A clear look at the issues in B & L

Elizabeth Nowicki wonders whether B & L violated a duty of disclosure by not earlier disclosing problems with its lens cleaner, and about any director duties that are implicated by this scenario. This raises some interesting questions about the interrelationships between securities law, fiduciary duties and products liability. 

Quick point to start out with: the commenters to Elizabeth's post correctly observe that any duty to disclose is not covered by Basic v. Levinson, contrary to Elizabeth's suggestion, and is distinct from materiality. This is a point I’ve been trying to hammer home in my securities law classes for 20 years. There’s nothing in the post about insider trading, or about making misleadingly incomplete statements that would have triggered a duty to disclose.

The basic problem here is one that is, in my view, caused by the securities laws. In an unregulated world, B & L as an entity actually has a self-interest in disclosing negative information. After all, the information is going to come out eventually. Maintaining a reputation for accurate and timely disclosure minimizes the cost of capital. Of course, B & L’s agents may not have such an incentive – for example, they may want to unload their stock or options first. So this is a potential agency problem. But this agency problem is mitigated to a significant extent by liability for trading on material information (and by the fact that trading would trigger a duty to disclose, as discussed below).

Now let’s add extensive firm and agent liability for misrepresentations. As long as B & L is not liable for non-disclosure alone, the firm has a significant incentive not to make a disclosure that could trigger liability for incompleteness. Same for the agents, if they can be held personally, and perhaps even criminally (see Enron), liable for making the misstatements.

Does the problem go away if they're completely honest? How can you be sure the disclosure won’t be second-guessed in court? That’s particularly true in this scenario, given the complexity and uncertainty inherent in whether the product was defective and whether the defect caused the injury.

Should the agents and the firm protect themselves by disclosing any possible defect or causation scenario? Consider whether this is really what the shareholders would want them to do, given the effect of such disclosures on the firm’s eventual product liability exposure. Indeed, note that the agents may have a conflict of interest here. They may want to protect themselves from securities law liability by disclosing completely, even if this exposes the company to product liability.

Now add SOX. Even if the disclosure is perfectly complete at this point, the problem with the lens cleaner might indicate an internal control problem that was not disclosed earlier. If so, the agents might be civilly and even criminally liability for signing off on the internal controls whether or not they were or should have been aware of the specific problem, and whether or not that problem was material at that point. The damages would be determined by the stock price reaction at the time of disclosure. So the agents now have an incentive to wait or to time the disclosure to mitigate their exposure.

With respect to any director liability, I suspect it’s unlikely that the directors would simply keep quiet about any knowledge they had here, the scenario Elizabeth proposes. The more interesting question is whether they’d be liable for not pushing more aggressively for action or disclosure assuming they and management knew about the possible problems. Wouldn’t this scenario cry out for business judgment rule protection, particularly given 102(b)(7)?

As for Elizabeth’s complaint that the directors didn’t respond to her question about the private label solution – wouldn’t that question more appropriately have been addressed to lower level employees in the firm? 

Finally, this scenario raises questions about the rationality of liability for corporate mistakes that I’ve been thinking about for years. First, given the rationale for the bjr under state law that protects the directors against second-guessing of their management decisions (see above), why no equivalent rule protecting the company regarding their disclosures. The above scenario suggests that the disclosure decisions, particularly in the current regulatory environment, are just as multi-layered and complex as the management decisions.

Second, should liability for defective disclosures be more, less or as extensive than that for defective products? This is something I’ve been thinking about since the dual litigation over the Dalkon shield. In other words, should the company be liable for not disclosing a product risk that would not trigger tort liability, or vice versa? Note from the above discussion the problems the company faces in dealing with both liability tracks simultaneously.

Third, does our current securities law regime promote or discourage disclosure?

Anyway, thanks to Elizabeth for raising these questions.

