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Disclosing Environmental Liabilities
Recent Developments in Legal and Accounting Standards
By Bernie Hawkins, Cory Manning, and Mike Bryan
Disclosing environmental liabilities has never been a simple task, and it could become even more challenging with changing accounting rules, changing attitudes toward environmental stewardship, and the changing administration in Washington. In the past, the relevant accounting rules favored the certainty of potential liability projections over the theoretical possibility of those projections. New accounting rules are likely to displace this paradigm, favoring fair-value loss projections over the predictability that such a loss will occur. Under the new rules, businesses could be required to disclose more potential environmental liabilities that will be estimated at higher levels.

Furthermore, public and regulatory attitudes are shifting toward increasing the transparency of public companies' disclosure of environmental risks. Legislative initiatives at the federal and state levels are underway that could trigger additional disclosure requirements for risks relating to climate change, and investor and environmental advocacy groups are clamoring for new requirements and standards by which companies must disclose financial risks posed by climate-change developments.

This article discusses the relevant disclosure requirements for environmental liabilities, changes (and proposed changes) in applicable accounting rules for disclosure of environmental liabilities, several climate-change initiatives, and the effect these initiatives may have on companies' disclosure practices.

Relevant Disclosure Requirements
Among the SEC regulations, four items in Regulation S-K are particularly relevant to disclosures of environmental contingencies: Items 101, 103, 303, and 503(c).

Item 101 (Disclosure of Capital Expenditures) requires companies to disclose any material effect that compliance with federal, state, and local laws and regulations may have on the capital expenditures, earnings, and competitive position of the company.

An effect is "material" if there is a substantial likelihood that a reasonable investor would have viewed disclosure of the missing information as having significantly altered the total mix of available information.

Item 103 (Disclosure of Legal Proceedings) requires disclosure of pending or contemplated administrative or judicial proceedings that meet one of three criteria. First, companies must disclose a proceeding that includes a claim that is material to its business or financial condition.

Second, companies must disclose a proceeding that involves a claim for damages or involves potential monetary sanctions or capital expenditures that exceed 10 percent of the assets of the company's consolidated balance sheet.

Finally, companies must disclose proceedings where a government entity is a party and the proceeding involves potential monetary sanctions, unless there is a reasonable basis to believe that the sanctions will be less than $100,000.

Item 303 (Management's Discussion and Analysis) requires a company to disclose "any known trends . . . or uncertainties" that are "reasonably likely" to affect the company's liquidity or capital expenditures.

The SEC assumes that a known trend or uncertainty is reasonably likely to occur, unless management determines otherwise. In addition, if company management cannot determine whether the known trend is reasonably likely to occur, then it must evaluate the potential consequences of the known trend under the assumption that it will occur. Disclosure is required unless company management determines that the trend is not reasonably likely to have a material effect on the company's financial condition or operations.

Item 503(c) (Risk Factors) requires a discussion of the most significant risks that could impact the company's business, financial condition, or future results.

Rule Changes and Proposed Changes
Public companies are also required to file financial statements that have been prepared in accordance with generally accepted accounting principles (GAAP). Recent changes in accounting rules relevant to environmental liabilities could well increase the burden both of identifying and calculating environmental liability risks and of disclosing those risks in periodic company reports.

FAS 141, Business Combinations
Financial Accounting Standards (FAS) No. 141 addresses financial accounting and reporting guidelines for assets and liabilities assumed as part of a business combination. In December 2007, the Financial Accounting Standards Board (FASB) revised this standard with FAS 141(R) and expanded the information that an entity is required to provide in its financial reports about a business combination and its effects. In April 2009, in response to issues raised by accountants, lawyers, and the business community, the FASB revised FAS 141(R) through a staff position (FAS 141(R)-1).

