13 July 2015
Practice Groups:
Government
Enforcement
Global Government
Solutions
Consumer Financial
Services
Are Public Companies Required to Disclose that the
Government is Investigating Them?
By: Jonathan N. Eisenberg
For many public companies, the first issue they have to confront after they receive a
government subpoena or Civil Investigative Demand (“CID”) is whether to disclose publicly
that they are under investigation. Curiously, the standards for disclosure of investigations
are more muddled than one would expect. As a result, disclosure practices vary—
investigations are sometimes disclosed upon receipt of a subpoena or CID, sometimes when
the staff advises a company that it has tentatively decided to recommend an enforcement
action, sometimes not until the end of the process, and sometimes at other intermediate
stages along the way. In many cases, differences in the timing of disclosure may reflect
different approaches to disclosure. We discuss below the standards that govern the
disclosure decision and practical considerations. We then provide five representative
examples of language that companies used when they disclosed investigations at an early
stage.
THE SIGNIFICANCE OF AN INVESTIGATION
A government investigation, whether formal or informal and whether involving a voluntary
request for information, a subpoena, or CID, is a fact-finding exercise. It is designed to
gather those facts necessary for an agency to make an informed decision about whether
violations of law have occurred and whether an enforcement action is warranted. As the
Securities and Exchange Commission states in its standard subpoena-related disclosures:
This investigation is a non-public, fact-finding inquiry. We are
trying to determine whether there have been any violations of
the federal securities laws. The investigation and the
subpoena do not mean that we have concluded that you or
anyone else has broken the law. Also, the investigation does
not mean that we have a negative opinion of any person,
entity or security.
Similarly, 12 U.S.C. § 5562(c) provides that the Consumer Financial Protection Bureau, like
many other federal agencies, may issue a CID when it has reason to believe that a person
“may” have information relevant to a violation. It is not a finding or allegation of a violation.
Government agencies often gather information for years before the enforcement staff
concludes whether a company has engaged in wrongdoing. Even then, there is usually a
process for the company to address any concerns raised by the staff as a result of its
investigation and try to convince the staff and ultimately the agency itself that an
enforcement action is not warranted. The significance of an investigation is not that the
government has reached a conclusion that wrongdoing has occurred or that an enforcement
action is warranted; it is that the government is seeking information that might or might not
lead to that conclusion.
Are Public Companies Required to Disclose that the Government is
Investigating Them?
“LEGAL PROCEEDINGS” DISCLOSURE REQUIREMENTS
SEC Regulation S-K, Item 103, titled “Legal Proceedings,” sets forth the types of legal
proceedings a public company is required to publicly disclose. When companies disclose
investigations, they often include such disclosure in the “Legal Proceedings” sections of their
public filings.
Item 103 includes a directive that companies “describe any material pending legal
proceeding … known to be contemplated by government authorities.” While the word
“contemplated” is imprecise in this context, existing authorities conclude that Item 103
requires more than mere knowledge of an investigation and instead requires at least a
communication that the agency is contemplating bringing a proceeding.
For example, in one recent case a district court held that Item 103 did not trigger a duty to
disclose even at the Wells Notice stage (at which the staff notifies the company that it has
reached a preliminary decision to recommend an enforcement action), and stated that
disclosure is not required until “the regulatory investigation matures to the point where
litigation is apparent and substantially certain to occur ….” 1 While the court did not explicitly
consider whether the company had to disclose the commencement of an investigation and
receipt of the SEC’s subpoena, the implication of the decision is that the company also need
not have disclosed those events because the mere fact of an investigation does not mean
that litigation “is apparent and substantially certain to occur.” 2
In a more recent case, plaintiffs argued that Item 103 required defendants to disclose state
regulatory investigations of their insurance practices. The court, in dismissing that claim,
stated, “[T]he state investigations were not pending legal proceedings and thus Item 103 is
inapplicable.” 3
Commentators agree with this interpretation of Item 103. Two of the most prominent
securities law commentators concluded more than 20 years ago that an investigation is not a
“proceeding” within the meaning of Item 103 and “[t]he implication of Item 103 is that
disclosure of an investigation is not required before governmental authorities indicate that an
enforcement action against the company is contemplated.” 4 More recently, an article coauthored by a former branch chief for the SEC’s Division of Enforcement concluded that
under Item 103 “[a]n investigation on its own is not a ‘pending legal proceeding’ until it
reaches a stage when the agency or prosecutorial authority makes known that it is
contemplating filing suit or bringing charges.” 5
MISLEADING OMISSIONS UNDER SEC RULES 10b-5 AND 12b-20
Item 103 creates an affirmative disclosure obligation when it applies but, as noted above,
does not create an obligation to disclose a mere investigation. That, however, is not the end
