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On March 29, 2016, the Second Circuit held that a “probability” standard applies to claims alleging a failure to disclose a loss contingency for unasserted claims pursuant to Financial Accounting Standard 5 (“FAS 5”) only if there has been “no manifestation by a potential claimant of an awareness of a possible claim or assessment.” Indiana Pub. Ret. Sys. v. SAIC, 2016 WL 1211858 (2d Cir. 2016) (Lohier, J.) (SAIC IV). In cases where a potential claimant has manifested awareness of a possible claim, the court held that FAS 5’s disclosure requirements apply if a loss in connection with that claim is a “reasonable possibility.”

The Second Circuit further held that Item 303 of Regulation S-K, which mandates the disclosure of certain “known trends or uncertainties” in a public company’s Form 10-Ks and other SEC filings,[1] “requires the registrant’s actual knowledge of the relevant trend or uncertainty” (emphasis added).

Background

The case before the Second Circuit concerned allegations that SAIC and several of its executives made “material misstatements and omissions in SAIC’s public filings regarding its exposure to liability for employee fraud in connection with SAIC’s contract work for New York City’s CityTime project,” an automated timekeeping program for government employees.

In 2002, SAIC hired Gerard Denault to run the CityTime project. Denault soon initiated “an elaborate kickback scheme” which increased the costs of the CityTime project by hundreds of millions of dollars.

In late 2010, SAIC placed Denault on administrative leave and commenced an internal investigation. On March 9, 2011, SAIC’s audit team reported that its investigation uncovered “improper timekeeping practices” by Denault. Around the same time period, then-Mayor Michael Bloomberg announced he was considering seeking recovery of the City’s payments to SAIC in connection with the CityTime project. A criminal investigation into the CityTime project was also underway.

On March 25, 2011, SAIC filed its Form 10-K. The company did not disclose any potential liability related to the CityTime project but instead “touted its commitment to high standards of ‘ethical performance and integrity.’” It was not until SAIC filed its Form 8-K on June 2, 2011, that the company disclosed its exposure to potential criminal liability and the possible reimbursement of payments made by the City for the CityTime project. Ultimately, SAIC terminated Denault’s employment and entered into a deferred prosecution agreement, “pursuant to which SAIC agreed to reimburse the City approximately $500.4 million and to forfeit $40 million in unpaid receivables.”

Among other claims, plaintiffs alleged that SAIC’s March 2011 Form 10-K failed to disclose (1) loss contingencies as required under FAS 5 of the Generally Accepted Accounting Principles (“GAAP”), and (2) “known trends or uncertainties” that could have a material impact on SAIC’s income, as required under Item 303 of Regulation S-K. On January 30, 2014, the district court dismissed plaintiffs’ FAS 5 and Item 303 claims. In re SAIC Sec. Litig., 2014 WL 407050 (S.D.N.Y. Jan 30, 2014) (SAIC II). Plaintiffs sought leave to amend their complaint to include additional allegations in support of their FAS 5 and Item 303 claims. On September 30, 2014, the district court denied plaintiffs’ motion to file an amended complaint, finding that any such amendment would be futile. In re SAIC Sec. Litig., 2014 WL 4953614 (S.D.N.Y. Sept. 30, 2014) (SAIC III). Plaintiffs appealed.

Second Circuit Holds the District Court Erred in Applying a “Probability” Standard to Plaintiffs’ FAS 5 Claims  

Under FAS 5 of GAAP, an issuer must “disclose a loss contingency when a loss is a ‘reasonable possibility,’ meaning that it is ‘more than remote but less than likely.’” SAIC IV, 2016 WL 1211858 (quoting FAS Board, Statement of FAS 5).

The district court determined that under FAS 5, disclosure of a loss contingency in connection with a potential claim “is not required . . . unless it is considered probable that a claim will be asserted.” SAIC II, 2014 WL 407050 (emphasis added). The court held that plaintiffs had failed to state a claim for failure to disclose a loss contingency under FAS 5 because the allegations did “not suggest that, by the time of the March 2011 filing, the information available left the company with the belief that a claim or assessment against it was probable.” SAIC II, 2014 WL 407050.

On appeal, the Second Circuit determined that the district court “appear[ed] to have misunderstood the standard applicable to claims under FAS 5.” SAIC IV, 2016 WL 1211858. The Second Circuit explained that “[t]he ‘probability’ standard applies in lieu of the ‘reasonable possibility’ standard only if the loss contingency arises from ‘an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment’” (quoting FAS Board, Statement of FAS 5). In the case before it, however, the Second Circuit held “the ‘reasonable possibility’ standard applie[d] in view of the [amended complaint’s] allegation that by March 2011 the City had manifested an awareness of a possible, sizeable claim against SAIC.”

The Second Circuit found the amended complaint adequately alleged that by March 2011, “the CityTime criminal investigation was as focused on SAIC as it was on SAIC’s individual employees[.]” The complaint also “alleged that by March 9, 2011, when SAIC received the results of its internal investigation about possible fraud, SAIC was aware not only of Denault’s wrongdoing but also its own potential liability to the City.” In view of these allegations, the Second Circuit held the amended complaint stated a claim based on SAIC’s failure to disclose a loss contingency under FAS 5.

