A recent federal appeals court ruling has drawn a fine line between what risk disclosures are and are not protected from legal liability under federal safe-harbor laws.

The decision in Iowa Public Employees’ Retirement System v. MF Global by the U.S. Second Circuit Court of Appeals limits the “bespeaks caution” defense in securities lawsuits to forward-looking statements only—not to statements that communicate present or historical fact.

Gorman

The ruling is “going to make people sit down and take a hard look at how they write their policies,” says Tom Gorman, former senior counsel for SEC enforcement and now a partner with Porter Wright.

The dispute stems from a securities class action filed by a group of pension funds after a broker at MF Global, Evan Dooley, lost $141.5 million by speculating in wheat futures substantially beyond the firm’s trading limit. That revelation caused the brokerage firm to suffer a $1.1 billion loss in market capitalization in two days in February 2008.

According to the plaintiffs, MF Global misled investors because its July 2007 prospectus for an initial public offering failed to disclose weaknesses in controls in its risk-management system. Specifically, the investors said, MF Global wrongly claimed in its prospectus that it had a “robust” risk-management system, when in practice it allows traders to exceed the firm’s trading limits for their own accounts and that the firm sometimes removed the limits to speed transactions.

MF Global argued that it was immune from liability under the “bespeaks caution” doctrine, pointing to cautionary statements in the prospectus about its risk-management methods. MF Global’s prospectus stated: “[O]ur risk-management methods may prove to be ineffective because of their design, their implementation, or the lack of adequate, accurate, or timely information. If our risk-management efforts are ineffective, we could suffer losses that could have a material adverse effect on our financial condition or operating results.” MF Global went on to cite risks of employee misconduct, including employees executing unauthorized trades on behalf of clients.

A federal district judge in New York sided with MF Global and dismissed the case in July 2009. But in a decision handed down Sept. 14, the 2nd Circuit appeals court said the lower court applied the bespeaks-caution doctrine too broadly. The appellate court stressed that the doctrine applies only to forward-looking statements (“we might have weaknesses in the future”) rather than statements of present or historical fact (“we might have weaknesses right now”). Because MF Global knew its risk-management system might be flawed at the time the statement was made, that constituted a present fact.

“I think the decision is going to make people sit down and take a hard look at how they write their policies.”

—John Stigi,

Partner,

Sheppard Mullin

“Characterizations of MF Global’s risk-management system—that the system was ‘robust,’ for example—invite the inference that the system will reduce the firm’s risk,” the court wrote. “Cautionary words about future risk cannot insulate from liability the failure to disclose that the risk has transpired.”

The appeals court further noted that statements “may contain some elements that look forward and others that do not.” Importantly, the court observed that “in each instance the forward-looking elements and the non-forward-looking are severable.”

The appeals court then sent the case back to lower court to review each alleged mis-statement individually and determine which were forward looking and which weren’t.

“The court laid out the basic principles and sent it back to the district court to figure it out,” explains Gorman.

Broad Implications

Securities lawyers warn that while this particular case focuses on the prospectus for an IPO, the decision could apply to other disclosures, such as those in the Management Discussion & Analysis statement in annual reports. The rationale “can apply to any statement in the MD&A,” says John Stigi, a partner in the trial practice group of law firm Sheppard Mullin.

Hershman

The decision “really should change the way a company looks at what it needs to disclose and how to disclose it,” says Scott Hershman, a lawyer with law firm White & Case. Issuers should check to see whether a statement contains both present and future components, and if so, whether they can be split into separate components.

“It’s important for issuers in my view to use language like ‘we predict’ or ‘we forecast,’ rather than ‘we believe’ or words that seem less connotative of a forecast or prediction about the future,” Stigi says. For example, a statement by a company that it may be unable to meet certain material industry standards in the future would be unlikely to preclude claims arising from a current failure to meet those industry standards.

Stigi

The MF Global decision is only the latest in a string of cases addressing liability protections related to present and future risks. “It’s a fascinating decision analytically, because it gets into an area that actually has created a fair amount of confusion in a lot of different courts,” Stigi says. “District courts have been wrestling with this for quite some time.”

