Until recently, the US Court of Appeals for the Second Circuit had never rendered an opinion analyzing the safe harbor for forward looking statements in the Private Securities Litigation Reform Act (the “PSLRA”). It finally did so on May 18, 2010 in a decision that upheld a district court’s dismissal of a lawsuit brought by investors in American Express against the company and several of its officers and directors. Among other things, a two-judge panel of the Second Circuit consisting of Judges Katzmann and Calabresi held in Slayton v. American Express Company, No. 08-5442-cv, 2010 WL 1960019 (2d Cir. May 18, 2010), that because the safe harbor provision is “written in the disjunctive,” a defendant is not liable under Section 10(b) of the Securities Exchange Act of 1934 for making an allegedly false or misleading forward-looking statement if the 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.” The panel also applied the weighing-of-inferences analysis dictated by the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. to the “actual knowledge” prong of this inquiry. Thus, 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 [forward looking] 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.’”
The panel in Slayton found that the plaintiffs failed to allege sufficient facts to meet these standards. Although the defendants’ forward-looking statement was neither accompanied by meaningful cautionary language nor immaterial, the court nevertheless affirmed the lower court’s decision because the inference that defendants made the statement with actual knowledge that it was false or misleading was not “‘at least as compelling as any opposing inference one could draw from the facts alleged.’”
The Second Circuit’s decision in Slayton provides much needed guidance to issuers that routinely offer projections of anticipated future economic performance. In addition to confirming generally that the PSLRA safe harbor will protect issuers’ forward-looking statements that are accompanied by meaningful cautionary language, the court held that recklessness will not suffice to demonstrate that a defendant made a false or misleading forward-looking statement with fraudulent intent. The court also held that in order to be considered “meaningful,” cautionary language must convey substantive information about factors that realistically could cause results to differ materially from those projected in the forward-looking statement, i.e., boilerplate warnings will not suffice. Separately, the Slayton court found that while the PSLRA safe harbor excludes from its protections forward-looking statements that are “included in a financial statement prepared in accordance with generally accepted accounting principles,” that exclusion does not apply to statements in the “Management’s Discussion and Analysis” section of a public filing.
Because cases asserting claims under Section 10(b) premised on allegedly false or misleading forward-looking statements are fact sensitive, we set out below in some detail a description of the background facts in Slayton – which are somewhat intricate – and the court’s decision.
The plaintiffs in Slayton alleged that starting in the 1990s, American Express, through its subsidiary American Express Financial Advisors (“AEFA”), began to invest heavily in high-yield debt securities, including junk bonds and collateralized debt obligations (“CDOS”). In early 2001, after American Express disclosed losses in AEFA’s high-yield debt portfolio of $123 million for fiscal-year 2000, American Express’s chief executive officer Kenneth Chenault ordered a “very hard look” at AEFA’s high-yield debt. Subsequently, in April 2001, American Express announced losses of $182 million in AEFA’s high-yield debt portfolio for the first quarter of 2001. In early May 2001, Chenault was advised by AEFA’s management that “American Express was facing additional losses on its high-yield debt investments beyond those already booked.” AEFA’s CEO advised Chenault that “[w]e really don’t know enough to even give you a range.” At Chenault’s direction, American Express assembled a team to conduct a detailed internal review of AEFA’s high-yield portfolio.
While the internal review was ongoing, on May 15, 2001 American Express filed its quarterly report on Form 10-Q for the first quarter of 2001 (the “Form 10-Q”). The company reported the $182 million in first quarter losses from AEFA’s high-yield portfolio and explained, “[t]he high yield losses reflect the continued deterioration of the high-yield portfolio and losses associated with selling certain bonds.” Importantly, it added that “[t]otal losses on these investments for the remainder of 2001 are expected to be substantially lower than in the first quarter.” The Form 10-Q also cautioned – several pages after the statement that losses for the remainder of 2001 were expected to be substantially lower – that it “contain[ed] forward-looking statements, which are subject to risks and uncertainties.” It added that “[f]actors that could cause actual results to differ materially from these forward-looking statements include . . . potential deterioration in the high-yield sector, which could result in further losses in AEFA’s investment portfolio.”
In early July 2001, American Express completed its review of AEFA’s high-yield portfolio. On July 18, 2001, American Express announced that its earnings for the second quarter of 2001 would likely decline 76% from the previous year in part because of an $826 million pre-tax charge to recognize “additional write-downs in the high-yield debt portfolio at [AEFA] and losses associated with rebalancing the portfolio towards lower-risk securities.”
