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Loss Contingency Disclosures–A Warning from the SEC

    Client Alerts
  • December 06, 2016

Companies frequently struggle with how to account for loss contingencies and when to make the related disclosures. A recent complaint by the SEC against RPM International, Inc. and its General Counsel highlights the importance of getting it right…and the potential consequences of getting it wrong. It also provides a useful summary of the SEC’s analysis of the issue.

In its complaint, the SEC alleges that that RPM was under investigation for three years by the U.S. Department of Justice for overcharging the government on certain contracts. Edward W. Moore, RPM’s General Counsel and Chief Compliance Officer, oversaw RPM’s response to the DOJ investigation, but according to the SEC, did not inform RPM’s CEO, CFO, Audit Committee and independent auditors of material facts about the investigation. As a result, the SEC alleges that RPM failed to disclose in its filings any loss contingency related to the DOJ investigation, or to record an accrual on its books, as required by GAAP and securities laws. Also as a result, in the SEC’s opinion, RPM failed to disclose a material weakness in its internal control over financial reporting and its disclosure controls. The SEC noted that RPM ultimately restated its financial results for three quarters that occurred during the DOJ investigation, filed amended SEC filings disclosing the DOJ investigation and related accruals and disclosed errors relating to the timing of its disclosure and accrual for the DOJ investigation.

The final resolution of the SEC’s complaint and the merit of its allegations are, of course, uncertain at this time. The RPM complaint is instructive, however, due to its articulation of the loss contingency accrual and reporting standard, and as a reminder of the severe consequences of failing to abide by that standard.

The SEC begins its analysis by noting that Accounting Standards Codification 450-20 (formerly known as “FAS 5”) defines loss contingencies as an existing condition, situation or set of circumstances involving uncertainty as to a possible loss that will be resolved when one of more future events occurs or fails to occur, including both (i) actual or possible claims and (ii) pending or threatened litigation. GAAP requires that companies disclose a loss contingency if a material loss is reasonably possible, and a company must record an accrual for a loss contingency, as a charge against income, if a material loss is probable and reasonably estimable.

The complaint then points out that a company’s MD&A must describe any known trends or uncertainties that have had, or that the issuer reasonably expects will have, a material unfavorable impact on net sales, revenues, or income from continuing operations. The SEC also highlights Exchange Act Rule 12b-20, which requires that, along with the information expressly required to be included in an SEC filing, companies must also disclose such further material information as may be necessary to make the required statements, in light of the circumstances, not misleading. The facts in this case, in the SEC’s estimation, amounted to violations of multiple antifraud provisions of the securities laws, as well as violations of applicable books and records and internal controls provisions.

The RPM complaint is a sobering reminder that decisions made during the course of an investigation or the pendency of some other type of loss contingency are more than just theoretical debates about damage estimates and disclosure timing. The SEC apparently believes that these determinations go to the heart of meaningful disclosure in a variety of contexts and may be material to investors. As such, failure to follow proper internal procedures and reach correct conclusions may result in personal and corporate liability, perhaps even in the category of fraud.

The complaint also highlights the importance of full internal discussion and updated disclosure of circumstances as they unfold. It is critical that senior management, the Audit Committee and the outside auditors be kept fully informed every step of the way to ensure that proper decisions are being made with full, informed input from all relevant persons. Anything less invites trouble.