United States: Increased Scrutiny of Environmental Reporting Systems Warrants Carefully Calculated Response

Originally published June 2004

For nearly two years now, rules implementing the Sarbanes-Oxley Act of 2002 have required CEOs and CFOs of public companies to certify both the contents of their companies’ SEC reports and the financial and disclosure controls and processes that produce these reports. The certification process has put a bright spotlight on how environmental health and safety (EHS) managers and in-house counsel identify, estimate, internally report and prepare public disclosures of potential environmental costs and loss contingencies. During that same period, auditors have more frequently asked for documentation showing what procedures EHS managers follow in gathering and gauging information concerning the existence of potential costs and liabilities and the likelihood of their occurrence. That trend is likely to increase with the approaching effective date of SEC and Public Company Accounting Oversight Board rules requiring management evaluations and certifications of – and auditor attestation reports on – companies’ internal control over financial reporting.

The basic legal requirements for identifying and accounting for environmental costs and liabilities have not changed significantly for most companies since enactment of the Sarbanes-Oxley Act. For many companies, however, the procedural mandates of the Sarbanes-Oxley and related rulemaking, especially the certification requirements and strict new requirements governing systematic financial and disclosure controls and procedures, have made the process more personal, deliberate, and rigorous. In addition, rules intended to increase the transparency of financial statements now require disclosure of a variety of liabilities and contingencies that may not have previously been reflected in financial statements prepared under generally accepted accounting procedures. These can include, among others, indemnities and guarantees relating to potential environmental costs and liabilities. As the SEC’s review of Fortune 500 companies’ filings indicates, disclosure of environmental matters remains a key SEC focus, and the SEC believes that many companies are not complying with applicable disclosure requirements.

Additional substantive legal developments may be on the horizon. The SEC is in the process of promulgating rules that will formalize its existing interpretations concerning critical accounting estimates and policies. Once adopted, the new rules will apply to environmental and other loss contingencies where different estimates reasonably could be used, the outcome is highly uncertain, and the impact could be material. As proposed, the rules would require an explanation of the methodology underlying the estimate, the assumptions concerning the highly uncertain aspects of the estimate, and a sensitivity analysis demonstrating the potential impacts of reasonably possible alternative assumptions and outcomes.

On the policy front, more change is in the air. In response to a request from several Democratic senators, in July the General Accounting Office is expected to issue its report describing existing SEC disclosure requirements, evaluating the extent to which they result in reporting of environmental costs and risks that are material to investors, and recommending changes to encourage greater environmental disclosure. Meanwhile, the Rose Foundation’s rulemaking petition, requesting that the SEC adopt the more detailed and conservative standards issued by the American Society of Testing and Materials (ASTM) for estimating and disclosing environmental costs and loss contingencies, is wending its way slowly through the administrative process.

Against this backdrop, companies are actively examining their internal systems for tracking and reporting environmental costs and loss contingencies. The breadth and sophistication of these systems varies widely, as they should, depending on the size of each company and the nature and organization of their operations. Even where they have established "state of the art" controls and procedures for internal reporting and SEC disclosures, most companies are finding at a minimum a need to reevaluate how they gather data to identify existing and impending regulatory obligations, how company personnel report information up the chain within the company, what methodology they apply for gauging the operational and financial impacts of those obligations, and how the process for evaluating and disclosing each environmental issue is documented. The purpose of this advisory is to identify key questions that will help public companies to evaluate and shape the design of their individual internal programs.

From the perspective of environmental disclosure, the starting point for evaluating a system of internal controls is how well it is tailored to produce the information necessary to meet existing SEC and GAAP requirements applicable to environmental matters. Specifically, public companies currently are required to meet SEC regulations governing disclosure, and Financial Accounting Standards Board (FASB) rules applicable to estimation and accrual, of environmental costs and liabilities. The following is a brief summary of the principal requirements.

SEC Items of Regulation S-K (17 C.F.R. Part 229) contain three provisions which, either by their terms or as interpreted in SEC guidance, specifically pertain to disclosure of environmental matters. The duty to disclose, in each case, generally extends only to those costs and liabilities that are "material."

