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On January 22, 2016, the Southern District of New York dismissed a securities fraud action against Lions Gate Entertainment Corporation alleging that the company had a duty to disclose an SEC investigation and the issuance of Wells Notices concerning certain transactions designed to prevent a minority stockholder from gaining control of the company. In re Lions Gate Entertainment Corp. Sec. Litig., 2016 WL 297722 (S.D.N.Y. 2016) (Koeltl, J.). The court held that there is no “generalized duty to disclose” SEC investigations and Wells Notices because, among other reasons, “the securities laws do not impose an obligation on a company to predict the outcome of investigations.” The court further ruled that defendants have no duty to update or correct statements made prior to the class period because there would otherwise be a “never-ending duty of disclosure.”

Background

In the summer of 2010, Lions Gate and several of its executives (collectively, “defendants”) entered into a series of transactions allegedly designed to prevent Carl Icahn, a minority investor, from gaining control of the company. Several months later, the SEC initiated a formal investigation into these transactions. In July 2012, the SEC’s Enforcement Division issued several Wells Notices[1] indicating that it was considering recommending that the SEC file a civil action against defendants.

In February 2014, Lions Gate signed a settlement agreement with the SEC pursuant to which the company agreed to pay a civil penalty of $7.5 million and admit wrongdoing under Sections 13(a) and 14(d) of the Securities Exchange Act. On March 13, 2014, the SEC both commenced and resolved administrative proceedings against Lions Gate. That same day, Lions Gate filed a Form 8-K disclosing the SEC investigation and the terms of its settlement with the SEC. Notably, the SEC did not bring any action against Lions Gate’s executives.

Shareholders subsequently brought suit alleging that “the SEC staff investigation and Wells Notices from the Enforcement Division triggered a duty of disclosure.” Plaintiffs contended that the failure to disclose the investigation and the Wells Notices “rendered misleading statements about the potential adverse effect of pending litigation” in the company’s SEC filings between February 2013 and March 2014. Specifically, plaintiffs challenged Lions Gate’s representation that it did “not believe that the outcome of any currently pending claims or legal proceedings [would] have a material adverse effect on the [c]ompany’s financial statements.” Defendants moved to dismiss plaintiffs’ claims.

Court Finds Defendants Had No Duty to Disclose Either the SEC Investigation or the Wells Notices

The court explained that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.” Here, the court found that “defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities laws do not impose an obligation on a company to predict the outcome of investigations.” The court further explained that “[t]here is no duty to disclose litigation that is not substantially certain to occur.”

The court emphasized that the issuance of a Wells Notice “does not necessarily indicate that charges will be filed.” The court observed that “the Enforcement Division may not proceed with a recommendation to commence an action and the SEC may not authorize the filing of an action even if the Enforcement Division recommends it.” In the instant action, the court noted that “the SEC never proceeded with a charge that Lions Gate [had] violated Section 10(b) and Rule 10b-5 and never proceeded with any litigation against individual defendants, despite the issuance of Wells Notices discussing their potential liability.” 

The court found that the cases cited by plaintiffs purporting to support the existence of a duty to disclose Wells Notices and SEC investigations were “inapposite because (1) the defendants in those cases were subject to a preexisting duty of disclosure under the securities laws or [had] made express prior disclosures related to the investigation which were rendered materially misleading by omitting information about the investigation, and (2) the investigation itself was material.” The court explained that those “cases stand for the proposition that when a company speaks on a subject, it cannot omit material facts about that subject, and cannot make a material misrepresentation about the existence of an investigation.”

Here, plaintiffs did not allege that defendants had made any statements during the class period about the transactions in question or the SEC investigation of those transactions. As to Lions Gate’s representation in its SEC filings that it did not believe that pending claims or legal proceedings would have a material adverse effect on the company’s financial statements, the court found that plaintiffs did not allege that “defendants’ opinions were not supported by the facts known to them at the time” as required under the Supreme Court’s decision in Omnicare v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S. Ct. 1318 (2015).[2]

The court further determined that plaintiffs had “failed to allege that the investigation itself was material” given that the final SEC penalty “was less than one percent of Lions Gate’s consolidated revenue . . . for the third quarter of 2014.” The court noted that this was “much lower than the five percent numerical threshold that the . . . Second Circuit has determined is a ‘good starting place for assessing the materiality of [an] alleged misstatement’” (quoting ECA, Local 134 IBEW Joint Pension Tr. Of Chicago v. JP Morgan Chase, 553 F.3d 187 (2d Cir. 2009)).