Plaintiffs filed suit against American Express, Chenault and several other officers and directors of American Express and AEFA in July 2002, asserting, among others, claims under Section 10(b). In January 2007, plaintiffs filed an amended complaint, alleging, among other things, that when the defendants stated on May 15 in the Form 10-Q that losses for the remainder of 2001 were expected to be “substantially lower,” they knew that they had no reasonable basis upon which to say so because Chenault was expressly warned earlier that month that the $182 million first quarter write-down did not reflect the true magnitude of the deterioration of AEFA’s high-yield debt portfolio.
The defendants moved to dismiss, and the district court granted the motion, finding that:
The information . . . Chenault received in May 2001 could support an inference of scienter because it suggests that [he] had access to information indicating that the May 15, 2001 statement was no longer accurate. However, in light of the fact that Defendants immediately put together a team to analyze all of AEFA’s High Yield Debt and then announced the results of the analysis in July 2001, the more compelling inference is that Defendants were not acting with an intent to deceive, but rather attempting to quantify the extent of the problem before disclosing it to the market.
In re American Express Co. Sec. Litig., No. 02 Civ. 5533, 2008 WL 4501928, *8 (S.D.N.Y. Sept. 26, 2008). The district court therefore held that the plaintiffs failed to state a claim with respect to the forward-looking statement contained in the Form 10-Q.
The Second Circuit’s Decision
The PSLRA established a statutory safe-harbor for forward-looking statements that insulates defendants from liability to the extent that the statement is “[(1)] “identified as a forward-looking statement, 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 [(2)] . . . immaterial; or [(3)] . . . the plaintiff fails to prove that the forward-looking statement . . . if made by a business entity; was . . . made by or with the approval of an executive officer of that entity; and . . . made or approved by such officer with actual knowledge by that officer that the statement was false or misleading.” In Slayton, the Second Circuit noted that “the safe harbor is written in the disjunctive.” Thus, a defendant is not liable for a statement that is forward-looking and satisfies any of the aforementioned enumerated criteria.
Turning to the facts, the court first found that the statement in American Express’s Form 10-Q that “[t]otal losses on these investments for the remainder of 2001 are expected to be substantially lower than in the first quarter” was indeed forward looking insofar as it was both a projection of future losses and a statement of future economic performance. The plaintiffs argued that even if the statement in the Form 10-Q was forward looking, it was excluded from the PSLRA’s safe harbor, which does not apply to forward-looking statements “included in a financial statement prepared in accordance with generally accepted accounting principles [‘GAAP’].” However, because the statement at issue appeared in the “Management’s Discussion and Analysis” section of the Form 10-Q, the court concluded that it was not excluded from the PSLRA’s safe harbor because Congress explicitly included “a statement of future economic performance . . . contained in a discussion and analysis of financial condition by the management” in the PSLRA’s definition of a forward-looking statement.
The court next considered whether American Express’s forward looking statement was accompanied by “meaningful cautionary language.” The court noted that the Form 10-Q included a broad disclaimer that that it “contain[ed] forward-looking statements, which are subject to risks and uncertainties,” which were identified by words such as “‘believe’, ‘expect’, ‘anticipate’, ‘optimistic’, ‘intend’, ‘aim’, ‘will’, ‘should’ and similar expressions. . . .” It added that “[f]actors that could cause actual results to differ materially from these forward-looking statements include . . . potential deterioration in the high-yield sector, which could result in further losses in AEFA’s investment portfolio.” The court disagreed with the plaintiffs’ argument that forward-looking statements must be specifically labeled as such, siding with defendants and the SEC, which submitted an amicus curiae brief in the case arguing that “the facts and circumstances of the language used in a particular report will determine whether a statement is adequately identified as forward-looking.” In particular, “[t]he use of linguistic cues like ‘we expect’ or ‘we believe,’ when combined with an explanatory description of the company’s intention to thereby designate a statement as forward-looking, generally should be sufficient to put the reader on notice that the company is making a forward-looking statement.”
