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The SEC is still dogging banking behemoth Wells Fargo & Company with questions about its handling of the now 10-year-old customer cheating nightmare, first reported by the Los Angeles Times in 2013. The Consumer Financial Protection Bureau settled with the bank for a $185 million fine back in September 2016, but since then the bank has paid billions more to public and private punishers.

On June 14, 2023, the SEC issued a comment letter to Wells Fargo & Company (Ticker: WFC) requesting more transparency regarding the historical legal, regulatory, and customer remediation matters covered by a series of operating charges for $7 billion, $1.5 billion, and $3.5 billion in the years ended December 31, 2022, December 31, 2021, and December 2020, respectively.

In its June 29, 2023, response to the SEC, Wells Fargo provided details of several large cases that contributed to the $7 billion charge and noted that the bank does not generally break the accruals down by individual matters because it may “hinder …negotiations or settlement discussions” – an argument commonly used by companies to obfuscate disclosure of legal contingencies.

Uber's Legal Contingencies - Can SEC Inquiries Add Clarity to "Unprecedented" Legal Charges?

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November 1, 2023

On October 24, 2023, the SEC issued a follow-up letter to Wells Fargo with three requests:

• Provide a breakdown of operating charges separately for legal, regulatory, and customer remediation categories.

• Provide more clarity regarding expenses for customer remediation matters and an explanation of whether new developments or updates to historical developments contributed to the operating charges.

• Clarify why the $7 billion fiscal 2022 charge was more than twice the high-end earlier estimate of $2.9 billion as of December 31, 2021.

The third request may be explained with more context.

Accounting guidance states that a loss contingency should be accrued if it is both probable and reasonably estimable.

According to Wells Fargo, the bank records accruals — charges to expense that hit net income — at the lower end of the range for its losses that are both probable and reasonably estimable. Wells Fargo provided the following disclosure in the Legal Actions section (emphasis added) of its December 31, 2021, annual report:

We establish accruals for legal actions when potential losses associated with the actions become probable and the costs can be reasonably estimated. For such accruals, we record the amount we consider to be the best estimate within a range of potential losses that are both probable and estimable; however, if we cannot determine a best estimate, then we record the low end of the range of those potential losses.

However, as we discussed in our previous piece, investors are often left in the dark about the amount and the timing of the accruals for a specific case until the case is settled.

In addition, when a contingency is reasonably possible but not probable – an accounting term that implies that there is a less than 50% probability that the loss would materialize — the expected range of loss needs to be disclosed but does not need to be accrued. From the Wells Fargo 2021 Annual Report disclosure (emphasis added):

OUTLOOK. As described above, the Company establishes accruals for legal actions when potential losses associated with the actions become probable and the costs can be reasonably estimated. The high end of the range of reasonably possible potential losses in excess of the Company’s accrual for probable and estimable losses was approximately $2.9 billion as of December 31, 2021.

The $2.9 billion high-end loss estimate implies that should the plaintiffs prevail in all the cases included under the “outlook” section, the most the bank would have to record is an additional $2.9 billion in losses.

So, if the maximum exposure was supposed to be $2.9 billion, how did Wells Fargo end up with $7 billion in operating losses?

Let’s look at the breakdown of the $7 billion charge provided by Wells Fargo in response to the SEC’s comments but not in its 10-K filing for the year ended December 31, 2022:

According to Wells Fargo, the discrepancy between the disclosed $2.9 estimate and the actual $7 billion charge is attributable to losses that were not estimable – such as customer remediation charges. Customer remediation charges are what Wells Fargo eventually had to reimburse or pay as compensation to harmed customers.

In its response to the SEC, Wells Fargo elaborated on why the customer remediation loss amount was so difficult to estimate (emphasis added):

Customer remediation

The expense for customer remediation activities in 2022 predominantly resulted from the further refinement in third quarter 2022 of the scope of remediation for historical mortgage lending, automobile lending, and consumer deposit accounts matters. This further refinement led to the higher expense in 2022 and was not estimable prior to completion of the work in third quarter 2022. In addition, there were expense amounts for customer remediation activities in fourth quarter 2022 primarily related to the December 2022 CFPB consent order.

As discussed in our prior response letter, customer remediation matters often span multiple years, and typically require reviews and discussions with internal and external parties, including communications with our regulators, which may result in variability related to the timing and the determination of the amount of loss. These reviews and discussions may result in expansions of populations of affected customers and/or time frames, as well as changes to customer remediation payment amounts.

We establish an accrual for the probable and estimable costs related to each customer remediation matter, which amounts are refined over time in light of any additional information; however, given the complexity and unpredictability of these matters, it is not possible to determine the ultimate loss or reasonably estimate possible loss in excess of amounts accrued until these reviews and discussions are complete.

The conversation between Wells Fargo and the SEC illustrates the current limitations of the GAAP accounting standard that applies to these issues, ASC 450. Specifically, the standard allows for ambiguous disclosure and significant judgment and discretion when estimating loss contingencies despite the fact they often lead to material unexpected charges.

As reported for Market Watch — by co-author McKenna — after Wells Fargo’s $185 million settlement with the SEC in 2016, the impact of regulatory actions and investigations is notoriously difficult to estimate:

Given the uncertainty surrounding the outcome of most governmental investigations, the decision about when to disclose to the SEC and investors and the public can be difficult judgment calls for executives to make.

As we progress through the earnings season, the SEC’s comments to Wells Fargo about this case provide a helpful framework for evaluating the impact of legal contingencies.

More specifically, investors should consider the following questions when reviewing these disclosures, or the lack of disclosures:

• What fraction of the legal costs has already accrued, and when were the costs accrued?

• What is the high-end estimable loss, and does this estimate seem reasonable given the company’s and industry’s litigation environments?

• The ability to estimate losses is likely to improve as negotiations progress and each side gets a better understanding of the other side’s arguments. How many legal cases are in the early stage, so the loss cannot yet be estimated?

• How significant is the loss that cannot be estimated at the time of the filing?

Finally, this framework is generalizable to other companies with significant public or private litigation exposure. For instance, using Calcbench’s XBRL Data page, we identified at least 98 S&P 500 companies – including large banks such as JPMorgan Chase (Ticker: JPM) and Citigroup (Ticker:C) - that disclosed the range of possible losses in excess of losses that were already accrued. (Note that our search is not comprehensive because companies are inconsistent in tagging loss contingencies.)

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