The novel coronavirus, and the disease that it causes, COVID-19, has serious implications for public and private companies’ interactions with financial regulators, investors, and the general public. The Securities and Exchange Commission (“SEC”) has already taken steps both to mitigate the disruption the outbreak may have had on companies’ compliance obligations and crack down on suspicious behavior relating to misinformation about the pandemic. Private plaintiffs’ attorneys have also begun to survey the market for potential COVID-19 related securities cases. Morrison & Foerster outlines key disclosure obligations concerning this outbreak, and how to minimize exposure to both regulatory and private scrutiny. In brief:
- Corporate Disclosures: Companies should evaluate whether they must disclose specific information about the effects of COVID-19 on their business.
- Companies affected by COVID-19 may qualify for extended deadlines for SEC filings and materials provided to security holders.
- Companies should consider how to address the effects of COVID-19 in risk factors, financial disclosures, the description of business, legal proceedings, earnings information, and in response to market rumors.
- SEC Enforcement: The SEC has already taken quick steps to shut down suspicious trading activity related to COVID-19’s impact on business operations. In addition to trading suspensions, the SEC has reminded companies of their obligation to minimize the risk of insider trading on material non-public information (“MNPI”) about the pandemic’s effects.
- Given the deep impact of COVID-19, employees at all levels of a company — from rank-and-file employees to directors, officers, and other high-level corporate insiders — could possess MNPI about the outbreak’s effect on business operations.
- Corporations should identify and educate employees who have, or are likely to have, MNPI about their compliance obligations, and may wish to consider additional steps to restrict trading activity.
- Private Securities Litigation: Private plaintiffs will bring either securities class action or derivative suits based off of companies’ statements and actions responding to COVID-19.
- Two securities class action complaints based on COVID-19 disclosures were filed last week; more are coming.
- As discussed above, companies should carefully review their disclosures to adequately reflect known risks and uncertainties.
- There are concrete steps that companies can take to mitigate the risk of private securities litigation, including updating their cautionary language to maximize the protections of the safe harbor, drafting internal documents with the knowledge that they may become public in the event of litigation, and reviewing their Directors & Officers insurance policy.
More in depth guidance follows below.
COVID-19 has far-reaching implications for public companies. The impact of COVID-19 on operations and financial performance raises difficult questions of when and how much information to provide to existing shareholders, prospective investors and the public. The communications by companies about COVID-19 will be subject to heightened scrutiny by both the SEC and potential litigants, making it critical for companies to consider their disclosure obligations arising from COVID-19.
A company must evaluate whether it has an affirmative disclosure obligation that would require the company to address material risks and uncertainties arising from COVID-19, including any upcoming SEC periodic and current reports, potential securities offerings, ongoing share repurchases, or other public statements (such as earnings announcements or investor day presentations). If a company chooses to make a statement regarding COVID-19, such statement may not be materially misleading, or omit information that would make the statement materially misleading. Companies have a duty to correct prior disclosure that the company determines was untrue (or omitted a material fact necessary to make the disclosure not misleading) at the time the disclosure was made.
In addition to the information expressly required by SEC rules and forms, a public company is required to disclose “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” The SEC considers omitted information to be material if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or that disclosure of the omitted information would have been viewed by the reasonable investor as having significantly altered the total mix of information available.
The materiality of risks and uncertainties associated with COVID-19 depends upon the nature, extent, and potential magnitude of the impact on the company’s business and the scope of the company’s operations. In accordance with Basic v. Levinson, a company should consider both the probability of and anticipated magnitude of any COVID-19 impacts in light of the totality of the company’s business activity.
On January 30, 2020, SEC Chairman Jay Clayton stated that he had asked the SEC staff (the “Staff”) to “monitor and, to the extent necessary or appropriate, provide guidance and other assistance to issuers and other market participants regarding disclosures related to the current and potential effects of the coronavirus.” He further stated that the effects “may be difficult to assess or predict with meaningful precision both generally and as an industry- or issuer-specific basis,” noting that “actual effects will depend on many factors beyond the control and knowledge of issuers.” Chairman Clayton also stated, “how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.”
