US insurers and their reinsurers may find that SEC-mandated disclosure of year 2000 problems will reduce their exposure to D&O and accountants' E&O lawsuits, according to Ronald S. Gass.
Insurance industry awareness of the year 2000 problem - also known as the year 2000 bug - grows daily. US insurers and their reinsurers are busy taking inventory of their exposures, starting with internal computer systems and business operations and then looking outward to the year 2000 compliance of their agents, brokers, clients, and vendors. Underwriters are also grappling with the multiple exposures being generated by their companies' products, with year 2000 underwriting guidelines, exclusions, and sublimits frequent topics of conversation these days. This information gathering and assessment stage probably describes most of the industry's year 2000 efforts to date, with a few companies ahead but a fair number of them trailing behind the rest.
As insurers strive to meet their own year 2000 assessment milestones, the Securities and Exchange Commission (SEC) and the accounting profession have been hard at work developing new year 2000 disclosure guidelines, advice, and questionnaires that will inevitably alter the liability landscape. As publicly-traded companies, many insurers and reinsurers must disclose the impact of their own year 2000 exposures and compliance efforts. Unlike other businesses, the insurers and reinsurers of directors, officers, accountants and other professionals have an added concern - they must assess their policy and treaty exposures to the year 2000 problem.
Notwithstanding the stream of doom and gloom scenarios and the usual reaction to regulatory involvement, NAC Re believes that year 2000 guidelines and disclosures may do more to mitigate, not detonate, the predicted exposures for D&O and accountants' E&O carriers. This article discusses how new guidance from the SEC and the accounting profession can help insulate directors and officers of publicly-traded companies and auditors from year 2000 exposure.
SEC urges cost disclosure
The SEC's first foray into this area was an 8 October 1997 Staff Legal Bulletin No. 5 (the Bulletin) issued by the Divisions of Corporate Finance and Investment Management. This "interpretive guidance" was subsequently revised on 12 January. The Bulletin's stated objective is to "remind" publicly-traded companies, investment advisers, and investment companies to "consider" their disclosure obligations relating to the anticipated costs, problems, and uncertainties of the year 2000 issue. Finding the existing SEC regulatory framework generally adequate to address a public disclosure approach, the Bulletin exhorted companies to review "on an ongoing basis" whether they need to disclose the anticipated costs, problems, and uncertainties associated with the year 2000 consequences, particularly in their SEC filings.
The Bulletin offered a two-prong approach to year 2000 disclosure. First, it recommended that publicly-traded companies include appropriate disclosures in their Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) if:
* the cost of addressing the year 2000 issue is a material event or uncertainty that would cause reported financial information not to be necessarily indicative of future operating results or financial condition, or
* the costs or the consequences of incomplete or untimely resolution of their year 2000 issue represent a known material event or uncertainty that is reasonably likely to affect their future financial results, or cause their reported financial information not to be necessarily indicative of future operating results or future financial condition.
Second, the Bulletin suggested that some companies may need to disclose their year 2000 issues in the "Description of Business" included in their various SEC filings if it materially affected that company's products, services, or competitive conditions. When the Bulletin was first published, some securities and accounting industry representatives were critical of the SEC's laissez-faire disclosure approach because it initially offered so little solid interpretative guidance to auditors. Accountants, confronting audits of companies without a clue as to their year 2000 exposures, decided more was needed.
AICPA voices accountant concerns
The accounting profession, shrewdly sensing a looming professional liability nightmare in the Bulletin's superficial approach, launched a campaign for more definitive SEC interpretative guidance on year 2000 disclosure. In a first rate overview of the many accounting issues associated with the year 2000 issue, the American Institute of Certified Public Accountants (AICPA) published a 31 October 1997 report entitled The Year 2000 Issue - Current Accounting and Auditing Guidance, a copy of which may be found on the association's web site at http://www.aicpa.org. It covers current financial reporting requirements; year 2000 issue disclosure considerations; auditing the year 2000 issue; auditor communications with a client regarding the year 2000 issue; and various other accounting practice management issues. Among its many recommendations is a warning to auditors to be "extremely cautious" about being associated with assertions that clients' systems are year 2000 compliant or guarantees that systems will become compliant by a specified date. It also proposed wording for audit engagement letters making it clear that the company's management is responsible for the year 2000 issue and, in some ways, is an effort to distance auditors from company representations regarding year 2000 compliance.
In a 9 December 1997 letter to the SEC, the AICPA criticised the 8 October Bulletin and highlighted its concern that many companies have not yet recognised the commitment necessary to address the significant technology challenges involved in resolving the year 2000 issue. The AICPA thought that many registrants would take refuge in the view that the year 2000 issue is still too speculative and uncertain to constitute a material event or condition requiring discussion in public filings. Thus, there was a real danger that the investing public will not receive important and necessary information about the potential effect of the year 2000 issue on many registrants in a timely manner.
