Facebook is well known as a social platform on which users share information with others. In an ironic twist, Facebook is now the subject of a class action lawsuit alleging that Facebook itself had failed to share information—in this case, with investors in its 2012 IPO regarding intra-quarter trends affecting its business prior to the offering.
Facebook concerned an allegation that, under Item 303 of SEC Regulation S-K, the defendants violated their duty to disclose that the company was aware of a projected material negative impact on its revenues as a result of increasing use of the company’s mobile platform, to the detriment of the then-more lucrative desktop version of Facebook. The existence of this trend was allegedly evidenced by, among other things, the company’s changes to its internal projections that were then shared with syndicate analysts.1 Refusing to dismiss plaintiffs’ complaint at the pleading stage, the court (Judge Robert W. Sweet) found that although there is generally no duty to disclose intra-quarter results, the fact that the trend toward mobile use of Facebook was identified intra-quarter “is of no issue” because under Item 303, there was still a duty to disclose such a trend as well as the expected impact on Facebook’s revenue.2
Taken against the backdrop of two recent decisions from the U.S. Court of Appeals for the Second Circuit concerning Item 303, Facebook provides some important lessons concerning disclosures of a “trend” identified intra-quarter that has not yet materially affected revenues, sales, or income, but which arguably should be disclosed because such a trend is “reasonably expected” to have a material effect. And while the apparent lack of bright line rules in this area is challenging for issuers, underwriters, and securities lawyers, one clear take aware from these cases is that the disclosure or not of intra-quarter information (and what constitutes sufficient disclosure of such information) is a topic that deserves ample attention from issuers and underwriters in all offerings.
As a general matter, there is no duty to disclose the “results of a quarter in progress.”3 That is because the “disclosure structure set out by the SEC … recognizes how unworkable and potentially misleading a system of instantaneous disclosure out [of] the normal reporting periods would be.”4
Because of this principle, “the case law reflects that ‘courts have been reluctant to impose liability based upon a failure to disclose financial data for a fiscal quarter in progress … .’”5 On this basis, courts have dismissed cases where, for instance, plaintiffs alleged that in light of the fact that the third quarter would close only three days later, defendants knew, or were reckless in not knowing, that the company would actually generate lower gross margins in the third quarter than suggested by its disclosed revenue and income projections.6 In another case, a court cited this principle in dismissing allegations that a company should have disclosed, intra-quarter, a reduction in sales volume to its largest customer.7
Nevertheless, in a doctrine that is easy enough to articulate in judicial decisions but more difficult to apply in the real world, courts have also held that “intra-quarter updates may be required if intervening events trigger a duty to disclose….”8 For instance, courts have noted that “updating might be required if a prior disclosure [had] become materially misleading in light of subsequent events.”9 Thus, for example, a court in the Southern District of New York found in 2010 that a complaint adequately alleged securities fraud where it averred that Merrill Lynch’s undisclosed losses of October 2008, the largest monthly losses in the company’s history, should have been disclosed in a joint proxy statement issued in November 2008 in connection with Merrill’s acquisition by Bank of America. While the proxy “painted a grim portrait of Merrill’s near-term and medium-term prospects,” the court found that such disclosure could be insufficient where the defendants were allegedly already aware that Merrill had suffered historically large losses in October.10
As demonstrated by Facebook, one reason that issuers and underwriters must be concerned in particular with disclosing material “trends” occurring intra-quarter is because of the obligations imparted under Item 303 of SEC Regulation S-K, which requires disclosure of all “known trends … 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.”11 Item 303 applies to securities offerings (i.e., registration statements), tender offer statements, annual and quarterly reports, as well as any other documents required to be filed under the Exchange Act.12 In interpreting Item 303, the SEC has cautioned that, “a disclosure duty exists where a trend … is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operation.”13
In applying Item 303, the court in Facebook looked to two recent precedents from the Second Circuit. In Litwin v. Blackstone Group, the Second Circuit vacated Judge Harold Baer’s dismissal of a complaint that alleged that the downward trend in the real estate market was already known and existing at the time of Blackstone’s IPO, and that disclosure was required because the trend or uncertainty in the market was reasonably likely to have a material impact on Blackstone’s financial condition.14 The Second Circuit held that plaintiffs were not required to identify in their complaint any “specific real estate investments made or assets held by Blackstone funds that might have been at risk as a result of the then-known trends in the real estate industry.”15 Rather, it was actionable that Blackstone had allegedly failed to disclose how “particular investments might be materially affected by the then-existing downward trend” in the housing market.16