Comments

[Elizabeth Nowicki]

Two responses:
1. "As for Elizabeth’s complaint that the directors didn’t respond to her question about the private label solution – wouldn’t that question more appropriately have been addressed to lower level employees in the firm?"
Yep. But are you envisioning a world, Larry, where (a) someone at a low level knew the answer to the question and (b) someone at a low level actually cared enough to call me back with the answer? I actually tried to get but could not get an answer at a lower level. That is why I tried to contact the directors.
My sage conclusion was that I was *sure* to get an answer from the directors (or someone to whom they handed my queries). I mean, look at the evolution of director liability - look at Disney - look at Sarbanes-Oxley - look at Caremark - it's almost like we're back in the times of Smith v. Van Gorkom! The Target/RiteAid directors were going to have someone get back to me - I just knew it!
That was the plan, anyway. My phone has yet to ring.

2. Let's try this Basic v. Levinson discussion again, shall we?
My position is that Basic is relevant to the B&L situation b/c we are dealing with the TIMING of disclosure about a contingency, and TIMING in these sorts of situations (in my view) most on the morphing of non-material information into material information.
Allow me to expand on that: As you know, when we talk about timing of disclosure of information like this, we have two questions:
(a) When did the issue become material (because, up until that point, we are generally off the disclosure hook)?
and
(b) When did we actually lose the option to keep the material information confidential?

When dealing with a registered, reporting issuer - particulalry one who is big and in the public eye (no pun intended) - question 1 often (almost always, in my experience) makes moot question 2. Phrased differently, the only time an issuer that is registered and reporting can *refrain* from disclosing material information is if he/she is not really speaking. With B&L (and most large reporters, I imagine), that window of silence is TINY - either B&L is filing timely disclosure documents (10-K, 8-K, 10-Q, etc., etc.) or B&L is filing notices discussing why they are *not* on time with their disclosure. I can think of precious few disclosures filings that B&L could make with the SEC that would not somehow likely create for B&L the obligation to 'fess up to the MoistureLoc problem or instead risk a "materially misleading omission" (apologies to Bill for the shorthand). So, for a big, reporting issuer who is likely "speaking" regularly to the public, I see the oppportunity to selectively keep a material item confidential as much narrower than the range of situations "triggering" its disclosure.

[Larry Ribstein]

Elizabeth

So I guess we both agree that Basic did not deal with the duty to disclose, which was my main point on this issue. Now I see that you're arguing that affirmative reporting obligations are so extensive that there is essentially no separate duty to disclose issue -- it's all part of materiality. If you can prove your thesis, you'd have a major article. Among many other things, insider trading is no longer a problem. The "abstain" part of "abstain or disclose" is gone. I'm pretty skeptical, but I always have an open mind.

[Jeff Lipshaw]

As the person primarily responsible for the decision whether we had a legal obligation to disclose (assuming no duty arising out of a partial or misleading disclosure), I was of the view (supported by lawyers at Skadden and Kirkland), there was no duty to disclose, notwithstanding Basic. Often, however, the issue was mooted by non-legal considerations (better to disclose so as to not surprise the analysts) or by a "might as well" decision if there was no real downside to the disclosure.

I was concerned the "real time disclosure" provision of Sarbanes-Oxley changed the fundamental duty but the provision was not self-actuating, and the regs the SEC promulgated pursuant to that section were very narrow.

There was an area of law and lore that DID change. Many company officers and directors had the idea that the adoption of a board resolution to undertake a restructuring (asset writeoffs and employee reductions) was a material disclosable event. I think that came from the time when you had to take the entire accounting charge in the period the restructuring was approved, which made sense (i.e., it was almost certainly material, and you'd be showing it in the next set of financials anyway, and it was hard to keep the secret once the decision was made), but it morphed into a kind of lore about the securities disclosure duty.

The new 8-K regulations did in fact change this particular duty by explicitly requiring the disclosure on Form 8-K within two days of the decision to effect a major layoff (I don't remember the precise wording).

But, unless things have changed in the last year (since I had to worry professionally about it), I do not believe that because the board has done something that an investor would want to know in making the decision to buy or sell the security (for example, concluding that management should begin exploration of the possibility of selling a major division or the company as a whole), there would be a duty to disclose merely because you can fit the undisclosed act into the securities law definition of materiality. (As an aside, I had regular "arguments" with accountants about the difference between a GAAP or accounting view of materiality (usually 5% of something) and the securities law definition - I can't remember the case name, or if it was an SEC interpretation, on "qualitative" vs. "quantitive" offhand.)