Friday, November 20, 2020

Petition asks High Court to examine the scope of Reg. S-K Item 105

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to resolve a circuit split on the level of knowledge required to trigger an obligation to disclose under Item 105 of Regulation S-K. In this case, the Third Circuit held that Item 105 requires that companies disclose facts unknown to them at the time of disclosure and, further, to disclose uncharged, unadjudicated wrongdoing. The petition argues that the Third Circuit's decision, if left standing, will expose public companies to significant, hindsight-based liability (M&T Bank Corporation v. Jarosalwicz, November 15, 2020).

The case involves the disclosure requirement in Item 105 of Regulation S-K. Item 105 imposes an affirmative obligation to disclose material factors that make an investment in the registrant speculative or risky.

Compliance concerns. In 2012, M&T Bank Corporation agreed to merge with another bank, Hudson City Bancorp, Inc., and filed a joint proxy with the SEC. Pursuant to Item 503 of Regulation S-K (since amended and recodified as Item 105), the proxy discussed the risk factors of the merger. Among these factors was the risk that regulators could delay or halt the transaction based on the Federal Reserve's evaluation of the companies' efforts to thwart money laundering (BSA/AML), but M&T explained that it believed that its policies and procedures were compliant.

Shortly before the shareholder vote, M&T and Hudson announced that the Federal Reserve Board had identified regulatory concerns about M&T's BSA/AML and that regulatory approval would be delayed. Undeterred, shareholders approved the merger. M&T worked over the next two years to address these concerns, and the Fed issued an order approving the merger in September 2015.

Journey through the courts. A few weeks before the merger closed, a class of Hudson shareholders brought a suit alleging that the joint proxy had omitted material risks associated with the merger, in violation of Exchange Act Section 14(a). The plaintiffs asserted, essentially, that M&T had negligently failed to discover its noncompliant practices and thus had failed to comply with Item 105. The district court dismissed the action, finding that regulatory risks had been adequately disclosed.

In late 2018, the Third Circuit issued an opinion vacating the dismissal of the Section 14(a) claim to the extent that it was premised on a failure to comply with Item 105. This opinion was subsequently vacated in light of the Court's dismissal of the petition in Emulex. In June 2020, the Third Circuit concluded, as it did in the 2018 opinion, that the BSA/AML deficiencies and consumer checking practices posed significant risks to the merger before M&T issued the joint proxy. Because the proxy omitted these material deficiencies and weaknesses, the plaintiffs met their pleading burden, the court said, adding that it did not matter whether or not M&T had actual knowledge of any shortcomings—the risk to the merger posed by an upcoming regulatory inspection triggered the need for disclosure.

Cert petition. The petition first argues that the Third Circuit's decision conflicts with the decisions of two other circuits regarding the scope of Item 105. First, in Silverstrand Investments v. AMAG Pharmaceuticals (2013), the First Circuit held that the plaintiffs stated an Item 105 claim where the defendant failed to disclose serious adverse events even though it knew about them. The Third Circuit, the petition asserts, splits from the First Circuit in not requiring actual knowledge of the allegedly-omitted facts; in this case, the plaintiffs did not allege that M&T knew of the BSA/AML deficiencies at issue—only that it "failed to detect" its alleged noncompliance. Unlike the Third Circuit, the First Circuit did not hold that knowledge of imminent regulatory scrutiny was enough to state a claim, and this, the petition says, creates a split on the question of whether actual knowledge is required to trigger a disclosure obligation.

Next, the plaintiff in City of Pontiac v. UBS AG (2014) alleged that UBS AG violated Item 105 by failing to disclose that the bank was engaged in tax evasion, while disclosing that it was being investigated by the DOJ. Even though it ultimately was revealed that UBS had violated the tax laws, the Second Circuit rejected this argument, stating that Item 105 does not create a duty to disclose "uncharged, unadjudicated wrongdoing." If the Second Circuit's standard were applied here, the petition says, the Third Circuit would have dismissed the claim. Instead, the Third Circuit distinguished M&T's disclosures as being more generic than UBS's. That case, however, did not rest on the specificity of the disclosures, the petition maintains, and the information at issue is exactly the sort of unadjudicated wrongdoing that the Second Circuit found to be outside of the ambit of Item 105.

Finally, the petition argues that the Third Circuit was simply wrong. First, the SEC has never suggested that Item 105 requires disclosure of facts unknown to the company, and has advised that disclosures are delimited by facts of which registrants are aware. Secondly, to ask companies to disclose unadjudicated wrongdoing is to require them to judge the lawfulness of their own conduct, and this can only be known in hindsight, the petition says. In this case, M&T believed that its BSA/AML procedures complied with the law, and said so.

The petition concludes by contending that the Third Circuit has created "a nightmare scenario" for reporting companies, in which they are required to disclose facts as yet unknown to them. So long as some high-level risk can be alleged, disclosure of unknown facts that later cause the risk to materialize would be required. Moreover, given the Third Circuit's status as the domicile of choice for U.S. companies (i.e., Delaware), this outlier position could become the de facto national standard.

The petition is No. 20-678.