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Imminent supreme court ruling may leave directors tongue-tied.

Your company purchased another, and you disclosed to your shareholders that you paid a fair price for the target company in this accretive transaction. This disclosure is included in a registration statement that is used to sell shares of the company.

The next month, however, you learn that--despite your due diligence--you clearly overpaid. You disclose this new information, and the company's stock price drops precipitously.

Shareholders who bought securities in the offering bring a securities class action suit against the company.

Here's the question: Are the company and its directors and officers (D&O) liable to shareholders for material misrepresentations in the registration statement, even though everyone believed the disclosures were accurate when they were made?

Depending on how the U.S. Supreme Court handles the decision in Indiana State District Council of Laborers v. Omnicare, the answer may be yes.

The fourth quarter of 2014 welcomed a new term for the U.S. Supreme Court, and with it, a new case exploring what could be a significant decision when it comes to directors and officers making objectively or subjectively false statements.

The case involves Omnicare Inc., a pharmacy service for long-term care facilities. The plaintiffs allege that the disclosures in the registration statement used for the company's 2005 initial public offering (IPO) contained material omissions, including the fact that Omnicare was allegedly engaged in illegal activities that included false Medicaid and Medicare claims and kickbacks from pharmaceutical companies.

The issue before the Supreme Court in Omnicare is not whether Omnicare was engaged in illegal activities. It's about whether the law cares only if a statement was objectively false, or is it relevant that the speaker believed the objectively false statement to be true at the time he or she made it?

Omnicare could disrupt the status quo

The issue of whether a statement is objectively or subjectively false arises in Omnicare because it is a Section 11 matter. Section 11 of the Securities Act of 1933 provides for strict liability for materially false or misleading disclosures in registration statements filed with the U.S. Securities and Exchange Commission.

At issue in Omnicare is what is needed for the plaintiffs to state a claim--or, conversely, in what circumstances defendants can win a motion to dismiss for failure to state a claim. The lower courts are divided on this question. The 2nd, 3rd and 9th Circuits have all held that defendants will win their motion to dismiss a Section 11 case if plaintiffs fail to allege that the statements in question were both objectively and subjectively false.

Making it easier for plaintiffs to survive a motion to dismiss, the 6th Circuit says that since Section 11 provides for strict liability, the fact that an incorrect belief was honestly held is irrelevant. Instead, the 6th Circuit says the only question is whether the statement in question was objectively false or not.

If the 6th Circuit prevails and disrupts the status quo, it will be harder to settle Section 11 cases because it will be more difficult to win a motion to dismiss. If this is the case, we'll see plenty of Section 11 claims and should also expect D&O insurance prices to rise for IPO companies and other companies that do a lot of public offerings.

In the end, if the 6th Circuit prevails in Omnicare, the results will harm shareholders. If disclosures made honestly and sincerely might nevertheless lead to liability, fewer disclosures will be made. As much as directors and officers may want to offer their view of the business to their shareholders, the threat of litigation with a low bar for the plaintiffs to prevail will have a chilling effect.

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Title Annotation:INSIDE: Corporate Governance
Author:Huskins, Priya Cherian
Date:Feb 1, 2015
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