Sarbanes Oxley Act
Sarbanes Oxley: Disclosure of Environmental Liabilities
By Goodwin Procter LLP
Jan 13, 2003, 20:58

Disclosure of Potential Environmental Liabilities in the Wake of Sarbanes-Oxley

The Securities and Exchange Commission (SEC) has imposed disclosure requirements specifically for environmental matters since 1982. SEC rules for disclosure of environmental liabilities require publicly held companies to evaluate and, if material, to disclose liabilities from actual or threatened legal proceedings, and financial impacts that may result from emerging trends in environmental regulations. Although the SEC has not amended these specific requirements recently, the legal and political context in which they must be interpreted has changed. The Sarbanes-Oxley Act of 2002, new rules the SEC is promulgating, and increased public attention to financial disclosures and corporate governance issues are resulting in greater scrutiny of methods for quantifying and disclosing potential environmental liabilities.

Sarbanes-Oxley requires that CEOs and CFOs submit written certifications of their company's (i) quarterly and annual SEC reports; and (ii) procedures for preparing and disclosing the required information. Sarbanes-Oxley also mandates that the SEC adopt rules setting forth new minimum standards of conduct for lawyers appearing and practicing before the agency. These proposed rules, issued earlier this month, will require attorneys to make "up-the-ladder" reporting of material violations of securities laws or similar laws to CEOs, audit committees, and boards of directors. The SEC also has proposed rules addressing the disclosure of off-balance sheet arrangements and contingent liabilities, as well as critical accounting policies and assumptions, in the Management's Discussion and Analysis of Financial Condition and Results of Operation (MD&A) section of SEC filings. Because they are written in very broad terms, these rules, too, may affect the requisite method and scope for estimating and disclosing environmental liabilities.

In March 2002, the American Society of Testing and Materials (ASTM) adopted two new standards for estimating and disclosing environmental liabilities. These were instigated, in part, to address claims that the absence of uniform standards has resulted in underreporting of contingent environmental liabilities. In August, various environmental organizations and financial institutions petitioned the SEC to adopt and enforce these standards as regulations. The petitioners claim that existing SEC rules and enforcement policies are inadequate to compel disclosure of information sufficient for investors to make informed choices between different companies based on their record of environmental compliance and liability.

Congress, too, has begun to question the adequacy of existing SEC rules and policies. The Senate Committee on Environment and Public Works has requested that the General Accounting Office (GAO) perform a critical review of existing practices in the area of environmental disclosures, questioned whether the SEC is doing enough to promote improvements in this area, and asked whether changes in existing requirements would encourage greater disclosure.

In light of these recent developments, this advisory revisits existing SEC requirements for environmental disclosures, and provides a preview of impending new regulations in this area.

Sarbanes-Oxley - The Congressional Response to Calls for Corporate Accountability
The demise of WorldCom and Enron, among many others, provoked Congress to enact legislation to promote greater scrutiny of and personal accountability for corporate financial controls and disclosures. The Sarbanes-Oxley Act requires that CEOs and CFOs each file two separate certifications with their company's quarterly and annual SEC filings, under Sections 302 and 906 of the Act, respectively.

The two certifications require, in general terms, the CEO and CFO (or persons performing similar functions) to certify that:

* to his or her knowledge, the report does not contain any material
misstatements or omissions;

* to his or her knowledge, the financial statements contained in the report fairly present the company's financial condition, results of operations and cash flows in all material respects;

* he or she is responsible for establishing and maintaining a system of disclosure controls and procedures that is designed to ensure that information required to be disclosed in SEC filings is recorded and reported in a timely manner; and

* he or she has evaluated the effectiveness of these controls within the 90-days preceding the report and provided any conclusions with respect to that evaluation in the report.

The SEC expressly required that public companies adopt and maintain controls and procedures to ensure adequate and timely SEC disclosures.

Congress also directed the SEC to adopt federal standards of conduct for attorneys appearing and practicing before the SEC, including those involved in the process of identifying potential liabilities and preparing SEC disclosures, even if not employed in their capacities as lawyers. These rules, which have been proposed but not finalized, would apply to both outside and in-house counsel, and would impose a duty of "up-the-ladder" reporting of violations of law that come to be known by counsel. See www.sec.gov/rules/proposed/33-8150.htm. While the American Bar Association's Model Rules of Professional Conduct have long required attorneys that represent an organization and become aware of potential legal violations that may affect the welfare of the organization to refer such matters to a higher authority within the organization (see Model Rule 1.13(b)(3)), the degree to which the ABA's Model Rules have been adopted varies significantly from state to state. The proposed SEC rule would federalize this up-the-ladder requirement, at least with respect to attorneys practicing before the SEC.

