In deciding, courts have been forced to tackle competing concerns—namely, the differing legal standards of Item 303 and Rule 10b-5 and the practical consequences of increased litigation and forum shopping. Inconsistency of results among the courts of appeals is troubling because the most divergence has come from the circuits where the bulk of this litigation occurs.
Less than two years after declining to resolve this circuit split in the wake of the Ninth Circuit’s decisions in In re Nvidia Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), the Supreme Court has granted certiorari in Leidos, Inc. v. Indiana Public Retirement System, to review similar questions presented by the Second Circuit in Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016).
Disclosure: A Regulatory Tool
Disclosure has long been a favorite and forceful tool of the federal government in regulating the securities markets, as evidenced by the Securities Exchange Act of 1934. Regulations promulgated under that act have wielded this tool by imposing a complex system of mandatory disclosure requirements. The act itself was an outgrowth of the congressional goal to “protect investors against false and deceptive practices that might injure them.” Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). The current tension between circuit court decisions arises from the interplay of two rules designed by the SEC to further this goal: Item 303 of Regulation S-K and Rule 10b-5.
Section 10(b): Fraud with a Cause (of Action)
As the Supreme Court has remarked, section 10(b) was specifically designed to safeguard against “manipulative and deceptive practices which . . . fulfill no useful function.” Hochfelder, 425 U.S. at 204–5 (quoting S. Rep. No. 792, 73d Cong., 2d Sess., at 6 (1934)). Courts have read Rule 10b-5 to imply a private right of action for individual investors, although the rule itself contains no express language. Elisse B. Walters, Commissioner, Remarks Before the FINRA Institute at Wharton (Nov. 8, 2011).
To bring a successful Rule 10b-5 claim, six elements must be satisfied. A plaintiff must demonstrate “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157 (2008).
In this context, the Supreme Court has construed “materiality” as “a substantial likelihood that a reasonable shareholder would consider [information] important in deciding how to vote.” Basic Inc. v. Levinson, 485 U.S. 224 (1988). If the information or event is contingent or speculative, the question of materiality depends on a balancing of the probability of occurrence and the anticipated magnitude of the event in light of the totality of the company activity (the “probability/magnitude test”). Allan Horwich, An Inquiry into the Perception of Materiality as an Element of Scienter under SEC Rule 10b-5 (Nw. Univ. Sch. of Law, Faculty Working Paper 15, 2011). Central to this cause of action is a regulated entity’s duty to disclose “material fact[s] necessary in order to make . . . statements made . . . not misleading.” Arnold S. Jacobs, “What Is a Misleading Statement or Omission under Rule 10b-5?,” 42 Fordham L. Rev. 243 (1973).
Item 303: Fraud Without a Cause (of Action)
Item 303 of Regulation S-K was similarly designed to foster disclosure by companies filing with the SEC and their investors. Specifically, “the SEC has long viewed [Item 303] as an important and unique opportunity to get a glimpse of the company ‘through the eyes of management.’” SEC, Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operation, Release Nos. 33-8350, 34-48960 (Dec. 19, 2003). Item 303 accomplishes this goal by requiring SEC-registered entities to provide investors and other users information relevant to assess the entity’s financial condition. The specific information required is aimed at targeting and evaluating risk related to cash flows from operations and from outside sources. Discussion and analysis must focus on “material events and uncertainties [known to management] that would cause reported financial information not to be necessarily indicative of future operating results or future financial condition.” Id.
To comply with Item 303’s requirements, an SEC-registered body must anticipate known facts or events that have the potential to affect future operations, where those operations have or have not yet occurred or been formerly impactful. As with Rule 10b-5, the question of materiality arises. In the Item 303 context, materiality is a twofold consideration of (1) whether an uncertainty is reasonably likely to occur, and (2) if so, what is an objectively evaluated consequence of its occurrence. Lauren M. Mastronardi, “Shining the Light a Little Brighter: Should Item 303 Serve as a Basis for Liability under Rule 10b-5?,” 85 Fordham L. Rev. 335 (2016). The materiality calculus in this realm is flexible. Because Item 303 provides no private right of action, the question before the courts has become whether an alleged disregard of disclosure requirements constitutes an actionable omission for purposes of supporting a Rule 10b-5 securities fraud claim.
