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Two federal appeals courts, including the 2nd U.S. Circuit Court of Appeals, have split over the degree to which a federal law on company disclosures shields them from shareholder suits. The law, a “safe harbor” provision of the 1995 Private Securities Litigation Reform Act, gives companies a defense from liability for forward-looking statements made in their communications if they include warnings of risks to investors. Nearly a year ago, the 2nd Circuit held that companies can apply the defense at the pleadings stage of a shareholder suit even if their cautionary statements — or disclaimers — are somewhat formulaic, a powerful weapon for defendants in terminating cases before the onset of expensive and time-consuming discovery. The case, Rombach v. Chang, 355 F.3d 164, was brought by shareholders of a now defunct company claiming executives and underwriters failed to disclose the company’s troubles in public filings and statements. The split occurred when the 7th U.S. Circuit Court of Appeals established a different doctrine. In July, it overturned a lower court’s dismissal citing the safe harbor defense in Asher v. Baxter, 377 F.3d 727. The Baxter case also focused on forward looking statements that shareholders claimed failed to disclose risks that undermined the company’s projections of its future performance. The appellate panel found that at the pleadings stage, a court could not determine whether the defendant’s cautionary statements included the main risks the company faced and declined to apply the defense in the broad manner applied by the 2nd Circuit. “This was considered a huge blow to the defense bar,” said William Lawlor of Dechert’s Philadelphia office. The decision makes it easier for plaintiffs to survive the pleadings stage and enter into discovery. In the class action setting, where discovery does not begin until a judge has ruled on the pleadings, that step serves as a giant boost for plaintiffs. It shifts the case in their favor and raises the settlement value. Congress included the safe harbor provision in the 1995 act to encourage companies to disclose as much information as possible about their prospects. Shareholder litigation before the passage of the act limited the willingness of companies to reveal information about future events that could ultimately fail to materialize out of fear of being sued, Joseph De Simone, a partner at Mayer, Brown, Rowe & Maw, wrote in an article for the conservative Washington Legal Foundation. The act shielded companies from suits by allowing them to make “forward looking statements,” essentially prognostications about their business, as long as they included “meaningful cautionary statements” that identified risks that could dislodge these predictions. “[T]he stated goal,” wrote Sarah Gold of Proskauer Rose in an October column for the New York Law Journal, “was to facilitate early dismissals based solely on the cautionary language without discovery of a defendant’s knowledge at the time the statement was made.” The act raised pleadings standards and postponed discovery in order to curb allegedly abusive class actions and the plaintiffs’ bar. The safe harbor provision fit within this broader goal but its efficacy as a defense has been cast into doubt. NEW YORK DECISION The Rombach case involved Family Golf Centers Inc., once a lead player in the market for golf centers, having 119 under its control in 1998. In that year alone, it absorbed three other giants in the industry. The company made optimistic statements in its public filings, stating that it had successfully integrated the new acquisitions. In one example from 1998, the company announced that “we are pleased with our results” soon followed by a warning that the “results of four [acquired] centers were significantly impacted by their shortage of working capital.” By the winter of 1999, the once rosy picture looked bleak. Family Golf announced lower earnings and its stock plummeted by 43 percent. By the spring of 2000, it had fallen into bankruptcy. Class actions followed, accusing executives and underwriters of making deceptively optimistic statements in its public communications, namely securities filings and press releases. In 2002, Eastern District of New York Judge Sterling Johnson Jr. dismissed the claims, holding that the optimistic remarks included “substantial cautionary language and specific risk factors.” In January, a three-member 2nd Circuit panel affirmed the ruling in Rombach. The opinion by Judge Dennis Jacobs held that “[w]hile some of these cautionary statements were formulaic, we conclude that as a whole they provided a sobering picture of Family Golf’s financial condition and future plans.” The panel cited a handful of specific warnings of risk or potential setbacks from Family Golf’s securities filings that it opined satisfied the safe harbor provision. CHICAGO OUTCOME As Family Golf lay buried in bankruptcy, Baxter International, a Deerfield, Ill., medical products manufacturer ran into its own problems. In 2002, Baxter’s earnings fell short of its previous projections, leading to a 25 percent drop in its stock price. Again, class action suits followed and Baxter, like Family Golf, wielded the safe harbor defense. In Asher the 7th Circuit overturned a lower court ruling and declined to dismiss the case at the pleadings stage. The ruling, by Judge Frank Easterbrook, held that Baxter was obligated to include what the court called “principal risks” in its disclosures. This obligation carried over into oral statements and press releases in addition to securities filings. In one filing, Baxter’s cautionary statements indicated “[m]any factors could affect the company’s actual results.” Alone, the statement would not withstand judicial scrutiny. But it went on to include a laundry list of individual risks from interest rates and currency fluctuations to the development of its dialyzers and other potential technological setbacks. Even though Easterbrook found that many of Baxter’s cautionary statements were not boilerplate provisions and were specific to its business and industry, he found that “Baxter’s chosen language may fall short” because its cautionary statements stayed the same as business risks evolved over time. The judge held that a court needed to determine whether Baxter included the “principal or important risks” in its statements. Merely listing a set of potential pitfalls and risks was not enough, he ruled: Baxter was obligated to include the most important risks it faced during each disclosure. The only way to make that determination, Easterbrook ruled, was to conduct discovery. The Baxter decision has begun to ripple through the securities class action setting. The safe harbor was considered a strong defense, said Lawlor. “People thought the safe harbor would be not bullet proof but a leg up,” he said, and could be pierced only in the most egregious instances. “The 1995 Act delayed discovery until initial pleadings were decided upon by the court,” Lawlor said. This forced plaintiffs to plead with particularity their claims of fraud and deception without the benefit of the information one normally learns through discovery. Once plaintiffs survive the pleadings stage and enter into discovery, the dynamics of the case changes drastically. DISCOVERY EXPENSE “Discovery is enormously expensive, prolonged and a drain on management resources,” said Lawlor. “The stakes go up.” It is too early to tell whether plaintiffs firms have increased their filings in the 7th Circuit to take advantage of the ruling, said Lawlor, but he would not be surprised if they headed in that direction. Baxter International has indicated that it will appeal to the U.S. Supreme Court. The Court often acts to resolve splits among federal circuits. For example, in its upcoming term it will settle the issue of “loss causation” in securities litigation by deciding Broudo v. Dura Pharmaceuticals, 339 F.3d 933.

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