Disclosure of Environmental Liabilities: SEC Obligations, Auditing Standards, and the Effect of Sarbanes-Oxley

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1 2177 Twenty First Annual Advanced ALI-ABA Course of Study The Impact of Environmental Law on Real Estate Transactions: Brownfields and Beyond October 2-3, 2008 Boston, Massachusetts Disclosure of Environmental Liabilities: SEC Obligations, Auditing Standards, and the Effect of Sarbanes-Oxley By Robert C. Kirsch Tina Y. Wu WilmerHale Boston, Massachusetts

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3 2179 Disclosure of Environmental Liabilities: SEC Obligations, Auditing Standards, and the Effect of Sarbanes-Oxley Robert C. Kirsch, Esq. Tina Y. Wu, Esq. WilmerHale Boston, Massachusetts I. Introduction PRESENTATION SYNOPSIS Reporting obligations for publicly traded companies are governed primarily by the Securities Act of 1933 and Securities Exchange Act of 1934, which are administered by the U.S. Securities and Exchange Commission ( SEC ). The obligations applicable to environmental liabilities have been in place for many years and, historically, they largely fell within the purview of a company s financial and legal service providers. The Sarbanes-Oxley Act of 2002 ( SarbOx ) (excerpts attached) raised the profile of environmental and other disclosures for public companies. More significantly, it added key executives CEOs and CFOs to the list of individuals who must participate regularly in the disclosure process. The SarbOx rules require key executives to certify to the adequacy of controls and procedures for collecting and reporting to management the information needed for SEC disclosures. SEC enforcement actions and settlements in the last two years suggest increased scrutiny by SEC on the application of accounting methods to and the disclosure of environmental liabilities. In addition, public companies have experienced in the last two years increasing investor interest in the impacts of climate change to their businesses. Even in the absence of guidance from Congress and the SEC on whether and how such disclosures must be made, many companies have chosen to report this information voluntarily. In light of elevated public scrutiny, the promulgation of reporting requirements specific to climate-related risks likely are not far off. II. Baseline Regulations SEC promulgated Regulation S-K in 1982 to consolidate the disclosures required for filings made under the Securities Act of 1933 and Securities Exchange Act of In addition, several financial accounting standards (FASs) issued by the Financial Accounting Standard Board (FASB) have implications for the disclosure of environmental liabilities. The relevant SEC regulations are attached. A. SEC Regulation S-K, Item 101 (17 C.F.R ) Disclosure of environmental compliance costs and investments that materially affect business. Item 101 requires that an SEC registrant disclose, in its narrative description of business, the material effects that compliance with environmental laws and regulations may have upon the capital expenditures, earnings, and competitive position of the registrant and its subsidiaries and any material estimated capital expenditures for environmental control facilities for the remainder of the current fiscal year,

4 2180 succeeding fiscal year, and additional time periods, if material. 17 C.F.R (c)(1)(xii). This requirement includes an obligation to disclose the material effects of failing to comply with environmental laws and regulations. Levine v. NL Industries, Inc., 926 F.2d 199, (2d. Cir. 1991). See also SEC Interpretive Release No. 6130, 44 Fed. Reg (Oct. 3, 1979) (attached); SEC Staff Accounting Bulletin No. 92, 58 Fed. Reg (June 14, 1993) (attached). B. SEC Regulation S-K, Item 103 (17 C.F.R ) Disclosure of environmental legal proceedings. Item 103 requires SEC registrants to disclose material pending legal proceedings and proceedings known to be contemplated by government authorities to which the registrant or its subsidiaries is a party or that involve any property of the registrant or its subsidiaries. The instructions to Item 103 prevent environmental proceedings from being exempted from disclosure as ordinary routine litigation incidental to the business and expressly require the reporting of administrative or judicial proceedings arising under environmental laws and regulations if the proceeding meets one of three qualifying conditions: the proceeding (1) is material to the business or financial condition of the registrant; (2) may require payment of damages or sanctions or require expenditures exceeding 10% of current assets; or (3) is a government enforcement action reasonably likely to result in monetary sanctions of $100,000 or more. CERCLA 107 or 113(f) cost recovery actions are pending judicial proceedings, subject to Item 303 (see discussion in part II.C. below). Clean-up costs incurred as a result of a CERCLA remedial agreement are not considered sanctions under Item 103. See SEC Interpretative Release 6835, 54 Fed. Reg , 22430, n.30 (May 18, 1989) (attached); SEC No-Action Letter, 1989 WL C. SEC Regulation S-K, Item 303 (17 C.F.R ) Disclosure of known environmental trends and uncertainties that materially affect business. Item 303 requires registrants to provide, in a Management s Discussion and Analysis of Financial Condition and Results of Operations (MD&A), a narrative description of financial statements and a short- and longterm analysis of the future performance of the company. In particular, the MD&A must disclose known trends or uncertainties that materially affect liquidity, capital resources, and net sales, net revenue, or income from continuing operations. 17 C.F.R (a)(1)-(3). This obligation extends to environmental trends and uncertainties (such as pending changes in environmental laws, environmental legal proceedings, or revocation of permit or product registration). SEC Interpretative Release 6835, 54 Fed. Reg (May 24, 1989) (attached). Registrants must make two assessments for every known trend or uncertainty. First, the registrant must determine whether the trend, event, or uncertainty is likely to come to fruition. If not, disclosure is not required. If so, the registrant must then determine whether the trend, event, or uncertainty will result in a material effect. If so, disclosure is required, unless the registrant concludes that the material effect is not reasonably likely to occur. These assessments go beyond the traditional probability and materiality test (discussed in Section IV below) in two important ways. First, if the registrant cannot determine the likelihood that the trend, event, or uncertainty will come to fruition, it must assume that it will, and conduct the second assessment. Second, unless the registrant can show that a material effect is unlikely to occur, disclosure is required. The traditional materiality standard discussed below is inapposite to Item 303 (MD&A) disclosure. SEC Interpretive Release 6835, n.27. Thus, generally, a PRP designation under CERCLA must be disclosed because the registrant cannot make a determination that a material effect is not reasonably likely to occur. Registrants are not required, but may opt, to disclose forward-looking information, such as information on an anticipated trend or on an unlikely impact of a known trend. 17 C.F.R and 240.3b-6.