The crucial overlap analyzed by courts between the requirements of Rule 10b-5 and Item 303 is the construction and application of respective materiality standards. The Second, Third, and Ninth Circuits, in which an overwhelming number of securities class actions are initiated (Svetlana Starykh & Stephan Boettrich, Recent Trends in Securities Class Actions: 2015 Full-Year Review (Jan. 25, 2016)), have increasingly grappled with Item 303’s and Rule 10b-5’s standards for defining materiality. These courts have arrived at different conclusions about whether alleged Item 303 violations can serve as a valid means of imposing liability under Rule 10b-5.
2000: No Automatic Liability: Third Circuit
In Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), Circuit Judge Samuel Alito addressed Item 303 in the context of a putative class action brought against American Home Products Corporation (AHP) and select directors and officers of the corporation for alleged omissions made regarding certain weight-loss drugs pulled from the market due to safety concerns. Kate Cohen, “Fen Phen Nation,” Frontline (Nov. 3, 2003). Investors banded together in suit, claiming to have suffered substantial financial loss as a result of the withheld information related to the medications’ side effects. The complaint, alleging violations of Rule 10b-5, was dismissed because the failure to disclose certain reports relating to the drugs’ health concerns was “immaterial as a matter of law”—their disclosure “would not have materially altered the substance of [AHP’s press] release.”
On appeal to the Third Circuit, the plaintiffs posited a theory of liability rooted in AHP’s obligations under Item 303. The plaintiffs aimed to prove that Item 303 imposed an obligation to disclose “known trends and uncertainties” sufficient to support a claim under Rule 10b-5. The Third Circuit, noting that no private right of action exists independently under Item 303, held that “a violation of [Item 303’s] reporting requirements does not automatically give rise to a material omission under Rule 10b-5” due to the differing standards of materiality. While the “general test for securities fraud materiality set forth by the Supreme Court . . . was forward-looking and confined to an analysis of the event’s probability versus the anticipated magnitude of the event viewed in light of the company’s activity,” Item 303’s definition was not so restrictive. In finding the materiality standards of 10b-5 and Item 303 inapposite (Brief for the Securities Industry and Financial Markets Association and the Chamber of Commerce as Amicus Curiae Supporting Petitioner, Leidos Inc. v. Ind. Pub. Ret. Sys., No. 16-581)), the Third Circuit set a precedent against transposing Item 303 violations into automatic Rule 10b-5 liability.
2014: No “Material” Link: Ninth Circuit
In 2014, the Ninth Circuit, drawing on Oran, held that Item 303 does not create a duty to disclose for purposes of Rule 10b-5 liability. The plaintiffs banded together in suit against NVIDIA Corporation (In re NVIDIA Corp. Sec. Litig., 767 F.3d 1046 (2014)), a publicly traded semiconductor company, for failing to disclose product defects on several forms filed with the SEC, which investors claimed to have been “materially false and misleading” in violation of Item 303. Charlie Demerjian, “Why NVIDIA’s Chips Are Defective,” Inquirer, Sept. 1, 2008. NVIDIA’s subsequent disclosure of the product defects caused a substantial decline in the company’s share price and market capitalization.
Wrestling with the varying materiality standards of Item 303 and Rule 10b-5, the court found that Item 303 uses different criteria for obligatory disclosures than Rule 10b-5, requiring more disclosures than Rule 10b-5 does. Given the differing standards, the court explained, demonstrating an Item 303 violation does not inevitably mean that Rule 10b-5 is violated. Essentially, the Ninth Circuit adopted a view whereby there may be a correlation between Item 303 violations and Rule 10b-5 violations; however, such correlation is not tantamount to a premise for liability under Rule 10b-5.
The NVIDIA plaintiffs submitted a petition for certiorari in the hopes of obtaining Supreme Court review of the holding, which was denied on May 26, 2015. Proponents of the petition argued that NVIDIA conflicts directly with Second and Third Circuit precedent. Opposition to the petition argued that this proliferating body of case law is not so at odds as to necessitate immediate review.
2015: Second Circuit’s Cautious Attachment in Stratte-McClure
After Oran and NVIDIA, the Second Circuit took on this issue as a matter of first impression in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015). In this putative securities class action, the plaintiffs alleged that Morgan Stanley and six of its present and former officers made material misstatements and omissions to conceal the entity’s exposure to and losses from the subprime mortgage market. Landon Thomas, “$9.4 Billion Write-Down at Morgan Stanley,” N.Y. Times, Dec. 20, 2007. The plaintiffs alleged that the defendants made numerous material misrepresentations and omissions that fraudulently inflated Morgan Stanley’s stock price and caused the plaintiffs to incur financial losses when Morgan Stanley’s exposure and losses came to light.
