Second Circuit Finds That Failure to Make Required Item 303 Disclosure Can Provide Basis for Securities Fraud Claim
Recently, the United States Court of Appeals for the Second Circuit in Stratte-McClure v. Morgan Stanley, No. 13-0627-CV, 2015 WL 136312 (2d Cir. Jan. 12, 2015) affirmed dismissal of a securities fraud class action lawsuit. The Court also ruled, as a matter of first impression in the Second Circuit, that “a failure to make a required disclosure under Item 303 of Regulation S-K … in a 10-Q filing is an omission that can serve as the basis for a Section 10(b) securities fraud claim, if the omission satisfies the materiality requirements outlined in Basic v. Levinson, 485 U.S. at 224, and if all of the other requirements to sustain an action under Section 10(b) are fulfilled.”
The Court’s decision clarifies that Item 303’s affirmative duty to disclose in Form 10-Qs can form the basis for a Section 10(b) claim under the Securities and Exchange Act of 1934, and highlights the Second Circuit’s disagreement with the Ninth Circuit, which recently held in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014) “that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b-5.”
Lead plaintiffs were investors who brought a securities fraud class action against defendants Morgan Stanley and six of its officers and former officers. Plaintiffs alleged that defendants “made material misstatements and omissions … in an effort to conceal Morgan Stanley’s exposure to and losses from the subprime mortgage market.”
After their amended complaint was dismissed with leave to replead certain claims, plaintiffs filed a second amended complaint, which defendants moved to dismiss under Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure and Section 78u-4(b) of the Private Securities Litigation Reform Act. Relying on two intervening Second Circuit decisions that held that Item 303 may provide a basis for disclosure obligations under Sections 11 and 12(a)(2) of the Securities Act of 1933 (the “Securities Act”),
The Second Circuit ruled that a failure to disclose material information under Item 303 can serve as the basis for a Section 10(b) securities fraud claim when the omission is material under the Supreme Court’s Basic v. Levinson
[A] plaintiff must first allege that the defendant failed to comply with Item 303 in a 10-Q or other filing. Such a showing establishes that the defendant had a duty to disclose. A plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test, because 10b-5 only makes unlawful an omission of material information that is necessary to make statements made … not misleading.
In addition, the Second Circuit noted that a plaintiff must also sufficiently plead the other elements of a Rule 10b-5 claim, namely, scienter, reliance, and causation of economic loss.
In applying the above framework, the Second Circuit stated that plaintiffs had “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.”
At Odds With the Ninth Circuit
The Second Circuit noted that its holding that Item 303 may trigger Section 10(b) liability “is at odds” with the Ninth Circuit opinion in In re NVIDIA Corp. Securities Litigation. Relying heavily on the Third Circuit decision of Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), the Ninth Circuit ruled that Item 303 imposes no duty of disclosure and is not actionable under Section 10(b) and Rule 10b-5. The Second Circuit also relied on Oran, reasoning that the Third Circuit merely stated that an Item 303 omission “does not automatically give rise to a material omission under Rule 10b-5.”
There are several key practical implications flowing from the Morgan Stanley decision. Importantly, although the Second Circuit has now stated that omissions of information required by Item 303 can sustain a Rule 10b-5 securities fraud claim, the materiality threshold established in Basic must still be satisfied. In addition, by rejecting the district court’s determination that Item 303 necessitated Morgan Stanley revealing its trading positions, the Second Circuit ensured that a company’s disclosure obligations do not require revealing internal business strategies or other proprietary information. Nevertheless, the decision puts companies on notice that Item 303 “require[s] disclosure of a known trend and the manner in which it might reasonably be expected to materially impact a company’s overall financial position”
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