The Second Circuit Addresses the Meaning of "Materiality" Required for Disclosure Under Item 303(A) of Regulation S-K


In Litwin v. The Blackstone Group, L.P.1 the United States Court of Appeals for the Second Circuit considered whether the plaintiffs -- investors in Blackstone's June 2007 IPO -- had adequately alleged that the registration statement and prospectus issued in connection with Blackstone's IPO omitted material information required to be disclosed by Item 303(a) of Regulation S-K. The district court granted the defendant's motion to dismiss the plaintiffs' claims under the Securities Act of 1933 (the "Securities Act"), holding that the misstatements and omissions alleged were immaterial as a matter of law.2 In reversing, the Second Circuit panel held that the district court had erred in its analysis of the qualitative materiality of the alleged omissions. The decision highlights the importance of trend disclosures in public filings, even if these trends are material only to one segment of an issuer's overall business.

Factual Overview

The Blackstone Group is a hedge fund manager and financial advisory firm that conducted an IPO in 2007, selling common units to the public and raising more than $4.5 billion. Subsequent to the IPO, the value of the common units declined substantially and plaintiffs brought suit under Sections 11 and 12(2) of the Securities Act,3 alleging that Blackstone's registration statement and prospectus failed to disclose that two of Blackstone's portfolio companies, as well as its real estate fund investments, were experiencing problems and that Blackstone knew of, and reasonably expected, these problems to subject it to a claw-back of performance fees and reduced performance fees, thereby materially and adversely affecting its future revenues.4

Specifically, the plaintiffs alleged that Blackstone failed to disclose risks associated with its private equity investments in FGIC Corp., a monoline insurer that in the years leading up to Blackstone's IPO had begun issuing credit default swaps insuring collaterized debt obligations and residential mortgage-backed securities backed by sub-prime mortgages, and in Freescale Semiconductor, Inc., a manufacturer of semiconductors that had lost an exclusive contract to manufacture chips for Motorola. The plaintiffs also alleged that Blackstone omitted material information and made affirmative misstatements regarding the risks facing its real estate funds in light of the downturn in the subprime residential market (although no more than 15% of Blackstone's real estate holdings were residential).5

The plaintiffs contended the omitted disclosures were required by Item 303(a) of Regulation S-K.6 Item 303(a) requires a discussion of known trends or uncertainties that the issuer "reasonably expects" will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."7

The District Court's Decision

The district court found that Blackstone's investments in FGIC and Freescale were not quantitatively material. The district court noted that FGIC represented only 0.4% of Blackstone's assets under management at the time of the IPO.8 Similarly, the district court found Blackstone's investment in Freescale to be quantitatively immaterial in relation to Blackstone's total assets under management.9 Regarding the eventual $122.2 million decrease in Blackstone's 2007 annual revenues caused by FGIC's drop in value, the district court found that while the decline may have been significant relative to Blackstone's Corporate Private Equity segment's annual revenues, it was quantitatively immaterial as compared with Blackstone's $3.12 billion 2007 total revenues. The district court similarly found that none of the alleged omissions regarding FGIC and Freescale were qualitatively material considering the factors set forth in SEC's Staff Accounting Bulletin No. 99 ("SAB 99").10

The district court separately analyzed the alleged omissions and misstatements regarding Blackstone's real estate investments, finding that plaintiffs had failed to link the problems in the subprime market and home price declines to Blackstone's real estate investments.11 The district court further found that Securities Act Sections 11 and 12(a)(2) do not require disclosure of publicly available information, stating: "The omission of generally known macro-economic conditions is not material because such matters are already part of the 'total mix' of information available to investors."12 Finally, the district court noted that the complaint contained no allegations that Blackstone knew that market conditions "were reasonably likely to have a material effect on its portfolio of real estate investments," and stated that "generalized allegations that problems brewing in the market at large made it 'foreseeable' that a particular set of unidentified investments would sour are insufficient to 'nudge...[the] claims across the line from conceivable to plausible.'"13