of the analysis. Under SEC Rules 10b-5 and 12b-20, companies may not omit material facts
necessary to make the statements that they make “not misleading.” The Supreme Court
recently emphasized the obligation not to mislead through omissions under the Securities
Act even when the affirmative statements made were accurate.6
Whether a company misleads by not disclosing an investigation depends on what affirmative
statements it has made. In the opinion discussed above in which the court held that a
company did not have a duty to disclose the receipt of a Wells Notice, the court observed
(consistent with many other decisions) that “revealing one fact about a subject does not
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
trigger a duty to reveal all facts on the subject, so long as what was revealed would not be so
incomplete as to mislead.” It held that in that case there were no affirmative statements that
were rendered misleading by the failure to disclose the receipt of a Wells Notice. 7
There are at least two cases, however, in which courts found that affirmative statements
created an obligation to disclose an investigation. In United States v. Yeaman, 194 F. 3d
442 (3d Cir. 1999), the defendant was allegedly involved in a scheme in which he helped
lease stock of nearly worthless public companies for $12 million by manipulating the market
quotes and inflating the financial statements of these corporations. One of the public
company’s annual reports on Form 10-K stated that the company and its officers and
directors were not aware of any material legal proceedings “contemplated” or “threatened”
that would which impair the operation of the company. The court of appeals affirmed a
conviction based in part on this representation and found no error in the district court’s
conclusion that “disclosure of the investigation was necessary in order to make not
misleading the disavowal of knowledge of threatened proceedings that would impair the
operations of the corporation.” It accepted the government’s argument that the defendant
“must have been aware of the scope and gravity of the investigation … and, given his
knowledge of his own activities … must have known of the probability of a proceeding ….”
In RMED International, Inc. v. Sloan’s Supermarkets, Inc., 207 F. Supp. 2d 292 (S.D.N.Y.
2002), the defendant represented that there were no pending actions before any government
agency or “threatened” actions that could materially adversely affect the company’s financial
condition. At the time it made the statement, it was the target of an FTC antitrust
investigation and had engaged in negotiations that made clear it was a target. In denying
reconsideration of its denial of defendant’s motion for summary judgment, the court stated
that the disclosure “misleadingly indicates that [the defendant] was not being investigated by
the FTC, and that [the defendant] does not know of any potential investigation by the FTC.”
Together, these cases arguably stand for the proposition that while there is no general duty
to disclose investigations, an affirmative denial that there are threatened actions may trigger
an obligation to disclose an investigation that is material. Moreover, they highlight that, as
two commentators previously observed, there may be circumstances in which “some of the
extensive information needed in the 10-K or prospectus may well be so closely related to the
matter being investigated that the document will be materially misleading without a
disclosure of the investigation and its possible or probable effects.” 8
ACCOUNTING STANDARDS CODIFICATION 450
It’s never wise for lawyers to weigh in on the meaning of accounting standards, but it is
important for companies to consult with their accountants on the potential application of
Accounting Standards Codification (“ASC”) 450. ASC 450 addresses, among other things,
disclosure requirements for “loss contingencies,” including disclosure of both asserted and
unasserted claims. With respect to unasserted claims, ASC 450 states that disclosure is
required if there has been a “manifestation by a potential claimant of an awareness of a
possible claim” and the claim is at least “reasonably possible.” ASC 450 does not state
whether the commencement of an investigation is a manifestation of awareness of a possible
claim.
ASC 450 also states that in the absence of a manifestation by a potential claimant of an
awareness of a possible claim, disclosure of an unasserted claim is still required if it is
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
“probable” that the claim will be asserted and there is a reasonable possibility the outcome
will be unfavorable. Of course, the mere fact that an investigation is commenced does not
mean that it is probable that a claim will be asserted. But, as United States v. Yeaman
suggests, if the underlying conduct is sufficiently grave—in that case manipulation that
resulted in nearly worthless stock being treated as if it were worth $12 million—and the party
being investigated knew of that conduct, that may contribute to a court’s conclusion that a
claim was probable even at the investigatory stage.
One decision by a highly-respected judge applied the same analysis to Item 103 and ASC
450 in addressing whether an investigation had to be disclosed, and held that ASC 450 did
not require disclosure of investigations because “the state investigations were not pending or
threatened litigation.” 9 The court’s analysis of the ASC 450 standard, however, is only one
sentence and it is not clear whether the SEC or other courts would take the same approach.
In recent years, the SEC has been particularly focused on the disclosure of litigation loss
contingencies under ASC 450; the main focus, however, has been in the context of pending
litigation rather than investigations.
