This article discusses the potential impact of a Court ruling in Leidos, while providing a general overview of the state of the law in certain areas of private securities litigation. The Leidos appellants have asked the Court to defer to a Ninth Circuit decision rejecting an expansive view of securities fraud liability and to a Third Circuit decision authored by then judge Alito. The Second Circuit’s decision, if affirmed, could open the floodgates to fraud claims based on the failure to comply with any of a host of regulatory disclosure requirements, many of which were never intended to provide for private rights of action in general, let alone for fraud under section 10(b), a concern highlighted in the amici briefs submitted by the Chamber of Commerce, the Securities Industry and Financial Markets Association (SIFMA), and National Association of Manufacturers (NAM). The ascent of Justice Gorsuch, viewed as a strict constructionist who favors curbing regulatory overreach, combined with Justice Alito’s previous position on this issue, positions the Court to put the private sector’s concerns to rest.
Summary of the Facts
In 2000, SAIC, a technology company, contracted with the city of New York to build an automated timekeeping program known as “CityTime.” SAIC, 818 F.3d at 89. (Leidos was named SAIC, Inc., when the litigation was first filed. As a result, the Second Circuit’s opinion refers to the defendants as SAIC.) In working on the project, two Leidos employees and a CityTime subcontractor defrauded the city of New York and Leidos through an elaborate kickback scheme. Leidos potentially first learned of the CityTime fraud in late 2010 or, at the latest, in March 2011. Yet, Leidos did not disclose any potential liability related to the CityTime fraud in its annual report or 10-K filed with the SEC on March 24, 2011. It was not until June 2011 that Leidos disclosed, in a current report on Form 8-K filed with the SEC, that federal and local criminal authorities were investigating possible criminal conduct connected to CityTime.
The plaintiffs filed a private action against Leidos alleging, among other claims, that Leidos violated section 10(b) of the 1934 Act when it failed to disclose the potential liability arising out of the CityTime fraud in response to Item 303 on Leidos’s March and June 2011 SEC filings. Item 303 requires disclosure of “any known trends or uncertainties” that could have a material effect on liquidity, capital resources, or revenues. 17 C.F.R. § 229.303. The district court dismissed the case, finding that the complaint failed to sufficiently plead a violation of Item 303’s disclosure requirements because it did not establish that Leidos had “actual knowledge” of the purported trend. Essentially, the court found that Item 303 omissions were not sufficient to plead a section 10(b) claim.
The plaintiffs appealed to the Second Circuit Court of Appeals, which disagreed with the district court, finding that the failure to disclose an Item 303 matter can be the basis for a section 10(b) fraud claim. The Second Circuit decision conflicts with decisions from the Ninth and Third Circuits, thus creating the circuit split that led the Supreme Court to grant certiorari on the question of whether Item 303 creates a duty to disclose that is actionable under section 10(b) and Rule 10b-5 promulgated thereunder.
The Lines Are Drawn: Summary of Immediate and Significant Law and Precedents
The conflicting decisions of the Second, Ninth, and Third Circuits are a culmination of case precedent stemming from the Supreme Court’s decision in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), which established the principle that “silence, absent a duty to disclose, is not misleading under Rule 10b-5.”
The Third Circuit Court of Appeals was the first to address this principle in the context of Item 303 in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), written by then circuit judge Alito. Oran held that Item 303 does not impose an affirmative duty to disclose actionable as securities fraud “[b]ecause the materiality standards for Rule 10b-5 and [Item 303] differ significantly.” The Third Circuit found that because a violation of Item 303’s disclosure requirements “does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5,” an Item 303 omission is insufficient to support a private fraud claim under section 10(b) and Rule 10b-5.
The Supreme Court reaffirmed its Basic decision in recent years in Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011), stating that section “10(b) and Rule 10b-5 do not create an affirmative duty to disclose any and all material information.” The Court stated that “[e]ven with respect to information that a reasonable investor might consider material, companies can control what they have to disclose under these provisions by controlling what they say to the market.”
The Ninth Circuit relied on the Supreme Court’s decisions in Basic and Matrixx when it addressed this issue in In re NVIDIA Corp. Securities Litigation), 768 F.3d 1046, 1056 (9th Cir. 2014), finding that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” The Ninth Circuit also relied on the Third Circuit’s opinion in Oran to find that “[m]anagement’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic” for Rule 10b-5 liability and that “what must be disclosed under Item 303 is not necessarily required” for Rule 10b-5.
One year later, in Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 100 (2d Cir. 2015), the Second Circuit took a different route and 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” (emphasis added). In an express rejection of the Ninth Circuit’s NVIDIA decision, the Second Circuit interpreted Oran to mean that “in certain instances[,] a violation of Item 303 could give rise to a material 10b-5 omission.” The Second Circuit also relied on its own decision in Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012), which reasoned that because the prohibition on omissions provided by section 12(a)(2) of the 1933 Act is textually identical to that of Rule 10b-5, Item 303 omissions should be actionable under both.
