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The Year 2000 Problem and Corporate Disclosure
Obligations
Periodical: The Business Suit
It is the rare American who has
not at least heard of the computer programming glitch commonly known
as the Year 2000 (or “Y2K”) problem.
The Y2K problem arises because most computers (including
so-called “embedded” chips incorporated into automobiles,
elevators and countless other mechanisms) are programmed to use only
two digits to identify years in dates, with the software being
instructed to assume that the date is in the twentieth century. Thus, when the year 2000 rolls around, any systems using such
software will read the date as January 1, 1900. The result of this programming convention is that affected
computers or embedded chips will miscalculate dates, resulting in
miscalculations of ages, benefits, interest and other amounts which
could lead to missed deadlines, over- or under-billing for services
and system crashes.
If such consequences eventuate,
those arguably responsible (potentially including the affected
businesses and their officers and directors, software providers and
consultants, and their suppliers), could face lawsuits under legal
theories including negligence, professional malpractice, breach of
warranty, fraud and others. Thus,
depending on the facts of a particular case and the applicable law, a
non-Y2K-compliant company may face substantial liabilities.
In addition, the costs of remediating computer systems to
achieve a Y2K “fix” can be substantial.
For example, it has been estimated that the cost of a Y2K
makeover for a major financial institution like the Chase Manhattan
Bank would be between $200 and $300 million.
These costs and potential
liabilities create significant issues for corporations under an
obligation to make disclosures in periodic reports made pursuant to
the Securities Exchange Act of 1934 (the “1934 Act”) and/or in
registration statements pursuant to the Securities Act of 1933 (the
“1933 Act”). Generally,
“a disclosure duty exists where a trend, demand, commitment, event
or uncertainty is both presently known to management and reasonably
likely to have material effects on the registrant’s financial
condition or results of operation.”
Securities Exchange Act Release no. 6835, text at n. 23 (May
18, 1989). The test for
determining materiality consists of two steps. First, the company must objectively determine if the known
trend, event or uncertainty is reasonably likely to occur: if not, no disclosure is required. Id., text at n. 27. Second, if the company is unable to determine that the known
trend, event or uncertainty is not reasonably likely to
occur, it must assume it will occur and determine
whether it is reasonably likely that the trend or uncertainty will
have a material effect on the financial condition or results of
operations of the company. Id.
Such disclosures of material facts
must be made in registration statements or prospectuses associated
with the initial offering of securities, as well as in periodic
reports pursuant to the 1934 Act such as the Annual Report on Form
10-K. In addition,
disclosures may also be necessary in certain circumstances to avoid
liability under Rule 10b-5 pursuant to Rule 10(b) of the 1934 Act, ,
which allows a civil cause of action against any person who, in
connection with the purchase or sale of any security, makes an
“untrue statement of a material fact or omit[s] to state a
material fact necessary in order to make the statements made, in the
light of the circumstances in which they were made, not misleading.”
(Emphasis added.) A disclosure necessary to avoid a misleading omission or to
correct prior statements in light of new facts may be made by press
release, in a Current Report on Form 8-K or otherwise.
Failure to make adequate
disclosures can result in substantial liability to corporate
management under various statutes.
For example, Section 11 of the 1933 Act imposes liability for
(1) making an untrue statement of material fact in a registration
statement or prospectus or (2) omitting to state a fact necessary to
be disclosed in order to make the statements contained therein not
misleading. 15 U.S.C. §
77k(a). Section 11
liability applies to (1) any persons who signed the registration
statement; (2) any director of the issuing company (regardless of
whether the director has signed the registration statement); (3) any
expert such as an accountant, engineer or appraiser whose work is
incorporated into the registration statement; and (4) underwriters.
Id. (Pursuant
to 15 U.S.C. §§ 77k(f) and 78u-4(g), outside directors are only
liable in proportion to their fault unless they knowingly violated the
securities laws).
Similarly, section 12(2) of the
Securities Act imposes liability on offerors and sellers of securities
for misstatements or omissions in a prospectus unless the defendant
shows (1) he did not know and (2) in the exercise of reasonable care,
could not have known of the alleged material
misstatements. 15 U.S.C.
§ 77l(2). Section
12(2) liability does not apply to directors and officers who are not
involved in soliciting the sale of securities for financial gain.
Section 15 of the Securities Act imposes liability on
“controlling persons” of an issuer for violations of Sections 11
and 12. To recover under
Section 15, however, a defendant must be shown to have actual power to
direct corporate affairs. Durham
v. Kelly, 820 F.2d 1500, 1502-04 (9th Cir. 1987).
