The Second Circuit Second Guesses Failure To Disclose Pending SEC Investigation

• Published date: 07 June 2022
• Subject Matter: Corporate/Commercial Law, Corporate and Company Law, Securities
• Law Firm: Morrison & Foerster LLP
• Author: Mr Michael D. Birnbaum and Mark R.S. Foster

Determining whether and when to disclose an SEC investigation is a challenging judgment call for many public companies. This decision often turns on many factors, including the nature, scope, stage, and subject matter of the investigation. A recent Second Circuit decision highlights the risk that courts will find fault with decisions not to disclose a pending SEC investigation.

InNoto v. 22^ndCentury Group, Inc., the Second Circuit ruled that defendants' failure to disclose an active SEC investigation was actionable as a material omission. The court reasoned: "Defendants had a duty to disclose the SEC investigation in light of the specific statements they made about the Company's accounting weaknesses." The court explained: "[B]y not mentioning the investigation, [defendants'] disclosures of [their] accounting deficiencies were misleading." The court's ruling makes it more likely that courts-particularly in the Second Circuit-will second-guess companies that do not disclose an SEC investigation in connection with statements that touch on those matters the SEC is investigating.

TheNotodecision also provides helpful guidance relating to the contours of liability for statements made by others promoting a stock. The court affirmed dismissal of claims where the plaintiffs failed to allege that the defendants had ultimate authority over content published by those who were paid to promote the stock and had no independent duty to disclose such payments themselves.

Key Takeaways

• Issuers should takeNotointo account when evaluating whether they have a duty to disclose a pending SEC investigation and pay particular attention to how their public statements relating to the subject matters being investigated might trigger a duty to disclose such investigations.
• Companies paying for media coverage of interest to investors should continue to be careful to avoid unintentionally taking steps that would convert the company into a "maker" of media statements-and where companies do exercise ultimate control over suchcontent-theyshould maintain proper procedures to ensure such statements are truthful.Notounderscored that "only an article's maker, not its benefactor, has a duty to disclose that it was paid for."

Background

The Second Circuit inNotopartially reversed dismissal of securities fraud claims by a class of investors against 22^ndCentury Group and its former CEO and CFO. The plaintiffs alleged defendants defrauded investors by failing to disclose an investigation by the...