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Federal litigation about the duty of public companies to disclose material trends affecting their business has slowly been gaining momentum. Recent highly publicized revelations concerning inadequate disclosure by major corporations will give further impetus to securities complaints alleging that those who have fallen failed to alert investors in a timely fashion to obvious adverse trends. There is little likelihood that the federal judiciary will prove to be indifferent to the media clamor about incomprehensible off-the-books transactions, dubious accounting practices or unchecked self-dealing in public companies. [FOOTNOTE 1] It behooves all, therefore, to be aware of a controlling regulation known as Item 303. Section 229.303 of title 17 of the Code of Federal Regulations (known as Item 303 and entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) has existed in one form or another for two decades, although in recent years it has assumed new importance. Item 303 spells out what must be disclosed in a public company’s annual Form 10-K and its quarterly Form 10-Q, both filed with the Securities and Exchange Commission, with regard to significant changes in its financial condition and results of operations. MATERIAL TRENDS DISCLOSURE On the Form 10-K, the company must disclose material trends affecting its capital, liquidity, sales, revenues or income. Specifically, the company has to “identify any known trends or any known demands, commitments, events or uncertainties that will result in or are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way,” whether in the short or long term. [FOOTNOTE 2] The company also must describe “any known trends, favorable or unfavorable, in [its] capital resources.” [FOOTNOTE 3] If there are “any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations,” these must be disclosed. [FOOTNOTE 4] Likewise, there must be disclosure of any “known trends or uncertainties” that have had or reasonably may have a “material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” [FOOTNOTE 5] With a couple of minor exceptions, the same information is required on the Form 10-Q where there have been any material changes in those items since the most recent report. [FOOTNOTE 6] DEFINING ‘TREND’ Materiality is a familiar term of art to lawyers, in general and as parsed in securities law for nearly 70 years. But when does a complex array of facts reveal a “trend” that must be disclosed? What exactly is a trend: a business, economic or legal concept? Item 303 does not address this. Undeterred by such ambiguity, lawyers representing plaintiffs in securities class actions gradually came to view Item 303 as a possible basis for holding public companies liable for material misstatements and omissions. Item 303 was often linked with SEC Rule 10b-5, which prohibits material misrepresentations and omissions in connection with the purchase or sale of a security. Rule 10b-5 creates a private right of action for damages. [FOOTNOTE 7] Did Item 303 likewise create a private right of action for a person allegedly damaged by a company’s failure to disclose a material trend affecting its revenues or finances? This was long an open question. Some plaintiffs’ counsel argued without success that Item 303 in itself creates a private cause of action for private plaintiffs. [FOOTNOTE 8] Others contended that if there was a violation of Item 303, because a material trend should have been but was not disclosed in SEC filings, there was necessarily also a material nondisclosure creating liability under Rule 10b-5. Most courts, however, were unwilling to endorse that equation categorically, insisting instead that materiality for Rule 10b-5 purposes be viewed under traditional, normative fact-based criteria as to when a duty to disclose arose. [FOOTNOTE 9] The most a court would say about Item 303 in terms of private liability claims was that any failure to disclose material trends under Item 303 would be “relevant” to determining Rule 10b-5 liability. [FOOTNOTE 10] For the most part, the courts, while focused on materiality, seemed to assume they needed no definition of a “trend.” At least two federal judges in Manhattan assumed in recent decisions that a failure to comply with Item 303 in a registration statement or prospectus can constitute a violation of the registration provisions of the securities laws (� 11 of the 1993 Securities Act), leading to a damage claim. [FOOTNOTE 11] Even so, the 3rd U.S. Circuit Court of Appeals ruled in 2000, that does not apply to disclosures made outside a prospectus, which are governed by Rule 10b-5. [FOOTNOTE 12] No court, the 3rd Circuit noted, had accepted the proposition that a violation of Item 303 gives rise to a private cause of action. [FOOTNOTE 13] That was arguably correct then but it remained so for only a few months, when the 2nd Circuit decided a Rule 10b-5 case concerning the educational publisher Scholastic. [FOOTNOTE 14] ‘SCHOLASTIC’ Scholastic regularly treated as income the proceeds of any book it sold to a retailer or distributor, even though there was a full right of return. In book publishing, the level of profitability partly depends on the volume of returns. Even after Scholastic learned its returns had begun to increase significantly, it continued to advise industry analysts that returns were running at normal levels. Shortly after that, the company twice took sizable pre-tax special charges to set up reserves for unanticipated book returns. The Court of Appeals, reversing a lower court, found in Scholastic that a violation of Item 303 had been adequately pleaded. Without discussion, the appellate court treated the Item 303 violation as a Rule 10b-5 violation. Scholastic allegedly had access to detailed information showing a widespread drop in sales and a sharp increase in returns before it advised industry analysts that its returns were at normal levels. If company officials, after stating that books “were selling well” in the customarily slow summer months, learned that