When a public company resolves a Foreign Corrupt Practices Act (FCPA) investigation by either the U.S. Department of Justice (DOJ) or Securities and Exchange Commission (SEC), private litigation by investors under the Securities Exchange Act (Exchange Act) often follows. Such litigation can be extremely difficult to defeat at the motion to dismiss stage given the Second Circuit’s stated preference against finding alleged misstatements or omissions immaterial as a matter of law unless they were “so obviously unimportant to a reasonable investor.”1 Once these suits survive a motion to dismiss, the expense of litigating or settling them can mirror the magnitude of the initial criminal penalties. Last month, however, the U.S. District Court for the Southern District of New York demonstrated that an early victory in FCPA-based Exchange Act class actions is possible by dismissing with prejudice the claims in Emps. Ret. Sys. of the City of Providence v. Embraer S.A., No. 16-cv-6277, 2018 U.S. Dist. LEXIS 56895 (S.D.N.Y. Mar. 30, 2018).
Embraer’s FCPA Enforcement Action
Embraer, a Brazilian aerospace conglomerate, agreed in October 2016 to a deferred prosecution agreement with the DOJ and a corresponding settlement with the SEC, in which it admitted to violating both the anti-bribery and books and records provisions of the FCPA.2 As part of those settlements, Embraer agreed to pay a US$107 million criminal penalty to the DOJ, US$83.8 million in disgorgement to the SEC (plus US$14.4 million in prejudgment interest), and to retain an independent monitor for a three-year term.3 Of particular assistance to the plaintiffs in the ensuing securities class action, Embraer admitted as part of the deferred prosecution agreement to a 72-paragraph statement of facts detailing the history of its bribery scheme.4 The plaintiffs filed their complaint on August 8, 2017, little more than a week after Embraer filed a Form 6-K disclosing its imminent settlement with the DOJ and SEC, and amended their complaint about a month and a half after the deferred prosecution agreement was executed.5
The Embraer Decision
Disclosure of Government Investigation
Despite the plaintiffs’ allegations to the contrary, the court held that Embraer’s periodic disclosures of the government’s FCPA investigation in its SEC filings were adequate and not misleading. Embraer initially disclosed that it had received a subpoena from the SEC and was under investigation by both the SEC and DOJ, specifically for violations of the FCPA.6 Embraer further explained that it had commenced an internal investigation into the alleged violations, produced documents to the SEC and DOJ, and that its legal counsel had met in person with both agencies.7 Embraer did not, however, predict the duration, outcome, or potential financial impact of the investigation.8 Instead, Embraer disclaimed any ability to make such predictions for the majority of the class period, and simply said that the investigation could result in “substantial fines” or “other sanctions.”9
The court rejected the plaintiffs’ attempts to “Monday morning quarterback” Embraer’s opinion that it could not accurately estimate its potential liability during the early stages of the SEC and DOJ investigations.10 At various points in the investigation, Embraer disclosed that it and its legal counsel had reached the conclusion that no estimate of liability was feasible.11 It was not until Embraer was in the midst of actual settlement discussions with the DOJ and SEC that it set aside and disclosed liability reserves of approximately US$200 million.12 The court explained that these liability estimates were statements of opinion and, therefore, entitled to heightened protection from Exchange Act liability.13 Since the plaintiffs failed to allege facts casting doubt as to whether Embraer and its advisors sincerely held these opinions, those opinions could not be false or misleading.14
Financial Statements and Descriptions of Business Operations
The court promptly rejected the plaintiffs’ argument that Embraer’s historical financial statements were misleading because Embraer failed to disclose the amount of revenue that was obtained through bribery.15 So long as the revenue was actually received, it did not matter that the DOJ and SEC later decided that it was improperly obtained.16
Similarly, the fact that certain Embraer subsidiaries had obtained some revenues as a result of bribery did not render misleading Embraer’s description of those subsidiaries’ legitimate business operations. By disclosing the existence of the investigation, Embraer made investors adequately aware of these illegitimate activities.17 Embraer was not required to portray its subsidiaries as though they had no legitimate business functions.
