Opinion ID: 532765
Heading Depth: 1
Heading Rank: 4

Heading: Failure to Predict

Text: 41 The district court also dismissed plaintiffs' securities claims to the extent they relied on Subparagraphs 49(a), (d), (e), (g), (m), and (p). The court found that the alleged omissions outlined in these subparagraphs are immaterial as a matter of law because they call for speculation, would have provided only minimal aid--if any--to prospective shareholders, and seek to impose liability based upon defendants' failure to predict future business developments. 42 In their complaint, plaintiffs allege that defendants failed to disclose that:Craftmatic's advertising and marketing program was based on deceptive, illegal sales practices that would and did result in serious charges being brought against Craftmatic ..., p 49(a); 43 Craftmatic's rapid expansion program entailed an unusual and extremely high risk of failure ... and that ... the Company was essentially gambling with its profitability, p 49(d); 44 application of the advertising and marketing strategies to new product lines would far outstrip the revenues generated ... and hurt the Company's profitability, p 49(e); 45 Craftmatic required an increasing number of distributorships in uncertain markets without which Craftmatic's total net sales would stagnate or decline, p 49(g); 46 Craftmatic's rate of growth in its core business was not sustainable, p 49(m); 47 Craftmatic's new products were not amenable to being marketed successfully by the sales methods developed for its core business, p 49(p). 48 Plaintiffs contend that the averments are not predictive but concern existing facts that defendants knew or should have known. Moreover, plaintiffs maintain that the district court erred in ruling on the materiality of the omissions in a Rule 12(b)(6) motion to dismiss, claiming that the determination of materiality should be left to the trier of fact. 49 Our analysis of plaintiffs' claims begins with two interrelated inquiries. First, were defendants under a duty to disclose the information at issue? Second, were the alleged omissions material? Staffin v. Greenberg, 672 F.2d 1196, 1202 (3d Cir.1982). In addition to the duty to disclose specific information required by law, sections 11(a) and 12(2), and Rule 10b-5 impose upon defendants the duty to disclose any material facts that are necessary to make disclosed material statements, whether mandatory or volunteered, not misleading. See 15 U.S.C. Secs. 77k, 77l, 78j (1982). 17 It is this duty that plaintiffs claim has been breached. Thus, our determination of the scope of defendants' disclosure duty is necessarily intertwined with an inquiry into the materiality of the alleged omissions. 50 As in our prior discussion, we turn to the Supreme Court's decision in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976), in which the Court held that the issue of materiality is a mixed question of fact and law, involving the application of a legal standard to a specific set of facts. Id. at 450, 96 S.Ct. at 2133. Only when the disclosures or omissions are so clearly unimportant that reasonable minds could not differ should the ultimate issue of materiality be decided as a matter of law. Id.; Berg v. First American Bankshares, Inc., 796 F.2d 489, 495 (D.C.Cir.1986); see also Basic Inc. v. Levinson, 485 U.S. 224, 239, 108 S.Ct. 978, 987, 99 L.Ed.2d 194 (1988) (materiality of merger discussions assessed by factfinder). The Court defined materiality as follows: 51 An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.... Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. 52 426 U.S. at 449, 96 S.Ct. at 2132. 18 However, the Court cautioned:the disclosure policy embodied in the proxy regulations is not without limit.... Some information is of such dubious significance that insistence on its disclosure may accomplish more harm than good.... [I]f the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management's fear of exposing itself to substantial liability may cause it to simply bury the shareholders in an avalanche of trivial information--a result that is hardly conducive to informed decisionmaking. 53 Id. at 448-49, 96 S.Ct. at 2132. 54 The task of determining whether a given omission is material is especially difficult when the plaintiff alleges nondisclosure of soft information. The term soft information refers to statements of subjective analysis or extrapolation, such as opinions, motives, and intentions, or forward looking statements, such as projections, estimates, and forecasts. Hiler, The SEC and the Courts' Approach to Disclosure of Earnings Projections, Asset Appraisals, and Other Soft Information: Old Problems, Changing Views, 46 Md.L.Rev. 1114, 1116 (1987) (citing Kohn v. American Metal Climax, Inc., 458 F.2d 255, 265 (3d Cir.), cert. denied, 409 U.S. 874, 93 S.Ct. 120, 34 L.Ed.2d 126 (1972)). 55 Until the late 1970's, the SEC and the courts generally discouraged disclosure of soft information, on grounds that purchasers could be misled by overly optimistic claims and that soft information was neither reliable nor susceptible to SEC examination. In the late 1970's, however, SEC policy began to change as the agency recognized that its prohibition effectively kept valuable data from shareholders who were trying to decide whether to sell their securities. Flynn v. Bass Bros. Enterprises, 744 F.2d 978, 985-87 (3d Cir.1984). Today, the SEC encourages the disclosure of management's projections so long as the projections have a reasonable basis, are presented in an appropriate format, and are accompanied by disclosures that facilitate investor understanding. See 17 C.F.R. Sec. 229.10(b) (1988) (Commission policy on projections). 19 56 In recent years, the Supreme Court and other courts have adopted a number of approaches for applying the TSC Industries standard in cases involving the nondisclosure of soft information. 