Does Item 303(b) Implement Section 10(b)?—Chevron Analysis
In claiming that a failure to comply with Item 303(b) creates an omission that is actionable fraud under section 10(b), the plaintiffs in SAIC make the implicit—but required—presumption that Item 303 is a regulation promulgated to implement section 10(b), an act of Congress. A review of the history of federal court deference to federal agency interpretation of federal statutes under Chevron suggests that such a presumption is untenable. There is no express authority in section 10(b), or intention by the SEC in promulgating Item 303, indicating that a violation of the broad disclosure requirements in Item 303 could serve as the basis of a fraud claim under section 10(b).
Administrative agencies like the SEC may regulate with rules or regulations only when statutorily empowered to do so by Congress. See Chevron USA v. Nat. Res. Def. Council, 467 U.S. 837 (1984); United States v. Mead Corp., 533 U.S. 218 (2001). This is because “[t]he rulemaking power granted to an administrative agency charged with the administration of a federal statute is not the power to make law.” Rather, it is “‘the power to adopt regulations to carry into effect the will of Congress as expressed by the statute.’” Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
When examining whether a rule or regulation promulgated by an agency—such as Rule 10b-5 or Item 303 of Regulation S-K—is supported by the statute empowering the agency to act, the court will examine the language of the implementing statute, the language of the agency rule, and the intent of the agency as expressed in the rulemaking documents and records. If the intent of Congress in the enabling legislation is clear, both the agency and the reviewing court “must give effect to the unambiguously expressed intent of Congress.” Chevron, 467 U.S. at 842–43. To judge how much leeway an agency has in administering a statutory program created by Congress, the court must determine whether Congress has expressly delegated power to the agency or whether the agency is exercising an implicit delegation of authority to administer the statute. “If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation.” Id. at 843–44. The court will approve Chevron deference to the agency rule or regulation when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law and that the agency properly exercised that authority in making its interpretation under the rule or regulation.
The SEC could not have been clearer in word and procedure that it was enacting Rule 10b-5 pursuant to express congressional authority granted by section 10(b) and that Rule 10b-5 was intended to regulate conduct proscribed by section 10(b). Section 10(b), the antifraud provision of the 1934 Act, expressly authorizes the SEC, “as necessary or appropriate in the public interest or for the protection of investors,” to prohibit by “rules and regulations” any “manipulative or deceptive device or contrivance” that is “in connection with the purchase or sale of a security,” the “contravention” of which is “unlawful.” 15 U.S.C. § 78j(b). Rule 10b-5, which literally tracks some of the language of section 10(b), furthers this purpose. In its initial release of Rule 10b-5, the SEC noted it was promulgating the rule “pursuant to authority conferred upon it by the Securities Exchange Act of 1934, particularly Sections 10(b) and 23(a) thereof.” SEC Release No. 3230 (May 21, 1942). The SEC explains the issuance of Rule 10b-5 in a section of the Federal Register entitled “Manipulative and Deceptive Devices and Contrivances,” which contains language taken directly from section 10(b). Legions of cases and scholarship support this obvious principle and uphold the SEC’s creation of Rule 10b-5 to regulate conduct prohibited by section 10(b). See, e.g., Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157 (2008) (“Rule 10b-5 encompasses only conduct already prohibited by §10(b).”); Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 173 (1994) (“We have refused to allow 10b-5 challenges to conduct not prohibited by the text of the statute [section 10(b)].”); Aaron v. SEC, 446 U.S. 680, 687–88 (1980) (“Pursuant to its rulemaking power under this section [10(b)], the Commission promulgated Rule 10b-5.”); Ernst & Ernst, 425 U.S. at 195 (“In 1942, acting pursuant to the power conferred by §10(b), the Commission promulgated Rule 10b-5.”); Michael Raymond, “Validity Challenges to SEC Rule,” 23 J. Marshall L. Rev. 305 (1990).
Accordingly, there is little doubt that Rule 10b-5 carries out the purpose of section 10(b) in a way that satisfies Chevron deference. If anything, the debate in the case law centers around how far courts can go in proscribing certain types of conduct under Rule 10b-5 and what standards should be imposed to prove a violation of that conduct. See, e.g., Cent. Bank of Denver, 511 U.S. at 164 (finding section 10(b) and Rule 10b-5 do not support liability for aiding and abetting in private securities actions based on the absence of any textual reference to “aiding and abetting” in section 10(b) or Rule 10b-5). Notably, the Supreme Court has “cautioned against” expansion of private causes of action under section 10(b) and Rule 10b-5, stating that “the §10(b) private right should not be extended beyond its present boundaries.” Stoneridge, 552 U.S. at 165.
