8-K Changes: Safe Harbor, Or False Sense of Security?

Sunday, August 1, 2004 - 01:00

On Aug. 23, 2004, the SEC's amendments to the reporting requirements of Form 8-K will take effect. Included in these amendments is a limited "safe harbor" provision that protects from potential liability under the "antifraud provisions" of the Securities Exchange Act of 1934. Section 10(b) And Rule 10b-5 Of The Securities Exchange Act Of 1934 ("Exchange Act")

Generally speaking, the antifraud provisions - or, officially: Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 - prohibit material misstatements and omissions in connection with the purchase and sale of securities.

The Form 8-K "safe harbor" is referred to as such, because it protects or exempts issuers from a specific liability, for a specific time, and with respect to specific situations; for example: failure to disclose certain of the events itemized on the Form 8-K.

But for the safe harbor, failure to disclose such events could be considered a material omission that triggers liability under Section 10(b) and Rule 10b-5. As discussed below, the safe harbor protects from this liability, but not forever.

More Burden, Little Comfort

The safe harbor to the SEC's amended Form 8-K disclosure requirements is small and of limited duration. Access to the safe harbor is available with respect to only seven out of 22 items listed on the Form 8-K, and only with respect to liability under the antifraud provisions of the Exchange Act.

Access to the safe harbor is not conditioned upon documentation of disclosure decisions or upon the existence of a system of disclosure controls and procedures. However, "disclosure controls" are required under Exchange Act Rules 13a-15(a) and 15d-15(a). Accordingly, companies should take little comfort in the safe harbor and should be vigilant in establishing a system of disclosure controls that will ensure that they meet their Form 8-K disclosure obligations with respect to all of the Form 8-K items, and not just the 15 items that lack safe harbor protection.

The amendments will expand the Form's list of items from 12 to 22 events that must be disclosed, and shorten the timeframe in which the Form must be filed to as little as four business days for most events.

These amendments require companies to use Form 8-K to disclose material information "on a rapid and current basis," and were issued pursuant to Section 409 of the Sarbanes-Oxley Act of 2002, which is titled "Real-Time Issuer Disclosure." The result of these amendments is to require companies to disclose more events and to disclose them sooner. Undoubtedly, the amendments will increase the burden on companies to assess the events and determine whether a disclosure obligation has been triggered.

In recognition of this greater burden, the amendments provide a safe harbor that precludes liability under Section 10(b) and Rule 10b-5 of the Exchange Act for not filing the Form 8-K with respect to certain items on the Form's list of triggering events.

The following items are excepted from this liability, at least in part, because they require management to make quick judgments about materiality:

• Entry Into or Amendment of a Material Definitive Agreement Not Made in the Ordinary Course of Business (Item 1.01);

• Termination of a Material Definitive Agreement Not Made in the Ordinary Course of Business (Item 1.02);

• Creation of a Direct Financial Obligation or an Obligation Under An Off-Balance Sheet Arrangement (Item 2.03);

• Triggering Events that Accelerate or Increase a Direct Financial Obligation or an Obligation Under an Off-Balance Sheet Arrangement (Item 2.04);

• Costs Associated with Exit or Disposal Activities (Item 2.05);

• Material Impairments (Item 2.06); and

• Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review (Restatements) (Item 4.02(a)).

Sea Of Liabilities

While the safe harbor is significant, it is small relative to the sea of liabilities that it does not cover.

Not only does the safe harbor limit 10(b) and 10b-5 liability to only seven out of 22 items, it also expires when the company's next periodic report is due.

Furthermore, while the safe harbor protects from 10(b) and 10b-5 liability for failure to file a Form 8-K, it does not shield against such liability for misstatements in a Form 8-K that is filed, nor does it shield against liability for failure to meet disclosure obligations under other provisions of the securities laws. For example, companies should still be concerned about meeting disclosure obligations under 13(a) and 15(d) of the Exchange Act, which require issuers to file reports with the SEC, including quarterly reports, annual reports, transition reports, and Forms 8-K; and to keep them accurate and current. In fact, the release to the final rule states that the SEC staff adopted the limited safe harbor in lieu of the safe harbor that had been proposed for 13(a) and 15(d) liability.

It is also important to note that the safe harbor does not protect from liability under the other antifraud provisions of the federal securities laws, like Section 17(a) of the Securities Act of 1933. Accordingly, companies should use the safe harbor with deliberate caution and should not view it as a reason to lessen their vigilance in maintaining a system of disclosure control to ensure the collection of information concerning all of the itemized events that the Form requires to be disclosed.

A system of disclosure controls is not a prerequisite to the safe harbor. However, it would have been a prerequisite under the proposed safe harbor, and is now mandated by Exchange Act Rules 13a-15 and 15d-15. These rules require that companies maintain disclosure controls that are "designed to ensure that information required to be disclosed ... is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms."

According to the rules, disclosure controls and procedures include "controls and procedures designed to ensure that information required to be disclosed is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure." A failure to establish a system of disclosure controls as described by those rules would violate Sections 13(a) and 15(d) of the Exchange Act, and the safe harbor provides no protection from liability under those provisions.

Effective Disclosure Controls

There are no explicit guidelines concerning what type of system of disclosure control is sufficient. No single system would be appropriate for all companies. Accordingly, each company should create a disclosure control system that fits its own organization.

Such a system would entail informing all of the company's employees and agents, who may learn of the required information, that they must provide it to those responsible for filing the disclosure. Procedures for such a system could be written and distributed via a company-wide e-mail notification and/or training classes, through which everyone could be notified of the need to disclose reportable events, what events must be disclosed, and to whom to report them.

A disclosure control system should also include the collection and documentation of information concerning deliberations about whether or not to disclose an event on the Form 8-K. As discussed below, documenting the reasons for a disclosure decision may be useful in demonstrating that disclosures were made in a timely fashion, and that decisions not to disclose were not made recklessly or with fraudulent intent.

A committee could be responsible for establishing this system, documenting it, communicating it to the relevant employees, and periodically evaluating it to ensure that it works. The committee should report to senior management, including the CEO and CFO, who are required - under Rules 13a-15(b) and 15d-15(b) - to evaluate the effectiveness of the disclosure controls at the end of each fiscal quarter.

While such a committee is not mandated by the rules, the proposal that preceded them recommended that a committee be formed for considering the materiality of information and determining disclosure obligations on a timely basis, and suggested that the committee include the principal accounting officer, general counsel, risk management officer, investor relations officer, and others involved in the preparation of the company's reports.

Documentation of disclosure decisions is not a prerequisite to the safe harbor; however - while such documentation is not explicitly mandated by any rule - it should be part of the disclosure controls described above. Such information could be used to address potential concerns of the SEC staff, which are reflected in one of the conditions to the proposed safe harbor (i.e., absence of knowledge or recklessness concerning a failure to disclose).

Proving such an absence - in other words, proving a negative - is difficult, yet it can be important in addressing a challenge to a decision not to disclose. This is especially true when such decisions are made quickly and are subject to second guessing. Oftentimes, such second guessing can only be put to rest with information or documentation that provides a "real time" perspective of how the decision was made, including what information was available at the time it was made.

Contemporaneous documentation of disclosure decisions may be a way to provide this "real time" perspective. The level of detail that should be documented depends upon each situation, and should be determined with the help of legal counsel.

Joaquin M. Sena is a securities litigator who joined Chadbourne & Parke LLP as counsel in April 2004. Previously, he served at the Securities and Exchange Commission for nearly 12 years, most recently as assistant chief litigation counsel in the Division of Enforcement. This article originally appeared in Compliance Week (www.complianceweek.com).