However, the court was more troubled by the fact that defendants “knew of the major and specific risk that rising defaults on the bonds underlying AEFA’s investment-grade CDOs would cause deterioration in AEFA’s portfolio at the time of the [Form 10-Q], and yet did not warn of it” (emphasis added). The panel noted that the PSLRA protects forward-looking statements that are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” While the PSLRA does not define “important factors,” the Conference Report accompanying the PSLRA explained that “[u]nder this first prong of the safe harbor, boilerplate warnings will not suffice. . . . The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected in the forward-looking statement, such as, for example, information about the issuer’s business.” The Conference Report further advised, however, that this requirement was not intended to provide “an opportunity for plaintiff counsel to conduct discovery on what factors were known to the issuer” at the time the statement was made, and stressed that “[c]ourts should not examine the state of mind of the person making the statement.” While the court found these directions rather contradictory, it was unnecessary to decide this “thorny issue” because the panel concluded that defendants’ cautionary statements were vague and “[verging] on the mere boilerplate, essentially warning that ‘if our portfolio deteriorates, then there will be losses in our portfolio.’” The court noted that the cautionary language in the Form 10-Q warning of potential deterioration in the high-yield sector appeared in numerous earlier reports issued before American Express received new information in early May 2001 that demonstrated continuing deterioration of AEFA’s high-yield portfolio, which “belie[d] any contention that the cautionary language was ‘tailored to the specific future projections.’”
Having concluded that the cautionary language in the Form 10-Q was not sufficient to bring it within the PSLRA’s safe harbor, the court next considered whether the facts alleged by plaintiffs demonstrated that defendants made their statement with actual knowledge that it was false or misleading. Relying on the Third Circuit’s decision in Inst. Investors Group v. Avaya, Inc., the court held that “because the safe harbor specifies an ‘actual knowledge’ standard for forward-looking statements, ‘the scienter requirement for forward-looking statements is stricter than for statements of current fact. Whereas liability for the latter requires a showing of either knowing falsity or recklessness, liability for the former attaches only upon proof of knowing falsity.’” Moreover, the weighing-of-inference analysis articulated by the Supreme Court in Tellabs would apply to this inquiry. Thus, while accepting all allegations in the complaint as true, the court would consider whether “‘all of the facts alleged, taken collectively, give rise to a strong inference of scienter.’” The court would also consider “‘plausible opposing inferences,” and the complaint would survive “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.’”
While it found “this question close,” the court concluded that application of Tellabs’ stringent standard to the facts alleged by plaintiffs required dismissal of the complaint. The court first considered the facts that supported an inference of scienter, including that the defendants were presented with the highly likely risk that AEFA’s high-yield portfolio would deteriorate due to rising defaults in the underlying bonds in early May, and defendants did not know the extent of the likely deterioration and therefore had no reasonable basis for predicting that “[t]otal losses on these investments for the remainder of 2001 are expected to be substantially lower than in the first quarter.” While these facts would support an inference of scienter, the court found that the opposing non-fraudulent inference was no less compelling:
The opposing nonfraudulent inference is that while the defendants knew that their high-yield portfolio was likely deteriorating, and that they did not know the extent of the deterioration, they subjectively believed that the extent of the deterioration would lead to losses that would be substantially less than $182 million. . . . While the defendants’ prediction that losses would be substantially lower does give us pause, nothing in the [record] directly supports the plaintiffs’ contention that the defendants had reason to believe that the scope of the expected losses would be comparably large, i.e. that they had no basis to believe that the extent of the losses would be substantially lower than $182 million.
The court also found it significant that plaintiffs had not attributed any fraudulent motive to defendants. Absent allegations of motive to defraud, the court concluded that “under our holistic review, [plaintiffs’] circumstantial evidence of actual knowledge must be correspondingly greater.” And viewing the facts alleged holistically, “[r]ather than suggesting an intent to deceive investors, the [record exhibited] the defendants engaging in a good-faith process to inform themselves and the public of the risks.” Accordingly, the court held that defendants’ statement that they expected losses in AEFA’s high-yield portfolio to be substantially less than $182 million was protected under the PSLRA safe harbor, and the district court therefore correctly dismissed the plaintiffs’ claim under Section 10(b).
The Second Circuit’s decision in Slayton confirms that the PSLRA safe harbor will protect a forward-looking statement if the 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. In order to be considered “meaningful,” cautionary language must consist of more than mere boilerplate warnings. Rather, it must convey substantive information about factors that realistically could cause results to differ materially from those projected in the forward-looking statement. The Second Circuit’s decision also confirms that forward-looking statements made in annual and quarterly reports filed with the SEC are entitled to safe harbor as long as they satisfy one of the criteria above and do not appear in the financial statement portion of the report. Perhaps most importantly, Slayton confirmed that recklessness will not suffice to demonstrate that a defendant made a false or misleading forward-looking statement with fraudulent intent, and courts must consider all non-fraudulent inferences when assessing whether a defendant had actual knowledge that a forward-looking statement was false or misleading.