Item 303 of Regulation S-K requires issuers to disclose in their annual reports on Form 10-K and quarterly reports on Form 10-Q “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 and income from continuing operations.” In a ruling last year, the Second Circuit held that the alleged failure to comply with this item could support an anti-fraud claim under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Critics of this decision have argued that Item 303 necessarily entails subjective reasoning and alleged breaches of these provisions are merely “fraud by hindsight.” Last month, the United States Supreme Court granted certiorari to review the Second Circuit decision. While typically lawsuits under Rule 10b-5 are brought by equityholders claiming injury from a stock drop, the Supreme Court’s decision, when it is handed down next term, should be of interest to debtholders as well, as it will undoubtedly affect the kinds of disclosures that issuers of both equity and debt will be making in the gray area of trending events.

Background

Indiana Public Retirement Systems v. SAIC, Inc., 818 F. 3d 85 (2nd Cir. 2016) at first blush may appear to be a garden variety Rule 10b-5 lawsuit by stockholders against an issuer claiming a violation of the issuer’s disclosure obligations with the requisite scienter to support an anti-fraud claim under the federal securities laws. In short, SAIC was the prime contractor on a New York City project to develop and implement a program known as CityTime, which is an automated timekeeping program for employees of various city agencies. SAIC hired Gerard Denault as the program manager of the project, and Denault hired a small company named TechnoDyne to provide staffing services on the project. Unbeknownst at the time to SAIC management, Denault and another SAIC employee, Carl Bell, engaged in an elaborate kickback scheme with TechnoDyne, whereby Denault and Bell hired more TechnoDyne workers than the project required in order to inflate billable hours and hourly rates. SAIC billed NYC approximately $635 million for the CityTime project through May 2011, with the city assuming the risk of the major cost overruns encountered by the project.

In late 2010, the scheme began to unravel. Denault was removed from the project, and SAIC hired an outside law firm to work with its internal auditors to review timekeeping practices related to the project. At the same time, then-Mayor Bloomberg announced that the city was reevaluating SAIC’s role in the project and was reviewing whether to seek recovery of payments made to SAIC. On March 9, 2011, SAIC’s audit team reported on the results of its findings. On March 25, 2011, SAIC filed its Form 10-K for the year ended December 2010. It not only failed to disclose SAIC’s potential liability related to the CityTime project, it touted in its annual report to shareholders, released at the same time, the company’s commitment to high standards of “ethical performance and integrity.”

By the end of May 2011, Denault, Bell, the principals of TechnoDyne and others were charged in a federal criminal complaint. Denault was fired and SAIC made an offer to repay the city a total of $2.5 million, representing amounts billed by Denault from 2006 forward. On June 2, 2011, SAIC filed a Form 8-K in which it was disclosed that the U.S. Attorney’s office and the NYC Department of Investigation were conducting a joint criminal investigation into the CityTime contract. On July 1, 2011, SAIC filed another Form 8-K including a letter from Mayor Bloomberg demanding that SAIC reimburse the city in the approximate amount of $600 million. Ultimately, in March 2012, SAIC agreed to reimburse the city in the amount of $500.4 million and to forfeit $40 million in unpaid receivables.

The plaintiffs in the SAIC action — the Indiana Public Retirement System, the Indiana State Teachers’ Retirement Fund and the Indiana State Employees’ Retirement Fund — filed a class action against SAIC. Among other things, the plaintiffs alleged that SAIC’s SEC filings in March and June 2011 failed to disclose the company’s potential liability arising out of the CityTime project. The plaintiffs also alleged that SAIC failed to disclose loss contingencies and known trends or uncertainties associated with a fraud as required by Financial Accounting Standard 5 (currently Accounting Standards Codification 450-20) and Item 303 of Regulation S-K. In January 2014, the district court granted SAIC’s motion, on reconsideration, to dismiss the plaintiffs’ FAS 5 and Item 303 claims, and in September 2014 denied plaintiffs’ request for leave to file an amended complaint. The appeal to the Second Circuit followed.

