Late in December, the most important securities legislation in decades became law. The Private Securities Litigation Reform Act of 1995 had a difficult labor 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 harbor for forward-looking information. The safe harbor 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 companies' disclosure practices to ensure thorough implementation of the safe harbor's requirements. The statute's protection is worth the effort.
I. CREATING THE SAFE HARBOR
When the 104th Congress turned to securities reform, creation of a safe harbor for forward-looking information was a topic of great controversy. The safe harbor 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.
The statutory safe harbor (contained in section 102 of the law) creates a new section 27A of the Securities Act of 1933 and a corresponding section 21E of the Securities Exchange Act of 1934. [Citations in this article are to the provisions amending the 1933 Act (contained in section 102(a) of the new statute); unless otherwise noted, identical provisions can be found in the 1934 Act provisions as well.]
The safe harbor defines "forward-looking statement" broadly, including projections of future financial results, statements of plans and objectives for future operations, statements of future economic performance, required disclosures in MD&A, and statements of assumptions related to the foregoing. Section 27A(i)(1). See Securities Litigation Reform, H.R. Rep. No. 104 -369, 104th Cong., 1st Sess., at 45-46 (Nov. 28, 1995) (Joint Explanatory Statement of the Committee of Conference).
The safe harbor 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.
II. PRONG ONE: THE COMPANY'S STATEMENTS
The heart of the safe harbor is section 27A(c)(1)(A)(i), which provides that a company "shall not be liable with respect to any forward-looking statement, whether written or oral, if and to the extent that the forward-looking statement is 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 [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 section 27A, etc., and is subject to the safe harbor created by that section."
The more challenging aspect of Prong One is the second requirement: inclusion of cautionary statements. Many lawyer-years will be spent 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, "[t]he cautionary 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 realized." 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 emphasized 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 harbor." Report at 44. This is a key part of the safe harbor. A company's projections will be protected even if it does not identify the specific risk that later causes disappointing results.
Third, the safe harbor does not protect a "cautionary statement that misstates historical facts." The Conference Committee explained, however, that a plaintiff could not survive a motion to dismiss merely by alleging "that a cautionary statement misstates historical facts." To survive a motion to dismiss, the plaintiff "must plead with particularity 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 harbor 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 harbor. A decision as to whether the "cautionary statements" safe harbor 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 thestatement.").
Fifth, the Prong One safe harbor 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 harbor 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 harbor, 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 harbor if two conditions are met.
First, the statement must be "accompanied by a cautionary statement that the particular oral statement is a forward-looking statement; and that the actual results could differ materially from those projected in the forward-looking statement." Section 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. Section 27A(c)(2)(B). The statute provides that "readily available" documents shall include those filed with the SEC or "generally disseminated. Section 27A(c)(3).
The Conference Report limits the oral safe harbor "to issuers or the officers, directors, or employees of the issuer acting on the issuer's behalf." Report at 45.
III. 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." section 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." Section 27A(c)(1)(B)(ii).
Conceptually, Prong Two is less a safe harbor 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 Act's stringent pleading standard. section 21D(b)(2) requires the plaintiff to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The Conference Committee explained that the pleading requirement was based in part on Second Circuit U.S. Court of Appeals precedents, which it "[r]egarded as the most stringent pleading standard." The Committee emphasized 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.
IV. STAYING DISCOVERY PENDING A MOTION TO DISMISS
The Act generally imposes a stay of discovery pending resolution of a motion to dismiss. section 21D(b)(3)(B). The Act repeats that stay in the context of a motion to dismiss based on the applicability of the safe harbor, except with respect to "discovery that is specifically directed to the applicability of the exemption provided for in this section." 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 harbor "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 known to the issuer at the time the forward-looking statement was made." Report at 44.
V. EXCEPTIONS TO THE SAFE HARBOR
The Act provides certain exceptions to the safe harbor, both in terms of parties that may not invoke it and transactions to which it does not apply. The safe harbor 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. Section 27A(b)(1)(A). Nor is it available to penny-stock companies, companies involved in "blank check" offerings or roll-ups, or to companies that are going private. Section 27A(b)(1)(B)-(E).
The safe harbor does not apply to forward-looking statements made in connection with an initial public offering, a tender offer, or a partnership offering. Section 27A(b)(2)(C)-(E). The safe harbor does not apply to beneficial ownership filings under section 13(d) of the 1934 Act or to investment company registration statements. Section 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." section 27A(b)(2)(A).
The Conference Committee invited the SEC to expand the applicability of the safe harbor to additional types of information and transactions, as the Commission deems appropriate. Report at 46.
VI. NO DUTY TO UPDATE
Section 27A(d) provides that: "[n]othing 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 harbor. 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 harbor 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 harbor 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.
Boris Feldman is a partner in the litigation department of Wilson, Sonsini, Goodrich & Rosati. A version of this article was published in The Recorder. Boris Feldman, Informing the Investor, Stiffling the Shareholder Suit, The Recorder, January 3, 1996.