Are Item 303 Omissions Actionable Under Rule 10b-5?
The Legal Intelligencer
Reprinted with permission from the June 5, 2017 issue of The Legal Intelligencer. © 2017 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
During its October term this year, the U.S. Supreme Court will hear argument in Leidos v. Indiana Public Retirement System, No. 16-581, on an important federal securities fraud issue: Whether a publicly held company's omission of "known trends and uncertainties" in its annual or interim reports, as required by Item 303 of Securities Exchange Commission (SEC) Regulation S-K, can give rise to a private securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 (Rule 10-5). The court granted Leidos Inc.'s writ of certiorari to resolve a conflict between the U.S. Court of Appeals for the Second Circuit—which held in the securities class action against Leidos that a violation of Item 303 can give rise to Rule 10b-5 liability—and the Ninth and Third circuits—which, in earlier decisions, had held to the contrary.
Applying the holding and reasoning of its 2015 opinion, Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 101 (2d Cir. 2015), the Second Circuit held in Indiana Public Retirement System v. SAIC, 818 F.3d 85, 94 & n.7 (2d Cir. 2016), that the failure of Leidos (formerly known as SAIC Inc.) to disclose under Item 303 its exposure for alleged employee fraud and overbilling in connection with certain government contract work stated a cause of action under Rule 10b-5. The Second Circuit's decisions in Stratte-McClure and SAIC conflict with the Ninth Circuit's opinion, In re NVIDIA Securities Litigation, 768 F.3d 1046, 1054-56 (9th Cir. 2014), and the Third Circuit's opinion, Oran v. Stafford, 226 F.3d 275, 287-88 (3d Cir. 2000), in which the courts held that an Item 303 omission is not actionable under Rule 10b-5.
In granting certiorari, the court may have found this circuit split particularly compelling since, as Leidos pointed out in its cert petition, most securities class actions are filed in the Second and Ninth circuits. The Third Circuit is the third most popular circuit for filing securities class actions. In addition, Justice Samuel Alito authored the opinion in Oran when he served on the Third Circuit.
If the court affirms the Second Circuit's decision in Leidos and implies a private cause of action under Rule 10b-5 for Item 303 omissions, we can expect to see an increase in the length and detail of public companies' Item 303 disclosures as well as an uptick in plaintiffs' Rule 10b-5 claims based on allegedly deficient Item 303 disclosures. Indeed, as Leidos noted in its petition, the Second Circuit already has seen "a proliferation of Section 10(b) claims predicated on Item 303 omissions."
Background
Item 303 requires that publicly held companies describe in the management's discussion and analysis of financial condition and results of operations (MD&A) section of their periodic SEC reports: 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. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed, 17 C.F.R. Section 229.303(a)(3)(ii).
In Oran, the Third Circuit was the first circuit to address the question of whether a violation of Item 303 is actionable under Rule 10b-5. The court compared the SEC's test for disclosure under Item 303 to the Supreme Court's securities fraud materiality test set forth in Basic v. Levinson, 485 U.S. 224, 237 (1988). The SEC's Item 303 test provides that: Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:
- Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.
- If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the company's financial condition or results of operations is not reasonably likely to occur.
In comparing this test to Basic's general test for securities fraud materiality, the Third Circuit concluded that the Item 303 test "varies considerably" from the Basic test in that Basic "premised forward-looking disclosure 'upon 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 company activity.'" The court pointed out that the SEC itself "specifically noted" that "'the probability/magnitude test for materiality approved by the Supreme Court in Basic ... is inapposite to Item 303 disclosure'; rather, [Item] 303's disclosure obligations extend considerably beyond those required by Rule 10b-5." The court reasoned that, "because the materiality standards for Rule 10b-5 and Item 303 differ significantly, the 'demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5. Such a duty to disclose must be separately shown.'" Accordingly, the court held that "a violation of Item 303's reporting requirements does not automatically give rise to a material omission under Rule 10b-5."
Fourteen years later, the Ninth Circuit held in NVIDIA, 768 F.3d at 1056, that, under the Supreme Court's opinion in Matrixx Initiatives v. Siracusano, 563 U.S. 27, 44 (2011), NVIDIA 's omission of certain product defects and customer complaints in its annual and quarterly reports under Item 303 did not give rise to a claim under Rule 10b-5. As the court explained, "for purposes of Section 10(b) and Rule 10b-5, material information need not be disclosed unless omission of that information would cause other information that is disclosed to be misleading." Thus, the court agreed with the Third Circuit's holding in Oran "that Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5."
The Second Circuit's Decisions
As explained above, in SAIC—the decision the Supreme Court will specifically review—the Second Circuit heavily relied on the holding and reasoning of its earlier decision in Stratte-McClure. In Stratte-McClure, the court held that "a failure to make a required Item 303 disclosure in a 10-Q filing is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim." The court explained, however, that "such an omission is actionable only if it satisfies the materiality requirements outlined in Basic ... and if all of the other requirements to sustain an action under Section 10(b) are fulfilled." The court emphasized that—unlike the Ninth Circuit—the Second, First, Third, and Seventh circuits "have long recognized that a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak." And "due to the obligatory nature of the SEC's mandatory reporting regulations, 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.'" Thus, the court concluded, "it follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b)."
Notably, the Second Circuit took issue with the Ninth Circuit's interpretation of the Third Circuit's decision in Oran, explaining that "contrary to the Ninth Circuit's implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b-5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b-5 omission." Especially since Alito authored the Oran opinion when he served on the Third Circuit, we can expect the Supreme Court to specifically address the question of whether an Item 303 violation can ever be actionable under Rule 10b-5 and, if so, under what circumstances. Until the Supreme Court provides this guidance, public companies should assume that any omission in their Item 303 disclosures, if deemed material under Basic, could give rise to a 10b-5 violation.
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