The Court’s Analysis of Plaintiffs’ Claims

FAS 5. Plaintiffs alleged that SAIC violated generally accepted accounting principles by failing to comply with FAS 5 in the financial statements included in the March 2011 Form 10-K. That standard requires an issuer to disclose a loss contingency when a loss is a “reasonable possibility.” In this context, a reasonable possibility means something that is “more than remote but less than likely.” The plaintiffs claimed that the reasonable possibility standard applied because by March 2011 the city was aware of a possible claim against SAIC.1

The court held that the plaintiffs’ proposed amended complaint adequately alleged a violation of FAS 5. By the time SAIC filed the 2010 Form 10-K, the CityTime criminal investigation was focused on SAIC employees. There was a criminal complaint alluding to SAIC’s improper actions; Denault had been interviewed by prosecutors; both SAIC and Denault had received grand jury subpoenas; Mayor Bloomberg had announced a re-evaluation of SAIC’s role in the CityTime project; SAIC had agreed to pay Denault’s and Bell’s legal fees in connection with the criminal proceedings; and SAIC had received results of its internal investigation and was aware of its own potential liability to the city.

Item 303. Item 303 requires disclosure of known trends or uncertainties reasonably expected to have a favorable or unfavorable impact on net sales, revenues or income from continuing operations. The Second Circuit cited to the SEC’s interpretive release on Item 303, in which the Commission said 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.”

As a preliminary matter, the Second Circuit held that Item 303 requires actual knowledge of the relevant trend. The court then held that the proposed amended complaint supported a strong inference of actual knowledge of the trend at the time SAIC filed its 2010 Form 10-K. In December 2010, the city and state of New York rejected contract awards to SAIC valued at more than $150 million. Exposure of the fraud also jeopardized SAIC’s relationships with other governmental entities accounting for a significant portion of the company’s revenues. Finally, the court rejected SAIC’s arguments that the CityTime contract was not material and that it was implausible that SAIC could have acted with the requisite scienter to support a Rule 10b-5 claim.

The Petition for Certiorari2

SAIC presented to the Supreme Court the question of whether the Second Circuit erred in holding that Item 303 creates a duty to disclose under Section 10(b) of the Exchange Act and Rule 10b-5. (For whatever reason, the company did not challenge the holding of the Second Circuit under FAS 5.) SAIC alleged that the Second Circuit ruling was in conflict on the issue with the holdings of the Ninth Circuit in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2016) and the Third Circuit in Oran v. Stafford, 226 F.3d 275 (3rd Cir. 2000).

As a substantive matter, SAIC maintained in its petition that under Supreme Court precedent, a duty to disclose arises under Section 10(b) in only two circumstances: where there is trading on inside information and where previously misleading information must be corrected. In SAIC’s view, the Supreme Court never held that an SEC regulation creates a duty to disclose that is actionable under Section 10(b).

SAIC also argued that allowing a Section 10(b) action based on Item 303 encourages “fraud-by-hindsight pleading, as Item 303 primarily concerns ‘soft information’ that is easily susceptible to manipulation by plaintiffs’ attorneys.”

Observations

Section 10(b) and Rule 10b-5 lawsuits are typically thought of as the province of the equity markets, where shareholder attorneys are quick to bring stock drop lawsuits. This case has the potential of influencing not only the conduct of the plaintiffs’ bar, but also how issuers — including issuers for whom SEC reporting is required only because of their publicly issued debt securities — approach reporting of trends and allied predictive information. SEC enforcement, especially in gray areas of disclosure, has historically been slow and selective. A threat of private action under Item 303 — if the Supreme Court sides with the Indiana pension funds in the case — is likely to impel issuers of all stripes to earlier disclosure of trending developments that they might otherwise have deferred to a later time or waited out in the hopeful expectation that the developments would not materialize. The Supreme Court decision in the case is therefore worth watching for even for those whose interests are focused primarily on the debt markets.