In 2012, the Second Circuit had the opportunity to expand on its Rule 303 jurisprudence in Panther Partners v. Ikanos Communications. There, plaintiffs alleged violations of the Securities Act based on the failure to disclose in equity offering documents known defects in the company’s semiconductor chips. The Second Circuit held that the complaint plausibly alleged that the defect should have been disclosed under Item 303. Among other things, the plaintiffs alleged that the company was receiving increasing complaints about the chips and that the problem had risen to the level of the company’s board of directors. In addition, the court noted the allegations that the complaining customers accounted for 72 percent of revenue for the prior year and that the company knew at the time of the complaints that it would be unable to determine which particular chip sets contained defective chips. Thus, the court held that the complaint gave rise to a plausible inference that the company knew it had sold faulty chips to its largest customers and that it “may therefore have to accept returns of all the chips that it had sold to these two important customers.”17 The court, citing Litwin, also held that it “goes without saying that such ‘known uncertainties’ could materially impact revenues” and therefore such information must be disclosed.18
Applying Item 303 in deciding the motion to dismiss in Facebook, Sweet first noted that the Facebook defendants did not automatically violate the law when they decided not to disclose updated internal second quarter and yearly projections. In fact, the court noted a long line of cases holding that there is no general obligation to disclose internal forecasts or even changes to internal forecasts.19
However, the court found the fact that Facebook allegedly changed its internal projections as a result of the growing shift toward Facebook’s mobile platform and then made calls to syndicate analysts to inform them of the reduced estimates gave rise to a plausible inference that Facebook “had identified a trend leading up to its IPO alleged to be material.” The court therefore upheld the complaint on the reasoning that “Item 303 does require the disclosure of a company’s analysis of the future impact of a material trend or the impact such trend currently has on an issuer.”20
Notably, the court found that Facebook had made “significant disclosures” on the issue, including that “if users continue to increasingly access Facebook mobile products as a substitute for access through personal computers, and if we are unable to successfully implement monetization strategies for our mobile users, our revenue and financial results may be negatively affected. ” However, the court went onto find that “ these disclosures satisfy only part of Defendants’ Item 303 obligations.”21
Finding that “identification of a past trend does not satisfy a company’s disclosure obligations under Item 303″ because “Item 303 requires specific disclosure of whether, and to what extent a material trend has impacted or is expected to impact future revenues,” the court held that the complaint sufficiently alleged, for pleading purposes only, that Facebook had used terms that were too “generalized and indefinite” to describe “the impact the increase of mobile users and product decisions could have had on the company’s revenues and financial results.”22
Turning to the materiality of the alleged misstatements and omissions, the court purported to apply the familiar standard that a “statement or omission is considered material if ‘viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available.’”23 In holding that materiality had been sufficiently pled, the court noted the allegations that Facebook had reduced its revenue figures for the second quarter of 2012 in its internal projections by more than 8.3 percent, and that the company also cut its revenue figures for the year by as much as 3.5 percent. The court further relied on the allegation that Facebook’s registration statement “repeatedly highlighted that Facebook’s revenue and advertising revenue was Facebook’s most significant financial metric.” In addition, the court found that the allegation that Facebook had called syndicate analysts (who were considering the price and quantity of shares to be issued) to inform them of the change in internal projections supported a finding that the complaint had adequately alleged materiality. Thus, the court determined that the complaint sufficiently alleged securities fraud to survive a motion to dismiss.24
Lessons From ‘Facebook’
Mere General Risk Disclosure May Be Insufficient Where the Specific Risk Has Materialized Already. Facebook provides an important reminder that, although there is precedent to the contrary,25 courts may take a negative view toward disclosures that they perceive to warn about a risk in the face of allegations that the risk had already materialized. In Facebook, the court noted that plaintiffs alleged that Facebook misled investors when it warned that increased mobile usage and product decisions “‘may negatively affect [Facebook's] revenue’ when, in fact, these factors allegedly already ‘had negatively impacted [the company's] revenue.’” The court found that such contentions supported an allegation that Facebook’s “purported risk warnings misleadingly represented that this revenue cut was merely possible when, in fact, it had already materialized.”26
Other courts have taken a similar view with respect to disclosure allegations. In Panther Partners, the Second Circuit held that the company’s representation that its products “‘frequently contain defects and bugs’ was incomplete and … did not fulfill [the company's] duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks leading up to the secondary offering.”27
Mere Identification of a Trend May Be Insufficient Where the Effects of the Trend Can Be Quantified. While Facebook suggests that courts may increasingly require disclosure of the existence of so-called “trends” under Item 303, it also shows that courts may find even such disclosure to be insufficient where a company fails to also disclose the “extent” of the impact of such trend. Thus, Facebook suggests that issuers and underwriters must be thoughtful as to the amount of detail they disclose with respect to known material trends.