On March 4, 2020, the SEC adopted an exemptive order extending deadlines for many SEC reports (the “Order”), and encouraged “all companies and other related persons to consider their activities in light of their disclosure obligations under the federal securities laws.”
In the press release, the SEC reminds companies that when they do choose to disclose material information regarding the impact of the coronavirus, they should “take the necessary steps to avoid selective disclosures and to disseminate such information broadly” and the issuer may need to consider whether it is necessary to “revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate.” The SEC notes that issuers providing forward-looking information about material developments, including known trends or uncertainties regarding the coronavirus, can “take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for this information.”
The SEC’s Order relates to the time period from and including March 1, 2020, to April 30, 2020. The SEC notes in the Order that it “intends to monitor the current situation and may, if necessary, extend the time period during which this relief applies, with any additional conditions the Commission deems appropriate and/or issue other relief.”
Under the Order, a company that is subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act, and any person required to make any filings with respect to such a company, is exempt from any requirement to file or furnish materials with the SEC under Exchange Act Sections 13(a), 13(f), 13(g), 14(a), 14(c), 14(f), and 15(d); Regulations 13A, Regulation 13D-G (except for those provisions mandating the filing of Schedule 13D or amendments to Schedule 13D), 14A, 14C, and 15D; and Exchange Act Rules 13f-1, and 14f-1, as applicable, where the following conditions are satisfied:
- The company or any person required to make any filings with respect to such a company is unable to meet a filing deadline due to circumstances related to COVID-19;
- Any company relying on the Order must furnish to the SEC a Form 8-K (or a Form 6-K, as applicable), by the later of March 16 or the original filing deadline of the report, which provides the following information:
- The company must state that it is relying on the Order;
- The company must provide a brief description of the reasons why it could not file the report, schedule, or form on a timely basis;
- The company must provide the estimated date by which the report, schedule, or form is expected to be filed;
- If appropriate, the company must provide a risk factor explaining, if material, the impact of COVID-19 on the company’s business; and
- If the reason the subject report cannot be filed timely relates to the inability of any person, other than the company, to furnish any required opinion, report, or certification, the Form 8-K or Form 6-K shall have attached, as an exhibit, a statement signed by such person stating the specific reasons why such person is unable to furnish the required opinion, report, or certification on or before the date such report must be filed.
- The company or any person required to make any filings with respect to a company files with the SEC any report, schedule, or form required to be filed no later than 45 days after the original due date; and
- In any report, schedule, or form filed by the applicable deadline, the company or any person required to make any filings with respect to the company must disclose that it is relying on the Order and state the reasons why it could not file such report, schedule, or form on a timely basis.
The Order provides relief from the requirements under the proxy rules to furnish proxy materials (or information statement materials) to security holders when mail delivery is not possible. The order provides that a company or any other person is exempt from the requirements to furnish proxy statements, annual reports, and other soliciting materials, as well as the requirements to furnish information statements and annual reports, where the following conditions are satisfied:
- The company’s security holder has a mailing address located in an area where, as a result of COVID-19, the common carrier has suspended delivery service of the type or class customarily used by the company or other person making the solicitation; and
- The company or other person making a solicitation has made a good faith effort to furnish the applicable proxy soliciting materials to the security holder (as required by the applicable rules for the particular method of delivering proxy soliciting materials to the security holder), or, in the case of an information statement and related materials, the company has made a good faith effort to furnish the materials to the security holder in accordance with the rules applicable to information statements.
The Order states that a company relying on the Order does not need to also file a Form 12b-25 announcing the delay if the report, schedule, or form is filed within the extended time period specified in the Order. Companies relying on the Order when filing annual or quarterly reports have a due date 45 days after the filing deadline for the report; therefore, those companies can rely on Rule 12b-25 to obtain an additional extension of the filing deadline if they are unable to file by the extended due date.