Ethics Policies & Internal Controls
The court held that Embraer’s description of its ethics and anti-corruption policies were not rendered misleading by the DOJ’s and SEC’s eventual finding that Embraer violated the FCPA. According to the Court, these generalized ethics policies, even though they specifically discussed anti-corruption, were too vague and “aspirational” to form the basis of material misstatements.18 The court emphasized that the Exchange Act does not transform every violation of an issuer’s code of ethics into a securities law violation, even if that ethics violation is undisclosed.19
The court spent more time grappling with and ultimately rejecting the plaintiffs’ challenges to Embraer’s statements about the strength of its “internal controls.” The plaintiffs alleged that Embraer misleadingly failed to disclose weaknesses in these internal controls because they failed to prevent the bribery from occurring in the first place and allowed employees with knowledge of the bribery to continue working at Embraer. The court, however, held that the plaintiffs’ generalized attack on Embraer’s internal controls failed particularly to explain “how they were deficient, when, and why.”20 Furthermore, Embraer’s acts of bribery did not occur during the class period when it described its internal controls in public filings, so there was no suggestion that Embraer’s internal controls were deficient at the time the statements were made.21 Finally, the court explained that “internal controls” inherently relate to establishing adequate controls over the accuracy of financial reporting, and the court had already decided that Embraer’s historical financial statements were accurate despite its past bribery.22
Best Practices and Lessons Learned From the Embraer Decision
By disclosing the existence of the DOJ and SEC investigation, Embraer avoiding placing itself in the precarious position of defending against investors’ arguments that the existence of the investigation itself was a material omission. Potential regulatory and enforcement liability is a major risk to many companies across a wide variety of industries, and many public SEC filings include forward-looking disclosures of this risk. Putative shareholders’ recent success in an FCPA-based securities class action against hedge fund manager Och-Ziff Capital Management demonstrates that these general disclosures can be rendered misleading by the issuer’s failure to disclose a known SEC or DOJ investigation of FCPA violations.23 Disclosing the existence of an investigation, especially after receipt of a formal subpoena, is clearly the best practice to guard against liability from inevitable yet unpredictable news reports that make the investigation public.
A decision to disclose a civil or even criminal investigation into potential FCPA or other regulatory violations may ultimately tempt certain investors to file an Exchange Act suit, but it by no means dooms an issuer to actual securities law exposure. The Southern District has confirmed—even when refusing to dismiss class action complaints—that the FCPA does not contain a private right of action, and a failure to disclose conduct giving rise to an FCPA violation prior to the conclusion of the government’s investigation is not a per se violation of the Exchange Act.24 Embraer provides a roadmap for appropriate disclosure. An issuer should identify the law potentially violated, the agencies involved in the investigation, and generally update investors about the status of the investigation, including settlement negotiations. The issuer need not, however, detail the exact scope of the improper conduct, calculate the amount of revenue implicated by that conduct, or predict with perfect accuracy the penalties it might face.
The Embraer decision reiterates that an FCPA investigation should not place at risk an issuer’s neutral reporting in its financial statements. Even successful class action complaints, such as the investor lawsuit following the DOJ’s FCPA enforcement action against VimpelCom, confirm that historical financial statements of revenues or profits do not become misleading when that money is revealed to be the fruit of bribery.25 A comparison between Embraer and Och-Ziff, however, demonstrates that an issuer is better off disclosing that it has retained legal and financial advisors to assess the magnitude of potential regulatory exposure—even if those advisors reach the opinion that such exposure cannot reliably be estimated. Such disclosures are statements of opinion that courts are unlikely to second-guess, but the absence of such disclosure can lead to liability. For example, the plaintiffs in Och-Ziff were successfully able to allege an Exchange Act violation based on the issuer’s failure to comply with GAAP by estimating a reasonably possible loss.26
Statements about an issuer’s compliance program or other internal policies are likely to be too generalized to form a basis for Exchange Act liability. Even in certain instances where FCPA-based securities class actions have survived a motion to dismiss (as in Och-Ziff), these claims have failed.27 Issuers should, however, heed the Embraer court’s implicit warning not to tout their compliance programs or ethics policies as a means to assure investors of the lack of potential harm posed by an FCPA or other regulatory investigation.28 Separate disclosure of the investigation and generalized description of a compliance policy is acceptable, but the confluence of such statements can make descriptions of compliance programs misleading. A failed motion to dismiss an Exchange Act class action by another Brazilian conglomerate, Electrobras, is one example. The company on multiple occasions responded to media reports of corruption investigations by emphasizing its rigorous adherence to its internal code of ethics.29 The misleading nature of these statements was later revealed, however, when the company was forced publicly to disclose that a key executive was sentenced for violating Brazil’s anti-corruption law and that it had hired legal counsel to conduct an internal FCPA investigation.
Finally, some of Embraer’s success in dismissing the Exchange Act class action must be attributed to the lucky circumstance that the misconduct giving rise to its FCPA violations occurred relatively long ago, prior to the start of the class period. Although the court found that Embraer’s description of its subsidiaries’ legitimate business activities was not actionable, another Southern District judge found that VimpelCom’s similar description of its business operations was materially misleading because of its failure to warn that their prosperity was potentially tainted by bribery.30 Accordingly, companies that are still in the midst of remedying bribery or other misconduct should be extremely cautious when describing their operations and should avoid prominently promoting business lines in which they know misconduct recently has occurred.
The Southern District’s dismissal with prejudice of the Exchange Act class action in Embraer provides hope that not every FCPA settlement will give rise to expensive private litigation. Issuers should take care proactively to disclose the existence of an FCPA (or other regulatory) investigation, but they need not provide a blow-by-blow account of the alleged misconduct. They typically may continue to report their financial statements and describe their system of compliance policies and internal controls as normal, so long as they do not expressly identify these policies and controls as a justification for their innocence. As common sense would dictate, issuers should take care when publicly promoting the profitability of business segments that they know are afflicted by bribery or other misconduct, especially if that misconduct remains unresolved.