Bank and Corporate Governance Law Reporter 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 Do You Have to Disclose a Government Investigation? Practical Considerations, Legal Standards, and Recent Case Law Deborah Birnbach, Michael T. Jones, Nicole L. Chessari & Morgan Mordecai Goodwin Procter LLP is otherwise nearing conclusion.

However, a few When a public company is under government recent cases out of federal courts in the Southern investigation, there is no bright line standard for District of New York and the Court of Appeals for whether or when disclosure is required. In many the Ninth Circuit in California provide some addicases, disclosure is not automatic. Companies un- tional guidance for companies navigating this issue. der investigation or inquiry should consult outside For public companies, it is important to undercounsel, review D&O insurance coverage and con- stand that disclosure is generally not automatic. tinue reevaluating the status of the investigation to While there are some circumstances where a comdetermine whether any disclosure obligations have pany must disclose an investigation promptly, other arisen. circumstances may be less clear and it may be in the company’s best interest not to publicly disclose --------this information until a later time, if at all.

With After receiving an inquiry from a government the assistance of counsel, companies should careagency, such as a subpoena, a Civil Investigativevv fully consider their own unique facts and circumDemand (“CID”), or an informal request for infor- stances to reach a judgment as to their disclosure mation, public companies ask whether they must obligations. disclose publicly that they may be under investigaPractical Reasons for Disclosing tion. A corollary question to public disclosure is or Not Disclosing an Investigation how broadly to disclose internally, to lenders, or to D&O insurers. There are practical reasons that may cause companies to disclose investigations even when a The standards for disclosing government investigations are not straightforward, due in part particular rule or regulation does not require immeto an absence of cases and SEC interpretive guid- diate disclosure. ance providing meaningful direction on this topic First, a company may feel pressure to disclose under the securities laws. As a result, disclosure due to certain business relationships or obligations. practices vary.

Companies sometimes disclose in- For example, the company’s auditors may strongly vestigations upon receipt of a subpoena or CID, encourage the company to disclose the investigasome wait until an intermediate stage after the in- tion, leading the company to do so to avoid tense vestigation progresses, and some wait until the SEC conversations or potential delays in SEC filings. advises the company that it tentatively decided to Additionally, a company may have contractual recommend an enforcement action by sending the agreements requiring it to disclose a government company a “Wells” notice1 or until the investigation investigation to lenders or others, which may cre* Deborah S. Birnbach and Michael T. Jones are partners, and ate concerns about issues related to selective discloNicole L.

Chessari and Morgan Mordecai are associates, with sure under SEC Regulation Fair Disclosure, often Goodwin Procter LLP. This article appeared on the Harvard referred to as “Reg. FD.” In other cases, a comLaw School Forum on Corporate Governance and Financial pany may have an M&A deal pending and choose Regulation.

Used by permission. to disclose to give shareholders a better understand1 Under Section 2.4 of the SEC’s current Enforcement Manual ing of the transaction and the sale price. Finally, a and as part of long-standing SEC practice, the SEC’s staff company may decide to disclose in order to ensure may, but is not required to, send a letter to the company or individual providing notice of a decision by the staff to that the company or insiders who are aware of the recommend to the Commission that an enforcement case be investigation may trade their company stock withfiled. This letter is known as a “Wells Notice.” out concern that the investigation may constitute Speed Read Volume 56, Number 3, May 2016.

Copyright © 2016 Computer Law Reporter, Inc. All Rights Reserved. 297 . Bank and Corporate Governance Law Reporter 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 material nonpublic information that would prevent those insiders from trading. Consider the Type of Government Request and the Stage of the Investigation Second, a company may decide to disclose a government investigation to address concerns regarding potential negative reactions if the investigation is likely to be disclosed later. Companies may worry that if they do not disclose the investigation at the outset, shareholders, analysts, rating agencies, institutional investors, and others (including shareholder plaintiffs’ lawyers) will react poorly if they learn of the investigation later. There may also be a concern that third parties may leak news about the investigation—for example, persons who are not the subject of the investigation but who receive subpoenas.

If an investigation does get leaked, even the slightest rumors can lead to questions about whether the company is a target of an investigation. A company may prefer to respond substantively to these inquiries rather than with a “no comment” answer in order to avoid even more speculation. News or rumors of pending investigations may also be leaked by organizations that specialize in mass FOIA requests.

