Omission under Item 303 of Regulation S-K Can Serve as Basis for a Section 10(b) Securities Fraud Claim: Second Circuit | Practical Law

Omission under Item 303 of Regulation S-K Can Serve as Basis for a Section 10(b) Securities Fraud Claim: Second Circuit | Practical Law

In Stratte-McClure v. Morgan Stanley, the US Court of Appeals for the Second Circuit held for the first time that failure to make a required disclosure under Item 303 of Regulation S-K in a Form 10-Q filing is an omission that can serve as the basis for a securities fraud claim under Section 10(b) of the Exchange Act, if the omission satisfies certain other requirements.

Omission under Item 303 of Regulation S-K Can Serve as Basis for a Section 10(b) Securities Fraud Claim: Second Circuit

by Practical Law Corporate & Securities
Published on 14 Jan 2015 • USA (National/Federal)
In Stratte-McClure v. Morgan Stanley, the US Court of Appeals for the Second Circuit held for the first time that failure to make a required disclosure under Item 303 of Regulation S-K in a Form 10-Q filing is an omission that can serve as the basis for a securities fraud claim under Section 10(b) of the Exchange Act, if the omission satisfies certain other requirements.
On January 12, 2015, in Stratte-McClure v. Morgan Stanley, the US Court of Appeals for the Second Circuit held for the first time that failure to make a required disclosure under Item 303 of Regulation S-K in a Form 10-Q filing is an omission that can serve as the basis for a securities fraud claim under Section 10(b) of the Exchange Act, if the omission satisfies certain other requirements (No. 13-0627, (2d Cir. Jan. 12, 2015)).

Background

In December 2006, Morgan Stanley's Proprietary Trading Group entered into a proprietary trade that consisted of a $2 billion short position and a $13.5 billion long position. In the short position, Morgan Stanley purchased credit default swaps (CDSs) on collateralized debt obligations (CDOs) backed by mezzanine tranches of subprime residential mortgage-backed securities (RMBSs). Morgan Stanley paid annual premiums for these CDSs for the assurance that it would receive payments if the housing market worsened and the mezzanine RMBS tranches backing its CDOs defaulted or declined in value. In the long position, on the other hand, Morgan Stanley sold CDSs on CDOs backed by mezzanine tranches of subprime RMBSs under which it received premiums for the guarantee that it would pay the CDS purchasers in the event the CDO tranches would default or decline in value.
The CDOs referenced by the long position were super-senior tranches of CDOs that were rated higher and carried lower risk than the CDOs referenced by the short position. Through the proprietary trade, Morgan Stanley had essentially been betting that defaults in the subprime mortgage markets would be significant enough to impair the value of the higher-risk tranches in the short position but not significant enough to impair the value of the lower-risk tranches in the long postion. Subprime mortgages rapidly began to suffer delinquencies and defaults. The value of Morgan Stanley's swap positions declined substantially in 2007 and the company ultimately lost billions of dollars on the proprietary trade.
Lead plaintiffs State-Boston Retirement System and Fjarde AP-Fonden brought a class action on behalf of themselves and other similarly situated investors (plaintiffs) under Sections 10(b) and 20(a) of the Exchange Act, alleging that Morgan Stanley and six of its officers and former officers (defendants) made material misstatements and omissions between June 20, 2007 and November 19, 2007 regarding Morgan Stanley's exposure to and losses from the subprime mortgage market, in particular:
  • Exposure Claim. Misrepresentations and omissions regarding Morgan Stanley's exposure to credit risk related to the US subprime mortgage market arising from its long position (exposure claim). Plaintiffs relied on four statements from Morgan Stanley officers and one alleged omission. Plaintiffs also alleged that the defendants made material omissions in their Form 10-Q filings in violation of Item 303 of Regulation S-K by failing to disclose:
    • the existence of the long position;
    • that Morgan Stanley had sustained losses on the long position in the second and third quarters of 2007; and
    • that Morgan Stanley was likely to incur additional significant losses on the position in the future.
  • Valuation Claim. Misrepresentations regarding Morgan Stanley's losses arising from its long position (valuation claim). Plaintiffs alleged that Morgan Stanley overstated its earnings in the third quarter of 2007 because it did not sufficiently write down the value of the long position.
Plaintiffs alleged that these misrepresentations and omissions fraudulently inflated Morgan Stanley's stock price during the class period and caused them financial losses when the market became aware of Morgan Stanley's exposure and losses.
On April 4, 2011, the US District Court for the Southern District of New York granted the defendants' motion to dismiss, ruling:
  • On the exposure claim, that the amended complaint did not specify why the defendants' statements about risk and the company's trading positions were false or misleading. The district court decided that the defendants had no obligation to disclose the long position.
  • On the valuation claim, that the plaintiffs failed to plead loss causation.
The district court granted the plaintiffs leave to amend their pleadings with regard to the exposure claim and loss causation on the valuation claim, and otherwise dismissed the plaintiffs' claims with prejudice.
On June 9, 2011, the plaintiffs filed a second amended complaint and the district court again dismissed all of the claims, finding no reason to alter its earlier decision that the plaintiffs failed to plead loss causation for the valuation claim and failed to sufficiently plead falsity for the exposure claim. However, the district court ruled that Morgan Stanley did have a duty under Item 303 of Regulation S-K to disclose the long position in its 2007 Form 10-Q filings. In so ruling, the court relied on intervening 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)), which held that Item 303 may provide a basis for disclosure obligations under Sections 11 and 12(a)(2) of the Securities Act.
However, the district court ultimately dismissed the exposure claim after deciding that the second amended complaint failed to plead "a strong inference of scienter" with respect to defendants' failure to disclose the long position. The plaintiffs appealed both district court decisions.