As the Second Circuit held in Panther Partners and Litwin, Item 303 requires disclosure not just of a trend, but also “whether, and to what extent” that known trend “might reasonably be expected to materially impact … future revenues.”28 The SEC’s guidance supports the need for caution in this area. The SEC has stated that if “[m]anagement is unable to determine that a material effect … is not reasonably likely to occur,” then “disclosure of the effects of [the known trend, development or uncertainty], quantified to the extent reasonably practicable, would be required.”29 Caution is especially required where, at least as alleged in Facebook, a company has already internally quantified such effect. As the SEC advised in a 2003 Release, “Quantitative disclosure … may be required to the extent material if quantitative information is reasonably available.”30 And the mere fact that such quantitative disclosure may seemingly be speculative may not be enough of a reason to withhold such disclosure; under guidance from the SEC, such a duty may exist even where the “required disclosure regarding the future impact of presently known trends, events or uncertainties [under Item 303] may involve some prediction or projection.”31
Thus, as the court in Facebook put it, “the mere identification of a trend is, in some cases, not sufficient disclosure.”32 Companies, as well as their underwriters and counsel, must therefore consider not just whether a “trend” has sufficiently materialized (and is sufficiently material) to warrant disclosure, but also whether disclosure is required of the projected impact of such a trend.
Companies Must Have Adequate Internal Controls For Evaluating Trends and Should Consult Experienced Counsel for Judgments That Do Not Turn on Quantitative Tests. In light of a recent focus by the plaintiffs’ bar on “trend” litigation,33 it is prudent for issuers to ensure that they have sufficient controls in place to evaluate and understand “trends” that are known to management that could materially impact the company’s fortunes. In addition, the highly fact-specific nature of cases such as Facebook demonstrate the importance of consulting skilled counsel with experience in determining the extent of disclosure obligations under the current state of the law. This is especially so in light of the Second Circuit’s holding that “Item 303′s disclosure obligations … do not turn on restrictive mechanical or quantitative inquiries.”34
Courts Must Balance Obligations to Disclose With the Desire to Avoid a Continuous Disclosure Regime. In applying Item 303, the courts should be mindful that the SEC’s quarterly reporting system is premised on the recognition that “a system of instantaneous disclosure out [of] the normal reporting periods” would be “unworkable and misleading.”35 Thus, courts must be cautious to avoid requiring ever-more instantaneous reporting that would amount to the disclosure of mere “blips” on a large radar screen and that could ultimately serve to undermine the goals of the securities laws by confusing investors. Thus, while courts may, in certain cases, properly require disclosure of “trends” even though they have not yet had a material effect on quarterly results, requiring too much disclosure of perceived “trends” could serve to frustrate rather than assist investors seeking to understand a company’s prospects.
Cases like Facebook inevitably will be difficult to apply in a formulaic fashion to new offerings, because they provide no bright lines for determining what constitutes a “trend” or what constitutes sufficient disclosure regarding such “trend.” They nevertheless provide a reminder to issuers and underwriters that simply because a particular fact has not yet affected a company’s bottom line (as demonstrated through quarterly financial figures) does not mean (i) that there is no disclosure obligation, or (ii) that disclosure of the existence of the trend itself will be sufficient to avoid liability.
Gregg L. Weiner is the vice-chair of, and Israel David is a partner in, the global litigation department of Fried, Frank, Harris, Shriver & Jacobson. Adam M. Harris, a litigation associate of the firm, assisted in the preparation of this article.
1. See In re Facebook IPO Sec. & Derivative Litig., 2013 WL 6665399, at *13 (S.D.N.Y. Dec. 12, 2013).
2. See id., 2013 WL 6665399, at *19.
3. Arfa v. Mecox Lane, 2012 WL 697155, at *12 (S.D.N.Y. March 5, 2012), aff’d, 504 F. App’x 14 (2d Cir. 2012); see also Facebook, 2013 WL 6665399, at *19.
