INFORMING THE INVESTOR, STIFLING THE SHAREHOLDER SUIT:
Passed in late December over Clinton's veto, the Private Securities Litigation Reform Act of 1995 encourages public companies to disclose forward looking information by protecting them from suit if that information does not come to pass.
Late in December, the most important securities legislation in decades became law. The Private Securities Litigation Reform Act of 1995 had a difficult labour and birth. Its infancy promises to be no less tempestuous, as litigants await definitive appellate construction of the new statute.
The Reform Act contains important procedural provisions intended to end abuses that have marked the shareholder class action phenomenon.
The legislation also changes various substantive legal requirements and remedies. But by far the most important provision for public companies is the new safe harbour for forward looking information.
The safe harbour seeks to encourage public companies to disclose forward looking information by protecting them from suit if that information does not come to pass. Corporate counsel and investor relations personnel will want to review their company's' disclosure practices to ensure thorough implementation of the safe harbours requirements. The statute's protection is worth the effort.
CREATING THE SAFE HARBOUR:
When the 104th Congress turned to securities reform, creation of a safe harbour changed markedly as the legislation went from committee to floor passage in each house. With substantial participation by the SEC, the conference committee finally hammered out a compromise Nov.28, 1995. The bill reported out by the conference committee was passed by the senate on Dec. 6 and by the House on Dec. 7. It was vetoed by President Clinton on Dec. 19. The House overrode the veto Dec.20 and the Senate on Dec 22.
This statutory safe harbour (contained in S.102 of the law) creates a new 27A of the Securities Act of 1993 and a corresponding 21E of the Securities Act of 1933 of the Securities Exchange Act of 1934.
[citations in this article are to the provisions amending the 1993 Act (contained in 102(a) of the new Statute);unless other wise noted, identical provisions can be found in the 1934 Act provisions as well.]
The safe harbour defines "forward looking statement" broadly, including projections of future financial results, statements of plans and objections for future operations, statements economic performance, required disclosures in MD&A, and statements of assumptions related to the foregoing 27A(I)(1). See Securities Litigation Reform, H.R. Rep. No. 104-369, 104th Cong., 1st Sess., as 45-46 (Nov. 28 1995) (Joint Explanatory Statement of the Committee of Conference).
The safe harbour consists of two prongs: The first focuses on the company's cautionary statements; the second, on the company's knowledge of falsity. The prongs are joined by "or" meaning that a plaintiff must prevail on both prongs to survive a motion to dismiss.
PRONG ONE: THE COMPANY'S STATEMENTS:
The heart of the safe harbour is 27A(c)(1)(A)(I), which provides that a company "shall not be liable with respect to any forward looking statement, to any whether written or oral, if and to the extent that the forward looking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in he forward looking statement; or is immaterial." That densely packed sentence invites Talmud like scrutiny.
To fall within this provision, a company must satisfy two requirements. First, it must identify the statement in question as a forward looking statement. Compliance with this requirement does not require much creativity: e.g., "the following information constitutes a forward looking statement within the meaning of 27A, etc., and is subject to the safe harbour created by that section."
The more challenging aspect of Prong One is the second requirement: inclusion of cautionary statements. Many lawyer years will be sent litigating the meaning of the two dozen words that make up this clause. Fortunately, the Conference Committee that crafted the legislation provided substantial guidance in its report on the bill. Report at 31-49. Five issues are especially noteworthy.
First, the Conference Committee set forth the parameters of what constitutes adequate disclosure. The requirement of "meaningful cautionary statements" means that "boilerplate warnings will not suffice." Rather, "the statements must convey substantive information about factors that realistically could cause results to differ materially from those projected in the forward looking statement, such as, for example, information about the issuer's business." The standard of "important factors" has two components: The factors identified "must be relevant to the projection "and they "must be of a nature that could actually affect whether the forward looking statement is realised." The statutory reference to "important factors" is designed "to provide guidance to issuers" - "not to provide an opportunity for plaintiff counsel to conduct discovery on what factors were known to the issuer at the time." Report at 43-44.
Second, the Conference Report emphasised that the cautionary statements need not identify "all factors" that could cause results to differ from the projections. "Failure to include the particular factor that ultimately causes the forward looking statement not to come true will not mean that the statement is not protected by the safe harbour." A company's projections will be protected even if it does not identify the specific risk that later causes disappointing results.
Third, the safe harbour does not protect a "cautionary statement that misstates historical facts." The conference Committee explained, however, that a plaintiff could survive a motion to dismiss, the plaintiff "must plead with particularly all facts giving rise to a strong inference of a material misstatement in the cautionary statement." Report at 44.
Significantly, the Committee limited that "out" to material "misstatements," and did not include "omissions." This suggests that a cautionary statement should not be denied the safe harbour if it contains a material omission, but only if it contains an affirmative falsehood.
Fourth, the company's state of mind is irrelevant to the Prong One safe harbour. A decision as to whether the "cautionary statements" safe harbour is applicable "shall be based upon the sufficiency of the cautionary language and does not depend on the state of mind of the defendant." Report at 47. Accord Report at 44 ("Courts should not examine the state of mind of the person making statement.")
Fifth, the Prong One safe harbour does not "replace the judicial "bespeaks caution" doctrine" or "foreclose further development of that doctrine." Report at 46. Thus, in circumstances in which the safe harbour does not apply - such as an IPO - a court could still apply the bespeaks caution doctrine to dismiss the complaint. Similarly, even if a particular case did not satisfy the requirement of the Prong One safe harbour, a court would still be free to dismiss under the doctrine.