In the press release announcing the Order, the SEC states that the Staff will deem a company relying on the Order to be current and timely with its SEC filings for Form S-3 eligibility purposes (and for meeting the definition of a well-known seasoned issuer), as long as the company was current and timely with its SEC filings as of the first day of the relief period and files any report due during the relief period within 45 days of the filing deadline for the report. For purposes of Form S-8 eligibility and the current public information requirement in Securities Act Rule 144(c), a company relying on the Order will be deemed current with its SEC reports if it was current as of the first day of the relief period and files any report due during the relief period within 45 days of the filing deadline for the report.
On February 19, 2020, SEC Chairman Jay Clayton, Division of Corporation Finance Director William Hinman, SEC Chief Accountant Sagar Teotia, and PCAOB Chairman William D. Duhnke III issued guidance about auditing considerations arising from COVID-19. The joint statement included the observation that U.S.-listed companies (including companies based in the U.S., companies based in China, and companies based outside of the U.S., but not based in China) may have significant operations in China and other jurisdictions that may be affected by COVID‑19. The statement further noted that companies that do not themselves have operations in China or other potentially affected jurisdictions may depend on companies that do have operations in those jurisdictions, including, for example, as suppliers, distributors, and/or customers. The authors of the joint statement noted that, in recent dialogue with the senior leaders of the largest U.S. audit firms, they have discussed the potential exposure of companies to the effects of COVID-19 and the impact that exposure could have on financial disclosures and audit quality. In those discussions, they emphasized:
- The need to consider potential disclosure of subsequent events in the notes to the financial statements in accordance with guidance included in Accounting Standards Codification 855, Subsequent Events; and
- The SEC’s general policy to grant appropriate relief from filing deadlines in situations where, in light of circumstances beyond the control of the company, filings cannot be completed on time with appropriate review and attention.
It was noted that the Staff welcomes questions regarding the reporting of matters related to the potential effects of the coronavirus, including potential subsequent event disclosure. The joint statement encouraged companies and advisors to contact the Staff regarding any need for relief or guidance. It was further noted that based on these communications and its continuing monitoring of the situation, the Staff will determine whether to provide additional guidance and relief as appropriate for affected parties, including relief that may be made available on a case‑by-case or on broader basis, as circumstances merit.
Public companies filing periodic reports and releasing earnings information may need to address the impact of COVID-19 in their upcoming disclosures. The following are examples of specific disclosure obligations that may arise as a result of COVID-19.
Item 105 of Regulation S-K and Item 3.D of Form 20-F require companies to disclose the most significant factors that make an investment in the company’s securities speculative or risky. The outbreak of COVID-19 and the resulting governmental restrictions on travel and in-person meetings, as well as private-sector efforts to contain the spread of the virus, could give rise to a significant number of risks. Even if a company has a general risk factor addressing the risks of global pandemics in the context of other catastrophic events, it may be necessary to now address the risks of COVID-19 in a specific risk factor focused on the topic.
The SEC and the Staff have expressed concern with risk factor disclosure that is hypothetical and therefore does not put the risk described in appropriate context. For example, in the SEC’s 2018 interpretive release on cybersecurity, the SEC stated that, “[i]n meeting their disclosure obligations, companies may need to disclose previous or ongoing cybersecurity incidents or other past events in order to place discussions of these risks in the appropriate context.” The Staff has raised comments on risk factor disclosure expressing the concern that the risk is presented in a hypothetical context when the company has, in fact, experienced the matters discussed in the risk, and the SEC has brought Enforcement actions emphasizing this point. As a result, companies drafting risk factors regarding COVID-19 should not present the risks from the pandemic in only hypothetical terms, but should identify specific events and circumstances that have occurred that are necessary to put the associated risks in context.
