The Second Circuit’s recent decision in Stratte-McClure v. Morgan Stanley, No. 13-0627-cv (Jan. 12, 2015) (2015 WL 13631) (slip opinion available here: Stratte-McClure v. Morgan Stanley) (also referred to as Fjarde AP‐Fonden v. Morgan Stanley), stirs the pot on the important issue of private section 10(b) claims based on alleged violations of Item 303 of SEC Regulation S-K, 17 CFR § 229.303. Claims founded on a purported failure to comply with Item 303 are problematic because Item 303 is the SEC’s effort to enhance disclosures of “soft information,” not historical facts, about a public company. It requires that a company evaluate and discuss the future prospect that some developments or uncertainties could be important in future company performance. Because such decisions (i) inevitably involve the exercise of management judgment the need for disclosure, and the nature and scope any such discussion, and (ii) are almost always subject to second-guessing in retrospect, when the future is revealed and the uncertainties become less uncertain, they present serious risks of converting private section 10(b) claims into a form of hindsight insurance against stock price declines.
The SEC at one time excluded forward-looking information from SEC filings, but about 40 years ago started to encourage companies to provide forward-looking information in SEC filings. This eventually led to the development of mandatory disclosure requirements of “MD&A,” the short term for the Management Discussion and Analysis of Financial Condition and Results of Operations required by Item 303.
Item 303 arose out of SEC concerns that investors were missing out on key elements of company information if they obtained only purely historical information. Informed investment decision-making could be greatly improved if investors were able to get management insights into areas of company risk and uncertainty that had not yet been realized. This type of non-historical, future-looking evaluation is often referred to as “soft information.” The area of soft information disclosure is problematic because the SEC wants to encourage management to share such evaluative analysis, but to do so in a way that does not expand company and management exposure for not reading the future correctly. Accordingly, along with developing rules encouraging such disclosure, the SEC, Congress, and the courts have taken steps to limit private securities claims based solely on allegedly inadequate forward-looking disclosures.
The SEC adopted so-called “safe harbor” rules (Rule 175 under the Securities Act of 1933 and Rule 3b-6 under the Securities Exchange Act of 1934), under which a forward-looking statement in a company’s MD&A disclosures could not be found fraudulent absent proof that it “was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.” In the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress enacted a more general safe harbor precluding liability in private actions for a forward-looking statement if: (i) it is identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially,” or (ii) immaterial, or (iii) the plaintiff fails to prove that the forward-looking statement was made “with actual knowledge . . . that the statement was false or misleading.” 15 U.S.C. § 78u-5(c). The first portion of this statutory safe harbor was effectively a legislative adoption of the judicially-created “bespeaks caution” doctrine under which a forward-looking statement accompanied by meaningful cautionary language was deemed immaterial as a matter of law.
Nevertheless, forward-looking statements that turn out to be inaccurate, or the failure to provide advance warning of a likely future impact of a current problem, has been a theory underlying private securities actions for decades. Because this allows a backward-looking theory of fraud to be pursued after events occurring after the alleged misleading statements or omissions are accompanied by significant stock price impact, it is a powerful lure for the plaintiffs’ class action bar.
This theory can be especially powerful in the context of so-called “material omissions.” In those cases, the plaintiff can seek damages supposedly arising out of a company’s failure to provide a prediction about the future – the failure to disclose the potential impact of facts or circumstances that later turn out to harm the company. The most difficult hurdle in these cases is finding a “duty to disclose.” The securities laws do not require the disclosure of all company information to investors, nor even all material company information. Instead, public companies are required to disclose only the specified information mandated in SEC regulations, and to ensure that when they do disclose information, they do not at the same time withhold information without which the disclosed information becomes misleading. In general, companies have no obligation to provide evaluations or predictions about possible future developments, so this “duty to disclose” requirement can be a major obstacle to a private securities action based on a failure to do so.
It is in this context that recent cases have considered the impact on private securities actions of Item 303 of Regulation S-K. Two recent appellate cases adopt very different approaches to this issue: the Second Circuit’s decision in Stratte-McClure and the Ninth Circuit’s decision in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014). It is no exaggeration to say that billions of dollars of future litigation costs and liabilities may turn on which of these approaches ultimately prevails.
Item 303(a)(3)(ii) requires that as part of its annual (Form 10-K) and quarterly (Form 10-Q) MD&A disclosures, a company must:
Describe 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 SEC discussed this requirement further in an interpretive release:
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 registrant’s financial condition or results of operations is not reasonably likely to occur.
