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No statute requires a corporation to disclose actual or potential criminal wrongdoing in its public filings and/or proxy statements, and courts are reluctant to impose criminal penalties for nondisclosure of such conduct. Nevertheless, advising a corporate client whether to disclose uncharged, potentially criminal conduct is a perilous assignment. A number of courts have upheld shareholder suits under Rule 10b-5 of the Securities Exchange Act of 1934 when a company failed to disclose uncharged conduct. Although these cases are fact-bound, somewhat inconsistent and difficult to categorize, it is fair to say that Rule 10b-5 requires disclosure of uncharged conduct when (1) that conduct is material to investors, and (2) there is a duty to disclose. In addition, if a company decides to disclose uncharged misconduct, the disclosure must be drafted with meticulous care to assure that it does not create additional liability. Obviously, the stakes in making the right disclosure call are quite high. Failure to make a required disclosure can expose a client to significant liability. Premature or unnecessary disclosure will unduly increase the risks of civil suits and government investigation. Here are three steps that defense counsel should take in advising whether uncharged conduct should be disclosed. STEP 1. ASSESS MATERIALITY Generally, any uncharged conduct that has the potential to effect the business or economic well-being of a company is considered material. For example, in the leading case on uncharged conduct, Roeder v. Alpha Indus. Inc., 814 F.2d 22 (1st Cir. 1987), bribes paid by Alpha — a government subcontractor — were held material because, if discovered, the company would be barred from obtaining future government business. In another key case, uncharged conduct demonstrating that the defendant’s success in advertising and marketing depended on illegal practices was held material under the federal securities law. In re Craftmatic Securities Litigation, 890 F.2d 628, 640 (3d Cir. 1990). With respect to proxy solicitations, the 9th U.S. Circuit Court of Appeals and the Northern District of Illinois have held that a director’s misconduct is not material and need not be disclosed on a proxy statement unless the director engaged in self-dealing or received a kickback. See Gaines v. Haughton, 645 F.2d 761, 774 (9th Cir. 1981), overruled in part on other grounds, In re McLinn, 739 F.2d 1395, 1397 (9th Cir. 1984); Shields v. Erickson, 710 F. Supp. 686 (N.D. Ill. 1989). STEP 2. ASSESS DUTY TO DISCLOSE Statutory and regulatory obligations: No statute or SEC rule specifically requires the disclosure of an investigation into alleged criminal activities. However, certain disclosure items in Regulation S-K, which governs disclosures in registration statements, annual reports and proxy information, can be broadly construed to require disclosure of illegal practices. The line-item disclosure requirements that require consideration are as follows: � Item 103: general disclosure requirements:Requires disclosure of all “material pending legal proceedings” and “information as to any such proceedings known to be contemplated by governmental authorities.” Unfortunately, neither Item 103 nor its instructions clarifies what constitutes a “proceeding[] known to be contemplated,” and the case law interpreting the phrase “known to be contemplated” is somewhat inconsistent. For example, one district judge has held that receipt of a target letter is insufficient to trigger an obligation to disclose under Item 103. See In re Browning-Ferris Indus. Inc.830 F. Supp. 361, 369 (S.D. Tex. 1993). Another, however, has indicated in dicta that “knowledge that the government was contemplating formal criminal proceedings” might trigger this obligation. See United States v. Crop Growers Corp., 954 F. Supp. 335, 347 (D.D.C. 1997) (defendant not liable because it had no such knowledge). Unfortunately, determining what communications (subpoena or target letter) from which officials (agent or U.S. Attorney) provides the required knowledge of a contemplated proceeding is often a speculative exercise. Thus, disclosure under this item usually turns more on the client’s tolerance for risk than defense counsel’s aptitude for prophecy. � Item 401: proxy statement requirements:Requires each director, executive officer, promoter and control person of a corporation to disclose whether he “was convicted in a criminal proceeding or is a named subject of a pending criminal proceeding.” Because Item 401 is limited to pending proceedings, it does not appear to capture uncharged conduct. � Item 303: MD&A requirements:The management discussion and analysis (MD&A) that accompanies prospectuses, 10-Ks and 10-Qs must describe “any known trends or uncertainties that � the registrant reasonably expects will have a material � unfavorable impact on net sales or revenues” and identify “known � uncertainties � that are reasonably likely to result in the