It is against this backdrop that the Supreme Court will decide whether to expand the duties that can create omission liability under section 10(b) by holding that a reporting violation of Regulation S-K will give rise to a material omission under Rule 10b-5.
Item 303 of Regulation S-K Was Not Enacted Pursuant to Section 10(b)
In contrast to Rule 10b-5, the statutory authority pursuant to which the SEC enacted Item 303 in no way indicates that it was enacted to carry out the purpose of section 10(b). The SEC expressed no intention to use Item 303 as a mechanism to enforce section 10(b)’s prohibition against any “manipulative or deceptive device or contrivance” that is “in connection with the purchase or sale of a security,” the “contravention” of which is “unlawful.” To the contrary, “[n]either the language of the regulation [Item 303] nor the SEC’s interpretive releases construing it suggest that it was intended to establish a private cause of action, and courts construing the provision have unanimously held that it does not do so.” Oran, 226 F.3d at 287.
Indeed, the SEC has expressly indicated that standards for disclosure under Item 303 are different from the standards of disclosure governing fraud actions under section 10(b): “The probability/magnitude test for materiality approved by the Supreme Court [for section 10(b) cases] in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), is inapposite to Item 303 disclosure,” which requires disclosure of information “reasonably likely to have a material effect.” SEC Release No. 33-6835 n.27 (May 18, 1989) (emphasis added). In other words, Item 303’s “disclosure obligations extend considerably beyond those required by Rule 10b-5.” Oran, 226 F.3d at 288. Thus, the SEC was explicit in stating that the disclosure duties under Item 303 are different from the disclosure requirements that implicate section 10(b) in a private securities fraud case. Judge Alito, writing for the Third Circuit in Oran, noted that this interpretation by the SEC “is entitled to considerable deference.” Id. at 287. But see SEC v Conaway, 698 F. Supp. 2d 771 (E.D. Mich. 2010) (permitting section 10(b) jury instruction based on an Item 303 violation but acknowledging the “real concern that an unrestrained use of Item 303 in conjunction with Rule 10b-5 will lead to a surge in private securities litigation,” and ultimately justifying its section 10(b) jury instruction without reference to Item 303).
As previously stated, the Supreme Court’s concerns about the tenuous nature and support for the judicially created private cause of action under section 10(b) has caused the Court to “caution against its expansion” and to declare that “the §10(b) private right should not be extended beyond its present boundaries.” For one thing, while private actions exist for violations of section 10(b) and Rule 10b-5, they do not for Item 303 or Regulation S-K. For another, section 10(b) and Rule 10b-5 tether liability to a fraudulent act or omission occurring “in connection with the purchase or sale of any security.” Item 303 is not so limited—its purpose is “to provide to investors and other users information relevant to an assessment of financial condition and results of operations of the registrant. . . .” 17 C.F.R. § 229.303, Instruction No. 2 to Item 303(a) (emphasis added). In addition, unlike Rule 10b-5, Item 303 contains no language evidencing any intent that Item 303 was meant to prohibit “manipulative or deceptive” conduct. And “the language of §10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.” Cent. Bank of Denver, 511 U.S. at 174 (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462 (1977)).
Congress has given no authority under section 10(b), nor has the SEC indicated such intent in Item 303, to base a section 10(b) fraud action on a violation of the broad disclosure requirements in Item 303. Any attempt by the SEC to do so would be subject to challenge under a Chevron analysis, as discussed above. Moreover, if the SEC has no authority to make such claims, it is questionable whether private plaintiffs should be permitted to do so.
Notwithstanding the Second Circuit’s SAIC Decision, Government Investigations Do Not Trigger a Generalized Duty to Disclose
The Second Circuit in SAIC held that the company had a duty under Item 303 to disclose “ongoing criminal and civil investigations that exposed it to potential criminal and civil liability. . . .” SAIC, 818 F.3d at 96 n.8. The court found that the investigations were “known trends or uncertainties” in which the company “could be” implicated in fraud and concomitant monetary penalties, thus triggering disclosure under Item 303, and by extension, section 10(b). See id. at 95.
But courts in the Second Circuit have held that companies have no general duty to disclose specific pending but uncharged and unadjudicated government investigations under various securities statutes and regulations. City of Pontiac Policemen’s & Firemen’s Ret. Sys. v. UBS, 752 F.3d 173, 183–84 (2d Cir. 2104) (finding no duty under sections 11 or 12 of the 1933 Act or Item 503(c)); Richman v. Goldman Sachs Grp., 868 F. Supp. 2d 261, 273–75 (S.D.N.Y. 2012) (section 10(b) of the 1934 Act and no duty to disclose SEC investigation or Wells Notice under Item 103); In re Lions Gate Entm’t Corp. Sec. Litig., 165 F. Supp. 3d 1, 11–16, 18–21 (S.D.N.Y. 2016) (finding no duty under Items 103, 303, and 503 of Regulation S-K to disclose SEC investigation or Wells Notice even when it resulted in administrative action).
