Accounting for Litigation Contingencies

INSIGHTS VOLUME 31, NUMBER 1, JANUARY 2017 27

SECURITIES LITIGATION Accounting for Litigation Contingencies

Certain questions seem to recur when it comes to out- has been incurred, the company must record the side counsel’s communications with a company’s audi- estimated loss or the best estimate from within a tors about potential exposures as a result of litigation, range of losses as a charge to income. If a liability is regulatory, or enforcement matters and the underlying possible or probable, but no reasonable estimation accounting for such matters. First, how can clients satisfy of the loss can be made, the company must disclose auditors’ requests for information without waiving the the nature of the contingency and state that such an attorney-client and work-product privileges? Second, estimate cannot be made. how do the standards for accounting for loss contingen- Although a company often must apply consider- cies apply in circumstances where a company expects able judgment in assessing and estimating contin- insurance to cover any ultimate losses? gent liabilities under ASC 450, these judgments and the facts and circumstances supporting them By Michael Y. Scudder and Andrew J. Fuchs bring careful secondary examination by a company’s independent auditors. A very good example of the Waiving Privilege in Response scrutiny applied to such judgments comes from the to Auditor Requests SEC’s recent enforcement action captioned SEC v. RPM International Inc.1Th e Commission charged an Under the Financial Accounting Standards issuer and its general counsel with violating the secu- Board’s Accounting Standards Codification rities laws for failing to record an accrual or disclose Topic 450 (ASC 450), titled “Contingencies” a loss contingency for a pending DOJ investigation (formerly Financial Accounting Standards No. 5, at the time when the material loss became probable “Accounting for Contingencies”), the preparation and reasonably estimable. Th e SEC also charged the of fi nancial statements under principles of accrual general counsel with failing to provide the issuer’s accounting requires companies to make many auditor with all material information about the DOJ judgments about contingent liabilities, including investigation, which prevented the contingency from ones arising from pending or anticipated litiga- being properly audited. tion, regulatory or law enforcement proceedings or In the normal course of an external audit, inde- investigations, and, in some circumstances, internal pendent auditors routinely request information investigations. to support a company’s judgment about how to Under ASC 450, if a liability from a contingency account for these litigation and regulatory-related is reasonably possible, the company must disclose contingencies. Th e basic facts, claims and allegations the contingency and provide an estimate of the pos- related to a particular contingency generally are not sible loss or range of loss. If it is probable a liability privileged. However, auditors regularly request addi- tional information to evaluate the reasonableness of Michael Y. Scudder is a partner based in Skadden, Arps, a company’s judgment on how to apply the contin- Slate, Meagher & Flom LLP’s Chicago, IL, offi ce and gency standards to a particular or potential claim or leads the fi rm’s accounting practice. Andrew J. Fuchs exposure. It is common, for example, for auditors to is an associate in the fi rm’s litigation department in ask the company’s in-house and outside counsel for Chicago, IL. The views expressed in this article are those of the authors and not necessarily the views of Skadden information and perspective on the likelihood (or Arps or any one or more of its clients. lack thereof) of any ultimate loss—a request that

