July 23, 2008
Sunshine is the Best Disinfectant: Shareholder Activists Promote Corporate Transparency
by Bill Baue
SocialFunds writer Bill Baue speaks with Sanford Lewis of the Investor Environmental Health Network
on his shareholder activism promoting corporate disclosure
Supreme Court Justice Louis Brandeis famously said, "Sunshine is the best disinfectant."
Shareholder activists have long promoted transparency in corporate reporting. Now, the Financial
Accounting Standards Board (FASB) acknowledges
inadequacies in its rules governing company disclosures. In June, FASB released an ďExposure Draft on Disclosure of
Certain Loss ContingenciesĒ proposing new rules.
Health Network (IEHN) General Counsel
Sanford Lewis applauds the strengths in the proposed rules, but also cautions against several
disconcerting weaknesses. IEHN has issued an action alert outlining these strengths and weaknesses to
guide submissions during the public comment period ending August 8.
Bill Baue recently spoke with Sanford Lewis about his shareholder activism on corporate disclosure.
Bill Baue: Why is corporate disclosure so important to investors?
When we talk about disclosure in financial reports, the question arises whether corporations paint
a reasonably full picture for their investors of the risks that the company is subject to. Right
now this is a really hot issue. The problem is that disclosure has been a very subjective activity.
Between accountants and lawyers making a whole lot of judgment calls, thereís a lot of paper being
released, but some of the critical issues are left out of disclosures.
BB: And why is
SL: The reason is that there is so much subjectivity within the range of disclosure
rules. And right now there are some opportunities to remove some of the subjectivity and replace it
with some more objective criteria that would fill out more of the picture. I think itís a very
exciting time, from the standpoint of investors that want to get a fuller picture. You know when
you think about disclosure issues, examples that come to mind include the lack of warning that
investors had around Enron, around the sub-prime mortgage lending issues and going back
historically, the companies that were producing a lot of asbestos and that eventually became
bankrupt over that. All of those are issues that were not very well disclosed by the companies and
that took investors by surprise.
BB: What are the existing rules requiring companies to
disclose such information Ė is this a question of there not being good enough rules, or of the
rules not being enforced well enough?
SL: I think itís actually a question of not good
enough rules and also not good enforcement. But there are two basic domains involved. One is the
Securities and Exchange Commissionís disclosure requirements and the other is what are called
Generally Accepted Accounting Principles, which are standards set by the Financial Accounting
Standards Board Ė and both of these leave a lot of subjective areas.
An example of
subjectivity allowed under the Financial Accounting Standards Board, or FASB, rules: when it comes
to liabilities companies face, such as big lawsuit claims that have been filed, they can say, ďwe
canít estimate that.Ē And of course, it just depends on how much effort somebody goes to whether or
not they will estimate it. And so whatís happened is companies have widely said, ďwe canít
estimate.Ē And they say they canít estimate until the day they actually pay the claim. So
investors get no real estimation under the current rules.
BB: And thereís a case that was
just profiled in a RiskMetrics research report where a company claimed in its securities filings it
couldnít estimate, and yet a few days after one of these filings, it gave a very precise number
that it was settling for with litigants.
SL: Thatís right. That was Merck, which had the
Vioxx issue. Vioxx is a painkiller, and it was causing heart attacks. The company had been saying
right up until the time of the settlement on the first of November 2007, ďwe cannot estimate.Ē And
then a week later they announced they had settled for $4.85 billion. Well, you have to think they
had some idea of how much this was going to cost them a week before they offered a $4.85 billion
BB: And no accountability? How can investors hold them accountable for that
SL: There have been lawsuits against them saying that, in part, they did
not adequately disclose what they knew about those heart attack risks over time. So there are some
ways that investors try to hold companies accountable, after the fact. But what I think is
needed is more objective rules that would allow investors to get more information upfront,
and where you remove some of these judgment calls from the process.
BB: What are some of
the options for solutions and what is the current landscape for proposing new rules for disclosure?
SL: Right now the most exciting thing thatís going on is that the Financial Accounting
Standards Board has recognized that their existing rules are inadequate when it comes to reporting
on potential liabilities. And so they have proposed a set of changes. And one of the changes is
that if a company says they cannot estimate, as Merck did, then what they must do in their report
is disclose the amount of claims that are against them, or what they view as the worst-case
scenario. Now they could also then say, ďwe donít think weíre going to have to pay that amount.Ē
And that would be a fine result. But this will result in much more quantitative information going
to shareholders. And so itís a very exciting opportunity.
BB: So in other words, instead
of saying nothing, they say, ďx amount, but we donít think thatís going to happen.Ē
Right. Theyíd say, ďweíve been sued for x amountĒ or ďthe most that this could result in would be
xĒ. These would be important numbers to go to shareholders. So thatís one development in that
proposed rule that is very exciting.
BB: And what is the process for that rule moving
forward Ė weíre in a public comment period?