Prong One also shields companies from liability based on forward looking statements that are "immaterial." The Conference Report expressly did not overrule judicial decisions dismissing complaints on materiality grounds. Report at 44. Some courts have used that rationale in cases involving "puffing" or vague statements of corporate optimism. Others have dismissed complaints on materiality grounds where the allegedly concealed information entered the market from sources other than the company itself.
The Reform Act has special provisions with respect to forward looking statements that are made orally. Oral statements are protected by the safe harbour if two conditions are met.
First, the statement must be "accompanied by a cautionary statement that the particular oral statement ; and that the actual results could differ materially from those projected in the forward looking statement." 27A(c)(2)(A)
Second, the statement must note that "additional information concerning factors that could cause actual results to differ materially from those in the forward looking statement is contained in a readily available written document," and must identify that document. Moreover, such written information must itself satisfy the standard for written forward looking statements. 27A(c)(2)(B). The statute provides "readily available" documents shall include those filed with the SEC or "generally disseminated." 27A(c)(3)
The Conference Report limits the oral safe harbour "to issuers or the officers, directors, or employees of the issuer acting on the issuer's behalf." Report at 45.
PRONG TWO: ACTUAL KNOWLEDGE OF FALSITY:
Even if an issuer fails to include sufficient cautionary disclosures, it can only be held liable for forward looking statements if the plaintiff proves that the statement, "if made by a natural person, was made with actual knowledge that the statement was misleading." 27A(c)(1)(B)(I). If the statement was made by a company, then the plaintiff must prove that the statement was "made by or with the approval of an executive officer of that entity with actual knowledge by that officer that the statement was false or misleading." 27A(c)(1)(B)(ii)
Conceptually, Prong Two is less a safe harbour than it is a substantive scienter standard. No longer will allegations of "reckless" forecasts suffice. Thus, decisions such as In re Apple Computer Sec. Litig., 886 F.2d 1109 (9th Cir. 1989), cert. denied, 496 U.S.943 (1990), which focused on whether the issuer had a "reasonable basis" for forward looking statements, are implicitly overruled.
Prong Two must be read in conjunction with the Acts stringent pleading standard. 21D(b)(2) requires the plaintiff to "state with particularity facts giving rise to a string inference that the defendant acted with the required state of mind." Th Conference Committee explained that the pleading requirement was based in part on Second Circuit U.S. Courts of Appeals precedents, which it "regarded as the most stringent pleading standard." The Committee emphasised that it "intends to strengthen existing pleading requirements," and therefore did not include any reference to "motive, opportunity, or recklessness." Report at 41 & n.23.
STAYING DISCOVERY PENDING A MOTION TO DISMISS:
The act generally imposes a stay of discovery pending resolution of a motion to dismiss. 21D(b)(3)(B). The Act repeats that stay in the context of a motion to dismiss based on the applicability of the safe harbour, except with respect to "discovery that is specifically directed to the applicability of the exemption provided for in this section." 27A(f).
The Conference Report makes clear, with respect to motions brought pursuant to Prong One (cautionary or immaterial statements), that applicability of the safe harbour "shall be based upon the sufficiency of the cautionary language under those provisions and does not depend on the state of mind of the defendant." Report at 47. Thus, discovery should not be allowed into the defendant's state of mind with respect to cautionary statements. Accord Report at 44 ("Courts should not examine the state of mind of the person making the statement.")
Indeed, the Conference Committee expressly stated that the requirement that the cautionary statement identify "important" factors was designed "to provide guidance to issuers and not to provide an opportunity for plaintiff counsel to conduct discovery on what factors were to be known to the issuer at the time the forward looking statement was made." Report at 44.
EXCEPTIONS TO THE SAFE HARBOUR:
The Act provides certain exceptions to the safe harbour, both in terms of parties that may not invoke it and transactions to which it does not apply. The safe harbour is not available in connection with an issuer that was convicted of certain securities-related crimes, or was the subject of securities related consent decrees, during the prior three years. 27A(b)(1)(A). Nor it is available to penny-stock companies that are going private. 27A(b)(1)(B)-(E).
The safe harbour does not apply to forward looking statements made in connection with an initial public offering, a tender offer, or a partnership offering. 27A(b)(2)(c)-(E). The safe Harbour does not apply to beneficial ownership filings under 13(d) of the 1934 Act or to investment company registration statements. 27A(b)(2)(B),(F). Nor does it apply to forward looking statements "included in a financial statement prepared in accordance with generally accepted accounting principles." 27A(b)(2)(A).
The Conference Committee invited the SEC to expand the applicability of the safe harbour to additional types of information and transactions, as the Commission deems appropriate. Report at 46.
NO DUTY TO UPDATE:
Section 27A(d) provides that: "nothing in this section shall impose upon any person a duty to update a forward looking statement." Given that the Act creates a comprehensive scheme governing disclosure of forward looking information, plaintiffs will be hard pressed to argue that a duty to update exists, at least with respect to statements protected by the safe harbour. Plaintiffs will certainly not give up the duty to update without a fight. Companies should consider whether updating forward looking statements when circumstances change is an appropriate business decision, wholly apart from whether it is legally required.
The ultimate purpose of the safe harbour is to "enhance market efficiency by encouraging companies to disclose forward looking information." Report at 43. As courts demonstrate over the coming years that they will use the safe harbour to shut down meritless forecasting suits, the ultimate beneficiary should be the investing public. Investors will receive a greater flow of information from companies once they gain confidence that a lack of prescience will not land them in a suit.
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Tim Scott Wilson, Sonsini, Goodrich & Rosati, 650 Page Mill Road, Palo Alto, CA, 94304, 650 493 9300
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