A wide variety of risks may need to be addressed by companies, depending on their particular circumstances. Most companies will need to address the broader risks arising from the economic and societal uncertainties resulting from the global pandemic. Depending on their business, some companies may need to address disruptions in their factories and in the logistics necessary to move goods in affected countries, as well as similar issues affecting suppliers. Further, risks associated with the disruption of sales channels, such as closing retail operations or reducing the hours they are opened, as well as curtailing wholesale operations, may need to be addressed. Certain issuers may be particularly affected by a decline in the demand for goods and services. Some issuers may experience significant disruptions in their overall business plans, particularly in those countries or regions that are particularly impacted by the pandemic. Airlines, cruise ship operators, and entertainment companies may face particular risks, given the impact that COVID‑19 has had on worldwide travel and entertainment. Numerous other potential or actual risks could arise as the situation unfolds.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)
Item 303 of Regulation S-K and Item 5 of Form 20-F require a company to discuss its financial condition, changes in financial condition, and results of operations. These items require a discussion of events, trends, or uncertainties that are reasonably likely to have a material effect on its results of operations, liquidity, or financial condition, or that would cause reported financial information not to be necessarily indicative of future operating results or financial condition and such other information that the company believes to be necessary to an understanding of its financial condition, changes in financial condition, and results of operations. Disclosure of a trend, demand, commitment, event or uncertainty is required, unless a company is able to conclude either that it is not reasonably likely that the trend, uncertainty or other event will occur or come to fruition, or that a material effect on the company’s liquidity, capital resources, or results of operations is not reasonably likely to occur. The SEC expects quantification of effects of the trend or uncertainty to the extent that such information is available.
COVID-19 has caused many companies to assess whether they have a known trend or uncertainty associated with the pandemic, and many companies have concluded that disclosure about the situation is necessary in MD&A. Among the trends and uncertainties that companies may need to address include: (i) declines in revenue and earnings due to the impacts of COVID‑19; (ii) increases in costs associated with, for example, facilitating a remote workforce, shuttering operations, providing special benefits to employees, and addressing customer or client concerns; (iii) declining cash flows; and (iv) diminishing access to capital resources due to ongoing market volatility and disruptions arising from COVID-19.
If a company addresses the impact of COVID-19 using key performance indicators or other metrics, the company should consider the SEC recent interpretive guidance. The SEC’s guidance indicates that, when a company discloses a key performance indicator or metric, it should consider existing MD&A requirements and the need to include such further material information, if any, as may be necessary in order to make the presentation of the metric, in light of the circumstances under which it is presented, not misleading. Further, the SEC notes that companies should consider the extent to which an existing regulatory disclosure framework applies to the key performance indicator or metric, such as generally accepted accounting principles or the non-GAAP financial measure requirements. The SEC states that companies should consider what additional information may be necessary to an understanding of the key performance indicator or metric presented, indicating that it would generally expect, based on the facts and circumstances, the following disclosures to accompany the key performance indicator or metric:
- A clear definition of the key performance indicator or metric and how it is calculated;
- A statement indicating the reasons why the key performance indicator or metric provides useful information to investors; and
- A statement indicating how management uses the key performance indicator or metric in managing or monitoring the performance of the business.
The SEC indicates that companies should consider whether there are estimates or assumptions underlying the key performance indicator or metric or its calculation and “whether disclosure of such items is necessary for the metric not to be materially misleading.”
Description of Business
Item 101 of Regulation S-K and Item 4.B of Form 20-F require companies to discuss their products, services, relationships with customers and suppliers, and competitive conditions. If COVID-19 materially affects a company’s products, services, relationships with customers or suppliers, or competitive conditions, the company may need to provide appropriate disclosure. In addition, given the potential impact of COVID-19 on a company’s workforce, a company should consider addressing human capital considerations in the context of discussing the company’s overall business.