registrant’s liquidity � decreasing in any material way.” Although Item 303 does not specify that investigations must be disclosed, the Securities and Exchange Commission (in a release pertaining to the disclosure obligations of defense contractors’ procurement practices) has stated that the potential effects of government inquiries should be disclosed if they are expected to be material. SeeSEC Rel. No. 33-6791(1988). � General disclosure obligation:After reviewing the applicable statutory disclosure duties, counsel must next consider whether the client is required to disclose uncharged misconduct because nondisclosure would render other earlier-issued statements misleading. Several courts have held that a complaint alleging a civil claim under Rule 10b-5 should survive a Rule 12(b)(6) motion when the plaintiff has alleged that earlier statements were rendered misleading by nondisclosure of uncharged conduct or a government investigation. The leading cases discussing the kinds of statements that can lead to civil liability for failure to disclose uncharged criminal conduct are identified as follows: — Directors were required to disclose the illegal payments of foreign subsidiary about which they had actual knowledge because the payments could have effected the company’s ability to sell its product in the foreign countries. Decker v. Massey-Ferguson, Ltd., 681 F.2d 111 (2d Cir. 1981). — Company was required to disclose contingent liability stemming from company’s earlier securities law violations because it represented a large potential financial loss to the company. Securities and Exch. Comm’n v. Fehn, 97 F.3d 1276 (9th Cir. 1996). — Company should have disclosed uncharged bribe to correct earlier statements that company’s business acumen led to Food and Drug Administration approval of drugs (when in reality the bribe led to approval) and that sales were expected to be strong because of FDA approvals. In re Par Pharmaceuticals, 733 F. Supp. 668 (S.D.N.Y. 1990). — Company should have disclosed uncharged bribe because failure to disclose made financial statements misleading; certain payments that were unlawfully obtained were subject to forfeiture, and thus they should not have been counted as earnings. Greenfield v. Professional Care, Inc., 677 F. Supp. 110 (E.D.N.Y. 1987). — Company should have disclosed uncharged, unlawful conduct that threatened its licenses to sell its products in other countries. Securities and Exch. Comm’n v. Joseph Schlitz Brewing Co., 452 F. Supp. 824 (E.D. Wis. 1978). Thus, the general rule established in the leading cases can be simply stated: Although there is no general affirmative duty to report an uncharged violation to the SEC, a private action under Rule 10b-5 should survive a motion to dismiss where plaintiff’s counsel adequately alleges that (1) the undisclosed misconduct was material and (2) disclosure of the misconduct was required to assure that other earlier disclosures by the corporation were not inaccurate, incomplete, or misleading. On the other hand, a failure to disclose uncharged conduct will not result in criminal liability. (This is because of concerns about Fifth Amendment protection, see United States v. Matthews II, 787 F.2d 38 (2d Cir. 1986), and due process, see Crop Growers, supra.) STEP 3. ASSURE THAT ALL DISCLOSURES REGARDING UNCHARGED CONDUCT ARE ACCURATE AND REALISTIC Typically, disclosures regarding uncharged misconduct report the subject matter of the misconduct, the existence of any government investigation and, where appropriate, the corporation’s cooperation with law enforcement authorities. Additional details regarding the status of the matter should be included only after careful consideration to limit the burdensome and risky duty of continually updating disclosures as the investigation develops. Statements assessing the materiality of the investigation’s impact on the company’s financial condition and denials of wrongdoing require particular care. The SEC will regard a statement by a company denying wrongdoing as fraudulent if the company knew or should have known of the unlawful conduct. For example, the SEC instituted civil proceedings against a corporation that issued a press release in which it “denie[d] any wrongdoing and [was] unaware of any wrongdoing on the part of its officers or employees” when in fact the author of the press release had refused to testify before the SEC on the ground that testifying would violate his right against self incrimination under the 5th Amendment. Report of Investigation in re Cooper Companies, 1994 WL 707149, at *4, *6 (S.E.C. Dec. 12, 1994). Laurence A. Urgenson is a partner at Kirkland & Ellisin Washington, D.C. He has served as acting deputy assistant attorney general, chief of the fraud section, and executive director of the Economic Crime Council in the Criminal Division of the Department of Justice. Traci L. Jones is an associate at Kirkland & Ellis specializing in appellate advocacy.

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