Most companies prefer to be the source of information about an investigation, rather than having that information reach the public via third parties, so that it has the ability to shape the messaging and ensure that the information is fulsome and accurate. Before disclosing any developments related to an investigation, the company should consider the type of government inquiry received, the stage of the investigation, the potential impact of the investigation on the company, and any other relevant facts. For example, if a company receives a Wells Notice indicating that it is the target of a government investigation that may result in a large penalty or settlement, the company will usually conclude that it should disclose receipt of the Wells Notice. Conversely, if the SEC issues a subpoena seeking information pertaining to a third party, a company will usually conclude that disclosure is not required. In other cases, however, the circumstances of a government investigation are not this cut and dry and the company cannot assess the scope or potential impact until it has conducted its own investigation into the matter. In many cases, it is prudent to delay disclosure at least until the company has a more complete understanding of the potential implications and costs of the government inquiry. Thus, practical considerations often point in conflicting directions and it is important to evaluate the specific facts of each scenario and understand the applicable legal disclosure obligations. entity or security.” Similarly, 12 U.S.C.

§ 5562(c) provides that the Consumer Financial Protection Bureau, like many other federal agencies, may issue a CID when it has reason to believe that a person “may” have information relevant to a violation. A company should keep in mind that a government investigation, whether formal or informal and whether involving a voluntary request for information, a subpoena, or a CID, is a fact-finding exercise. It is not a determination that any person or entity has violated the law; rather, it is designed to At the same time, companies should consider gather those facts necessary for an agency to make the costs of early disclosure. Shareholders may an informed decision about whether violations of give an investigation greater weight than is merited law have occurred and whether an enforcement acbecause they are generally not in a position to dis- tion is warranted.2 tinguish between investigations resulting from inThese fact-finding exercises can in some cases dications of actual malfeasance and investigations take years to complete.

Early disclosure by a comthat are more akin to fishing expeditions. In this pany may create a situation in which the company same vein, the mere fact that the company discloses has an ongoing legal or practical duty to provide an investigation may be misunderstood by some updates about the investigation in its SEC filings shareholders as indicating that the company en- and at other times and by other means that satisfy gaged in wrongdoing, which, among other things, 2 As the SEC states in the standard may lead to baseless lawsuits and/or books and re- subpoenas: “This investigation isdisclosures contained in its a non-public, fact-finding cords demands by shareholders. In addition, ear- inquiry.

We are trying to determine whether there have been ly disclosure of an investigation may actually put any violations of the federal securities laws. The investigation more pressure on regulators to ultimately bring an and the subpoena do not mean that we have concluded that you or anyone else has broken the law. Also, the investigation enforcement action against the company. does not mean that we have a negative opinion of any person, Volume 56, Number 3, May 2016.

Copyright © 2016 Computer Law Reporter, Inc. All Rights Reserved. 298 . Bank and Corporate Governance Law Reporter 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 other potential disclosure requirements (such as governmental authorities inform a company that stock exchange listing requirements) and comply they are likely to commence a civil or criminal proceeding, Item 103 requires the company to disclose with Reg. FD. the potential proceeding if it is material. Rules and Regulations Governing Disclosure Obligations The securities laws require disclosure: (1) when an affirmative duty to disclose arises under applicable rules or regulations; or (2) when failing to disclose it would render other disclosures misleading.3 The disclosure rules most commonly considered when evaluating whether to disclose a government investigation are SEC Regulation S-K, Items 103 and 303. In the absence of other triggers (such as filing a registration statement or purchases or sales of company securities by the company or an affiliate of the company), both of these disclosure items are required in quarterly reports on Form 10-Q and annual reports on Form 10-K filed by domestic public companies.

Companies must also consider additional disclosure obligations set forth by the New York Stock Exchange and Nasdaq Stock Exchange. Item 103, titled “Legal Proceedings,” sets forth the types of legal proceedings a public company is required to publicly disclose. Item 103 generally requires companies to disclose “material” pending legal proceedings, which requires review of the relevant facts and circumstances. Item 103 also provides a disclosure threshold for pending proceedings for which the amount involved, exclusive of interest and costs, does not exceed 10% of the company’s consolidated current assets.

