The Public Company Accounting Reform and Investor Protection Act of 2002, enacted as the Sarbanes-Oxley Act (SOX), has been called the most sweeping securities reform legislation since the 1933 and 1934 Securities Acts. The Act was intended to mandate ethical corporate governance practices in the wake of the now-infamous incidents of corporate accounting failures discovered in the two years prior to its enactment.

Even before SOX, there was a growing acknowledgement that voluntary approaches to such issues as transparent corporate governance, corporate social responsibility, and corporate sustainability all had real, measurable, positive effects on corporate financial performance. These benefits are the direct consequence of improved reputation and branding, better stakeholder relations, and the lower cost of and increased ability to raise debt and equity capital.

Unfortunately, even as the most forward-thinking corporations were increasing expectations for ethical and transparent corporate governance, others were engaging in fraudulent disclosure practices which shocked the very core of a market system which relies on the complete disclosure of financial information as the basis for properly valuing public companies.

Environmental Disclosures Before Sarbanes-Oxley

Disclosure of environmental liabilities is not new. The SEC has mandated disclosure of environmental liabilities, including contingent liabilities, for more than two decades. Item 101 (Description of Business) of Regulation S-K requires disclosure of, among other things, the material effects of complying or failing to comply with environmental requirements on capital expenditures, earnings, and the competitive position of the company and its subsidiary.

In the past, most public companies have focused their financial reporting only on existing regulations and have not reported the likely effect of pending legislative and regulatory reform. Further, most have focused only on capital costs.

Based on a study by the World Resources Institute (WRI), to the extent that competitive position has been discussed, the reporting company has generally said something to the effect that “we expect our competitors will be affected similarly so there will be no net change in competitive position within the industry as a result of new regulations.” However, the same WRI study clearly demonstrates that not all companies in the same industry will be equally affected by new regulations. Specifically, WRI found that past business decisions have positioned different companies differently with respect to environmental issues. As a result some firms may be highly vulnerable to certain issues and while others remain virtually unaffected. And, since in today’s economy, commerce is global while regulation is local, the differences in regulatory environments among competitors can clearly place some at an advantage over others.

Item 103 (Legal Proceedings) of Regulation S-K specifically calls out environmental liabilities as a special class of liability for disclosure purposes. Item 103(5) essentially requires registrants to report at least quarterly any “administrative or judicial proceeding … arising under any Federal, State or local provisions … for the purpose of protecting the environment” if the potential liability is (1) material to the business or financial condition of the company, (2) exceeds 10% of the company’s current assets, or (3) has a governmental agency as a party (presumably in a regulatory capacity) and the probable liability is equal to or greater than $100,000. Note that materiality is not an issue under the last two conditions. And, since these last two conditions are specific to environmental liabilities, it was clearly the intent of the SEC to treat such liabilities as a special class.

In a 1998 study, EPA concluded that 74% of publicly traded companies failed to properly disclose environmental fines of $100,000 or more and that 90% of publicly traded companies facing hazardous substances cleanup expenses did not properly disclose those pending expenses to their shareholders. In 2001, EPA issued an Enforcement Alert notifying parties of their potential duty to disclose EPA-initiated enforcement actions. (See http://www.epa.gov/compliance/incentives/programs/marketbased.html for a link to EPA’s “Notice of Securities and Exchange Commissions Registrants’ Duty to Disclose Environmental Legal Proceedings.”) Fortunately, the SEC has not, to date, aggressively enforced the Item 103 requirements. However, while it is not clear what the future holds, the trend is clearly toward more scrutiny and enforcement of all SEC disclosure requirements.

Finally, Item 303 (Management’s Discussion and Analysis) requires the disclosure of environmental contingencies that may reasonably have a material effect on net sales, revenues or income from continuing operations.

Here again, a review of pre-SOX reporting patterns reveals a wide range of inconsistencies in how contingent environmental liabilities have been valued and disclosed. In a 1993 study of the insurance industry, the General Accounting Office (GAO) identified significant under reporting of these liabilities and speculated that, because companies did not know how to accurately value contingent environmental liabilities, those liabilities were often carried on the books at minimal or zero value. The GAO also noted that looking at these liabilities individually rather than in aggregate significantly affected whether they were or would be considered material.

Pertinent pre-SOX guidance on these matters include:

• SEC Staff Accounting Bulletin 92: Quantification of Environmental Loss Contingency
• SEC Staff Accounting Bulleting 99: Concept of Materiality
• Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5: Accounting for Contingencies
• American Institute of Certified Public Accountants (AICPA) Statement Of Position (SOP)
  96-1: Environmental Remediation Liabilities
• AICPA Statement on Audit Standards (SAS) No. 73: Using the Work of a Specialist
  

FASB-5, for example, requires that a loss be recognized only when it is both (1) probable and (2) the amount can be reasonably estimated. When both of these conditions are met, the guidance goes on to suggest the appropriate value to use based on the nature of the estimates. If, within a range of values, one value in the range is more likely to occur, FASB-5 identifies that most likely value as the appropriate value to use. However, if no one value is more likely than any other, the Standard allows use of the lowest value in the range.

