From PLI S Course Handbook s5

From PLI’s Course Handbook

Securities Litigation & Enforcement Institute 2008

#14673

is the pslra’s safe harbor

becoming a safe puddle

Lyle Roberts

Noelle Francis

Dewey & LeBoeuf LLP

Lyle Roberts is a partner in the Washington, D.C. office of Dewey & LeBoeuf and the author of The 10b-5 Daily blog (www.the10b-5daily.com). Noelle Francis is an associate in the same office. The views expressed in this article are those of the authors and do not necessarily represent the view of Dewey & LeBoeuf or its clients.

Is the PSLRA’s Safe Harbor Becoming a Safe Puddle?

Lyle Roberts

Noelle Francis

Dewey & LeBoeuf

June 2008

One of the more controversial provisions of the Private Securities Litigation Reform Act of 1995 (“PSLRA”) is the safe harbor for forward-looking statements, which was designed to encourage companies to provide investors with information about future plans and prospects. The interpretation of the safe harbor in federal courts has left companies with mixed guidance about its usefulness as a barrier to liability.

The safe harbor provides that a defendant is not liable with respect to any forward-looking statement if (1) the forward-looking statement is identified as forward-looking 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; or (2) the plaintiff fails to prove that the forward-looking statement was made with actual knowledge that the statement was false or misleading. 15 U.S.C. §§ 78u-5(c)(1)(A), (B). Does that mean that if a company provides “meaningful cautionary statements” under the first prong of the safe harbor it can knowingly make a false projection? Both the plain language and legislative history of the statute suggest that this is exactly what Congress intended. Some courts, however, have declined to enforce what they view as a “license to defraud.”

The judicial opposition falls roughly into two camps, both of which focus on the definition of “meaningful cautionary statements.” A handful of district courts have addressed the issue by conflating the two prongs of the safe harbor. Under these decisions, a plaintiff’s allegation that the forward-looking statement was made with actual knowledge of its falsity is enough to demonstrate that the accompanying cautionary statements could not have been “meaningful” (unless, presumably, the cautionary statements were directly contradictory). Meanwhile, the U.S. Court of Appeals for the Seventh Circuit has questioned whether a court can determine, in the absence of discovery, if the cautionary statements made by a company were actually “meaningful.” These decisions undermine the plain language and purpose of the safe harbor.

Background

Congress enacted the PSLRA “to protect investors, issuers, and all who are associated with our capital markets from abusive securities litigation.” H.R. Rep. No. 104-369, at 32 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730, 731. Congress found that “[u]nderstanding a company’s own assessment of its future potential would be among the most valuable information shareholders and potential investors could have about a firm” and “[f]ear that inaccurate projections will trigger the filing of securities class action lawsuit has muzzled corporate management.” Id. at 43. To address this chilling effect on companies’ willingness to disclose forward-looking information, Congress created a “bifurcated safe harbor” based on two existing legal approaches. Id. First, Congress looked to the judicially created “bespeaks caution doctrine,” which generally provides that a forward-looking statement is rendered immaterial if it is accompanied by meaningful cautionary statements. See, e.g., In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357 (3d Cir. 1993)). Second, Congress looked to SEC Rule 175, which provides that, subject to additional conditions, an issuer is not liable with respect to a forward-looking statement unless it is shown that the statement was made without a reasonable basis or was disclosed other than in good faith. 17 C.F.R. § 230.175.

The first prong of the safe harbor, which is modeled after the bespeaks caution doctrine, protects a written or oral forward-looking statement that is (i) identified as forward-looking and (ii) accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement. 15 U.S.C. § 78u-5(c)(1)(A). On the question of whether meaningful cautionary statements protect a defendant who made false forward-looking statements with actual knowledge that they were false, Congress made its intention clear:

The use of the words “meaningful” and “important factors” are intended to provide a standard for the types of cautionary statements upon which a court may, where appropriate, decide on a motion to dismiss, without examining the state of mind of the defendant. The first prong of the safe harbor requires courts to examine only the cautionary statement accompanying the forward-looking statement. Courts should not examine the state of mind of the person making the statement.

H.R. Rep. No. 104-369, at 44 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730, 743 (emphasis added). Moreover, the cautionary statement “must be relevant to the projection,” but does not have to contain “the particular factor that ultimately causes the forward-looking statement not to come true.” Id. at 43-44. Congress’ decision not to include a state of mind requirement in the first prong is emphasized in its discussion of the second prong. The Conference Report notes that the second prong is “an alternative analysis” that “focuses on the state of mind of the person making the forward-looking statement.” Id. at 44.

Despite these clear statements of intent, which backstop the plain language, courts have sometimes balked at applying the first prong of the safe harbor as written. These courts have either: (1) collapsed the two prongs by creating a “state of mind” requirement for whether a cautionary statement is “meaningful;” or (2) found that discovery is almost always necessary to determine whether a cautionary statement is “meaningful.”

How Many Prongs Are There?

Freeland v. Iridium World Commc’ns, Ltd., 545 F. Supp. 2d 59 (D.D.C. 2008) provides a recent example of a court that collapses the two prongs of the safe harbor. See also In re Nash Finch Co., 502 F. Supp. 2d 861, 873 (D. Minn. 2007); In re SeeBeyond Techs. Corp. Sec. Litig., 266 F. Supp. 2d 1150, 1165 (C.D. Cal. 2003). In Iridium, the plaintiff alleged that both Iridium and its former parent, Motorola Inc., knew and failed to disclose that Iridium would not be able to meet certain business and financial targets that it had covenanted to meet as part of a bank loan agreement. Id. at 65-66. Motorola, the sole defendant remaining in the case, moved for summary judgment based, in part, on the PSLRA’s safe-harbor provision.