triggers considerations about whether the informa- such protection is waived only if the third party is tion being sought is protected, in whole or in part, by itself adverse to the company or if the disclosure to the attorney-client or work-product privileges and, the third party results in a substantial likelihood that in turn, about the risks of waiving such privileges. the material will be disclosed to adverse litigants. Th e attorney-client privilege protects the sub- Applying various formulations of that standard, stance of legal advice, including an outside counsel’s courts generally have held that the work-product assessment of likely exposure. Th e general rule is that protection is not waived when outside counsel, act- providing a third party with information otherwise ing at their client’s direction, share information with protected by the attorney-client privilege waives the auditors.4 With respect to adversity, as the U.S. Court privilege and allows third parties, including adverse of Appeals for the District of Columbia Circuit stated litigants, to discover that information (assuming in 2010, “an independent auditor [ ] cannot be the the absence of another applicable privilege). Courts company’s adversary” in the sense contemplated by generally have held that there is no exception to this the work-product doctrine because “even the threat principle for companies that choose to share other- of litigation between an independent auditor and wise privileged information with their independent its client can compromise the auditor’s indepen- auditors. Th e U.S. Court of Appeals for the Fifth dence and necessitate withdrawal.”5 As to creating a Circuit aptly summarized the prevailing view many substantial likelihood that the otherwise protected years ago in U.S. v. El Paso Co., explaining that the information would be disclosed to adverse litigants, disclosure of information “to the auditors destroys that court recognized companies’ reasonable expecta- confi dentiality with respect to it. With the destruction of confi dentiality for information conveyed to tion of confi dentiality goes as well the right to claim auditors because independent auditors’ professional the attorney-client privilege.”2 obligations require them to maintain the confi dentiality of client information.6 To be sure, the work-product doctrine should not The disclosure of information be viewed as an absolute backstop to disclosure of to the auditors destroys attorney-client privileged information. In addition to the fact that it can be overcome or waived under conﬁ dentiality with respect to it. certain circumstances, the doctrine applies only to analyses prepared in anticipation of litigation. Take, Although disclosure to independent auditors for example, the circumstance where a company generally waives the attorney-client privilege as to anticipates a material claim for breach of contract that information, the separate protection conferred but has not reserved for any loss under ASC 450-20 by the work-product doctrine may still apply, thus because outside counsel has advised the company protecting the information from discovery. In gen- that it does not believe a material loss is probable eral, the work-product doctrine shields materials based upon the totality of known facts and circum- prepared in anticipation of litigation, absent a show- stances. If an auditor asks for support for the basis ing of substantial need by an adverse party. Courts for the company’s judgment not to record a litigation have adopted various formulations of the standard reserve for the potential breach of contract claim, the for determining whether materials were prepared company should be cautious of providing (in form in anticipation of litigation, including whether or substance) an attorney’s analysis if it was prepared materials were prepared “because of” the prospect before any reasonable expectation of litigation. Th is of litigation.3 includes, for instance, a memo from outside counsel To the extent that information shared with a third addressing potential legal risks prepared at the time party is protected by the work-product doctrine, the contract originally was negotiated. If the legal INSIGHTS VOLUME 31, NUMBER 1, JANUARY 2017 29

analysis was not prepared in anticipation of litiga- that the ultimate exposure for impacted businesses’ tion, it might not be covered by the work-product damage and lost income claims will be material to the doctrine and thus might be discoverable. company but also recovered through insurance. Th e Companies would be well served to evaluate company in this hypothetical scenario might prefer carefully how best to respond to auditors’ requests not to record a material charge when it reasonably for information from in-house or outside coun- expects that there will be no net fi nancial impact sel to minimize the potential for exposing privi- from losses from the anticipated litigation. Th e SEC leged communications and analyses to discovery. staff , however, has advised that companies should Companies should consider the circumstances in not ordinarily consider the presence of an insurance which information or documents were generated so recovery when accounting for loss contingencies. they understand the applicability of the attorney- Instead of off setting or netting the amount of the client and work-product privileges, and thus the expected insurance coverage against the estimated consequences of disclosure. Where alternatives loss, companies should record the full estimated exist, companies can strive to provide information loss independent of any loss recovery from possible that carries the least severe waiver consequences. insurance recovery. For example, providing an analysis protected by the work-product privilege would be preferable to providing one protected by only the attorney-client Companies should not ordinarily privilege. In preparing attorney response letters to consider the presence of an auditor inquiries, counsel should (and regularly insurance recovery when do) consult and follow the ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ accounting for loss contingencies. Requests for Information (1975), which provides guidance on how attorneys can maintain confi - Perhaps the most direct accounting guidance on dentiality while responding to auditors’ requests. the issue comes originally from SEC Staff Accounting Finally, a company’s representatives should clearly Bulletin 92 (SAB 92) regarding accounting and dis- convey to auditors their expectation of confi dential- closures for loss contingencies. Issued in June 1993, ity with respect to the information being provided, and itself the source of controversy at the time, SAB even considering whether to do so subject to a writ- 92 generally prohibits the formerly widespread prac- ten confi dentiality agreement. tice of off setting insurance coverage before disclos- ing or accruing a loss contingency. As the SEC staff Accounting for Litigation Exposure explained in the original SAB 92, the Covered by Insurance separate presentation of the gross liability Companies also frequently encounter the question and related claim for recovery in the bal- of how the potential for insurance coverage impacts ance sheet most fairly presents the potential the accounting for a particular loss contingency. consequences of the contingent claim on the More specifi cally, companies often encounter cir- company’s resources and is the preferable cumstances in which a material loss is probable and method of display. estimable, but where management expects insurance to cover all or part of the estimated loss. SAB 92 relied upon Financial Accounting For example, assume that a fi re at a company’s Standards Board Interpretation No. 39 (FIN 39), main manufacturing plant leads to the destruction of titled “Off setting of Amounts Relating to Certain surrounding businesses and the company anticipates Contracts,” noting that FIN 39 “indicates that the

