Valuation of contingent liabilities: some risk management considerations for lenders

RMA Journal, The, Sept, 2005 by Benjamin S. Seigel

Finding little information on valuating contingencies beyond FASB's Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, the author, a California attorney, went on to tackle the problem for himself and now shares that information with Journal readers.

Lenders, at least the ones I know, seem to spend a great deal of time, effort, and money evaluating the asset section of their borrowers' balance sheets. They will frequently retain appraisers to provide values of such significant assets as:

* Furniture.

* Fixtures.

* Machinery.

* Equipment.

* Inventory.

* Accounts receivable.

* Patents.

* Trademarks.

* Copyrights.

* Customer lists.

* Real estate.

* Leasehold interests.

* Motor vehicles.

* Rolling stock.

Those lenders also attempt to determine the nature, extent, and validity of the borrower's liabilities, particularly accounts payable, accrued operating expenses, accrued salaries, other employee benefits, and whatever else the borrower or its accountants have chosen to state on the balance sheet.

However, I question the amount of attention devoted to the valuation of contingent liabilities--in particular, pending, threatened, and remotely potential litigation and governmental action--based on the lack of information available to assess their risks. The starting point for my analysis of this problem is the only writing of any substance I have found on the subject:

Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, promulgated by the Financial Accounting Standards Board of the Financial Accounting Foundation.

Statement of Financial Accounting Standards No. 5 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise. The uncertainty factor would ultimately be resolved when one or more future events occur or fail to occur. SFAS No.5 defines three classes of contingencies: probable (likely to occur), reasonably possible (more than remote but less than likely), and remote (slight chance of occurrence). Although SFAS5 teaches how to identify and report contingencies, it does not provide a standard for valuation of loss contingencies that can be used by a lender, nor does existing literature or law shed any light on such standards.

Some contingencies quickly become unwieldy and difficult to assess: expropriation of assets and catastrophes caused by weather, earth movements, plagues, famine, locusts, frogs, and other events of biblical proportions. Therefore, this article is confined to an exploration of the valuation of risks attendant to litigation and governmental action.

A Hypothetical Borrower

Question of Balance, Inc. (QBI) was formed 10 years ago by a group of high-net-worth engineers who had invented a vehicle that could operate on a combination of salt water, hydrogen, methane, and oxygen. After years of research and development work, QBI developed a prototype vehicle that could go 50 miles per hour for 10 hours at a time without refueling. The small vehicle held only the driver; chemical tanks and equipment used all remaining space. However, QBI was certain that with some additional R&D work, the size and passenger capacity could be increased and demand for the vehicle would be overwhelming.

So certain was the firm that it retained investment bankers to initiate an initial public offering (IPO) of its stock, engaged dealers in 20 states for its soon-to-be-produced four-passenger QBIMobile, and applied to Little Bank of Detroit (the Bank) for a $25 million loan to be repaid from the proceeds of the impending IPO.

While the loan application was being completed, the Securities & Exchange Commission (SEC) raised concerns about the disclosures in the Registration Statement filed in connection with the IPO and threatened to bring action against the company and its principals. The attorneys general of 18 of the 20 states where the new dealers were located raised concerns and threatened to conduct investigations about potential violations of the states' franchise investment laws. When the Federal Trade Commission (FTC) got wind of those state activities, it opened an investigation regarding possible violations of federal franchise investment laws. Those actions received so much press that the federal Environmental Protection Agency (EPA) and similar agencies from 10 states opened investigations regarding possible violations of air pollution laws resulting from the exhaust emitted by the QBIMobile. Meanwhile, four female employees filed suit against the company and four of its principals for sexual harassment resulting from activities following the celebration held to introduce the QBIMobile concept car to the motoring public.

Preparing to Assess the Risk

QBI submitted with its loan application an audited balance sheet prepared by its regular outside CPAs. The liability section of the balance sheet disclosed the actions of the governmental agencies and reflected the pending harassment litigation. QBI also provided reasonably detailed footnotes to the statement; however, no dollar value was assigned to these contingencies. The assets of the company consisted principally of machinery and equipment with a fair market value of $18,000, a commercial building with equity of $7 million, and intellectual property valued at $50 million. The stated liabilities of $400,000 consisted of accounts payable and an accrued amount due to the company's employee benefit plan. There were no tax liabilities shown, nor were there any loans to or from officers or other insiders. The principals agreed to guaranty the Bank's loan and secure their guaranties with improved real property located in major markets.