First, Regulation S-K Item 101 focuses on compliance with environmental laws that have been "enacted or adopted." In considering this requirement, it is important to note it is not limited to environmental laws and regulations enacted or adopted within the United States. Moreover, public companies must not only disclose material effects that existing environmental laws will have on earnings and competitive position, but also material capital expenditures required to comply with existing laws and regulations in the current fiscal year, next fiscal year, and potentially beyond.

Second, Regulation S-K Item 103 focuses on the effects of legal proceedings that are pending or known to be contemplated against the company. These, in turn, may be divided into two types. Enforcement actions in which the government is a party must be disclosed if they reasonably may be expected to result in sanctions greater than $100,000. Other legal proceedings, most notably those concerning the allocation of costs to clean up Superfund and other contaminated sites, must be disclosed if they are material.

Third, Regulation S-K Item 303 and related SEC interpretations require several types of disclosure in Management’s Discussion and Analysis of Financial Condition and Results of Operation, or MD&A. First, MD&A requires disclosure of "any known trends, demands, commitments, events or uncertainties" unless management can reasonably determine that the event or contingency is not reasonably likely to occur or, if management is unable to make that determination, that the event or contingency would not have a material effect on the company’s business or financial statements. It is notable that this provision specifically requires companies to anticipate the future effects of present events, and calls for disclosure of material uncertainty. As the SEC states in its instructions for MD&A, "[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or financial condition." In making materiality determinations, companies should consider applicable SEC rules and guidance. Management should also remember that its judgments concerning disclosure in MD&A, like all other disclosure decisions, may be tested later, with the benefit of 20/20 hindsight.

MD&A also requires disclosure of "off-balance sheet arrangements" that satisfy certain conditions. In some cases, companies may be required to disclose indemnification obligations or other similar contingent arrangements with respect to potential environmental liabilities.

Finally, existing SEC interpretive statements about disclosure of critical accounting policies, assumptions and estimates may require disclosure of the effects of the critical accounting policies, the judgments made in their application, and the likelihood that the company would report materially different results if assumptions or conditions that were different from those relied on by management were to prevail. As noted earlier, proposed SEC rulemaking would formalize these existing SEC interpretations.

In addition to these requirements governing disclosure of environmental matters in SEC filings, the FASB has adopted standards for estimating and accounting for environmental and other loss contingencies on financial statements. FASB’s standards for estimating contingent liabilities should not be confused with the SEC’s regulations governing disclosure. As noted above, the SEC’s regulations generally require disclosure of environmental compliance costs, legal proceedings, and known trends likely to affect future operations if they are "material," without regard to whether they are "probable" or can be "reasonably estimated," as those terms are used in FASB’s standards.

Under Financial Accounting Standard (FAS) No. 5, a loss contingency should be accrued if it is "probable" that it will occur and the amount of the loss can be "reasonably estimated." FAS No. 5 defines "probable" merely as "likely" to occur; "probable" means more than "reasonably possible," and not "remote." Actual and anticipated claims in litigation are considered probable under FAS No. 5 only if it is likely both that the claim will be asserted and the result will be unfavorable.

FAS No. 5 supplies different rules for estimation, accrual and disclosure depending upon the relative susceptibility of the potential loss to quantification. The loss is considered "estimable" if a reasonable range of potential outcomes can be calculated. Either the best estimate of the loss within the range of outcomes, or if that cannot be determined, the low end of the range must be accrued. If the overall loss or liability cannot be reasonably estimated, but some components can, then the sum of those components must be accrued.

FAS No. 5 requires disclosure of a contingent loss or liability in financial statements where there is at least a "reasonable possibility" that a loss may be incurred. The disclosure must indicate the nature of the contingency and give an estimate of the possible loss, or the range of loss, or state that such an estimate cannot be made.

Additional guidance on the estimation of remediation liabilities is provided in the American Institute of Certified Public Accountants’ Statement of Position 96-1 (SOP 96-1). SOP 96-1 suggests that the probability of loss and the extent to which it may be reasonably estimable can be determined at different benchmark points in the Superfund process, from identification as a Potentially Responsible Party (PRP) to implementation of the remedy. Estimates for the site as a whole can be derived by separately analyzing the expected costs of reaching each benchmark. The guidance also states that estimates should be based on current laws and technology (rather than anticipated changes favorable to the company), full consideration of all direct costs of remediation (including legal fees), and a fair share of those costs based on all available information concerning participating PRPs.

