§ 5_14                   

What Constitutes Actual Knowledge?

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The proponents of the safe harbor that emerged tended to divide company executives between the venal and the well intentioned, assuming that CEOs of successful high-tech companies cannot sin and at the very least are to be forgiven for overoptimistic statements. Senator Bennett thought it inconceivable that a CEO would make a misleading statement as it would affect his/her credibility and, indeed, without regard to any issue of liability, this is an important reason why company officers should not make misleading statements. One, however, is capable of making misleading statements relating to future events without being venal in the sense of deliberately intending to defraud investors. A chief executive officer who has made a success of a company may be so confident of the company’s future that s/he knowingly omits existing facts that undermine the statement because in the long run s/he thinks it will not make any difference and the unfavorable circumstance will go away or be overcome.[1] Unfortunately, markets are volatile and, although volatility is not a substitute for fraud, investors relying on misleading forward-looking statements may be hurt as much or more by those made by a blinded CEO as by one engaged in a deliberate scheme to defraud when the undisclosed factors are not overcome and the adverse factor(s) become apparent to the investing public. Similarly, in connection with a public offering, the officers of a company may not be beyond omitting undermining facts because they are confident in their own mind that with the additional financing they will solve the company’s problems.[2]

This poses some interesting issues as to the significance to be attached to the concession made to Senator Sarbanes by adopting the actual knowledge criterion rather than “knowingly made with the purpose and actual intent of misleading investors,”[3] assuming plaintiff gets past the first prong of the safe harbor. It was also this provision of S. 240 that caused SEC Chairman Levitt to remark that “I cannot embrace proposals which allow willful fraud to receive the benefit of safe harbor protection. The scienter standard in the amendment may be so high as to preclude all but the most obvious frauds.”[4] The Commission had suggested to the Senate[5] before S. 240 was passed a change in the scienter language close to that adopted by the Conference Committee. Presumably, the adoption of the Sarbanes criterion played a role in Chairman Levitt’s endorsement of the Conference Committee safe-harbor.[6] Supplanting the “actual intent” with “actual knowledge” language strongly suggests that knowledge of the undermining facts that made the statement misleading is sufficient to meet the scienter standard and that it is not necessary to prove the maker’s intent or purpose. Similarly, it affords a basis for contending that actual knowledge of the facts that deprive the forward-looking statement from having a reasonable basis meets the standard, although this may be more debatable.

Assuming that the first prong requires only adequate disclosure of important factors, whatever that may mean, provided the cautionary statements do not misstate existing facts (see § 5_8 to 5_11), it is clear that there is no liability absent proof of actual knowledge that the statement is false or misleading. There is no liability if the maker fails to exercise due care or even if the maker is reckless in making the statement. This is a significant departure from existing law; particularly, in the context of Sections 11 and 12(2) of the Securities Acts which otherwise require persons within the scope of these provisions to carry the burden of proof that they exercised due care. See § 1.02[7]. The extended wrangling over the precise language of what became the third (or second, in the view of the Managers) prong of the safe harbor never involved any consideration of imposing liability for recklessness or failure to exercise care.[7] To make this absolutely clear, Senators Frist and Domenici engaged in the following colloquy:[8]

Mr. FRIST.

Mr. President, I would like to briefly discuss with Senator Domenici one important issue concerning the section 102 “Safe harbor for forward-looking statements.” It is the clear intention of the conference committee that reckless conduct cannot constitute actual knowledge for purposes of the safe harbor, isn’t it?

Mr. DOMENICI.

Yes. It is the clear intention of the conference committee that reckless conduct will not constitute either actual knowledge or be construed to constitute a knowing commission of a violation of the securities laws for purposes of section 102 safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

There is no longer any obligation under Section 11 of the Securities Act as to a forward-looking statement, assuming none of the exclusions is applicable, for the issuer, principal officers of the issuer, or the underwriter to exercise due diligence. In this respect, as to forward-looking statements, the safe harbor takes much of the terror out of the “in terrorem” Section 11 remedy. Cf. § 14.08.

This attaches increased significance as to the extent to which the lack of a reasonable basis makes a forward-looking statement misleading.[9] Lack of a reasonable basis is another way of saying that the assumptions underlying the statement are not reasonable. If the assumptions are disclosed, the assumptions are within the safe harbor’s definition of a forward-looking statement and, hence, are protected if there is an adequate disclosure of the important factors that may result in the assumption proving incorrect.[10] If no disclosure is made as to the assumptions and cautionary statements are absent or inadequate, and the maker of the statement has actual knowledge of the facts that undermine the assumptions, it may be a thin line between determining whether this is “reckless” or whether it constitutes actual knowledge that the forward-looking statement is misleading.

Consider the Merrill Lynch analyst who, according to the findings of the Administrative Law Judge, assisted a company in preparing a press release on December 1, 1990, stating:[11] “Analysts’ 1991 estimates show $80-$110 million for revenue, $17-$20 million or $0.85-1.00 per share for income, and $20-$22 million or $1.00-1.10 per share for cash flow.” The Administrative Law Judge concluded as follows:[12] “The 1991 revenue, income, and cash flow estimates attributed to analysts were unfounded and were therefore false and misleading. The projections showed Barton virtually tripling its revenues in the coming year and enjoying substantially increased earnings. There was no reasonable basis for these 1991 projections, given Barton’s grim financial situation. Barton lacked the financial strength to finance the growth that the 1991 projections represented.” The respondent analyst conceded that the projections were subject to a number of undisclosed conditions, including (1) obtaining bridge financing, (2) entering into a substantial contract in preliminary stages of negotiation for a new product the company was developing, (3) the likelihood of which depended on general conditions in the industry, including oil prices. The evidence also established that she knew that the company did not have adequate resources to finance the projected growth and that the accountants intended to issue a qualified (“going concern”) opinion relating to the 1990 financial statements. The administrative law judge, although citing and quoting a recklessness standard of extreme departure from the standard of ordinary care since this is all that was necessary, also concluded “Cook had or could have had sufficient knowledge to realize that the projections had no reasonable basis. The record shows that she had no genuine belief that the projections were reasonable.”[13] The Commission in a one sentence opinion and with no explanation beyond the findings are not supported by the record reversed the Administrative Law Judge.[14] The Commission’s failure to explain its disagreement with the ALJ is inexplicable. Although the Commission undoubtedly had what it regarded appropriate reasons to reverse the findings, the ALJ deserved some explanation. The Commission’s desire to encourage forward-looking statements is well known, but it has some obligation to provide guidance to the staff and the ALJs in sorting out what is permissible and what is not. See § 5_30.