Given the high degree of subjectivity in these analyses, some companies have, in the past, chosen not to recognize a potential environmental loss based on either the “probable outcome” or the “estimable value” tests. And, when recognized, the lowest value was often the value disclosed. It has also often been the case that, once these evaluations were complete, they were not reviewed and updated based on changes in the status of the underlying matter. Generally, this resulted not as an attempt to under report or to avoid disclosure requirements, but as a result of the environmental staff and their outside experts (legal advisors and technical consultants) being almost exclusively focused on resolving the underlying matters to the exclusion of the associated business implications.

Enter Sarbanes-Oxley

Among the more notable SOX requirements are those of Section 302 which requires that CEOs and CFOs certify all quarterly and annual financial reports, stating (1) that, to the best of their knowledge the report contains no material misstatements or omissions, (2) that the report fairly represents the financial condition and results of operation of the company for the reporting period, (3) that they have established internal controls to ensure that the material information is known to them, (4) that they have evaluated the effectiveness of those controls and have presented their conclusions regarding their effectiveness, (5) that they have disclosed to their auditors any ineffectiveness in those controls and any fraud involving managers or employees with significant roles in those controls, and (6) if any significant changes to their internals controls were made after the evaluation.

What does this mean to the Corporate Environmental, Health and Safety (EHS) Manager on a day-to-day basis? And how will it affect the relative priority his or her senior management places on valuing and disclosing environmental losses and liabilities?

It does not take too great a leap of imagination to expect, now that their personal futures are at stake, that corporate executives will expect more and more detailed financial information from both their staffs and their outside advisors. In order to be able to provide the required information at a useful level of detail and in a timely manner, both the internal staff and the outside advisors will need, even more than before, a well-organized system to manage the required information. As it relates to the EHS Manager, organizations with effect Environmental Management Systems (EMS) may be ahead of those without such systems.

Much attention and effort has recently been directed to establishing the internal financial controls required by Sections 302 and 404 of SOX. The seamless integration of relevant elements of a firm’s EMS into that process not only makes sense, but can provide a degree of management controls and information sharing that facilitates compliance with both EPA and SEC regulations.

Further, both the organization and the EHS Manager can benefit from more senior management attention to environmental matters. For several years now, academic studies have shown a strong positive correlation between a company’s environmental performance and their business performance. For example, in The Environmental Fiduciary, the Rose Foundation reports a 2000 study which analyzed over 600 U.S. manufacturing firms for the decade ending in 1996 which found a positive association between environmental and financial performance and a 2001 study which found that multinational firms which adopt a single, stringent, global environmental standard enjoyed higher market value than firms which defaulted to less stringent host country standards. Is this merely a function of management capacity? Do firms with enough capacity to actually attend to environmental matters do well because they also have all of the other issues covered, or is there more to it than that?

However, even organizations with a current EMS should not just assume their existing systems will be sufficient to the new SOX demands.

Real-Time Disclosure Requirements

For example, SOX for the first time requires plain English disclosures of material changes in operations or financial conditions on a “rapid and current basis.” For the EHS Manager, this may mean that, in addition to coping with an actual environmental emergency, it will also be necessary, virtually in real time, to prepare and provide the related financial information to senior management and the Disclosure Committee. And this will have to happen while trying to address an environmental episode of such proportion as to be financially material to your company. Ever tried counting the alligators while you’re trying to drain the swamp?

While most environmental episodes can be anticipated to fall short of the level of materiality, this is an example of an additional demand on the EHS Manager and his or her EMS. One which a proactive EHS Manager will want to anticipate when reviewing the EMS, hazard evaluations, and other environmental scenarios.

Other Environmental Disclosures and Reserves

As noted above, while the SEC has required disclosure of environmental liabilities for over 20 years, recent studies indicate industry’s compliance record is spotty at best. Fortunately, to date, the SEC has not aggressively enforced these requirements. Given the government’s newly increased focus on transparent corporate governance and accurate corporate disclosures, it is probably prudent to anticipate that enforcement of these requirements will increase, at least in the short term.

In addition, two recently adopted standards from the American Society for Testing Materials (ASTM) may revise the ways in which costs associated with environmental liabilities are estimated and disclosed. In addition to being endorsed by ASTM, these standards are also the subject of a rule-making petition filed with the SEC by The Rose Foundation and a number of other non-governmental environmental organizations (NGOs) asking SEC to adopt them as regulation.

