The Exxon Valdez Crashes into Fair Value Accounting

The Supreme Court's slap at the "stark unpredictability" of punitive damages in the oil tanker case highlights the challenge of making companies report future lawsuit liabilities to investors.

Nearly two decades after the Exxon Valdez spilled millions of gallons of oil into Alaska’s Prince William Sound, the Supreme Court ordered that punitive damages paid by the oil company should not exceed the compensatory damages it paid. That ruling cut Exxon’s punitive damages — initially set at $5 billion, but reduced on appeal to $2.5 billion — down to just over $500 million.

In legal terms, the case is fairly narrow one. Though the Supreme Court said that punitive damages should not exceed a 1:1 ratio with compensatory damages, the ruling applies only to maritime law, and not the state courts in which most companies are sued.

But the case also has unintended implications for accounting. The ruling — which complains vigorously about the “stark unpredictability” of punitive damages — comes just two weeks after the Financial Accounting Standards Board proposed substantially increasing the amount of information that companies must disclose about potential future losses from lawsuits, and it highlights just how challenging an order that is.

FASB’s proposal stopped short of requiring that companies assign a fair value to all pending litigation — a possibility that had prompted a joint letter of protest from the corporate counsels of 13 of America’s largest corporations last December. But it would still require that companies disclose “specific quantitative and qualitative information” about loss contingencies.

In an mid-year update on FASB’s activities webcast earlier this week, FASB Technical Director Russ Golden admitted that “We recognize that this will be controversial,” adding that an exemption had been put in to counter company complaints that such disclosures would provide plaintiff’s lawyers with confidential information.

But for many corporate attorneys, the larger problem is that the financial outcome of litigation is nearly impossible to gauge. “Litigation is inherently unpredictable,” wrote Pfizer associate general counsel Sandra L. Phillips in a December letter also signed by attorneys for GE, DuPont, Viacom, Boeing, McDonald’s, Kimberly-Clark, Time Warner, Johnson & Johnson, Wachovia, Tyco, and Bank of America. “Proof of that unpredictability can be seen in cases, such as the infamous case against McDonald’s involving damages from a spilled cup of coffee, the differing verdicts for the first Vioxx cases tried against Merck or in a variety of other contexts,” the letter said.

In his ruling on the Exxon case, Justice David Souter said that unpredictability was particularly “stark” when it comes to punitive awards. “Courts of law are concerned with fairness as consistency,” he said, adding that all evidence suggests the spread between high and low punitive damage awards was not acceptable. Souter cited a study of punitive damages in state civil trials by jury that found a median ratio of punitive to compensatory awards of just 0.62:1, but a mean ratio of 2.90:1 and a standard deviation of 13.81.

“Even to those of us unsophisticated in statistics,” Souter wrote, “the thrust of these figures is clear: the spread is great, and the outlier cases subject defendants to punitive damages that dwarf the corresponding compensatories.”

“When you start getting into things like punitive damages, it is just so judgmental and subjective . . . there’s just no economic model you could ever construct to figure out what punitive damages could be,” says Larry Levine, head of business valuation and corporate finance at RSM McGladrey.

Levine, who says about a quarter of his practice involves litigation, still says it is possible to apply valuation techniques to litigation. “Valuation is expected future cash flow divided by risk,” he says. If it isn’t possible to discount the future liability of a lawsuit from cash flows, he says, then investors need as much information as possible to decide how much to increase the risk factor. “Obviously, that is subjective, but the beauty of the market is that it reaches a consensus.”

But that’s little solace to advocates of tort reform. Steve Hantler, former assistant general counsel for DaimlerChrysler, and now Director of Free Enterprise and Entrepreneurship with the Marcus Foundation, believes that plaintiff’s attorneys deliberately put pressure on the value of company shares in an effort to force companies to settle faster.

Under current accounting rules, companies are only required to take a financial charge for a contingent loss if it appears probable that the loss has occurred and its amount can be reasonably estimated. If those conditions are not met, companies must disclose the loss contingency only if there is a reasonable possibility that a loss has occurred.

Under the new rule, companies would have to disclose all loss contingencies unless their likelihood is remote. And companies also would be required to disclose any contingency — no matter how remote — that is expected to be resolved within a year and could have a severe impact on the company’s financial position, financial results, or cash flow.

Hantler says he supports the idea of having companies disclose their actual litigation losses to shareholders after the fact, but says the FASB proposal is “a bad idea” that is likely to give plaintiff’s lawyers more ammunition against companies. “There’s so much room for mischief if companies have to report something, even if they think [the case against them] is utterly frivolous.” In a worst case scenario, says Hantler, he could even imagine plaintiff’s lawyers filing frivolous lawsuits “trying to set them up for [subsequent] fraud lawsuits or poor record-keeping suits.”

By expressing the court’s preference for a maximum ratio of 1:1, says Hantler, the Exxon ruling “will certainly help” corporate attorneys try to control punitive damages, “but it doesn’t solve the problem of punitive damages,” says Hantler. “We have seen some judges in state courts ignore a [2003] Supreme Court ruling that said 9:1.”

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