Saturday, April 10, 2021

Future Imperfect

The Eastern District of Pennsylvania recently issued a lengthy opinion, largely refusing to dismiss a Section 10(b) complaint alleging that Energy Transfer LP made a series of misstatements about certain pipelines that were under construction.  See Allegheny County Employees’ Ret. Sys. v. Energy Transfer LP, 2021 WL 1264027 (E.D. Pa. Apr. 6, 2021). There’s probably a lot worth examining here but I’m actually just going to use it as a jumping off point to talk about the PSLRA safe harbor.

The safe harbor insulates forward-looking statements from private securities fraud liability if:

(A) the forward-looking statement is—

(i) identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement; or…

(B) the plaintiff fails to prove that the forward-looking statement--

(i) if made by a natural person, was made with actual knowledge by that person that the statement was false or misleading; …

(2) Oral forward-looking statements

In the case of an oral forward-looking statement …the requirement set forth in paragraph (1)(A) shall be deemed to be satisfied--

(A) if the oral forward-looking statement is accompanied by a cautionary statement—

…(ii) that the actual results might differ materially from those projected in the forward-looking statement; and

(B) if--

(i) the oral forward-looking statement is accompanied by an oral statement that additional information concerning factors that could cause actual results to materially differ from those in the forward-looking statement is contained in a readily available written document, or portion thereof;

(ii) the accompanying oral statement referred to in clause (i) identifies the document, or portion thereof, that contains the additional information about those factors relating to the forward-looking statement; and

(iii) the information contained in that written document is a cautionary statement that satisfies the standard established in paragraph (1)(A).

15 U.S.C 78u-5.

There are certain preconditions, then, for safe harbor protection based on cautionary language: first, that the statements be identified as forward-looking explicitly, and second, that the cautionary language be included in a written document, or incorporated by reference if made orally.

In Energy Transfer, the court concluded that while some of defendants’ forward-looking statements qualified for safe harbor protection based on cautionary language, some did not meet the preconditions, see 2021 WL 1264027, at *5, *9, and went on to conclude that the plaintiffs had adequately alleged claims based on some of the unprotected ones.

The reason this intrigues me is that, as far as I know, courts have been rather free with allowing defendants to claim the protection of the safe harbor even if they fail to meet the preconditions (for example, if they fail to incorporate the warnings by reference in an oral statement, or try to incorporate by reference for a written one), so long as the cautionary language appears somewhere in a public document.  The Seventh Circuit laid out the rationale in Asher v. Baxter Int’l, 377 F.3d 727 (7th Cir. 2004).  (Disclosure: I was one of the attorneys representing the plaintiffs in Asher v. Baxter).  In that case, the Seventh Circuit said:

When speaking with analysts Baxter’s executives did not provide them with …directions to look in the 10–K report for the full cautionary statement. It follows, plaintiffs maintain, that this suit must proceed with respect to the press releases and oral statements even if the cautionary language filed with the SEC in registration statements and other documents meets the statutory standard.

…[T]his is not a traditional securities claim. It is a fraud-on-the-market claim. None of the plaintiffs asserts that he read any of Baxter's press releases or listened to an executive's oral statement. Instead the theory is that other people (professional traders, mutual fund managers, securities analysts) did the reading, and that they made trades or recommendations that influenced the price. In an efficient capital market, all information known to the public affects the price and thus affects every investor. …

When markets are informationally efficient, it is impossible to segment information as plaintiffs propose. They ask us to say that they received (through the price) the false oral statements but not the cautionary disclosures. That can’t be; only if the market is inefficient is partial transmission likely, and if the market for Baxter's stock is inefficient then this suit collapses because a fraud-on-the-market claim won't fly.

The problem with that logic, though, is that PSLRA safe harbor protection is not predicated on the idea that cautionary statements will impact prices in the same way as the initial false statement and thereby nullify the effects of the lie.  True, the common law bespeaks caution doctrine insulates all forward looking statements if cautionary language renders them immaterial, Harden v. Raffensperger, Hughes & Co., 65 F.3d 1392 (7th Cir. 1995), but the PSLRA standards are more forgiving.  Defendants need only identify “important factors that could cause actual results to differ materially from those in the forward-looking statement,” 15 U.S.C. § 78u-5(c)(1)(A)(i), and “[f]ailure 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 harbor.” H.R. Conf. Rep. No. 104-369, at 44 (1995).

