Gregg Weiner ()
We live in the age of instant communication. But the long-standing rule under the federal securities laws is that “[s]ilence, absent a duty to disclose, is not misleading.” Basic v. Levinson, 485 U.S. 224, 239 n.17 (1988). Item 303 of SEC Regulation S-K requires that public companies disclose “any known trends and uncertainties” that have or will have a material impact on the business in public filings. There is no doubt that a violation of Item 303 can give rise to liability under the Securities Act of 1933, which allows civil lawsuits when a registration statement filed in connection with a public offering “omit[s] to state a material fact required to be stated therein.” What is less clear, however, is whether a violation of Item 303 can give rise to liability under §10(b) of the Securities and Exchange Act of 1934, which, pursuant to Rule 10b-5, makes 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 … not misleading” in connection with the purchase or sale of securities. The U.S. Supreme Court will decide the issue when it reviews a ruling from the Court of Appeals for the Second Circuit in Leidos v. Indiana Public Retirement System, holding that Item 303 creates a duty to disclose that can subject companies to civil liabilities for securities fraud under §10(b). A ruling by the high court, expected to come in the October 2017 term, could significantly impact the scope of potential liability for nondisclosures under §10(b) and change the disclosure practices of public companies.
Section 10(b) and Item 303
Section 10(b) of the Securities Exchange Act of 1934, through its implementing regulation, Rule 10b-5, makes it unlawful for any person 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 … not misleading” in connection with the purchase or sale of securities. 17 C.F.R. §240.10b-5. Neither §10(b) nor Rule 10b-5 expressly contemplate liability for omissions where no statement has been made at all—that is, when the speaker in question has remained silent on a particular subject. Thus, the Supreme Court had long held that “[s]ilence, absent a duty to disclose, is not misleading” and therefore does not give rise to liability under §10(b). Basic, 485 U.S. at 239 n. 17. As the Supreme Court has recognized, this allows public companies to “control what they have to disclose” under §10(b) “by controlling what they say to the market.” Matrixx Initiatives v. Siracusano, 563 U.S. 27, 45 (2011).
Item 303 is an SEC disclosure rule that requires companies to disclose “any known trends or uncertainties” that have or will have a material impact on “net sales or revenues or income from continuing operations.” 17 C.F.R. §229.303(a)(3)(ii) (2017). The SEC has explained that management should engage in the following process when evaluating trends or uncertainties under Item 303:
• First, determine whether the trend or uncertainty is “likely to come to fruition.” If management determines the trend or uncertainty is not “reasonably likely to occur,” then disclosure is not required.
• Second, if management cannot make a “likelihood” determination, then it should “evaluate objectively the consequences” of the known trend or uncertainty assuming that it will come to fruition. Disclosure is required unless management determines the trend or uncertainty is “not reasonably likely” to have a “material effect” on the company’s financial condition or results of operations. SEC MD&A Release, 1989 WL 1092885 at *6.
The rule applies to securities offerings, going-private transaction statements, tender offer statements, annual and quarterly reports, proxy and information statements, and any other documents required to be filed under the Exchange Act. Id. §229.10. Courts have uniformly held that Item 303 does not provide for a private right of action. Thus, a private plaintiff can only sue for an Item 303 violation if such a violation is independently actionable under the federal securities laws.
