- Will Disclosure Really Hurt Your Company More Than Silence Hurts Your Investors? Product Liability Disclosures and the Sarbanes-Oxley Act
- February 20, 2006 | Author: Richard T. Williams
- Law Firm: Holland & Knight LLP - Los Angeles Office
Nobody enjoys self-exposure of actual or potential shortcomings. For manufacturers, public disclosure of the details of warranty claims and product liability experience historically has been viewed as repugnant, exposing one's firm to potential competitive disadvantage and to threats of litigation.
Accordingly, public company manufacturers preparing quarterly and annual reports for the Securities and Exchange Commission (SEC) and public distribution commonly report no more than aggregate annual expenses for warranty claims and product liability cases, comparing current period figures to prior periods. These discussions typically make no mention of individual products or product lines. Discussions of product liability lawsuits, if any are identified and described, tend to be carefully worded in generalities to emphasize the availability of meritorious defenses and avoid indications that a material adverse impact may result for the company.
Reticence by manufacturers to provide greater detail about product liability issues is understandable, for a number of reasons, not least of which are these:
- consumers and investors may not appreciate or acknowledge unavoidable and irreducible risks associated with particular products, compounding the difficulty to their understanding larger risks
- individuals' perceptions about death or the sanctity of life may lead them to different conclusions about risks than are consistent with a rational calculation of returns on corporate investment in particular products or the volatility of such returns
- no "bright lines" have been published to tell companies the earliest moment and the precise extent to which product liability disclosures are mandatory, nor to define precisely where a company may halt in its disclosures
Investor Concerns and Historical SEC Requirements
In deciding to buy or sell shares of stock in publicly-traded manufacturing companies, investors and investment advisors depend upon and use disclosures of current and historical information to project the future for their chosen companies. They seek assurances that particular risks have been adequately explained and are already priced into shares. Surveys of the information investors claim is most important to them in deciding to buy or sell a company's stock include the company's reputation (often related to the quality and product liability experience of its products), recent developments and potential risks for the company.1
The SEC has prescribed general formats for companies to follow in preparing quarterly and annual public reports. Manufacturers are to discuss their financial exposure to warranty claims and product liability expense in four principal sections of these reports: (1) description of the business; (2) risks; (3) management discussion and analysis (MD&A) and (4) notes to financial statements. Mindful of investor concerns, the SEC staff has studied corporate disclosures about product liability contingencies and criticized them generally as too terse and uninformative.2
For years, the SEC has instructed companies to include the following information in their discussions: (1) a description of the nature of the loss contingencies they face, including for product liability; (2) an estimate of the range of reasonably possible losses; and (3) an explanation as to how the amounts accrued for particular losses or categories of losses were determined. Disclosures about warranties and product liability are to be detailed enough to explain how unasserted claims are reflected in any accrual. Discussions should also include the possibilities of joint and several liability for product liability with other firms as well as the existence of cost sharing agreements and availability of insurance or indemnification as sources of recovery for product liability expense. Where particular products or claims may be material in affecting financial results, individualized disclosure (rather than aggregate discussion) may be required.
The Sarbanes-Oxley Act of 2002 and Product Liability Disclosures
Spurred by accounting scandals at Enron and Worldcom, among others, Congress enacted the Sarbanes-Oxley Act of 2002 (SOX) that prescribes detailed standards for corporate governance and financial reporting. SOX also introduced the concept of mandatory "disclosure controls," procedures to be implemented and certified by top management to assure that all disclosures required by the securities laws are contained in reports to investors and the SEC. Disclosure controls further mandate public presentation of any additional information necessary to ensure that the required statements are not misleading in regards to the circumstances in which they were made.
Disclosure controls are intended by the SEC to assure adequate and straightforward discussion in a company's public reports in the following areas:
- disclosures are to provide a view of the company through the eyes of management, offering both a short- and long-term analysis of the business3 -- including known trends, events or uncertainties that are reasonably likely to have a material effect on a company's financial condition
- companies are to provide insight into material challenges and risks -- including warranty claims and product liability experience -- and explain those risks, their implications and how management is addressing them4
- disclosure of an event or uncertainty is required unless it is not reasonably likely that it will occur or have a material effect on the company's financial results5
- if there is a reasonable likelihood that reported financial information is not indicative of a company's future financial condition, additional disclosures about the estimates for uncertainties and the susceptibility of such estimates may be required
Reinforcing disclosure controls are mandatory certificates signed by a public company's chief executive officer and chief financial officer attesting that quarterly and annual financial reports contain all required disclosures. An officer who provides a false certification potentially could be subject to SEC enforcement action for violating Section 13(a) or 15(d) of the Exchange Act and to both SEC and private lawsuits for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5, in addition to possible criminal penalties.
