[IMGCAP(1)]The impact of a class-action settlement can be devastating for a company not just in terms of the potential financial settlement costs and related expenses, but also in terms of degradation to the financial statements.

Class-action settlements typically have a maximum payout established by the parties and approved by the court. Once the settlement has been approved, the process can take months or even years for the settlement to become final and the claims process to be completed. All the while, the settling company has to carry the liability for the full amount of the claims-made settlement fund on its books.

The actual claim rate can vary dramatically, thereby creating uncertainty as to the actual financial cost of the settlement which can wreak havoc on a company’s liquidity and financial planning.

U.S. GAAP mandates that a company is required to disclose any asset impairment or liability incurrence that is considered to be “probable.” Since a class-action settlement agreement creates a known and probable liability, GAAP requires that the company book the entire settlement and assumes 100 percent “take rate” participation in order to provide legal and financial transparency to the public regarding the claim.

Thus, when a company settles a class-action lawsuit and establishes a claims-made process, it has two choices: (1) take a charge on its financial statements for the entire amount of the settlement, thereby possibly devastating its financial position with shareholders and others, or (2) purchase insurance, thereby capping its maximum net liability to the amount of the insurance premium.

Even in the event that the contingent loss cannot be easily estimated or the loss contingency is only “reasonably possible” (i.e., less than likely but more than remote), GAAP requires that a company must still disclose the nature of the contingency. “Disclosure” of the loss contingency generally involves the “nature of the contingency” and, to the extent known, an estimate of the possible loss (or a statement that an estimate cannot be made).

In addition, the disclosure should include the basis of the claim, the progress of the case (including progress after the date of the financial statements but before those statements are issued), the opinions or views of legal counsel and other advisers, the experience of the company in similar cases, and any decision of the company's management as to how the enterprise intends to respond to the lawsuit (e.g., defend vigorously) or assessment.

Financial accounting of contingencies is governed by the Financial Accounting Standards Board’s Accounting Standards Codification Topic 450, also known as ASC 450. As a consequence of the ASC 450 regulations, a company is generally obligated to provide substantial information regarding a class-action settlement and how it originated. The company can be adversely impacted by both the description of the underlying facts giving rise to the class litigation, as well as the GAAP charges for fully booking the settlement on the financial statements.

The obligation to report litigation applies to both public and private companies. Further, because a settlement may continue for months or even years, the liability and disclosure requirement can linger. A company may find itself in a position where the negative impact of the settlement must be disclosed over numerous quarters or years.

In addition to the reporting requirements of ASC 450, the Securities and Exchange Commission mandates reporting requirements on Form 8-K, requiring that a company disclose class-action settlements if the settlement is classified as a “material definitive agreement.”

The definition of “material definitive agreement” includes an agreement that provides for obligations that are material to and enforceable against the company. A company must disclose the following information upon entry into, or material amendment of, a material definitive agreement:

a) The date on which the agreement was entered into or amended, the identity of the parties to the agreement and a brief description of any material relationship between the company or its affiliates and any of the parties, other than in respect of the material definitive agreement or amendment; and

b) A brief description of the terms and conditions of the agreement or amendment that are material to the company.

Generally, the filing of Form 8-K must be done within four business days after the occurrence of the “event” (i.e., the class-action settlement that triggers the filing of the form). In addition, the filing of Form 8-K may constitute the first “public announcement” for purposes of Rule 165 under the Securities Act of 1933. Also note, a Form 8-K filing mandates that the company’s next quarterly report must include a disclosure of the material definitive agreement, which will include the full amount of the class-action settlement fund.

The nature of disclosure must be carefully considered by the company. ASC 450 mandates that certain loss contingencies must be disclosed in financial statements regardless of whether the loss is determined to be probable or reasonably possible. For example, assume Company X is forced with “probable” loss contingencies in the form of a $250 million class-action settlement; this amount must be reported as an accrued liability. Furthermore, Company X must provide a detailed explanation of the nature of the claim, the process, and other important aspects of the contingency (including how it will be funded). These important aspects may include relevant names, issues, or components of the litigation.

