrence of a liability– Contingency: a past event that may cause a loss, the amount of which

will be determined by some future event

• A reserve or accrual is required when a potential loss is both– Probable– Reasonably estimable: can be a specific number or a range

• Principles-based accounting standard. No bright-line rules

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FAS 5: Interpretive Guidance

• FIN 14: interpretive guideline from Financial Accounting Standards Board (FASB)

• “Likelihood” and “reasonably estimable” determinations should be based on:– Nature of the claim or assessment– Progress of the case (as of the date of issuance of the financial filing)– Opinions of internal and external legal counsel, expert witnesses, etc.– Experience of the company in similar cases– Experience of other companies in similar cases– Decisions by management as to response, e.g., “defend the case

vigorously” or “seek an out-of-court settlement”

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How Likely is Likely: Assessing Probability Under FAS 5

FAS 5 defines “probability” in terms of levels of likelihood, but it leaves companies to decide for themselves what exactly “likely” means

FAS 5’s levels of likelihood– Probable: likely to occur – Reasonably possible: more than remote but less than likely– Remote: slight chance

Companies are left to set their own standards– Some accrue for any probability over 50 percent– Most common and defensible is probably between 66 to 75%– Over-reserving is just as problematic as under-reserving– Consistency is at least as important as the percentage threshold.

Switching the standard from case to case could be seen as manipulating earnings by using reserves as a “piggybank”

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Estimability: Accruing the Right Number

– If one number is clearly the best estimate, accrue that number

– If there are a range of possibilities and no estimate is better than another, accrue the lowest amount in the range

– Accrue only for amounts that are “reasonably likely.” If the amount is speculative, do not accrue

– Don't accrue, but do disclose “reasonably possible” losses exceeding the accrual amount (if material)

– Insurance? Do NOT net down the reserve

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Discoverability of Reserves

• Most circuits have explicitly held that litigation reserves are not discoverable

• Assessment conducted by inside and outside counsel, for internal purposes, would usually be privileged

• Disclosure to outsiders, including external auditors, usually results in a privilege waiver. But . . .

• Confidentiality usually protected by the Work Product Doctrine

• Accrual amounts on individual cases are typically not disclosed in the company's periodic reports

• FASB's proposed changes to the disclosure rules casts doubt on all the above

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Disclosure

• SEC disclosure requirements (Regulation S-K 103)– Asserted claims: disclose if a material loss is “reasonably possible”– Unasserted claims disclose if

• Claim assertion “probable”

• Unfavorable outcome at least “reasonably possible”

– Remote contingencies: no disclosure required (for now)– Regulatory proceedings: no commonly accepted standard– Materiality threshold

• Greater than 10 percent of consolidated current assets

• Reasonable shareholder standard

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Reserves and Disclosures: Difficult Issues

• Governmental actions: What constitutes a “proceeding” under Item SK-104?

• Settlement offers– Accrue only once offer is actually made?– What if offer was made for tactical reasons and doesn't reflect actual

risk assessment?– Some companies routinely accrue at least the amount of an actual

offer, but it's hard to tease that out of the rule

• Tipping your hand by disclosing your assessment and the reserve.

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FASB Topic 450: New and Riskier Disclosure Requirements

• New qualitative and quantitative disclosures– Basis for the parties’ contentions and information on where to get

more information– Amount claimed by plaintiff and/or amount indicated by expert

witnesses– Amount or range of estimated loss, including any accruals. If no range

can be estimated, a statement regarding why– Tabular reconciliations showing changes in accruals from period to

period. Could be disclosed by category or type, but basis for doing so would require disclosures

– Possible recoveries from insurance if disclosed to plaintiffs or if discoverable

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FASB Topic 450: ACC and ABA Objections

• The disclosure may itself increase the chance the contingency will result in a loss

• Accrual amount will become the “floor” for any negotiations• Risk of being sued for getting it wrong: estimates not granted

“safe harbor” protection as forward looking statements• Increased risk of waiver of attorney client privilege and work

product protections• Aggregation of accrual information by category or type would

not help companies with small amounts of litigation. Easy to track changes in risk assessment from quarter to quarter

• Disclosure of remote and immaterial risks will confuse, not aid, investors

• Early disclosure of regulatory matters invites parasitic securities litigation

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Communications with Auditors: The “Treaty”

• BA Standards for ABA Statement of Policy Regarding Lawyers‘ Responses to Auditors' Requests for Information (the “ABA Statement”)

• The “treaty” reflects compromise between auditors' demands for information and lawyers' concerns re: privilege and confidentiality

• Lawyers should opine on an outcome only if that outcome is either probable or remote– Very high bar: The contingency must be almost certain to occur or

almost certain not to occur

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Communications with Auditors: The “Treaty” (continued)

• Audit response letters– Letters from GC and outside counsel– Usually annual letters plus quarterly updates, and as needed for other

filings

• Outside firms chosen by the external auditors based on– Yearly legal spend – Quarterly meetings among auditors, GC, and chief litigation counsel– Other information sources

• Materiality threshold for matters reported in each letter usually set by the auditors on a quarterly basis based on revenue

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Audit Letters: Typical Process

• External auditors asks the company to request audit letters or external letters from its outside counsel. Firms typically chosen based on– A/P records identifying law firm spending– Recommendations of and presentations by general counsel and chief

litigation counsel – Other information garnered from finance, compliance, or business

units

• External auditors typically provide template letter from the GC to the chosen firms requesting an audit response letter, setting the financial threshold, a variety of other directives (such as reporting unasserted claims) and setting due dates for responses identifying loss contingencies pursuant to ABA Statement

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Audit Letters: Typical Process (continued)

• Auditors will also typically require an internal letter from GC. Typically should identify– Cases that entail a substantial risk of a loss that is above the auditors

financial threshold– The parties, the court, and a simple description of the major claims

and the amount of the claim (if identified)– Assessment of whether a loss is probable or remote– General approach to the case: settle, defend, etc.– Outside counsel, if any

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Communications with Auditors: Steps For a Successful Process

• Auditors usually provide several weeks notice prior to letter due date– As date approaches, send reminders to firms– Make sure the firms do not date or send the letter early. Auditors will

consider information stale if it is received more than a few days prior to their consent date

– Try to build some cushion into the schedule. If a ball has been dropped, the auditors may be able to give an extra day or may be satisfied with telephone conference until the letter is available

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