A recent order was issued by the Securities and Exchange Commission (SEC) against Ashland Inc. (Ashland) and William C. Olasin, the former Environmental Remediation Director of Ashland. The significance of the order arises, first, from the fact that a whistleblower alleged wrongdoing in the preparation and reporting of environmental liabilities by the company and sought protection under the Sarbanes-Oxley Act. Second, it is significant that the SEC took enforcement action regarding environmental disclosure issues. Third, the SEC revealed some initial indications of the Agency’s expectations for environmental internal controls. The case suggests a potentially heightened risk for corporations if they do not establish appropriate policies, procedures, and internal controls for identifying, analyzing, valuing, and reporting environmental liabilities as required under GAAP and SEC requirements.
Let’s examine each of these points.
Environmental Whistleblower Seeks Protection under the Sarbanes-Oxley Act
I think it is quite significant that an employee of a large public company has invoked the protections of the whistleblower provisions of the Sarbanes-Oxley Act (Sarbanes-Oxley) for alleged misdeeds involving environmental disclosure. This demonstrates that Sarbanes-Oxley, while not designed to address environmental issues, must be considered by environmental staff and accountants as well as legal counsel involved in the process of identifying, valuing and disclosing environmental liabilities. Since environmental managers and their staff will be developing the base calculations for environmental reserves, where those estimates are change in a fashion that they do not feel is appropriate, the in-house environmental staff will likely be the people who report issues to compliance officers and integrity programs and invoke the whistleblower protections under Sarbanes-Oxley.
That the starting point for environmental disclosure investigations may often be employee or ex-employee complaints, is no different than traditional environmental regulatory enforcement. Many significant environmental investigations and prosecutions start with a "disgruntled employee", or a fired, former employee.
Hotlines set up for integrity programs at companies, perhaps as a compliance too under Sarbanes-Oxley, serve as a means of employees reporting issues to the company and asking for action on environmental, health, and safety issues, whether it be a traditional environmental compliance issue or one relating to environmental disclosure. These issues in some instances have to be reported to the board of directors through the audit committee.
We may start to see more complaints that reach not only management, but the board of directors. Thus, the need for external attorneys and accounts to conduct internal investigations over these matters may start to grow. Directors will probably demand that any complaint of failing to properly report environmental liabilities be investigated immediately and thoroughly by outside firms.
SEC Order Shows the SEC Will Take Enforcement Action When Allegations of Improper Environmental Disclosure Are Made
In the order, the SEC makes it clear that a public company is “required to fairly, accurately, and timely report its financial results and condition” in conformity with GAAP. “Under GAAP, items listed in financial statements must be reliable, i.e., sufficiently faithful in their representation of the underlying obligations and sufficiently free of error and bias to be useful to others making decisions based on the financial statements. Financial statements filed with the Commission that are not prepared in accordance with GAAP are presumed to be misleading or inaccurate.”
In the environmental context, the SEC stated that corporate “expenditures for environmental compliance have a significant effect on [certain companies] businesses. In particular, the SEC pointed out that the Ashland financial report stated that it reflects the company’s “estimates of the most likely costs which will be incurred over an extended period to remediate identified environmental conditions for which the costs are reasonably estimable. . . .”
SEC States That the Internal Controls for Environmental Financial Disclosure Must Be Robust, Including Management’s Review and Changes to Calculation Made by the Environmental Staff
One of the most significant aspects of the SEC order in the Ashland case may be the Agency’s review of the internal controls that resulted in the changes in the reserves. Since this process was applied to chemical and refinery sites, those in the chemical and refining industry in particular may want to pay special attention to the SEC discussion of the processes used by Ashland.
First, the SEC appeared to endorse the methods for identifying and estimating the reserves in place at Ashland at the time. Once a year, a group of engineers met with an outside environmental consultant to review each remediation site. Interestingly, the outside consultant asked that the Remediation Director not participate in this process out of concern that he might bias the process. The work sessions had two steps. First, the engineers presented each site and discussed potential remediation alternatives and the estimated cost for each one. Second, the group, including the outside consultant, critiqued each remedial alternative and the cost estimate for each. The outside consultant served as the facilitator for this discussion and critique.
Following this session in which a consensus had to be reached for each site, the consultant entered the estimates for each remediation alternative for each site into a computer program called Crystal Ball. This software is a simulation program that allows users to analyze the risks and uncertainties associated with Microsoft Excel spreadsheet models. The software uses a type of simulation called Monte Carlo analysis. This process randomly generates values for uncertain variables over and over to simulate a model. The result is a probabilistic range that can be used to determine the expected value of an environmental remediation liability. The use of Monte Carlo analysis to develop expected value estimates environmental remediation liabilities is considered to be best practice (e.g., see ASTM E2137-06). In the Ashland case, this process was used to produce future remediation cost estimates for each site.
