Public companies should consider updating disclosures describing the risk of hypothetical events where the stated event has actually occurred, as continuing to describe the risk as hypothetical could be viewed as a material misstatement. A recent ruling by the Second Circuit may encourage private plaintiffs to file complaints predicated on a company’s failure to update hypothetical risks disclosed in filings with the Securities and Exchange Commission. In City of Hialeah Employees’ Retirement System v. Peloton Interactive, Inc., the plaintiffs filed a putative class action alleging, among other claims, that Peloton Interactive, Inc. (“Peloton”) and its executives violated the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-5 promulgated thereunder by including false and misleading statements in certain Form 10-Q and Form 10-K filings (collectively, the “Filings”) about the potential for inaccurate forecasting and excess inventory when the company was already experiencing significant inventory buildup and responding by discounting prices.
In the “Risk Factors” section of each of the Filings, Peloton stated that “[i]f we fail to accurately forecast consumer demand, we may experience excess inventory levels or a shortage of products available for sale. Inventory levels in excess of consumer demand may result in inventory write-downs or write-offs and the sale of excess inventory at discounted prices, which would cause our gross margins to suffer.” The plaintiffs alleged that this disclosure amounted to materially false and misleading statements since, at the time of the Filings, the hypothetical consequences had already occurred, and Peloton had reduced its prices in response to the inventory buildup. The United States District Court for the Southern District of New York dismissed the complaint, finding that the plaintiffs did not allege any actionable material misstatement or omission under the Exchange Act and Rule 10b-5.
While the Second Circuit agreed with the district court’s holding that the hypothetical disclosure in Peloton’s May 2021 Form 10-Q filing was not actionable, the Second Circuit overruled the district court’s findings with respect to that same disclosure included in Peloton’s August 2021 Form 10-K and November 2021 Form 10-Q filings. The Second Circuit determined that the risk factor disclosure in those filings was potentially misleading because “by August 26, 2021, the specific financial consequences described in these disclosures were not merely hypothetical ‘but had already materialized and resulted in significant disruption to [Peloton’s] business.’” Referencing its decision in Set Cap. LLC v. Credit Suisse Grp. AG, the Second Circuit explained that a hypothetical statement about potential risks can become an actionable misstatement if such disclosure is not updated once the risk has occurred and is no longer purely theoretical in nature.
The Second Circuit’s decision serves as a reminder that, while hypothetical disclosure in Exchange Act filings may be appropriate in certain circumstances, such disclosure should be continuously reviewed in light of recent developments and changes in market conditions to determine if a hypothetical risk has come to fruition.
