A senior officer’s violations of a corporation’s code of conduct do not give rise to a claim for violation of the federal securities laws—even where the corporation (including the officer himself) has touted the company’s high standards for compliance with its own ethical code.  That was the Ninth Circuit’s holding in a recent opinion affirming a district court’s dismissal of a putative class action filed against Hewlett-Packard and its former CEO and Chairman, Mark Hurd.  Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co. and Mark A. Hurd, 845 F.3d 1268 (9th Cir. 2017).  The case arose out of Hurd’s departure from the company following revelations of Hurd’s relationship with an HP contractor and subsequent efforts to cover up the relationship.  Plaintiffs brought claims under Section 10 of the Securities Exchange Act of 1934 and Rule 10b-5, alleging that HP had materially misrepresented or alternatively made material omissions about its high ethical standards and compliance with its Standards of Business Conduct (“SBC”), where its Chairman and CEO was found to have violated the SBC.

HP touted its strict code of conduct prior to Hurd’s resignation for violating the code.

Several years earlier, under Hurd’s leadership, HP had revised and strengthened its SBC following a 2006 ethics scandal in which it was revealed that HP had hired detectives to spy on directors, employees and journalists.  While the then-Chairman and General Counsel faced criminal charges, Hurd (then-CEO) was found free of any wrongdoing in that scandal, and was promoted to Chairman in addition to his role as CEO.  As the Ninth Circuit noted, following the scandal “Hurd took many opportunities to proclaim HP’s integrity and its intention to enforce violations of the SBC.”

Four years later, in 2010, former HP contractor Jodie Fisher contacted HP’s Board of Directors through her attorney, alleging that Hurd had sexually harassed Fisher.  The Board launched an investigation, and Hurd initially lied to the Board about the nature of his relationship with Fisher before admitting to a “very close personal relationship” with her.  The investigation revealed that Hurd had also falsified expense reports to hide his relationship.  Hurd resigned following the investigation, and HP acknowledged in a press release that Hurd knowingly violated the SBC and acted unethically.  HP’s stock dropped immediately upon the announcement of Hurd’s resignation, resulting in a $10 billion loss in market cap.

Statements about a code of conduct must be both objectively false and material to be actionable.

Investors filed a putative class action claiming that the violations of the SBC amounted to securities fraud, either in the form of material misrepresentations because HP’s statements about its ethics were inconsistent with Hurd’s conduct, or in the form of material omissions regarding Hurd’s unethical behavior, which Plaintiffs claimed HP had a duty to disclose.  The district court rejected both theories and dismissed the complaint with prejudice.  A three-judge panel of the Ninth Circuit unanimously affirmed the dismissal.

In this issue of first impression before the Ninth Circuit, the court articulated a two-part test for determining whether a violation of a corporate code of ethics may give rise to a securities fraud claim.  First, it examined the objective falsity of the company’s statements regarding its code of ethics.  Second, it turned to the materiality of those statements.  The court found that Plaintiffs’ claims failed under both elements.

As to objective falsity, the Ninth Circuit held that HP and Hurd had made no “objectively verifiable” statements about its compliance with the SBC, and instead characterized the code of conduct and statements about it as “inherently aspirational.”  Plaintiffs pointed in particular to Hurd’s comments prefacing the SBC as revised following the 2006 scandal, in which Hurd urged employees to “commit together, as individuals and as a company, to build trust in everything we do . . .”  But the Court reasoned that such statements are not “capable of being objectively false,” and thus found no affirmative misrepresentation.

The Ninth Circuit further found that the challenged representations were not material.  It noted that companies are required by the SEC to publish their codes of conduct, and “it simply cannot be that a reasonable investor’s decision could conceivably have been affected by HP’s compliance with SEC regulations requiring publication of ethics standards.”  Moreover, while plaintiffs pointed to the stock drop as evidence of materiality, the court cited its decision in Police Ret. Syst. Of St. Louis v. Intuitive Surgical, Inc., 759 F.3d 1051, 1060 (9th Cir. 2014), for the proposition that the stock drop goes to reliance, not materiality.  Where, as here, there was no actionable misstatement, the court would not reach the reliance analysis.

The court also rejected plaintiffs’ alternative theory that HP failed to disclose material facts concerning Hurd’s noncompliance with the SJC.  The court found that HP’s “transparently aspirational” statements in and about the SBC did not amount to a suggestion that nobody at HP would ever violate the SBC.  Absent statements creating the impression that everyone at HP was in full compliance with the ethical standards, there was nothing that gave rise to a duty to disclose noncompliance.

The future is dim for securities claims based on violations of a company’s ethical code—and that’s good news for companies and their directors and officers who wish to adopt and tout strong codes of conduct.

Plaintiffs may complain that the Ninth Circuit’s opinion takes away a tool for enforcing compliance with codes of conduct, as (at least in the Ninth Circuit) securities class actions based on alleged noncompliance with SEC-mandated codes of conduct are unlikely to survive a motion to dismiss.  Indeed, defense counsel are already brandishing Hewlett-Packard to support the assertion that statements about ethics-policy compliance are not actionable under the securities laws—Goldman Sachs sent a letter to the Second Circuit recently citing the HP decision in support of Goldman’s bid to decertify a class of investors suing over its Abacus CDO.

But I think the better view is that the court’s ruling finding that “aspirational” statements will generally not support a finding of falsity or materiality under the securities laws should provide a level comfort to companies seeking to adopt robust ethical codes, and to speak freely both within the company and publicly about their values and compliance goals—with a few notes of caution.

First, it probably goes without saying that, even under the Ninth Circuit’s newly-articulated standard, companies should avoid unequivocal statements in or about their codes of conduct suggesting for example that there will be no violations of the ethical code.  Such statements will likely prove false over time, and probably demonstrably so.  But apart from those types of unequivocal statements, the Ninth Circuit’s ruling should be an encouraging sign for companies who adopt and publish strong codes of conduct, and for directors and officers who make statements about their efforts to abide by such codes.  As the court made clear, these “aspirational statements” about a company’s compliance with its own code of conduct—even where strongly stated or oft-repeated—will typically be neither objectively false nor material under the securities laws.  As the court noted, “A contrary interpretation—that statements such as, for example, the SBC’s ‘we make ethical decisions,’ or Hurd’s prefatory statements, can be measured for compliance—is simply untenable, as it could turn all corporate wrongdoing into securities fraud.”

The second caution is that the Ninth Circuit’s ruling did not go so far as to say that non-compliance with a code of conduct could never be actionable under federal securities laws.  The court imagined that “the analysis would likely be different if HP had continued the conduct that gave rise to the 2006 scandal while claiming that it had learned a valuable lesson in ethics.”  Accordingly, companies should continue to be particularly vigilant to avoid repeating (or continuing) prior ethical lapses, which the Ninth Circuit suggested could give rise to causes of action, particularly where the company indicated through public statements that such conduct had ceased.