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Corporate & Securities Law

: Jim Hamilton's World of Securities Regulation

Federal Court Rules Financial Company Had No Duty to Disclose Receipt of SEC Wells Notice

By Jim Hamilton

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A federal judge ruled that a securities fraud action could not be based on a financial company?s failure to disclose receipt of a Wells Notice from the SEC. At best, said the court, a Wells Notice indicates not litigation but only the desire of the SEC Enforcement staff to move forward, which it has no power to effectuate. This contingency need not be disclosed. While the investors claimed to want to know about the Wells Notice, a corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact. (Richman v. Goldman Sachs Group, Inc., SD NY, 10 Civ. 3461, June 21, 2012.)

The SEC provides a target of an investigation with a Wells Notice whenever the Enforcement Division staff decides, even preliminarily, to recommend charges. The party at risk of an enforcement action is then entitled, under SEC rules, to make a Wells submission to the SEC, presenting arguments why the Commissioners should reject the staff?s recommendation for enforcement.

In the court?s view, a party?s entitlement to make a Wells submission is obviously based on recognition that staff advice is not authoritative. Indeed, continued the court, the Wells process was implemented so that the Commission would have the opportunity to hear a defendant?s arguments before deciding whether to go forward with enforcement proceedings. Thus, receipt of a Wells Notice does not necessarily indicate that charges will be filed.

Item 103 of Regulation S-K requires a company to describe any material pending legal proceedings known to be contemplated by governmental authorities. Exchange Act Rule 12b-20 supplements Regulation S?K by requiring a person who has provided such information in a statement or report to add such further material information as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.

A Wells Notice may be considered an indication that the staff of a government agency is considering making a recommendation, noted the court, but that is well short of litigation that would have to be disclosed. Moreover, the investors did not show that the company?s nondisclosure of the receipt of Wells Notice made prior disclosures about ongoing governmental investigations materially misleading; or that it breached a duty to be accurate and complete in making

disclosures.

The court rejected the argument that the company had an affirmative legal obligation to disclose receipt of the Wells Notice under Regulation S-K, Item 103. There is nothing in Item 103 which mandates disclosure of Wells Notices, emphasized the court. Item 103 does not explicitly require disclosure of a Wells Notices, and no court has ever held that this regulation creates an implicit duty to disclose receipt of a Wells Notice. When the regulatory investigation matures to the point where litigation is apparent and substantially certain to occur, said the court, then Section 10(b) disclosure is mandated. Until then, disclosure is not required.

FINRA Rule 2010, and NASD Conduct Rule 3010 explicitly require financial firms to report an employee?s receipt of a Wells Notice to FINRA within 30 days. There is no dispute that the firm was bound by and violated these regulations by failing to disclose receipt of the Wells Notice within 30 days.

However, federal courts have cautioned against allowing securities fraud claims to be predicated solely on violations of NASD rules because such rules do not confer private rights of action. The court reasoned that these historic precedents are applicable to FINRA rules, since FINRA is the NASD?s successor.

Full post as published by Jim Hamilton's World of Securities Regulation on June 27, 2012 (boomark / email).