Exchange Act Release No. 34–26831 (May 24, 1989).
NVIDIA and Stratte-McClure examine whether the failure to comply with this SEC disclosure requirement can form the basis for a private securities fraud action under section 10(b) and Rule 10b-5. NVIDIA says “no”; Stratte-McClure says “yes.”
NVIDIA involved the company’s alleged failure to include in its Item 303 MD&A disclosures the potential financial impact of a defect in a chip incorporated into various manufacturers’ computers and other devices. Although the existence of the defect was disclosed, the amounts to be paid under warranty obligations were allegedly known uncertainties, and the MD&A allegedly failed to include a required discussion of that prospect. Stratte-McClure involved the alleged failure by Morgan Stanley to include in its MD&A a discussion of the potential future financial impact of long positions it held on collateralized debt obligations or credit default swaps at the time of the housing mortgage meltdown.
Let’s start with a key point on which both courts agree. They both emphasize that information required to be disclosed under Item 303 may not satisfy one of the key elements of a section 10(b) claim: materiality. That is because the SEC instructions make it clear that disclosures may be required “unless management determines that a material effect . . . is not reasonably likely to occur” (emphasis added). As a result, disclosures of immaterial information are required if management cannot “determine” they are unlikely to have a future material impact. Accordingly, plaintiffs will still have the burden of pleading facts showing a required disclosure was, in fact, material. See NVIDIA, 768 F.3d at 1055; Stratte-McClure, slip op. at 18-19.
Add to this another point of agreement: a section 10(b) claim requires proof that the defendants acted with scienter, which means that a claim can proceed only if the plaintiff pleads particular facts – under the PSLRA pleading standard, as further interpreted in Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322-23 (2007) – plausibly supporting that the defendants’ omission was intended to defraud shareholders. That could be even more difficult than normal for these cases to the extent the safe harbor provisions mentioned above may apply. Both NVIDIA and Stratte-McClure found the allegations of scienter in failing to make required Item 303 disclosures were deficient and supported dismissal of the claims. See NVIDIA, 768 F.3d at 1056-65; Stratte-McClure, slip op. at 26-29. In Stratte-McClure, the Second Circuit found the failure to plead scienter adequately was grounds to affirm the district court’s dismissal of claims, even while reversing the lower court’s ruling that Item 303 did not create a disclosure duty. (Technically, that makes the panel decision on the “duty to disclose” issue dicta, which theoretically has diminished precedential value, but don’t count on it.)
The difference between the courts – a critical one – is that the NVIDIA court concluded that Item 303’s requirement that certain immaterial information must be disclosed prevents it from creating the “duty to disclose” necessary to support a fraud claim under section 10(b), while the Stratte-McClure court concluded that the “duty to disclose” and materiality elements should be disaggregated for this purpose.
The NVIDIA court relied heavily on reasoning in the Third Circuit decision Oran v. Stafford, 226 F.3d 275, 287–88 (3d Cir. 2000) (Alito, J.), which in turn relied heavily on the discussion of section 10(b) elements in the Supreme Court’s opinion in Basic, Inc. v. Levinson, 485 U.S. 224, 238 (1988). The NVIDIA wrote as follows:
[I]n Basic, the Supreme Court stated that materiality of forward-looking information depends “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 the company activity.” . . . As the court in Oran also determined, these two standards differ considerably. 226 F.3d at 288. Management’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic. The SEC intimated this point as well: “[Item 303] mandates disclosure of specified forward-looking information, and specifies its own standard for disclosure—i.e., reasonably likely to have a material effect…. The probability/magnitude test for materiality approved by the Supreme Court in [Basic] is inapposite to Item 303 disclosure.” Exchange Act Release No. 34-26831, 54 Fed. Reg. at 22430 n. 27. The SEC’s effort to distinguish Basic’s materiality test from Item 303’s disclosure requirement provides further support for the position that Item 303 requires more than Basic—what must be disclosed under Item 303 is not necessarily required under the standard in Basic. Therefore, “[b]ecause the materiality standards for Rule 10b5 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.’” Oran, 226 F.3d at 288.
