U.S. Supreme Court to Decide Whether Failure to Make Required MD&A Disclosure Can Provide Basis for Damages Under Rule 10b-5


U.S. Supreme Court to Decide Whether Failure to Make Required MD&A Disclosure Can Provide Basis for Damages Under Rule 10b-5

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Allan Horwich

On March 27, the U.S. Supreme Court granted a petition for certiorari to decide whether a public reporting company can be held liable for damages under Rule 10b-5 of the Securities Exchange Act of 1934 for failure to include a disclosure mandated by an SEC rule. The narrow issue raised by the case is whether the omission can provide the basis for a private damage claim even if the omitted information did not render the disclosure document as a whole materially incomplete in violation of the half-truth provision in SEC Rule 10b-5(b). Leidos, Inc. v. Indiana Public Retirement System, Case No. 16-581. The Second Circuit Court of Appeals opinion is reported at 818 F.3d 85.

The decision accepted for review allowed the plaintiff to amend its complaint to include a claim that the company could be held liable for the failure to include a disclosure mandated by SEC Regulation S-K Item 303, the Management's Discussion and Analysis (MD&A) disclosure requirement. That is a core element of the annual and quarterly reports filed with the SEC by public reporting companies. Among other things, Item 303 requires disclosure of “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.” As the question presented by the petitioner to the Supreme Court stated, “[T]he Second Circuit held that a company can be liable for securities fraud merely for omitting information required by [an SEC] regulation, even if those disclosures are not necessary to make affirmative statements not misleading” in violation of Rule 10b-5.

The lower court decision followed an earlier decision by the Second Circuit, Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015), where that court held that the “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 under the established criteria for materiality under the federal securities laws. These Second Circuit decisions conflict with those of two other courts of appeal, the Ninth (In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014), ruling that Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b–5) and the Third, in an opinion by then Judge Alito (Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), ruling that a violation of Item 303’s reporting requirements does not automatically give rise to a material omission under Rule 10b–5).

The case could have implications beyond the MD&A disclosure requirement, if the ruling were to favor the plaintiff and suggest that noncompliance with other mandatory disclosure rules could provide the predicate for a Rule 10b-5 damage claim. On the other hand, even if the outcome were favorable to the plaintiff the ruling could have a limited impact because there are few cases where information omitted in noncompliance with a specific SEC disclosure requirement would not otherwise be the omission of a material fact necessary to make the other statements made in the challenged disclosure not misleading, in violation of the second subclause of Rule 10b-5. To be sure, the petitioner portrays a more draconian potential. “The Second Circuit dramatically expanded the scope of omissions liability under Section 10(b). . . . The Second Circuit now imposes liability for violating the disclosure requirements of Item 303, requirements that are, according to the SEC, ‘intentionally general’ and ‘inapposite’ to [the Supreme Court’s] test for materiality under Section 10(b).” (Petition, p. 3)

The case directly addresses only the scope of a private damage claim under Rule 10b-5. The SEC, of course, has clear authority to pursue an enforcement action for a company’s failure to satisfy a Securities Exchange Act reporting company disclosure requirement. This includes an administrative proceeding under Section 15(c)(4) of the Exchange Act, which empowers the SEC to order a company that has failed to comply with an Exchange Act disclosure requirement in any material respect to comply with that disclosure requirement.

The case will be argued next fall, with a decision expected by June 2018.