A recent federal appeals court decision has cast a shadow over the protection provided by the forward looking statement safe harbor provided by the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The ruling inIn re: Harman International Industries, Inc. Securities Litigation (No. 14-7017) (D.C. Cir. June 23, 2015)reinstated a securities fraud class action lawsuit against an electronics company and three of its officers, who were charged with “knowingly and recklessly” propping up the company’s stock price with erroneous forward looking statements when the company was being considered for an acquisition that eventually fell through. The ruling should serve as a warning to public companies to be more vigilant in reviewing their safe harbor language and ensuring it is both meaningful and current.
Safe Harbor Protection
Congress enacted the PSLRA “to protect investors, issuers, and all who are associated with our capital markets from abusive securities litigation.” The forward looking statement safe harbor provision was designed by Congress to encourage companies to provide investors with information about future plans and prospects. Companies were often reluctant to provide forward looking information due to the prevalence of strike suits which, irrespective of the merits of the claim, were usually less costly to settle than fight. The safe harbor was intended to provide a strong defense against such suits that would discourage their commencement and provide grounds for their summary dismissal when the relevant conditions are satisfied.
The safe harbor provides that a company is not liable with respect to any forward-looking statement if (1) the forward-looking statement is identified as forward-looking and is accompanied by “meaningful cautionary statements” identifying important factors that could cause actual results to differ materially from those in the forward-looking statement or is immaterial; or (2) the plaintiff fails to prove that the forward-looking statement was made with actual knowledge that the statement was false or misleading. The interpretation of the safe harbor in federal courts, however, has left companies with mixed guidance about its usefulness to fend off strike suits.
Harman International In-Play
In April 2007, Harman announced its potential acquisition by a private equity firm led by Kohlberg Kravis Roberts and a Goldman Sachs affiliate. The same day, its CEO, Sidney Harman, told analysts on a call that, with regard to the company’s forecasted fiscal 2007 sales, “the plan is proceeding.” A few months later, the company’s fiscal 2007 annual report on Form 10-K said that its aftermarket sales, especially the company's personal navigational device (“PND”) products, were “very strong during fiscal 2007.” A subsequent analyst call had Harman CFO Kevin Brown forecasting the company’s “very strong” fiscal 2008 sales, especially in Europe.
Harman’s stock price rose markedly after the initial announcement. In September 2007, however, Harman announced that the acquisition plan had been abandoned, and its shares fell by more than 24 percent. The share price fell again in January 2008 when the company lowered its projected earnings per share, and once more in February 2008, when Harman announced its second-quarter 2008 financial results, including lower sales on its PNDs.
Harman International In Court
A consolidated amended complaint filed in May 2008 alleged that Harman and three of its officers knowingly and recklessly propped up the stock price by making materially false and misleading statements about the company's financial condition. The complaint alleged the statement that the company’s PND sales were “very strong” was false and misleading when made because the company failed to disclose: (1) the growing inventory of obsolete PNDs, (2) the fact that the company had missed PND sales targets for the previous fiscal year by more than $85 million, and (3) that the company had recently sold 100,000 obsolete PND units at a substantial discount. The complaint alleges further that the CFO’s statement during the subsequent analyst call that “growth and expansion” would “continue” in the PND business was materially false and misleading, primarily because of the historical evidence of growing inventory, widespread obsolescence, and stagnant sales.
The company countered that it did warn of obsolescence many times. Moreover, the moderator began both analyst calls by warning generally of risk and referring listeners to the company’s most recent annual report on Form 10-K. In this regard, the annual report stated in its risk factor section that sales could suffer if the company failed to “develop, introduce and achieve market acceptance of new and enhanced products,” that it had to “maintain and improve existing products, while successfully developing and introducing new products,” and could “experience difficulties that delay or prevent the development, introduction or market acceptance of new or enhanced products,” and that competitors could “introduce superior designs or business strategies, impairing [the company’s] distinctive image and [its] products’ desirability.”
The district court granted the company’s motion to dismiss the complaint stating that the two statements made during the analyst calls “fell within the statutory safe harbor for forward-looking statements accompanied by meaningful cautionary language, and the third statement that sales were “very strong” was ‘puffery’ and thus inactionable.” But the appellate court picked up on a different aspect of this issue, emphasizing instead that cautionary information accompanying these types of statements must be meaningful.
The D.C. Circuit Court of Appeals reversed the dismissal, finding that the complaint plausibly alleged two statements focusing on the company's PND products were not entitled to the safe harbor protection. The court held that the accompanying cautionary statements were misleading because they failed to disclose historical facts about PNDs that would have been important to a reasonable investor. The Court also held that, contrary to defendants' arguments, their use of the words "very strong" to describe sales at Harman were plausibly understood by investors to be important and to describe a "historical fact rather than unbridled corporate optimism, i.e., immaterial puffery," and thus was actionable.
What is “Cautionary”?
According to the Court, cautionary language cannot be “meaningful” if it is misleading in light of historical facts that were established at the time the statement was made. In this regard, the Court noted that the absence of historical data from Harman’s statements about the obsolescence of its products and how that obsolescence could impact sales made its CEO’s and CFO’s statements misleading, and therefore not meaningful. Further, the safe harbor requirement for “meaningful” cautionary statements calls for “substantive company-specific warnings based on a realistic description of the risks applicable to the particular circumstances.” Thus, “cautionary statements must be substantive and tailored to the specific future projections, estimates or opinions in the [forward looking statements]…” The Court also noted that boilerplate does not meet “the statutory standard because by its nature it is general and ubiquitous, not tailored to the specific circumstances of a business operation, and not of useful quality.”
The Court mused that the forward-looking “safe harbor” disclaimer would not protect from liability a person “who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.” The Court wryly concluded that, “By the end of FY 2007,... the risk of which [the Company] warned... had already transpired.”
As a threshold matter, companies should be judicious in their use of the forward looking statement disclaimer. It is not necessary and perhaps counterproductive to include the disclaimer in press releases that do not include a forward looking statement, such as simple announcements of employee hirings. Including a form of it in every press release as a matter of routine makes the use of the disclaimer look more like boilerplate than a meaningful, tailored warning of the risks that could cause actual results to differ materially from those in the forward-looking statements.
The cautionary language of the disclaimer should be reviewed and updated regularly. It should warn of specific, important risks, include a discussion of actual developments that are relevant to the risks and exclude risks that are true of any company.
As Harman shows, it is dangerous merely to cut-and-paste or incorporate by reference cautionary language without a careful review of the specific forward looking statements intended to be covered by the cautionary language. Intervening events may have caused the language to have gone stale or misstate historical facts. Each use of the safe harbor provides an opportunity to reexamine the company’s safe harbor disclosure, to add any new, specific and important risks that are relevant to the forward-looking statements being made, and to update the disclosure with any material developments in facts and circumstances that may have occurred. AsHarman illustrates, if the harm about which you are warning has already begun to materialize, a safe harbor disclaimer will not protect you absent disclosure of the developments.