4. In re Turkcell Iletisim Hizmetler, A.S. Sec. Litig., 202 F. Supp. 2d 8, 13 (S.D.N.Y. 2001).
5. In re Focus Media Holding Litig., 701 F. Supp. 2d 534, 540 (S.D.N.Y. 2010) (quoting Schoenhaut v. American Sensors, 986 F. Supp. 785, 791 (S.D.N.Y. 1997)).
6. See Focus Media, 701 F. Supp. 2d at 539.
7. See Schoenhaut, 986 F. Supp. at 793.
8. In re Bank of Am. Sec. Corp. Derivative & ERISA Litig., 757 F. Supp. 2d 260, 304 (S.D.N.Y. 2010).
9. Id. (quoting In re Burlington Coat Factory, 114 F.3d 1410, 1432 (3d Cir. 1997)).
10. Id. at 305.
11. Regulation S-K, Item 303, 17 C.F.R. §229.303(a)(3)(ii); see also In Re SAIC Sec. Litig., 2014 U.S. Dist. LEXIS 13629 (S.D.N.Y. Jan. 30, 2014) (“actual knowledge” of trend required to trigger Item 303 disclosure obligation).
12. See Regulation S-K, Item 10.
13. See Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Release No. 6835, 54 Fed. Reg. 22427, 22429 (May 18, 1989) (1989 SEC Release); Facebook, 2013 WL 6665399, at *13.
14. See Litwin v. Blackstone Grp., 634 F.3d 706, 716 (2d Cir. 2011).
15. See id. at 721.
17. Panther Partners v. Ikanos Commc’ns, 681 F.3d 114, 121 (2d Cir. 2012).
19. Facebook, 2013 WL 6665399, at *13.
21. Id. at *18.
22. Id. at *17-18.
23. Facebook, 2013 WL 6665399, at *24 (quoting TSC Indus. v. Northway, 426 U.S. 438, 449 (1976)).
24. Facebook, 2013 WL 6665399, at *25. The defendants in Facebook are seeking to pursue an immediate interlocutory appeal of the decision, arguing that the ruling stands at odds with other decisions in the Second Circuit holding that the omission of interim financial information is actionable only where there is an “extreme departure” from past performance or anticipated financial results. See In re Noah Educ. Holdings Sec. Litig., 2010 WL 1372709, at *7 (S.D.N.Y. 2010); In re N2K, 82 F. Supp. 2d 204, 208 (S.D.N.Y. 1999), aff’d, 202 F.3d 81 (2d Cir. 2000).
25. See In re Noah Educ. Holdings Sec. Litig., 2010 WL 1372709, at *7-8 (S.D.N.Y. 2010); DeMaria v. Andersen, 318 F.3d 170, 181-82 (2d Cir. 2003).
26. Facebook, 2013 WL 6665399, at *20.
27. Panther Partners, 681 F.3d at 114-16; see also Bank of Am. Sec. Corp. Derivative & ERISA Litig., 757 F. Supp. 2d 260, 304 (S.D.N.Y. 2010); In re Prudential Secs. P’Ships Litig., 930 F. Supp. 68 (S.D.N.Y. 1996).
28. Panther Partners, 681 F.3d at 121 (quoting Litwin, 634 F.3d at 716).
29. 1989 SEC Release, 54 Fed. Reg. at 22,430.
30. Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release Nos. 33-8350; 34-48960, 68 Fed. Reg. 75,056, 75,062 (2003 SEC Release) (emphasis added).
31. See 1989 SEC Release, 54 Fed.Reg. at 22,429; 2003 SEC Release, 68 Fed. Reg. at 75,059.
32. Facebook, 2013 WL 6665399, at *17.
33. See, e.g., In McKenna v. SMART Techs., 2012 WL 3589655 (S.D.N.Y. Aug. 21, 2012) (complaint alleging company “‘was experiencing a precipitous decline in the demand for its interactive whiteboards, as the [c]ompany’s sales pipeline essentially began to dry up’ … plausibly allege[d] that the (imminent) decline in demand, and its potential impact on [the company's] business, ‘constituted a known trend or uncertainty that [the company] reasonably expected would have a material unfavorable impact on revenues or income.’”).
34. Panther Partners, 681 F.3d at 122.
35. Turkcell, 202 F. Supp. 2d at 13.