The Stratte-McClure court, on the other hand, saw no reason why a “duty to disclose” sufficient to make an omission potentially actionable must satisfy the Basic materiality requirement. Instead, it concluded the materiality standard should be applied separately, only after the determination whether there was a duty to disclose the omitted information. Immaterial information could still satisfy the “duty to disclose” requirement, even if a plaintiff could not show it was material:
The Supreme Court has instructed that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b–5.” Basic, 485 U.S. at 239 n. 17…. Such a duty may arise when there is “a corporate insider trad[ing] on confidential information,” a “statute or regulation requiring disclosure,” or a corporate statement that would otherwise be “inaccurate, incomplete, or misleading.”…
As Plaintiffs correctly argue, Item 303 of Regulation S–K imposes disclosure requirements on companies filing SEC-mandated reports, including quarterly Form 10–Q reports…. Those requirements include the obligation to “[d]escribe any known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” … The SEC has provided guidance on Item 303, clarifying that disclosure is necessary “where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.” …
Item 303’s affirmative duty to disclose in Form 10–Qs can serve as the basis for a securities fraud claim under Section 10(b). Rule 10b–5 requires disclosure of “material fact[s] necessary in order to make … statements made … not misleading.” This Court and our sister 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 this conclusion stands to reason—for omitting an item required to be disclosed on a 10–Q can render that financial statement misleading…. Due to the obligatory nature of these 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.”… 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).
The failure to make a required disclosure under Item 303, however, is not by itself sufficient to state a claim for securities fraud under Section 10(b)…. Since the Supreme Court’s interpretation of “material” in Rule 10b–5 dictates whether a private plaintiff has properly stated a claim, we conclude that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b–5 if the allegedly omitted information satisfies Basic’s test for materiality. That is, a plaintiff must first allege that the defendant failed to comply with Item 303 in a 10–Q or other filing. Such a showing establishes that the defendant had a duty to disclose. A plaintiff must then allege that the omitted information was material under Basic‘s probability/magnitude test….
Stratte-McClure, slip op. at 14-20 (citations and footnotes omitted).
The Stratte-McClure court noted the NVIDIA court’s disagreement, arguing that the NIVIDIA court conflated the “duty to disclose” and materiality requirements, and misapplied then-Judge (now Justice) Alito’s reasoning in Oran:
We note that our conclusion is at odds with the Ninth Circuit’s recent opinion in In re NVIDIA Corp. Securities Litigation…. That case held that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b–5, relying on a Third Circuit opinion by then-Judge Alito, Oran v. Stafford…. But Oran simply determined that, “[b]ecause the materiality standards for Rule 10b–5 and [Item 303] differ significantly,” a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b–5” (emphasis added).… Having already decided that the omissions in that case were not material under Basic, the Third Circuit concluded that Item 303 could not “provide a basis for liability.”… 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. At a minimum, Oran is consistent with our decision that failure to comply with Item 303 in a Form 10–Q can give rise to liability under Rule 10b–5 so long as the omission is material under Basic, and the other elements of Rule 10b–5 have been established.
It is possible that the differences between these decisions reflect the proverbial “distinction without a difference.” After all, the Stratte-McClure court requires that materiality be pleaded and proved in addition to a disclosure duty, which eventually may lead to the same result. But “eventually” can be a big word. The name of the game is these cases is surviving dismissal and getting into discovery. Materiality is a notably hard element on which to get a claim dismissed. Even scienter-based dismissals tend to be arduous litigated results with multiple amended complaints, and plaintiff’s counsel often manage to survive dismissal by presenting often dubious “confidential witness” allegations that prevent dismissal, even if they don’t stand up in discovery. Dismissing these cases will be much easier if the “duty to disclose” is understood to mean “duty to disclose material information,” as the NVIDIA (and arguably Oran) court ruled. That would require a disclosure duty in an omissions case to be founded in the substance of omitted material, and not just on a disclosure duty not founded in the importance to investors of the omitted information. The practical effect of the two different rules could be enormous, since the issue is not which side will win at trial, or even summary judgment, but will the case survive to the point that a hefty settlement may be the preferred result for both sides.
It is important to remember, as the Supreme Court has done in past private actions under section 10(b), that the section 10(b) private right of action was judicially created, and for that reason is more amenable to judicial interpretation and refinement than statutory causes of action. The Supreme Court has in the past, and likely will in the future, taken into account the policy implications of endorsing one approach or another in determining the precise parameters of the elements of private section 10(b) claims. In doing this, the Court may also place some weight on obvious efforts by the SEC and Congress to limit exposure to private actions from the forward-looking disclosure requirements. As a result, even if the Second Circuit’s disaggregation approach is arguably more sound from the standpoint of pure logic, the practical appeal of interpreting “duty to disclose” to include, at least implicitly, a materiality aspect could ultimately prevail.
January 19, 2015
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