On June 21, 2012, Judge Paul A. Crotty of the U.S. District Court for the Southern District of New York in Richman v. Goldman Sachs Group, Inc. became the first judge to consider disclosure obligations with respect to Wells notices, opining that a public company does not have an affirmative duty, upon which a federal securities fraud claim could be based, to disclose the receipt of a Wells notice from the Securities and Exchange Commission (“SEC”).

A Wells notice is a ‘courtesy’ alert from the SEC that it is considering enforcement action. Typically, it comes after the fact-gathering in an investigation is complete, but before the five members of the SEC have voted on, or considered, whether an enforcement action should actually be taken. The process gives the recipient an opportunity to make a written ‘Wells submission’ urging that enforcement action not move forward. Regardless of whether the company responds to the SEC, it must choose whether or not to disclose receipt of the notice to investors. Some companies take a transparent approach and promptly disclose the receipt of a Wells notice in an 8-K filing. Others choose not to disclose, instead relying upon Rule 103 of Regulation S-K which requires disclosure, in the context of 10-Q and 10-K filings, of material pending a legal proceeding.

The plaintiffs in Richman sued Goldman and three of its officers for securities fraud under Section 10(b) of the Securities Exchange Act claiming that Goldman had fraudulently failed to disclose Wells notices regarding its role in a synthetic collateralized debt obligation (“CDO”) offering. The complaint provides that in 2008 the SEC commenced an investigation into Goldman relating to the CDO offering and that Goldman disclosed in subsequent securities filings that “requests for information from various governmental agencies and self-regulatory organizations relating to subprime mortgages, and securitizations, collateralized debt obligations and synthetic products relating to subprime mortgages.” The SEC issued a Wells notice to Goldman in July 2009. The plaintiffs asserted that Goldman’s failure to disclose the Wells notices made its prior disclosures regarding the investigation misleading and that Goldman had an affirmative duty to disclose the Wells notices under various SEC regulations and FINRA rules.  

The court disagreed, stating that “…an investigation on its own is not a ‘pending legal proceeding’ until it reaches a stage when the agency or prosecutorial authority makes known that it is contemplating filing suit or bringing charges ... a Wells notice may be considered an indication that the staff of a government agency is considering making a recommendation, but that is well short of litigation.”  The court also noted that “a corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.” Corporations are “not obligated to predict and/or disclose their predictions regarding the likelihood of suit,” and a Wells notice is a “contingency that need not be disclosed.” 

While Judge Crotty’s decision suggests that there is no generalized duty to disclose receipt of a Wells notice, inevitably the existence of such duty will depend on the facts and circumstances of the case. Of note is that Judge Crotty was opining on Wells notices issued in 2008 and 2009. If the Wells’ notices were issued post-2010, against the stricter requirements imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (“Dodd-Frank”), he may have reached an entirely different conclusion. Section 929U of Dodd-Frank provides that within 180-day of a Wells notice “…the Commission staff shall either file an action against such person or provide notice to the Director of the Division of Enforcement of its intent to not file an action.” Although the decision as to whether to commence an action ultimately rests with the members of the SEC, any public sector litigator will appreciate that the ‘red-tape’ and approval process surrounding this 180-day time frame compels the SEC enforcement staff to be very confident that an action will follow before a Wells notice is issued. Under the regulations implemented pursuant to Dodd-Frank, a Wells notice is now unlikely to be considered “well short of litigation”, rather as evidence that litigation is imminent or pending.

Further, from the companies’ perspective, there is little upside to disclosure, which triggers an adverse market reaction. In this case, disclosed Wells notices issued by FINRA against two Goldman officers caused the stock price of Goldman to plummet by 13%. However, from a markets’ perspective, failure to disclose may be akin to harboring ‘material non-public information.’ A pertinent example occurred in 2010 when Moody’s received a Wells notice on March 18^th and did not disclose its receipt until two months later in its 10-Q. Moody’s CEO Raymond McDaniel dumped 100,000 shares of stock the day the Wells Notice arrived. Similarly, Berkshire Hathaway sold 678,000 shares that day and another 300,000 in the week that followed.  Did these parties know about the Wells notice when they sold their stock? If so, is this not trading while in the possession of material non-public information?

The question faced by recipients of Wells notices therefore becomes to disclose, or not to disclose?  Depending on the background of the case, the path favoring disclosure will result in a short-term, self-correcting stock price drop while the market absorbs the effect of what the SEC ‘could’ be investigating.  The ramifications of path two are more problematic, providing an interesting case study for the policy debate as to whether all material non-public information need be disclosed and whether insider trading is a victimless crime.  What is certain is that there may be no right answer.