More recently, the SEC has proposed rules that will require enhanced disclosure of off-balance sheet arrangements and contingent liabilities, as well as rules specifically requiring the disclosure of critical accounting estimates. Together, these proposed rules are likely to require many companies to include significantly expanded disclosure concerning both potential environmental expenses and liabilities, as well as the company's process for estimating them. Companies will need to provide a quantitative sensitivity analysis, showing the effects of changes in their assumptions.

SEC Requirements for Disclosure of Environmental Liabilities: A New Approach to Old Rules?
SEC rules for disclosure of environmental liabilities presently require publicly held companies to evaluate costs of achieving compliance with laws, liabilities from actual or threatened legal proceedings, and prospective financial impacts that may result from emerging "trends" in environmental regulations and developments. Whether a company is required to disclose these liabilities turns on whether they are deemed "material." Generally, 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. The SEC has explicitly warned companies that there is no quantitative threshold for materiality, stating that even relatively small numerical differences could influence investors significantly. The SEC has cautioned companies, in fact, against making materiality determinations based solely on quantitative "rules of thumb," such as 5% or 10% of total assets. See SEC Staff Accounting Bulletin No. 99 (5AB99) (www.sec. gov/interps/account/sab99.htm). The SEC also has emphasized that the purpose of disclosure requirements is to permit a would-be investor to see inside the company through management's eyes.

At present, the specific SEC rules governing disclosure of environmental costs and liabilities remain, briefly, as follows:

* Item 101 of Regulation S-K, 17 C.F.R. ~ 229, requires a company to disclose material effects of compliance with environmental laws.

* Item 103 of Regulation S-K requires a description 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." Item 103 specifically requires that a description of any administrative or judicial proceedings arising under federal, state, or local environmental laws or regulations be included if the proceeding is material. It also requires disclosure of any enforcement proceedings that reasonably may be expected to result in sanctions of $100,000 or more, regardless of materiality.

* Item 303 of Regulation S-K, concerning MD&A, contains a general requirement to disclose "any known trends, demands, commitments, events or uncertainties" that are reasonably likely to have a material effect on a company's bottom line. The SEC has developed a two-part test to aid companies in determining whether disclosure is required in MD&A. Management must first determine whether the trend or event is not reasonably likely to occur, in which case, no disclosure is required. If management cannot make that determination, then disclosure is required unless management can determine that, assuming it occurs, such trend or event is not reasonably likely to be material.

The SEC has emphasized that "reasonably likely" is a lesser standard than "more likely than not." Under this standard, doubts about the likelihood that an event or uncertainty will occur, or will be material, should be resolved in favor of disclosure.

While these reporting requirements have been in place for a number of years, the passage of Sarbanes-Oxley and its new implementing regulations are altering the context for their interpretation. Putting aside regulations that the SEC has proposed but not yet adopted, new rules already in effect require companies to adopt procedures and controls for identifying and disclosing material information, to evaluate the effectiveness of these systems, and to obtain certifications of personal responsibility for these systems from the CEO and CFO. To the extent it ever was open to question, therefore, companies now are on notice that they should be able to point to an established protocol for identifying, tracking, estimating, and judging the materiality of environmental matters.

The specific steps that a company should take may vary significantly depending on the nature and size of the company, the scope and complexity of its environmental compliance responsibilities, and its financial condition. In developing a process that fits its specific needs, however, a company may consider the following:

* Delegate specific responsibility for identifying and documenting emerging trends in environmental regulation or enforcement that may have a material financial impact on the company*s operations. Examples of regulations that may have such an effect are changes in air emission controls, regulation or outright ban of chemicals used or produced, or significant new reporting requirements.

* Establish a method for evaluating potential environmental liabilities in threatened or pending enforcement and litigation matters, including state and federal "Superfund" sites. As noted above, the SEC has established a low threshold - $100,000- for disclosure of enforcement actions regardless of materiality. Clean-up costs under CERCLA, RCRA, and the Clean Water Act are not considered enforcement actions for this purpose. For those matters, the company needs to establish a procedure for determining the potential range of clean-up costs, and a standard for determining what costs are material.

* Involve senior management in evaluating information concerning potential compliance, enforcement, clean-up, and other environmental costs and liabilities. Sarbanes-Oxley requires a "top-down" certification by CEOs and CFOs as to both the quality of the company's disclosures and the internal systems from which they were derived. Depending on the size and complexity of the company, these officers typically will need to assure themselves that the information they have been provided from many different areas of the company is acceptable. Thus, substantial communication, well in advance of any filing deadline, may be required among environmental professionals, legal counsel, and managers responsible for individual businesses to identify potential costs and liabilities, determine the extent to which they can be estimated, summarize the results, and obtain peer review of information for inclusion in a formal disclosure.

