February 17, 2015 Practice Points

Second Circuit Finds Failure to Make Item 303 Disclosure May Be Actionable Under Section 10(b)

By Mollie Kornreich

On January 12, 2015, the Second Circuit affirmed the dismissal of a securities fraud suit against Morgan Stanley for failure to inform investors of exposure to losses from swap positions tied to the subprime mortgage market, concluding that plaintiffs failed to allege facts giving rise to a strong inference of scienter. Stratte-McClure v. Morgan Stanley, No. 13-0627-CV (2d Cir. Jan. 12, 2015). In so holding, the court addressed “a matter of first impression” in the circuit and found that “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,” so long as the omission is material and the other elements of the claim are satisfied.

Plaintiffs alleged that Morgan Stanley and six of its officers and former officers made material misstatements and omissions in an effort to conceal the bank's exposure to and losses from the subprime mortgage market. Plaintiffs contended that Item 303 imposed a duty on Morgan Stanley to make disclosures regarding the impact of the deteriorating mortgage market on the company’s financial position. Item 303 of Regulation S-K requires companies to disclose, among other things, “any known trends or uncertainties . . . that the registrant reasonably expects will have a material . . . unfavorable impact on . . . revenues or incomes from continuing operations.”

In January 2013, the district court dismissed the action, finding that Morgan Stanley did have a duty to make certain disclosures under Item 303, but nevertheless dismissing the case for failed to plead "a strong inference of scienter." See Stratte-McClure v. Morgan Stanley, No. 09-Civ-2017, 2013 WL 297954 (S.D.N.Y. Jan. 18, 2013).

On appeal, the Second Circuit concluded that “Item 303’s affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b).” The court noted that under its previous decisions in Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012), and Litwin v. Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011), failure to comply with Item 303’s disclosure requirements could be “actionable under Sections 11 and 12(a)(2) of the Securities Act of 1933.” The court reasoned that Section 10(b), like Section 12(a)(2), requires disclosure of material facts necessary to make statements not misleading, and because Item 303 disclosures are “obligatory . . . 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.’” Moreover, “a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak.”

In a key limitation, the Second Circuit held that any omission must still meet the Section 10(b) materiality standard, as articulated by the Supreme Court in Basic Inc. v. Levinson.  Accordingly, merely meeting the different standard for a duty to report under Item 303 does not necessarily establish the materiality element of a Section 10(b) claim. The court further emphasized that the other elements of the claim must be met, including that the defendants acted with scienter.

The view that failure to disclose under Item 303 may give rise to 10(b) liability creates a split with the Ninth Circuit, which recently held otherwise in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014).

Ultimately, the Second Circuit held that although plaintiffs “adequately alleged that defendants breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market that, in light of the company's exposure to the market, was likely to cause trading losses that would materially affect the company's financial condition,” plaintiffs had failed to adequately plead scienter.

Judge Livingston drafted the Second Circuit opinion, which was joined by Judges Cabranes and Wesley.  The circuit affirmed the dismissal of the remaining claims in a summary order.

Andrew J. Kennedy, Indiana, PA. This piece originally appeared in Litigation News on January 7, 2015.


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Mollie Kornreich – February 17, 2015