Limitations of Safe Harbor Under the Private Securities Litigation Reform Act


In 1995 Congress overrode a presidential veto and passed the Private Securities Litigation Reform Act (PSLRA). The Act sought to provide protection to honest companies that run into hard times by making it harder to file frivolous class-action shareholder lawsuits, typically brought as either: (1) accounting fraud cases; or (2) forecasting cases. Among other things, the PSLRA contains safe harbor provisions, but these only apply to certain aspects of forecasting cases and don't apply to accounting fraud cases. Regardless, there are still ways for your clients to be proactive in avoiding shareholder lawsuits or to at least obtain early dismissals in litigation.

Finding Safe Harbor

Before the PSLRA, plaintiffs preferred accounting fraud cases and would routinely allege accounting improprieties to gain access to auditors' work papers and search for debatable entries. Over the years, however, courts caught on to the tactic and tended to dismiss such allegations, absent a high level of detail. With no safe harbor for accounting fraud cases, the PSLRA does nothing to discourage such claims. Also, because it only extends safe harbor to forecasting information in certain situations, it may not dissuade forecasting claims either. After all, while the safe harbor provision generally protects forward-looking information, especially if accompanied by cautionary disclosures (under the Bespeaks Caution Doctrine), it expressly does not protect forecasting information contained in financial statements. Because of this, how and where your clients issue forecasting information can determine whether safe harbor protections apply.

Shielding Your Clients

The PSLRA offers some protection for your clients when it comes to forecasting information, but there are also steps they can take to minimize exposure to all shareholder claims, as described below.

Separate Protected From Non-Protected Disclosures

Financial results in a company's SEC filings would not fall within the safe harbor as they are not forward-looking. However, sometimes forecasting information is included in those filings, which can be protected unless it is included in financial statements. Whenever possible, forward looking information should be moved out of the financial statements and into the Management's Discussion and Analysis (MD&A) section. If SEC regulations require forecasting information in the financial statement, your clients should comply, but can also add those statements in the MD&A with appropriate cautionary disclosures. Although plaintiffs may argue that inclusion of the forward-looking statements elsewhere in the filing should not result in safe harbor protection, a court may disagree, based on the overall circumstances of the disclosure.

Involve Auditors In Accounting Decisions

Companies have won a number of class actions on pretrial motions because challenged accounting decisions had been blessed by outside auditors. Even if the decisions were wrong, courts have used auditor pre-approval as evidence that there was no fraudulent intent. This protection can be strengthened if auditors conduct timely quarterly reviews, instead of retrospective reviews for a year-end audit.

Disclose Accounting Policies

Since an accounting fraud claim requires plaintiffs to prove that your client misled investors, their case will be undermined if your client discloses its accounting policies and addresses financial market impacts ahead of time.

Take Accounting Manuals Seriously

Most companies have manuals containing accounting policies and practices, but these can be fodder for plaintiffs if not maintained properly. Your clients should periodically review their manuals to ensure that they reflect actual practices. Outside auditors can also review the manual for consistency with GAAP. Manuals should avoid absolute terms, because circumstances may sometimes require deviation.

Set Reserves Consistently

Some companies use reserve accounts (particularly bad debt and obsolete inventory) to manage earnings. In a good quarter, they can salt away extra pennies per share; in a tight quarter, they can draw down on excess reserves. This practice can be risky and plaintiffs frequently allege manipulation of reserves to inflate earnings. The SEC also focuses on reserves, particularly when they see large reserve increases in the fourth quarter in anticipation of an audit. Your clients should consider disclosing their reserve methodology or at least have auditors sign off on reserve decisions each quarter, and should always be able to justify quarter-to-quarter variations in their reserve accounts.

Root Out Fraud

Few CFOs tolerate improper accounting practices on their watches, but abuses can still occur even in honest companies. A salesman desperate to make quota may give a customer a secret side letter transforming the sale into a consignment; a foreign subsidiary may continue booking sales beyond the quarterly cut-off. If your client has procedures to prevent such practices, this can reduce the impact of isolated transgressions.

To address inadvertent abuses, your clients should consider further invigorating their audit committees. Sometimes they only meet sporadically and just receive clean bills of health from the auditors. However, after a complaint is filed, defense lawyers can usually uncover accounting problems during the first ten interviews, something audit committees could do on a regular basis. They can also conduct one-on-one, periodic interviews with employees at various levels, which alone may make an employee think twice before booking an improper transaction. In addition, your clients can require employees to sign certifications that the revenue they've booked complies with company accounting guidelines.

Looking Ahead

The importance of taking preventative measures is heightened by Title III of the Reform Act, which imposes a duty on outside auditors to establish procedures to detect illegal acts and report them to the company unless "clearly inconsequential." If the illegal act materially affects the company's financial statements and no remedial action is taken, the auditors must then report to the board and to the SEC. Such a report could pummel a company's stock and sully its reputation. Shareholder lawsuits would be filed within hours and safe harbor would be unavailable.

Fortunately, your clients can avoid these outcomes by adopting strong internal fraud-detection procedures and by careful placement of forecasting information. To learn more about securities litigation and how to protect your clients going forward, see the free resources available at FindLaw's Corporate Counsel section.