The Courts of Appeals are split on whether Item 303 may establish a “duty to disclose” giving rise to potential liability for nondisclosures under §10(b). In Oran, issued by then-Judge Alito in 2000, the Court of Appeals for the Third Circuit held that a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b-5″ because Item 303′s disclosure obligations “extend considerably beyond” those required by §10(b). Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000). In NVIDIA issued in 2014, the Ninth Circuit adopted the Third Circuit’s reasoning and held that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5,” because “[m]anagement’s duty to disclose under Item 303 is much broader than what is required” under Rule 10b-5. In re NVIDIA Sec. Litig., 768 F.3d 1046, 1054-56 (9th Cir. 2014). But the Second Circuit reached the opposite conclusion three months later, holding in Stratte-McClure v. Morgan Stanley that a failure to make a required Item 303 disclosure is “an omission that can serve as the basis for a Section 10(b) securities fraud claim,” so long as the other elements of a §10(b) claim are met. Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 100 (2d Cir. 2015). In so holding, the Second Circuit recognized that its conclusion was “at odds with the Ninth Circuit’s,” but reasoned that the Ninth Circuit’s decision had misapplied Oran and “misconstrue[d] the relationship between Rule 10b-5 and Section 12(a)(2) of the Securities Act.” Id. at 104.
The Second Circuit reaffirmed the holding of Stratte-McClure this past year in Leidos. Leidos is a large, publicly traded defense company that provides intelligence, security, and other services to government and commercial customers. In 2013, Leidos investors filed a putative class action asserting Rule 10b-5 claims against the company, alleging that, at the time Leidos issued its 2011 Form 10-K, it knew that it was under investigation for a billing fraud scheme which was likely to result in material liability for the company. The plaintiffs alleged that Leidos was required, but failed to disclose the company’s potential liability for billing fraud in its annual report pursuant to Item 303, and that this nondisclosure subjected Leidos to liability under Rule 10b-5.
The district court dismissed the complaint, but the Second Circuit reversed, holding that the plaintiffs had pled an actionable omission by alleging that Leidos’s annual report failed to disclose the threatened liability as a “known trend or uncertainty” under Item 303. The Second Circuit cautioned that while the alleged failure to disclose “trends, events, or uncertainties that it actually knows of when it files the relevant report with the SEC” may subject a company to liabilities for securities fraud,” it is “not enough that it should have known of the existing trend, event, or uncertainty.” Ind. Public Ret. Sys. v. SAIC, 818 F.3d 85, 95 (2d Cir. 2016) (emphasis added). Because the plaintiffs adequately alleged that Leidos was actually “aware of the [billing] fraud” and “uncertain about its likely effect on [the company's] current and future revenues” when it issued its annual report, the Second Circuit held that Leidos was required to disclose the matter under Item 303, and its failure to do so gave rise to a claim under §10(b). Id. at 96.
Leidos filed a petition for a writ of certiorari with the Supreme Court, arguing that the Second Circuit’s Item 303 holding was at odds with the law in other circuits and dramatically expanded the scope of omissions liability under §10(b). Petition for Writ of Certiorari at 17, Leidos v. Ind. Public Ret. Sys., No. 16-581 (Oct. 31, 2016). Leidos also argued that the Second Circuit’s approach would “encourage fraud-by-hindsight pleading” because Item 303 primarily concerns disclosure of “soft information,” such as predictions and opinions, which are not easily susceptible to objective verification. Id. at 25, 27. In response to the petition for Supreme Court review, the plaintiffs argued that Leidos unreasonably seeks “a blanket rule preventing Item 303 from ever serving as the basis for a duty to disclose in §10(b) cases,” id. at 22, and that the Second Circuit properly established a case-by-case approach by holding that only Item 303 violations that meet all the elements of a §10(b) claim (including materiality and scienter) will result in liability. Id. at 23-25.
The Supreme Court granted cert on March 27, 2017, and is expected to hear the case during the October 2017 term. A ruling in favor of Leidos—holding that Item 303 does not give rise to a duty to disclose under §10(b)—would limit federal securities suits premised on Item 303 violations to claims based on offering materials under the Securities Act. It would also ensure greater certainty for public companies making disclosure decisions by allowing them to “control what they have to disclose” under §10(b) “by controlling what they say to the market.” Matrixx Initiatives, 563 U.S. at 45.
