In-House Insight

Beware of Securities Law Disclosure Regulations During the Pandemic

By Ariadna Caulfield

Ariadna Caulfield is an attorney at Cetrulo LLP. She focuses her practice on banking and financial law, as well as commercial real estate transactions, and complex civil and business matters. ©2021 Ariadna Caulfield. All rights reserved. Back in the first quarter of 2020, the U.S. Securities and Exchange Commission (SEC) made its first pronouncements about pursuing enforcement actions for securities law violations arising out of the COVID-19 pandemic. Addressing the impact of the coronavirus in the securities market, SEC Chairman Jay Clayton instructed his staff to monitor disclosures related to the pandemic as early as Jan. 29, 2020.1 Clayton also reminded companies in early March 2020 that the way in which they plan for uncertainties and their responses to the pandemic “can be material to an investment decision.”2

Following the warnings made by the SEC in connection with the above-referenced pronouncements, a series of enforcement actions by the SEC ensued.

On April 28, 2020, the SEC announced charges against Praxsyn Corporation, a Florida-based company, and its CEO for allegedly issuing false and misleading press releases claiming the company was able to acquire and supply large quantities of N95 or similar masks to protect wearers from the COVID-19 virus. In reality, the SEC alleged, the company never had any masks in its possession, had received no mask orders, and did not have a single contract with any manufacturer or supplier to obtain masks. The SEC’s complaint, filed in U.S. District Court for the Southern District of Florida, charged Praxsyn and its CEO with violating the antifraud provisions of Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b5 thereunder, and sought permanent injunctive relief and civil penalties.3

On May 14, 2020, the SEC filed enforcement actions against two more companies for allegedly making fraudulent statements related to COVID-19. In the first action, the SEC charged Applied BioScience, a biotech company in the Southern District of New York, with fraud based on the company’s claims in a press release that it was offering and shipping products to combat the COVID-19 virus.4 According to the SEC’s complaint, the company issued a press release on March 31, 2020, stating that it had begun offering and shipping finger-prick COVID-19 tests to the general public that could be used for “Homes, Schools, Hospitals, Law Enforcement, Military, Public Servants or anyone wanting immediate and private results.” The complaint alleged that, contrary to Applied BioScience’s claims, the tests were not intended for home use by the general public and could be administered only in consultation with a medical professional. The complaint further alleged that Applied BioSciences had not shipped any COVID-19 tests as of March 31, 2020, and its press release failed to disclose that the tests were not authorized by the U.S. Food and Drug Administration. On Dec. 4, 2020, the U.S. District Court for the Southern District of New York entered a final judgment against Applied BioSciences Corp. Without admitting or denying the allegations in the complaint, Applied Biosciences consented to the entry of a final judgment enjoining it from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and ordering it to pay a $25,000 civil penalty.5

In the second May 14 enforcement action, the SEC filed a complaint in U.S. District Court for the Middle District of Florida against Turbo Global and its CEO, Robert W. Singerman, alleging that the company issued false and misleading press releases on March 30 and April 3, 2020, regarding a purported “multi-national public-private-partnership” to sell thermal scanning equipment to detect whether individuals had fevers. According to the complaint, the company claimed that this technology could be instrumental in “breaking the chain of virus transmission through early identification of elevated fever, one of the key early signs of COVID-19.” As alleged, the press releases also included statements—attributed to the CEO of Turbo Global’s supposed corporate partner in the partnership—that the technology “is 99.99% accurate” and was “designed to be deployed immediately in each State.” In fact, the complaint alleged, Turbo Global had no agreement to sell the product, there was no partnership involving any government entities, and the CEO of Turbo Global’s supposed corporate partner did not make or authorize the statements attributed to him. According to the complaint, Mr. Singerman drafted the releases, which he knew to be false.6

In addition to these actions, on Dec. 4, 2020, the SEC announced it had settled charges against The Cheesecake Factory Incorporated (“Cheesecake Factory”) for making misleading disclosures about the impact of COVID-19 on its business operations and financial condition. As set forth in the SEC’s order, in its SEC filings on March 23 and April 3, 2020, the Cheesecake Factory stated that its restaurants were “operating sustainably” during the pandemic. According to the order, the filings were materially false and misleading because the company’s internal documents at the time showed that the Cheesecake Factory was losing approximately $6 million in cash per week and that it projected that it had only 16 weeks of cash remaining. The order also stated that, although the March 23 filing described actions the company had undertaken to preserve financial flexibility during the pandemic, it failed to disclose that the Cheesecake Factory had already informed its landlords that it would not pay rent in April 2020 due to the damage that COVID-19 inflicted on its business. The Cheesecake Factory agreed to pay a $125,000 civil penalty to settle SEC allegations that the company’s Form 8-K contained material misstatements concerning COVID-19’s impact on its business.