In Richman, the plaintiffs alleged that the SEC investigated Goldman Sachs relating to its role in a synthetic collateralized debt obligation. The investigation led to the SEC’s transmission of a Wells Notice (a document indicating that the SEC was considering recommending charges of securities fraud against Goldman), Goldman’s response with a written “Wells submission,” Wells Notices to two Goldman employees, and a complaint against Goldman and one executive alleging securities fraud violations. Goldman subsequently reached a $550 million settlement with the SEC in which it admitted the securities fraud violations. After these events, the Financial Industry Regulatory Authority (FINRA) fined Goldman $650,000 for failing to disclose that its employees, who were registered with FINRA, had received Wells Notices, in violation of FINRA rules. Goldman admitted this violation when settling with FINRA.
The Richman class action suit for securities fraud followed this disclosure. The plaintiffs argued that Goldman had a duty to voluntarily disclose the pending SEC investigation and receipt of a Wells Notice before being compelled to do so by FINRA. In dismissing the Richman claim regarding nondisclosure of the investigation, the court recited the section 10(b) omission standard that a duty arises when a corporation chooses to speak, so that when it does choose to speak, it must be accurate and complete. But the court also found that “[t]he federal securities laws ‘do not require a company to accuse itself of wrongdoing.’” The district court stated that “[w]hile Goldman and [its employee] were ultimately sued, the Defendants were not obligated to predict and/or disclose their predictions regarding the likelihood of suit. . . . While Plaintiffs claim to want to know about the Wells Notices, ‘a corporation is not required to disclose a fact merely because a reasonable investor would very much like to know the fact.’” Richman, 868 F. Supp. 2d at 274 (quoting In re Time Warner Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993)). This holding was consistent with other decisions out of the Second Circuit. See, e.g., In re Lions Gate, 165 F. Supp. 3d at 12 (“[T]he defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities laws do not impose an obligation on a company to predict the outcome of investigations. . . . [A] government investigation, without more, does not trigger a generalized duty to disclose.”).
The Second Circuit decision in SAIC, however, implicitly rejects these section 10(b) standards of disclosure and replaces them with its view that under Item 303, and by extension section 10(b), corporations have a duty to volunteer the existence of pending governmental investigations even before they ripen into charged, adjudicated wrongdoing. In short, according to Leidos, the Second Circuit appears to require companies to accuse themselves of wrongdoing contrary to preexisting well-established Second Circuit case law. Notably, the case law addressing similar disclosures under Regulation S-K, including Item 303, does not find a duty thereunder to disclose pending investigations. See, e.g., In re Lions Gate, 165 F. Supp. 3d at 20 (“An SEC investigation could not be characterized as a ‘known trend’ or ‘uncertainty’ under Item 303.”); id. at 19 (“[A]n investigation alone is not a ‘pending legal proceeding’ or a ‘proceeding known to be contemplated by governmental authorities’ under Item 103” (citing City of Westland Police & Fire Ret. Sys. v. MetLife, Inc., 928 F. Supp. 2d 705, 711 (S.D.N.Y. 2014)); City of Pontiac, 752 F.3d at 183–84 (finding that pending Department of Justice investigation was not a “significant risk factor” under Item 503(c) that required disclosure).
The Second Circuit in SAIC did not address this issue or any of the holdings above directly. It only cited Lions Gate as an example of a “run of the mill civil enforcement investigation by the SEC” that did not have to be disclosed, whereas SAIC involved “serious, ongoing criminal and civil investigations that exposed it to potentially criminal and civil liability and that ultimately did result in criminal charges and substantial liability.” SAIC, 818 F.3d at 96 n.8 (emphasis added). There are two significant problems with this position by the SAIC court. First, there is no reasonable basis for courts to be in the business of determining when a pending investigation is “run of the mill”—and thus not disclosable—or “serious” and thereby disclosable under the federal securities laws. U.S. companies and their investors simply cannot be expected to operate under this loose, judicially created, and wholly subjective disclosure standard. Second, it is entirely inappropriate to rely on criminal charges and liability that arose after the Item 303 disclosure at issue to create a duty to disclose investigations under Item 303 before the charges or liability arise. If 20/20 hindsight can create duties of disclosure, then the U.S. securities markets will suffer serious consequences and potentially collapse. See, e.g., Richman, 868 F. Supp. 2d at 273 (“‘[D]efendants are not bound to predict as the ‘imminent’ or ‘likely’ outcome of the investigations that indictments of [the company] and its chief officers would follow, with financial disaster in their train.’”) (quoting Ballan v. Wilfred Am. Educ. Corp., 720 F. Supp. 241, 248 (E.D.N.Y. 1989)); In re Lions Gate, 165 F. Supp. 3d at 12 (“[T]he defendants did not have a duty to disclose the SEC investigation and Wells Notices because the securities laws do not impose an obligation on a company to predict the outcome of investigations. . . . [A] government investigation, without more, does not trigger a generalized duty to disclose.”).