On the other hand, a ruling affirming the Second Circuit would likely result in an increase in the number of Item 303 cases filed and could result in companies flooding the market with information in an attempt to ward off potential §10(b) liability. Importantly, such a ruling would also create increased uncertainty for issuers and their advisors attempting to determine their disclosure obligations under the federal securities laws. As an eminent physicist once said, “predictions are hard, especially about the future.”1 Yet companies would need to engage in a multi-step, wide-ranging, and fact-intensive judgment process regarding a number of contingent, but potentially material trends and uncertainties in order to comply with their disclosure obligations under §10(b). These forward-looking judgments regarding “uncertainties” would be fertile ground for second-guessing by plaintiffs’ attorneys with the benefit of hindsight.
The Second Circuit’s decision in Litwin v. Blackstone Grp., L.P., 634 F.3d 706 (2d Cir. 2011) provides a good example. There, in the months leading up to Blackstone’s IPO, some of its investments suffered losses due to the downturn in the real estate and mortgage securities markets. Blackstone did not specifically disclose this risk in the offering documents it filed in June 2007, but Blackstone did report significantly reduced annual revenues in subsequent quarterly filings. A lawsuit followed, and the Second Circuit ultimately held that the plaintiffs adequately alleged that Blackstone violated Item 303—and §11 of the Securities Act—by failing to disclose the manner in which the downturn in the real estate market “might reasonably be expected to materially impact Blackstone’s future revenues.” Id. at 719. Of course, the conclusion that a decline in revenues was “reasonably … expected” is much clearer with the benefit of hindsight—after the decline in revenues occurred. At the time of the offering, the real estate market had not taken a severe downturn, the financial crisis had not yet occurred, and management may well have expected that the slump in the real estate market was temporary. They guessed wrong, and substantial §11 exposure followed.
The Facebook IPO case provides an even starker example of how a company can face liability even where in hindsight it did not misjudge a business uncertainty. There, the plaintiffs alleged that, under Item 303, Facebook violated its 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. See In re Facebook IPO Sec. & Derivative Litig., 2013 WL 6665399, at *13 (S.D.N.Y. Dec. 12, 2013). The district court denied a motion to dismiss these claims, holding that the plaintiffs plausibly alleged that Facebook “had identified a trend leading up to its IPO alleged to be material,” and that Facebook had violated Item 303 by failing to disclose “the impact the increase of mobile users and product decisions could have had on the company’s revenues and financial results.” Id. at *17-18. The court reached this conclusion notwithstanding that, as the court found, 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.” Id. at *18. Of course, ultimately, the move of Facebook users to its mobile platform was a boon to Facebook, with its stock now trading well above the IPO price. This case, therefore, illustrates the real world difficulty in determining whether a business challenge is an ongoing “trend” that requires quantification and disclosure, or whether it is a short term “blip” on the radar—a determination that is easy for plaintiffs to attack and courts to second-guess after the fact.
Even if the Supreme Court affirms the Second Circuit, it is important to note that an Item 303 violation should not automatically give rise to §10(b) liability. As the Second Circuit recognized in Stratte-McClure, a plaintiff will still have to plead and prove each element of a 10(b) claim to establish liability—including that the defendants acted with scienter (an intent to defraud) and that the omitted information would be material to a reasonable investor. Either way, the Supreme Court’s ruling in Leidos is likely to significantly impact the decisions public companies make about what to disclose in their periodic reports, as well as the types of the §10(b) claims filed by federal securities plaintiffs in coming years. In the meantime, companies should continue to carefully monitor trends and uncertainties that may influence their businesses going forward and remain vigilant about whether or not to disclose such trends and uncertainties under Item 303.
1. Congress appears to have recognized as much in passing the Private Securities Litigation Reform Act of 1995 (the PSLRA). The PSLRA contains a “safe harbor” provision which immunizes certain forward-looking statements from liability if the statement is identified as such and accompanied by “meaningful cautionary statements,” if the statement is immaterial, or if the defendants are not shown to have actual knowledge of the falsity of the statements. See Section 21E(c)(1), 15 U.S.C. §88u-5(c)(1) (2000).