5 2181 III. Baseline Accounting Standards FASB is the private sector organization responsible for establishing standards of financial accounting and reporting. FASB standards are recognized by the SEC as authoritative. While Regulation S-K describes the types of information that must be disclosed, the FASs provide the accounting methods that must be used and also contain provisions for disclosure. The FASs rely less on a materiality standard and more on the probability that a liability will occur and whether or not the liability may be estimated. A. FAS 5 (March 1975) / FIN 14 (1977) Accounting and disclosure of contingent environmental liabilities. FAS 5 requires a charge to income for any contingent loss that appears probable (i.e., more likely than not to happen) and is reasonably estimable, unless the loss is not material. A contingent loss is an anticipated loss whose occurrence depends upon one or more future events. Essentially, FAS 5 requires that a material loss be recognized when it becomes probable, and not later when it becomes payable. Registrants must disclose this loss accrual if necessary to prevent the financial statement not to be misleading. In addition, registrants must disclose losses that are reasonably possible (i.e., less than probable) and not yet estimable, such as the possibility of future remediation costs at an existing site. FASB has issued an interpretation of FAS 5. See FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss (FIN 14) (1977). B. Asset Retirement Obligations ( AROs ) FAS 143 (June 2001) / FIN 47 (March 2005) / FAS 157 (September 2006) Accounting and disclosure of environmental obligations upon asset retirement. FAS 143, which became effective in 2003, requires companies to recognize the fair value of an asset retirement obligation ( ARO ) if the retired asset would trigger a duty under current law and the fair value of that loss can be reasonably estimated. The existence of the ARO must be disclosed even when no fair value can be estimated. Examples of AROs include asbestos remediation, retirement of wood telephone poles, and facility de-commissioning and closure (e.g., semiconductor wafer fabrication facilities, TSD facilities, nuclear power stations). Essentially, for any given asset whose retirement would be a material loss, FAS 143 requires an even more accelerated disclosure schedule than FAS 5. As discussed in the January 2008 Newsletter of the American Bar Association Environmental Disclosure Committee, comment letters released by the SEC in 2007 indicate that the practice of delaying the recognition of conditional AROs due to indeterminate retirement dates will be scrutinized. FASB has issued an interpretation of FAS 143. See FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47). In addition, FASB issued a new standard in 2006 that set forth, for the first time, a definition of fair value and a method for measuring the fair value of assets and liabilities under GAAP. See FAS 157, Fair Value Measurements (September 2006). This standard became effective on November 15, 2007; however, FASB has deferred implementation of FAS 157 for nonfinancial assets and liabilities, such as AROs. IV. Problematic Standards A. Materiality

6 2182 For purposes of the analysis required under Items 101 and 103, a fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote, or, in other words, that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. TSC Industries, Inc. v. Northway Inc., 426 U.S. 438, 449 (1976) (attached); Basic, Inc. v. Levinson, 485 U.S. 224 (1988) (attached). Materiality may not be defined using a numerical threshold or rule of thumb. SEC Staff Accounting Bulletin No. 99, 64 Fed. Reg (Aug. 19, 1999). Consequently, even an error considered acceptable under GAAP may be material if it is qualitatively important. Likewise, information that otherwise would be subject to disclosure may be rendered immaterial due to the availability of insurance, indemnification, or contribution. Levine v. NL Industries, Inc., 926 F.2d 199 (2d. Cir. 1991); see also SEC Interpretative Release 6835, 54 Fed. Reg , 22430, n.166 (May 18, 1989). Item 303 has its own materiality standard, which is discussed in Section II.C above. B. Reasonably Estimable and Other Estimation Standards The FAS 5 reasonably estimable standard has been particularly problematic. In the CERCLA context, potential liability for a cleanup as a PRP may be considered a contingent loss. While a PRP designation makes the liability probable, whether it is reasonably estimable may be difficult to assess for a number of reasons, including the joint and several nature of the liability, the likelihood of multiple PRPs, ever-changing remediation technology, and uncertainty of third-party recovery actions. Ultimately, the registrant must estimate a range of liability and accrue the best estimate within that range. If a best estimate is impossible, the registrant must accrue the low end of the range. Calculating a reasonable estimate of the fair value of an ARO under FAS 143 has proven to be even more challenging. Until FIN 47 was issued in March 2005, most companies had applied the FAS 5 contingent loss standard and determined that the fair value of their AROs could not be reasonably estimated because they were not probable. FIN 47 clarified that fair value can be reasonably estimated with less certainty than other contingent losses. However, fair value estimation remains daunting for most companies, given the many variables surrounding asset retirement (e.g., uncertainty with respect to an asset s retirement age, contractual obligations to third parties upon retirement, necessity of partial asset retirement). V. Impact of the Sarbanes-Oxley Act of 2002 on Disclosure Responsibilities While none of the scandals motivating the enactment of the Sarbanes-Oxley Act ( Sarbanes-Oxley) involved inadequate disclosure of environmental liabilities, Sarbanes-Oxley nonetheless places a unique burden on environmental counsel, since environmental matters continue to be subject to special treatment under the securities disclosure laws.