Item 103 of Regulation S-K requires companies to disclose information relating to material pending legal proceedings to which they or their subsidiaries are a party. COVID-19 may ultimately result in litigation for companies, as pre-existing contractual and business relationships are tested by the pandemic. For example, if a company breaches a contract with a customer as a result of COVID-19 and the incident results in material litigation by that customer against the company, the company may need to disclose the litigation, including the name of the court in which the proceedings are pending, the date the proceedings are instituted, the principal parties thereto, a description of the factual basis alleged to underlie the litigation, and the relief sought.
Financial Statement Disclosures
A variety of issues arising from COVID-19 may affect a company’s financial statements. For example, COVID-19 may result in:
- Expenses related to addressing the impact of travel and other restrictions on a company’s workforce, supply chain, and sales channels;
- Loss of revenue;
- Claims related to breach of contract;
- Indemnification of counterparties;
- Increases in insurance premiums;
- Diminished future cash flows;
- Impairment of intangible or other assets;
- Recognition of liabilities;
- Increased financing costs;
- Growing concern or similar considerations as to viability of the enterprise; and/or
- A subsequent event footnote addressing material COVID-19 developments.
The SEC expects that a company’s internal controls over financial reporting and disclosure controls and procedures are designed to provide reasonable assurance that information about the range and magnitude of the financial impacts from COVID-19 will be accurately reported in the company’s financial statements.
Earnings and Guidance Disclosure
While public companies are not obligated to release earnings prior to filing their periodic reports with the SEC, many companies do so because of market expectations. Similarly, many companies provide guidance regarding selected financial measures on an annual or quarterly basis. The financial impact of COVID-19 may cause a company to release earnings information earlier than it otherwise would and to revise or withdraw existing guidance. The decision to release earnings information early, provide updated guidance or withdraw guidance is driven by a desire to maintain credibility with investors and analysts by avoiding a surprise, and to reduce the overall negative impact on the company’s stock price. If developments arising from COVID‑19 make it possible that the company will miss its outstanding earnings guidance by a significant extent, it may be necessary for the company to consider a “pre-release” of the company’s results, disclosure of revised guidance, or the withdrawal of guidance. Pre-release of earnings information is expected in the period from a few weeks before the end of the fiscal quarter to one week into the next fiscal quarter. A number of companies have determined to withdraw their 2020 earnings guidance due to the level of uncertainty arising from COVID-19.
Addressing Market Rumors
Companies may need to consider addressing market rumors about the impact of COVID-19. In instances of unusual market or rumor-driven trading activity, the New York Stock Exchange (the “NYSE”) expects a company to contact the exchange and promptly release to the public any news or information that may reasonably be considered to be affecting the market in its securities. When a company has no knowledge of material news, the NYSE may contact the company to request that it issue a press release promptly so that the market activity or rumors can be addressed for the overall market. NASDAQ takes the position that whenever unusual market activity takes place, the company normally should determine whether there is material information or news that should be disclosed. If rumors or unusual market activity indicate that information on impending developments has become known to the investing public, or if information from a source other than the issuer becomes known to the investing public, a clear public announcement may be required. It may be appropriate, in certain circumstances, to publicly deny false or inaccurate rumors that are likely to have, or have had, an effect on the trading in a company’s securities or would likely have an influence on investment decisions
All companies, whether public or privately-held, should also consider what measures they can take to mitigate the risk of immediate and future SEC scrutiny of actions taken by them and their employees during this period of uncertainty. First, the SEC has already taken emergency enforcement action, in the form of trading suspensions, to protect investors from COVID‑19‑related investment fraud. Second, the SEC has reminded companies that when they become aware of a virus-related risk that would be material to investors, they must take steps to prevent their employees and insiders from insider trading. Third, SEC enforcement efforts stemming from past market crises may provide a preview of the types of enforcement actions the SEC may bring in the outbreak’s aftermath.