books were not selling well during the usually busier fall and winter months, it was reckless of them not to acknowledge that this would affect the stock price. Thus, the complaint adequately pleaded that company officials knew of a “material downward secular trend” that should have been disclosed. Critical to the holding in Scholastic was the Court of Appeals allowing the plaintiff shareholders to use data and other information from both before and after the period of alleged nondisclosure to prove what company officials knew or should have known then. [FOOTNOTE 15] This was not considered to be permitting the pleading of “fraud by hindsight.” [FOOTNOTE 16] Although the 2nd Circuit stated it does not require the pleading of “detailed evidentiary matter” in securities litigation, [FOOTNOTE 17] the Private Securities Litigation Reform Act of 1995 does require a pleading to create a “strong inference” of fraud and does prevent discovery, without prior court approval, prior to a decision on a motion to dismiss the complaint for insufficiency. [FOOTNOTE 18] That has come to mean that class action securities complaints are front-loaded with details and do not resemble other federal “notice” pleadings. Plaintiffs in Scholastic had what probably is atypical access at the pleading stage not only to written reports, both internal and external, but also to employee statements confirming decreasing sales and increasing returns. [FOOTNOTE 19] The evidence-laden complaint in Scholastic was held sufficient to create an issue of fact as to the company’s claim that its business was so inherently cyclical that no trend had been shown. [FOOTNOTE 20] Still, the Court of Appeals offered little general insight as to how and when a business person, upon becoming aware of unwelcome information about the company’s capital, sales, revenues or finances, should know whether he or she is faced with a “trend.” In re NBTY, Inc. Securities Litigation [FOOTNOTE 21] accepted the reasoning of Scholastic that a violation of Item 303 created liability under Rule 10b-5. However, the district court distinguished Scholastic on the facts, finding that the alleged trends in each instance were pleaded in vague and conclusory fashion, without specific internal or industry data or identified documentary sources. No trends were adequately alleged, the court held, albeit without explaining what a material trend is. For the time being, then, the 2nd Circuit stands alone in treating a failure to identify a material trend in a Form 10-K or 10-Q filing as sufficient predicate for a violation of Rule 10b-5. This means that those filings, already seen as fertile ground for civil complaints, become all the more important to both sides in Rule 10b-5 litigation. CONCLUSION After Scholastic, it has become difficult for a company to argue that, for any issue (such as product sales) as to which Item 303 requires disclosure of material trends, the company need only provide material raw data, without connecting the dots and explicitly noting a negative trend. Many public companies, of course, will resist such doom-saying, preferring to regard as transitory what disinterested investors might view as inevitable. For lawyers representing public companies, the corporate specialists on the transactional side and the securities litigators will increasingly need to hear and accommodate each others’ sometimes competing concerns about how much to disclose about possibly material adverse trends and when to do so. Neither the regulators nor the courts have given bright-line guidance about these issues to the transactional or the litigation lawyers in the securities field. As they make decisions with their clients, each will need to have in mind that judges and juries only view these disclosure issues in clairvoyant hindsight. The price of a misjudgment may, in today’s climate, prove dear. Robert H. Hermann is counsel at Thacher Proffitt & Wood. ::::FOOTNOTES:::: FN1 Witness, for example, Judge Shira Scheindlin’s 238-page decision denying in substantial part the motions to dismiss the consolidated complaint against several major investment banks in connection with their practices concerning initial public offerings from 1998 to 2000, In re Initial Public Offering Securities Litigation, 21 MC 92 (U.S.D.C., S.D.N.Y. Feb. 19, 2003). FN1 17 C.F.R. �303(a)(1). FN1 17 C.F.R. �303(a)(2)(ii). FN1 17 C.F.R. �303(a)(3)(i). FN1 17 C.F.R. �303(a)(3)(ii). FN1 17 C.F.R. �303(b). FN1 Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). FN1 Oran v. Stafford, 226 F.3d 275, 287 (3rd Cir. 2000). FN1 Id.; In re Canandaigua Securities Litigation, 944 F.Supp. 1202, 1209 1210 (S.D.N.Y. 1996); In re Campbell Soup Co. Securities Litigation, 145 F.Supp.2d 574, 590-591 (D.N.J. 2001). On materiality standards, see Basic v. Levinson, 485 U.S. 224, 239 n. 17 (1988). FN1 In re Quintel Entertainment Inc. Securities Litigation, 72 F. Supp. 283, 293 (S.D.N.Y. 1999). FN1 DeMaria v. Andersen, 153 F. Supp.2d 300, 311 (S.D.N.Y. 2001); Milman v. Box Hill Systems Corp., 72 F. Supp.2d 220, 232 (S.D.N.Y. 1999);. FN1 Oran, 226 F.3d at 288n.9. FN1 Id. at 287. FN1 In re Scholastic Corp. Securities Litigation, 252 F.3d 63, 69 (2d Cir.), cert. denied sub nom. Scholastic Corp. v. Truncellito, 122 S.Ct. 678 (2001). FN1 252 F.3d at 72, citing Rothman v. Gregor, 220 F.3d 81, 92 (2nd Cir. 2000). FN1 Shields, v. Citytrust Bancorp, Inc., 25 F.32 1124, 1129 (2nd Cir. 1994). FN1 252 F.3d at 72. FN1 15 U.S.C. � 78u-4(b)(2); 15 U.S.C. � 78u-4(b)(3)(B). FN1 In response to the congressional shackles created by the 1995 Reform Act, resourceful class action securities counsel have obtained the equivalent of discovery, even before a case is filed, from disgruntled former (and perhaps terminated) officers and employees of the company in question — which, judging by the shareholder disaffection vented in the litigation, may have fallen on hard times. FN1 252 F.3d at 73-74. FN1 224 F.Supp. 2d 482 (E.D.N.Y. 2002). If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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