Outcome

The Second Circuit addressed the district court's decision that Morgan Stanley's failure to disclose the long position in its July and October 2007 Form 10-Q filings under Item 303 of Regulation S-K constituted an actionable omission under Section 10(b) and Rule 10b-5. The court concluded, as a matter of first impression, that failure to make a required Item 303 disclosure in a Form 10-Q filing is an omission that can serve as the basis for a Section 10(b) securities fraud claim. However, an omission is only actionable if:
The Second Circuit concluded that the district court properly dismissed the plaintiffs' exposure claim predicated in Morgan Stanley's failure to disclose under Item 303 because the second amended complaint did not sufficiently plead scienter.

Omission under Item 303 of Regulation S-K Can Give Rise to Liability under Section 10(b)

Item 303 of Regulation S-K imposes disclosure requirements on companies filing required reports with the SEC, including Form 10-Q reports. Item 303 requires corporate management to describe known trends or uncertainties that have had, or that the registrant reasonably expects will have, a material favorable or unfavorable impact on net sales, revenues or income from continuing operations. SEC guidance clarifies that disclosure is necessary where a trend, demand, commitment, event or uncertainty is both:
  • Presently known to management.
  • Reasonably likely to have material effects on the registrant's financial conditions or results of operations.
The Second Circuit noted that, under its existing case law, failure to comply with Item 303 by omitting known trends or uncertainties from a registration statement or prospectus is actionable under Sections 11 and 12(a)(2) of the Securities Act. Like Section 12(a)(2), Rule 10b-5 requires disclosure of material facts necessary in order to make the statements made not misleading. The court noted that, like registration statements and prospectuses, Form 10-Qs are mandatory filings that speak to the entire market. As a result, a reasonable investor would interpret the absence of an Item 303 disclosure to imply that no trends or uncertainties exist that the registrant reasonably expects will have a material unfavorable impact on the business. Therefore, Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).