The Second Circuit's Analysis

The Court began its analysis by stressing the limited burden imposed on the Litwin plaintiffs in order to survive a motion to dismiss under Rule 12(b)(6). The plaintiff's claims under Sections 11 and 12(2) sounded in negligence rather than fraud, thus to survive a motion to dismiss their "complaint must plead enough facts to state a claim ... that is plausible on its face."14 The Court noted that prior Second Circuit cases have considered SAB 99 as providing appropriate guidance in assessing materiality. The Court agreed that, as a starting place or preliminary assumption, 5% is an appropriate numerical threshold for materiality, but noted that courts must consider both quantitative and qualitative factors in assessing materiality.15

The Court then turned to Item 303 of Regulation S-K as the legal basis for Blackstone's disclosure obligations. The SEC's 1989 interpretive release explains that Item 303(a)(3) requires disclosure "where a trend, demand, commitment, event or uncertainty is both (1) presently known to management and (2) reasonably likely to have material effects on the registrant's financial condition or results of operations."16 The Court then summarily rejected Blackstone's contention that plaintiffs had failed to adequately allege that Blackstone was required to disclose trends in the real estate market.17

While acknowledging that Blackstone's investments in FGIC and Freescale fell below the presumptive 5% threshold of materiality at the parent level, the Court stressed that the numerical threshold was simply a starting point for the assessment of materiality.18 In particular, the Court held that where, as in Blackstone, the issuer has multiple business segments, if a misstatement or omission relates to a segment that plays a "significant role" in a registrant's business it may be material even if it is "quantitatively small compared to a registrant's firm-wide financial results."19 In holding that the alleged omissions relating to FGIC and Freestyle were plausibly material, the Court reasoned that "[b]ecause Blackstone's Corporate Private Equity segment plays such an important role in Blackstone's business and provides value to all of its other asset management and financial advisory services, a reasonable investor would almost certainly want to know information related to that segment that Blackstone reasonably expects will have a material adverse effect on its future revenues."20

The Court rejected Blackstone's argument that Item 303(a) disclosure was not required because information concerning Freestyle's loss of its contract with Motorola and the downturn in the real estate market was publicly available and thus part of the "total mix" of information available to the market. The Court acknowledged that, as a general matter, the total mix of information may include information already in the public domain and facts known or reasonably available to potential investors.21 However, Item 303 is not directed at the mere fact of the market trends, what is required is disclosure of the "potential future impact [on Blackstone's investments], which was certainly not public knowledge."22

The Court declined to hold that Blackstone's structure permitted it to avoid disclosing information about individual portfolio companies because gains and losses on the investments are aggregated at the fund level.23 To hold otherwise, the Court found, would "effectively sanction misstatements in a registration statement or prospectus related to particular portfolio companies so long as the net effect on the revenues of a public private equity firm like Blackstone was immaterial."24

Finally, the Court held that the plaintiffs were not required to identify specific real estate investments that had been adversely effected by the downturn. Because Blackstone's real estate segment played a "significant role" in Blackstone's business and it was possible that the residential market downturn would come to affect the commercial markets in which Blackstone owned substantial assets, the Court reasoned that "[a] reasonable Blackstone investor may well have wanted to know of any potentially adverse trends" concerning Blackstone's real estate investments.25 In any event, the plaintiffs had alleged enough facts connecting the real estate downturn with potential adverse effects on Blackstone's real estate investments to state a plausible claim.

Potential Impact of Litwin

While it is too early to tell whether Litwin will prove to be the harbinger of an influx of new MD&A cases, at a minimum the decision is likely to encourage plaintiffs to consider Item 303(a) as a basis for private litigation under the Securities Act. As a result, issuers should carefully consider the potential effects of economic trends on their financial condition and results of operations, even if these trends are in the public domain. Litwin makes it clear that disclosing the general trend(s) is not enough. Instead, issuers must "connect the dots" by disclosing the manner in which those then-known trends, events or uncertainties might reasonably be expected to materially impact their future revenues."26

Additionally, the decision's focus on individual business segments rather than the publicly reporting entity itself will likely promote efforts by plaintiffs to circumvent the traditionally accepted 5% materiality threshold. As a result, issuers with multiple business units should focus on known trends that are reasonably likely to materially impact revenues or income and consider the impact of such trends on all material aspects of the issuer's business.