It’s too early to tell how the Second Circuit decision will be interpreted by other jurisdictions, but if one possible lawsuit currently in the works is any sign, the MF Global ruling is sure to have wide-ranging implications in similar cases.

IOWA DECISION

The following excerpt is from Chief Judge Dennis Jacobs’ decision in Iowa Public Employees’ Retirement System v. MF Global Ltd:

DENNIS JACOBS, Chief Judge:

Plaintiffs appeal from a July 23, 2009 judgment of the

United States District Court for the Southern District of

New York (Marrero, J.), dismissing their putative securities

class action complaint for failure to state a claim. They

allege material misstatements and omissions in the July 2007

prospectus and registration statement of defendant MF

Global, Ltd., and assert claims under §§ 11, 12(a)(2), and

15 of the 1933 Securities Act. In a nutshell, the stock of

MF Global plummeted after the February 2008 revelation that

a broker had evaded trading restrictions. Of four groups of

allegations …

1. Directional Trading: That the prospectus

misrepresented the types of trading—directional

or only hedging—conducted by MF Global;

2. Refco: That the prospectus failed to disclose

the lack of adjustments to MF Global’s risk-

management systems made during and after Man

Group’s acquisition of Refco, another brokerage

firm;

3. Risk Management: That the prospectus

misrepresented and failed to disclose material

facts relevant to the strengths and weaknesses of

MF Global’s risk-management system; and

4. Client Accounts: That the prospectus failed to

disclose “that traders did not have limits when

trading for clients, and that with the proper

password anyone could access client accounts and

trade in them at any time”

… dismissal of two is not appealed. As to the claim that the prospectus and registration statement exaggerated risk-management measures, we vacate the dismissal because the district court erroneously applied the bespeaks-caution doctrine. As to the remaining claim, that the prospectus and registration statement failed to disclose deficiencies in the firm’s controls of client accounts, we affirm in part the district court’s dismissal for lack of causation, and in part vacate and remand.

Source

Iowa Public Employees’ Retirement System v. MF Global Ltd (Sept. 14, 2010)

Just last month, the law firm of Hagens Berman said it was investigating potential fraud claims against TeleNav, a provider of navigation applications for cell phone carriers, relating to its May 13 IPO. Less than three months later, TeleNav’s stock plunged amid news that the company was renegotiating its contract with wireless carrier Sprint Nextel. According to TeleNav’s filings with the SEC, Sprint provided TeleNav with 55 percent of its business and the contract wasn’t due to expire until December 2011. Investors feared that reopening the contract would mean less revenue for TeleNav.

“Our investigation causes us to believe that the risk of renegotiation of the Sprint contract was not just a possibility, but a current reality in which TeleNav’s management knew they were in trouble. It was not a future risk, but one that had already transpired by the time of the IPO,” a client alert from Hagens Berman stated, citing MF Global as an example.

As recent as August, the 3rd Circuit Court of Appeals based in Pennsylvania dismissed a derivative securities lawsuit, In re Aetna Securities Litigation, where shareholders were suing insurance giant Aetna and four of its officers. According to the allegations, Aetna falsely asserted it had “disciplined” pricing strategies, when in reality the company had set out to gain market share by under-pricing its policies—which, the plaintiffs said, demonstrated a lack of discipline.

But the appeals court took the side of Aetna, reasoning that the plaintiffs couldn’t have determined whether Aetna’s pricing was “disciplined” at the time Aetna made its statements. “Thus, to the extent that ‘disciplined’ pricing said anything about the current price of premiums, [Aetna] did so in the form of a projection.”

The court cited an earlier 3rd Circuit decision, Institutional Investors Group v. Avaya, which found that if present statements can’t be distinguished from future projections, “the assertions of current fact are too vague to be actionable.” That case was dismissed.

For now, legal experts say, the differing appellate interpretations about risk disclosures will need more development before corporate legal departments will fully understand what is protected and what isn’t. Until then, companies would be wise to practice greater caution in how they draft their disclosures to the SEC.

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