When should companies disclose SEC probes? 2nd Circuit clarifies in the case of biotechnology

People leave the U.S. Securities and Exchange Commission (SEC) headquarters in Washington, DC, U.S., May 12, 2021. REUTERS/Andrew Kelly

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(Reuters) – Public companies do not have an absolute duty to notify investors when they are under investigation by the U.S. government, under a precedent from federal courts in New York.

But they are also not entirely free to hide these investigations from shareholders. And it’s not always obvious when disclosure obligations come into play.

Just ask 22nd Century Group Inc, a biotechnology company that develops low-nicotine tobacco plants and genetically modified hemp and cannabis plants. In 2021, U.S. District Judge John Sinatra of Buffalo, New York, dismissed a shareholder class action lawsuit against the company, ruling (among other things) that 22nd Century was not required to disclose an alleged Securities investigation. and Exchange Commission on its accounting practices. On Tuesday, the 2nd Circuit challenged that finding and revived the case.

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Circuit Judges John Walker, Guido Calabresi and Raymond Lohier said in an opinion by Walker that 22nd Century was required to disclose the SEC investigation because the company had previously informed shareholders in SEC filings of the weaknesses in its financial reporting controls. 22nd Century, the court noted, had even assured investors in a 2018 quarterly filing that it had adopted new procedures to address its weakness in segregation of accounting duties and that the new plan had resolved the issues.

Once 22nd Century informed shareholders of the accounting issue, the 2nd Circuit said, it triggered a tell-the-truth obligation. “By failing to disclose that the SEC was investigating the company’s specific accounting weakness, the defendants’ statements about that weakness were not accurate and complete,” Walker wrote. “The fact of the SEC’s investigation would have a direct bearing on a reasonable investor’s assessment of the seriousness of the reported accounting weaknesses.”

22nd Century also denied there was an SEC investigation when an anonymous short seller who went by the name “Fuzzy Panda” first claimed in 2018 that the company was under regulatory scrutiny. . (Fuzzy Panda’s evidence was a letter from the SEC denying a Freedom of Information Act request for documents under an exemption that allows the agency to withhold information if disclosure “could reasonably be expected. to interfere with enforcement proceedings”.)

The 2nd Circuit said the company’s alleged “false public denial of any knowledge of the SEC investigation” was actionable. The appeals court also said the denial amounted to an admission that 22nd Century’s previous non-disclosure was material because “otherwise the company wouldn’t have tried to hide it.”

22nd Century attorney Jonathan Friedman of Foley & Lardner did not respond to my email request for comment on the ruling. Shareholder attorney Brian Calandra of Pomerantz said via email that the ruling will not only help plaintiffs in this class action, but will also “benefit investors generally by encouraging greater transparency from issuers of securities.”

Based on its brief to the 2nd Circuit, 22nd Century relied on rulings from the Manhattan Federal District Court dismissing shareholders’ claims that the companies had fraudulently failed to disclose government investigations.

The brief discussed, for example, U.S. District Judge John Koeltl’s 2016 decision in the Lions Gate Entertainment Corp Securities Litigation case, dismissing a shareholder class action lawsuit based on the company’s failure to disclose an investigation by the SEC on the maneuvers of the board of directors to prevent a takeover by a minority investor. Carl Icahn.

Even though Lions Gate received a Wells notice of pending enforcement action from the SEC and ended up paying the SEC a $7.5 million fine, the judge said that “a government investigation, without more, does not trigger a general obligation to disclose”. (Koeltl relied, in turn, on the 2014 2nd Circuit decision in City of Pontiac v. UBS AG, which said a company “has no affirmative duty to speculate or disclose wrongdoing or mismanagement unaccused and untried.”)

22nd Century also said it was under no obligation to disclose “any ‘uncharged and untried wrongdoing’ like the SEC’s alleged investigation”, particularly because its disclosure of its accounting weaknesses “was complete and completely accurate”.

But that was the exact opposite of what the 2nd Circuit concluded. The appeals court said 22nd Century’s initial disclosure of accounting issues was precisely why the company was required to notify investors of the SEC’s alleged investigation. The omission, according to the 2nd Circuit, made those previous disclosures misleading.

Tuesday’s decision wasn’t all good news for shareholders. In addition to their claim based on the undisclosed SEC investigation, they also alleged that 22nd Century defrauded investors by ordering promotional items touting the company’s prospects without disclosing that the company had paid the authors of the items. In several instances, according to the plaintiffs, 22nd Century’s stock price rose after these buy-and-pay items appeared.

The 2nd Circuit said the shareholders failed to show that 22nd Century executives (or the outside investor relations firm they hired) controlled the content of the articles. But even if they had, the appeals court said, 22nd Century had no obligation, under the U.S. Supreme Court’s decision in Janus Capital Group v. First Derivative Traders in 2011 to disclose that she paid for the articles because she was not their ultimate author.

It’s an interesting thought exercise to ask whether 22nd Century would have been better off, at least from the perspective of potential liability to investors, by not disclosing anything at all about its accounting control issues. If he had remained silent, would he still face a claim based on his subsequent decision not to disclose the related SEC investigation?

It would be unfortunate for investors if the conclusion of this week’s ruling is that companies should be quiet about issues that could lead to regulatory investigations.

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Alison Frankel

Thomson Reuters

Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A graduate of Dartmouth University, she worked as a journalist in New York covering the legal industry and law for more than three decades. Before joining Reuters, she was an editor and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.

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