If the Supreme Court upholds the SAIC decision, it risks creating substantial uncertainty in the securities markets as to when uncharged and unadjudicated government investigations and allegations must be disclosed as “potential fraud” and “known trends or uncertainties” under Item 303 in order to avoid securities fraud liability under section 10(b).
The Second Circuit’s Reliance on Section 11 Is Misplaced
Among the grounds for the Second Circuit’s decision in Stratte-McClure—on which its SAIC decision largely rests—is the proposition that section 11 and section 12(a)(2) of the 1933 Act provide a cause of action for the failure to comply with Item 303. The Second Circuit noted that it previously held in Panther Partners v. Ikanos Communications, 681 F.3d 114 (2d Cir. 2012), that the failure to comply with Item 303 is actionable under sections 11 and 12(a). The Second Circuit then equated Rule 10b-5 with section 12(a)(2) in that they both require disclosure of material facts necessary to make statements made not misleading. Although that argument is not repeated in the SAIC decision being appealed, the Supreme Court might need to consider that argument in deciding whether section 10(b) also supports a private right of action for a failure to comply with a regulatory requirement or whether a section 10(b) cause of action is distinct from a section 11 or 12(a) cause of action in this context.
The causes of action—generally speaking—are distinct. The similarity between sections 11 and 12(a)(2) does not appear to go far enough to support the SAIC plaintiffs’ right of action under section 10(b). Sections 11 and 12(a)(2), while useful tools for private litigants, do not support a cause of action in fraud for an omission to disclose information required by a regulation. They are not antifraud provisions; they provide for strict liability for misstatements or omissions by issuers in, respectively, a registration statement or a prospectus. Thus, they need not satisfy the heightened pleading standard for fraud under the PSLRA. They also do not require proof of reliance or loss causation. Panther Partners, 681 F.3d at 120 (“Neither scienter, reliance, nor loss causation is an element of § 11 or § 12(a)(2) claims. . . .”). To successfully state a cause of action under section 11, a plaintiff must only show that (1) the plaintiff purchased a registered security, either directly from the issuer or in the aftermarket following the offering; (2) the defendant participated in the offering in a manner sufficient to give rise to liability under section 11; and (3) the registration statement contained an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary to make the statements made not misleading. Thus, compared with section 10(b), those provisions “apply more narrowly,” In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 360 (2d Cir. 2010)—that is, only to material misstatements or omissions in a registration statement or prospectus—“but give rise to liability more readily”—that is, have a lower burden of proof. It is for that reason that the Second Circuit also stated that those private rights of action provisions are “notable both for the limitations on their scope as well as the interrorem nature of the liability they create.” Id. at 359.
Thus, the plaintiff/appellee’s ability to rely on the Stratte-McClure decision’s implicit expansion of the scope of sections 11 and 12(a)(2) might well be tested at the Supreme Court.
Scienter Looms Large
In considering whether an omission supports a cause of action for fraud, it is important to remember that fraud does not occur in the absence of scienter. Interestingly, the Leidos Petition for Writ of Certiorari does not raise the subject of scienter except to point out that the district court dismissed the original action based on the plaintiffs’ failure to adequately plead it. Petition for Certiorari, Leidos Inc. v. Ind. Pub. Ret. Sys., 137 S. Ct. 1395 (2017) (No. 16-518). Note that the Second Circuit, in the decision being appealed from, did consider the issue and concluded “that the allegations support the inference that SAIC acted with at least a reckless disregard of a known or obvious duty to disclose when, as alleged, it omitted this material information from its March 2011 10‐K in violation of FAS 5 and Item 303.” SAIC, 818 F.3d at 96.
However, it is difficult to consider liability for an omission in isolation from the other elements of fraud, and scienter in particular. The failure to adequately plead scienter proved fatal to the plaintiffs in Stratte-McClure, notwithstanding the court’s approval of the theory that an Item 303 omission can constitute fraud. 776 F.3d at 100. Stratte-McClure involved allegations that Morgan Stanley faced a deteriorating subprime mortgage market that was likely to cause trading losses that would materially affect the company’s financial condition. Id. at 104. Such information constituted a “downward trend in the real estate and subprime markets,” and the court assumed for the purpose of its decision that the omission was material. Id. Nevertheless, the Second Circuit upheld the district court’s dismissal based on its holding that the plaintiffs failed to allege that the defendants were at least consciously reckless regarding whether their failure to provide adequate Item 303 disclosures would mislead investors about material facts; the court found no basis to infer a state of mind beyond heightened negligence. Id. at 106–7. Therefore, Stratte-McClure suggests that the requirement to adequately plead scienter in accordance with the standards set by the PSLRA could swallow up the issue of whether a duty to disclose arising under a regulatory requirement such as Item 303 exists. The Second Circuit’s SAIC decision did not have the same scienter problem and therefore allowed the Item 303 issue to survive its trip to the Supreme Court.