The court rejected plaintiffs’ contention that defendants had a duty to disclose the SEC investigation because there was a “reasonable likelihood that the [SEC] penalty could have materially affected” Lions Gate’s financials.” The court found that “[t]he securities laws do not require a company to hypothesize the worst results of an investigation when those results do not materialize and when the company chooses not to speak about the investigation.”

Court Holds Defendants Have No Duty to Correct Statements Made Prior to the Class Period

The court found meritless plaintiffs’ claim that defendants had a “duty to correct” statements they had made before the start of the class period concerning the transactions at issue. The court explained that under Second Circuit precedent, there is no “duty to correct previous misstatements” if “defendants made the original statements before the [c]lass [p]eriod and became aware of the errors in those statements before the [c]lass [p]eriod” (citing Lattanzio v. Deloitte & Touche, 476 F.3d 147 (2d Cir. 2007)). The court reasoned that “[a]ny other rule would undercut the meaning of the [c]lass [p]eriod and eviscerate the statute of limitations” because “[i]t could always be argued that allegedly false statements made long before the [c]lass [p]eriod and outside the statute of limitations should be corrected by a statement within the [c]lass [p]eriod.” The court found that “impos[ing] a never-ending duty of disclosure would circumvent the general rule that pre[-][c]lass [p]eriod statements are not actionable.”

Court Finds Defendants Have No Duty to Disclose Government Investigations and Wells Notices Under Regulation S-K

The court also rejected plaintiffs’ argument that defendants were required to disclose the SEC investigation and Wells Notices under Regulation S-K. First, the court explained that “a failure to make a required disclosure under Item 303 [of Regulation S-K] in a Form 10-Q filing is an omission that can serve as the basis for a Section 10(b) securities fraud claim” only “if it satisfies the materiality requirement under Basic.” Here, the court determined that the investigation at issue was not material under either the Basic test or Item 303’s “distinct materiality test,” which provides that “[n]o information need be given with respect to any proceeding that involves primarily a claim for damages if the amount involved, exclusive of interest and costs, does not exceed 10 percent of the current assets of the registrant and its subsidiaries on a consolidated basis” (quoting Item 303 of Regulation S-K).

Second, the court found that “an investigation alone is not a ‘pending legal proceeding’ or a ‘proceeding [ ] known to be contemplated by governmental authorities’” within the meaning of Item 303 of Regulation S-K. The court reasoned that when the SEC conducted its investigation in the instant action, “the SEC had not yet decided whether it would charge Lions Gate and the individual defendants with securities violations.” Similarly, the court found that “the issuances of the Wells Notices did not mark the beginning of a ‘pending legal proceeding’” because “[a] Wells Notice only informs an individual or company that the SEC Enforcement Division staff is considering recommending that the SEC file an action.”

Finally, the court found that “[a]n SEC investigation [cannot] be characterized as a ‘known trend’ or ‘uncertainty’ under Item 303,” or as a “risk factor” under Item 503(c) of Regulation S-K. The court explained that the complaint did “not plausibly allege” that the civil penalty assessed “put Lions Gate’s profits at risk or made the stock ‘risky’ as a result of Lions Gate’s ongoing operations.”

Court Finds GAAP Does Not Mandate Disclosure of SEC Investigations

The court further determined that defendants were not required to disclose the SEC investigation and the Wells Notices under Accounting Standards Certification Topic 450 (“ASC 450”), which addresses the disclosure of certain loss contingencies. First, the court found that the investigation was not a loss contingency for ASC 450 purposes because it “was not pending or threatened litigation.” Second, the court determined that there was “no plausible allegation that the amount of the loss could have been estimated” until after Lions Gate had reached a potential settlement with the SEC.

Court Holds Plaintiffs Failed to Allege Scienter

Finding “no clear case law that would require the disclosure of the SEC investigation and the Wells Notices in the absence of a pre-existing duty to disclose,” the court held that plaintiffs could not “show that the defendants [had] acted in reckless disregard of the securities laws.” The court further found that “an inference against scienter” was supported by numerous factors, “including . . . the small civil penalty the SEC imposed relative to the [c]ompany’s net assets, the uncertainty of whether the Commission would move forward with the proceedings against Lions Gate, and the fact [that] the Commission never brought charges against individual officers or directors.” The court concluded that “[t]he more cogent inference [was] that Lions Gate did not specifically disclose the investigation until the settlement had been concluded because it did not believe that there was a requirement to do so.”