When do companies have to disclose SEC probes? 2nd Circuit clarifies in biotech case

People exit the headquarters of the U.S. Securities and Exchange Commission (SEC) in Washington, D.C.
People exit the headquarters of the U.S. Securities and Exchange Commission (SEC) in Washington, D.C., U.S., May 12, 2021. REUTERS/Andrew Kelly

(Reuters) - Public companies do not have an absolute obligation to tell investors when they are under investigation by the U.S. government, under precedent from New York federal courts.

But they’re also not entirely free to hide those investigations from shareholders. And it’s not always obvious when disclosure duties kick in.

Just ask 22nd Century Group Inc, a biotechnology company developing low-nicotine tobacco plants and genetically engineered hemp and cannabis plants. In 2021, U.S. District Judge John Sinatra of Buffalo, New York, dismissed a shareholder class action against the company, ruling (among other things) that 22nd Century had not been required to disclose an alleged Securities and Exchange Commission probe of its accounting practices. On Tuesday, the 2nd Circuit disputed that conclusion and revived the case.

Circuit Judges John Walker, Guido Calabresi and Raymond Lohier said in an opinion by Walker that 22nd Century was required to reveal the SEC investigation because the company had previously informed shareholders in SEC filings about weaknesses in its financial reporting controls. 22nd Century, the court noted, had even assured investors in a 2018 quarterly filing that it had adopted new procedures to address its weakness in the segregation of accounting duties and that the new plan had solved the problems.

Once 22nd Century told shareholders about the accounting issue, the 2nd Circuit said, it triggered an obligation to tell the whole truth. “By not disclosing that the SEC was investigating the company’s specific accounting weakness, defendants’ statements about that weakness were not accurate and complete,” Walker wrote. “The fact of the SEC investigation would directly bear on the reasonable investor’s assessment of the severity of the reported accounting weaknesses.”

22nd Century also denied the existence of an SEC investigation when an anonymous short-seller who went by the name “Fuzzy Panda” first asserted in 2018 that the company was under regulatory scrutiny. (Fuzzy Panda’s evidence was an SEC letter denying a Freedom of Information Act request for records under an exemption that allows the agency to withhold information if the disclosure “could reasonably be expected to interfere with enforcement proceedings.”)

The 2nd Circuit said the company’s allegedly “false public denial of any knowledge of the SEC investigation” was actionable. The appeals court also said the denial amounted to an admission that 22nd Century’s previous non-disclosure was material because “otherwise, the company would not have tried to hide it.”

22nd Century counsel Jonathan Friedman of Foley & Lardner did not respond to my email request for comment on the ruling. Shareholder lawyer Brian Calandra of Pomerantz said by email that the decision will not only help the plaintiffs in this class action but will also “benefit investors in general by encouraging greater transparency from issuers of securities.”

Based on its brief at the 2nd Circuit, 22nd Century was counting on Manhattan federal district court decisions rejecting shareholder claims that companies fraudulently failed to disclose government investigations.

The brief discussed, for instance, U.S. District Judge John Koeltl’s 2016 decision In re Lions Gate Entertainment Corp Securities Litigation, dismissing a shareholder class action premised on the company’s failure to disclose an SEC investigation of the board’s maneuvers to ward off a takeover by minority investor Carl Icahn.

Even though Lions Gate received a Wells notice of a pending enforcement action from the SEC and ended up paying a $7.5 million penalty to the SEC, the judge said that “a government investigation, without more, does not trigger a generalized duty to disclose.” (Koeltl relied, in turn, on the 2nd Circuit’s 2014 decision in City of Pontiac v. UBS AG, which said that a corporation “has no affirmative duty to speculate or disclose uncharged, unadjudicated wrongdoings or mismanagement.”)

22nd Century said it similarly had no obligation to disclose "'uncharged, unadjudicated wrongdoings' like the alleged SEC investigation," especially because its disclosure of its accounting weaknesses "was complete and entirely accurate."

But that was exactly the opposite of what the 2nd Circuit concluded. The appeals court said 22nd Century’s initial revelation of accounting problems was precisely why the company was required to inform investors of the alleged SEC probe. The omission, according to the 2nd Circuit, made those previous revelations misleading.

Tuesday’s ruling was not all good news for shareholders. In addition to their claim based on the undisclosed SEC investigation, they also alleged that 22nd Century defrauded investors by commissioning promotional articles that touted the company’s prospects without revealing that the company had paid the articles’ authors. In several instances, according to plaintiffs, 22nd Century’s share price rose after these bought-and-paid-for articles appeared.

The 2nd Circuit said shareholders hadn’t shown that 22nd Century executives (or the outside investor relations firm they engaged) controlled the content of the articles. But even if they had, the appeals court said, 22nd Century had no obligation, under the U.S. Supreme Court’s ruling in 2011’s Janus Capital Group v. First Derivative Traders, to disclose that it paid for the articles because it was not their ultimate author.

It’s an interesting thought exercise to contemplate whether 22nd Century would have been better off, at least from the vantage of prospective liability to investors, by revealing nothing at all about its accounting controls problems. If it had stayed mum, would it still be facing a claim based on its subsequent decision not to disclose the related SEC investigation?

It would be a shame for investors if the takeaway from this week’s ruling is that companies should clam up about problems that could lead to regulatory probes.

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.