Motorola argued that under the safe harbor, actual knowledge of a statement’s falsity is immaterial so long as the statement is identified as forward looking and is accompanied by a meaningful cautionary statement. Id. at 71. The Iridium court concluded that the cautionary statements at issue could not be “meaningful” if Iridium and Motorola knew their statements to be false and misleading at the time they were made. See id. at 71-74. The court noted that Motorola had presented this argument on a motion to dismiss and that the court had rejected the argument, stating that “[n]o degree of cautionary language will inoculate statements that the defendants knew were simply not true when made.” Id. at 71.

The imposition of a “state of mind” requirement into the first prong of the safe harbor is problematic. First, Congress did not impose a state of mind limitation in the first prong of the safe harbor, instead leaving that examination for the second prong. It is difficult to justify collapsing the two prongs into a single “actual knowledge” test on the basis of “statutory interpretation.” Second, the Iridium court found that whether the cautionary statements rendered the forward-looking statements immaterial was only relevant to a “bespeaks caution” analysis, not whether the cautionary statement was meaningful. Id. at 73. It came to this conclusion despite acknowledging that the “[bespeaks caution] doctrine and the PSLRA’s safe harbor are intertwined.” Id. at 73 n.1. Finally, the Iridium court expressly based its decision on policy concerns – citing a law review article written by an SEC staffer arguing that the safe harbor should not provide what the court described as an “incentive to lie” – without a single citation to the policy concerns articulated by Congress in creating the safe harbor.

The Need for Discovery

The Seventh Circuit has taken a different approach to the issue of determining whether a cautionary statement is meaningful, but its effect on defendants is similar. In Asher v. Baxter Int’l. Inc., 2003 WL 21825498 (N.D. Ill. Jul. 24, 2003), the plaintiffs alleged that Baxter, a manufacturer of medical products, attempted to hide the fact that it was facing numerous business and financial problems in part by making misleading forward-looking statements. Baxter, 2003 WL 21825498 at *1-2. Baxter moved to dismiss arguing, among other things, that it was not liable with respect to its forward-looking statements because those statements were accompanied by meaningful cautionary statements and, therefore, fell under the PSLRA’s safe harbor provision. Id. at *4.

The district court granted Baxter’s motion to dismiss. Id. at *7-17. The court noted that the words “meaningful” and “important factors” within the safe harbor’s first prong were “intended to provide a standard for the types of cautionary statements upon which a court may, where appropriate, decide a motion to dismiss, without examining the state of mind of the defendant.” Id. at *11 (citing H.R. Rep. No. 104-369, at 44 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730, 743). The district court rejected the view taken by other courts that the safe harbor was not applicable when a defendant made false statements at a time when it was aware of facts that rendered its statements false. Id. at *11 n.5. The district court noted that Congress had “explicitly instructed that ‘[c]ourts should not examine the state of mind of the person making the statement.’” Id. at *11 n.5 (quoting H.R. Rep. No. 104-369, at 44). The district court ultimately determined that “the total mix of cautionary statements available to Plaintiffs at the time of the alleged misstatements and omissions . . . were substantive and tailored to the specific future projections, estimates or opinions in the forward-looking statements . . . so as to give a reasonable investor notice of the risks of investing in Baxter and to undertake further investigation into Baxter before investing in its stock.” Id. at *14 (citations and internal quotation marks omitted).

On appeal, the Seventh Circuit reversed. The court held that a company need not have “prevision” to provide cautionary statements that are meaningful. Id. at 732. It is enough for the cautionary statements “to point to the principal contingencies that could cause actual results to depart from the projection.” Id. at 734. Nevertheless, the court held that it may be impossible to determine whether cautionary statements are “meaningful” on a motion to dismiss. The court found that although Baxter’s cautionary statements were company-specific and not boilerplate, the cautionary statements may have fallen short because there “is no reason to think – at least, no reason that a court can accept at the pleading stage, before plaintiffs have access to discovery – that the items mentioned in Baxter’s cautionary language were those thought at the time to be the (or any of the) ‘important’ sources of variance.” Id. In particular, the plaintiffs had alleged that Baxter’s forecasts and cautions remained unchanged even when the company closed plants that had been its principal source of low-cost products. Id. The court found, however, that it could not exclude the possibility that “if after discovery Baxter establishes that the cautions did reveal what were, ex ante, the major risks, the safe harbor may yet carry the day.” Id.

Although arguably less problematic than the imputation of a “state of mind” requirement into the first prong, the Baxter decision also is inconsistent with the PSLRA: The Conference Committee specified “that the cautionary statements identify ‘important’ factors 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.” H.R. Rep. No. 104-369, at 44 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730, 743 (emphasis added). In addition, most securities class actions are settled if the action is not dismissed for failure to meet the PLSRA’s pleading standards – which is why Congress clarified that the first prong of the safe harbor should be effective at the motion to dismiss stage of a case. Instead, under Baxter, the safe harbor becomes a defense that can only be invoked at the summary judgment or trial stages of a case.

Conclusion

By forcing defendants to go through discovery to receive the benefit of the safe harbor, the recent decisions redefining “meaningful cautionary statements” undermine the primary goals of the PSLRA. They also create a disturbing lack of uniformity across the federal courts. As the legislative history makes clear, Congress intended for the first prong of the safe harbor to embody the existing “bespeaks caution” doctrine, which courts have routinely applied at the motion to dismiss stage of securities cases. If litigants and courts disagree with the public policy embraced by Congress, the appropriate remedy is legislative, not in judicial decisions that turn the safe harbor into a safe puddle.