In a post earlier this month, I summarized the three securities law cases that the U.S. Supreme Court will hear its current term. Among the three cases on the Court’s docket is Leidos, Inc. v. Indiana Public Retirement System. As discussed in greater detail here, in Leidos, the Court will address the question 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. In an interesting September 26, 2017 article entitled “Ask Me No Questions and I Will Tell You No Lies: The Insignificance of Leidos Before the United States Supreme Court” (here), Stanford Law Professor Joseph Grundfest argues that the Leidos case is “not a big deal” and is a “nothing-burger,” because, he contends, regardless of which way the Court comes out in the case, the outcome will make little practical difference.
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.”
Issuers’ Item 303 disclosures appear in the Management Discussion & Analysis (MD&A) sections of their annual reports (and in interim or quarterly reports, where there have been material changes since the last annual report).
The federal circuit courts have reached contrary conclusions on the question of whether or not Section 303 creates an actionable duty of disclosure. The Second Circuit has held that Item 303 does create an actionable duty of disclosure, while the Ninth and Third Circuits have held that it does not.
Professor Grundfest’s Analysis
Fundamental to Grundfest’s analysis is his thesis that a “pure omission” is not actionable under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Because the concept of a “pure omission” is central to understanding Grundfest’s analysis, it is important at the outset to understand what he means by this term, and the contrast between what he calls a “pure omission” and what he calls a “half-truth.”
Grundfest draws a distinction between the language Congress used in creating express liability under Section 11(a) of the Securities Act of 1933, for example, and the language the Commission used when it drafted Rule 10b-5 in 1942. Section 11(a) creates liability not only for material misrepresentation or omissions in a registration statement, but also if the registration statement “omitted to state a material fact required to be stated therein.” In Rule 10b-5(b), by contrast, the Commission only rendered it unlawful to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”
In light of this textual analysis, Grundfest contends that nothing in Section 10(b) or Rule 10b-5 “expressly addresses ‘pure omissions,’ the omission of information that Commission regulations requires to be disclosed in periodic reports but that does not render any affirmative statement false or misleading.” The Rule, Professor Grundfest says, prohibits lies and half-truths (that is, omissions making affirmative statements misleading), but, and by contrast to Section 11(a), does not prohibit pure omissions.
I should note here that while Professor Grundfest and the defendant petitioner characterize an Item 303 omission by using the term “pure omission,” the plaintiff respondent rejects this characterization: “Whatever that phrase means, it cannot reasonably be used to describe the actions of a company that publicly files an annual report that purports to comply with the securities laws but in fact omits required, material information.”
The parties to the Leidos case have argued strenuously on the merits of the issue and the potentially dire consequences of the outcome, but, Grundfest argues, because there is so much information in the public domain about publicly traded companies “it becomes trivially easy for plaintiffs to allege that material omissions cause affirmative statements to become materially misleading.”
As a result, Grundfest contends, the outcome of the Leidos case may not matter:
If the Court holds that pure omissions are not actionable under Rule 10b-5, plaintiffs will simply reframe those omissions as creating actionable half-truths. If the Court holds that pure omissions are actionable under Rule 10b-5, plaintiffs will describe those same fact patterns as generating actionable pure omissions and-or half-truths. The framing of the claim does not alter the materiality of the alleged misrepresentation, the scienter with which the alleged violation occurred, the damages caused by the omission, any other element of the cause of action, or the likely outcome of the litigation. Changing the framing of the complaint to allege a half-truth or a pure omission is thus a semantic device. It is not a substantive modification of the law that alters outcomes or settlement cash flows.
The Leidos case itself underscores this point, Grundfest contends. In Leidos, the plaintiffs allege that the defendants should be liable for failing to disclose a significant contingent liability of which the company allegedly was aware. The plaintiffs pled not only that the omission is actionable because the failure to disclose the contingency violated Item 303 (that is, because it represents what Grundfest calls a “pure omission”) but also and in the alternative that it is actionable because it rendered other statements about the companies’ financial condition false and misleading (that it, it represented a “half-truth”). The plaintiffs in Leidos did not need to pursue a “pure omission” theory to advance a viable claim, or even to increase their complaint’s settlement value. Whichever way the Supreme Court decides the case, Grundfest contends, it will be remanded to so that the lower courts can resolve the half-truth claim that exists independently of the Item 303 pure omissions claim.