Unlike the Third Circuit, the court in Stratte-McClure held that “a failure to make a required Item 303 disclosure . . . is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim.” The court was careful to note that “such an omission is actionable only if it satisfies the [requisite] materiality requirements” and other elements of a 10b-5 claim. To the court, because section 10(b) liability has long been permissible as a derivative of other statutes or regulations that require a party to “speak,” omissions that constitute a violation of Item 303 can also give rise to liability under Rule 10b-5 in the appropriate circumstance.
The Second Circuit’s analysis carefully describes how a violation of Item 303 may permit a plaintiff to state a viable 10b-5 claim. Alone, an Item 303 violation is insufficient to impose liability. Rather, the violation must be isolated and placed into a Rule10b-5 analysis, meeting all requisite elements. This includes satisfaction of Rule 10b-5’s probability/magnitude test for determining the materiality of an event, as set forth in Basic. This overlay suggests that an Item 303 violation can offer evidence of possible 10b-5 liability. Stephen J. Crimmins & James K. Goldfarb, “Will the Supreme Court Expand Silence as a Basis for Securities Fraud?,” CLS Blue Sky Blog, Apr. 4, 2017. However, for liability to attach, the Item 303 violation must pass muster under Rule 10b-5’s well-established elements, including the rule’s more tailored materiality standard.
2016: U.S. Supreme Court “Material”: Certiorari Granted in Leidos
On March 29, 2016, the Second Circuit rendered its decision in Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85 (2016). That case arose from a series of alleged material misstatements in SAIC’s public filings regarding its exposure to liability for employee fraud. SAIC was in charge of implementing an expansive automated timekeeping program known as CityTime for employees of various agencies. SAIC’s deputy program manager, however, enlisted a small unknown company to provide staffing services on the project, which later gave rise to an elaborate kickback scheme. Benjamin Weiser, “3 Found Guilty in CityTime Corruption Trial,” N.Y. Times, Nov. 22, 2013. The scheme was detected and an audit conducted into SAIC’s role in the CityTime project, which revealed the deputy program manager’s heavy involvement.
Despite the audit findings, SAIC did not disclose its potential liability on its SEC Form 10-K. After SAIC disclosed its potential exposure in later SEC filings, the affected putative class of plaintiffs sued, claiming that SAIC’s initial omission gave rise to liability through Item 303. At the district court level, SAIC won and the case was dismissed.
On appeal, the Second Circuit reversed in part, holding that the plaintiffs adequately alleged that SAIC failed to make required disclosures under Item 303 in its March 2011 10-K. To the court, omitting statements from SAIC’s Management’s Discussion & Analysis that Item 303 requires could give rise to securities fraud liability under section 10(b). Building on Stratte-McClure’s permissive language, the court acknowledged that its holding was “at odds with the Ninth Circuit’s recent opinion” in NVIDIA.
On October 31, 2016, Leidos, Inc. (SAIC’s new name) filed a petition for certiorari. In arguing in its reply brief against the expansion of 10b-5 liability, Leidos focuses on the specific situations that give rise to an affirmative duty to disclose under Rule 10(b), as compared with the speculation inherent in Item 303 disclosures. The respondents’ present argument against expanding 10b-5 liability to include Item 303 violations is that section 10(b) and Rule 10b-5 do not create a broad and affirmative duty to disclose. Rather, disclosure is required only when necessary “to make . . . statements made, in the light of the circumstances under which they were made, not misleading.” “Why Item 303 Just Doesn’t Matter in Securities Litigation,” Law360, Oct. 13, 2015. (Log-in required.) Item 303 thus imposes disclosure obligations surpassing the outer limits of what Rule 10b-5 requires, insofar as Item 303 “mandates disclosure of specified forward-looking information and [provid]es its own standard for disclosure—i.e., reasonably likely to have a material effect.”
Because of the great conflict between the Ninth Circuit’s and the Second and Third Circuits’ approaches to the interplay of Item 303 and Rule 10b-5, the U.S. Supreme Court has agreed to step in and resolve the circuit split. The case is set to be argued in its October 2017 Term.