SL: Thatís right. Until August 8th thereís an
opportunity for the public to comment. We expect that the corporate community Ė the community that
has to actually report on that type of information Ė is going to oppose the various improvements
that are proposed in that rule. So itís important for investors and other members of the public
that use financial reports to support this important proposal.
BB: The Investor
Environmental Health Network has put out a model for writing a public comment on this?
Now thereís a second thing that I think is even more important in that FASB
proposal. FASB has said that most liabilities would need to be disclosed. And that sounds good as
it stands. But thereís one category of liabilities that I think is the most profound and
interesting: where a company could be subject over time to a severe liability but the company views
it as only remotely likely that it would be subject to it.
When you look at the history
of corporations and these issues, whether itís Enron or asbestos or sub-prime lending, in all of
those instances the companies treated the possibility of a severe result as being only remotely
likely. And so they said under the existing rules, ďwe donít have to report that.Ē What FASB has
said is, ďif itís a severe outcome, but you view it as only remotely likely, you have to report it
if the issue would be resolved within the next year.Ē
Now to me thatís an interesting
step but itís a very, very weak idea because these issues resolve over the long term. And if
investors are going to have a complete picture, there ought to be disclosure regardless of
when the issue will resolve.
Letís take something thatís actually going on now: a
lot of companies are using new nanotechnology products, some of which actually resemble asbestos in
lab tests showing they could create mesothelioma-like symptoms, an illness caused by asbestos. And
now these new nano technology products are showing they have the same kinds of potential effects,
and yet some companies are deploying these materials widely. And they are not right now, by and
large, disclosing to their shareholders the fact that theyíre doing this and the existence of these
risks, which could be severe.
Now the question is, would they disclose it under the new
rule as FASB proposes? And the answer is no, they would not Ė because asbestos-like illness happens
over the course of decades. So even though they might be taking a severe risk and they might say,
ďwell, we think the outcome likelihood is remote of having that severe risk,Ē it will only resolve
over the course of decades and so it would not be disclosed. So what I believe needs to happen
instead is that any severe risks, even if a company views them as remote, needs to be disclosed.
And thatís what the Investor Environmental Health Network is advocating.
BB: So in
essence itís a question of taking away the one-year limit?
SL: Thatís right. We do make a
concession, in that itís much less important to quantify how big that severe risk would be over
twenty years, than to just admit that it could be a severe risk to the company if it were to come
BB: And leave it up to investors to know thereís a risk and they can do their
SL: Yes, they can do their own calculations. But this then gives them
the freedom to say whether or not this is the type of risk they want to make. Some investors, if
they know a company is using an asbestos-like material broadly, might say, ďlook, weíre in this for
the long-term. We donít want to sit around and wait and see whether youíre going to have liability
for this. Weíre going to invest somewhere else.Ē And that should be an investorís prerogative, not
information thatís withheld from them as is commonly done under the current rules.
And this has broader implications: if the moneyís going elsewhere, itís not going to support the
kind of corporate practice that takes on such risks.
SL: Thatís right. I hope it would
make companies think twice about taking such severe risks with the publicís health. And thatís why
itís both a very important financial issue, and also a public health issue.
BB: Ok. The
third issue in the FASB rulemaking proposal Ė what is that?
SL: The third issue is a
question of whether companies can conceal information they designate as prejudicial. The rule
theyíre proposing about quantification says you have to describe the worse case: thatís an
accountantís issue Ė whether they can estimate or not.
This is a lawyerís loophole. And
so what they seem to be doing is replacing an accountantís loophole with a lawyerís loophole.
Lawyers love to say information shouldnít be disclosed because it would be prejudicial to their
case. Thatís the stock-and-trade of lawyers. And now FASB is proposing to allow lawyers to
designate information as prejudicial and therefore not disclose it. I think itís a very bad idea.
BB: And youíre a lawyer.
SL: Iím a lawyer and I think itís a very bad idea
because I know how aggressively lawyers tend to use loopholes like this.
give an example.
SL: Okay. Letís just take the same issue: nanotechnology particles that
might cause a health risk. And lawyers donít want to disclose the fact the companyís using these
particles because at some point somebody might sue them over it.
BB: Itís a Catch-22
where investors want to know this is a potential risk and the lawyers say, itís a potential risk
and therefore we need to hide it.
SL: Thatís right. One of the things lawyers do is try to
protect as much information as possible, so their clients have as little litigation as possible.
But when it comes to these types of fundamental risks companies are taking, investors should have a
right to that information. Itís not the kind of information thatís in the interest of investors to
BB: So FASB is proposing this. What are the alternatives, in your view, to
instituting this prejudicial ruling?
SL: I think they shouldnít add this new loophole.
Fundamentally, thatís what I think needs to happen. If they are going to edit it, they need to
circumscribe it much more clearly, they need to set some rules that describe for lawyers the very
limited circumstances in which they can use it. And thatís not in the proposal now. And perhaps
they need to create some kind of third party checks on the process.
Basically I think
itís a bad idea. FASB should not be adding this loophole because it may negate the good that
theyíre going to otherwise do with the rule.
BB: What I hear you saying is to make it the
exception instead of the rule.