20 In Basic Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988), the Supreme Court considered whether the failure to disclose preliminary merger discussions was a material omission. 21 The Court stated that where an event is contingent or speculative in nature, it is difficult to ascertain whether the 'reasonable investor' would have considered the omitted information significant at the time. Id. at 232, 108 S.Ct. at 983. The Court rejected the approach applied in this circuit under which preliminary merger negotiations were deemed immaterial as a matter of law until an agreement in principle as to the price and structure of the transaction had been reached. Id. at 233-34, 108 S.Ct. at 986 (rejecting Greenfield v. Heublein, Inc., 742 F.2d 751 (3d Cir.1984), cert. denied, 469 U.S. 1215, 105 S.Ct. 1189, 84 L.Ed.2d 336 (1985); Staffin v. Greenberg, 672 F.2d 1196 (3d Cir.1982)). According to the Court, the materiality of preliminary merger discussions should depend on the facts and involves the balancing of both the probability that the event will occur and the anticipated magnitude of the event. Id. at 238-39, 108 S.Ct. at 987 (citing SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir.1968), cert. denied, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969)). 22 57 In Flynn v. Bass Bros. Enterprises, 744 F.2d 978 (3d Cir.1984), we considered the materiality of undisclosed asset appraisals in the context of a tender offer. In light of the policy change by the SEC, we held that asset appraisals and other soft information are not immaterial as a matter of law; rather, courts should ascertain the duty to disclose on a case-by-case basis, weighing the potential aid such information will give a shareholder against the potential harm, such as undue reliance, if the information is released with a proper cautionary note. Id. at 988. We listed seven factors a court should consider in evaluating the omitted information: 1) the facts upon which the information is based; 2) the qualifications of those who prepared or compiled it; 3) the purpose for which the information was originally intended; 4) its relevance to the stockholders' impending decision; 5) the degree of subjectivity or bias reflected in its preparation; 6) the degree to which the information is unique; 7) and the availability to the investor of other more reliable sources of information. Id. 23 58 In this case, the prospectus indicated that management planned to invest approximately $4.5 million of the $7.5 million proceeds from the initial offering in expanding the business. This would involve expansion of the wholesale distribution network for beds and chairs and the acquisition of other related businesses and other types of products for in-home direct sales by the Company and its distributors. The prospectus made no representation as to what or how new products would be marketed in the future. The prospectus stated with respect to the proposed expansion: 59 The Company considers the acquisition of additional related businesses or products to be an acceptable method of achieving growth and is presently engaged in negotiations and product studies with respect to potential acquisitions in the water purification and security/energy saving window shutter markets. No understanding or agreement in principle relating to any acquisition presently exists between the Company and any third party. There can be no assurance that any acquisition will be effected, or that, if effected, it will be successful. 60 The Company proposes to establish a finance subsidiary to supplement its existing financing arrangement for customers of the Company and its distributors and believes that this will also permit the Company to expand. See Use of Proceeds. 61 The Company's expansion program will require substantial additional funds for advertising and promotion, higher levels of inventories, additional personnel and, in the case of acquisitions of a business or new products, funds for such acquisition, development of a distribution network and the purchase or production of such products. 62 These statements are not challenged by plaintiffs. 63 Thus, in the Spring of 1986, Craftmatic sought to raise substantial new capital for the purpose of significantly altering its business. Moreover, the form that this significant alteration would take had not yet been determined. Understandably, Craftmatic and its underwriter chose not to predict the future course of its business and its future profitability. The prospectus makes no reference to future income, expenses, or profits other than the additional funds statement quoted above. In fact, plaintiffs make no claim that management possessed any forecasts regarding these matters, much less forecasts with some indicia of reliability. Therefore, it would be impossible for the district court to make a Flynn type evaluation of the omitted information. 64 Since corporations rarely make deliberate decisions to suffer large business losses, we think it highly unlikely that management would have disclosed any information that would have altered the mix of information available to potential investors, even if the law at the time had required that management formulate and include such predictions in the prospectus. Indeed, had the omitted projections been made, we are confident that plaintiffs would have asserted that such predictions lacked a reasonable basis and, accordingly, were actionable, as they have with respect to the predictions that were made at a later time. 65 In these circumstances, we have no difficulty in affirming the district court's conclusion that the omitted predictions would have been sufficiently speculative and unreliable to be immaterial as a matter of law.