The SEC’s Division of Enforcement has acted swiftly over the past weeks to suspend trading in two public companies to protect investors from what is has stated is coronavirus-related investment fraud. The federal securities laws allow the SEC to immediately suspend trading in any stock for up to 10 business days if the SEC believes the suspension is necessary to protect investors and the public interest. In the context of the COVID-19 outbreak, the SEC can suspend trading when it determines that publicly available information about the company is not accurate and/or it suspects insider trading or market manipulation. Stocks that trade on a national securities exchange will resume trading automatically at the end of the suspension period. Stocks that trade on the Over-The-Counter (OTC) market, however, do not resume trading automatically at the end of the suspension period. Rather, broker-dealers who seek to solicit investors to buy or sell a previously-suspended must file certain information with the SEC and FINRA regarding the company before solicited trading can resume.
On February 4, 2020, the SEC’s Office of Investor Education and Advocacy issued an Investor Alert concerning COVID-19. It stated that the SEC had “become aware of a number of Internet promotions, including on social media, claiming that the products or services of publicly-traded companies can prevent, detect, or cure coronavirus, and that the stock of these companies will dramatically increase in value as a result.” On February 7, 2020, the SEC suspended trading in Aethlon Medical, Inc. (NASDAQ ticker: AEMD) from February 7, 2020, to February 21, 2020. The SEC cited, as the bases for the suspension, concerns about the “accuracy and adequacy of information” available about AEMD’s “product to treat coronavirus” that was disseminated by third party stock promoters as well as “recent and unusual market activity” since January 22, 2020. AEMD stated that it did not solicit or have advanced knowledge of the third-party stock promotion materials. AEMD has since resumed trading. On February 24, 2020, the SEC suspended trading in Eastgate Biotech Corp. (OTC ticker: ETBI) from February 24, 2020, to March 6, 2020. The SEC cited concerns about the accuracy of publicly available information concerning ETBI’s “purported international marketing rights to an approved coronavirus treatment,” among other things.
These trading suspensions show that the SEC’s Division of Enforcement has been quick to scrutinize publicly available information concerning the impact of the virus outbreak on public companies’ business operations. Indeed, this seems to be true even when the inaccurate and unreliable information appears to be disseminated by third parties and not the company itself. Moreover, the SEC will not comment on the status of a suspended company when the 10-day suspension period ends and can continue to investigate the company to determine if it violated the federal securities laws. These trading suspensions, therefore, may serve as an indication of future SEC investigations into whether companies and individuals violated the federal securities laws during this turbulent period.
The federal securities laws prohibit buying or selling a security on the basis of MNPI about that security. In the current crisis, MNPI could include confidential corporate developments concerning the effect of COVID-19’s spread on business operations. Anyone who trades any security on the basis of COVID-19-related MNPI could run afoul of insider trading laws and face a potential SEC, FINRA, or even criminal investigation.
The SEC’s March 4, 2020, Order provided conditional relief for companies affected by the spread of COVID-19; however, while explicitly acknowledging and accommodating the challenges companies face due to the outbreak, the SEC reminded all companies and related individuals to guard against insider trading in the press release announcing the Order. Specifically, the SEC stated that where a company becomes aware of a COVID-19-related risk that would be material to investors, the company and its directors and officers (and other corporate insiders who are aware of these matters) must refrain from engaging in transactions in the company’s securities until the risk is disclosed to investors. This may serve as a warning that the SEC is closely monitoring the markets for signs of insider trading on the basis of MNPI concerning COVID-19.
COVID-19-related MNPI presents unique challenges to companies due the vast array of employees that may possess such information. Unlike confidential financial information, which may only be known by directors, officers, and other high-level corporate insiders, many employees could possess MNPI concerning the impact that COVID-19 is having on their own companies. For example, inventory clerks working for a manufacturing company may notice that an essential manufacturing input has not arrived from a supplier for several weeks due to supply chain disruptions. In the private company context, as another example, employees of a private equity firm that is engaging in a public company transaction could have confidential information about COVID-19’s impact on the public company. Companies should think critically about how to mitigate the risk that any employee trades on the basis of confidential corporate information or that they “tip” others.
