Corporate Governance

Nacchio and the Supreme Court: The Cert Petition (The Basic Argument)

By J. Robert Brown

The main substantive argument is presented in a confusing fashion.  According to the brief:

• The Tenth Circuit's materiality analysis conflicts with several other circuits, which have held that internal predictions and interim operating results are immaterial as a matter of law unless they establish a very strong likelihood that the company's eventual reported performance will be substantially below what the market is expecting.

The first observation about the question is that it conflates several issues.  Internal predictions and interim operating results are entirely different types of information.  One is soft (predictions) and the other is hard (actual operating results).  The tests for each are different and cannot be conflated.  Moreover, the issue with interim operating results ordinarily centers not on materiality but on the duty do disclose.  When must companies, in between quarterly reports, disclose changes in interim financial results.  Finally, while the issue is pitched as the materiality of internal forecasts, the government will likely argue that what Nacchio knew was hard information that alerted existing, public forecasts.  In other words, the government will argue that this is not about internal forecasts at all.

Nonetheless, the brief argues that the standards for assessing the materiality of "predictive information" is murky and unclear and requires clarification.  The brief seeks clarity.  At the same time, the standard adopted by the Court ought to be high, with the brief contending that the "extreme departure" standard in the First Circuit is the appropriate one.

The case relies mostly on language from Shaw v. Digitial, 82 F.3d 1194, 1201-02 (1st Cir. 1996), a somewhat dated First Circuit case.  According to the brief, "[t]he First Circuit held that 'soft' information like internal predictions is always immaterial."  Soft information is generally a category of information that encompasses projections and appraisals. 

It is a relatively extraordinary statement since most would recongize that in fact projections are extraordinarily material to those trading in the market.  Indeed, the very importance of the information is what makes the category of information such a difficult and sensitive disclose issue.  Given that, we povide the language from footnote 21, which does not say that soft information is always immaterial.

• 21 It bears reemphasizing that the plaintiffs' claim is sustainable only to the extent it relates to the nondisclosure of "hard" material information, as opposed to "soft" information in the nature of projections. See In re Verifone Sec. Litig., 784 F. Supp. 1471, 1482 (N.D. Cal. 1992), aff'd, 11 F.3d 865 (9th Cir. 1993); see generally 2 Loss & Seligman, supra, at 622 n.66. Although DEC had no obligation to disclose a forecast of results for the quarter in progress at the time of the offering, it was permitted to do so. If it had chosen to disclose such a forward-looking projection, and if the projection was made with reasonable basis and in good faith, it would have been protected by the SEC's safe harbor provision. See SEC Rule 175, 17 C.F.R. § 230.175; see also Arazie v. Mullane, 2 F.3d 1456, 1468 (7th Cir. 1993); Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995);  cf. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, § 102, 109 Stat. 737, 749-55 (creating expanded statutory protection for forward-looking statements). Furthermore, had DEC chosen to disclose projected results, such a disclosure (if reasonable) could very well have rendered the "hard" interim information underlying the projection immaterial as a matter of fact or of law, unless the market would have had some reason to discredit the projection, thereby creating a substantial likelihood that a reasonable investor might still have found the underlying information important to the total mix of information available.

The footnote arose in the context of whether a company was required to disclose projections in a shelf registration statement and amounts to nothing more than the general view that, in general, there is no obligation to disclose internal projections in the first instance.  It does not deal with a situation where the company discloses a projection then obtains internal information suggesting that the projection is incorrect. 

Moreover, the remainder of the discussion of Shaw in the brief, oddly, does not involve projections at all but, as the brief notes, the standard for the disclosure of ''hard' intra-quarterly operating results the company."  In other words, it addresses when changes in earnings must be disclosed in between quarterly reports, not the standard for soft information. 

There is a split in the circuit.  Some courts have applied a "substantial certainty" standard in determining the materiality of projections, a standard reminiscent of the "agreement in principle standard" for merger negotiations that was done away with in Basic. But this case is not about when projections are material enough that non-disclosure would make another statement inaccurate or incomplete under the anti-fraud rules.  This case involves the standard for information known to an insider that suggests an existing, already disclosed projection is now inaccurate.  As a result, these cases do not help Defendant.

Full post as published by The Race to the Bottom on March 27, 2009 (boomark / email).