SEC Views Scope of PSLRA's Safe Harbor for Forward-Looking Statements at Invitation of Second Circuit

Invited by a federal appeals court to give its view on the scope of the PSLRA’s safe harbor for forward-looking statements, the SEC said that statements in the MD&A section of a Form 10-Q were within the scope of the safe harbor since the MD&A is separate and distinct from the financial statements in the 10-Q. In its amicus brief, the Commission also opined that it is not a meaningful cautionary statement to warn of a potential deterioration in yields when you are aware that such a deterioration is actually occurring. In addition, a forward-looking statement need not be included in a section marked “Forward-Looking Statements” or specifically labeled as a “forward-looking statement” to be “identified as a forward-looking statement” under the safe harbor. Finally, the SEC said that, under the safe harbor, a person has actual knowledge that a statement of projection is misleading if the person knows that he or she has no reasonable basis upon which to make the statement. The Second Circuit Court of Appeals invited the SEC’s views of the safe harbor for forward-looking statements in the case of Slayton v. American Express Co., which is on appeal from a district court’s dismissal of allegations regarding a company’s statement in its Form 10-Q that losses on high-yield investments for the remainder of 2001 are expected to be substantially lower than in the first quarter.

Section 21E(b)(2)(A) of the Exchange Act excludes from the safe harbor forward-looking statements that are included in a financial statement prepared in accordance with GAAP. Since the forward-looking statement here was included in the MD&A, the court asked the SEC if it came within the exclusion. In the SEC’s view, the challenged statement is not excluded from the statutory safe harbor, since the MD&A section is separate and distinct from the financial statements of a Form 10-Q. The SEC has consistently believed that the MD&A section should provide a discussion and analysis of a company’s business as seen through the eyes its managers, and should not be a recitation of financial statements in narrative form.

Section 21E(c)(1)(A)(i) requires that in order to receive safe-harbor protection a statement must be identified as a forward-looking statement. There is no bright line rule on this element, said the SEC, rather, the facts and circumstances of the language used in a particular registration statement or report will determine whether or not a forward-looking statement is sufficiently identified to receive safe-harbor protection.

But generally, the SEC does not believe that to sufficiently identify forward-looking statements a company must include all forward-looking statements in a separate section or label each forward-looking statement as such. According to the SEC, a forward-looking statement can be adequately identified, as the company did here in its Form 10-Q, by including an explanatory note indicating that the use of certain forward-looking words is intended to identify a forward-looking statement. The 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.

Section 21E(c)(1)(A)(i) also provides that a forward-looking statement that is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement is protected under the safe harbor. In the SEC’s view, the company’s statement that potential deterioration in the high-yield sector could result in further losses in the investment portfolio was not meaningful under the safe harbor provision because, according to the allegations, it misleadingly warned of a potential deterioration in the high yield sector when management was aware that such was actually occurring at the time. The safe harbor provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.

The SEC cautioned that safe harbor coverage does not apply when the cautionary statement is itself misleading. In adopting the safe harbor in the Private Securities Litigation Reform Act of 1995, reasoned the Commission, Congress did not intend to deviate from the well-established proposition that misleading cautionary language does not render inactionable a misleading forward-looking statement. The Conference Committee expressly recognized that a company could not rely upon a cautionary statement that misstates historical facts.

Finally, Section 21E(c)(1)(B) states that a person is not liable with respect to a forward-looking statement if the plaintiff fails to prove that the statement was made with actual knowledge that the statement was false or misleading. In the Commission’s view, a forward-looking statement is made with actual knowledge that it is misleading if the speaker makes the statement with the knowledge that he or she had no reasonable basis, or no basis at all, upon which to make it.

A statement of prediction or expectation, like the company’s statement here that losses are expected to be substantially lower, contains at least the implicit factual assertion that the statement is reasonably genuinely believed and the speaker is not aware of any undisclosed facts undermining its accuracy. A speaker has actual knowledge that a forward-looking statement is misleading if the speaker actually knows that these implicit factual representations are not true.

This standard is distinct from, and requires more than, a showing that a speaker acted recklessly in making a misleading forward-looking statement. Although the PSLRA’s legislative history is not illuminating on the matter, noted the SEC, the plain language of the provision requiring actual knowledge indicates that, to avoid the safe harbor, a plaintiff needs to show more than that a defendant acted recklessly.

Thud, to remove a forward-looking statement from the protection of the safe harbor, it must be shown that the company actually knew that the statement was misleading. In other words, to survive a motion to dismiss, an investor must plead facts sufficient to establish that company management was subjectively aware that one of the implicit factual assertions underlying its forward-looking statement was false when the statement was made.

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