The Initial Change: FAS 141(R). Effective December 15, 2008, acquiring companies are required to disclose the market value of a contingent environmental liability of an acquired company. Thus, beginning in 2009, public companies must recognize and disclose all material environmental indemnities and other contract-related liabilities assumed in a merger or business acquisition. With respect to potential liabilities under environmental remediation laws and other noncontractual liabilities, such as litigation contingencies, acquiring companies must recognize and disclose such potential liabilities if it is "more likely than not" that such liabilities exist as of the date of the merger or acquisition. Moreover, each recognized liability for environmental contingencies must be recorded at its fair-market value as of the acquisition date.

This standard is at odds with the standard for recognizing loss contingencies found in the current version of FAS 5. Under the current version of FAS 5, a liability is recognized if it is probable that it will be incurred and the loss amount is reasonably estimable. Thus, recognition of a liability is contingent on the likelihood of a loss rather than the likelihood of liability. Conversely, under FAS 141(R), recognition of a liability depended on the likelihood of a liability finding, not the loss associated with that liability.

The Revision: FAS 141(R)-1. FAS 141(R) created a torrent of comments from auditors, attorneys, and members of various industry lobbying groups regarding its new disclosure standard for contingent liabilities, the difficulties in applying the standard, and the prejudicial effect this may have on each group's clients.

In response to this controversy, the FASB issued the staff position on April 1, 2009, eliminating the distinction between contractual and noncontractual obligations, eliminating the "more likely than not" standard for noncontractual contingencies, and providing new guidance for disclosing contingent liabilities.

Under the revised rule, companies acquiring contingent assets or assuming contingent liabilities in a business combination must disclose those contingencies at the acquisition date as follows:

Yen If the fair value of an asset or liability can be determined within a year following the acquisition, then a company must recognize that asset or liability at its fair value as of the date of the acquisition.

Yen If the fair value of an asset or liability cannot be determined within a year following the acquisition, then a company must recognize that asset or liability if (1) it is probable that a liability has been incurred, based on information available within a year following the acquisition, and (2) the amount of the asset or liability can be reasonably estimated.

Yen If the fair value of a contingency cannot be determined and the contingency is not probable or cannot be reasonably estimated, such a contingency should not be recognized as of the acquisition date and should instead be accounted for in subsequent periods per FAS 5.

Thus, the revised rule provides a standard for disclosing contingent assets and liabilities in business combinations that allows for the exercise of discretion in certain circumstances. However, although the board has pulled back from its initial change, the resulting standard still appears to favor fair-value loss projections over the predictability that a loss will occur.

FAS 5, Accounting for Contingencies
Environmental liability for remediation, regulatory violations, and litigation has generally been accounted for as a loss contingency under FAS 5. As stated, current standards require disclosure of a contingent liability if it is probable that liability will be incurred and the amount of the liability can be reasonably estimated. However, the FASB is considering a proposal that would change this standard and increase the scope of disclosures of environmental liabilities.

In June 2008, the FASB sought to expand disclosure of loss contingencies under FAS 5 with a proposed standard requiring disclosure of all loss contingencies with more than a remote chance of loss. This proposed significant expansion of the disclosure standard led to another flood of comments from auditors, attorneys, and industry lobbying groups. As a result, the FASB has delayed the implementation of the revised FAS 5 until at least December 15, 2009, and it has invited comment on alternative disclosure structures. The FASB held a roundtable discussion in early March 2009. It is expected that the board will meet again in June 2009 to deliberate about a revision to the proposed change, and that it will release a final new standard or at least a new exposure draft of a revised standard by the third quarter of 2009.

The promulgation of new disclosure standards for contingencies resulting from an acquisition and the proposal of new standards for nearly all other types of contingencies appear to signal a paradigm shift for accounting principles relating to environmental and other contingencies. This shift favors market-based projections over the certainty of any contingent loss. If this trend continues, companies may be forced to revise estimates for environmental liabilities currently on their books.

