In Leidos, Inc. v. Indiana Public Retirement System, No. 16-581, the U.S. Supreme Court will resolve an important circuit split regarding securities fraud liability. Specifically, the Court will determine whether Item 303 of SEC Regulation S-K (“Item 303”) creates a duty to disclose that is actionable under Section 10(b) of the Securities Exchange Act of 1934 (“Section 10(b)”) and SEC Rule 10b–5 (“Rule 10b–5”).
The Second Circuit recently held that Item 303 imposes a duty of disclosure that gives rise to liability, while the Ninth Circuit has held that it does not. The Court’s resolution of the case will not only resolve this circuit split, but could potentially expand the scope of securities fraud liability for omissions and open the door to Section 10(b) claims based on violations of other statutes or regulations.
Overview of Item 303
Item 303 requires corporate managers to “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.”1 The SEC has clarified that management must make two assessments when considering the existence of a trend or uncertainty:
- 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.
- 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.2
The Ninth Circuit Holds that an Item 303 Violation is Not Actionable Under Section 10(b)
In In re NVIDIA Corp. Sec. Litig., the Ninth Circuit held that a violation of Item 303 is not actionable under Section 10(b) and Rule 10b–5.3 Specifically, the court held that a semiconductor company could not be liable for securities fraud by failing to disclose certain product defects, as the plaintiffs argued was required under Item 303.4 In affirming the dismissal of the plaintiffs’ complaint, the Ninth Circuit relied on Supreme Court precedent holding that neither Section 10(b) nor Rule 10b–5 “creates an affirmative duty to disclose any and all material information” and that “silence, absent a duty to disclose, is not misleading under Rule 10b–5.”5 Instead, “[d]isclosure is required under these provisions only when necessary to make . . . statements made . . . not misleading.”6
Addressing Item 303 specifically, the Ninth Circuit held that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b–5. Such a duty to disclose must be separately shown.”7 The court explained that Item 303 requires disclosure of forward-looking information which would not be material under Basic v. Levinson, a seminal Supreme Court case addressing the materiality standard under Section 10(b).8 In 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.”9 Discussing these differing materiality standards, the Ninth Circuit explained:
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.”10
The Ninth Circuit also relied on Oran v. Stafford, a Third Circuit decision written by then-Judge Alito, holding that “[b]ecause 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.”11
The Second Circuit Disagrees with the Ninth Circuit
In Stratte-McClure v. Morgan Stanley, the Second Circuit reached a contrary result. In that case, plaintiffs alleged that Morgan Stanley’s failure to disclose its exposure to risky subprime mortgages under Item 303 could give rise to Section 10(b) liability. The court agreed, “conclud[ing], as a matter of first impression in this Court, 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.”12 The court went on, however, to explain 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.”13
In holding that a violation of Item 303 could give rise to Section 10(b) liability, the Second Circuit explained that a failure to disclose material information required by Item 303 would, in fact, be misleading because investors expect such information to be disclosed.14 The court wrote:
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).15
The Second Circuit also relied upon Judge Alito’s decision in Oran—the same case which the Ninth Circuit relied upon in In re NVIDIA. The Second Circuit explained that, although the Oran court held that the plaintiff had not pleaded a Section 10(b) claim in that particular case, Oran did not hold that an Item 303 violation can never give rise to Section 10(b) liability:
Oran simply determined that, because 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. 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.16
The Supreme Court Grants Certiorari to Resolve the Circuit Split
In Indiana Public Retirement System v. SAIC, Inc., the Second Circuit applied Stratte-McClure to reinstate a Section 10(b) claim based on an alleged violation of Item 303.17 The lawsuit arose from an alleged kickback scheme in which a project manager for SAIC (which subsequently changed its name to Leidos) and a subcontractor defrauded New York City.18 The plaintiff alleged that the company was obligated under Item 303 to disclose its potential liability relating to the scheme, including its potential obligation to reimburse the City for hundreds of millions of dollars, and the likely negative impact on its government contracts, a main source of the company’s revenue.19 Relying on Stratte-McClure, the court noted that Item 303 did, in fact, impose an affirmative duty to disclose the omitted information for purposes of Section 10(b) liability, and held that the plaintiffs had adequately pleaded an Item 303 violation.20
Following the ruling, Leidos filed a petition for a writ of certiorari, seeking review of whether the Second Circuit erred in holding, contrary to the Ninth Circuit, that Item 303 creates a duty to disclose that is actionable under Section 10(b) and Rule 10b–5.21 In addition to seeking a resolution of the circuit split, Leidos argued that the case presents the Supreme Court with an opportunity to clarify the scope of the duty to disclose under Section 10(b).22 Specifically, Leidos argued that the Supreme Court has held that such a duty arises only in two circumstances—insider trading and when necessary to avoid making other disclosures misleading—and not when a statute or regulation requires disclosure.23 On March 27, 2017, the Supreme Court granted certiorari.24
Implications of the Supreme Court’s Decision
The Supreme Court’s decision will have a significant impact on issuers. Of most importance, an affirmance of the Second Circuit’s ruling would expose issuers to lawsuits that are unfairly based on plaintiff hindsight. Item 303 concerns the disclosure of soft information, including predictions and matters of opinion not subject to objective verification, such as “known trends.” However, it is often difficult to determine in real time whether or not a “trend” exists based on a few existing data points. Likewise, predicting the future impact of a purported trend involves the exercise of managerial judgment against a backdrop of incomplete, imperfect, and evolving information. Plaintiffs, however, will view these events with the benefit of hindsight and will not hesitate to second guess those difficult judgments. By exposing issuers to liability based on Item 303, therefore, the Supreme Court would significantly expand the risks that issuers face. Indeed, since the Ninth Circuit’s decision in In re NVIDIA in October 2014, there have been 21 new cases alleging liability for Item 303 violations in the Second Circuit, compared to only five in the Ninth Circuit.25 Obviously, an affirmance of the Second Circuit’s decision will lead to additional Item 303-based claims throughout the country.
Moreover, if the Supreme Court agrees with the Second Circuit that a violation of Item 303 is actionable under Section 10(b) and Rule 10b–5, then the door may be opened to claims based on violations of other SEC rules. SEC rules require disclosure of all sorts of different information. Under the Second Circuit’s reasoning, a failure to disclose any of this information could give rise to omission liability under Section 10(b).
In sum, the Supreme Court’s decision will be significant. Not only will the Court’s ruling resolve a pending circuit split, it will also have a considerable effect on liability under the securities laws and the extent to which companies will make forward-looking statements in the MD&A sections of their future SEC filings. Most troublingly, it could open the door to new theories of liability under Section 10(b) and Rule 10b–5 and expose issuers to fraud lawsuits unfairly based on hindsight.