Court Focuses on Representations in Agreements Filed with SEC

This post from James Morphy is based on a client memo by Sullivan & Cromwell LLP.

The United States Court of Appeals for the Ninth Circuit recently rejected an issuer’s contention that a securities fraud complaint should be dismissed because the alleged misstatements were contained in an acquisition agreement attached as an exhibit to an Exchange Act report, instead of in the report itself. The court’s decision highlights the continuing need for issuers to consider the disclosure issues that can arise from representations and warranties included in exhibits to reports, proxy statements and registration statements filed under the federal securities laws.

On March 15, 2004, InVision Technologies Inc. announced that it would be acquired by General Electric Company, and attached the merger agreement as an exhibit to the Form 10-K that it filed that day. The merger agreement contained customary representations by InVision (with customary exceptions), including statements to the effect that InVision was in compliance with applicable laws, InVision was in compliance with certain provisions of the Securities Exchange Act of 1934 (the “Exchange Act”), and InVision had not violated the anti-bribery provisions of the Foreign Corrupt Practices Act of 1977 (the “FCPA”).

More than three months following the merger announcement, InVision announced that an internal investigation had revealed possible violations of the FCPA, and warned that subsequent investigations could cause a delay or termination of the merger transaction. Stockholders filed a class action complaint alleging that the representations in the merger agreement contained material misstatements that violated Rule 10b-5 under the Exchange Act. InVision later resolved the FCPA matter in settlements with the government, and the parties completed the merger. The securities fraud complaint was ultimately dismissed by the district court for failure to adequately plead falsity and scienter.

Ninth Circuit Decision
The Ninth Circuit reviewed the dismissal in Glazer Capital Management v. Magistri, No. 06-16899 (9th Cir., Nov. 26, 2008). Before addressing the pleading standards, the court considered InVision’s argument that the alleged misstatements could not support a securities fraud claim because they were contained in an agreement that was filed as an exhibit to the Form 10-K, and not in the Form 10-K itself. The court observed that the representations were expressly qualified by reference to a separate disclosure schedule listing exceptions to the representations (which was not filed and not publicly available), and that the merger agreement contained a “no third party beneficiaries” clause. Nonetheless, the court stated:

InVision’s proposed merger with GE was a very significant event for the company. InVision could have expected intense interest in the details of the merger, particularly from institutional investors like [the lead plaintiff]. The mere fact that the company chose to communicate the details of the merger in the form of an attachment to its publicly-filed Form 10-K, as opposed to in the body of the document itself, cannot work as a per se bar to securities law liability. Moreover, that the merger agreement was a private document and included reference to a non-public disclosure schedule would not, as a matter of law, prevent a reasonable investor from relying on its terms.

The court went on to conclude that the plaintiffs had failed to adequately plead scienter and falsity, and affirmed the dismissal on those grounds. While the analysis of the exhibit question was thus arguably not necessary to the court’s decision, issuers will still want to consider its implications.

Earlier SEC Guidance
The Ninth Circuit’s approach in Glazer is consistent with a 2005 position advanced by the SEC in connection with its investigation of The Titan Corporation. See Exchange Act Release No. 51283 (March 1, 2005). Like InVision, Titan entered into a merger agreement containing a “no FCPA violations” representation. Titan filed the agreement as an exhibit to a proxy statement, which also mentioned the representation. In fact, Titan had violated the FCPA. The counterparty terminated the merger agreement, and the SEC conducted an investigation. In its report of investigation, the SEC asserted that the inclusion of the representation in a filed disclosure document (even if just in an exhibit) constituted a disclosure to investors. Continuing with this reasoning, the SEC stated that, depending on factual circumstances, the representation could be material and a reasonable investor could conclude that the representation described the actual state of affairs. If facts made the disclosure misleading, the issuer would be required to disclose those facts.

The Titan report generated extensive commentary among issuers and law practitioners who believe reliance by investors on contract representations made to a third party in connection with a merger or acquisition transaction should not be considered “reasonable”. The SEC has not subsequently asserted such a position publicly.

Focus on potential disclosure issues
It is not certain that courts outside the Ninth Circuit would uniformly adopt the approach taken in Glazer. Issuers should nonetheless remain sensitive to potential disclosure issues arising out of representations contained in exhibits to reports, proxy statements and registration statements filed under the federal securities laws. In particular:

• First and foremost, issuers should consider whether there exist material facts that contradict representations contained in exhibits, and whether there is public disclosure about those facts sufficient to make disclosure of the representations not misleading.

• In addition, when disclosing representations in exhibits, or disclosing or summarizing them in the body of a filing, issuers should consider including in the filing disclosure emphasizing that the representations were made as of a specified date in connection with negotiating the contract between the parties thereto, are subject to qualifications and limitations agreed by the parties (and therefore may be subject to a contractual standard of materiality different from those standards generally applicable to stockholders and may have been used for purposes of allocating risk between the parties rather than for the purpose of establishing matters as facts), and should be read only in conjunction with information provided elsewhere in the filing and in the issuer’s other filings.

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