First, corporate counsel should assess their insider trading policies to ensure that they guard against trading on the basis of COVID-19-related MNPI by all employees. Second, corporate counsel should identify groups within their organizations that have, or are likely to have, MNPI. Third, corporate counsel should disseminate the organization’s insider trading policies to the identified groups and require these employees to confirm electronically that they have received, read, and understood the policies. Counsel should consider sending these policies with an email written in plain, understandable language stating that the recipient may have confidential information concerning the effect of COVID-19 on the company’s business operations and that trading on the basis of that information, or providing it to someone else so that they can trade, is prohibited. Taking these steps can be challenging with so many people working remotely due to the spread of the virus, and counsel should consider how to leverage their technology to swiftly remind employees of the prohibitions against insider trading.
Companies can consider other preventative measures as well. Depending on the scope of the virus-caused business impact, companies should consider imposing an event-specific trading blackout period, during which all, or an identified group of, employees are prohibited from trading in the company’s securities. Financial service providers and other organizations with restricted security lists should review these lists regularly to ensure that they are up to date. Companies should consider heightened preclearance requirements for employee stock purchases and sales. If the size of the organization permits it, companies may wish to consider reviewing employee trades to identify bad actors. Finally, in light of the many types of employees who may be aware of COVID-19-related MNPI, companies should consider promptly holding web‑based trainings on insider trading and track employee attendance.
The SEC has Brought Enforcement Actions Against Companies for a Wide Range of Violations After Past Market Crises
Finally, it is important to remember that the SEC engages in a deliberative process before bringing enforcement actions. This could result in the SEC bringing enforcement actions concerning COVID-19-related securities laws violations years after the outbreak has abated. For example, the SEC brought enforcement actions against companies and individuals that took advantage of past crises, such as hurricanes and other natural disasters, to commit securities fraud. The SEC also brought numerous actions after the 2008 financial crises that alleged disclosure failures related to subprime mortgages, insider trading, and other securities laws violations. Companies should consider what steps to take now to avoid, or at least mitigate, the consequences of SEC scrutiny of their actions during this turbulent time.
The SEC is not the only one monitoring COVID-19 disclosures. The private plaintiffs’ bar is also paying close attention. Moreover, the private plaintiffs’ bar may be less discerning than the SEC in deciding whether to assert securities claims based on allegedly inadequate disclosures. Many plaintiffs’ securities class action lawyers operate on high volumes: file as many suits as you can in the hopes that a few are strong enough to survive a motion to dismiss. The COVID‑19 pandemic creates an environment ripe for potential private securities suits brought by such firms.
After a stock price drop following a COVID-19 related disclosure, plaintiffs will scour the company’s past disclosures. Focusing on the types of disclosures discussed above, plaintiffs will look to manufacture a story that the company deliberately hid from its investors the true negative effects that COVID-19 was having on the company’s finances and operations.
Two COVID-19 related securities suits have already been filed. On March 12, 2020, a putative securities class action was filed against Norwegian Cruise Lines, its CEO and CFO. The complaint alleges that the defendants violated Section 10(b) of the Exchange Act when they offered a positive outlook for the company in February 2020 after the COVID-19 outbreak had already begun in China. The other suit is against Inovio Pharmaceuticals and alleges false and misleading statements related to the development of a COVID-19 vaccine. The complaint alleges that Inovio’s stock price rose sharply after the company announced that it had developed a COVID-19 vaccine in three hours, but then the stock price plummeted when another company challenged the vaccine claims. These suits confirm that the heightened scrutiny on COVID-19 disclosures by the plaintiffs’ bar, and there can be no doubt that more suits are coming.
In formulating these suits, plaintiffs will carefully review the company’s risk disclosures. If, even after COVID-19, the risk disclosures continued to discuss the risks of a pandemic to the company’s operations in only hypothetical terms, plaintiffs will likely argue that the risk factors were materially misleading. Plaintiffs may argue that the company should have updated its risk factors to disclose events and circumstances that had already occurred as a result of the pandemic, along with those that could still occur. In other words, plaintiffs will contend that it is not enough to have warned that a pandemic may cause supply chain disruptions or declining demand; the company should also have disclosed that it had already done so. For the last several years, the private plaintiffs’ bar has been increasingly focused on this type of event-driven litigation, and COVID-19 securities litigation will no doubt follow course.