These enforcement actions have highlighted the continuous efforts on the part of the SEC to prevent misleading disclosures. At the same time, they illustrate the pitfalls that companies and their principals should avoid when dealing with securities law disclosures. While the COVID-19 pandemic has highlighted post-disclosure ill-fated results, the reality is that disclosure is generally seen as desirable and beneficial to the public and highly incentivized by the SEC.

Main Objectives of Disclosure

In the field of securities, disclosure is understood as the “release by companies of all information, positive or negative, that might bear on an investment decision, as required by the Securities and Exchange Commission and the stock exchanges.”7 Disclosure is considered to be the primary method used by regulators to provide the market with protections desired for investing in an informed manner.8

The system of rules governing disclosure in the securities market is said to be “integrated.”9 In 1982, the SEC created a unified approach to disclosure under the two main acts that regulate securities transactions, the Securities Act of 1933 (the 1933 Act) and the Securities Exchange Act of 1934 (the Exchange Act).10 The 1933 Act controls the registration of securities with the SEC and national stock markets, and the Exchange Act governs the trading of those securities. These laws require public companies and certain individuals to publicly disclose facts that would be material to an investor’s decision to buy or sell securities, and to impose civil and criminal liabilities on those who fail to comply or make false and misleading statements. 11 Further, they prohibit fraudulent and deceptive practices and untrue statements or omissions of material facts in connection with the purchase or sale of any security,12 and impose liability in the context of securities offerings, among other restrictions.

Disclosure regulations are triggered at the beginning of an intended IPO and continue to cover changes or decisions made by the company even after the securities are issued. The goal behind fostering and requiring disclosure is to provide an efficient public securities market.13 According to Professor Alan R. Palmiter, when people say that a public security market is efficient, they mean that “the markets are ‘informationally efficient’ and that prices at any time ‘fully reflect’ all information available to the public.”14

While the intrinsic importance of disclosure does not seem to be in dispute, and the general consensus is that disclosure benefits the marketplace, what, when, how, and to whom information is disclosed still divides opinions among market participants.

Voluntary vs. Compulsory Disclosure

Some experts believe that subjecting issuers to compulsory disclosure imposes a greater economic cost to the company, and they express concerns about the effectiveness of SEC disclosure enforcements in terms of their actual results15. Such observers postulate that the appeal of disclosure requirements is “illusory” and that the costs and benefits of imposing disclosure requirements are complex, highly dependent on the context in which they are imposed, and generally difficult to measure.16 In professor Michael D. Guttentag’s opinion, the ramifications of requiring disclosure usually range well beyond what is intended.17

Other commentators understand, instead, that without a coercive element, the information provided by public companies would be deficient.18 Securities lawyer Morton A. Pierce points out that “the disclosure philosophy was a direct result of abusive investment banking practices which had developed prior to 1933.”19 Pro-compulsory disclosure authors believe that there are many circumstances in which management and investors have different interests in disclosure20 and that without mandatory disclosure, companies will carefully select what to say and what to keep secret, regardless of whether the information is material or not for investors. 21

Reporting

The “integrated” system not only requires disclosure but also regulates how to do it. In 1998, the SEC led the “Plain English” initiative, seeking to foster clarity of content in the offering of securities and when reporting information. The primary means of achieving this objective was to require clear explanations in prospectuses, proxy materials, and tender offer documents, including more white space, shorter sentences, more tables and charts, and less jargon.22 Further, the integrated system relies on a set of “forms” specially intended to cover certain items to be disclosed by the companies.23 These forms are “set out in Regulation S-K for nonfinancial disclosure and Regulation S-X for accounting information …”24 and examples include Forms 8-K, 10-Q, and 10-K.

Issuers must use Form 8-K in connection with periodic reporting of “reportable events.” Reportable events include the acquisition/ disposition of significant assets; a change in auditors; any departure or resignation of directors or officers, material plans, or contracts with officers and directors; and many other events important to investors.25 Form 10-Q is used for quarterly reporting that includes condensed financial statements.26 Also, issuers must, within 90 days of the end of each fiscal year, file with the SEC annual reports using Form 10-K, which shall include audited financial statements, description of the company’s business, and market information, among other items. Furthermore, certain executive officers of the issuer must make certifications on each annual and quarterly report filed by the company.

