Margaret A. Dale and Mark D. Harris ()
Can a company be sued for securities fraud for omitting from its public filings information required to be disclosed by an SEC regulation? That is the question the U.S. Supreme Court recently agreed to address in Leidos v. Indiana Public Retirement System. The answer could have a profound impact on the volume of investor-driven securities litigation and the types of disclosures companies would have to make to attempt to avoid claims of securities fraud.
At issue in Leidos is Item 303 of the SEC’s Regulation S-K, also known as Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A). Item 303 requires the issuer to describe in its regular filings “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.” Essentially, the regulation calls for forward-looking statements based on management’s analysis of risks, market trends, or other circumstances that they believe are likely to have a material impact on the company’s performance.
The Ninth and Second Circuits have split over whether Item 303 creates a duty to disclose that can give rise to liability for securities fraud under §10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 (collectively, §10(b)). The Ninth Circuit has held that Item 303 creates no such duty while the Second Circuit has held that it does, and that an omission under Item 303 can form the basis of a securities fraud claim if it meets Rule 10b-5′s materiality requirements. Interestingly, both circuits rely on divergent interpretations of the same Third Circuit case decided in 2000 by then-Circuit Judge Samuel Alito.
In a 2014 case called In re NVIDIA Corp. Securities Litigation, the Ninth Circuit held that Item 303 does not create a duty to disclose that is actionable under §10(b). 768 F.3d 1046, 1054 (9th Cir. 2014). There, NVIDIA was accused of delaying disclosure of a known defect in silicon chips that it manufactured and sold to major technology companies. The shareholders argued that the failure to make this Item 303 disclosure in the company’s 10-K and 8-K filings constituted a material omission for purposes of securities fraud.
While the Ninth Circuit agreed that Item 303 requires disclosure of certain information, it held that Item 303 does not create a duty to disclose for purposes of §10(b). Instead, “[d]isclosure is required under these provisions only when necessary ‘to make … statements made, in  light of the circumstances under which they are made, not misleading.’” Id. at 1054 (quoting Matrixx Initiatives v. Siracusano, 563 U.S. 27 (2011) (emphasis added)). In other words an omission, standing alone, cannot form the basis of a securities fraud claim; omissions become actionable when there is a duty to disclose the information to correct an otherwise misleading statement.
Citing the Third Circuit’s decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000) (Alito, J.), the Ninth Circuit went on to highlight the difference between the materiality standards set forth by the SEC for Item 303 and by the Supreme Court in Basic v. Levinson for securities fraud. While Item 303 requires disclosure where management determines that an event or uncertainty is both likely to occur and will have a material effect on the company, Basic requires a narrower balancing of the probability that an event will occur with the magnitude of its potential impact.1 The Ninth Circuit interpreted this difference to mean that the SEC’s materiality threshold was lower than that set for §10(b); in other words, that Item 303 would require disclosure of more information than that required under the Basic test. Finding the standards dissimilar, the court concluded that an Item 303 violation, absent the need to correct an otherwise misleading statement, cannot form the basis of securities fraud liability. Instead, “such a duty to disclose must be separately shown.”
Thus, in the Ninth Circuit, while the SEC has enforcement authority to ensure compliance with its rules, companies that violate Item 303 will not face private claims of securities fraud on that basis alone.
Just three months after NVIDIA, the Second Circuit reached a different conclusion in Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 101-05 (2d Cir. 2015). Although affirming the complaint’s dismissal for failure to adequately plead scienter, the court held that Item 303 creates an affirmative duty to disclose that can give rise to liability for securities fraud. While a violation of Item 303 does not automatically trigger liability under §10(b), the court found that it can form the basis of such a claim, so long as the omission meets the materiality requirements set forth in Basic v. Levinson.
The Second Circuit also relied on the Third Circuit’s decision in Oran v. Stafford. The court interpreted Oran as leaving the door open to the possibility that Item 303 creates a duty to disclose that could be actionable under §10(b). It noted that according to the Third Circuit, the omissions “in that case” did not meet the materiality threshold under Basic, implying that the result could be different where the omission is sufficiently material.2
While the Ninth Circuit, citing the Supreme Court’s decision in Matrixx Initiatives, stressed that “material information need not be disclosed unless omission of that information would cause other information that is disclosed to be misleading,” the Second Circuit in Stratte-McClure, citing to Second Circuit precedent, stated that statutes or regulations requiring disclosure can create a duty to disclose even where there is no misleading statement to correct. That is to say, a standalone omission can give rise to liability where a statute or regulation requires disclosure.
One of the court’s reasons for treating a standalone omission as a basis for securities fraud (assuming all other requirements are met) was that it viewed an omission in the face of a regulation requiring disclosure as an affirmative statement. The court emphasized:
A reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties … that the registrant reasonable expects will have a material … unfavorable impact on … revenues or income from continuing operations.
(citing 17 C.F.R. Sec. 229.303(a)(3)(ii)).
While Stratte-McClure formed the basis of the circuit split, the case on appeal to the Supreme Court is Indiana Public Ret. System v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016).3 In SAIC (which involved a company now called Leidos), investors claimed that the company should have disclosed under Item 303 its exposure to liability for a kickback scheme perpetrated by two program employees in connection with a New York City contract for work on a timekeeping system called CityTime. By the time of the filing at issue, which made no disclosure under Item 303, the company had removed the offending project manager, hired an outside law firm to conduct an internal investigation into possible fraud, and received an audit report showing the manager’s improper timekeeping practices.
The Supreme Court ultimately granted certiorari to answer the question of whether Item 303 of the SEC Regulation S-K creates a duty to disclose that is actionable under §10(b).
What to Expect
If the Supreme Court sides with the Second Circuit in this split, expect to see a few different developments. First, a holding that Item 303 creates a duty to speak could open the floodgates to dozens of other SEC regulations forming the basis for securities fraud liability. That could lead to a significant increase in §10(b) cases based on violations of SEC Item 303 (or other regulations). And third, a decision in line with the Second Circuit would also leave companies to grapple with ambiguity about the contours of materiality as it relates to “trends and uncertainties,” leading to increased litigation on that point. Should the court reject the Second Circuit’s position, on the other hand, the playing field will be reset to pre-Stratte-McClure jurisprudence.
1. Indeed, the Ninth Circuit took refuge in the SEC’s own Exchange Act Release No. 34-26831, 54 Fed. Reg. at 22430 n. 27, which explicitly acknowledges the significant difference between the materiality standards for Item 303 and §10(b).
2. While the Ninth Circuit might agree with the Second that Oran did not decide whether Item 303 creates an affirmative duty to disclose that could give rise to 10(b) liability, the Ninth Circuit interpreted the Third Circuit’s reasoning, in particular the significant difference between the materiality tests for Item 303 disclosures and for §10(b) liability, to require the opposite result.
3. It is possible that the Supreme Court chose to take up Leidos instead of Stratte-McClure because Stratte-McClure found that the plaintiffs had failed to adequately plead scienter, rendering its decision on Item 303 immaterial to the outcome.