Environmental Disclosure Under SEC and Accounting Requirements

Jonathan S. Klavens, Esq.
Goodwin, Procter & Hoar LLP

Why Comply with Environmental Disclosure Requirements
Failure to comply with SEC disclosure requirements can result in delay in SEC review of certain filings, agency enforcement action (including enforcement action against individual officers and directors), or shareholder suits. The specter of shareholder suits should not be taken lightly. A booming stock market, coupled with an increasingly watchful and sophisticated plaintiff's bar, creates a greater risk of shareholder lawsuits when the fortunes of particular companies fail to meet investor expectations. When shareholders sue, all disclosures, including environmental disclosures, will be subject to exacting scrutiny. In addition, public interest organizations are also increasingly likely to monitor corporate filings with the SEC and call public attention to inadequate disclosures.

Companies submitting financial statements in filings to the SEC face the same consequences if the financial statements fail to meet accounting disclosure requirements. But even companies that do not publicly file their financial statements will likely submit such statements to lenders, investors, vendors, or other third parties. In these circumstances, materially deficient disclosure can subject companies to such claims as fraud, misrepresentation, and unfair business practices.

Documents Potentially Requiring Environmental Disclosure

• Stock registration statement
• Annual report
• Form 10K
• Financial statements
• Form 10Q

All financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP), whether or not filed with the SEC, must recognize and display environmental liabilities and contingent losses consistent with GAAP.

Basic SEC Requirements for Environmental Disclosure
Description of Business. Item 101 of Regulation S-K, 17 C.F.R. § 229, requires disclosure of the material effects of compliance with environmental laws, including "any material estimated capital expenditures for environmental control facilities for the remainder of [the Company’s] current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material."

• Materiality is not a bright line concept. In general, an item is "material" if there is a substantial likelihood that its disclosure would be viewed by a "reasonable investor" as having significantly altered the "total mix" of information. Where ultimate costs are uncertain, materiality hinges on a combined calculation of probability and magnitude (e.g., a $1 billion compliance cost that is only 5% likely might still need to be disclosed because of the item’s large magnitude). While many companies have relied on quantitative rules of thumb (e.g., 10% of current assets, 2% of net income) to make materiality determinations, the SEC’s recent Staff Accounting Bulletin No. 99 signals the agency’s refusal to accept purely quantitative measures of materiality in favor of an analysis that includes a host of qualitative factors.
• If a company is aware of noncompliance, it must generally disclose not only the costs of ultimate compliance but also the amount of additional known material penalties or fines for noncompliance.
• If costs of compliance are likely to be material at some uncertain point in the future, the company should generally disclose the uncertainty.

Legal Proceedings. Item 103 of Regulation S-K requires a description in annual 10-K filings and quarterly 10-Q filings of "any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries is a party." A company must also disclose information about material legal proceedings known to be contemplated by governmental authorities.

• According to the SEC, environmental litigation does not constitute "ordinary routine litigation incidental to the business."
• Any proceeding is deemed to be material if it involves a potential monetary loss exceeding 10% of the company’s current assets.
• Any proceeding brought by a governmental authority seeking a monetary sanction is deemed to be material, unless the company reasonably believes that the proceeding will result in fines of less than $100,000. (In general, remediation costs to be incurred pursuant to an agreement with the government under the federal Superfund program do not constitute "sanctions.")

Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A). Item 303 of Regulation S-K generally requires disclosure of "any known trends, demands, commitments, events or uncertainties" that are reasonably likely to have a material effect on financial conditions or results of operations.

A special two-step "materiality analysis" distinguishes MD&A from other types of disclosure:

Step 1: If management cannot determine that the known trend, demand, commitment, event or uncertainty is not reasonably likely to come to fruition, the company must assume that it will come to fruition and proceed to step two.

Step 2: Disclosure is required unless management can reasonably determine that a material effect on financial condition or results of operation is not reasonably likely.