Materiality

The “materiality” standard for public companies is meant to elevate internal decision-making on public disclosures to a market-wide standard. Materiality is assessed by reference to the views of a hypothetical “reasonable investor,” A material fact is one that has a

substantial likelihood of assuming actual significance to a reasonable investor in reaching an investment decision.27 “For decades, the reasonable investor standard has been a flashpoint for debate—with critics complaining of the uncertainty it generates and defenders warning of the under-inclusiveness of bright-line alternatives.”28 In essence, the determination of whether a piece of information is material to an investment decision is not a clear-cut enterprise.

Conclusion

Certainly, the scale of the COVID-19 pandemic has stressed the relevance of public companies’ disclosures. This crisis, like others in the past, has created an environment that incentivizes misleading statements to the investing public. The SEC has demonstrated, in its statements and enforcement actions since early 2020, that it will not allow companies to skirt their disclosure obligations during the pandemic. Public companies ought to be transparent and distill, to the best of their abilities, the information they release in order to comply with applicable disclosure regulations and avoid being the target of enforcement actions and charges for securities law violations. Companies and their principals should consider such disclosures as another part of their pandemic routine, like wearing a mask and washing their hands.

Endnotes

1See U.S. Sec. & Exch. Comm’n, Proposed Amendments to Modernize and Enhance Financial Disclosures (Jan. 30, 2020), (https://www.sec.gov/news/public-statement/claytonmda-2020-01-30). 2Id. 3See U.S. Sec. & Exch. Comm’n, SEC Charges Company and CEO for Covid-19 Scam (Apr. 28, 2020), (https://www.sec.gov/litigation/ litreleases/2020/lr24807.htm); see also Sec. & Exch. Comm’n v. Praxsyn Corp. & Frank J. Brady, No. 20-cv-80706 (S.D. Fla. Apr. 28, 2020). 4Complaint at 1-2, Sec. Exch. Comm’n v. Applied BioSciences Corp., No. 1:20-cv-03729 (S.D.N.Y. May 14, 2020). 5See U.S. Sec. & Exch. Comm’n, SEC Obtains Final Judgment Against Company for Misleading Covid-19-Related Claims (May 14, 2020),(https://www.sec.gov/litigation/litreleases/2020/lr24977. htm). 6See U.S. Sec. & Exch. Comm’n, SEC Charges Companies and CEO for Misleading COVID-19 Claims (May 14, 2020), (https://www.sec. gov/news/press-release/2020-111). 7John Downes & Jordon Elliot Goodman, Dictionary of Fiance and Investment Terms 190 (Barron’s Educational Series, 8th ed. 2010). 8See Michael D. Gettentag, An Argument for Imposing Disclosure Requirements on Public Companies, 32 Fla. St. U. L. Rev. 121, 124 (2004) (citing Basic Inc. v. Levinson, 485 U.S. 224, 230 (1988) (“This Court ‘repeatedly has described the ‘fundamental purpose’ of the [Exchange] Act [of 1934] as implementing a ‘philosophy of full disclosure.’” (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477-78 (1977) (quoting SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963)). 9Alan R. Palmiter, Securities Regulation; Examples & Explanations 21 (Aspen Publishers, 5th ed. 2011). 1015 U.S.C. § 77; 15 U.S.C. § 78. 11Section 18 of the Exchange Act imposes liability for false and misleading statements in documents filed with the SEC to any person who makes such false or misleading statements, subject to applicable defenses. 15 U.S.C. § 78r(a). 1215 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. 13See Palmiter, supra note 9, at 13-14. 14Id., at 15. 15Guttentag, supra note 8, at 124. 16Id. 17Id. 18See Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 24-25 (3d ed. 2012). 19Morton A. Pierce, Current and Recurrent Securities Section 5 GunJumping Problems, 26 Case W. Res. L. Rev. 370, 378 (1976). 20See Palmiter, supra note 9, at 30. 21See Choi & Pritchard, supra note 18, at 22-26. 22Palmiter, supra note 9, at 27. 23Palmiter, Id., at 21. 24Id. 25U.S. Sec. & Exch. Comm’n, Existing Regulatory Protections Unchanged by Either H.R. 3606 or S. 1933 (Oct. 20, 2011), https:// www.sec.gov/info/smallbus/acsec/ongoinginvestorprotections.pdf. 26Id. 27See Basic Inc. v. Levinson, 485 U.S. 224, 229 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). 28Amanda M. Rose, The 'Reasonable Investor' of Federal Securities Law: Insights from Tort Law's 'Reasonable Person' & Suggested Reforms, 43 J. Corp. L. 77, 77 (2016).