Public companies have always struggled with when to disclose a Securities and Exchange Commission (“SEC”) informal inquiry, formal investigation, or receipt of a Wells Notice1 due mainly to the paucity of decided cases providing meaningful guidance on the issue. A recent federal case from New York, however, has suggested such inquiries are not material, joining the limited number of prior decisions on this issue.2
On January 22, 2016, Judge John Koeltl of the Southern District of New York dismissed In re: Lions Gate Entertainment Corp. Securities Litigation,3 a shareholder class action against the movie studio Lions Gate. The district court held that there is no general obligation under the federal securities laws to disclose to investors an ongoing SEC investigation or the receipt of a Wells Notice and that these developments were not per se material to investors.
Lions Gate and several of its officers received Wells Notices regarding defensive measures taken in a control fight initiated by investor Carl Icahn. The SEC Enforcement Division advised that it was considering recommending a civil action against the company and the executives. The Wells Notices led to settlement discussions, resulting in an agreement to pay a $7.5 million civil penalty. Under the terms of the settlement, the company admitted wrongdoing under federal securities law in that it had made misleading statements in connection with its defensive strategy against
Lions Gate filed a form 8-K on the same day that the SEC publicly issued the administrative Consent Order. Lions Gate's stock subsequently fell, allegedly as a result of the disclosure of the SEC settlement.
Several shareholder plaintiffs sued, alleging that Lions Gate had an affirmative duty to disclose the receipt of the Wells Notices in order to prevent its prior disclosures from being misleading. The court rejected the claim.
As the court explained, after issuing a Wells Notice, the Enforcement Division staff may choose not to proceed with a recommendation to commence an action and, even if the staff does make a recommendation, the Commission may not authorize filing of an action. Therefore, the court held, “the defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities law do not impose an obligation on a company to predict the outcome of investigations. There is no duty to disclose litigation that is not ‘substantially certain to occur.’”4
The court also rejected plaintiffs’ argument that Lions Gate had a duty to disclose the existence of the regulatory investigation because it could have affected the company’s financial condition due to the potential for a material penalty. In this case, the court observed that the $7.5 million civil penalty was less than one percent of Lions Gate’s consolidated revenue of $839.9 million for the third quarter of 2014 and well below the five percent numerical threshold that the Second Circuit has determined is a “good starting place for assessing the materiality of the alleged misstatement.”5 The court further explained that the “possibility of materiality” is not enough to support a securities fraud claim: “The materiality analysis thus requires a showing of actual materiality; the possibility that the information may be material does not suffice if a reasonable investor would not view the information as significantly altering the total mix of information available.”6
In addition, the court rejected plaintiffs’ argument that under Regulation S-K, Item 103, a company is required to “describe briefly any material pending legal proceedings... known to be contemplated by governmental authorities.” The court held that an SEC investigation itself is not a “pending legal proceeding” for purpose of Item 103, nor is it an indication that the government is “contemplating” a proceeding, since the Commissioners had not yet decided whether to bring a case. Apparently, because the Commissioners, and not the staff, must approve the filing of an enforcement action, the staff’s preliminary intention to recommend action is not “proximate” enough to constitute a contemplated proceeding.
Judge Koeltl’s decision provides important disclosure guidance to companies facing SEC inquiries. It, however, does not hold that a company is never obligated to disclose ongoing investigations or receipt of a Wells Notice. A careful evaluation of the factual circumstances, including other statements made by a company that could trigger a duty to correct, and consultation with disclosure counsel, must be made in connection with any investigation disclosure decision.