VIA E-MAIL TO firstname.lastname@example.org
August 6, 2002
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan G. Katz
Re: File No. S7-16-02
Release No. 33-8098; 34-45907
Disclosure in Management's Discussion and Analysis About the Application of Critical Accounting Policies
Ladies and Gentlemen:
We submit this letter in response to the request of the Securities and Exchange Commission (the "Commission") for comments on its May, 2002, Release No. 33-8098/34-45907, entitled "Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies" (the "Proposing Release").
The group submitting this letter consists of a Stanford Law School securities law professor, securities lawyers practicing in the Silicon Valley who work for private law firms and lawyers from corporations with headquarters in Silicon Valley. The views as reflected in this letter constitute a consensus of our individual perspectives. They do not reflect the official positions of the law firms or other organizations with which we are affiliated, or the clients of any of our law firms. Because this is a consensus document, we and our firms each reserve the right to express views that may not be fully reflected in this letter.
We have commented on numerous proposals issued by the Commission in the past, including most recently the proposal to require company reporting on insider transactions (Rel. No. 33-8090; Comment Letter dated July 2, 2002) and the proposal to accelerate Form 10-Q and Form 10-K filing dates (Rel. No. 33-8089; Comment Letter dated May 30, 2002). Previously, we submitted comments on the "aircraft carrier" proposal (Rel. No. 33-7606; Comment Letter dated October 8, 1999); the proposal to amend Form S-8 (Rel. No. 33-7506; Comment Letter dated April 23, 1998); and the executive compensation disclosure rules (Rel. No. 33-6940; Comment Letter dated August 24, 1992). We have also requested and received a number of interpretive letters, including three letters regarding the application of the Section 16 rules (Interpretive Letters to Joseph A. Grundfest et al. dated April 25, 1991, August 19, 1991 and March 4, 1992). We are often referred to as the "Grundfest Group."
The law firms with which we are affiliated primarily represent technology companies, and have been involved with a large majority of the capital formation activity in Silicon Valley. We are individually familiar with the issues that arise in the preparation and filing of reports by public companies and their insiders under the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78a et seq., and we believe that we have a broad insight into the workings of the public company reporting process in the high-technology industry, particularly as it has developed in Silicon Valley. In addition, we are uniquely situated to suggest innovative ways to use technology to improve the reporting process, as we observe, on a daily basis, our clients' use of the Internet in innovative ways to facilitate the gathering of information.
We submit this comment letter because we do not believe that the initial Proposing Release provides for an adequate litigation safe harbor. We strongly urge the Commission not to adopt any rule even remotely similar to those described in the Proposing Release (the "Proposed Rules") without a suitable corresponding safe harbor. Accordingly, we respectfully suggest that the Commission consider reissuing whatever rules, if any, that it determines to propose in this area together with an appropriate private litigation safe harbor, through the exercise of its authority under Section 28 of the Securities Act of 1933, as amended (the "Securities Act"), and Section 36 of the Exchange Act. 15 U.S.C. §77z-3; 15 U.S.C. §78mm. We expect to file a subsequent additional comment letter by August 19, 2002 to address other issues raised by the Proposing Release.
1. The Forward-Looking Safe Harbors Are Inadequate.
As the Commission is well aware, forward-looking statements have long been a source of great concern from a litigation perspective. Because of the ease with which plaintiffs can allege "fraud by hindsight," even the most honest and diligent of issuers are wary of the litigation risk associated with forward-looking statements. Issuers have traditionally controlled this risk by simply not making forward-looking statements. The Proposed Rules fundamentally change this equilibrium. They, for the first time, mandate that every issuer must make extensive forward-looking statements and thereby impose mandatory litigation risk for forward-looking statements on every publicly traded issuer.
The Proposing Release rests on the premise that existing safe harbors for forward-looking information provide adequate safeguards against the risk of vexatious and non-meritorious private party litigation that accompanies forward-looking disclosures. See Proposing Release at III.K.1 This assumption is incorrect for at least three distinct reasons.
