In the last five years, the trends in the filing of securities class actions have resulted in a decline in filings in the Ninth Circuit, which formerly was the epicenter of securities class action litigation, and an increase in filings in the Second Circuit.More recently, as that trend toward filing in the Southern District of New York reverses itself and more actions are filed in the Ninth Circuit again, the jurisprudence of the Ninth Circuit becomes an increasingly important consideration in drafting corporate disclosures for public companies.A series of recent Ninth Circuit decisions have reversed course from prior Ninth Circuit pronouncements regarding the safe harbor provisions of the Private Securities Litigation Reform Act and loss causation in ways that impact issuer drafting strategies.
In In re Cutera Securities Litigation , 610 F.3d 1103 (9th Cir. 2010), the Ninth Circuit held that the safe harbor provisions of the Private Securities Litigation Reform Act protect even statements made with actual knowledge of their falsity.This decision was a dramatic departure from dicta in No. 84 Employer-Teamster Joint Council Pension Trust Fund v. American West Holding Corp., 320 F.3d 920, 937 n. 15 (9th Cir. 2003), which stated that a "strong inference of actual knowledge" of falsity could exempt forward-looking statements from the safe harbor of the Reform Act.In Cutera , the court unequivocally characterized this statement as dicta and held that the defendant's state of mind is not relevant to the determination of whether the defendant's statements are protected by the safe harbor afforded by meaningful cautionary statements.The court may, however, have signaled in a footnote its approval of a different approach to statements made with actual knowledge of falsity, i.e., acceptance of the statutory safe harbor protection, but with an intense focus on whether the company's risk factors constitute "meaningful cautionary language" in the context of a knowingly false statement.See Cutera at 1113 n. 5.
The benefits afforded by the safe harbor provisions as interpreted by Cutera are substantial and should be a focal point of any corporate disclosure strategy.As an initial matter, extreme care should be taken to satisfy the first requirement of the safe harbor, the identification of forward-looking statements as such.More complex and difficult, the potential scrutiny regarding the sufficiency of the "meaningful cautionary language" accompanying such forward-looking statements suggests that practitioners should take heed of the Second Circuit opinion in Slayton v. American Express, 604 F.3d 758 (2d Cir 2010).That court found that "boilerplate" risk factors that were not specific, that did not change over time, and that were not tailored to the forward looking statements which they accompanied were not "meaningful cautionary statements" and thus did not protect the company's forward-looking statements.Practitioners should therefore take particular care to revise their client's risk factor warnings with every filing, constantly updating them with a quantitative as well as qualitative date relevant to the particular quarter and the particular forward-looking statements being made at the time.At the same time, it is not critical that every risk factor be repeated in every filing.Ninth Circuit law is clear that the safe harbor does not require that the cause of a market decline be previously identified as a risk factor in the companies' filings.Rather than including every risk factor, it is more important that the risks that are described are described adequately and that they relate to the forward-looking statement that they accompany.
A similar change of course has taken place in the Ninth Circuit regarding loss causation.In Metzler Investment GMBH v. Corinthian Colleges, Inc. , 540 F.3d 1049 (9th Cir. 2008), the Ninth Circuit rejected the "materialization of the risk" theory of loss causation.That theory, accepted by the Second Circuit, holds that if the alleged fraud resulted in a disappointing revenue or earnings miss, the stock drop resulting from the revenues or earnings miss constitutes a "materialization of the risk" sufficient to satisfy loss causation requirements.In Metzler , the Ninth Circuit found that because a release announcing an earnings miss did not reveal or otherwise attribute the miss to alleged enrollment fraud, it did not satisfy loss causation principles.In In re Gilead Securities Litigation , 536 F.3d 1049 (9th Cir. 2008), decided almost simultaneously as Metzler , the court seemed to decide just the opposite.It found that a stock decline following a disappointing earnings announcement served to establish loss causation with respect to an allegation of off-label promotion that was revealed by an FDA warning letter six weeks prior.While the court suggested that the six-week delay in the market reaction was a question of fact, the real basis of its holding was the "materialization of the risk" theory of loss causation; i.e. , that the off-label marketing generated a demand that dissipated upon issuance of the FDA's warning letter, thereby resulting in the disappointing earnings announcement.The tension between Metzler and Gilead was recently resolved by the Ninth Circuit in In re Oracle Securities Litigation , 2010 WL 4608794 (9th Cir. November 16, 2010), which reaffirmed Corinthian and expressly rejected the materialization of the risk theory of loss causation. Metzler, the court reasoned, requires that "the market learn[] of a react[] to the practices the plaintiff contends are fraudulent."It expressly rejected plaintiffs' assertion that loss causation can be proven by the market's "react[ion] to the purported 'impact' of the alleged fraud - the earnings miss -rather than to the fraudulent acts themselves."
The Ninth Circuit's rejection of the "materialization of the risk" theory of loss causation is significant to the preparation of corporate disclosures both prior to and after any revenue or earnings disappointment.First, at its heart, loss causation as articulated by the Ninth Circuit is comprised primarily of a comparison of earlier disclosures with the disclosures that precipitate a market disappointment.This approach suggests the importance of the drafter's intimate familiarity of his or her client's prior disclosures.While this would seem self-evident, it is actually a difficult goal to accomplish, particularly for the in-house counsel who is privy to the day-to-day operations of the client.With such daily exposure, it becomes difficult to distinguish what has been disclosed and discussed publicly from what has been kept internal to the client.Second, the Ninth Circuit's view of loss causation places a premium on the adequacy and accuracy of the factual investigation leading to the disclosure of the disappointment.Simply announcing a revenue or earnings miss without attributing such a miss to any causes is not acceptable to the market, yet that attribution will likely define whether or not the plaintiffs in the upcoming securities litigation will be able to plead and prove loss causation.It is absolutely critical that the investigation leading to the causal attribution be thorough and accurate and that the drafter of the client's disclosure not simply accept the easiest or most obvious explanation. This is particularly true where the miss is attributable to intervening events.The resulting disclosure should be fulsome; it should disclose both the positive and negative events leading to the miss, and it should not simply be retrospective but should include the impact of the miss on future quarters (with appropriate safe harbor cautionary language) as well as how the company intends to avoid a similar miss in those future quarters (with the same cautionary language).
Published January 3, 2011.
