Companies Resist Litigation Cost Reporting

By Bailey Somers

Law360, New York (August 12, 2008) -- A newly proposed accounting amendment that would modify the rules governing the disclosure of the costs of ongoing litigation has drawn fire from some of the world's largest pharmaceutical companies, which argue that the amendment threatens attorney-client privilege.

The rule change, proposed by the Federal Accounting Standards Board earlier this year, would make several amendments to current disclosure guidelines, including an expansion of the loss contingencies that are required to be disclosed, the disclosure of specific quantitative and qualitative information about the loss contingencies, and a tabular reconciliation of the loss contingencies.

The proposed change also stipulates that companies may avoid disclosing certain information if the disclosure would be prejudicial to the ongoing legal proceeding.

The rule change would have a huge impact on companies involved in litigation, said William L. Banowsky, a partner with Thompson & Knight LLP.

“First of all, it changes the number of loss contingencies or litigation contingencies that you have to disclose,” he said. “Now you'll have to disclose things that are remote. Because of the additional disclosure, it's going to require much more frequent updates. This information is going to have to be updated on a quarterly basis and it's going to involve both outside and inside counsel, so overall it's going to increase costs significantly. It will also impact litigation strategy.”

Many corporate giants, including several pharmaceutical companies, have objected to the rule amendments. Last week, the companies – Pfizer Inc., Merck & Co., Eli Lilly & Co., Johnson & Johnson, Novartis AG and Wyeth – lodged a comment with the FASB expressing reservations about the proposal and asking the FASB to withdraw the rule.

“We share concerns others have raised in comments on the 'Exposure Draft, Proposed Statement of Financial Accounting Standards, Disclosure of Certain Loss Contingencies,'” the companies said in the letter. “In particular, we are concerned that the new disclosure rules will undermine the attorney-client privilege and work product protection and, more generally, will tilt the litigation balance in favor of disclosing companies’ litigation adversaries and, thus, work to the ultimate detriment of our shareholders without providing meaningful disclosure to investors.”

The FASB said that the changes come at the behest of investors, who have often taken issue with companies' disclosure procedures.

“Investors and other users of financial information have expressed concerns that disclosures about loss contingencies under the existing guidance in FASB Statement No. 5, Accounting for Contingencies, do not provide adequate information to assist users of financial statements in assessing the likelihood, timing and amount of future cash flows associated with loss contingencies,” the FASB said in its exposure draft of the rule change. “This proposed statement would require expanded disclosures for those loss contingencies unless certain criteria are met.”

Proper disclosure has long been an issue championed by investors, so the amendments should not come as too much of a surprise, said Elizabeth Nowicki, a professor at Tulane Law School.

“This is a reflection of the increasing investor voice being conveyed to the regulators,” she said. “Litigation disclosure has always been an issue. This notion that companies do not give helpful disclosure to investors about pending litigation, about cases about to be settled – the notion that that sort of disclosure is not made in a helpful way to investors has always been an issue. The fact that this resulted in a proposed amendment represents the increasing voice large investors are being given.”

Just as the amendment is not entirely a surprise, the consternation of the pharmaceutical companies is to be expected as well.

“Pharmaceutical companies are in a risky business,” Nowicki said. “They spend billions developing a product, and they take a huge risk when they put a drug or a medical device out into the flow of commerce. Pharmaceutical companies are always getting sued, either because now and again a product will fail, or because lawyers know that there's big money in suing them.

“So pharmaceutical companies have a big dog in the fight in terms of litigation disclosure because they have such inherent litigation problems,” she continued. “If these amendments are adopted, these companies are going to have to rethink in detail what they say and how they say it and how it's going to impact their positions in any litigation.”

Though few experts have voiced opposition to increasing transparency for the good of investors, many have argued that this may not be the best way to go about it.

“I don't think anybody quarrels with the goal of the proposal, but I think a lot of people quarrel with how it's being implemented,” said Michael C. Phillips, a partner with Davis Wright Tremain LLP. “The problem is that the information that's being required to be disclosed is extraordinarily difficult to quantify and disclosing it could be highly prejudicial to a company's position in disputes or litigation.

“The idea that early in the litigation the company should have to disclose what the other side is claiming and has to give its own assessment of what the result would be just isn't really realistic,” he added.

Some experts have applauded the rule change, on the grounds that increased transparency will benefit investors and that the new disclosure requirements do not represent a major change to current regulations.

“Our securities regulation regime is based on full and fair disclosure,” said Stefan J. Padfield, an assistant professor at the University of Akron School of Law. “I believe companies make, and rely on, the kind of litigation cost estimates that are being sought by FASB as a regular part of their normal business activities. It probably goes without saying that this information would be material to investors.”

A handful of experts who weighed in on the rule during the comment period, which ended on Friday, argued that investors would not benefit from information disclosed under the new requirements due to its complexity. But Padfield said that the argument does not hold up in light of the current regulatory regime.

“The complaint that these kinds of estimates are too complicated and speculative to be of use to investors is an argument that has never had much success,” he said. “If we truly thought investors were too stupid to factor in all the disclaimers, we’d have a merit regulation regime rather than one based on disclosure.”

Many experts, however, have echoed the complaints of the drugmakers, claiming that the rule is unnecessary and potentially harmful to companies' litigation strategies.

“This rule would shift the balance in the adversarial system and undermine centuries of attorney client privilege by requiring essentially disclosure of the company's litigation strategy and analysis of the strengths and weaknesses of its position to a far greater extent than you've seen before,” Banowsky said. “The companies are getting nothing in return. That's why there is a tremendous backlash. You're undermining the careful balance between disclosure and nondisclosure that has been developed over numerous years.”

The rule does offer a few loopholes, though, that savvy companies may be able to use to their advantage, said Edward C. Martin, professor at the Samford University Cumberland School of Law.

“It seems that there's a loophole in the language that says if the company doesn't know, if it can't estimate, well then it doesn't have to disclose,” he said. “There's another exception that says if the company thinks that this is going to cause a disadvantage to the settlement, it doesn't have to disclose. The FASB proposal doesn't seem to think that the loophole is that big, but if I was representing a company, I'd rely heavily on it.”