Second Circuit Holds Item 303 of Regulation S-K Requires the Registrant’s Actual Knowledge of the Trend or Uncertainty At Issue  

The Second Circuit noted that it has “never directly addressed whether Item 303 requires that a company actually know or merely should have known of the relevant trend, event, or uncertainty in order to be liable for failing to disclose it.” The Second Circuit observed that in prior cases, it had “assumed, without deciding, that Item 303 required an allegation or showing of actual knowledge rather than a lesser standard of recklessness or negligence.”

Considering the question squarely for the first time, the Second Circuit held that “Item 303 requires the registrant to disclose only those trends, events, or uncertainties that it actually knows of when it files the relevant report with the SEC.” The court reasoned that “[t]he plain language of Item 303” supports this interpretation. Specifically, “Item 303 demands that the registrant ‘[d]escribe any known trends or uncertainties’ and also requires disclosure where ‘the registrant knows of events that will cause a material change in the relationship between costs and revenues,’ such as a ‘known future increase[ ] in costs of labor’” (quoting Item 303) (emphasis added by the court). The Second Circuit also noted that “[t]he SEC’s interpretation of Item 303 further confirms this plain-language reading of Item 303, insofar as it advises that the trends or uncertainties must be ‘presently known to management’” (quoting the SEC’s Interpretive Release) (emphasis added by the court). Significantly, the Second Circuit stated that “[i]t is not enough” for purposes of Item 303 that the registrant “should have known of the existing trend, event, or uncertainty” (emphasis added).

Second Circuit Determines Plaintiffs Adequately Alleged a Failure to Disclose a Known Trend or Uncertainty Under Item 303 of Regulation S-K 

Applying this standard to plaintiffs’ allegations, the Second Circuit held that the amended complaint “support[ed] a strong inference that SAIC actually knew (1) about the CityTime fraud before filing its Form 10-K on March 25, 2011, and (2) that it could be implicated in the fraud and required to repay the City the revenue generated by the CityTime contract.” The court also found the amended complaint alleged that “[e]xposure of the fraud also jeopardized SAIC’s existing or future relationships with other governmental entities that accounted for a significant amount of its revenue.” Given these allegations, the Second Circuit held that SAIC was required under Item 303 to disclose how the CityTime issues “might reasonably be expected to materially impact SAIC’s future revenues.”

Notably, the Second Circuit rejected defendants’ contention that “the loss of the CityTime contract was ultimately not material in view of the fact that it was a single contract out of SAIC’s more than 10,000 ongoing contracts and that it was worth a fraction of SAIC’s yearly revenues[.]” The court found that SAIC’s materiality argument suggested that it should “consider quantitative factors only in the narrowest light in determining the financial impact of losing the CityTime project due to the fraud, and to otherwise ignore qualitative factors.” The Second Circuit explained that given “[t]he seriousness of the CityTime fraud and the alleged importance of the CityTime project to SAIC’s future presence in the City and its ability to sell similar services to other municipalities around the United States,” it was “reluctant to conclude at this stage that the alleged misstatements were ‘so obviously unimportant’ either quantitatively or qualitatively that they could not be material.” 

Second Circuit Deems Inactionable SAIC’s Statements Concerning Its Commitment to Ethics and Integrity  

On appeal, the Second Circuit also considered plaintiffs’ contention that the district court erred in dismissing claims based on allegedly “materially false statements about SAIC’s commitment to ethics and integrity” in its 2011 Annual Report. The Second Circuit held “‘[p]laintiffs’ claim that these statements were knowingly and verifiably false when made does not cure their generality, which is what prevents them from rising to the level of materiality required to form the basis for assessing a potential investment’” (quoting City of Pontiac Policemen’s & Firemen’s Ret. Sys. v. UBS AG, 752 F.3d 173 (2d Cir. 2014)). The court explained the statements at issue here were indistinguishable from the “puffery” it had previously rejected in ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase, 553 F.3d 187 (2d Cir. 2009). In ECA, the Second Circuit held that statements concerning a company’s commitment to integrity are “typically ‘too general to cause a reasonable investor to rely upon them,’ in part because an investor ‘would not depend on [the statements] as a guarantee that [the company] would never take a step that might adversely affect its reputation’” (quoting ECA, 553 F.3d 187). The court therefore affirmed dismissal of claims based on those statements.

Notably, the Second Circuit clarified its decision should not be read to mean “that statements about a company’s reputation for integrity or ethical conduct can never give rise to a securities violation.” The court explained that “[s]ome statements, in context, may amount to more than ‘puffery’ and may in some circumstances violate the securities laws[.]” The Second Circuit offered as an example of this exception “a company’s specific statements that emphasize its reputation for integrity or ethical conduct as central to its financial condition or that are clearly designed to distinguish the company from other specified companies in the same industry.”