prohibition on setoff in the balance sheet should probable—thereby creating the prospect of reporting be applied more comprehensively than previously a liability and a loss recovery in diff erent periods. may have been the practice.” “It is the staff ’s view,” Th is perceived mismatch in the timing of when SAB 92 explains, “that presentation of liabilities net an estimated loss and insurance coverage should be of claims for recovery will not be appropriate after recorded may be an unsatisfying outcome for compa- the provisions of FIN 39 are required to be applied nies that want to avoid a perception among investors in fi nancial statements.” Th e risks surrounding an that the company may suff er material, uncovered entity’s contingent liability should be treated as litigation losses. To help investors understand that “separate and distinct from those associated with insurance coverage for litigation exists and the extent its claim for recovery against third parties,” the staff to which it may off set the estimated loss, companies explained in its original release, as did one of the generally can make appropriate disclosures in their then-commissioners of the SEC. Th is treatment fi nancial statements or other public disclosures about avoids leaving “investors unaware of the full mag- their general insurance coverage or coverage specifi c nitude of the liability” or even “lull[ing] them into to a particular claim. Th e consideration is double- a less rigorous consideration” of the relevant factors edged, however, as companies often are under- defi ning the full essence of liabilities. standably hesitant to disclose information about Th e current version of SAB 92 is found in SAB the scope of their insurance coverage for fear it will Topic 5Y on Accounting and Disclosures Relating make them a litigation target or paint a picture of a to Loss Contingencies and stands for the same deep, available pocket. Striking the right balance in proposition. particular facts and circumstances will continue to In accounting for a loss recovery, GAAP (gener- present challenges. ally accepted accounting principles) permits companies to record an asset only upon a determination Notes that the recovery is probable. Insurance coverage can 1. Case No. 16-cv-01803, United States District Court for the be uncertain and disputed, and it is often not clear District of Columbia. until later stages of a litigation how much of a claim 2. 682 F.2d 530, 541 (5th Cir. 1982). or settlement an insurance carrier will cover under a 3. See, e.g., id. at 542-42; U.S. v. Deloitte LLP, 610 F.3d 129, particular policy. Indeed, despite the insurer acknowl- 136-37 (D.C. Cir. 2010). edging some coverage, often the insured and insurer 4. See, e.g., Deloitte, 610 F.3d at 140-43; Gutter v. E.I. DuPont engage in extensive negotiations during litigation to De Nemours and Company, No. 95-CV-2152, 1998 WL determine their relative contributions to any settle- 2017926 at *5 (S.D. Fla. 1998); In re Pfizer Inc. Sec. Litig., ment. As a practical matter, this means that it may be No. 90 Civ. 1260, 1993 WL 561125 at *6 (S.D.N.Y. 1993). diffi cult to reach a conclusion at the time a litigation 5. Deloitte, 610 F.3d at 140. reserve is recorded that an insurance recovery is equally 6. Id. at 141-43.