First, the statutory safe harbors are subject to a broad range of exclusions. Most problematically, no safe harbor is available in any initial public offering that subjects the issuer to strict liability under Section 11 of the Securities Act. 15 U.S.C. §78k. An issuer in an IPO can therefore avoid the significant strict liability risk inherent in making a forward-looking statement only by being careful not to include any such statement in its registration statement. The Proposed Rules, however, eliminate this possibility and thereby de facto impose strict liability for forward-looking statements on every issuer in every IPO.
This is a prescription for disaster. Issuers going public for the first time are often young companies operating in risky environments that have low visibility as to future developments. The danger that honest forecasts will foment litigation based on allegations of "fraud by hindsight" is therefore greatest among the very class of issuers that will now be subject to strict liability for forecasts that are not within the statutory safe harbor. Put another way, the class of issuers who may most legitimately require the greatest protection against private litigation will receive the least. Other categories of issuers excluded from the safe harbor, such as participants in tender offers or going private transactions, face a similar Hobson's choice. The Proposed Regulations will now require that they too make forward-looking statements without any of the statutory safe harbor protections upon which the Release relies, unless they decide to forego the transaction that is excluded from the safe harbor.
We urge that no issuer be mandated to provide forward-looking statements that fall outside of the statutory safe harbor. Indeed, as the very structure of the statute and language of the Conference Committee Report makes clear, the safe-harbor provisions of the Securities Act and of the Exchange Act rest on the premise that the decision to make a forward-looking statement is elective with the issuer. Courts have thus observed that the purpose of the safe harbor was to prevent officers from being inhibited "from fully explaining their outlooks," and that the safe harbor was adopted "in order to loosen the `muzzling effect' of potential liability for forward-looking statements, which often kept investors in the dark about what management foresaw for the company." Harris v. Ivax Corp., 182 F.3d 799, 806 (11th Cir. 1999), reh'g denied, 209 F.3d 1275 (2000). See also, In re Splash Tech. Holdings Inc. Securities Litig., 2000 WL 1727377, at *5 (N.D. Cal. Sep. 29, 2000) ("The purpose behind this safe harbor is to encourage the disclosure of forward looking information."). Because the Proposed Rules undo that key assumption, the Commission should recognize that it is seeking to create private civil liability of a form that has never been endorsed by Congress. The Commission should proceed with commensurate caution.
Second, even as to statements that are not statutorily excluded from the safe harbor, plaintiffs will find that the Proposed Rules makes it trivially easy to allege fraud by hindsight. The Proposed Rules require that issuers make judgments about "reasonably possible near term changes" (Item 303(c)(3)(iii)(A)(1)) or about the location of the "upper end and the lower end of the range of reasonable possibilities" associated with such changes (Item 303(c)(3)(iii)(A)(2)). The law is unsettled as to whether a statement of present fact, whether or not articulated as a probability, qualifies as an assumption that is within the statutory definition of a "forward-looking" statement. See, generally, Harold S. Bloomenthal, Securities Law Handbook, §28.05 (2002). The law is also unsettled as to plaintiffs' ability to allege that the omission of an assumption related to a forecast qualifies for the safe harbor, and some courts have held that "allegations based upon omissions of existing facts or circumstances do not constitute forward looking statements protected by the safe harbor." In re MobileMedia Sec. Litig., 28 F. Supp. 2d 901, 930 (D.N.J. 1998). See also, In re Cell Pathways Inc. Sec. Litig., 2000 WL 805221, at *11 (E.D. Pa June 20, 2000); In re ValuJet, Inc. Sec. Litig., 984 F. Supp. 1472, 1479 (N.D. Ga. 1997). Under this logic, if a plaintiff alleges that an issuer has omitted probabilistic data or assumptions called for by the Proposed Rules, then the omitted probabilistic data or assumptions would not qualify for the safe harbor.
Alternatively, if the probabilistic assessments mandated by the Proposed Rules are construed as statements of current fact then a court may also conclude that they are not sheltered by the safe harbor, notwithstanding the analysis articulated in the Proposing Release. Here again, there is a clearly defined path that will allow plaintiffs to pursue dubious allegations of fraud by hindsight against issuers who would not make detailed forward-looking statements but for the requirements of the Proposed Rule. The Proposed rule can therefore only intensify the debate over the characterization of assumptions used in connection with forecasts and greatly expand the domain over which plaintiffs will be able to rely on "fraud by hindsight" to allege that statistical assumptions were misleading.
