Second Circuit Decides case under PSLRA Regarding Adequacy of Cautionary Statement

By Cydney Posner

The Second Circuit has decided an interesting case (courtesy of Chad Mills) that reminds us how important it is to pay close attention to the cautionary language we include in SEC filings and press releases when seeking the protection of the PSLRA safe harbor for forward-looking statements.

In Slayton v. American Express Company (2d Cir. 2010) , the court examined whether cautionary language was adequate to protect American Express from liability for a potentially misleading statement in a 10-Q. As you may recall, the PSLRA provides protection from liability for a forward-looking statement that has been identified as a forward-looking statement if (1) it is "accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement," or (2) if "the plaintiff fails to prove that the forward-looking statement . . . was . . . made or approved by [an executive] officer with actual knowledge by that officer that the statement was false or misleading." While Amex ultimately succeeded in dismissing the plaintiffs' complaint on the basis of the second element of the safe harbor (actual knowledge), the court held that, with regard to the first element, the cautionary language was altogether too vague to entitle the defendants to safe harbor protection.

The plaintiffs' claim involved a single sentence in a Form 10-Q. In the 1990s, Amex (through its subsidiary, AEFA) had invested heavily in junk bonds and CDOs (sound familiar?) and, in 2000, began to incur heavy losses from those investments (sound really familiar?). After incurring losses of $123 million from these investments in 2000, the CEO ordered a "very hard Look" at the company's high-yield debt portfolio. As a result of that effort, Amex reported in its first quarter 2001 press release a loss of $182 million from these investments, adding that it expected total losses from those investments to be substantially lower for the remainder of 2001. However, in early May, the CEO was advised that the company was facing additional, but as yet unquantified, losses as a consequence of the deterioration of its high-yield debt portfolio; in fact, because of a sharp rise in defaults in the underlying bonds, even its so-called investment grade CDOs showed potential deterioration. (No, you're not dreaming – this occurred in 2001. Note that we're talking about millions, not billions here.) While an internal review team dug deeper into the problem, Amex filed its 10-Q on May 15 reporting the $182 million loss. However, Amex continued to state, as in the earlier press release, that it expected total losses from those investments to be substantially lower for the remainder of 2001. (You see the problem.) The Form 10-Q also contained standard cautionary language regarding forward-looking statements, adding that "[f]actors that could cause actual results to differ materially from these forward-looking statements include . . . potential deterioration in the high-yield sector, which could result in further losses in AEFA's investment portfolio." Following its examination in July 2001, the internal review team reported to a "stunned" CEO that the additional loss estimate was $400 million. In mid-July Amex announced an $826 million portfolio write-down, including the $400 million related to the CDOs. This litigation ensued.

The court first concluded that, contrary to the plaintiffs' contentions, the statement at issue was a forward-looking statement within the definition of the PSLRA, and, because it was in the MD&A and not in the financial statements, not statutorily excluded from the safe harbor. The plaintiffs then contended that the statement was not adequately identified as required by the statute because it was not in a discrete section captioned "forward-looking statements" or otherwise specifically labeled as forward-looking. The court disagreed. The company had included the standard litany identifying certain expressions, such as "should" and "expect," intended to indicate forward-looking statements. The SEC, in an amicus brief filed in the case, took the position that "[t]he use of linguistic cues like ‘we expect' or ‘we believe,' when combined with an explanatory description of the company's intention to thereby designate a statement as forward-looking, generally should be sufficient to put the reader on notice that the company is making a forward-looking statement." Here, the court agreed with the SEC.

The real issue on this point was whether the 10-Q contained adequate cautionary language. The court concluded that it did not. The SEC's view was that the forward-looking statement was not accompanied by meaningful cautionary language because the cautionary language itself was misleading in light of historical fact: while the defendants warned of potential deterioration in the high-yield sector, they were aware of actual deterioration. While the court agreed with the SEC on the proposition that cautionary language cannot be meaningful where it is misleading in light of historical fact, it disagreed that that proposition was applicable here. On the facts presented, the plaintiffs did "not demonstrate that the defendants misstated a historical fact—that the risk of which they warned, deterioration in the high-yield market that could cause further losses in AEFA's portfolio beyond those projected, had already transpired." The court instead viewed the facts presented to show that Amex knew of only potential deterioration in the market sector. Rather, the problem was that Amex "knew of the major and specific risk that rising defaults on the bonds underlying AEFA's investment-grade CDOs would cause deterioration in AEFA's portfolio at the time of the [10-Q] statement, and yet did not warn of it."

To be protected under the safe harbor, a forward-looking statement must be "accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement." While, under the legislative history, boilerplate statements would not be sufficiently substantive to be considered "important" or "meaningful" under the statute, it was not clear whether a cautionary statement could be meaningful if the company omitted a major risk that it knew about at the time it made the statement. But the court elected to punt on this issue, relying instead on its conclusion that the cautionary statement at issue was too vague to be meaningful. The defendants' caution -- "potential deterioration in the high-yield sector . . . could result in further losses in AEFA's portfolio" -- did not, according to the court, warn of the risk that materialized. Rather, the court held, the reference to deterioration in the high-yield sector generally was vague, verging "on the mere boilerplate, essentially warning that ‘if our portfolio deteriorates, then there will be losses in our portfolio.' " The fact that Amex's cautionary language remained the same, even while the underlying facts changed from the time of the press release to the 10-Q, bolstered the court's conclusion that the cautionary language was not tailored to the specific forward-looking statement. Although the PSLRA's legislative history was clear that companies were not expected to identify every factor, or even the particular factor that ultimately causes the projection not to be true, Amex (which had the burden of proof on this point), did not identify other important factors that could realistically cause results to differ materially. Accordingly, Amex was denied protection of the safe harbor under the cautionary statement prong of the PSLRA test.

Ultimately, however, the plaintiffs' complaint was dismissed because they were unable to satisfy the other prong of the safe harbor, that the statement was made by an executive with actual knowledge that it was misleading, which requires a strong inference of scienter. The SEC explained in its brief that the statement in the 10-Q contained three implicit factual assertions—"(i) that the statement is genuinely believed; (ii) that there is a reasonable basis for that belief; and (iii) that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy of the statement." Moreover, it stated that "a forward looking statement is misleading if the speaker actually knows that one or more of these implicit factual representations is not true." In this case, while there was certainly enough evidence to cause the court to pause, the court, looking at all the facts collectively, found the circumstantial evidence supporting an inference of non-fraudulent intent to be more compelling. In particular, it appeared that the company was "endeavoring in good faith to ascertain and disclose future losses." Moreover, the plaintiffs did not posit any motive to mislead, and the company had a history of prompt disclosure.

The case confirms that common practices used to identify forward-looking statements should be effective in litigation. It also reinforces the importance of carefully reviewing the cautionary language and risk factors to tailor the risk factor to the specific risk involved. This process may require that companies and their advisors drill down to understand and highlight for readers the underlying sources of the risk. In particular, the case underscores that cloning can be dangerous if it is not accompanied by a studious effort to update forward-looking statements, risk factors and cautionary language to conform to changed circumstances.