THE SEC has threatened to take action against companies that fail to adequately disclose environmental liabilities in their annual reports.

Fueled by heightened public and political concern over environmental issues and a perception of non-compliance, the Securities and Exchange Commission recently announced it is cracking down on environmental disclosure under federal securities laws.

This stepped-up effort not only includes clarifying existing requirements and utilizing information from the U.S. Environmental Protection Agency, but also mandates that registered companies estimate their future environmental liabilities for shareholders.

Already coping with a host of other state and federal environmental laws, businesses must meet this new SEC challenge by establishing appropriate internal procedures and controls to ensure compliance.

Disclosure Obligations

SEC regulation S-K contains standard disclosure requirements for companies filing annual or quarterly reports under the 1934 Securities Exchange Act or registration statements under the 1933 Securities Act. Environmental disclosure requirements for the nonfinancial portion of filings are specifically set forth in items 101, 103, and 303 in regulation S-K.

Item 101 requires corporations to describe their business and disclose current and future estimates of environmental compliance expenses, while item 103 requires disclosure of material environmental legal proceedings.

Item 303 requires registrants to include a narrative discussion of their companies' financial condition, known as the management's discussion and analysis of financial condition and result of operations.

This management discussion is supposed to disclose "material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or future financial condition."

For example, a company that is labeled as a potentially responsible party, or "PRP," under the Comprehensive Environmental Response, Compensation, and Liability Act, also known as Superfund, is generally required to disclose the effects of their PRP status.

A discussion of the effects of PRP status under Superfund also must include estimates of cleanup liability where reasonably practicable.

The SEC, however, expressed concern with companies' handling of environmental matters in the disclosures and recently threatened to bring enforcement actions when a company inadequately discloses its environmental liabilities in the management discussion sections of its annual report.

While most companies do disclose liabilities and provide estimates of costs, they often omit these cost estimates in their actual financial statements.

A 1992 survey showed that 62% of responding companies did not disclose known environmental liabilities on their financial statements.

SEC Tightens Up

Financial Accounting Standard 5 governs the issue of estimating liability on a financial statement filing and requires companies to list a loss if available information indicates that the event of loss is "probable" and "reasonably estimable."

Before, companies justified their failure to recognize "probable" liability by claiming such liability was not "reasonably estimable." SEC closed this perceived loophole last summer by issuing Staff Accounting Bulletin No. 92, which went into effect this January for end-of-year 1993 reports.

Bulletin 92 now expressly requires that registrants must quantify estimated future liabilities. if a loss is probable, a corporation is expected to accummulate sufficient reliable information for use in making an estimate and must recognize its "best estimate" of the loss.

This should prevent companies from taking a wait-and-see approach with their environmental problems and force some real soul-searching regarding their future environmental liabilities.

Furthermore, bulletin 92 prohibits the use of possible claims of recovery to offset liabilities. In other words, the two should not be included in a single net amount on a balance sheet, but should be listed separately as a gross liability and a claim for recovery.

This provision resulted from litigation between insurance companies and their insureds. The result for companies, however, may be a potentially larger amount of gross liability shown on a balance sheet to shareholders and prospective investors.

The practical effects of bulletin 92 are that the quantity and quality of information provided to shareholders will be vastly increased, and companies will have to work harder to meet the disclosure requirements. Registered companies felt the impact of the bulletin in their year-end 1993 reports.

For example, Navistar International Corp.'s 1993 annual report listed a $10 million liability in potential future environmental cleanup costs - not the kind of information some companies would prefer to share with their stockholders.

In addition to bulletin 92, the SEC has teamed up with the EPA to provide an enhanced information exchange that could mean a knockout punch for companies that fail to disclose known environmental liabilities.

Companies should be aware that EPA provides reports to the SEC that list companies named as PRPs at hazardous waste sites, as well as current criminal and civil proceedings under federal environmental laws.

Likewise, the EPA is using SEC corporate financial information to aid its enforcement efforts. Additionally, the SEC is now using EPA to train staff in environmental disclosure review.

Given this significant increase in the SEC's attention to environmental disclosure matters, registered companies must place greater emphasis on determining what and how much environmental information must be disclosed. To meet this challenge, there are several steps companies can take.

One involves developing internal controls. Assign one or more people to receive and update environmental information about the company and prepare the appropriate environmental disclosures.

A communications network with company environmental managers should be established to facilitate this effort and to maintain updated reports regarding environmental issues from outside consultants and counsel. To this end, environmental managers should be encouraged to discuss sensitive issues openly.

Further, efforts should be made to document a company's investigations and discussions concerning environmental disclosure matters. Due diligence is an important aspect in environmental disclosure and can provide a defense against SEC enforcement actions or private shareholder actions.

A company, however, should be aware that not all documents prepared during internal investigations of environmental problems will be privileged information. Thus, management should be sensitized to disclosure consequences of "worst estimates" or admissions of liability in documents and work closely with in-house and outside legal counsel to ensure maximum protection of the information generated by this program.

A Disclosure Strategy

Likewise, registered companies should devise a disclosure strategy. Given the SEC's crackdown on environmental disclosure, particularly regarding contingent liabilities, it "can be complex to determine whether environmental information must be disclosed, and in what manner. In some instances, it can seem impossible.

Existing environmental audits are an excellent source of information to begin analyzing a company's present and future environmental liabilities. Reraining outside environmental consultants and counsel is also important in evaluating technical and legal issues.

Such outside assistance can be especially vital in light of SEC's requirement that companies estimate not only actual but. "possible" liabilities.

Also, keeping a watchful eye on developing regulatory issues and the pitfalls of other companies can be helpful in assessing what information should be disclosed. Given SEC's crackdown on environmental reporting, companies should consider including positive information as well.

For example, some chemical companies have begun to include information on their efforts to appear more environmentally responsible and to highlight the capital spending for such efforts in their annual reports.

In light of the SEC's increased attention to comprehensive environmental disclosure, increased effort by registered companies is no longer just an option.

This challenge can be met through appropriate internal controls and an effective disclosure strategy in which corporate officials responsible for financial reporting work closely with those involved in environmental compliance.

J. Stephen Shi and Susan H. Cooper are attorneys in the Winston-Salem, N.C. office of the law firm of Petree Stockton.

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