Third, the Proposed Rules are complex and ambiguous. There will be an inevitable period of learning and experimentation while the Commission and issuers alike wrestle in good faith with compliance concerns that are not clearly addressed in the proposal. The passage of time will also reveal issues that are not now contemplated by the Commission or the commenters. Such a period of adaptation is inevitable whenever the Commission and the market are required to adjust to a dramatic shift in the disclosure regime. Reporting companies should not be subject to potentially crippling litigation risk that arises during a period when the Commission itself will be evolving its own views regarding appropriate compliance and before there is a well-articulated consensus as to forms of disclosure that comply with the Proposed Rules. Simply put, this is an area of law that should be governed by consistent and thoughtful regulation, not by opportunistic and potentially inconsistent litigation.
2. The Commission Should Exercise its Exemptive Authority to Fashion Appropriate Safe Harbors.
The effective solution to these problems is quite different from the approach described in the Proposing Release.
Established Commission precedent recognizes that the adoption of broad new disclosure regimes can generate unwarranted private party litigation risk that justifies the creation of a safe-harbor provision tailored to the new disclosure regime. Most notably, when the Commission adopted Regulation F-D it recognized the need for a new litigation safe harbor specifying that "[n]o failure to make a public disclosure required solely by Regulation F-D Rule 100 shall be deemed to be a violation of Rule 10b-5 under the Securities Exchange Act." 15 CFR 243.102.
A safe harbor analogue to the one embedded in Regulation F-D is obviously inadequate for purposes of the Proposed Rules because the F-D safe harbor shelters persons only from Section 10b-5 liability but leaves them open to claims arising under all other express and implied private rights of action.
The Commission should instead, through the exercise of its authority under Section 28 of the Securities Act, 15 U.S.C. §77z-3, and Section 36 of the Exchange Act, 15 U.S.C. §78mm, adopt a rule that exempts from all private party actions, express or implied, all statements that are mandated solely by the Proposed Rules and that appear in the "separately captioned section" contemplated by the Proposed Rules. This approach will place investors and courts on clear notice as to the identity of the statements that are potentially covered by the new safe harbor. Issuers will remain liable in civil and administrative proceedings brought by the Commission. Senior executives will be required to certify as to the accuracy of these statements. Issuers and senior executives alike will also remain exposed to broadly expanded criminal liability in connection with any fraudulent misrepresentations or omissions related to the newly required disclosures. These serious and expanded forms of civil and criminal liability are, we believe, more than adequate to stimulate careful compliance by the issuer community.
3. Reproposal May Be Appropriate.
Because the initial Proposing Release did not describe a litigation safe harbor comparable to that proposed in this comment letter, and because we strongly urge the Commission not to adopt any rule even remotely similar to those proposed without a suitable corresponding safe harbor, we respectfully suggest that the Commission consider reissuing whatever rules, if any, that it determines to propose in this area together with an appropriate private litigation safe harbor.
Thank you for your consideration of the foregoing.
/s/ Joseph A. Grundfest
Joseph A. Grundfest
William A. Franke Professor of Law and Business
Stanford Law School
Stanford, CA 94305
Drafting Committee Members
Gray Cary Ware & Freidenrich LLP
Wilson Sonsini Goodrich & Rosati Professional Corporation
Venture Law Group LLP
Bingham McCutchen LLP
Fenwick & West LLP
Additional Grundfest Group Members
Submitting This Letter
Brobeck Phleger & Harrison LLP
Heller Ehrman White & McAuliffe LLP
|1||The Proposing Release refers to parallel statutory safe harbor protections contained in the Exchange Act and Securities Act, 15 U.S.C. 77z-2(b) and 78u-5(b), and to safe harbors articulated in Rule 175 under the Securities Act, 17 CFR 230.175, and Rule 3b-6 under the Exchange Act, 17 CFR 240.3b-6. See Proposing Release, notes 130 and 131, and accompanying text.|