Companies must aggregate similar legal proceedings, both pending and known to be contemplated, in calculating whether legal proceedings exceed this 10% amount. For purposes of Item 103 (but not Item 303, discussed below), companies should balance the probability that a loss will be incurred and the anticipated magnitude of those losses. Because governmental investigations typically precede any of the disclosure requirements of Item 103, companies often do not disclose the existence of an investigation under Item 103. Item 303, titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”), may also require companies to disclose information related to threatened or pending litigation. Item 303 requires public companies to disclose in MD&A “any known trends or uncertainties that have had or that the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” Item 303 specifically requires that “[t]he discussion and analysis shall focus specifically on material events and uncertainties know to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition,” including “descriptions and amounts of…matters that would have an impact on future operations and have not had an impact in the past… .” Although governmental investigations do not often trigger MD&A disclosure, plaintiffs’ lawyers frequently claim that Item 303 requires a company to disclose an investigation if it “reasonably expects” the investigation will have a material adverse effect on the company. Companies should work with their advisors in making these determinations and should also consider the interpretive guidance in SEC Staff Accounting Bulletin No.

99, which states that materiality cannot be determined solely on the basis of quantitative measures (such as the potential dollar Item 103 also requires companies to “describe amount involved), but requires analysis of a variety any material pending legal proceeding … known of other qualitative factors. to be contemplated by government authorities.” If Accounting Considerations. It is also impor3 Section 10(b), SEC Rules 10b-5, and 12b-20 of the tant to consider internally, and in discussions with Securities Exchange Act of 1934; and Section 11 and Rule 408 of Regulation C of the Securities Act of 1933 provide auditors, the potential application of Accounting that companies may not omit material facts necessary to make Standards Codification (“ASC”) 450 when considthe statements that they make “not misleading.” Whether a ering disclosure obligations. ASC 450 addresses, company misleads by not disclosing an investigation depends among other things, disclosure requirements for on what other affirmative statements it has made and needs to be evaluated as a whole with all other information that is “loss contingencies,” including disclosure of both asserted and unasserted claims.

With respect to available to the market. Volume 56, Number 3, May 2016. Copyright © 2016 Computer Law Reporter, Inc. All Rights Reserved. 299 .

Bank and Corporate Governance Law Reporter 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 unasserted claims, ASC 450 states that disclosure is required if there has been a “manifestation by a potential claimant of an awareness of a possible claim” and the claim is at least “reasonably possible.” ASC 450 does not state whether the commencement of an investigation is a manifestation of awareness of a possible claim. the federal securities laws to disclose to investors an ongoing SEC investigation or even the receipt of a Wells Notice and that these developments were not per se material to investors. As the court explained, after issuing a Wells Notice, the SEC Enforcement Division may choose not to proceed with a recommendation to commence an action and, even if the SEC staff does recommend enforcement action, the ASC 450 also states that in the absence of a man- SEC may decide not to authorize filing of an acifestation by a potential claimant of awareness of a tion. Therefore, the court held, “the defendants did possible claim, disclosure of an unasserted claim is not have a duty to disclose the SEC investigation still required if it is “probable” that the claim will and Wells Notices because the securities laws do be asserted and there is a reasonable possibility the not impose an obligation on a company to predict outcome will be unfavorable.

The mere fact that an the outcome of investigations. There is no duty to investigation has been commenced does not mean disclose litigation that is not ‘substantially certain that it is probable that a claim will be asserted or to occur.’” that, if it is, there is a reasonable possibility that the The court also rejected plaintiffs’ argument that outcome will be unfavorable. Nonetheless, if the company and its auditors conclude that the compa- Lions Gate had a duty to disclose the existence of ny must disclose the investigation per ASC 450 as the regulatory investigation because it could have a footnote regarding loss contingency and/or estab- affected the company’s financial condition due to lish a reserve for it, that decision will usually sup- the potential for a material penalty.

In this case, the port disclosure elsewhere in a filing, such as in the court observed that the $7.5 million civil penalty legal proceedings sections of a Form 10-Q or 10-K. ultimately imposed on it by the SEC was less than one percent of Lions Gate’s consolidated revenue Differences Among Item 103, Item 303 and of $839.9 million for the third quarter of 2014, and Accounting Disclosures. Although the disclosures well below the five percent numerical threshold that required by Item 103, Item 303 and ASC 450 may the Second Circuit has determined is a “good startoverlap to some extent, they are not identical.

