Today's Year 2000 Liability

Bank Securities Journal March/April 1997 by Vito C. Peraino

Most members of the banking community are familiar with the "year 2000 problem"-the computer glitch that renders much software and many items of computer hardware nonfunctional. What has received less attention is how the year 2000 problem may give rise to potential liability and may require firms to assess potential rights of recovery. The year 2000 problem may result in one of the largest litigation waves in history. To formulate an action plan to contain liability and assure recovery, firms should act today, but they should first understand the year 2000 problem form a technical, commercial and legal perspective.

The Technical Angle

The year 2000 problem derives from a common software convention. Much software reads a data field for a year as a two-digit number. For example, the year 1997 is represented as "97." To formulate a year, the software assumes that the first two digits are "19" and assembles the figure "1997."

In the year 2000, the software will continue to assume that the first two digits are "19" while reading the last tow digits as "00." Accordingly, the software will incorrectly read the year 2000 as the year 1900. While there are several variations on how this problem arises, this is the most common error that occurs.

The failure of software to interpret dates properly affects all date-sensitive calculations, corrupting calculations that relate to interest, dividend, billings, inventory, receivables, debt, and lease obligations, to mention a few. And, while the problem is seemingly simple, the cost of correcting the problem is very steep. The Gartner Group, a computer industry consulting firm, estimates that the cost of correction could run from $300 billion to $600 billion, exclusive of litigation costs. As the millennium approaches, increased pressure on programming personnel and testing facilities may cause costs to escalate even further. Industry consultants are advising their clients that they may be able to correct this problem in time if they begin work immediately and dedicate significant organizational resources. If businesses do act now to accomplish a year 2000 conversion, consultants estimate that the bankruptcy rate may reach 3% or higher at the turn of the century.

The Commercial Side

Commercial transactions operate on many assumptions that allow businesses to operate in a predictable and consistent fashion. For example, we assume that people will honor their contractual agreements and we have devised a system of rules which govern contractual relationships to assure that commerce flows in a reasonably predictable manner.

One of the most fundamental underlying assumptions of all modern economiesis that financial data is consistent and reliable. The year 2000 problem could potentially undermine this basic assumption.

Financial information is reported according to accounting conventions which establish a common ground for performance comparison of varied businesses. Investment and lending decisions, contractual relationships, as well as a myriad of other commercial decisions are based on an assumption that the financial information we review is correct, reliable and consistent.

The reason that the year 2000 problem is so serious is that it undermines some of the most basic assumptions on which modern commerce operates. At its most fundamental level, the year 2000 problem threatens the integrity of financial data by corrupting date-sensitive calculations. The economic and legal consequences of having even a relatively modest percentage of unsound financial data is staggering.

The Legal End

The first rule for avoiding year 2000 liability is to correct the institution's year 2000 problem before the turn of the century. Failure to correct the problem could lead to an inability to service a bank's customers.

If they do not correct the problem, financial services companies face several liability and disclosure issues.

Consumer Liabilities. On a consumer basis, class action and consumer fraud liability risk exists.

Large Liability from Large Clients. On a commercial level, inability to service a bank's corporate clientele could lead to substantial exposures, including liability for all damages that flow as a consequence of the bank's inability to service the corporate client's needs. While it might be overly simplistic, it is fair to say that the larger the client, the larger the potential liabilities associated with failure to accomplish year 2000 compliance.

Material Disclosures. Because of the substantial cost associated with the year 2000 problem, bank directors and fund fiduciaries, will need to determine whether the cost of year 2000 compliance of circumstances meets the definition of "material" as defined in federal securities statues, and must therefore be disclosed in financial reports.

The issue of materiality has been exacerbated by the Financial Accounting Standards Board (FASB). FASB has ruled that year 2000 costs must be expensed in the year that the cost is incurred, rather than amortized.

Accordingly, a firm's substantial costs of year 2000 compliance will be recognized against current-year income. While the issue of materiality will vary depending on the cost of the problem and the size of the institution, examination of disclosure requirements are essential for purposes of financial reporting. For national banks, the OCC notice advising that year 2000 efforts will be an audit point beginning this year will be another factor in considering whether or not and how to disclose year 2000 costs.

Exposures from Vendor Non-compliance. The year 2000 problem presents liability exposure even for institutions that responsibly address their internal computer problems. Institutions that rely on third-party entities face potential liabilities if that third-party provider has not addressed their year 2000 problem. For example, a company that contracts its retirement plan or payroll operations to another institution that cannot perform on New Year's Day 2000, will face potential liability from company employees.

Financial services companies often work with dozens of vendors or outsourcing partners integral to operations. Any upstream or downstream financial services firm or product sponsor unable to properly clear trades or settle deals can disrupt its strategic partners' operations and create a cascade of liability.

Recovery: Statutes of Limitations Run Out. Prudent management must also consider options it has to defray some of the substantial costs associated with year 2000 compliance. Assessment of whether or not third parties should pay for negligently providing software or software services that cause a year 2000 problem is essential to the discharging of a board's responsibilities to preserve an institution's assets. Because many institutions are currently expending funds on year 2000 problems, statutes of limitations may be running to foreclose any possible right of recovery. Immediate assessment of rights of recovery are essential to preserve an institution's rights.

The Essential Legal Audit

Financial institutions need to consider their year 2000 problem both from the point of view of avoiding liability and from the point of view of assuring recoveries. A legal audit that reviews all software contracts, licensing agreements, software vendor agreements and other legal relationships is a starting place for an institution to obtain insight as to its legal exposure. Legal counsel needs to be involved, not only to assess the institution's rights and liabilities, but also to offer the protection of privileged communications to certain aspects of the problem. A comprehensive effort to identify all critical third-party vendors and assure that those vendors meet their year 2000 compliance is another key aspect of a legal audit.

Vendors need to be on notice that the institution requires some binding representation that the vendor will be able to operate at the turn of the century. Finally, the audit needs to assess disclosure obligations and to assure that disclosures are adequate, accurate and prudent.

The year 2000 problem presents a host of legal issues which require assessment. Every institution faces unique problems, but prudent management can assure that potential liabilities and rights of recovery in navigating the hostile waters created by the year 2000 crisis are properly assessed.

Hancock Rothert & Bunshoft has formed a Year 2000 Team to assist companies with related legal problems. If you would like more information on Hancock's Year 2000 Team, or on the firm in general, please contact: Vito C. Peraino on Tel: 213-623-7777 or E-mail: Click Contact Link or visit the Hancock Rothert & Bunshoft website at Click Contact Link

Visit the Year 2000 website at Click Contact Link

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.