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SEC Investigations: To Disclose or Not to Disclose - That Is the Question

Authors: Jay A. Dubow and Erica Hall Dressler

3/31/2016
SEC Investigations: To Disclose or Not to Disclose - That Is the Question
Temple's Business Law Magazine

Companies under investigation should consider all potential consequences of disclosure or non-disclosure with the help of counsel in determining a strategy.

This article was originally published in Temple's Business Law Magazine, The Temple 10-Q on March 31, 2016 under the Alumni Comments, Commentary section.

Among the many important decisions a company facing an SEC investigation must make is the decision whether to publicly disclose the existence of the investigation. The decision may depend on the stage of the investigation, what is being investigated, and what is the likelihood of a bad outcome. While the weight of authority suggests that SEC investigations need not be disclosed, recent case law illustrates that the decision to disclose or not disclose carries with it certain consequences. Companies under investigation should consider all potential consequences of disclosure or non-disclosure with the help of counsel in determining a strategy.

In a recent decision from the U.S. District Court for the Southern District of New York, In re Lions Gate Entertainment Corp. Securities Litigation, Judge John G. Koeltl held that issuers do not have a general duty to disclose the existence of an SEC investigation or a Wells Notice. The plaintiffs primarily alleged that Lions Gate and the individual defendants were aware of, but failed to disclose, the SEC’s investigation into alleged misrepresentations relating to transactions that were announced two years earlier. The defendants moved to dismiss the claims on the basis that the plaintiffs failed to plead that any omissions by Lions Gate were material or, alternatively, that the defendants had a duty to disclose the SEC investigation and Wells Notices. The court agreed and dismissed the claims, holding that issuers do not have a general duty to disclose as “the securities laws do not impose an obligation on a company to predict the outcome of investigations.”

The Lions Gate court did, however, illustrate two situations in which non-disclosure of an SEC investigation could serve as the basis of a securities claim: (1) where the defendants had a preexisting duty to disclose; or (2) where the non-disclosed statements were material. The court emphasized that, in the case before it, there were no statements that needed to be updated because the plaintiffs failed to point to any statements during the class period about transactions that were the subject of the SEC investigation or statements about the SEC investigation. Additionally, the court observed that the plaintiffs failed to allege that the SEC investigation was material and would “significantly alter the total mix of information available to an investor” because the civil penalty was less than 1 percent of Lion Gate’s 2014 third-quarter revenue.

In another recent case, Lloyd v. CVB Financial Corp., the Ninth Circuit analyzed the different but related issue of whether disclosure of an SEC investigation can establish one of the elements a plaintiff must prove to prevail in a securities action – loss causation. The court in Lloyd held that a plaintiff satisfies the loss causation element of a securities claim when the plaintiff alleges: (1) that the defendants announced an SEC investigation connected to an alleged misrepresentation; and (2) that the defendants later revealed an inaccuracy related to that misrepresentation.

As part of its securities claim, the plaintiff in Lloyd alleged that the defendant reported in its SEC filings that it had no “serious doubts as to the ability of [its] borrowers to comply with their loan repayment terms,” despite the defendant knowing that one of its largest borrowers could not meet its borrowing obligations. The defendant subsequently received a subpoena from the SEC, which it disclosed in its Form 10-Q, resulting in a 22 percent drop in its stock price.  One month later, when the defendant announced that the previously mentioned borrower was unable to pay its loans, the announcement only had a minimal effect on the defendant’s stock price. The court reasoned that the plaintiff adequately pleaded loss causation because the minimal effect of the defendant’s announcement regarding its largest borrower “confirm[ed] that investors understood the SEC announcement as at least a partial disclosure of the inaccuracy of the previous ‘no serious doubts statements.’” Lloyd suggests that, though disclosing an SEC investigation may allow issuers to better prepare and control the response to the disclosure, issuers should also consider how the disclosure may affect potential securities actions against them.

Importantly, similar questions as to the need for disclosure can arise in the context of investigations by other government agencies. See, e.g., Lubbers v. Flagstar Bancorp, Inc. – dismissing lawsuit after finding that general language in SEC filings stating that defendants were involved in “ongoing investigations” was not misleading and that defendants had no duty to disclose that the Consumer Financial Protection Bureau was specifically investigating them.

All of these recent decisions reinforce that companies must consider their own specific circumstances while paying close attention to jurisdictional developments regarding whether companies must disclose SEC and other agencies’ investigations. Specific circumstances, such as conducting a securities offering, may weigh in favor of making disclosures. On the other hand, if the potential consequences of an SEC investigation are not material, or the likelihood of a bad outcome is very small, disclosure could send the wrong message to the public. Consequently, it is important to obtain legal advice as early as possible when faced with the choice to disclose an SEC or other regulatory investigation in order to help companies navigate this complex decision.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.