The AICPA recommended that the SEC "clearly communicate" its expectation that it would be "rare" that a registrant could not now conclude that it is reasonably likely that the year 2000 issue would have some significant effect on its operations. Calling it "highly likely" that the year 2000 issue would be a trend, demand, commitment, event, or uncertainty for almost all registrants, it found it "absolutely imperative" that the SEC promptly clarify the level of discussion expected in the 1997 and 1998 annual reports and the information that investors will need and should have to understand this issue. Although the AICPA stopped short of recommending additional rulemaking, it did request timely "interpretive guidance" from the SEC.
The SEC revisits year 2000 disclosure
The AICPA's letter must have hit its mark because on 12 January, the SEC released a revision of the Bulletin which added a section on specific disclosure considerations. It is still not a "how-to" cookbook, but it does highlight the SEC's chief concerns. Companies that have not assessed their year 2000 problem or determined its materiality are advised that disclosure of this "known uncertainty" is required. Even if the company has a year 2000 remediation programme in place, the disclosure decision must focus on whether the year 2000 issues are material to its business, operations, or financial condition.
If the year 2000 issues are material, the nature and potential impact of them, as well as any countervailing circumstances, should be disclosed. Specifically, the Bulletin advises companies to disclose: (1) their general plans to address their year 2000 issues, both internal and external, and the timetable for carrying out those plans; and (2) the total dollar amount that the company estimates will be spent to remediate its year 2000 issues, if material, and any material impact these expenditures are expected to have on the company's results, liquidity, and capital resources. Boilerplate disclosures, the SEC staff noted, will be unacceptable.
State regulators also seeking year 2000 disclosures
Growing concern about year 2000 compliance has prompted some state insurance regulators to circulate year 2000 bulletins, surveys, and questionnaires to licensed insurers. For example, New York's Circular Letter 1997-11 requested companies to state whether they had a written plan to ensure that their computer systems will be year 2000 compliant, asked for an overview of key year 2000 compliance milestones, and a budget breakdown of the expected year 2000 costs.
Connecticut, New Jersey and Texas have requested similar information. What the insurance departments intend to do with this information and whether it will be made available to the public, like the SEC disclosures, is unclear.
Thoughts for D&O and E&O underwriters
What does all this mean for D&O and accountants' E&O insurers?
* Publicly-traded companies will be disclosing material year 2000 problems with increasing frequency in their annual reports and SEC filings in 1998.
* Independent auditors will be probing more vigorously for year 2000-related disclosure issues, and companies will routinely be asked to answer year 2000 compliance questionnaires this year.
* The SEC will probably take a few high profile year 2000 disclosure enforcement actions later this year after companies file their 1997 annual reports and Form 10-Ks.
* To avoid professional malpractice lawsuits, auditor engagement letters will distance accountants from any year 2000 disclosures made by the companies they are auditing.
These recent developments bode well for D&O and accountants' E&O insurers for two reasons. First, there will be more auditor pressure on management to exercise due diligence in the investigation, assessment, and disclosure of material year 2000-related problems. This means that the directors and senior management of most publicly-traded companies will find it difficult, if not impossible, to avoid disclosing significant year 2000 problems in 1998. Such due diligence and early disclosures, assuming that they are timely and not materially misleading, should significantly reduce the risk of successful D&O lawsuits by disgruntled stockholders should the company's stock price or profits fall precipitously following these disclosures or, in later years, if the company's year 2000 fixes ultimately fail. The "business judgment rule," embodied in the corporate laws of nearly every state, should be an effective defence, shielding directors and officers from stockholder lawsuits that attempt to second-guess the company's reasonable year 2000 remediation efforts or honest disclosures (although NAC Re expects many plaintiffs will still allege untimely disclosure).
Second, the accounting profession is now largely sensitised to the year 2000 problem. Hence, auditors should be better prepared to detect and comment on significant year 2000 problems and assist management in addressing the issue and making meaningful year 2000 disclosures. By adhering to the AICPA's year 2000 engagement letter recommendations and any future interpretive guidance issued by the SEC, the risk of successful year 2000-related accountant malpractice lawsuits should diminish substantially.
Accountants and the businesses they audit are becoming increasingly mindful of the year 2000 issue and are being prodded to "do the right thing" in terms of remediation and public disclosure by the SEC and the AICPA. These recent developments should ease some of the anxiety D&O and accountants' E&O insurers have been feeling lately over the year 2000 issue. As more proactive year 2000 risk management initiatives take hold in 1998, NAC Re predicts that savvy D&O underwriters will be spending a lot more time perusing the SEC filings of the publicly-traded companies they insure, particularly the MD&As and Description of Business sections, for important underwriting clues about how well, or poorly, a company is coping with its potential year 2000 exposures.
Ronald S. Gass is associate general counsel of NAC Reinsurance Corporation. The opinions expressed in this article are those of the author and not necessarily those of NAC Re.