The Supreme Court provides some guidance in determining whether a plaintiff’s scienter allegations have satisfied the heightened pleading standards under the PSLRA. In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322–23 (2007), the Court defined the heightened pleading requirement for scienter as follows: “[T]he complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The Court instructed that “[i]n determining whether the pleaded facts give rise to a ‘strong’ inference of scienter, the court must take into account plausible opposing inferences.” The Court stated that the inference need not be irrefutable but must be “compelling” in light of other countervailing explanations. Id.
A complication in alleging the scienter element of a fraud claim results from the explicit language of Item 303. Item 303(a)(2)(ii), the subpart at issue in Leidos, requires this disclosure in an issuer’s public filings:
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. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.
17 C.F.R. § 229.303(a)(3)(ii) (emphasis added).
Read literally, Item 303 requires disclosure of trends and of events that will cause a change in the relationship between costs and revenues (or profitability) of which the company has knowledge. If the issuer does not “know” of such a trend or event, then Item 303 apparently does not require disclosure. On an issue of first impression, the Second Circuit, in its SAIC decision now under Supreme Court review in Leidos, made clear that “Item 303 requires the registrant to disclose only those trends, events, or uncertainties that it actually knows of when it files the relevant reports with the SEC. It is not enough that it should have known of the existing trend, event, or uncertainty.” SAIC, 818 F.3d at 95.
However, once that knowledge is established, the claim need only satisfy a recklessness standard that the Second Circuit applies in finding that the defendants acted with scienter. Thus, liability for a fraudulent omission under Item 303 requires knowledge of the undisclosed trends, events, or uncertainties, but only reckless disregard of a duty to disclose. Or, said differently, it is possible that the issuer did not necessarily consciously associate the known events with the failure to inform shareholders of them.
The Supreme Court takes cases on clearly defined issues, and in Leidos the scienter element of securities fraud is not before it. Nevertheless, it is the elephant in the room in private securities actions, and any parties relying on the decision in Leidos regarding the nature of the disclosure at issue will still have to train their vision on the adequacy of evidence of scienter in order to prevail.
Can the Court Impose an Item 303 Duty Based on “Soft” Information Disclosures in a Section 10(b) Case?
In light of certain circuit court decisions, the Supreme Court might have to consider whether a different standard applies to the nature of the information required by Item 303 and, if so, whether that different standard insulates the issuer from a fraud charge. The Sixth Circuit, for example, applies a higher threshold for pleading a duty to disclose “soft” information, “which includes predictions or matters of opinion,” as opposed to “hard” information, which “is typically historical information or other factual information that is objectively verifiable.” In re Sofamor Danek Grp., Inc. 123 F.3d 392, 401–2 (6th Cir. 1997) (cited in In re Omnicare, Inc. Sec. Litig., 769 F.3d 455, 471 (6th Cir. 2014)). The Sixth Circuit has “firmly established . . . that soft information must be disclosed only if virtually as certain as hard facts.” Id. at 402; see also In re Omnicare, 769 F.3d at 471 (“If the new information is soft, then a person or corporation has a duty to disclose it if it renders a prior disclosure objectively inaccurate, incomplete, or misleading.”) “In other words, the new [soft] information must be so concrete that the defendant must have actually known that the new information renders the prior statement misleading or false and still did not disclose it.” Id. (emphasis added). Thus, no duty exists in the Sixth Circuit to disclose soft information or information that consists mainly of predictions or matters of opinion. See In re Sofamor, 123 F.3d at 402.
By its very definition, the “trends” or “uncertainties” that Item 303 asks management to identify arguably include management’s predictions and matters of opinion and therefore constitute soft information. See, e.g., Denise Voight Crawford & Dean Galaro, “A Rule 10b-5 Private Right of Action for MD&A Violations?,” 43 Sec. Reg. L.J. 1 (2015) (observing that “Item 303 concerns disclosures of soft information and it’s therefore difficult to evaluate” and that “the MD&A disclosure standard is not particularly clear”) (cited in Petition for Certiorari at 27, Leidos). If the Plaintiffs/Appellees in Leidos convince the Court to find that Item 303 “soft” information omissions can form the basis of a section 10(b) claim, then this could drastically alter, if not entirely abrogate, the “firmly established” rule prohibiting this practice in the Sixth Circuit. Such a holding would create another “floodgates” risk—the Sixth Circuit’s “real concern that an unrestrained use of Item 303 in conjunction with Rule 10b-5 will lead to a surge in private securities litigation. . . .” Conaway, 698 F. Supp. 2d at 843 n.58. That is because the concepts at the core of Item 303—“trends” and “uncertainties”—are so malleable that it will take only the slightest bit of creativity to identify a “trend” or “uncertainty” that a company should have disclosed. See, e.g., Ted J. Fiflis, “Soft Information: The SEC’s Former Exogenous Zone,” 26 UCLA L. Rev. 95, 95–96 (1978) (cited in cited in Petition for Certiorari at 27, Leidos). See also In re Sofamor, 123 F.3d at 402–3 (finding “unpersuasive” the argument that “defendants’ disclosure duty under the Rule 10b-5 claim may stem from Item 303”).
