The Supreme Court recently agreed to review a case which has split the circuit courts and has potentially huge implications for disclosure liabilities of public companies. The case, Leidos Inc. v Indiana Retirement System, centers on the failure to disclose in SEC periodic reports the existence of a governmental investigation, which ultimately proved to be a very material development. The issue in the case is whether such failure to comply with a Regulation S‑K line item disclosure is actionable only by the SEC or raises a private cause of action for investors in the company’s stock under Rule 10b‑5. The particular line item at issue is Regulation S‑K Item 303, which requires disclosure of known trends or uncertainties reasonably likely to have a material impact.
Historically, the failure to address line item disclosures required by Form 10‑K and 10‑Q under the Exchange Act of 1934 does not, standing alone, provide investors with a private cause of action to sue. Instead, the SEC has the right to remedy such omissions through comment letters submitted directly to the issuer and, in more egregious circumstances, enforcement actions against the company. The primary tool for aggrieved investors to recover losses directly from an issuer has been Rule 10b‑5. However, by its express terms, a Rule 10b‑5 action based on an issuer’s failure to disclose can only be maintained if such omission causes affirmative statements made by the issuer to be misleading. So, while not disclosing a big, problematic governmental investigation may violate the Regulation S‑K line item disclosure, it is not a violation of Rule 10b‑5 if the issuer had never made any affirmative statement suggesting the absence of such an investigation. This is because there must be an underlying affirmative statement that is rendered false or misleading by the later omission.
The Supreme Court affirmed this fundamental principle in the seminal case of Basic v. Levinson, stating “silence, absent a duty to disclose, is not misleading under Rule 10b-5.” Periodic disclosure requirements have not been considered by courts or practitioners to raise such a duty to disclose under 10b‑5, until now, when the Second Circuit Court of Appeals took a different view in the Leidos case. The Second Circuit held that the failure to make a disclosure required by Regulation S‑K can form the basis for a 10b‑5 omission claim by investors, even if the omitted material facts do not render an affirmative statement misleading. This is contrary to holdings by the Ninth Circuit that a duty of an issuer to disclose information under SEC regulations does not necessarily create a duty for purposes of a 10b‑5 claim. This split in the circuits caused the Supreme Court to grant certiorari to resolve the split.
Both sides of this debate – issuers and investors – see great significance in the outcome of the Leidos case. The investor community contends that investors expect to see disclosure of information that the SEC requires by regulation and, if a public company fails to comply with those regulations, it is only fair that investors harmed by such failure be able to bring an action directly against the company.
Public companies facing lawsuits from investors view the Second Circuit’s ruling as threatening to open the floodgates of vexatious 10b‑5 litigation. They are particularly alarmed because the Regulation S‑K Item 303 mandatory disclosure involved in the Leidos case is one of the most difficult disclosure requirements found in Regulation S‑K, as it calls for a subjective determination as to what constitutes a “known trend or uncertainty” and then a prediction as to whether the uncertainty is likely to have a “material impact” in the future.
The issue is joined on a recurring, quarterly basis in drafting a company’s MD&A. Issuers often conclude that the best course is to be silent about a particular circumstance because it is not clear that the circumstance is likely to have a material impact, and drafting full and fair disclosure can be problematic in a fluid situation where the facts have not yet fully played out. Issuers contend that the appropriate forum within which to regulate those difficult disclosures is before the SEC Staff who have expertise in such matters, as opposed to in expensive and disruptive shareholder litigation. But, the Second Circuit’s position in Leidos would make a non-disclosure decision the basis for shareholder class actions anytime the omitted speculative matter later turns out to have been materially adverse, as was the case in Leidos.
The Leidos approach would substantially increase the exposure of public companies to shareholder lawsuits under Rule 10b‑5. Further, potential liability to investors would not necessarily be limited to the required Regulation S-K disclosures that are at issue in the Leidos case. The Second Circuit theory that a 10b‑5 claim may be based on a duty to disclose mandated by federal regulations could also be held to apply to any other statutes or regulations containing specific disclosure requirements.
Handicapping the outcome of a Supreme Court case is always difficult, but we read the tea leaves as pointing toward the court agreeing with the issuer that the basis of a private Rule 10b‑5 claim should not be expanded to include omissions of required Regulation S‑K disclosures. This view is based largely on the Supreme Court recent trend to limit private rights of action under Rule 10b‑5.
That trend may be advanced by the recent addition of Justice Neil Gorsuch to the Court. Justice Gorsuch published an article some years ago that suggested he would take a hardline on shareholder litigation, noting that securities class actions have “brought with them vast social costs.” Public company issuers and those responsible for drafting their periodic disclosure documents, particularly those charged with addressing the requirement to discuss the future impact of known trends and uncertainties, will be anxiously awaiting the result.