Balancing Risk, Lawsuits And Good ERM

Good enterprise risk management starts with effective detection of risks and early disclosure of the material ones. But determining which risks are material and at what point disclosure is required or advisable is often a judgment call—which means that even the best ERM scheme won’t thwart litigation when a stock price tumbles and angry investors are looking for someone to blame.

Lacey

“There will always be litigation,” says John Lacey, a partner with the law firm Connell Foley in Roseland, N.J. “Lawyers will always allege that risks associated with investing in a company were not properly disclosed and the likelihood of those risks coming true were not fully disclosed.”

But Lacey says companies can “absolutely” mitigate potential damages by disclosing risks early. “Doing so may have an adverse effect on the stock price; there may be an initial overreaction by the market,” he admits. “But that’s usually corrected within a relatively short period of time. Once the risk is out in the public domain, no investor from that moment forward can say he was misled by the company. Hence there’s no damage if they thereafter purchase or sell stock.”

Iavarone

Nicholas Iavarone, a plaintiffs’ lawyer with SimmonsCooper in East Alton, Ill., agrees that earlier risk disclosure is beneficial. “If there’s a risk that’s material, the faster you get it out the better you are,” he says. “You want the market to price your company fairly. If you disclose a risk and you’re wrong, the stock price might go down a little bit. But it’s going to go right back up.”

‘Stair-Step’ Disclosures

In a recent paper, economist David Tabak of NERA Economic Consulting noted that companies often disclose risks only after the risk has been realized—leading to a large drop in stock price that exceeds whatever tumble might have happened had the risk alone been disclosed. Tabak argues that companies can limit the damage by disclosing risk before it becomes a reality.

Tankersley

Mike Tankersley, a partner at law firm Bracewell & Giuliani, says Tabak’s analysis is one worth heeding. He likens wise disclosure to a series of “stair steps,” staggering down from one corner of a stock price chart to the other. Ideally, as new risks emerge, companies should disclose the “clouds on the horizon” and let the share price slowly stumble down a step or two as the market digests the news.

Too often, however, “what many companies do is keep saying everything is fine,” Tankersley says. “By the time they disclose anything, they’re up to their neck in water and the price does a vertical drop. The guy who does the stair-step disclosure is likely not to get sued or will get out of the suit early. The other company, being judged in hindsight, is going to find plaintiffs’ lawyers, and perhaps a court, agreeing that they should have done disclosure earlier.”

Landau

Eric Landau, a partner with McDermott Will & Emery, says that early risk disclosure can often eliminate litigation damages entirely—but he also cautions that companies cannot always disclose every risk as soon as it appears.

“You have to balance the magnitude of the potential downside if a risk [is realized] with the probability that a risk is going to come to pass,” he says. “The worse off that something could be if a risk comes to pass, the more likely I would be to counsel my clients for earlier disclosure.”

Real, Meaningful Disclosure

Weinstein

Joseph Weinstein, a partner with Squire Sanders & Dempsey, says Tabak’s theory is interesting but “may not be all that helpful” in practice. Weinstein notes that companies don’t necessarily know when a risk that is not material might suddenly become material and warrant disclosure. Corporations, Weinstein says, “are interested in creating value for shareholders. Disclosing potential risks, or risks that are real but that may never come to fruition, could be been seen as artificially holding down the price.”

If companies disclose risks that are too remote, that decision might also be grounds for liability, Weinstein says. “The plaintiffs’ bar is very creative,” he says. “You could see lawsuits being filed for artificially depressing the share price and harming the shareholders that way—a Chicken Little suit.”

David Scott, a plaintiffs’ lawyer with Scott & Scott, agrees that Tabak’s approach doesn’t really reflect the reality of securities litigation. Companies don’t want to cross the line into “over-disclosure,” or to be seen as dribbling out bad news. “When they leak out information, how do you know if something is the tip of the iceberg?” he says. Some plaintiffs might even argue that a series of small disclosures cloud their ability to decide on the riskiness of the investment.

Barnes

Dale Barnes, a partner with the law firm Bingham McCutchen, notes that a basic strategy in securities litigation is to determine whether a company has disclosed enough information to defeat a lawsuit at the earliest stages. “A significant way to do that is to have real meaningful disclosures out there,” Barnes says.

Still, determining the likelihood of certain risks is a fundamental part of enterprise risk management—and often is inherently unknowable. “It’s very hard to access the probability of an uncertain future event,” Barnes says. “Many companies make forward-looking statements to disclose risks that might happen. But you don’t want to be recklessly harming the company, or the shareholders’ value. A company must have a reasonable basis for whatever statements it makes.”

Davisson

Michael Davisson, a partner with Sedgwick, Detert, Moran & Arnold, says that risk disclosure and good corporate governance are “definitely a factor” that “could make it harder for plaintiffs’ lawyers to make a case.” But he notes that the plaintiffs’ bar is “looking for certain kinds of cases. When a company announces that it’s going to restate earnings, that may be a sign of better governance. But it’s not unusual for the stock to take a hit and for lawsuits to follow.”

Toll

Steven Toll, a plaintiffs’ lawyer with Cohen Milstein Hausfeld & Toll, sees the issue more simply. The law, he says, “requires disclosure of material risk. If you make those disclosures, and you make them timely, it’s more likely than not you’re not going to be sued. This is all about disclosure. If you’ve got things that are not going right, just disclose it timely.”