Ninth CircuitIn the wake of the era of corporate scandals, Congress enacted the Sarbanes-Oxley Act. Section 406 of the Act required the SEC to promulgate rules requiring reporting companies to disclose whether or not they have adopted a code of ethics for its financial officers. The SEC subsequently issued rules implementing this directive, and as a result companies facing the new disclosure obligations adopted codes of ethics.


The Ninth Circuit, in a recent case arising out the departure of former H-P CEO Mark Hurd for alleged misconduct, examined whether a senior official’s violation of a company’s ethics code, after having touted the company’s high standards for ethics and compliance, may state a claim for violation of the federal securities laws. The appellate court affirmed the district court’s holding that the shareholder claimants had failed to state a claim for securities fraud because they had failed to sufficiently allege that the defendants made a material misrepresentation or misleadingly omitted material information. The Ninth Circuit’s January 19, 2017 opinion can be found here.



Years before the specific events that led to Hurd’s resignation, H-P had been involved in a prior set of circumstances involving the company’s investigation of leaks of information to the press. These prior circumstances led to the resignation of the company’s then-CEO Carly Fiorina. Hurd became the company’s first joint Chairman and CEO. The company also intensified its promotion of ethical behavior within the company and reinforced the importance of its corporate code of ethics. Hurd himself took many opportunities to proclaim H-P’s integrity and its intention to enforce violations of its ethics code.


In 2010, Jodie Fisher, a former part-time independent contractor for H-P, asserted claims that both Hurd and H-P had discriminated against her, and alleged that Hurd had sexually harassed her. H-P’s board launched an investigation. Initially, Hurd lied to the Board about his relationship with Fisher. The board also uncovered that Hurd had doctored his expense reports on several occasions. At least twice, Hurd expensed meeting with Fisher when there had been no H-P event. The investigation concluded that while there was no evidence of sexual harassment, Hurd had falsified expense reports and lied about his relationship.


Hurd resigned. In a press release, H-P acknowledged Hurd’s knowing violation of H-P’s code of conduct, confirming that an investigation had found unethical behavior. Hurd himself was quoted in the press release as saying, among other things, that “I did not live up to the principles of trust, respect and integrity that I have espoused at HP.” Following Hurd’s resignation, HP’s share price declined, resulting in a $10 billion loss in market capitalization.


A plaintiff shareholder filed a securities class action lawsuit against H-P and Hurd, alleging that the defendants had committed securities fraud. The plaintiff alleged that the defendants’ public statements about the company’s code of ethics were material misrepresentations made demonstrably false by their inconsistency with Hurd’s conduct. The plaintiff also claimed that the defendants had omitted to disclose Hurd’s unethical behavior.  The district court granted the defendants motion to dismiss, holding that because materiality and falsity had not been alleged, the plaintiff’s claims could not survive. The plaintiff appealed.


The January 19, 2017 Opinion

In a January 19, 2017 opinion written by District of Montana Judge Dana Christensen, sitting by designation, a unanimous three-judge panel of the Ninth Circuit affirmed the district court’s dismissal of the case, holding that failed to sufficiently allege that the defendants made a material misrepresentation or misleadingly omitted a material fact.


First, in concluding that the plaintiff had insufficiently alleged falsity, the appellate court first noted that a code of conduct is “inherently aspirational,” and that as a result the defendants’ statements about the ethics code are not “objectively verifiable.” A contrary interpretation is “simply untenable” as it could “turn all corporate wrongdoing into securities fraud.” The court concluded because no statement about the ethics code during the class period “was capable of being objectively false,” there was no affirmative misrepresentation.


Second, in concluding that the plaintiff had insufficiently alleged materiality, the court noted that it cannot be said that that there is a substantial likelihood that the company’s disclosures about its ethics code “altered the total mix of information” available to stockholders, noting that not only was there nothing unusual about the promotion of business ethics at H-P, but the substance and online publication of the ethics code were mandated by the SEC. The court said that “it simply cannot be that a reasonable investor’s decision would conceivably have been affected by H-P’s compliance with SEC regulations requiring publication of ethics standards.”


Finally, the court held that the allegedly materially misleading omission – that is, failing to disclose Hurd’s noncompliance with the ethics code – is not actionable. The court noted that “just as there was no statement capable of being factually misleading, there was no omission that could have been actionable as misleading.” In reaching this conclusion, the court further noted that “absent a duty to disclose, an omission does not give rise to a cause of action under the securities laws.”


The court said that there was no duty to disclose because the defendants’ alleged failure to speak did not “affirmatively create an impression of a state of affairs that differs in a material way from the one that actually exists,” adding that the promotion of ethical conduct at H-P “did not reasonably suggest that there would be no violations” of the ethics code by the CEO or anyone else, and the even Hurd’s own statements did not “warrant that he had been personally compliant or that he personally would comply with [the ethics code] in the future.” The fact that the defendants touted the existence of the ethics code “does not, without more, transform the misbehavior into an actionable material omission under the securities laws.”



As I noted at the outset, many companies adopted ethics codes after the SEC released its regulations pursuant to the Sarbanes-Oxley Act. Plaintiffs’ lawyers subsequently have tried to bootstrap the disclosure of behavior allegedly violating a company’s ethics code into securities law violations, on the argument that the behavior was inconsistent with the representations embodied in the published code, or inconsistent with statements the company made about its code. As this case shows, it is going to be very difficult for shareholder plaintiffs to show that an alleged violation of a published ethics code is sufficient to state a claim for securities fraud.


As noted in a February 7, 2017 post on the Sheppard Mullin law firm’s Corporate & Securities Law Blog (here), the Ninth Circuit’s opinion in this case “curtails the ability of securities plaintiffs to rely upon alleged violations of vague, aspirational corporate codes to plead securities fraud.” The blog post further notes that in order for plaintiffs to be able to state a securities claim and to survive a motion to dismiss, plaintiffs must “plaintiffs must identify actual, testable and material statements of existing fact that are rendered ‘objectively false’ by other contemporaneous facts.”


The fundamental problem for plaintiffs trying to rely on alleged ethics code violations as the basis of claims under the federal securities laws is that no one adopting an ethics code ever says that no employee will ever violate it. As the Ninth Circuit said in the H-P opinion, if compliance with aspirational statements like an ethics code were interpreted to be objectively verifiable sufficient  for a violation to support a securities law claim, then the adoption of an ethics code could “turn all corporate wrongdoing into securities fraud.” Because an ethics code is inherently aspirational, there was no statement about the ethics code that was capable of being objectively false, and therefore there was no affirmative misrepresentation.