On Company X’s next financial statement, investors will be able to ascertain the fact that a potential $250 million liability is an obligation of the company, and be able to review as well supplemental information regarding the claim. In addition, Company X will be required to continue filing SEC and financial statement reports regarding the status of the claims and any other aspects of the underlying litigation. It should also be noted that failing to properly disclose a contingency in compliance with ASC 450 is classified as “financially unrepresentative” under the Sarbanes-Oxley Act of 2002, and could cause criminal charges to company management.

Even if the loss is deemed to be “reasonably possible,” footnote disclosures must be included in the company’s financial statements, thereby notifying the financial statement reader of the potential for loss and economic drain on the company. In either case, the class-action settlement will have a significant detrimental impact on the company’s financial statements.

Tax Treatment of Class-action Settlements
Considering the proliferation of litigation in today’s business world, it would seem reasonable that all the costs associated with settling lawsuits would be considered an “ordinary and necessary” business expense and thus deductible under Section 162 of the Internal Revenue Code. However, every experienced tax professional knows that the code is rife with exceptions and restrictions that can trap the unwary. Consequently, given the magnitude of most class-action settlements, the wise tax professional will examine the facts carefully to determine appropriate tax treatment for class-action settlements.

Section 162 provides, in part, that all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on trade or business may be deducted. Like most IRC rules, there are numerous exceptions to this general rule. In order to determine whether the payments to class members may be tax deductible, settling parties must consider the implications of Section 162(c)(2) and Section 162(f), which prohibit deductions for payments deemed to be illegal under U.S. or state law and payments for any fine or similar penalty paid to a government for the violation of any law, respectively.

In Talley Industries Inc. v. Comm., a case that ping-ponged back and forth between the Tax Court and Ninth Circuit Court, the central issue was whether the settlement was penal in nature which would prohibit the company from taking a tax deduction. The courts did in fact come to this conclusion. The courts were unpersuaded by how the settlement was classified or labeled in the settlement documents but rather reached the conclusion that the payment represented double damages under the False Claims Act and was consequently a nondeductible payment regardless as to what the parties tried to call it.

Talley Industries is just one of a multitude of cases where the IRS disallowed the deduction for settlements of lawsuits. Each class-action settlement must be evaluated separately to determine the proper tax return treatment based upon a review of the underlying transaction.

In summary, based upon the Tax Code, interpretative rulings, and case law, settling parties need to be aware that not all class-action settlements will result in tax deductible payments to class members.

The deductibility of class-action settlement costs is dependent on tracing the origin of the claims asserted in cause of the class-action lawsuit back to the source of the litigation and the origin and character of the claim and nature of the ultimate payment. To the extent the litigation arose from acts that can be construed to have been conducted in the ordinary conduct of the taxpayer’s business, a current tax deduction is warranted. In contrast, if the settlement and payment represents a fine or statutory penalty, then the payments are likely not tax deductible.

Further, to the extent the litigation arose from a capital transaction such as the acquisition of an asset or in a claim relating to ownership rights to a capital asset, Section 263(a) requires capitalization of class-action settlement payouts and related costs.

If capitalized, the deduction of settlement costs may be required to be spread over a number of years or the deduction may be disallowed entirely. This second scenario is problematic in that the settlement creates the degradation to the financial statements with no corresponding tax benefit.

Nightmare Scenario
Let’s go back to Company X, which was involved in a $250 million class-action settlement. This amount must be reported as an accrued liability and Company X must provide detailed disclosure of the claim to alert readers to the liability. Ongoing, quarterly disclosure will also be necessary and the current financial statements for Company X will show a charge to income of $250 million.

The management of Company X may attempt to spin the settlement in a positive light, but it will most likely be difficult to convince investors that a $250 million loss is anything but a significant loss that harms not only the company’s economic position, but also the investor’s individual investment in the company.