Climate-Change Initiatives
There are a number of climate-change initiatives under way that could result in additional disclosure requirements for companies with operations that may affect the climate—e.g., electrical power generation. Current SEC rules, regulations, and guidelines do not directly address disclosures related to climate change. Instead, they require disclosure of the material effects of environmental compliance through Regulation S-K, discussed above. There are numerous state and federal legislative and regulatory developments relating to climate change that could trigger additional disclosure requirements. Some examples of these developments include the following:

Legislative Initiatives
The Lieberman-Warner Climate Security Act, which the Senate Environment and Public Works Committee favorably reported out in December of 2007, sought to create a national cap-and-trade system for greenhouse gas emissions and to require that the SEC issue interpretative releases under Items 101 and 303 of Regulation S-K clarifying that commitments to lower greenhouse gas emissions are considered material and that global warming is a known trend. In addition, the bill sought to require that the SEC promulgate rules requiring companies to disclose material risks relating to financial exposure due to greenhouse gas emissions and the economic impact of climate change on the company's financials and operations. This bill failed to gain sufficient support for a vote of the full Senate, but a similar bill is presently gaining support in the House of Representatives.

Representatives Henry Waxman (D-Cal.) and Ed Markey (D-Mass.) of the House Energy and Commerce Committee are cosponsors of a comprehensive bill regarding climate change, which includes provisions for the creation of a cap and trade program. It is unclear whether this bill also will include a specific provision relating to corporate disclosures regarding climate change. Members of the House Energy and Commerce Committee are working closely with members of the Senate Environment and Public Works Committee, which appears to be waiting for the result of House deliberations on the Waxman-Markey bill before putting forth a draft bill of its own. The Waxman-Markey bill will very likely provide the basis for the federal government's strategy relating to climate change.

Investor and Environmental Advocacy Group Initiatives
Environmental interest groups, shareholder advocacy groups, and institutional investors have promoted initiatives that seek increased disclosures regarding risks associated with greenhouse gas regulations or lawsuits and other legal proceedings related to climate change.

In June 2008, a coalition of environmental groups, state officials, and institutional investors sent a petition to the SEC for interpretive guidance as to the inclusion of climate-related information in registrants' corporate disclosures. The request was a follow-up to a September 2007 Petition for Interpretive Guidance on Climate Disclosure. As of the date of publication submission, the SEC had not acted on either petition. Additionally, institutional investors have announced climate-change disclosure requirements for companies in their portfolios.

Insurance Industry Initiatives
In March 2009, the National Association of Insurance Commissioners (NAIC) announced a requirement that insurance companies disclose to regulators the financial risks they face from climate change and the actions they are taking to respond to those risks. Under the requirement, all insurance companies with annual premiums in excess of $500 million will be required to complete an Insurer Climate Risk Disclosure Survey, with an initial reporting deadline of May 1, 2010.

Regional Initiatives
Regional Greenhouse Gas Initiative. Started in 2003, the Regional Greenhouse Gas Initiative (RGGI) is a cooperative effort by 10 northeast and mid-Atlantic states to limit greenhouse gas emissions. RGGI created the first mandatory, market-based carbon dioxide emissions reduction program in the United States, the first of which took place in September 2008.

Western Climate Initiative. In February 2007, the governors of five western states announced the formation of this initiative to implement a strategy to reduce greenhouse gas emissions. Each participating state has adopted emission reduction goals and reporting requirements, and has committed to participating in a regional cap-and-trade program.

Midwest Greenhouse Gas Accord. In November 2007, the governors of nine midwestern states signed on to participate in or to observe this accord. Under the accord, the participating states agreed to establish targets and time-frames for greenhouse gas reductions and to participate in the formation of a regional cap-and-trade program.

New York Attorney General
In September 2007, New York's attorney general, Andrew M. Cuomo, subpoenaed five energy companies (Xcel Energy, Dynegy, AES Corporation, Dominion Resources, and Peabody Energy) to review the adequacy of the companies' risk disclosures regarding the impact of climate change and the regulation of greenhouse gas emissions on the companies' operations and financial condition.

After a year of negotiations, Cuomo reached an agreement with one of the companies, Xcel Energy, to provide investors with detailed disclosures regarding the financial risks that climate change poses to Xcel's investors in its annual report to the SEC, including the following:(1) present and probable future climate-change regulation and legislation; (2) climate change-related litigation; and (3) physical impacts of climate change.