Materiality Requirements for Section 10(b) Claims

The Second Circuit concluded that failure to make a required disclosure under Item 303 alone is not sufficient to state a claim for securities fraud under Section 10(b) because Rule 10b-5 only applies to material misstatements or omissions. Under Basic Inc. v. Levinson, in securities fraud cases under Section 10(b) and Rule 10b-5, the materiality of a required forward-looking disclosure is determined by balancing both:
  • The indicated probability that the event will occur.
  • The anticipated magnitude of the event in light of the totality of the company activity.
On the other hand, the test for a duty to report under Item 303 requires management to make two assessments on a known trend:
  • Whether the trend is likely to come to fruition. If not, no disclosure is required.
  • If management cannot make that determination, it must evaluate objectively the consequences of the known trend by assuming that it will come to fruition. Disclosure is required unless management determines that a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur.
Therefore, a plaintiff must first allege that the defendant failed to comply with Item 303 in a Form 10-Q or other filing. Then, the violation must satisfy Basic's test for materiality, since it is the US Supreme Court's interpretation of "material" in Rule 10b-5 that dictates whether a private plaintiff has properly stated a claim.
The Second Circuit concluded that the plaintiffs adequately alleged that the defendants breached their duty under Item 303. The court found that the plaintiffs plausibly alleged that there was a significant downward trend in the subprime residential mortgage market that could negatively affect Morgan Stanley's overall financial position, and that Morgan Stanley had significant exposure to a sharp downturn in the subprime market through its long position. Further, the plaintiffs adequately alleged that Morgan Stanley's generic disclosures about market trends, spread out over several different filings and unconnected to the company's financial position, did not meet the company's disclosure obligations under Item 303. The court stated that while it wasn't required to disclose the details of the long position, Morgan Stanley did need to disclose that:
  • It faced deteriorating real estate, credit and subprime mortgage markets.
  • It had significant exposure to those markets.
  • If trends came to fruition, the company faced trading losses that could materially affect its financial condition.
Next, the court assumed, arguendo, that the omission was material under the Basic test, but affirmed the district court's decision because the plaintiffs failed to adequately plead scienter (see below).

Additional Section 10(b) Requirements

In any Section 10(b) claim, a plaintiff must also plead:
  • Scienter.
  • A connection between the misstatement or omission and the purchase or sale of a security.
  • Reliance on the misstatement or omission.
  • An economic loss caused by that reliance.
To meet the scienter requirement in this case, the plaintiffs needed to allege that the defendants were at least consciously reckless (a state of mind approximating actual intent) regarding whether their failure to provide adequate Item 303 disclosures during the second and third quarters of 2007 would mislead investors about material facts. While the plaintiffs did make allegations about developments in the subprime market, internal concern about capital calls and write-downs on the long position and the creation of a task force to investigate selling off some of Morgan Stanley's subprime positions, these facts did not approximate actual intent to mislead investors by failing to make Item 303 disclosures. The Second Circuit affirmed the district court's dismissal, concluding that the plaintiffs failed to adequately plead scienter.

Practical Implications

Issuers should take note that, in the Second Circuit, failure to make a required disclosure under Item 303 of Regulation S-K in a quarterly or annual filing can serve as the basis for a securities fraud claim under Section 10(b) and Rule 10b-5, provided that other requirements for such a claim, including materiality, are met.
This is in contrast to the Ninth Circuit's recent In re NVIDIA decision (In re NVIDIA Corporation Securities Litigation, 768 F.3d 1046 (9th Cir. 2014)), where the court held that failures to make disclosure under Item 303 are not actionable under Section 10(b) and Rule 10b-5 (see Legal Update, Item 303 of Regulation S-K Creates No Duty To Disclose Under Section 10(b) and Rule 10b-5: Ninth Circuit). The Ninth Circuit reasoned that because disclosure requirements under Item 303 were broader than under Section 10(b), violations of Item 303's disclosure duty cannot be the basis for pleading scienter.
Interestingly, both the Second Circuit and the Ninth Circuit referenced the Third Circuit's decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), where the court held that, in that case, violations of Item 303 obligations did not provide the basis for Rule 10b-5 liability, because the omissions were not material under Basic v. Levinson. The Oran court also mentioned that violations of Item 303 do not automatically give rise to a material omission under Rule 10b-5 due to different materiality standards applying to Rule 10b-5 and Item 303, but did not decide whether and in what circumstances Item 303 omissions may constitute liability under Rule 10b-5. Counsel should be vigilant about any developments on this issue in other circuits.