One of the more interesting issues that has emerged recently in the securities litigation arena is the question of whether or not the alleged failure to make a disclosure required by Item 303 of Reg. S-K is an actionable omission under Section 10(b) and Rule 10b-5. The Ninth Circuit, in its October 2014 decision in the In re NVIDIA Corp. Securities Litigation (here), held that it is not, but in January 2015, the Second Circuit held in the Stratte-McClure v. Morgan Stanley (here), held that it is.
These two appellate decisions represent a clear split in the federal circuits on the question, leaving the federal district courts to try to sort their way through these issues. In a March 4, 2015 decision in the Tile Shop Holding securities litigation (here), District of Minnesota Judge Ann D. Montgomery followed the Second Circuit’s ruling on the question and held that an alleged failure to make a disclosure under Item 303 can serve as the basis of a Section 10(b) securities claim. The ruling is interesting in a number of other respects as well, as discussed below.
Item 303 of Reg. S-K states in pertinent part that in its periodic reports to the SEC, a company is to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a materially favorable or unfavorable impact” on the company. Guidance provided by the SEC on Item 303 clarifies that disclosure is necessary where a “trend, demand commitment event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”
In its October 2014 decision in In re NVIDIA Corp. Securities Litigation, the Ninth Circuit held that Item 303 does not create a duty to disclose for purposes of Section 10(b). In reaching this decision, the Ninth Circuit relied on language in an earlier opinion written by then-Judge (and now U.S. 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.”
In its January 2015 decision in the Morgan Stanley case, the Second Circuit expressed its view that Judge Alito’s language merely suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material omission. The Second Circuit concluded that the language is consistent with its conclusion that an Item 303 omission can serve as the 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. Ironically, though the Second Circuit held that an Item 303 omission can serve as the basis of a Section 10(b) claim, the appellate court nevertheless affirmed the dismissal of the plaintiff’s Section 10(b) claims, holding that the plaintiff had not adequately alleged scienter.
The Tile Shop Securities Suit
Tile Shop is a specialty tile retailer. The company went public in August 2012, and conducted secondary offerings in December 2012 and June 2013, in which there were a number of selling shareholders including directors and officers of the company. The company sourced much of its tile product overseas, including from a company in China that the CEO’s brother in law had an ownership interest. The amount of tile product Tile Shop purchased from the Chinese company increased from 8.3 percent in 2011 to 32.2 percent in 2013. In addition to having the ownership in the Chinese tile manufacturer, the brother- in-law also worked for Tile Shop; beginning in 2011 and continuing until 2013, the brother in law was employed as Tile Shop’s purchasing supervisor.
In November 2013, a research analyst published a report identifying the connections between Tile Shop, its CEO and the brother in law and the Chinese supplier. The analyst report also stated that the company’s margins and profits were overstated due to favorable transactions between related parties. The company’s share price dropped 39% on the news. On November 15, 2013, plaintiff shareholders filed the first of several securities complaints filed against the company, certain of its directors and officers, and its offering underwriters. The defendants moved to dismiss.
The March 4, 2015 Order
In a detailed, 36-page order dated March 4, 2015, Judge Ann D. Montgomery denied in part and granted in part the defendants’ motions to dismiss. Judge Montgomery’s order addresses a number of different substantive legal issues, two of which I touch on below.
First, Judge Montgomery denied in part and granted in part the plaintiffs’ claims under Section 10(b), in which the plaintiffs alleged that Tile Shop’s failure to disclose its dependence on companies controlled by the brother-in-law violated Item 303, by failing to disclose trends or uncertainties that would have a material impact on Tile Shop sales, revenues or income.
In denying the motion in part, Judge Montgomery considered the split between the Ninth and the Second Circuits on the question of whether a failure to make a required disclosure under Item 303 can serve as the basis of a claim under Section 10(b). Judge Montgomery reviewed both appellate courts’ reference to and analysis of Judge Alito’s Third Circuit opinion. She said that she found the Second Circuit’s reasoning “persuasive” and “consistent with” her own reading of the Third Circuit opinion.