Similarly, plaintiffs have recently been asserting more and more claims based on alleged failures to disclose known trends or uncertainties. As a result, we expect to see COVID-19 claims alleging that the company failed to disclose trends and uncertainties due to the impact of COVID-19, such as declines in revenue and earnings, increases in costs, and diminishing cash flows.
Plaintiffs will also carefully review statements made in press releases, during earnings calls, and at investor presentations about COVID-19. Because these types of statements are sometimes made with less time to thoroughly vet, plaintiffs often take them out of context. The rapidly evolving situation makes it extremely difficult to know what to say and when to say it. The plaintiffs’ bar, however, will review statements with the benefit of hindsight. For example, in an effort to calm investor concerns, a company may want to announce that coronavirus has had minimal impact on the company’s supply chain, and is not expected to have any impact on its 2020 outlook. If the company experiences a later stock price drop that can be linked to COVID‑19, but failed to timely update their disclosures, such statements will be a target for the plaintiffs’ bar.
In addition to securities fraud claims, there is also a heightened risk of suits alleging inadequate disclosures in connection with securities offerings (IPOs and secondary offerings). These suits are based on Section 11 and 12(a)(2) of the Securities Act, and do not require a showing of fraudulent intent — that is, the plaintiffs need only prove a material misstatement or omission in the offering documents. Thus, these claims operate on a strict liability basis, and arise almost by default when a company’s stock price falls below the offering price. For this reason, where market volatility abounds, companies considering securities offerings in the near-term should be particularly thoughtful about the need for COVID-19 specific risk disclosures.
In addition to securities class actions, there is also a risk of derivative suits arising from a company’s response to COVID-19. Here, the plaintiffs may allege that the company was damaged by the board and management’s response to the crisis. For example, plaintiffs may allege that the company failed to secure altrnative supply sources, failed to act quickly to protect manufacturing facilities that were severely impacted by the virus, or failed to have an adequate disaster response plan in place. The best defense to such claims is a record of thoughtful consideration of the issues at hand, and the exercise of sound business judgment.
To mitigate the risk of shareholder suits, companies should:
- Carefully consider their COVID-19 disclosures, including the need to provide adequate disclosures about what the company knows now and then provide additional information regarding the ongoing impact of this pandemic. As discussed above, companies should review their risk factors, MD&A, earnings guidance, financial statements and other relevant disclosure, and ensure that they appropriately disclose known risks, trends, and uncertainties.
- When offering guidance, review and update your cautionary language to maximize the protection of the safe harbor for forward-looking statements in Exchange Act Section 21E or Securities Act Section 27A. Carefully consider whether changed circumstances merit an update to or withdrawal of earlier guidance.
- Make sure you label documents that are drafts or preliminary analysis clearly as such. Given how quickly events are changing, it is likely that your analysis is changing just as quickly. If you eventually have to defend your public statements, you want it to be clear what internal documents supported those statements. Designate a spokesperson regarding COVID-19 to ensure that company statements are consistent, vetted and up to date.
- Be careful about disclosing when you learned about a circumstance or an event and its impact on the company’s business. Plaintiffs will seize on statements that indicate that you knew of the event before you publicly disclosed it.
- Be especially careful about board minutes and materials. Plaintiffs can get access to them easily by sending a request under Delaware 220 or Cal. Corp. Code 1601. Make sure the minutes and materials reflect the thoughtful consideration given to these issues, without transcript-like detail or lots of adjectives and adverbs. Also, take care to ensure that the materials are consistent with the company’s public disclosures.
- Review directors and officers liability insurance policy limits, and consider whether you have sufficient coverage.
- As always, assume that work-related emails, texts, and instant messages will come to light in the event of litigation.