Grundfest points out that even if theoretically there were a pure omission that misled investors but that generated no actionable half-truth such that investors could pursue a Rule 10b-5 claim, the Commission itself would have “unquestioned authority” to prosecute the claim under Section 13(a) of the Securities and Exchange Act. Section 13(a) is a strict liability provision that does not require the demonstration of scienter, meaning that is it easier for the Commission to pursue a Section 13(a) proceeding than an equivalent Rule 10b-5 case. The Commission’s agenda with not be affected by the outcome in Leidos, Grundfest contends. (This argument about the Commission’s enforcement authority seemingly represents an implicit response to the position the Solicitor General’s office took in its amicus brief in Leidos that Item 303 omissions are actionable under Rule 10b-5 as well as under Section 13.)
One argument that the Solicitor General’s office raised in its amicus brief filed is the argument that the item 303 omission would be actionable if the periodic filing document included the additional statement that the “MD&A section contains all of the information required by Item 303.” The absence of the express statement should not make a difference, the government and the plaintiff respondent argue, as reasonable investors understand and accepts the same representation implicitly. Grundfest argues under the statutes, rules, and applicable precedent, “the better interpretation is that pure omissions are to be addressed exclusively by the Commission under Section 13(a).”
None of this, Grundfest says, should be interpreted to suggest that the cert was improvidently granted in the case. There is “a virtue in semantic consistency among the lower courts, and a clear Supreme Court opinion describing the scope of Section 10(b) liability, if any, for pure omissions will contribute to a judicial efficiency.”
While Grundfest contends that “Rule 10b-5 cannot comfortably be interpreted to create liability for pure omissions,” the text of the statute and of the rule, as well as relevant precedent “all militate against such a conclusion.” All of that said, “no one should expect great changes in litigation practice as a consequence of Leidos.” Most importantly, Grundfest argues, “A holding in Leidos that Rule 10b-5 cannot support pure omission liability will therefore not open the floodgates for fraud in the form of pure omissions.”
Professor Grundfest is not the first to suggest that the outcome of the question of whether or not an omission under Item 303 is actionable under Rule 10b-5 may not make much of a difference. In an earlier post on his D&O Discourse blog (here), Doug Greene of the Lane Powell firm argued that “as a practical matter, a claim under Item 303 doesn’t add much, if anything, to a plain vanilla claim alleging that a statement was misleading for omitting the same information.”
While Professor Grundfest contends that the outcome of Leidos may not make that much of a difference in practical terms, he did concede the importance of having the Supreme Court address what the Second Circuit itself described in the Leidos case as a split in the circuit on the issue of whether or not an omission under Item 303 is actionable under Rule 10b-5. While it may be true as Grundfest contends that “reasonable minds differ as to whether the split is semantic or substantive,” from my perspective if you have different Circuit courts saying different and contrasting things you risk the possibility of a difference in outcomes based only on the circuit in which a case has pending. So the importance of having the Supreme Court address this question is, in my mind, more than just a matter of achieving “semantic consistency among the lower courts.”
There is another reason why, despite all of the points that Grundfest has raised, that I still think the Leidos case is important. Simply put, the question of whether or not an omission under Item 303 is actionable under Rule 10b-5 comes up frequently. Plaintiffs’ lawyers, armed with the benefit of hindsight, look back at the company’s later statements and contend that the information disclosed in later statements should have been disclosed earlier under the requirements of Item 303 in the “management discussion and analysis” section of the annual reports on Form 10-K. If for no other reason than the frequency with which these issues arise, it is important for the Supreme Court in the Leidos case to provide clear guidance for the district courts to follow on these issues. (To be sure, even if plaintiffs cannot frame their claims this way, they can, as Grundfest suggests, easily reframe the same claims based on alleged half-truths, but the plaintiffs’ reliance on Item 303 will be cut.)
There is another reason why I think the Leidos case will be important. This additional consideration has to do with the way the Item 303 issue is often framed in the district courts. The disputes in the district courts about Item 303 often have to do with a separate question. It is well-established under the federal securities laws that absent a duty to speak, a failure to speak cannot be actionable. The fight in the federal district courts about Item 303 is often framed in terms of whether or not Item 303 creates a duty to speak.
Under Professor Grundfest’s analysis, this dispute about whether Item 303 creates a duty to speak is misplaced; the duty to speak alone is not sufficient to create liability under Rule 10b-5 to create a liability. The question is whether an Item 303 omission alone creates an actionable duty to speak. Clearly, even with a duty to speak, there could be no liability without satisfaction of all of the other requirements for liability under Rule 10b-5 (materiality, scienter, loss causation, etc.). In Grundfest’s view, even if Item 303 creates a duty to speak, there can be no liability under Rule 10b-5 for an Item 303 omission unless the omission itself made another affirmative statement false or misleading; the “pure omission” of disclosure supposedly required by Item 303 does not support liability under Rule 10b-5.
In my view, the district courts would benefit from clarification on these issues. The clarification will not only aid the lower courts to sort through these issues, but even more importantly will help avoid a divergence of outcomes on these issues.