Further, the agreement requires Xcel to make a number of climate change-related disclosures, including the following: (1) current carbon emissions; (2) projected increases in carbon emissions from planned coal-fired power plants; (3) company strategies for reducing or otherwise managing greenhouse gas emissions and the expected reductions from these efforts; and (4) corporate governance actions related to climate change.

This agreement is widely discussed as setting the starting point for a universal disclosure standard for risks relating to climate-change initiatives, legislation, and other regulatory requirements.

On October 23, 2008, Attorney General Cuomo announced that an agreement similar to that reached with Xcel had been reached with Dynegy, Inc. As of the date of publication submission, the attorney general's inquiries regarding AES Corporation, Dominion Resources, and Peabody Energy were ongoing.

Discussion, Analysis, and Comment
For a host of reasons, companies with environmental liabilities and the shareholders of those companies are not likely to see a net benefit from increased requirements for contingent-liability disclosures. As an initial matter, given the significant uncertainty now as to environmental requirements at the state, regional, and national levels, determining the relevant requirements amounts to aiming at a moving target. Changing the scope of disclosure at the same time that requirements themselves are fluctuating appears more likely to compound risks of inaccurate disclosures of environmental liabilities rather than increase transparency for the benefit of investors.

Furthermore, at least with respect to the disclosures related to litigation contingencies, the proposed changes do not appear to address any pending problem with disclosures to investors. Concerns about the accuracy of estimates of environmental liabilities appear to have been confined to the insurance industry rather than to have extended to investors generally. The authors can think of very few examples where shareholders complained of inadequate disclosures of litigation-related contingencies.

Moreover, the draft proposals that attempt to fix what may not be broken may have unintended negative consequences. For example, if companies must disclose in detail the estimated outcome of environmental litigation, they would be tasked with predicting what is inherently unpredictable. Predictions would almost certainly yield misleading information by aiming either too high or too low in estimating the risk. Predicting litigation outcomes with any reasonable level of certainty is nearly an impossible task.

Even if predictions could be made, requiring increased disclosure of environmental litigation exposure increases the risk of waiver of the protections offered by the attorney-client privilege and the work-product doctrine. With the increased flow of information to the public comes the risk of the information being used by an adversary in litigation. Requiring company lawyers to provide increased information relating to environmental and other litigation-based contingencies could provide a window into confidential advice and strategies, which could increase the risk of waiver, and, in turn, the risk that a litigation adversary would ultimately obtain the right to review communications of company counsel in the very litigation at issue. Such an outcome would be at odds with the interests of both companies and investors, and ultimately with the legal system. A related risk would be that an estimate of a low likelihood of success would become a self-fulfilling prophecy: disclosing a weak litigation position may be taken advantage of by an opposing party in litigation and result in weaker negotiation and trial postures. This translates into increased exposure to adverse outcomes for the company and its shareholders.

Finally, increased requirements and new methods of valuing environmental contingencies may provide fodder for disgruntled shareholders and creditors to complain of harm from what they allege to be inaccurately stated environmental liability contingencies. If contingencies are understated, the complaints would be that investments would not have been made or loans would not have been extended had the litigation outcomes been accurately estimated. If contingencies are overstated, as they may well be under new and proposed rules that favor market-based projections over certainty, hostile creditors and shareholders may use these new standards to argue that companies with a history of environmental issues are environmentally insolvent. Companies would be put in a no-win situation.

For further information, the authors suggest the following sources:
You can retrieve the following article on the Business Law Today website at www.abanet.org/buslaw/blt. All issues since 1995 may be accessed under the "Past Issues" heading at the bottom of the Web page.

Environmental Disclosure Due Diligence—The Next Step in Environmental Due Diligence
By C. Gregory Rogers
Business Law Today
May/June 2007 Volume 16.
The authors are all partners of Nelson Mullins Riley & Scarborough LLP. Hawkins and Manning are located at the firm's Columbia, SC, office, while Bryan is in the Charleston, SC, office. Their respective e-mails are bernie.hawkins@nelsonmullins.com, cory.manning@nelsonmullins.com, and mike.bryan@nelsonmullins.com.

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