• Because of the separate fruition analysis (Step 1) required for MD&A, a company need not disclose a known trend, demand, commitment, event or uncertainty that would have a material effect if it is clearly unlikely to come to fruition. (This is unlike the combined probability/magnitude calculus applicable in other disclosure contexts.)
• Note that because of the "burden of proof" imposed on the company in the MD&A context, an absence of information can lead to disclosure.
• MD&A must be correct as of the date of filing, not as of the close of the fiscal period covered by the financial statements that are the subject of the MD&A.
• Certain disclosures in the MD&A may be considered "forward-looking statements" entitled to special legal protection under the Private Securities Litigation Reform Act of 1995. To benefit from this "safe harbor," companies should make appropriate "safe harbor disclosures" in the MD&A.

Basic Accounting Requirements for Environmental Disclosure
Relevant Standards. Various accounting pronouncements apply to the disclosure of environmental matters consistent with GAAP. These include, among others, American Institute of Certified Public Accountants Statement of Position 96-1 (Environmental Remediation Liabilities), Financial Accounting Standards Board (FASB) Statement No. 5 (Accounting for Contingencies), FASB Statement No. 14 (Reasonable Estimation of the Amount of a Loss), and SEC Staff Accounting Bulletin No. 92 (interpretation of accounting and disclosure requirements related to loss contingencies).

Liability Recognition and Measurement. An environmental liability must be accrued if, as of the date of the financial statements, it is probable (i.e., likely) that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated.

• Inability to estimate liability precisely does not preclude recognition. A loss is reasonably estimable when a range of loss can be reasonably estimated. Record the best estimate within the range. Where there is no best estimate, record the minimum amount in the range.

  Note: A forthcoming Standard Guide for Estimating Environmental Costs and Liabilities developed by the American Society for Testing and Materials (ASTM) establishes an "expected value" approach as a preferred alternative to use of the best estimate within a range. (An expected value is a probability-weighted average over the range of all possible values.) ASTM standards are voluntary, but may come to be required as a matter of contract or viewed as "best practice" by courts, the SEC, and the accounting profession.

• Use of discounting to reflect the time value of money is not appropriate unless the relevant costs and the amount and timing of cash payments are fixed or reliably determinable. (Where discounting is applied, the company should disclose both the undiscounted amount and the discount rate.)
• The amount of liability should be calculated independently from any claim for recovery from third parties (e.g., insurers, other responsible parties) and recoveries from third parties should not be recognized until they are deemed probable.
• Even when an environmental loss need not be accrued, it may still need to be disclosed:
• Where the loss is "probable" but not reasonably estimable, footnotes to the financial statements must still disclose the nature of any material contingent loss and the fact that an estimate cannot be made. (Companies are also encouraged to disclose the estimated time frame for resolution of the uncertainty about the amount of the loss.)
• Where the loss is only "reasonably possible" (more than remote but less than likely), footnotes to the financial statements should still disclose the nature of the contingency and, if estimable, an estimate of the possible loss or range of loss.

Display and Disclosure. Accrual of an environmental loss that is probable and reasonably estimable usually results in a charge to income on a company’s income statement.

• Costs may be capitalized in circumstances where (1) costs extend the life of a facility, increase capacity or improve safety or efficiency, (2) costs prevent future environmental contamination, or (3) costs are incurred in preparing property for sale.
• In addition to the footnote disclosures mentioned above, companies should, if necessary to prevent the financial statements from being misleading, disclose the nature of the accrual and the total amount accrued for the environmental loss.
• A forthcoming Standard Guide for Disclosure of Environmental Liabilities developed by ASTM attempts to further standardize both the due diligence process for evaluating environmental liabilities in preparing statements concerning financial conditions as well as the information to be disclosed in conjunction with such statements.

Practical Tips for Managing Environmental Disclosure

• The application of SEC and accounting standards to environmental matters demands an active and informed team process. It is unlikely that a lone CFO, environmental manager, auditor, securities counsel, or environmental counsel will always have the skills, experience, and information to make sound environmental disclosure decisions.
• Companies and their advisors should carefully weigh the risks of disclosure against the risks of nondisclosure. Prudent disclosure is often the best antidote.
• Deciding whether to disclose an environmental matter is only part of the challenge. The remaining challenge is to decide how to make the disclosure. Decisions about level of specificity, transparency of assumptions, identification of sources of data, and inclusion of mitigating circumstances, among others, can determine whether the disclosure complies with relevant requirements, set a disclosure "precedent" going forward, and help put the disclosed matter in context.