As the petitioners in Leidos rightly recognize, “the nature of Item 303 itself militates in favor of disallowing” these types of claims. Petition for Certiorari at 27, Leidos.
Public Policy Implications of Limiting the Availability of Private Rights of Action to Exclude Those Based on Item 303 Disclosures
Congress and the courts face a challenge on how to contain private securities litigation activity without unduly constraining the role that private attorneys general play in extending the agencies’ resources in enforcing the securities laws. The cert. petition in Leidos flips that balance on its head and looks to the government to fill in the gaps created by any restraints on private actions:
The absence of a private claim under Section 10(b) for violations of Item 303 does not mean that issuers will be free to disregard SEC regulations. Indeed, the SEC’s enforcement powers are not toothless, Stoneridge, 552 U.S. at 166, as demonstrated by actions it has taken against companies for violations of Item 303. . . .
Petition for Certiorari at 24, Leidos.
This theme is echoed in the NAM amicus brief, which cites cases supporting the proposition that “the SEC brings enforcement actions for violations of Item 303 that involve no claim for fraud under Rule 10b-5 or other anti-fraud provisions.” Brief of Amici Curiae National Association of Manufacturers in Support of Petitioners at 15, Leidos Inc. v. Ind. Pub. Ret. Sys., 137 S. Ct. 1395 (2017) (No. 16-518).
In considering a private securities action, the Supreme Court typically will consider the tension between a holding that permits an increase in potentially abusive lawsuits and one that chokes off meritorious litigation that could enable wronged shareholders to recover real losses. This same tension exists in Leidos.
The ability of a shareholder to bring a private action under the federal securities laws advances the public policy goal of deterring illegal conduct, in addition to providing a wronged party the ability to recover losses caused by an issuer’s misconduct. A private right of action by shareholders expands the reach of the securities laws beyond the resources of the government agencies responsible for enforcing them, specifically, the SEC and the Department of Justice. Shareholders serve as “private attorneys general,” private enforcers who are motivated by the ability to recover damages, and often spurred on by attorneys motivated by the opportunity to collect a potential contingency fee. This model is well-recognized: “[O]ur society places extensive reliance upon such private attorneys general to enforce the federal . . . securities laws, to challenge corporate self-dealing in derivative actions, and to protect a host of other statutory policies.” John C. Coffee, Jr., “Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working,” 42 Md. L. Rev. 215, 216 (1983).
Because the securities fraud private right of action is a “judicial creation,” the Supreme Court expressly provided that only Congress, and not the courts, has the ability to expand it. Stoneridge, 552 U.S. at 165 (“Though it remains the law, the §10(b) private right should not be extended beyond its present boundaries.”). In enacting the PSLRA, Congress imposed heightened pleading standards for fraud in order to limit the increase in private securities fraud claims.
Limits on the ability to bring a private action are based to a certain extent on checking the strong financial incentives to bring an action and compel a settlement even in the face of weak or unmeritorious fraud claims. As the SIFMA amicus brief quotes Stoneridge, 552 U.S. at 163, “[E]xtensive discovery and the potential of uncertainty and disruption will allow plaintiffs with weak claims to extort settlements from innocent parties.” Brief for SIFMA and the U.S. Chamber of Commerce as Amici Curiae In Supporting Petitioner at 16, Leidos Inc. v. Ind. Pub. Ret. Sys., 137 S. Ct. 1395 (2017) (No. 16-518). In another post-PSLRA case, the Supreme Court expressed continued concerns about private securities fraud actions that, “if not adequately contained, can be employed abusively to impose substantial costs on companies and individuals whose conduct conforms to the law.” Tellabs, 551 U.S. at 313.