Under the PSLRA, then, courts rarely, if ever, test whether the cautionary language was sufficient to offset the misleading effects of the projection.  This is precisely why some courts have described the safe harbor as a “license to defraud,” In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187 (1st Cir. 2005) – because even if the cautionary language is insufficient to nullify the effects of the false statement – so that, by hypothesis, markets were actually misled by the projection – defendants may still be protected.

Given that, the Seventh Circuit’s invocation of the fraud-on-the-market doctrine seems inapposite, because the cautionary language that suffices to trigger safe harbor protection isn’t really about ensuring that prices fully incorporate the risks associated with false projections, or at least, that’s not its primary function. Plus, Congress enacted the PSLRA in response to what it perceived as abusive class actions - if it wanted to distinguish between the preconditions for fraud-on-the-market actions and other actions, it certainly could have done so.

If all that’s right, then what does the safe harbor do? 

Well, I’m not a fan of the safe harbor but if I am going to justify it, I’d say the formalities associated with the safe harbor could prompt mindfulness on the part of corporate actors.  They have extra protection for projections – so they’ll be more inclined to make them – but they also know they can’t simply speak off-the-cuff; they must take care to include the warnings.  That enforced thoughtfulness may itself serve as some kind of protection against statements that aren’t rooted in reality, and it’s why the Seventh Circuit, in my view, was wrong to ditch the formalities.  Also, if defendants were truly held to the requirement that they identify which exact statements they believed to be forward-looking as a precondition of claiming protection via cautionary language, I think that would spare everyone a lot of litigation and force corporate speakers to be clearer about their claims

Anyway, in related news, Acting Corp Fin Director John Coates recently delivered a speech on the safe harbor and SPACs.  Going public via SPAC, rather than traditional IPO, is all the rage right now, apparently at least in part because while traditional IPOs are excluded from safe harbor protection entirely, the de-SPAC merger is not.  Specifically, the safe harbor says:

this section shall not apply to a forward-looking statement… that is… made in connection with an initial public offering...

15 U.S.C. 78u-5(b)(2)(D).

That regulatory distinction has led to some companies to offer wildly optimistic projections about SPAC acquisitions, a lot of which do not, ahem, come true.

Coates’s speech was notable in that he not only objected to the differential regulatory treatment on policy grounds – as he explained, companies going public for the first time pose particular risks to investors no matter what method they use to do so – but he also suggested that, read broadly, the existing safe harbor exclusion for initial public offerings might also be read to exclude de-SPAC transactions.  Full quote:

[T]he PSLRA’s exclusion for “initial public offering” does not refer to any definition of “initial public offering.” No definition can be found in the PSLRA, nor (for purposes of the PSLRA) in any SEC rule. I am unaware of any relevant case law on the application of the “IPO” exclusion. The legislative history includes statements that the safe harbor was meant for “seasoned issuers” with an “established track-record.”…

The economic essence of an initial public offering is the introduction of a new company to the public. It is the first time that public investors see the business and financial information about a company….

If these facts about economic and information substance drive our understanding of what an “IPO” is, they point toward a conclusion that the PSLRA safe harbor should not be available for any unknown private company introducing itself to the public markets. Such a conclusion should hold regardless of what structure or method it used to do so. The reason is simple: the public knows nothing about this private company. Appropriate liability should attach to whatever claims it is making, or others are making on its behalf...

[A]ll involved in promoting, advising, processing, and investing in SPACs should understand the limits on any alleged liability difference between SPACs and conventional IPOs. Simply put, any such asserted difference seems uncertain at best.

It should be noted that Commissioner Hester Peirce tweeted her (tentative) disagreement with his reading of the statute, but if he’s right, it would mean that all these companies who thought their cautionary language insulated them from liability … were, you know, wrong.

Ann Lipton | Permalink


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