SL: Thatís right. In their proposal, they say they think
it would only be used rarely. But thatís what they thought with ďcannot be estimated.Ē
BB: Itís a loophole, itís going to be used.
SL: Itís a loophole, and lawyers have a
duty to zealously represent their client. So actually, I donít blame the lawyers. I donít think the
lawyers are evil if they use this prejudicial exemption -- thatís what theyíre paid to do:
aggressively protect information for their clients. Now unfortunately, the lawyers donít view their
clients as the investors. They view their clients as managers of the companies that might want to
conceal the information. But, again, if youíre an investor in these companies you need a full
picture painted of the risks the company is taking Ė and therefore it shouldnít be an option to
conceal the information.
BB: Sanford, you and I collaborated on a recent report called Toxic Stock
Syndrome, which takes a look at disclosure particularly around toxic ingredients of
products. Give a brief overview of the reportís findings?
SL: We looked at an array of
industrial sectors to see how theyíre dealing with disclosure of issues related to toxic chemicals
in products. And we found some really striking results. For example, last year there were a lot of
recalls related to toxic toys. We looked at those companies and what they disclosed in the past.
And we discovered a trend Ė visible to anybody who did the research, and certainly known to those
companies Ė that products being manufactured in China were increasingly being recalled for lead
paint. And yet when you look at their financial report disclosures, that information wasnít in
there. And I think that was a significant omission by those companies.
looked at the issue of impending European regulations in chemicals. And we found that many
companies that are likely to be highly affected by those new European regulations taking effect
this year were not disclosing that information in their shareholder reports.
we looked at issues like nanotechnology and asthma and DuPontís PFOA issue, a set of issues about
emerging science: what are companies telling shareholders about new studies that show hazards of
their product? And again we found very widely that companies donít tend to report to shareholders
on the new science thatís coming out that shows that their products are likely to be dangerous to
consumers and from an investorís standpoint, are likely to be either subject to lawsuits or that
consumers are likely to abandon once they figure out the hazards related to them. And, again,
companies are not disclosing that information to investors despite the obvious interest that
investors would have.
BB: And these are issues that, in the cases examined in the report,
have financial implications of plummeting stock prices when the problems were actually revealed to
the public even though companies, one would assume, knew about them. And then thereís also the
environmental and human health implications that are not disclosed to investors or the public at
SL: Thatís right. Keeping that information out of the financial reports means that
investors donít have an opportunity to act on it and pressure the companies to attend to these
risks. So the ultimate implication is not only a financial issue, but also a public health issue.
BB: A couple of days before the report came out, the Bisphenol A issue really hit the
media. Tell us about what happened with Bishphenol A and how this report bears in on the risks
SL: Yes. Bisphenol A is the chemical many people would recognize as the hard
plastic material that was in Nalgene bottles for years. Itís also in baby bottles. And over the
last five years or so, thereís been increasing stacks of scientific studies coming out saying that
this can be either a breast cancer risk or a risk in exposure to developing babies. Iíve been
telling people for years that it was a problem.
It wasnít until this year when a couple
of government agencies, one in the US and one in Canada, finally acknowledged these studies and the
risks looked genuine, and suddenly the marketplace reacted. Various companies started pulling
these materials off their shelves. And a lot of the companies finally had to stop producing these
materials. I thought it was really interesting Ė there was very little disclosure on this issue in
companiesí financial reports until the issue broke.
The day of the report release, I had
to add an epilogue that talked about this specific issue. And in fact the Investor Environmental
Health Network plans to do some more study and reporting on this issue and how these alternatives
have come to the market and how the how that upheaval on this on these product lines has played
BB: So you lay out the status quo where there is a problem, many people know about
it, companies donít disclose it, and they poof, it ends up on the headline and the problem spills
out. Whatís a best-practice scenario that would prevent this kind of problem from an investment
perspective and an environmental and human health perspective.
SL: Well, itís a perfect
example of what Iíve been saying companies really need to do in their SEC filings and that, is they
need to report to shareholders when those scientific studies are stacking up raising serious issues
about a product. Now they could say our scientists disagree with that. Thatís fair game. But they
should mention as numerous studies pile up on a product like bisphenol A, the companies really need
to tell their investors about those studies that are emerging even if they want to say our
scientists donít think this is a real issue, they still really have an obligation to paint the
fuller picture to investors about the risks of posed to those product lines, the regulatory risks,
the risks that consumers are going to abandon them, the risks of eventual lawsuits of which there
have been a bunch of lawsuits about bisphenol A now. All of those risks didnít appear in the
shareholder reports before this issue broke, before the regulators chose to take it on. And to me
thatís too late. Regulators are often the last to act on all these scientific issues. Investors
need information earlier.
listen to the complete interview by Corporate Watchdog Radio co-host Bill Baue with Sanford
Lewis at the Corporate Watchdog
Radio website, where you can subscribe to the CWR podcast or listserve. Lewis and Baue
co-founded CWR in 2005, and Lewis left the show recently to focus on his shareholder activism work and documentary filmmaking.