May 21, 2010

Thorny Issues

Surprisingly, the U.S. Court of Appeals for the Second Circuit has never issued an opinion analyzing the PSLRA's safe harbor for forward-looking statements. It filled in that gap this week.

In Slayton v. American Express Co., 2010 WL 1960019 (2d Cir. May 18, 2010), the court considered whether the safe harbor shielded American Express from liability for a statement it made in its May 15, 2001 Form 10-Q. As paraphrased by the court, American Express had disclosed "that while it had lost $182 million from its high-yield debt investments in the first quarter of 2001, it expected futher losses from those investments to be substantially lower for the remainder of 2001." It turned out, however, that in July 2001 the company took a large write-down on those investments.

The court's decision contains a number of interesting holdings.

(1) Plain Language - Contrary to some other courts, the Second Circuit found that the safe harbor is "written in the disjunctive." Therefore, "a defendant is not liable if the forward-looking statement is identified and accompanied by meaningful cautionary language or is immaterial or the plaintiff fails to prove that it was made with actual knowledge that it was false or misleading."

(2) Scope of Financial Statement Exclusion - The safe harbor excludes forward-looking statements "included in a financial statement prepared in accordance with generally accepted accounting principles." The Second Circuit held that the Management's Discussion and Analysis ("MD&A") section of the Form 10-Q, which contained the alleged misstatement, was not part of the financial statement portion of the filing. As a result, the safe harbor could be applied.

(3) Meaningful Cautionary Language - The Second Circuit noted that it was difficult to follow Congress's instructions concerning the application of the safe harbor. To determine whether a defendant has identified the risks that realistically could cause results to differ, "the most sensible reference is the major factors that the defendants faced at the time the statement was made." But it is clear from the relevant Conference Report that Congress did not want courts to inquire into the defendant's knowledge of those risks.

The Second Circuit concluded that it did not have to "decide that thorny issue," however, because American Express's cautionary statement was too vague to satisfy the "meaningful" standard. While the company warned of the possibility of "potential deterioration in the high-yield sector," it did not warn of the risk that rising defaults on the bonds underlying its investments would cause that deterioration. Moreover, American Express's cautionary statement remained the same even as the problems related to its investments changed.

(4) Actual Knowledge - The Second Circuit held that the relevant pleading standard for actual knowledge is whether a reasonable person, based on the facts alleged, would "deem an inference that the defendants (1) did not genuinely believe the May 15 statement, (2) actually knew they had no reasonable basis for making the statement, or (3) were aware of undisclosed facts tending to seriously undermine the accuracy of the statement, 'cogent and at least as compelling as any opposing inference.'" In this case, the plaintiffs failed to allege sufficient facts to meet this standard.

Holding: Dismissal based on PSLRA's safe harbor affirmed.

Quote of note: "Congress may wish to give further direction on how to resolve this tension, and in particular, the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement? In this case, however, we need not decide that thorny issue because we conclude that at any rate the cautionary statement the defendants point to here was vague."

Posted by Lyle Roberts at May 21, 2010 4:21 PM | TrackBack
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