“Before I draw nearer to that stone to which you point, answer me one question. Are these the shadows of the things that will be, or are they shadows of things that may be only?”

– “A Christmas Carol” by Charles Dickens

Most lawyers can relate to Ebenezer Scrooge’s concern. Is there a possible legal risk, or a definite liability? Unfortunately, lawyers don’t have a Ghost of Christmas Yet to Come to show them the potential losses that may be incurred in the future, so they have to address potential future litigation events themselves.

Reserve Setting as a Competitive Advantage

The process for identifying, setting, and updating reserves is driven almost exclusively by the preparation and filing of financial statements. As a result, the timeliness and accuracy of reserves lives by the quarter.

But while financial reporting is focused on the end of each quarter, strategic decisions must be based on up-to-date information. This enables businesses to appropriately adapt and respond to market conditions and competitors. Most executives would find it unacceptable to make key decisions based on months-old data, yet that is precisely what happens when it comes to the financial, political, and reputational risks that businesses face due to possible legal claims.

Trends in SEC Loss Contingency Examination

Over the past decade, the SEC has increased its focus on two key issues:

• the timeliness of disclosures and reserves, and
• appropriate updates to these as new information becomes available

Notably, the SEC has emphasized that its guidance also applies to reserves or disclosures that have been omitted or not adequately updated. Companies that fail to identify, record, and update loss contingencies due to inadequate or lacking processes and procedures have poor internal controls.

Stakeholder Perspectives

As CEO, why do I care?

A large part of your job as CEO focuses on developing and implementing your company’s vision. Disclosures of and accruals for contingent losses may change how outside investors, potential business partners, and even the board views the risk of investing in or working with your company.

Having accurate legal reserves and contingent loss information will allow you to assess various risks to your company and manage these appropriately. If the tone at the top emphasizes the importance of managing risk through proper development and tracking of legal reserves, other individuals within your company will likely adopt a similar attitude.

As CFO, why do I care?

Your focus as CFO is on providing accurate, timely numbers that can be justified. Failure to accrue, or making an accrual that understates a potential loss, may result in a material misrepresentation of the financial statements. If financial statements must be restated, the market value of your company could take a hit. Overstatement of liabilities, on the other hand, may also negatively impact your metrics (e.g., EPS).

As an in-house attorney, why do I care?

Your company’s auditors (either internal or external) will likely come to you for assessments of various matters to determine whether they need to be disclosed or accrued for. Whether privilege applies or not, you are best suited to make these assessments, as you are likely the most well-informed on these matters.

As outside counsel, why do I care?

While legal costs are not accrued under ASC 450 and you are not directly responsible for this type of reporting, your clients may still contact you for estimates so that they can properly accrue for or disclose litigation and other legal matters that you handle. Your clients may use your predictions as a benchmark against which they measure the actual outcome. Furthermore, an increasing amount of your work is likely based on fixed fees or other alternative fee arrangements (AFAs). Originating new work may depend on your early case assessment or AFA bids, which require you to make predictions about cases. Consequently, in order to win and keep business, it may be in your firm’s best interest to estimate outcomes as accurately as possible.

As the board, why do I care?

The SEC Doesn’t Want Your Excuses

When a company fails to disclose or accrue for a possible loss as required, the SEC will frequently bring enforcement action against the company. The SEC also takes action when insufficient internal controls surrounding the identification and reporting of contingent losses results in missed disclosures or accruals.

Similarly, the SEC has pushed back on generic statements or assertions by companies that the amount or range of reasonably possible losses cannot be estimated. In these cases, companies are required to provide an explanation as to why they cannot do this (SEC: “tell us why you can’t do the thing you’re supposed to do. also try harder.”).

The Legal Crystal Ball: Setting Reserves

Predicting outcomes is a fundamental aspect of the provision of legal services (in fact, this is why my first company was named LexPredict! But, as is often the case, we pivoted away from our initial plan). Attorneys tend to be risk averse and are trained to spot legal issues, risks, and areas of uncertainty. While lawyers may shy away from concrete, objectively measurable predictions about what the future may hold, ABA rules of professional conduct suggest that a lawyer should inform clients of prospects of success during litigation. Although ASC 450 does not require certainty, it does require lawyers to provide some degree of quantitative prediction about matters.

What’s Next?

We’ve seen why it’s important to track legal reserves and update them and other loss contingencies. Proper attention to contingent losses and legal reserves will not only meet reporting requirements but also provide your company with valuable planning opportunities. In my next post, I’ll discuss the interplay of known and unknown risks in the reserve setting process, as well as how AI is helping to make this easier for companies and their boards.