CLS Blue Sky Blog

The SEC’s Covid-19 Disclosure Guidance Is a Litigation Trap

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 has encouraged extensive disclosures about a company’s current operating status and future operating plans under various Covid-19-related conditions. The guidance called for comments on the unknown future effects of the pandemic on a company’s business. The SEC’s chairman and another top SEC official 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. Advice from 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.”

Statements by businesses about future operations and effects are not historical facts and instead are forward-looking statements. 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. 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 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.”

The chairman’s pledge not to second guess does not bind private plaintiffs, however. Plaintiffs’ lawyers are waiting to pounce with securities class actions when a business problem precedes a noticeable stock price decline (see the 2019 review of securities class actions from Cornerstone Research), and 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 in the safe harbor, and plaintiffs’ lawyers are expert at exploiting the soft spots 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.

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. Directors and management should make the forward-looking statements required by law but should understand that going as far as the SEC discussed, which is not required by law, carries higher-than-normal litigation risk and, given the unknowns about the pandemic, has limited value to investors. If a company exercises restraint about Covid-19 disclosures and if the SEC later queries the absence of more information, companies should not be faulted for saying that they did not know enough to make the statements the SEC proposed.

This post comes to us from Andrew Vollmer, senior affiliated scholar with the Mercatus Center at George Mason University and former deputy general counsel of the Securities and Exchange Commission.  The full version is on the Mercatus Bridge site and available here.

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