The SEC has brought enforcement actions in the past for inadequate disclosure to investors about uncertainties. See, e.g., In the Matter of Sony Corporation and Sumio Sano, Release No. 34-40305 (Aug. 5, 1998); In the Matter of Gibson Greetings, Inc., Ward A. Cavanaugh, and James H. Johnsen, Release No. 34-36357 (Oct. 11, 1995). SOX provides the SEC with additional requirements to be enforced and additional stiff penalties of which manufacturers must be aware.
Disastrous Impacts on Investors From Unexpected Product Liability Events
Merck & Co., Inc. Thursday morning September 30, 2004, was already gloomy and rainy in New Jersey when Merck & Co., Inc, issued a stunning announcement: its best-selling product Vioxx was immediately being voluntarily withdrawn from sale worldwide!
That day, the price of Merck common stock plunged from $45.07 to $33, for a loss to shareholders of $26.7 billion. In December 2005, with publication by the New England Journal of Medicine (NEJM) of an editorial expressing concerns that Merck had failed to disclose several Vioxx patient deaths in an article it had submitted to NEJM in 2000, Merck's stock price dropped even further.
The shock from Merck's product recall has led to federal and international investigations, multiple nationwide shareholder class actions and derivative lawsuits that claimed Merck and its officers had long known of, but had concealed, adverse information about Vioxx and had committed securities fraud -- as well as more than 4,100 product liability suits, most of which involved patient deaths.
In its withdrawal notice, Merck explained that an increased risk of heart attacks had been observed among patients using the pills for at least 18 months. Previously, Merck had enthusiastically trumpeted the growth of Vioxx:
Worldwide sales of Vioxx ... grew 2% over 2002, achieving $2.5 billion in sales in 2003 ... with more than 91 million prescriptions written in the United States since its introduction in 1999. Outside the United States, Vioxx is the best-selling arthritis and pain medicine. (Merck 2003 Form 10-K).
Investors had been given scant basis for concern about this product in Merck's SEC filings:
Federal and state lawsuits involving numerous individual claims, as well as some putative class actions, have been filed against the Company with respect to Vioxx. Some of the lawsuits also name as a defendant Pfizer Inc., which markets a competing product. Certain of the lawsuits include allegations regarding gastrointestinal bleeding, cardiovascular events and kidney damage. Litigation is inherently subject to uncertainties and no assurance can be given on the outcome of any given trial. However, the Company believes that these lawsuits are without merit and will vigorously defend against them. (Merck 2003 Form 10-K, Legal Proceedings Section).
Obviously, the instant huge adverse stock market reaction to its withdrawal notice showed that Merck's Vioxx liability risks had not been priced into its common stock. The further stock price drop in December 2005, upon publication of the NEJM editorial indicating concealment of Vioxx patient deaths, reflected further surprise on the part of investors.
Merck's stock price plunge has been deeper and more protracted than others following adverse product liability announcements. A sampling of other recent instances follows.
Guidant Corporation. Guidant Corporation, a leading manufacturer of pacemakers and defibrillators, announced a recall in June 2005; its stock price dropped sharply from $73 to $64. Unlike Merck, the effect was not long-lasting: when word of merger discussions with Johnson & Johnson were made public, Guidant's stock price returned to $72.
However, in October 2005, when Johnson & Johnson stated it would not complete a merger with Guidant because of the scale of product liability issues, Guidant's stock again fell quickly, from $72 to $57.6
Taser International Corp. The prospect that its "stun gun" would provide an effective non-lethal weapon for law enforcement drove the share price of Taser International Corp. up sevenfold in 2004 to a high of $33 in late December. Reports of deaths from use of the product led to the announcement of an informal SEC investigation in disclosures about its safety in January 2005, leading to a plunge in stock price to $15. In September 2005, Taser announced the SEC had made the safety investigation formal, and the stock fell further, to $6. The company announced its legal fees and public relations expenses for the first half of 2005 were more than $12 million, double those expenses in the first half of the prior year.
