(Article from Securities Law Alert, January 2015)
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Item 303 of Regulation S-K sets forth the disclosure requirements for the Management’s Discussion and Analysis (MD&A) section of a public company’s Form 10-Qs and other SEC filings. In relevant part, Item 303 states that a public company must “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” 17 C.F.R. § 229.303(a)(3)(ii).
On January 12, 2015, the Second Circuit held “as a matter of first impression … that a failure to make a required Item 303 disclosure … is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim.” Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. 2015) (Livingston, J.). However, the Second Circuit found that “such an omission is actionable only if it satisfies the materiality requirements outlined in [Basic Inc. v. Levinson, 485 U.S. 224 (1988)], and if all of the other requirements to sustain an action under Section 10(b) are fulfilled.”
Second Circuit Finds That Failing to Make Required Item 303 Disclosures Could Render Form 10-Qs and Other SEC Filings Misleading Under Section 10(b)
The Second Circuit determined that “Item 303’s affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b)” because “omitting an item required to be disclosed on a 10-Q can render that financial statement misleading.” The court explained that “Form 10-Qs are mandatory filings that ‘speak …to the entire market.’” Item 303 disclosures are “required elements” of Form 10-Q filings that “give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant’s financial condition and results of operations.” In view of the “obligatory nature” of Item 303 disclosures, the Second Circuit explained that “a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.’” The court therefore concluded that “Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).”
In so holding, the Second Circuit noted that it has “already held that failing to comply with Item 303 by omitting known trends or uncertainties from a registration statement or prospectus is actionable under Sections 11 and 12(a)(2) of the Securities Act of 1933” (citing Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012) and Litwin v. Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011)). The Second Circuit underscored the similarities between Section 10(b) of the Exchange Act and Section 12(a)(2) of the Securities Act: “Like Section 12(a)(2), Rule 10b-5 requires disclosure of ‘material fact[s] necessary in order to make … statements made … not misleading.’”
Second Circuit Clarifies That Omitting a Required Item 303 Disclosure Is Actionable Under Section 10(b) Only If the Disclosure Would Have Been Material Under Basic
The Second Circuit underscored that “[t]he failure to make a required disclosure under Item 303 … is not by itself sufficient to state a claim for securities fraud under Section 10(b).” Rather, the court found that “a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b-5 if the allegedly omitted information satisfies Basic’s test for materiality.” For purposes of “Section 10(b) and Rule 10b-5, the materiality of an allegedly required forward [ ] looking disclosure is determined [under the Basic test] by ‘a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’” Stratte-McClure, 2015 WL 136312 (quoting Basic, 485 U.S. at 224).
The Second Circuit explained that “[t]he SEC’s test for a duty to report under Item 303 … involves a two-part … inquiry” that is “different” from the test for materiality under Basic. When determining whether Item 303 mandates disclosure of a “known trend,” “management must make two assessments.” First, management must consider whether the known trend is “likely to come to fruition.” Second, in the event that “management cannot make that determination, it must evaluate objectively the consequences of the known trend … on the assumption that it will come to fruition.” Item 303 then requires disclosure of the trend “unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.” The Second Circuit noted that “[a]ccording to the SEC, this disclosure standard is unique to Item 303.”
The Second Circuit “conclude[d] that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b-5 if the allegedly omitted information [also] satisfies Basic’s test for materiality.” A plaintiff must first establish a duty to disclose by “alleg[ing] that the defendant failed to comply with Item 303 in a 10-Q or other filing.” Then, a plaintiff must “allege that the omitted information was material under Basic’s probability/magnitude test.” In addition, a plaintiff must satisfy the other elements of a Section 10(b) claim, including scienter, reliance, and economic loss caused by plaintiff’s reliance.
Second Circuit Disagrees with the Ninth Circuit’s Contrary Holding in In re NVIDIA Corp. Securities Litigation
The Second Circuit noted that its “conclusion is at odds with the Ninth Circuit’s recent opinion in” In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014) (O’Connell, J.).[1] There, the Ninth Circuit held that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” NVIDIA, 768 F.3d 1046. In reaching its decision, the Ninth Circuit relied on the Third Circuit’s decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). The Oran court found that “a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under [Section 10(b) and] Rule 10b-5.” Oran, 226 F.3d 275.
The Second Circuit determined that the Ninth Circuit had read the Third Circuit’s decision in Oran too broadly. In the Second Circuit’s view, the Oran court held that “a violation of Item 303 ‘does not automatically give rise to a material omission under Rule 10b-5’” given the differing standards of materiality that govern disclosures under Section 10(b) and Rule 10b-5 as compared with disclosures under Item 303. Stratte-McClure, 2015 WL 136312 (quoting Oran, 226 F.3d 275) (emphasis added). The Second Circuit found that “Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material [Rule] 10b-5 omission … as long as the omission is material under Basic, and the other elements of Rule 10b-5 have been established.”
The Second Circuit further stated that the Ninth Circuit had “misconstrue[d] the relationship between Rule 10b-5 and Section 12(a)(2) of the Securities Act.” Like the Second Circuit, the Ninth Circuit has held that “Item 303 creates a duty to disclose for the purposes of liability under Section 12(a)(2).” Stratte-McClure, 2015 WL 136312 (citing Steckman v. Hart Brewing, Inc., 143 F.3d 1293 (9th Cir. 1998)). The Second Circuit noted that “Section 12(a)(2)’s prohibition on omissions is textually identical to that of Rule 10b-5: both make unlawful omission of ‘material fact[s] … necessary in order to make … statements, in light of the circumstances under which they were made, not misleading.” The Second Circuit explained that “SEC regulations, like Item 303, dictate the contents of mandatory disclosures — be they Form 10-Qs in the case of Rule 10b-5 or prospectuses in the case of Section 12(a)(2) — and are therefore an essential part of the circumstances under which such disclosures are made.’”
Second Circuit Addresses the Contours of the Duty to Disclose Under Item 303
As to the specific disclosure obligations imposed by Item 303, the Second Circuit found that “‘generic cautionary language’ does not satisfy Item 303[,]” particularly if these disclosures are “spread out over several different filings” and are “unconnected to the [discussion of] the company’s financial position.” Rather than a “patchwork commentary on the relevant market trends,” the Second Circuit determined that “Item 303 requires [both] disclosure of the known trend and the ‘manner in which’ it ‘might reasonably be expected to materially impact’ a company’s overall financial position.” Stratte-McClure, 2015 WL 136312 (quoting Litwin, 634 F.3d 706).
The Second Circuit recognized, however, that “[t]he SEC has cautioned that [Item 303] requires ‘quantitative information’ only when it is ‘reasonably available and will provide material information for investors.’” The Second Circuit explained that the SEC “has never gone so far as to require a company to announce its internal business strategies or to identify the particulars of its trading positions.”
Second Circuit Finds Plaintiffs Failed to State a Claim Under Section 10(b) and Rule 10b-5 Based on Morgan Stanley’s Alleged Failure to Make Required Item 303 Disclosures
Turning to the allegations of the complaint before it, the Second Circuit determined that plaintiffs had adequately alleged that Morgan Stanley and several of its current and former officers had “breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market that, in light of the company’s exposure to the market, was likely to cause trading losses that would materially affect the company’s financial condition.” The court “assume[d], arguendo, that this omission was material under Basic.” However, the Second Circuit affirmed dismissal of plaintiffs’ claim for failure to plead scienter adequately.