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The Second Circuit recently broadened the circumstances for when a public company should disclose government investigations. Bradley partner Elisha Kobre explains that companies will need to consider when reasonable investors would “want to know” about a probe, which is a higher standard than in earlier cases.

Must a public company disclose to its shareholders that it is under investigation by a government agency? The US Court of Appeals for the Second Circuit recently shifted the legal landscape by expanding when a company has a duty to disclose government investigations.

In Noto v. 22ndCentury Group, the Second Circuit found a company’s failure to disclose a government investigation could result in the company or its management being held liable for securities fraud, even without a materially false statement or omission, where the existence of the government investigation is something reasonable investors would “want to know” or would “bear upon” an assessment of the company’s prior disclosures.

Why Disclosure Is a Big Decision

A company’s decision whether and when to disclose a government investigation is one that carries significant consequences. Unnecessary or premature disclosure can result in a loss of investor confidence, business disruption, and other negative effects to the company.

Failure to disclose when required, on the other hand, may result civil or even criminal liability under Section 10(b), the principal anti-fraud provision of the Securities Exchange Act or other securities laws.

District courts within the Second Circuit and elsewhere have rejected claims for failure to disclose the existence of a government investigation, applying the well-established rule that “a government investigation, without more, does not trigger a generalized duty to disclose.” This principle is rooted in the Supreme Court’s holding in Basic Inc. v Levinson that silence, “absent a duty to disclose, is not misleading” under Section 10(b).

The courts have found such a duty to disclose when, for example, there is a statute or regulation requiring disclosure; a prior corporate statement would otherwise be rendered inaccurate, incomplete, or misleading; or where the company is facing litigation that is “substantially certain” to occur.

Applying these rules, courts have rejected securities fraud claims for failure to disclose a pending government investigation—unless necessary to correct a prior disclosure—because the existence of an investigation does not generally mean that charges are “substantially certain” to occur.

One widely cited case involved an SEC investigation into media conglomerate Lions Gate Entertainment for failure to adequately disclose transactions it undertook in 2010 to fend off a hostile takeover by Carl Icahn. Lions Gate shareholders brought a securities fraud class action alleging that the company’s failure to disclose the SEC investigation—which resulted in an enforcement action against the company—was a material omission under the securities laws.

The district court in Lions Gate dismissed the securities fraud claims. Lions Gate, along with many other decisions, recognized that disclosure of an investigation would be required where the company “made express prior disclosures related to the investigation which were rendered materially misleading by omitting information about the investigation.”

But the court rejected the application of that principle to that case. The company’s prior statement that “[f]rom time to time, the Company is involved in certain claims and legal proceedings arising in the normal course of business”—which plaintiffs read as an implicit representation that no specific government investigation was ongoing—was not rendered false or misleading by the existence of the SEC investigation.

Noto Goes Further in Imposing a Duty to Disclose

Noto goes much further than Lions Gate and similar cases in imposing a duty to disclose the existence of a government investigation. In Noto, the plaintiffs alleged that, for years, the company’s SEC filings “reported material weaknesses in its internal financial controls” until one filing finally reported that the company had completed the implementation and testing of a remediation plan targeted at eliminating those weaknesses.

During nearly the entirety of this period, the SEC was actively investigating the company. Noto held that the company had a duty to disclose the SEC investigation into the weaknesses throughout the class period—not because the prior statements were misleading; to the contrary, they accurately disclosed the “material weaknesses” and the company’s efforts at remediation—but rather because the existence of an SEC investigation was material information that a reasonable investor “would have wanted to know.”

Moreover, the court found that disclosure was required because the existence of an SEC investigation would “bear on the reasonable investor’s assessment of the severity of the reported accounting weaknesses.” (Another part of the decision that presents no novelty involves the company’s alleged affirmative false denials of any knowledge of the SEC investigation.)

Would a Reasonable Investor Want to Know?

While the focus previously had been on ensuring that prior disclosures or omissions were not actually misleading, Noto appears more broadly to require disclosure of a government investigation even where consistent with—but perhaps helpful to amplify, supplement, or complete—the company’s prior disclosures on the same subject.

Per Noto, disclosure may be required even where the fact of the investigation is merely something a reasonable investor would “want to know,” “bear on” investor assessments of prior disclosures, or complete “the whole truth.” That is a higher standard than the cases have thus far applied.

While many companies and disclosure counsel always have been inclined to err on the side of more, rather than less, disclosure, Noto increases the imperative to choose the cautious approach and disclose the existence of a government investigation as early as possible, particularly where there were prior disclosures—even accurate ones—on the subject as the investigation.

Republished with permission. This article, "Second Circuit Ups the Ante on Disclosing Government Probes," was published by Bloomberg Law on June 17, 2022.