Instead of emphasizing the private attorney general model of enhancing securities law enforcement, the petitioners posit that government enforcement will be adequate to address material omissions. To the extent that the Court’s decision in Leidos will be influenced even marginally by the existence of other mechanisms to enforce federal securities laws—that is, government regulators and law enforcement agencies—it is worth considering what that enforcement would look like. At the most fundamental level, the SEC can more easily bring an action for false and misleading disclosures than a private party. For starters, the SEC has investigative resources unavailable to private parties. In addition, the SEC can obtain relief—a permanent injunction (or cease-and-desist order), disgorgement, and penalties—without alleging fraud. In cases that justify fraud charges, the SEC has a lower standard of proof; while both the SEC and private plaintiffs need to show that a material representation was made with scienter, a private plaintiff (but not the SEC) also needs to prove reliance on the misrepresentation or omission, economic loss, and loss causation. See Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341–42 (2005). Pleading an effective private securities fraud cause of action is further complicated by the need to satisfy the PSLRA’s heightened pleading requirements for misrepresentations and scienter elements. The SEC does not have to satisfy those heightened pleading standards. Moreover, the SEC can expand the list of responsible parties from whom it can obtain relief by bringing aiding and abetting claims, while private litigants cannot. See Cent. Bank of Denver, 511 U.S. 164 (1994).
On the other hand, SEC actions do not necessarily provide relief to investors beyond the agency’s universal remedy of a civil injunction or a cease-and-desist order, both designed to prevent the violations from recurring. The federal securities laws also provide for assessment of a penalty paid to the U.S. Treasury. In order for an investor to obtain monetary relief from an SEC action, the SEC has to obtain disgorgement, which is an equitable remedy not provided by statute. Disgorgement is designed to deprive wrongdoers of unjust enrichment obtained as a result of their illegal conduct. While the SEC will in some cases require that these funds be returned to a defined class of wronged investors, there is no statutory or regulatory requirement that it do so. As a result, these funds also often find their way to the U.S. Treasury. This fact—that disgorgement funds are often paid to the U.S. Treasury—helped support the Supreme Court’s recent decision that the SEC’s disgorgement remedy is a “penalty” and thus subject to the five-year statute of limitations under 28 U.S.C. § 2462. See Kokesh v. SEC, ___ S. Ct. ___ (June 5, 2017). Consequently, a shareholder who believes he or she was hurt by an issuer’s fraudulent statements or omissions will have greater recourse to recover any losses through private litigation than in seeking disgorgement from an SEC action.
Thus, to the extent that the Court remains concerned about the balance between opening the floodgates and inordinately choking off meritorious litigation, it needs to bear in mind the ability of regulators and prosecutors to fill any gaps left after tightening the standards for initiating private actions.
Conclusion: The Need for a Limiting Principle
Supreme Court advocacy requires the ability to respond to hypothetical situations propounded by the justices that explore the implications of a ruling in the advocate’s favor. It is not enough for a litigant to argue its position; it also needs to provide the justices with comfort as to the impact of that decision on other cases. Will a favorable ruling lead to a disproportionate increase in litigation or, on the other hand, choke off access to the courts for a remedy?
At the Leidos argument, counsel for the class plaintiffs should expect to explain why permitting a cause of action based on the failure to comply with one particular regulatory disclosure obligation would not open the floodgates to litigation based on omissions. In Stratte-McClure, the Second Circuit appeared not to limit its holding to Item 303, but the court included any statute or regulation that creates a duty to disclose, stating that the Second Circuit and other circuits “have long recognized that a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak,” because omitting an item required to be disclosed in a periodic filing can render the financial statement misleading. See Stratte-McClure, 776 F.3d at 102. As the NAM amicus brief argues, at 4, this means that “any number of statutes and regulations requiring disclosure are now ripe to be grafted onto Rule 10b-5.” Indeed, that brief points out that Regulation S-K alone includes 105 separately captioned disclosure items, each of which has its own subparts. Counsel for the plaintiffs will have to explain why the Court should not be concerned that each of those disclosure items for every reporting company will be scrutinized by potential class action plaintiffs and attorneys.
On the other hand, counsel for the defendants will need to explain whether a decision in their favor will limit the ability of shareholders who do not receive adequate disclosure of current known trends to recover for their losses and why the government is an adequate substitute for a decrease in shareholder litigation that would motivate corporations to provide adequate disclosure.
Or it is possible that permitting a private right of action for fraud based on the failure to disclose information required by a regulation would have no practical effect. The position is that a claim under Item 303 for failure to disclose “doesn’t add much, if anything, to a plain vanilla claim alleging that a statement was misleading for omitting the same information.” David Greene, “Why Item 303 Just Doesn’t Matter in Securities Litigation,” Law360, Oct. 13, 2015 (subscription required). Greene argues that any omission that violates Item 303 also would likely cause the Item 303 disclosure to be materially false and misleading. That is, failure to disclose a “known trend or uncertainty” in accordance with Item 303 might be equivalent to failing to disclose a probable event of material magnitude, making the affirmative statements false and misleading and thus actionable under section 10(b) as well as Item 303. Moreover, as this article shows, plaintiffs alleging fraud must still establish the other elements of a private cause of action, including scienter in satisfaction of the PSLRA, to support any fraud claim, a significant barrier to successful pleading.
Thus, all eyes will be on the Supreme Court as it sorts through a panoply of issues raised directly and indirectly by the Leidos appeal.