Adverse stock price impact has been less significant where products disclosures would more likely result in property damage rather than consumer deaths.
Ford Motor Company and Toyota Motor Corporation. On September 8, 2005, Ford Motor Company and Toyota Motor Corporation separately announced recalls of nearly five million pickup trucks and sport utility vehicles. Ford's recall involved 3.8 million vehicles from the 1994-2002 model years, including its top-selling F-150 pickup, in which the cruise control switch system has been linked to engine fires. Ford said its inquiry found that brake fluid could leak through the cruise control's deactivation switch into the system's electrical components, leading to potential corrosion which could create a buildup of electrical current that could result in overheating and a fire. This was not Ford's first recall on this subject: in January 2005, Ford recalled nearly 800,000 vehicles from the 2000 model year because of concerns over engine fires. Ford shares rose 17 cents to close at $10.13 the same day as its recall announcement.
Toyota recalled 978,000 vehicles over complaints that a rod linking the steering wheel and drive wheels could fracture if the steering wheel is turned while the vehicle is stopped. Toyota shares fell $.07 to close at $83.78 on the day of the recall announcement.
Some Tentative Conclusions
Providing more complete early disclosures about risks of warranty claims and product failure can buttress a manufacturer's compliance with SOX obligations and offer some protection against SEC and investor claims, without seriously jeopardizing the company's share price or competitive position. The preceding examples illustrate the following propositions:
- Promptly disclosing to investors all the various risks included on product labels, as well as in public studies or articles about a product, seems to have little impact on share prices or investor attitudes. It also provides a foundation for defense of securities class action suits by showing how the manufacturer avoided undue optimism and by helping prevent inflation of the value of the company's shares. In contrast, Merck's unabashed promotion of Vioxx in its SEC reports without disclosing the same serious cautions that it printed on the labels for Vioxx have led to a disastrous loss of market value and tremendous litigation expense with investors.
- It is very difficult to sustain a public reputation for perfect products; where investors have endured multiple recalls over the years, the damage to stock prices from the latest recall may be transitory and comparatively insubstantial. Ford's experience indicates that context is everything to investors; multiple recalls, even large recalls, need not destroy share prices and trigger large securities litigation.
- Any basis for public perception that a manufacturer has knowingly withheld adverse products information from its disclosures is extremely dangerous to the company's share price and may increase prospects for the filing of securities class actions. The Merck, Guidant and Taser situations were all the more damaging to investors because of publicity indicating that more bad news may have been known but not disclosed.
- Recalls of products whose shortcomings are not life-threatening to consumers will usually not lead to deep plunges in share prices. The Ford and Toyota examples illustrate the lesser consequence paid by investors where individual injuries from products failures are less threatening, both financially and psychologically, than death.
In summary, products failures will lead to incremental litigation expense from consumer lawsuits; with appropriate early disclosures, those failures need not also trigger huge market value losses, shareholder lawsuits and SEC proceedings. Saying a bit more to investors about warranty claims and prospects of product failure will reduce their risks and may save the manufacturer a great amount in both the long term and the short term.
1 See, e.g., "Meeting the Information Needs of Investors and Creditors," Comprehensive Report of the Special Committee on Financial Reporting, American Institute of Certified Public Accountants (1994).
2 In December 2001, the SEC's Division of Corporation Finance determined it would monitor the annual reports filed by all Fortune 500 companies in 2002 as part of its process of reviewing financial and nonfinancial disclosures made by public companies.
3 SEC Release Nos. 33-8124, 34-46427, Certification of Disclosure in Companies' Quarterly and Annual Reports (Aug. 29, 2002)
4 SEC Release No. 33-8350, Disclosure Controls: SEC Interpretative Release on MD&A
5 Sec. 303, SEC Regulation SK, 17 CFR 229.303
6 When Johnson & Johnson renegotiated the tentative merger with a price reduction of $4 billion, Guidant's stock price recovered somewhat, improving further when a competitive bid was announced by Boston Scientific on December 5, 2005, only a little below Johnson & Johnson's original offer. Boston Scientific has its own history of managing products liability risks, having recalled last year 90,000 units of its most important "stent" product and surviving a federal Department of Justice inquiry without criminal penalties.