The first of these, ASTM E 2137-01, Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters, establishes a hierarchy of approaches for making such estimates. In order of increasing robustness and comprehensiveness (and decreasing uncertainty), these are:

• Known Minimum Value – used when the outcome and cost uncertainties are so great that it is premature to estimate a range of values. This approach only identifies those costs which are reasonably certain to occur. Examples might include, for example, the cost of initial site assessments at an early stage when it is not clear that a complete site characterization will be conducted.
• Range of Values – used with or in lieu of the Most Likely Value, this approach simply assigns a range of values without associating probabilities with any values within the range. If some outcomes are considered more likely than others, the standard recommends using one of the “higher order” approaches, if it is possible to do so.
• Most Likely Value – used when an expected value is not practicable or appropriate. MLV may be used in conjunction with the Range of Values approach. The MLV is, essentially, the value of the scenario considered most likely to occur. Note that under this approach, that scenario need not have a high probability of occurrence so long as its probability clearly exceeds the value of other possible scenarios.
• Expected Value – used when it is possible to determine a probability-weighted average of the range of all possible values using analyses such as decision-tree analysis, Monte Carlo analysis, and others.
  

The standard discusses the methods for implementing each approach, the required data quality and quantity, and the uncertainty associated with each.

ASTM E 2173-01, Standard Guide for Disclosure of Environmental Liabilities, is intended to apply to the Management’s Discussion and Analysis (MD&A) accompanying audited and unaudited financial statements. Perhaps the most significant provision of the standard is the provision that disclosure of environmental liabilities should be made when either a liability from an individual matter or the company’s environmental liability in aggregate (emphasis supplied) is material. Requiring companies to consider the materiality of aggregate liabilities would be a significant new requirement affecting disclosures.

The standard also requires disclosure of specific information including the number of sites at which it is a PRP and the number of other claims, demands, etc. that have been presented to the company; the nature of any cost-sharing agreements with other PRPs; the cost estimation methodology employed; and the estimate of the company’s environmental liabilities and the amounts accrued against those liabilities.

Although these ASTM standards are, for the moment, only voluntary consensus standards, past environmental standards from ASTM (think Phase I Environmental Site Assessments) have rapidly gained acceptance as common standards of practice and have, more slowly, been adopted into federal regulation. It is not unreasonable to anticipate the same here, especially given the existing SEC rule-making petition.

An Action Plan

Where from here? We encourage EHS Managers to become sufficiently familiar with the new SOX requirements and ASTM standards to understand how they affect the analysis and required disclosure of environmental liabilities. We then believe it will be worth the effort to review any existing EMS to see how these new requirements can be included in your daily environmental management activities and which relevant components can be made a seamless part of your company’s internal financial controls.

If not already included, we suggest identifying the types of events that should be reported to the Disclosure Committee as potentially material and that scenarios for the near real-time reporting of new information be developed.

To the extent that these activities can be systematized, they can be more readily and efficiently incorporated into the structure of your company’s environmental management and corporate governance strategies. As such, we suggest identifying regular milestones for each class of frequently occurring environmental matter which may require disclosure (e.g., CERCLA sites, pending regulations, and more). At each milestone, the previous cost estimate should be reviewed and updated as appropriate.

For example, for Superfund sites, the milestones and cost elements included in the estimate might be:

• Initial Notice – Investigation costs only.
• Confirmation of Contribution – RI/FS costs, apportioned appropriately based on, for example, ASTM guidance and existing cost-sharing agreements, FASB-5, or other guidance or standard.
• Final RI/FS Report – Remediation costs based on appropriate guidance or standard.
• ROD – As above but with a more detailed cost estimate.
• Construction Complete – Appropriately apportioned O&M costs.
  

Through such systemization, the EHS Manager can provide timely, cost-effective information to the Disclosure Committee and executive management while ensuring appropriate reserves against environmental liabilities. This, in turn, will allow the company to provide more timely and accurate disclosures and begin to see the real financial benefits associated with transparent corporate governance.

Benefits

There are demonstrable internal and external benefits to complying with Sarbanes-Oxley’s disclosure requirements. Internally, better, more complete information can facilitate more appropriate, cost-effective and proactive environmental management. Externally, the increased transparence enhances shareholder relations, brand and reputation and, ultimately, increases competitive advantage.

The EHS Manager can directly benefit from the increased awareness of the importance of environmental issues and environmental management to overall corporate performance. This can help move the corporate leadership’s view of the EHS function from that of a separate cost (only) center to that of a fully integration component of corporate governance which has significant effect on the corporation’s branding and reputation, stakeholder relations, and numerous other areas which directly affect corporate value. It can change the view of the EHS Manager from the person who fills out the Form Rs and OSHA 300 forms to a fully integrated member of the corporation’s risk management team.

And, an unintended benefit is that it also provides an opportunity for the corporation to report on its environmental assets which might include emission credits, cost savings from pollution prevention programs, and the financial benefits derived from other Corporate Social Responsibility and Corporate Sustainability programs.