The Supreme Court recently agreed to review a case involving the impact of MD&A disclosures on Rule 10b-5 liability, and its opinion will draw significant interest from public issuers, who frequently face the difficult question of when and how to disclose contingent, but potentially material, events. This alert discusses what companies and investors need to know.
On March 27, 2017, the Supreme Court agreed to review a Second Circuit decision, which allows a securities plaintiff to meet the “duty to disclose” element of a Rule 10b-5 omissions case by alleging that the withheld facts were required to be disclosed under Regulation S-K, Item 303. Leidos, Inc. v. Indiana Public Retirement System, 2016 WL 7011426 (U.S. March 27, 2017) (No. 16-581). Item 303 requires annual reports on Form 10-K and certain other securities filings to contain a management discussion and analysis (MD&A) section, and specifies the subjects required to be discussed in it, including “known trends or uncertainties.” The Court is now poised to resolve a split in the circuits as to the role that such Item 303 disclosures play in Rule 10b-5 litigation.
The Court’s opinion will draw significant interest from public issuers, who frequently face the difficult question of when and how to disclose contingent, but potentially material, events, a problem that can arise in a wide variety of circumstances such as ongoing government investigations, whistleblower claims or problems with a major product. The need to address the risk of Rule 10b-5 liability, while at the same time managing the underlying problem, is a common reason clients seek legal advice from their Nixon Peabody counsel.
Section 11 of the Securities Act of 1933 provides a private right of action for investors who purchase securities pursuant to a registration statement that “omit[s] to state a material fact required to be stated therein.” (Emphasis added.) Thus, SEC regulations regarding what is required in a registration statement also shape the scope of civil liability for non-disclosure.
Liability under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 has evolved along a different path; mere non-disclosure of a fact is not actionable absent some affirmative “duty to speak.” Defense lawyers – at least in some jurisdictions – may argue that the duty to speak under Rule 10b-5 has been held to arise in only two specific circumstances: (1) where an insider has material non-public information, he/she is barred from trading in the issuer’s securities unless the facts are disclosed, and (2) where a duty to disclose arises when necessary to “tell the whole truth”—i.e., where the omission of a fact would render other statements made on the same subject matter misleading. See, e.g., Dirks v. SEC, 463 U.S. 646, 654 (1983); Chiarella v. United States, 445 U.S. 222, 230 (1980). In the Leidos case, those two different approaches to omission liability have now become blurred, leading to the Court’s recent grant of certiorari.
The defendant in Leidos (then called SAIC) was a large publicly traded systems integration company. Plaintiff alleged that at the time Leidos issued its 2011 annual report on Form 10-K, it was aware that it was under investigation for a kickback scheme, which was likely to result in a material liability for the company. News reports had already disclosed criminal charges against certain persons involved in the scheme (but not SAIC itself). Nevertheless, SAIC’s annual report was silent on the subject. Five months later, SAIC disclosed that its financial results would be materially impacted by the scandal, and that it faced a “probable” large restitution obligation. A complaint under Rule 10b-5 promptly followed.
The district court dismissed the complaint, but the Second Circuit reversed, holding that plaintiff had adequately pled an actionable omission under Rule 10b-5 by alleging that the annual report failed to disclose the threatened kickback liability as a “known trend or uncertainty” in the MD&A section of the annual report. The fact that the annual report said nothing at all about the subject was no defense. The “duty to speak” element for omission liability under Rule10b-5 was satisfied by the SEC regulations concerning MD&A disclosure.
In its petition for certiorari, Leidos portrayed the Second Circuit opinion as a dramatic departure from the existing limited “duty to speak” principles under Rule 10b-5. From the defense perspective, the opinion potentially sweeps into Rule 10b-5 all of the subjects required to be addressed in Item 303. According to defendants, this erodes the principle articulated in Matrix Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011), that issuers can limit their duty to discuss sensitive topics by saying nothing about them at all. Even worse, the MD&A subjects are inherently “soft” and subjective. For example, Item 303 mandates disclosure of “known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact.” (17 C.F.R. § 229.303(3)(ii).) The specter of a duty by issuers to make predictions about the future under Regulation S-K combined with Rule 10b-5 liability if they guess wrong is a daunting prospect for company management. Moreover, defendant argued, the standards for materiality under Item 303 are broader and less certain than the well-established test for materiality in Rule 10b-5 litigation under Basic v. Levinson, 485 U.S. 224 (1988).
In opposing the certiorari petition, plaintiff pointed out that a number of prior cases have stated that the duty to disclose arises in three circumstances, not two, one of which is when disclosure is required by a statute or regulation. However, they also reassured the Court that allowing a duty to disclose to be premised on Item 303 will not unduly expand Rule 10b-5. For example, in another recent Second Circuit case, Stratte-McClure v. Stanley, 776 F.3d 102, 103 (2d Cir. 2015), the court held that a violation of the Item 303 disclosure obligation does not by itself establish an actionable omission under Rule 10b-5; all the elements of Rule 10b-5 liability still need to be met, including materiality under the standard in Basic and, of course, scienter.
Defendants counter that even though some prior cases have referred to a duty to disclose based on the mandate of a statute or regulation, few if any cases have found liability solely on that basis, and that Item 303 is the worst possible candidate to support such a duty. The SEC itself has stated that “[t]he 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, cited in Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000).
The Court’s decision to grant review was clearly prompted by a split in the circuits on this issue. The Ninth Circuit held in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046, 1056 (9th Cir. 2014), that “[I]tem 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” See also Oran v. Stafford, supra.
The securities defense bar values black and white tests for liability because they can potentially serve as the basis for a motion to dismiss or for summary judgment. The doctrine that there is no general duty to speak under Rule 10b-5 has, in many courts, served as such a test. The focus of the battle before the Supreme Court will be whether the defense bar can convince the justices to preserve or even enhance the “duty to speak” as a useable bright line test, or whether the duty to speak barrier will be eroded by the soft and subjective disclosure requirements of Regulation S-K.
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