The next step in this process is where the trouble occurred. The remediation costs estimates were provided to the Remediation Director who reviewed them for any mistakes or appropriate adjustments. According to Ashland’s policy, the Remediation Director could adjust an estimate “as long as he had a reasonable basis for doing so.” The ultimate enforcement case revolved around the adjustments made by the Remediation Director and the SEC’s view that the procedures and internal controls were inadequate for any management adjustments.
The SEC’s order states that the Remediation Director reduced the reserves at various times by set percentages for many of the sites. At subsequent times, he reduced some site remediation efforts by as much as 73 percent. The SEC enforcement arose as a result of what the Commission believed were arbitrary decisions. The Remediation Director neither documented the basis for these reductions nor developed any evidence the estimates he received were over estimated by the percentages they were reduced. In one year, this reduction in environmental reserves increased the net income of the company for the relevant period by 6.7 percent.
The SEC initiated the enforcement action not only to address these undocumented reductions, but also to address the changes in the cost estimates produced by the Monte Carlo analysis. The Agency found the internal controls to be inadequate “because they did not establish guidelines for, or require documentation or review of, adjustments to the engineers’ cost estimates.” In 2001, the company developed procedures permitting management to make adjustments in the initial estimates. No guidelines were set and no documentation or review of adjustments were required.
The focus on this issue may reflect a concern of the SEC that without established written policies and procedures, the environmental reserves may be a potential area for manipulation of earnings.
SEC Orders Ashland to Change Its Internal Controls and to Engage an Accounting Firm to Review Its Internal Controls
As a result of its factual and legal findings, the SEC ordered Ashland to take several steps.
- Document all adjustments to its environmental remediation estimates and the reasons for each adjustment to form a complete audit trail for environmental estimates.
- Retain relevant records for seven years.
- Require the manager to consult with the outside remedial engineer on each adjustment.
- Conduct annual best practices reviews with the company’s outside auditor.
- Prevent Olasin from having any involvement with environmental reserve estimates and disclosures.
- Retain PricewaterhouseCoopers (PWC) to review its policies, procedures and internal controls relating to environment reserves, its procedures to address internal complaints, and to submit the reports to Ashland’s audit committee and the SEC a full report.
- Review and adoption of PWC recommendations by the audit committee or full board of directors, or alternative policies or procedures reviewed and approved by PWC.
Would the Ashland Case Be Worse If Sarbanes-Oxley Had Applied?
The Ashland case involved events that pre-dated the Sarbanes-Oxley Act. The SEC cited violation of SEC regulations and the Exchange Act. I think without belaboring this issue, a case like this prosecuted under the provisions of the Sarbanes-Oxley Act may have subjected the individuals involved and the company to greater liability.
First, Sections 302 and 906 of Sarbanes-Oxley requires that the financial reports “fairly present” the financial condition and results of operations of the entity and that the company has complied with the Securities Exchange Act. Without justification for the adjustments in environmental reserves, the ability to attest to the financial reports may be questioned by the SEC and the financial auditor. Section 404 requires that management of public companies report annually on the effectiveness of the company’s internal control over financial reporting, and that the accounting firms auditing these companies review and report on the adequacy of internal controls. After the Ashland case, the auditing firms may begin to more critically review the internal controls and policies and procedures used by the company to estimate and disclose its environmental liabilities. At least one of the major accounting firms is applying particular attention to these matters.
Finally, Sarbanes-Oxley imposes civil and criminal liability under provisions not in effect in at the time of the events in the Ashland case. The CEO and CFO certifications are usually based on “sub certifications” by lower level staff, such as the environmental managers in the case of environmental disclosure estimates and reporting. As discussed above, as environmental managers and staff are called upon more and more to sign sub certifications for environmental estimates, they will feel increasing pressure to report anything they feel is inappropriate and, if they believe there is something amiss in what is finally reported on financial statements and in SEC reports, may become whistleblowers under Sarbanes-Oxley.
Taking into account the SEC review of environmental internal controls in the Ashland case and the greater burden now imposed by the Sarbanes-Oxley Act, management and directors of public companies should consider requiring a review of the corporate policies and procedures and internal controls for preparing and reporting environmental financial liabilities.