We are constantly bombarded with warnings about dangers to our health or wellbeing. Sometimes, however, the warnings might facilitate the danger. In a new article, I show how the cautionary statements that commonly accompany predictions of corporate performance fall into this camp.
The judicially created “bespeaks caution doctrine”[1] and a highly controversial provision in the Private Securities Litigation Reform Act (PSLRA)[2] enable speakers to avoid liability for failed predictions regarding corporate performance through cautions that accompany the predictions. Unfortunately, the cautions in court decisions applying these defenses constitute misdirection which, if anything, facilitates securities fraud.
To understand why, it is necessary to ask what leads investors listen to corporate managers’ predictions of future performance rather than make the investors’ own forecast based on raw data such as reported earnings. The answer is the same reason that people listen to any opinion: deference to the greater expertise of the speaker. This, in turn, allows us to understand that a prediction or other opinion is false or misleading when it does not represent what it purports to be: an expert judgment. This could be because, in the simple case, the speaker does not actually hold the opinion expressed or because, in the more complicated case, the opinion does not represent the application of the speaker’s expertise in the manner that causes the listener to value the opinion.
To assess which cautions alert investors to fraud and which constitute misdirection, my article divides cautionary statements into two types. One type, which I label credibility cautions, warns the investor of a potential lack of sincerity or the failure of the speaker to apply the expertise expected by the investor. This includes disclosing the speaker’s failure to investigate the matter prior to giving the prediction. It also includes disclosing facts in the speaker’s possession that are so misaligned with the prediction as to raise doubts about whether the speaker believes the prediction or, if so, whether this belief reflects the application of expertise that causes the investor to value the prediction.
The second type of cautionary statement (which I label contingency cautions) simply apprises the investor of various facts or events that might happen and could cause the prediction to be wrong. My article uses studies of corporate disclosure documents and a hand collected set of court opinions to document that contingency cautions, not credibility cautions, accompany corporate predictions. Unfortunately, contingency cautions facilitate fraudulent predictions by misdirecting investors and courts from the credibility of the speaker in giving the prediction. Such cautions commonly tell the investor little that the investor should not already know and, more fundamentally, do not flag predictions lacking sincerity or basis and thus leave the lemons market effect created by bogus predictions in full operation.
The article explains that the prevalence of contingency cautions in cases dealing with the bespeaks caution doctrine and the PSLRA safe harbor for forward-looking statements is the result of incentives given defendants, plaintiffs, courts, and Congress. Those incentives result from the fact that securities fraud litigation is itself a multi-sided lemons market in which all sides look for signals of who is the lemon before costly trial and discovery. Participants in securities fraud litigation thus pretend that contingency cautions are such a signal when, in fact, they distinguish the lemons from the non-lemons no more in the securities fraud litigation lemons market than in the securities lemons market.
The article also explains how the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund[3] — without courts or anyone else realizing it so far — provides authority for courts to limit the cautions that establish a defense under the bespeaks caution doctrine and the PSLRA safe harbor to credibility rather than contingency cautions. Omnicareclarifies when an opinion is false or misleading. Specifically, an opinion is false if the speaker does not believe it. More critically, an opinion is misleading if the speaker fails to disclose that the speaker did not investigate before giving the opinion to the degree expected by the reasonable investor or ignored facts undercutting the opinion to a greater degree than expected by the reasonable investor. In other words, what makes an opinion misleading under Omnicare is omission of the sort of facts that I have labeled credibility cautions. Indeed, the Supreme Court’s analysis of the cautionary statements given by Omnicare is consistent with the notion that what matters is disclosing reasons to question the credibility of the speaker rather than disclosing risks that might lead the opinion to be wrong.
Omnicare dramatically narrows what omissions might render an opinion misleading and cuts back the ability of plaintiffs to get forward-looking statement cases that are lemons past the pleading stage. Unrecognized so far, Omnicare should also dictate, because of the mirror image relationship between misleading omissions and sufficient cautions, what cautions are necessary to avoid liability. My article defends the view of the lower courts already applying Omnicare to Rule 10b-5 and not just Section 11 and to predictions rather than just opinions as to current facts. It addresses how the decision should change the application of the bespeaks caution doctrine – explaining that only credibility, not contingency, cautions can render a fraudulent prediction not material because only credibility cautions lead the reasonable investor to disregard the prediction whereas contingency cautions simply add to the total mix of information considered by the reasonable investor along with the fraudulent prediction.
The article closes by reconciling Omnicare and the PSLRA safe harbor for forward-looking statements. Requiring credibility cautions answers the criticism that the PSLRA safe harbor allows those giving knowingly false predictions to avoid liability by giving cautions. A credibility caution disclosing those facts that plaintiffs will later claim show the defendants’ lack of belief or basis enables investors rather than judges or juries to decide whether a prediction is sincere and reflects the expertise that makes it worth considering. The result is a sensible safe harbor allowing speakers to avoid litigation over their state of mind in grey areas – but only if speakers follow the advice trial lawyers give to their witnesses: Make sure that jurors (or in this instance investors) hear any reasons to question your credibility from you first.
ENDNOTES
[1] E.g., In re Donald J. Trump Casino Sec. Litig.-Taj Mahal Litig., 7 F.3d 357, 371 (3d Cir. 1993).
[2]15 U.S.C. §§ 77z-2, 78u-5.
[3] 575 U.S. 175 (2115).
This post comes to us from Professor Franklin A. Gevurtz at the University of the Pacific – McGeorge School of Law. It is based on his recent article, “Important Warning or Dangerous Misdirection: Rethinking Cautions Accompanying Investment Predictions,” available here.