If ing place for assessing the materiality of the alleged a company chooses to address these requirements misstatement.” The court further explained that the with a single set of disclosures, it should ensure that “possibility of materiality” is not enough to support its disclosures satisfy all applicable requirements. a securities fraud claim. For example, Item 103 requires principally descripIn addition, the court rejected plaintiffs’ argutive disclosure. Item 303 requires some analysis of ment that that company had a duty to disclose the the likelihood of an adverse outcome and its potential amount, as well as the potential effect on the investigation under SEC Regulation S-K, Items company’s income statement and balance sheet 103 and 303.

The court held that an SEC invesitems. ASC 450 requires a different and more tech- tigation itself is not a “pending legal proceeding” nical assessment of potential probabilities and out- for purpose of Item 103, nor is it an indication that the government is “contemplating” a proceeding, comes than Item 303. because the SEC had not yet decided whether to Recent Case Law Interpreting bring a case. The court held that based on the facts These Disclosure Standards of that case, the SEC investigation was not indicaTwo recent cases provide important disclosure tive of any trend or uncertainty reasonably likely to guidance for public companies facing government have a material impact on the company’s financial inquiries. condition or results of operations for purposes of On January 22, 2016, the Southern District of Item 303. New York dismissed In re Lions Gate Entertainment In addition to Lions Gate, the Ninth Circuit’s Corp.

Securities Litigation, a shareholder class action February 1, 2016 decision in Lloyd v. CVB against the movie studio Lions Gate. The district Financial Corporation may influence companies’ court held that there is no general obligation under decisions whether or not to disclose government Volume 56, Number 3, May 2016.

Copyright © 2016 Computer Law Reporter, Inc. All Rights Reserved. 300 . Bank and Corporate Governance Law Reporter 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 investigations, because such disclosures could • Disclosure is in many cases not automatic. Rather, upon receipt of a government inquiry, make it more difficult for companies to defend companies should promptly contact outside themselves against subsequent claims of violations counsel to help them carefully consider their of the federal securities laws. In that case, CVB own unique facts and circumstances to reach a made representations in SEC filings that there was judgment as to their disclosure obligations. no basis for “serious doubt” about the ability of its largest borrower to repay loans received from CVB. • Upon receipt of notice of an investigation or The SEC later served a subpoena on CVB, seeking similar proceeding, a company should review information about its loan underwriting methodoloits D&O insurance coverage to determine if gy and allowance for credit losses.

CVB announced there are any provisions requiring its insurer to receipt of the subpoena and the very next day its cover the legal costs associated with responding to the government. Internal disclosure should stock dropped 22%. Analysts speculated that the be made on an as needed basis, limiting the possubpoena was likely related to CVB’s loans to that sibility of leaks. large borrower.

A month later, CVB announced that the borrower could not repay its debt and, as a re- • Even if a company decides not to disclose an sult, it had to write down $34 million in loans and investigation in its early stages, the company place another $48 million in its non-performing catshould continue to reevaluate the status of the egory. CVB’s stock price only dropped by a couple investigation from time to time as it progressof cents after this announcement and quickly recoves to determine if an obligation to disclose the ered. Ultimately, the SEC never instituted any forinvestigation has arisen as the investigation mal proceedings against CVB. progresses. Shareholders initiated a securities class action accusing CVB of issuing false statements about its exposure to these under-performing loans, which the district court dismissed.

However, the Ninth Circuit reversed, reviving the case, holding that the disclosure of the SEC investigation, when taken together with a subsequent revelation that prior statements made by the company about the nonperforming loans were inaccurate, could form the basis for a theory of loss causation, equating the announcement of the investigation to a “corrective disclosure.” If CVB had chosen not to disclose the SEC investigation, the Ninth Circuit may have affirmed dismissal of this litigation for failing to plead loss causation because the company’s stock price barely reacted to the true “corrective disclosure” announcing the write off, providing yet another possible reason to refrain from disclosing investigations early in the process unless absolutely necessary. Key Take-Aways • There is generally no bright line standard for whether or when public companies must disclose government investigations. It is a fact specific inquiry with disclosure considerations arising from a variety of sources. Volume 56, Number 3, May 2016. Copyright © 2016 Computer Law Reporter, Inc.

All Rights Reserved. 301 .