Saturday, October 7, 2017
Readers of this blog know about the case of Leidos, Inc. v. Indiana Public Retirement System, currently pending before the Supreme Court, which will decide whether an omission of required information can give rise to private liability under Rule 10b-5. In Leidos, the corporate defendant engaged in a scheme of overbilling on a New York City contract, which ultimately resulted in a deferred prosecution agreement and significant monetary penalties. The plaintiffs alleged that the company violated Rule 10b-5 by failing to disclose the conduct and associated potential penalties as a “known trend” in its SEC filings, as required by Item 303. The Second Circuit allowed the claim to proceed; Leidos now argues before the Supreme Court that its failure to disclose required information cannot satisfy the element of falsity in a private claim brought under Rule 10b-5. In other words, the question is whether – assuming all the other elements of a fraud claim are established (materiality, scienter, loss causation, etc) – can the omission of required information count as a false statement?
Joan Heminway co-authored an amicus brief arguing that Rule 10b-5 does provide for omissions liability, and this is an issue I’ve blogged about a few times, so forgive me if this post treads some familiar ground.
The case has generated a fair amount of commentary from the bar, including various warnings of unlimited liability should the Supreme Court rule for the plaintiffs. Professor Joseph Grundfest has now jumped into the fray, contending that – while he agrees with various textual arguments as to why no liability should attach – in the end, he doesn’t think it matters very much. The crux of his argument is that the securities laws require so much disclosure as a matter of course that there will almost never be a case where a pure omission cannot be transmogrified into a misleading half-truth. In Leidos itself, he notes that the court also upheld the plaintiffs’ allegation that the corporate financial statements violated accounting rules for failure to allege a loss contingency – resulting from fines and recoupment of the overbilling – and speculates that the plaintiffs could have brought claims based on the company’s representations that it did not expect any losses resulting from pending litigation, as well as such “half-truths” as its warnings of potential risks from “[m]isconduct of our employees.” He also argues that – though the matter is uncertain – required CEO and CFO certifications under Sarbanes Oxley can also constitute affirmative misstatements when information has been omitted from a securities filing, which would once again make omissions liability unnecessary.
I agree that pure omissions cases are relatively rare, and that due to the extensive disclosure requirements of the federal securities laws, most undisclosed misconduct/misfortune can be pinned to an arguably false affirmative statement (a point that I’ve discussed in my articles Slouching Towards Monell and Reviving Reliance). But I don’t think the matter is quite as trivial as Prof. Grundfest sees it.
First, when it comes to certifications, those are attributed solely to the CEO and CFO. Not all securities claims depend on the liability of the CEO and CFO; at the very least, at the pleading stage, the plaintiffs may not be able to demonstrate the scienter of the CEO and CFO. In Leidos itself, for example, for reasons I don’t fully understand, somehow all of the individual defendants were dropped from the case, leaving only the corporate defendant. Thus, leaving aside other issues of whether such certifications are actionable in the first place, they’re an unreliable predicate for liability.
More broadly, however, what Prof. Grundfest overlooks is that many courts - rightly or wrongly - treat Rule 10b-5 claims with varying degrees of skepticism, and plaintiffs reasonably want to belt-and-suspender it. Now, to be sure, if a judge is determined to dismiss a claim, the judge will find a way to do so (naturally, the opposite is true for a judge who is determined to sustain a claim). But between those extremes there is a great deal of variation, and broadening the grounds for liability will make it harder for even the skeptical judge to dismiss a claim out of hand.
When it comes to omitted information, for sure, public companies are already subject to so many disclosure requirements that there will always be some affirmative statement that is arguably rendered misleading whenever there is a significant undisclosed problem, which should theoretically make pure omissions liability unnecessary. But courts are often hostile to these kinds of claims – I think of them as icebergs – where major trouble is pinned to a banal bit of boilerplate. (You know, like an iceberg, where the tiny above-water misstatement is the ostensible hook to bring a claim based on dramatic concealed problems.) Courts typically recognize – correctly – that in such cases, the plaintiff is not so much complaining about the statement so much as the conduct, and since it is only statements (not conduct) that are regulated by the federal securities laws, they find other grounds on which to base a dismissal. One favorite is puffery, which is precisely what happened in Leidos – the plaintiffs claimed that the defendants’ representations about ethics and integrity were rendered false by the scheme, and those claims were thrown out on materiality grounds. Omissions liability, by contrast, is immune from a puffery defense, and thus represents another weapon in the plaintiffs’ arsenal.
Similarly, in many cases the alleged “half-truth” will come in the form of a potentially forward-looking statement, which may then be protected by the PSLRA safe harbor. If so, pinning liability to that statement (or even to the risk disclosures) may be impossible for the plaintiffs. Once again, then, pure omissions liability will save the plaintiffs' complaint.
To be sure, as Prof. Grundfest points out, in Leidos, the Second Circuit agreed that the failure to account for potential losses due to the fraud rendered the corporate financial statements false. But that was highly unusual, and likely due to the fact that the misconduct was already the subject of a criminal investigation. Courts have often refused to treat financial statements as false simply because the income was generated in an illicit manner, see Steiner v. MedQuist, Inc., 2006 WL 2827740 (D.N.J. Sept. 29, 2006), and that’s particularly likely to be true when there is no governmental investigation underway.
The same goes for Leidos’s statements about potential liability from pending claims/litigation. Prof. Grundfest might be correct that these were also false statements, but only after 2010, when the first criminal complaint was filed. Though the plaintiffs altered their claims along the way, the original class period began in 2007 – before there was any pending litigation.
It is also worth observing that omissions cases might be easier to litigate procedurally. When plaintiffs allege the existence of affirmative misstatements, defendants often argue that the misstatement failed to result in a detectable impact on stock prices, and that therefore fraud on the market liability is unavailable (an argument I’ve repeatedly discussed). That’s not an issue for omissions liability.
Point being, I don’t think my disagreements with Prof. Grundfest are too dramatic – I’ll concede that we’re not talking about a massive number of cases – but I think there are enough to make a difference.
That said, I disagree with the “sky is falling” pronouncements of practitioners who fear that they will have to bury investors in an “avalanche of trivial information,” Basic, Inc. v. Levinson, 485 U.S. 224 (1988), if the Supreme Court permits the claims in Leidos to proceed. As I argue in Reviving Reliance, I actually think that if liability is expanded to cover omissions, courts will push back by narrowing their interpretation of the scope of required disclosures in the first place – which will have real repercussions for SEC enforcement.