By design, the present rules provide a broad measure of flexibility for identifying potentially material environmental matters, judging their likelihood of occurrence, estimating their magnitude, deciding whether and to what extent to set a reserve, and disclosing costs and loss contingencies to investors. The rules place the responsibility on management to identify the unique material impacts that environmental laws, regulations, and legal proceedings may have on a company’s operations and financial statements.

To meet that responsibility, each company must implement a system tailored to its own operations for data collection, data analysis, and cost estimating. The adoption of rules relating to disclosure controls and procedures and internal control over financial reporting make evaluation, and periodic reevaluation, a key priority. As a practical matter, information must be gathered well in advance of the periodic reporting and certification deadlines, and database systems may be required to ensure that past estimates and disclosures can be reconciled and updated with new information as it is received. The lack of effective internal controls and procedures can result not only in liability for disclosure violations but also liability for false certifications, and companies should note that certifications that SEC reports fairly present the company’s financial condition are not limited to compliance with GAAP. To ensure consistency – between reporting periods and among different factual circumstances – the internal process for identifying and measuring the effect of environmental compliance obligations, legal proceedings and known trends and uncertainties, and ensuring that they are disclosed in compliance with SEC requirements, should be documented and preserved.

Based on present requirements for estimating, accruing, and disclosing environmental costs and loss contingencies, key questions that each company’s internal reporting systems should be designed to address include the following:

• Costs of Compliance. How does the company track current costs of compliance with environmental laws affecting its operations, wherever those operations may be conducted? Can the company identify ongoing costs, and impending capital expenditures, that it must incur to remain in compliance with existing legal requirements? Are regulatory changes taking effect that will change control technologies, increase costs, or limit production rates? Is the company attempting to expand, or is it decommissioning old facilities, and have environmental costs and limitations that may affect those activities been identified and calculated?

• Legal Proceedings. How does the company keep track of environmental enforcement actions, notices of legal proceedings, and information indicating that claims are likely to be asserted? Can the company identify all proceedings in which the government is a party, and whether the monetary penalty sought exceeds $100,000? Are there known trends in the basis, number, and outcome of claims brought against the company? What system does the company have for tracking and updating assessments of exposure in pending and threatened litigation?

• Remediation Liabilities. With respect to remediation efforts, can the company identify all the sites at which it has been named, including Superfund sites and those in voluntary cleanup programs? Does the company have a system for tracking assessments and engineering cost estimates for each site? Does the company have a system for aggregating site information to create its own cost benchmarks over time? Does the company maintain up to date information concerning cost allocation information for each site?

• Estimates and Accruals. Does the company have a consistent approach, from site to site and year to year, for estimating environmental loss contingencies and establishing reserves? What systems does the company have in place to track expenditures against reserves? Does the company’s estimating process bring to bear a combination of engineering, accounting, and legal resources to assess the probability and range of likely outcomes for each loss contingency? • Disclosure. What system does the company employ to ensure full internal consideration of all potentially reportable environmental issues? How does the company ensure that information from the front lines is communicated up the chain completely and accurately? Does the company employ a team approach to assess the necessity for and contents of each environmental disclosure? Are there checks and balances to ensure that disclosure practices are consistent among different environmental matters and reporting periods, and with public pronouncements that may have been made in other contexts?

As a result of Sarbanes-Oxley’s requirement that CEOs and CFOs evaluate and certify their internal financial and SEC disclosure controls and procedures, environmental management systems are under renewed scrutiny. The upcoming effectiveness of rules governing internal control over financial reporting and the expected adoption of rules concerning disclosure of critical accounting estimates and internal control systems will demand even greater rigor in accounting for and reporting environmental costs and loss contingencies for many companies. Moreover, environmental groups, including the Corporate Sunshine Working Group, are attempting to leverage Sarbanes-Oxley, and the political events that led to its enactment, to make further reforms in corporate governance and disclosure rules, including by promoting adoption of the new ASTM standards for estimating and disclosing environmental liabilities. To respond to these demands, companies should audit their own environmental management systems to ensure that they provide adequate procedures for collecting and analyzing up-to-date information concerning existing and impending compliance obligations, enforcement actions, and other legal proceedings.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

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