Finally, misstatements or non-disclosures may also give rise to
liability under Rule 10b-5.
Accordingly, public corporations
making disclosures to shareholders are faced with the choice of
generously estimating the magnitude of Y2K-related costs and potential
liabilities (with the inevitable depressing effect this will have on
share prices) or casting them in a less alarming light (thus risking
shareholder litigation or SEC action). In an effort to clarify corporate disclosure obligations in
this area, on January 12, 1998, the SEC Staff revised its
previously-issued Legal Bulletin No. 5 (the “Bulletin”) on Y2K
issues to provide a suggested protocol for Y2K disclosures.
Although the Staff Legal Bulletin is not a binding SEC rule or
regulation, its contents are [not unreasonably] widely assumed to be
predictive of positions the SEC may take.
At the very least, compliance with the Bulletin’s suggestions
may be cited (however persuasively) as evidence of the reasonableness
of a corporation’s disclosure.
The Bulletin contains the
following guidelines for Y2K-related disclosures:
First the Bulletin makes clear
that, if a company has not made an assessment of its
Year 2000 issues or has not determined whether it has material Year
2000 issues, disclosure of such known uncertainty is required.
The Bulletin also states that the materiality of a company’s
Y2K issues relative to the enterprise’s business, operations or
financial condition must be determined without regard to
so-called “related countervailing circumstances (such as Year 2000
remediation programs or contingency plans).” If the enterprise’s Y2K issues are determined to be
material without regard to countervailing circumstances, the company
should disclose both the “nature and potential impact of the Year
2000 issues as well as the countervailing circumstances.”
Specifically, the Bulletin states that at least
the following topics should be addressed by the disclosure:
-
The company’s “general
plans” to address Y2K issues relating to its business, its
operations (including operating systems) and, if material, its
relationships with customers, suppliers, and other
“constituents”;
-
The company’s timetable for
carrying out those plans;
-
If expected to be material,
the total dollar amount that the company estimates will be spent
to remediate its Y2K problems;
-
Any material impact these
expenditures are expected to have on the company’s results of
operations, liquidity and capital resources.
The Bulletin admonishes that any
disclosures must “be reasonably specific and meaningful, rather than
standard boilerplate.” Clearly,
the sufficiency of any disclosure depends on the specifics of a
company’s financial situation and Y2K remediation status.
However, the following specimen of disclosure suggests some
elements which may be considered for inclusion in corporate
disclosures, depending on the specific circumstances of each case.
Year 2000 disclosure issues will
also affect accountants’ obligations in conducting audits.
Preparation of a company’s financial statements are guided by
“generally accepted accounting principles” (“GAAP”),
promulgated by the Financial Accounting Standards Board (“FASB”)
and the American Institute Of Certified Public Accountants (“AICPA”).
Pursuant to Statement of Financial Accounting Standards No. 5
(“SFAS 5”), financial statements must include a note identifying
all contingencies which are reasonably possible, whether or not the
amount can be calculated or estimated.
Moreover, SFAS 5 may require that certain estimated losses
(specifically, losses that are “probable”) be charged against
earnings, provided that an asset has been impaired or a liability
incurred as of the date of the financial statements and that the
amount of loss can be reasonably estimated.
In view of the above, a
company’s auditors may consider it advisable, even necessary, to
evaluate the business’ Y2K status in the course of conducting an
audit of its financial statements. Such a course may be advisable both in order to ensure
compliance with the guidelines set forth in the AICPA’s Generally
Accepted Auditing Standards (“GAAS”), as well as to avoid
potential liability under the heightened due diligence standards
applicable to “experts” under Section 11(b) of the Securities Act.
Thus, auditors may decide to include in their opinions specific
explanatory reference to any notes in financial statements respecting
Y2K contingencies, or to qualify its opinion to expressly exclude from
its scope any representations or assurances respecting Y2K
liabilities.
In short, both corporations and
their accountants face numerous thorny issues affecting their ethical
and legal obligations (and potential liabilities) in connection with
disclosures relating the Year 2000 problem.
Evaluating the required scope and content of Y2K disclosures
will require considerable factual inquiry and the exercise of
carefully considered professional judgment.
The only certainty is that inaction is no longer an acceptable
option.
Our Litigation
Department specializes in civil litigation at all levels of the
judiciary, and has wide-ranging experience in litigating business,
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extensive experience in accounting and partnership, antitrust, and
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liability litigation as well as in the appellate practice.
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Meyer & Susman was founded in 1957.
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