Katten's Sarah Eichenberger and Richard Zelichov say that when public companies publish risk factor disclosures, courts should analyze whether those can sufficiently excuse liability, but shouldn't transform them into liability sources for companies.
Risk factor disclosures by public company issuers have come under increased scrutiny in recent court decisions.
The scope, number, and length of risk factors has increased since the Securities and Exchange Commission amended its rules concerning risk factor disclosures in 2020. This has produced more such disclosures that are potentially subject to attack.
In addition, event-driven securities suits have become increasingly prevalent in recent years. These lawsuits often allege that an issuer has concealed or understated the risk of the "event" that gave rise to a stock price drop and the securities lawsuit.
This has resulted in stockholders judging risk factors after a negative event has occurred to try find some inadequacy after the fact.
Companies disclose risk factors to, among other things, protect forward-looking information under the Private Securities Litigation Reform Act of 1995 safe harbor. Risk factor disclosures should thus help reduce liability for public company issuers that wish to provide business forecasts without incurring liability for failing to predict the future accurately.
Misunderstandings in Court
Some courts, however, have wrongly held that risk factor disclosures actually create—not eliminate—liability for issuers and their directors and officers if they do not also disclose risks that have materialized or that are virtually certain to materialize. For example—In re Alphabet, Inc. Sec. Litig., Set Capital LLC v. Credit Suisse Group AG, Tutor Perini Corp. v. Banc of America Securities LLC.
Courts holding that risk factors can be a source of liability when issuers fail to disclose risks that have already materialized have misapplied Section 10(b) by invoking an inapplicable analogy—that there is no protection for someone who warns their hiking companion to walk slowly because there might be a ditch ahead, knowing full well that the Grand Canyon lies one foot away.
Likening risk factor disclosures to the Grand Canyon mischaracterizes their purpose.
As explained by the US Court of Appeals for the Sixth Circuit in Bondali v. Yum! Brands, Inc., risk factors are not designed to disclose backward-looking issues. Rather, "Risk disclosures like the ones accompanying 10-Qs and other SEC filings are inherently prospective in nature. They warn an investor of what harms may come to their investment. They are not meant to educate investors on what harms are currently affecting the company."
Bondali's view that there should not be potential securities fraud liability for risk factors is more consistent with US Supreme Court precedent, the language of the relevant regulation requiring risk disclosures, the purposes of the safe harbor for forward-looking statements, and the case law in which the Grand Canyon analogy developed.
Supreme Court Precedent
The Supreme Court held in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fundthat categorically assigning liability to speculative statements is not appropriate under the securities laws.
Omnicare reasoned that opinion statements challenged under Section 11 of the Securities Act which, like risk factor disclosures, are inherently speculative, must be analyzed "in [their] full context"—"in light of all of [their] surrounding text, including hedges, disclaimers, and apparently conflicting information." Bondali's analysis of risk factor disclosures tracks the Supreme Court's logic.
Congress and the SEC
Similarly, Item 105 of Regulation S-K—the rule describing what the SEC expects with respect to risk disclosures—acknowledges that risk disclosures are inherently imprecise, describing "risk factors" as "the material factors that make an investment in the registrant or offering speculative or risky."
The terms "speculative" and "risky" are commonly understood as possibilities or hypotheticals about the future and not as statements about the past. Holding issuers liable for risk disclosures that speculate about potential—or even likely—risks is antithetical to the language of Item 105.
In addition, Congress enacted the safe harbor for forward-looking statements in part to encourage issuers to provide forward-looking information. If risk factor disclosures intended to comply with the safe harbor increase liability, issuers may be less likely to provide forward-looking information.
Lastly, the Grand Canyon" analogy originated from cases where a risk disclosure was not sufficiently specific or meaningful to excuse liability for another allegedly false or misleading statement.
In those cases, a risk factor using conditional language when the risk has already materialized did not create liability where none previously existed. It simply did not absolve an issuer, and its directors and officers, from liability for a different statement that might be actionable for other reasons.
Courts should be analyzing risk factor disclosures solely to determine whether they are sufficient to excuse liability. They may not be in every instance, but courts should not transform such disclosures into a source of liability for public companies and their directors and officers.
Originally Published by Bloomberg Law
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