However, the Second Circuit had gone on to state in the Morgan Stanley case that a violation of Item 303 can be actionable only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. Indeed, in the Morgan Stanley case, the appellate court held that the plaintiffs had in fact not sufficiently pled scienter, and the court affirmed the district court’s dismissal of the case.
In the Tile Shop case, Judge Montgomery concluded that the plaintiffs had sufficiently pled materiality. In concluding that failure to disclose the trend of the company’s increasing reliance on the brother-in-law’s tile company was material, Judge Montgomery said that the “trend of consolidating the percentage of product sold to a single entity could have a material effect on Tile Shop’s financial condition if that relationship was somehow compromised.” She added that “given the significant reliance” of Tile Shop on the supplier “a disruption of this relationship would be reasonably likely to impact Tile Shop’s future performance.”
Judge Montgomery also concluded that the allegations of scienter were sufficient as to the CEO and as to the company itself, and accordingly she denied the motion to dismiss the Section 10(b) claims against the CEO and the company. However, she found that the scienter allegations were insufficient as to the other individual director and officer defendants, and she granted the motion to dismiss the plaintiffs’ Section 10(b) claims as to the other individual defendants.
Judge Montgomery also granted the motion to dismiss the plaintiffs’ Section 11 claims based on the June 2013 offering because none of the plaintiffs purchased securities in the June 2013 offering. The plaintiffs attempted to argue that they had standing to assert the claims related to the June 2013 offering, though they purchased no shares in that offering, asserting that because they had standing to assert Section 11 claims related to the December 2012 offering, they also had standing to represent the interests of those who purchase in the June 2013 offering because their claims implicated the same set of concerns. In making this argument, the plaintiffs relied on the Second Circuit’s 2012 decision in NECA-IBEW v. Goldman Sachs, in which the court held that a named plaintiff may have class standing to bring claims related to the residential mortgage-backed certificates that it had not purchased on behalf of absent class members who purchased them.
Judge Montgomery declined to follow what she called the Second Circuit’s “non-precedential position” on the matter, relying instead on a District Court opinion from the Central District of California in the Countrywide case, for the principle that a plaintiff must demonstrate standing for each claim he seeks to press.
When a circuit split exists, the district courts located outside of the circuits that have ruled on the issue have to decide which line of circuit authority to follow. The two issues from Judge Montgomery’s opinion that I discussed above show how district courts must struggle with these issues where there are competing lines of authority. Interestingly, on the Item 303 issue, Judge Montgomery followed the Second Circuit’s reasoning, but on the Section 11 standing issue, Judge Montgomery declined to follow the Second Circuit, preferring not the reasoning of a different circuit court, but rather the reasoning of a district court.
While the general topic of circuit splits is interesting, the split between the Second and Ninth Circuits on the Item 303 issue is particularly interesting. These issues are going to come up in other cases and other district courts outside of the Second and Ninth Circuits will have to wrestle with these issues. At a minimum, under the current state of play, there is the obvious risk of inconsistent outcomes on the issue between the courts in the Second Circuit and the Ninth Circuit. The existence of this type of circuit split is precisely the kind of thing that can, if teed up the right way in a particular case, attract the attention of the U.S. Supreme Court. Indeed, given the existence of the circuit split and the keen interest the Supreme Court has shown over the last eight years or so in taking up securities cases, the Item 303 issue could well wind up in the Supreme Court, perhaps sooner rather than later.
In any event, unless and until the Supreme Court has an opportunity to reconcile the holdings of the Second and Ninth Circuits on this issue, it is going to be increasingly important for companies to be particularly attentive in their periodic reporting documents to highlight company and industry trends and uncertainties, so as to ensure proper disclosure and to try to avoid attracting the unwanted attention of plaintiffs’ lawyers.
Special thanks to a loyal reader for sending me a copy of this opinion.