Not Everyone Thinks Pharma's Legal Liabilities Are Impossible to Calculate

Last Updated Aug 14, 2008 8:41 PM EDT

Few things are less sexy than proposed changes in accounting rules for drug companies, but bear with me -- this is actually interesting.

Lilly, Johnson & Johnson, Merck, Novartis, Pfizer and Wyeth have complained about a rule change that would require them to estimate how large their potential losses might be from lawsuits, and to disclose that to the public. Providing such estimates would be futile, costly and unlikely to provide meaningful information for investors, the companies told the WSJ.

They cite a Merck Vioxx case which at one point saw a decision giving the plaintiffs $250 million, but due to a court reversal is now worth nothing. How can such events be guessed at ahead of time, they argue. Attempting to do so would lead investors to wrongly downgrade their stocks.

In fact, most of the companies and sources cited in media coverage of this change are vehemently against the new rule, which would ask companies to provide investors with some idea of how bad things could get if that rainy day finally dawns.

You can look at some of this one-sided coverage here, here and here.

But not quite everyone thinks the proposed amendment to "FASB Statements No. 5 and 141(R)" is a load of rubbish. I went looking at the public comments submitted on FASB's rules change and found several organizations welcoming the proposal. They include the Social Investment Forum, CalPERS, The Rose Foundation for Communities and the Environment, the AFL-CIO, Jimmy Hoffa Jr. and the Teamsters' pension fund, and Domini Social Investments. (Disclosure: I have part of my retirement investment in a Domini fund.)

That's basically a lineup of America's top social and environmentally conscious investment funds, with several billions under management. The reason they support the change is simple -- they believe more information is better than less information, and that investors are not so stupid as to confuse estimated potential future losses with actual losses.

Let me add another argument: These potential losses are easy to estimate and involve exactly the same type of actuarial estimates that all these companies are already doing. Here's how you can do it:

Look at a company's past record of receiving and defending lawsuits. Look at how much all those suits could have cost, and how much they actually cost in reality. Take that total and amortize it quarter by quarter into the future, based on the current docket of suits against the company, and that's a reasonable estimate of future potential legal damages.

Lastly, the companies seem to be arguing that this rule will only punish their stock via bad information. But that works both ways: What goes down can also go up. If a stock was lowered because investors wrongly believed a future loss estimate was likely, that stock will rebound like flubber the day it becomes clear that the loss isn't going to happen.