The New ASTM Standards: More Accurate Disclosure or Just More Disclosure?
Warning of a new wave of accounting scandals involving failure to accurately disclose environmental liabilities, a coalition of charitable foundations and "socially responsible" investment funds have submitted a rulemaking petition urging the SEC to adopt as regulations the new ASTM standards for estimating and disclosing environmental costs and liabilities. The coalition*s petition claims that underreporting of environmental liabilities is rampant, and cites a 1993 General Accounting Office ("GAO") study that identified two potential structural reasons for this under reporting:

* Companies claimed that they could not estimate environmental costs and liabilities because of uncertainties due to, among other things, evolving judicial interpretations of legal liability for cleanup costs; and

* The GAO interpreted SEC rules to require that each discrete environmental matter only needed to be reported if it individually was deemed material. Therefore, a company may avoid disclosure even if, in the aggregate, the company's environmental liabilities would exceed the materiality threshold.

According to the rulemaking petition, SEC's adoption of the ASTM standards as regulation would address these structural issues by providing a uniform and more comprehensive approach to estimating environmental liabilities, and expanding those situations in which disclosure is required by closing loopholes that exist under current SEC rules.

ASTM's "Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters" (ASTM E 2137) is intended to provide uniform methods for estimating economic expenses, accrued liabilities, and loss contingencies arising from environmental matters. ASTM E 2137 provides a guide for financial analysis of environmental costs and liabilities. The standard states that it is not intended to address disclosure requirements.

ASTM E 2137 describes four known cost estimation methods and how and when to use each. The four approaches, presented by ASTM in order from "most preferred" to "least preferred," are:

* "Expected Value"Approach. The "expected value" of the cost of an environmental "event" is the estimate of the weighted-average over the range of all possible values. It is most appropriately used where there are multiple possible outcomes, each with its own probability of occurrence (which can be estimated), and a cost can be estimated for each outcome.

* "Most Likely Value "Approach. The "most likely value" represents the cost of the scenario believed to be most likely to occur. This approach is generally useful only if one (or a cluster of) scenario(s) has a probability of occurrence that is significantly greater than all others.

* "Range of Values" Approach. This approach develops a range of values without probabilities, because probabilities for various outcomes cannot be determined. If some outcomes within the range are more probable than others, than either the Expected Value or Most Likely Value approach should be used instead.

* "Known Minimum Value"Approach. This approach, the least-informed of the four, is to be used when the outcome and cost uncertainties are so great that it is premature to estimate a Range of Values or a Most Likely Value. Thus, this approach only identifies those costs that are reasonably certain to be incurred.

In essence, ASTM E 2137 proposes a hierarchy of estimation approaches based upon the quality and quantity of data available. Because the ASTM approach accounts for the level of uncertainty associated with the data available, the rulemaking petitioners argue that utilization of the ASTM approach would minimize those circumstances in which disclosure could be avoided altogether based on claims of uncertainty.

ASTM's "Standard Guide for Disclosure of Environmental Liabilities" (ASTM E 2173) expressly provides that it is intended to apply to management*s discussion and analysis accompanying financial statements. If adopted, ASTM E 2173 would require companies to consider the financial impact of all environmental liabilities. The standard provides, "Disclosure should be made when an entity believes its environmental liability for an individual circumstance or its environmental liability in the aggregate is material" (emphasis added). The Instructions to Item 103, by contrast, make clear that it is to be applied separately to each proceeding, or set of proceedings presenting "in large degree the same legal and factual issues as other proceedings pending or known to be contemplated."

ASTM E 2173 also would establish more detailed minimum requirements concerning the content of a company's disclosures. Whenever all of a company's environmental liabilities in aggregate are material, ASTM E 2173 would require the company to disclose:

* "number of sites for which the reporting entity has been named as a PRP and the number of claims, suits, actions, demands, requests for payment, notices, or cases that have been presented to the reporting entity for environmental liabilities";

* "reporting entity's estimate of its environmental liabilities, a description of the approach used to estimate the amounts, and the amounts accrued by the reporting entity for environmental liabilities";

* "cost estimation methodology employed for accrued liabilities and a characterization of any material loss contingencies"; and

* "nature and terms of cost-sharing arrangements with other PRP's."

Conclusion
Recent Congressional and SEC actions have significantly altered the context for rules requiring disclosure of material environmental costs and liabilities. Rules explicitly requiring implementation, evaluation, and certification of effective internal systems of disclosure controls have already been finalized, underscoring the importance of accurate and timely disclosure of environmental costs and liabilities. Proposed rules regarding off-balance sheet arrangements, contingent liabilities, critical accounting estimates, and a federal code of conduct for attorneys appearing and practicing before the SEC also are on their way. While the regulatory regime governing SEC disclosure rapidly evolves, it is imperative that companies stay abreast of developments in the field in order to comply with those requirements that have already been implemented, and to ensure compliance with new rules as they become final.

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