The SEC’s COVID-19 Disclosure Guidance Is a Litigation Trap
The disclosures would offer little useful information while opening firms up to securities class actions
The Securities and Exchange Commission (SEC) has been putting pressure on companies that regularly file public reports to make detailed statements about the effects of the coronavirus pandemic on their businesses. Given the many uncertainties about those effects, the disclosures will produce limited benefits for the securities markets but are likely to lead to securities class actions of questionable merit.
The SEC issued two significant documents encouraging extensive disclosures about a company’s current operating status and future operating plans under various COVID-19-related conditions. One was from the SEC’s chairman and another top SEC official, and the second was from the SEC disclosure staff.
Both documents called for comments on the unknown future effects of the pandemic on a company’s business. The chairman’s statement urged public company communications to provide “as much forward-looking information as is practicable,” including how a company’s “operations and financial condition may change” as the efforts to fight the disease progress. In its statement, the SEC disclosure staff acknowledged that the “impact of COVID-19 on companies is evolving rapidly and its future effects are uncertain” but advised that investors wanted to know “what management expects its future impact will be.”
As one might expect, statements by businesses about future operations and effects are not historical facts and instead are forward-looking statements, containing predictions, forecasts, opinions, assumptions, and other forms of soft information. Like other predictions, they have an unfortunate tendency to be inaccurate. Even the best companies that take care to provide complete and accurate information in response to these recommended disclosures will get important things wrong. Too much is not known. Too little can be predicted with confidence. A company that makes some or all of the recommended disclosures faces heightened risks of being sued in a securities class action for false or misleading statements.
To mitigate the increased risk of liability for a forward-looking statement, Congress, the courts, and the SEC developed special protections called safe harbors. The SEC’s recommendations on expanded COVID-19 disclosures put great faith in the safe harbors and explicitly referred to them to reassure nervous companies. The chairman encouraged “companies to avail themselves of the safe-harbors for forward-looking statements.”
The main safe harbor applies only in private litigation and not in SEC enforcement actions, but, to deal with this, the chairman’s statement said the SEC “would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information.” That is a heavily qualified assurance, perhaps because, after the financial crisis, the SEC sued public companies for disclosure violations involving forward-looking statements. As a result, public companies making predictions about the future effects of the pandemic on revenue, costs, or capital could end up being subject to SEC enforcement.
In any event, the chairman’s pledge not to second-guess does not bind private plaintiffs. Plaintiffs lawyers are waiting to pounce with securities class actions when a business problem precedes a noticeable stock price decline, and the safe harbor for forward-looking statements has proved to be an unreliable protection.
Securities class actions are a growing threat. According to a 2019 review from Cornerstone Research, the number of securities class actions (excluding merger and acquisition cases) increased each year for the past several years from 215 in 2017 to 238 in 2018 and 268 in 2019. A chilling statistic is that, in 2019 alone, 5.5 percent of US exchange-listed companies and 7.2 percent of S&P 500 companies were sued in securities class actions.
The safe harbor for forward-looking statements is not the shield the SEC thinks it is. Cornerstone reported that, in the past five years, 45-53 percent of class action complaints included allegations of false forward-looking statements, and circuit court decisions (here and here) show that the safe harbor has met with mixed success in disposing of those allegations. The provisions on the statutory safe harbor are complicated and not straightforward, turning on several different factors, such as the company’s actual knowledge of the falsity of a prediction or the presence of meaningful cautionary statements warning an investor of the reasons that could cause actual results to differ from a forecast.
These factors create weaknesses and breaches in the safe harbor, and plaintiffs’ lawyers are expert at exploiting these crevices to contest the availability of the defense. A decision from the Second Circuit illustrates that courts use hindsight to dissect warnings and the knowledge of corporate managers and second-guess a company’s basis for a forward-looking statement. In practice, the safe harbor for forward-looking statements is a perilous area and does not provide the certainty and predictability that public companies require at the time they communicate to the market.
Even if the defendant company and managers succeed before the courts, they are injured just by being sued. They incur defense costs and suffer reputational damage and litigation risk. They must devote time and attention to the litigation instead of the business.
The SEC’s guidance for public company disclosures about the coronavirus pandemic and faith in the safe harbor for forward-looking statements are distant from the contentious realities of securities litigation. By pressing companies to provide “as much forward-looking information as is practicable” and depend on the safe harbors, the SEC is asking for too much and is feeding the securities litigation beast. Discussing known trends and uncertainties is tricky enough in normal times but becomes more dangerous in the face of a once-a-century pandemic, as evidenced by the number of companies withdrawing earnings guidance and suspending dividends.
Public companies should think hard before providing the detailed and far-reaching discussions of the effects of the COVID-19 disease urged by the SEC. Some forward-looking statements are legally required, but SEC disclosure guidance does not have the force of law, even though public companies normally treat the recommendations as obligatory.
Directors and management should make the forward-looking statements required by law but should understand that going further carries higher-than-normal litigation risk and, given the unknowns about the pandemic, has limited value to investors. Companies should not guess, contrary to advice from the SEC chairman in an interview, and should not even compromise by labeling some statements as guesses. If the SEC later queries the absence of COVID-19 disclosures, companies should not be faulted for saying that they did not know enough to make the statements the SEC proposed.
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