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(Article from Securities Law Alert, February 2017) 

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On January 19, 2017, the Ninth Circuit held that a CEO’s violation of the company’s ethics code did not give rise to a claim for securities fraud under Section 10(b) and Rule 10b-5 on the grounds that corporate ethics codes are “inherently aspirational.” Retail Wholesale & Dep’t Store Union Local 338 Ret. Fund v. Hewlett-Packard, 845 F.3d 1268 (9th Cir. 2017) (Christensen, J.).[1] The court reasoned that holding otherwise “could turn all corporate wrongdoing into securities fraud.”

Background

The case before the court concerned the CEO’s alleged misrepresentations regarding “the nature and scope of his relationship with” an independent contractor, as well as the [alleged] falsification of company expense reports for meals he had eaten with her. These incidents ultimately led to the CEO’s resignation.

Plaintiffs subsequently brought suit alleging that the CEO’s misconduct rendered the company’s ethics code materially misleading under Section 10(b) and Rule 10b-5. The Ninth Circuit observed that “several provisions” of the ethics code were “inconsistent” with the CEO’s actions, including representations that the company “maintain[s] accurate business records” and “create[s] business records that accurately reflect the truth of the underlying transaction or event.” The court noted that the ethics code “contains similarly worded statements regarding: honesty; cooperation with investigators; using good judgment; [and] reporting misconduct.”

Aspirational Statements Concerning Corporate Ethics Cannot Be Objectively False

The Ninth Circuit stated that it has not previously “addressed how to determine whether statements made in or about an ethical code are actionable representations if the ethical code is violated.” The court approached the issue in the case before it “by first analyzing falsity, to determine whether an ethical code and statements made about the code contain any misrepresentations of fact, and then, if there was a misrepresentation, determining its materiality—that is, its significance to stockholder decisionmaking.”[2]

The Ninth Circuit next turned to the language of the corporate code of conduct at issue. The court explained that “a code of conduct is inherently aspirational” and “expresses opinions as to what actions are preferable, as opposed to implying that all staff, directors, and officers always adhere to its aspirations.” The court found that statements in the code of conduct in question were “vague,” “subjective,” and “not capable of objective verification.” The court concluded that the corporate ethics statements could not constitute affirmative misrepresentations for Rule 10b-5 purposes. Notably, the Ninth Circuit emphasized that a “contrary interpretation” would be “simply untenable” because it would allow plaintiffs to frame virtually any claim of corporate wrongdoing as a securities fraud violation.

The Ninth Circuit rejected plaintiffs’ contention that the “context” of the facts at issue “transform[ed] what would otherwise be aspirational into statements capable of objective verification.” The court stated that “context more appropriately factors into the question of whether an alleged misrepresentation was material to investors, not into whether a statement itself could be a misrepresentation.”

Alleged Misrepresentations in Corporate Ethics Codes Are Not Material

After addressing the question of falsity, the Ninth Circuit then considered whether the alleged misrepresentations in the company’s ethics code were material. The court found it significant that the statements were promulgated pursuant to SEC regulations. The court determined that “[i]t simply cannot be that a reasonable investor’s decision would conceivably have been affected by [the company’s] compliance with SEC regulations requiring publication of ethics standards.”

Publication of a Corporate Ethics Code Does Not Trigger a Duty to Disclose Ethics Violations

The Ninth Circuit also found meritless plaintiffs’ claim that the company had a duty to disclose ethics violations by its CEO. The court underscored that the ethics-related statements in question were “transparently aspirational.” The court found that “[t]he promotion of ethical conduct at [the company] did not reasonably suggest that there would be no violations of the [corporate code of conduct] by the CEO or anyone else.” In view of its finding that the ethics statements “did not create an impression of full compliance,” the court held that the company had no duty to disclose the “misuse of CEO authority and misbehavior” in violation of those statements.