Additionally, attempts to minimize or mitigate the real economic impact of the settlement may set up the company for potential shareholder derivative and securities fraud lawsuits.

Worse still, if the claim is found to have arisen from a capital transaction or is punitive in nature the loss may not be deductible on the tax return further harming the company’s financial position.

Even if the claim is deemed to be deductible, the company is further exposed to scrutiny by the IRS and potentially the necessity of defending the tax position.

Insurance: the Risk Transfer Alternative
A company that is entering into a claims-made settlement of a class-action lawsuit has only two paths it can take when booking the settlement and preparing its tax return. First, it can adhere to current ASC 450, Form 8-K and other disclosure requirements and take a GAAP charge for the full amount of the claims made settlement fund and review the facts and circumstances of the settlement to determine the proper tax filing position.

This approach can cause shareholders (both present and prospective) to impugn the company’s financial stability, which directly influences its capital reserves and operations. In addition, the tax consequence either further harms the company or opens an avenue for IRS scrutiny.

As an alternative, the company can insure the class-action settlement, which will effectively transfer the settlement liability from the company to the insurer. The purchase of an insurance policy for a specific class-action case can help minimize the economic, tax and investor disapproval exposure and result in more benign financial disclosure as the net liability is represented by the paid and incurred insurance premium.

The specific accounting treatment of the settlement and the insurance touch on numerous provisions under GAAP and must be evaluated on a case-by-case basis. Generally, with respect to the financial reporting requirements under ASC 720, insured entities recognize a liability for the probable losses from incurred but not reported claims and incidents if the loss is both probable and reasonably estimable. There is not a general rule that would eliminate the liability even with insurance in place unless certain requirements have been met.

Once the insurance is in place, a company would normally continue to present the liability on its balance sheet, but also report an insurance receivable for claims that the insurance contract will pay. The practical effect of this accounting treatment is that the settlement liability is balanced against the insurance asset thereby mitigating the ultimate financial impact of the claims made settlement fund.

Assuming the insurance covers 100 percent of the expected loss contingency; the balance sheet will contain both an asset and a liability in the same amount. The net impact on the income statement would be a charge for the cost of the insurance only rather than the charge for the entire amount of the claims made settlement fund.

Directly offsetting prepaid insurance and receivables for expected recoveries from insurers against a recognized incurred but not reported liability or a liability incurred as a result of a past insurable event is not appropriate. While at first blush it would seem that the liability and insurance receivable could offset and simply be eliminated from the statement, the fact that the liability has not been extinguished or legally released requires that the reader of the financial statements be made aware of the potential continuing obligation of the company in the event that the insurer is unwilling or unable to honor the insurance contract.

While insurance can be effectively used to eliminate or mitigate the GAAP charges arising out of the settlement, it is also a critical tool for tax purposes. Companies can face class-actions arising out of both federal and state statutory schemes including but not limited to the Telephone Consumer Protection Act, the Video Privacy Protection Act, and the Fair and Accurate Credit Transactions Act. These laws provide for statutory or punitive damages for violations. For this reason, many courts have taken the position that liability for the underlying conduct is not insurable.

A company faced with a class-action settlement must accept the variability of the class-action suit and GAAP charges on its financial statements, or obtain class-action settlement insurance coverage, thereby limiting the company’s exposure by fixing its loss to the amount of the insurance premium.

Companies need to weigh carefully the financial and investor impact of the charge against earnings, the ultimate take rate risk, the issue of tax deductibility, and the certainty and finality of the insurance alternative in order to determine whether the purchase of insurance will provide the best option to mitigate the financial and tax impact of the class-action settlement liability.

Peter Robbins, CPA, became a partner with CliftonLarsonAllen LLP in November 2011 when his predecessor firm, Middleton, Burns & Davis, merged into CLA. He was a shareholder of MBD and had been with the firm since January 1998. Previously he spent seven years with Ernst & Young in Milwaukee and four years with Grant Thornton in Dallas.