MD&A DISCLOSURE REQUIREMENTS
Regulation S-K, Item 303, captioned “Management’s Discussion and Analysis of Financial
Condition and Results of Operations” (“MD&A”), requires companies to disclose, among
other things, “known trends or uncertainties that have had or that the registrant reasonably
expects will have a material favorable or unfavorable impact on net sales or revenues or
income from continuing operations.” Item 303 requires a company to disclose an
investigation only if it “reasonably expects” the investigation will have a material adverse
effect on the company. For most companies, that will not be the case at the outset of an
investigation, but there will be exceptions where the company knows even at the beginning
that the matters being investigated involve especially significant risks or where multiple
investigations increase the risks.
PRACTICAL CONSIDERATIONS
There are practical reasons that sometimes cause companies to disclose investigations even
when disclosure is not required. For example, they may be asked by analysts, institutional
investors, or rating agencies whether they are being investigated and they may not want to
respond with a no comment answer. They may have agreements that require them to
disclose to lenders and others, and may be concerned about issues related to selective
disclosure. They may want to allow insiders who are aware of the investigations to trade and
may have a concern that in some circumstances the investigation may constitute material
nonpublic information that may prevent them from trading if the investigation has not been
publicly disclosed. They may have a concern that the investigation will be leaked by
others—for example, persons who are not the subject of the investigation but who are
subpoenaed—and they prefer that the company, not third parties, be the source of
information about the investigation. They may have a concern that if they do not disclose the
investigation at the outset, analysts, rating agencies, and others will react poorly when they
later learn of the investigation. Furthermore, companies may take the lack of clarity in the
disclosure standards as an additional reason to disclose because ambiguity might not be
resolved in the company’s favor.
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
At the same time, there is a cost to early disclosure that has to be considered as well.
Investors may give an investigation greater weight than is merited because investors
generally will not be able to distinguish between investigations resulting from indications of
serious wrongdoing and investigations that are more in the nature of fishing expeditions.
The mere fact that the company discloses may be misunderstood by some investors as
indicating that the investigation is based on wrongdoing. In some situations, the government
may not be pleased with companies making their non-public investigations public, and in
some cases companies are required to obtain the government’s permission before disclosing
a non-public investigation. Disclosure of an investigation may also put more pressure on
regulators ultimately to bring an enforcement action.
Thus, practical considerations often point in conflicting directions. Companies weighing
these considerations, reasonably interpreting the multiple disclosure standards that exist,
and acting in complete good faith may take different approaches to whether and when to
disclose an investigation. The fact that judgments about materiality also enter the
equation—because immaterial investigations need not be disclosed under any of the above
standards—adds to differences in disclosure practices because judgments about materiality,
especially in the context of an early-stage investigation, are often difficult to make.
EXAMPLES OF DISCLOSURE
There are many examples of companies disclosing their receipt of a subpoena or CID. Five
representative examples are included below, which show a range of approaches to the
disclosure:
1. Press Release Attached to a Current Report on Form 8-K: “[The company] …
announced that, on _________, it received a civil investigative demand (“CID”)
issued by the U.S. Department of Justice pursuant to the federal False Claims
Act. The CID requires the delivery of a wide range of documents and information
to the United States Attorney’s Office … relating to the Company’s clinical and
business operations, including reimbursement and billing claims submitted to
Medicare for home health services, and related compliance activities. The CID
generally covers the period from _________, 20__, through the present. The
Company intends to cooperate with the Department of Justice. No assurance can
be given as to the timing or outcome of this investigation.”
2. Press Release Attached to a Current Report on Form 8-K: “[The company]
announced it received today a Civil Investigative Demand (“CID”) from the
Federal Trade Commission (“FTC”). In response, the company issued the
following statement:
[The company] welcomes the inquiry given the tremendous amount of
misinformation in the marketplace and will cooperate fully with the FTC. We
are confident that [the company] is in compliance with all applicable laws and
regulations. [The company] is a financially strong and successful company,
having created meaningful value for shareholders, significant opportunities
for distributors, and positively impacted the lives and health of its consumers
for over 34 years.
“[The company] does not intend to make any additional comments regarding this
matter unless and until there are material developments.”
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
3. Quarterly Report on Form 10-Q: “CFPB Investigation. In _________, we
received a Civil Investigative Demand (a “CID”) from the Consumer Finance
Protection Bureau (the “CFPB”) as part of its investigation to determine whether
nationwide consumer reporting agencies have been or are engaging in unlawful
acts or practices relating to the advertising, marketing, sale, or provision of
consumer reports, credit scores, or credit monitoring products in violation of the
Dodd Frank Act or the Fair Credit Reporting Act. The CID requests the
production of documents and answers to written questions. We are cooperating
with the CFPB in its investigation and are in discussions with the CFPB regarding
our response to the CID. At this time, we are unable to predict the outcome of
this CFPB investigation, including whether the investigation will result in any
action or proceeding against us.”
