On January 12, 2015, the Second Circuit ruled, “as a matter of first impression” for the appellate court, that a failure to make a disclosure required by Item 303 of Reg. S-K is an omission that can serve as a basis for a Section 10(b) securities fraud claim, but only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. In ruling that a failure to make an Item 303 disclosure can state an actionable Section 10(b) claim, the Second Circuit reached a different conclusion on the issue than did the Ninth Circuit in an October 2014 decision on the same question. The Second Circuit’s January 12, 2015 opinion in Stratte-McClure v. Morgan Stanley can be found here.
Background
This case involves a claim by Morgan Stanley shareholders that the company and certain of its directors and officers made misleading statements to conceal the company’s exposure to and losses from a massive propriety trade the company had structured involving subprime mortgage backed derivative securities. Among other things, the plaintiffs alleged that the company failed to disclose – as, the plaintiffs’ alleged, the company was required to do by Item 303 of Reg. S-K – that the company’s proprietary subprime mortgage-backed derivative investment would have an unfavorable material effect on revenue. The district court dismissed the plaintiffs’ claims, including the plaintiffs’ claims made in reliance on Item 303, and the plaintiffs appealed.
Item 303 of Reg. S-K, entitled “Management’s discussion and analysis of financial condition and results of operations,” imposes disclosure requirements on companies filing SEC-mandated reports, including quarterly filings on Form 10-Q. The requirements include the obligation to “describe any known trends and uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.”
The January 14 Opinion
On January 14, 2015, in a 32-page opinion by Judge Debra Ann Livingston for a unanimous three-judge panel, affirmed the district court, holding that a failure to make an Item 303 disclosure can be actionable under Section 10(b), but ruling that in this case the plaintiffs’ claim in this case was properly dismissed because the plaintiffs did not adequately plead scienter.
In ruling that a failure to make a disclosure required by Item 303 can be actionable, the appellate court reasoned that Item 303 imposed an affirmative disclosure duty on reporting companies. Omitting a required disclosure item, the court said, “can render … financial statements misleading.” The Court said “due to the obligatory nature of these regulations, a reasonable investor would interpret the absence of Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties… that the registrant reasonably expects will have a material unfavorable impact.’”
However, the appellate court added that the failure to make a required Item 303 disclosure “is not by itself sufficient to state a claim for securities fraud under Section 10(b),” noting that the Rule 10b-5 make only ‘material’ omissions actionable.”
The court said that the plaintiff must first allege that the defendant failed to comply with the requirements of Item 303, in order to establish that “the defendant had a duty to disclose.” Having established the duty to disclose, the plaintiff must then allege that the omission was material, and further that, as with any Section 10(b) claim, the plaintiff must also sufficiently plead scienter.
The appellate court went on to conclude that the plaintiffs had not adequately pled scienter, and affirmed the district court’s dismissal of the case.
The Second Circuit expressly acknowledged that in ruling that an omission of a disclosure required under Item 303 can be actionable its conclusion was “at odds with” the Ninth Circuit’s October 2, 2014 opinion in In re NVIDIA Corp. Securities Litigation. In that case, the Ninth Circuit held that Item 303’s duty is not actionable under Section 10(b), in reliance on language in an earlier opinion written by then-Judge (and now Supreme Court Justice) Samuel Alito when he was on the Third Circuit, stating that because the materiality standards for Rule 10b-5 and Item 303 differ significantly, a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b-5.”
The Second Circuit felt that this language merely suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material omission. At a minimum, the Second Circuit noted, the language “is consistent with our decision that failure to comply with Item 303 … can give rise to liability under Rule 10b-5 as long as the omission is material … and the other elements of a Rule 10b-5 have been established.”
Discussion
This outcome of this appeal represents something of a win-the-battle-lose-the-war deal for the plaintiffs here. In the face of adverse recent precedent from the Ninth Circuit on the issue, the plaintiffs managed to persuade the appellate court on an issue of first impression for the Second Circuit that an Item 303 omission can be actionable under Section 10(b). But then having established that principle, the appellate court nevertheless affirmed the district court’s dismissal of the case based on the conclusion that the plaintiffs’ scienter allegations were insufficient.
The plaintiffs’ bar in general may be heartened by the Second Circuit’s conclusion that an Item 303 omission can be actionable. However, their celebration is likely to be muted, as the Second Circuit included significant limitations on plaintiffs’ ability to assert these kinds of claims. First of all, to make out the omission in the first instance, the plaintiffs are going to have to establish that the allegedly omitted information was actually known to the defendants and significant. Second, as the Paul Weiss law firm noted in its January 14, 2015 about the Second Circuit’s ruling (here), even if the plaintiff can show that the disclosures were inadequate, in many cases, as in this case, “plaintiffs will face significant difficulties showing that the defendants intended to mislead investors by omitting information or were consciously reckless in that respect.”
In any event, we now have a split between the Second and the Ninth Circuits on this issue. This case – or at least this issue – could now find its way to the U.S. Supreme Court. As the Paul Weiss firm noted in its memo, “the issue may now be ripe for potential review by the Supreme Court.” The Supreme Court has shown an inexplicable interest in taking up securities cases in recent years, so the plaintiffs in this case may well decide to try their luck. Or as the issue percolates up in another circuit, the disappointed litigant in another case may try to catch the Supreme Court’s attention on the issue. Given the split in the circuits, this could be the kind of securities law issue that might catch the attention of the highest court.
It probably should be noted that while the Second Circuit’s opinion in this case is at odds with the Ninth Circuit’s opinion in the NVIDIAcase, it arguably comes as no surprise as the Second Circuit’s holding about Item 303 is consistent with its2012 opinion in the Panther Partners case, in which the Second Circuit held that an Item 303 omission can state an actionable Section 11 claim, as discussed here.