Reprinted with permission from the March 3, 2015 issue of The Legal Intelligencer. © 2015 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
On Feb. 9, one of the plaintiffs in the federal securities class action against Nvidia Corp., Roberto Cohen, filed a petition for writ of certiorari with the U.S. Supreme Court, seeking review of the U.S. Court of Appeals for the Ninth Circuit's Oct. 2, 2014, decision affirming dismissal of the action, specifically, the court's holding that Item 303 of U.S. Securities and Exchange Commission (SEC) Regulation S-K does not create a duty to disclose for purposes of an omission actionable under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Cohen's petition (Cohen v. Nvidia, Petition No. 14-975) argues that this holding by the Ninth Circuit in In re Nvidia Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), conflicts with the Second Circuit's recent holding in Stratte-McClure v. Morgan Stanley, No. 13-0627, 2015 U.S. App. LEXIS 428 (2d Cir. Jan. 12, 2015), and the Third Circuit's 15-year-old decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). Although the Ninth Circuit's opinion states that its holding regarding Item 303 disclosures is consistent, not in conflict, with Oran, a split among these circuits exists nonetheless.
According to Cornerstone Research's "Securities Class Action Filings: 2014 Year in Review," since 1997, most federal securities class actions have been filed in these three circuits; indeed, 114 of the 170 new cases brought in 2014 were filed in the Second (52 cases), Ninth (40 cases), and Third circuits (22 cases). With the majority of securities class actions pending in these circuits, the Supreme Court may grant Cohen's petition in order to resolve this conflict so that public companies will have clear guidance for complying with their disclosure obligations under Item 303.
The Ninth Circuit's Decision in 'Nvidia'
According to the Ninth Circuit's opinion, on May 22, 2008, Nvidia, a semiconductor company, disclosed in its Form 10-Q filed with the SEC that it had received customer complaints regarding certain product defects and that the company was unable to estimate the amount of costs that it might incur to resolve these complaints. On July 2, 2008, Nvidia disclosed in an SEC Form 8-K that it would be taking a $150 million to $200 million charge to cover costs arising from these product defects. After this disclosure, Nvidia's stock price dropped 31 percent, resulting in a $3 billion decrease in its market capitalization. The court's opinion describes the claims Cohen and other shareholders asserted against Nvidia for alleged violation of Section 10(b) and Rule 10b-5, including their allegations that the company knew about the product defects and customer complaints at issue as early as Nov. 8, 2007, and that Item 303 required that Nvidia disclose these matters in the quarterly reports and annual report the company filed between that date and July 2, 2008. As the court noted, Item 303 requires that publicly held companies describe in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of their Forms 10-K and 10-Q:
"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."
The court held that this disclosure duty under Item 303 is not actionable under Section 10(b) and Rule 10b-5, reasoning that, as the Supreme Court held in Matrixx Initiatives v. Siracusano, 131 S. Ct. 1309, 1321-22 (2011), "neither Section 10(b) nor Rule 10b-5 'create[s] an affirmative duty to disclose any and all material information. Disclosure is required under these provisions only when necessary to make statements made, in ... light of the circumstances under which they were made, not misleading.'"
The Third Circuit's Decision in 'Oran'
In its analysis, the Ninth Circuit stated that its reasoning and holding were consistent with the Third Circuit's decision in Oran, which 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 (1988). As the Third Circuit explained in Oran, the SEC's test for Item 303 disclosure provides that:
"Where a trend, demand, commitment, event, or uncertainty is known, management must make two assessments:
(1) 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.
(2) 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."
The court's opinion points out that the SEC's Item 303 test "varies considerably" from the Supreme Court's test in Basic, "which 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 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,'" quoting Alfus v. Pyramid Technology, 764 F. Supp. 598, 608 (N.D. Cal. 1991)). 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. Because plaintiffs have failed to plead any actionable misrepresentation or omission under that rule, [Item] 303 cannot provide a basis for liability."
The Second Circuit's Decision in 'Stratte-McClure'
In Stratte-McClure, the Second Circuit reached the opposite conclusion from that of the Ninth Circuit in Nvidia and 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 [Form 10-Q] 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)."
Although the court held that the plaintiffs had adequately alleged that the defendants had breached their Item 303 duty to make certain disclosures and assumed without deciding that such omission met Basic's materiality threshold, the court ultimately affirmed the district court's dismissal of the complaint on grounds that the plaintiffs had failed to adequately allege a strong inference that the defendants acted with scienter.
Notably, in its discussion of Item 303's disclosure requirements, the Second Circuit took issue with the Ninth Circuit's analysis 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." As the court pointed out, Supreme Court Justice Samuel Alito wrote the Third Circuit's opinion in Oran when he served on that court. Should the Supreme Court grant Cohen's cert petition, it will have the opportunity to resolve this conflicting analysis of Oran. In the meantime, without guidance from the Supreme Court on this issue, public companies should assume when they are making their Item 303 disclosures that an omission, if deemed material under Basic, could give rise to a 10b-5 violation.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.