4. Form 8-K: “Item 7.01 Regulation FD Disclosure. On _________, [the company]
received a civil investigative subpoena from the U.S. Department of Justice
pursuant to the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 directing it to produce certain documents relating to subprime automotive
finance and related securitization activities. Earlier in December, the Company
received a civil investigative demand from the Office of the Attorney General of
the Commonwealth of Massachusetts relating to the origination of non-prime
auto loans in Massachusetts. The Company intends to cooperate with these
inquiries. The information furnished in this report shall not be deemed filed for
purposes of Section 18 of the Securities Exchange Act of that Section, nor shall
such information be deemed incorporated by reference in any filing under the
Securities Act of 1933, as amended.”
5. Form 10-K: “In ________, the Company received correspondence and
subpoenas from the Securities and Exchange Commission indicating that the
SEC is conducting an investigation of the Company. The SEC has requested the
production of documents and communications that, among other things, relate to
student information in the areas of recruitment, attendance, completion,
placement, defaults on federal loans and on alternative loans, as well as
compliance with U.S. Department of Education financial requirements, standards
and ratios (including the effect of certain borrowings under the Company’s
revolving credit facility on the Company’s composite score, and 90/10
compliance), and other corporate operational financial and accounting matters.
“We are continuing to cooperate with these investigations, but we cannot predict their
ultimate resolution. We expect to continue to incur significant legal costs and other
expenses in connection with responding to them. We may be required to pay damages or
settlement costs in excess of our insurance coverage, if any, related to these matters.
Government investigations, including the pending investigations in which we are involved,
and any related legal and administrative proceedings, may result in the institution of
administrative, injunctive, or other proceedings against us and/or our institutions, officers, or
employees or the imposition of fines, suspension, or other remedies and sanctions. Any
such material costs and expenses or injunctive relief could have a material adverse effect on
our financial condition and results of operations.”
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
CONCLUSION
As is clear from the above analysis, there is no practical black and white standard for
whether or when companies have to disclose investigations. Item 103 of Regulation S-K,
which is most directly on point, does not appear to require disclosure of an investigation until
the government communicates it contemplates bringing an enforcement action. Case law
and commentary supports that interpretation, and many companies in complete good faith
and consistent with reasonable interpretations of the relevant disclosure standards do not
disclose that they are being investigated at the outset of an investigation. Other companies,
however, disclose at the beginning of an investigation based on a combination of the factors
discussed above and the fact that ambiguities in disclosure standards, as well as the
application of those standards to particular facts, will not necessarily be resolved in favor of
non-disclosure. Given the virtual certainty of investigations into the practices of heavilyregulated entities, one hopes that investors and analysts will not overreact to the disclosure
of early-stage investigations that may ultimately go nowhere or otherwise lead to immaterial
outcomes.
Author:
Jonathan N. Eisenberg
jon.eisenberg@klgates.com
+1.202.778.9348
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1
Richman v. Goldman Sachs Group, Inc., 868 F. Supp. 2d 261, 275 (S.D.N.Y. 2012).
While citing the article referenced in endnote 5 below, the court rejected the position advanced
in the article that an SEC investigation evolves into a “proceeding known to be contemplated by a
government agency” when the SEC Enforcement staff issues a Wells Notice. 64 Bus. Law. at
982. Instead, the court focused on the fact that the staff could only recommend but not authorize
an enforcement action, and that the Wells process was implemented so that the SEC would have
the opportunity to hear a defendant’s arguments before deciding whether to go forward with an
2
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Are Public Companies Required to Disclose that the Government is
Investigating Them?
enforcement action. 868 F. Supp. 2d at 272. That is why the court concluded that even a Wells
Notice need not be disclosed.
3
Westland Police and Fire Ret. v. MetLife, Inc., 928 F. Supp. 2d 705, 718 (S.D.N.Y. 2013).
4
Alan R. Bromberg and Lewis D. Lowenfels, “Disclosure of Government Investigations,” 8
INSIGHTS 17 (June 1994).
5
David M. Stuart and David A. Wilson, “Disclosure Obligations Under the Federal Securities
Laws in Government Investigations,” 64 Bus. Law. 973, 982 (2009).
6
Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318
(Mar. 25, 2015).
7
868 F. Supp. 2d at 274.
8
Alan R. Bromberg and Lewis D. Lowenfels, “Disclosure of Government Investigations,” supra n.
5 at 19.
9
Westland Police and Fire Ret. v. MetLife, Inc., 928 F. Supp. 2d at 718.
8