On September 29, 2023, the U.S. Supreme Court granted certiorari in Macquarie Infrastructure Corp. v. Moab Partners, L.P., No. 22-1165, to decide whether an alleged failure to disclose a "known trend or uncertainty" under Item 303 of Regulation S-K can support a private securities fraud claim under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5.

Notably, the U.S. Court of Appeals for the Second and Ninth Circuits—where the vast majority of securities class actions have been filed in recent years—have reached conflicting answers to this question. The Supreme Court's resolution of this conflict could have a significant effect on the scope of public companies' potential liability for alleged securities fraud.

The implied private right of action under Rule 10b-5 provides the basis for private securities fraud claims. The rule prohibits both false statements and half-truths—i.e., statements that are misleading by omission. But Rule 10b-5 does not create an affirmative duty to disclose any particular information.

By contrast, other SEC rules—including those found in Regulation S-K—affirmatively require various disclosures in public companies' SEC filings. Item 303 of Regulation S-K requires a public company's management to provide its analysis of the company's financial results, including a discussion of all "known trends and uncertainties" that have had or may have a material effect on the company's financial results. Unlike Rule 10b-5, however, Regulation S-K does not provide a private right of action for investors to sue for violations.

In Macquarie, the Supreme Court will decide whether private plaintiffs can import Item 303's broad, subjective disclosure requirements into a Rule 10b-5 private securities fraud claim. Most federal appellate courts to answer the question agree that an alleged violation of Item 303 cannot give rise to liability under Rule 10b-5. Only the Second Circuit disagrees.

Background

Section 10(b) and Rule 10b-5.  Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 are the federal securities laws' general anti-fraud provisions. While neither Section 10(b) nor Rule 10b-5 "expressly creates a private right of action," the Supreme Court has held that "a private right of action is implied under [Section] 10(b)." Janus Cap. Grp., Inc. v. First Derivative Traders, 564 U.S. 135, 142 (2011).

Rule 10b-5 makes it unlawful either (i) "[t]o make any untrue statement of a material fact" or (ii) "to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading" in connection with a securities transaction. 17 CFR § 240.10b-5.

Thus, a speaker must make some affirmative statement—either an untrue statement (under the first prong) or a statement that is misleading by omission (under the second prong)—to face potential liability under Rule 10b-5. And the false statement (or the information misleadingly omitted) must be material. For purposes of Rule 10b-5, a fact is material "if there is a substantial likelihood that a reasonable shareholder would consider it important." Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).

But Rule 10b-5 does not "create an affirmative duty to disclose any and all material information." Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011). "Even 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." Id. at 44-45.

Item 303 of SEC Regulation S-K.  Regulation S-K—which governs the contents of "qualitative" or "non-financial statements" portions of public companies' periodic SEC filings—imposes various affirmative disclosure requirements on public companies distinct from Rule 10b-5. But Regulation S-K does not create an independent private right of action.

Some provisions of Regulation S-K require disclosure of specific identified information. For example, Item 202 requires companies to provide a description of their securities, including dividend rights and voting rights associated with each class of securities. See 17 C.F.R. §229.202. But other provisions—including Item 303—include more subjective disclosure requirements.

Item 303 requires a company's periodic SEC filings to include, along with its financial statements, "management's discussion and analysis of" the financial statements—the so-called MD&A section. 17 C.F.R. § 229.303.

Among other things, Item 303 requires disclosure of "matters that are reasonably likely based on management's assessment to have a material impact on future operations," including disclosure of "known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact" on its financial performance.

By its terms, Item 303's disclosure requirements are highly subjective. And they're meant to be. Item 303 is not a checklist of required disclosures; it is intended to provide investors with "management's perspective." As the SEC has explained, Item 303 is meant to "give investors an opportunity to look at the registrant through the eyes of management." Exchange Release No. 6835, 1989 WL 1092885, at *17.

Moreover, Rule 10b-5's materiality standard does not apply under Item 303. Rather, once a trend becomes known to management, it must be disclosed unless management determines either that "it is not reasonably likely to occur" or that, if it does occur, "a material effect on the [company's] financial condition is not reasonably likely to occur." Exchange Release No. 6835, 1989 WL 1092885, at *6. Thus, Item 303's disclosure requirements are considerably broader than Rule 10b-5's materiality standard.

Discussion

Securities fraud class actions are typically filed following the revelation of some bad news or negative event leading to a drop in a public company's stock price. In some cases, the negative news or event reveals that some earlier company statement was false at the time it was made. More often, however, plaintiffs base securities fraud claims on omissions.

Where the company has previously discussed the topic of the negative news or event that spurred the lawsuit, plaintiffs argue that those earlier statements were misleading by omission because they did not fully disclose the information that ultimately came to light or the risk that ultimately materialized.

And even where the company has not previously addressed the topic, plaintiffs may seek to assert claims based on alleged omissions by arguing that the company had some independent legal duty to disclose the information. Plaintiffs frequently cite Item 303 as the basis for that disclosure obligation.

The first two appellate courts to address the interaction between Rule 10b-5 and Item 303 (the Third Circuit in Oran v. Stafford (2000) and the Ninth Circuit in In re NVIDIA Corp. Securities Litigation (2014)) agreed that "Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5."

Both courts focused on the fact that "the materiality standards for Rule 10b-5 and [Item] 303 differ significantly." As the Ninth Circuit explained in NVIDIA, these differing standards mean that a duty to disclose allegedly omitted information under Rule 10b-5 "must be shown separately" from a purported obligation to disclose under Item 303.

In Stratte-McClure v. Morgan Stanley (2015), the Second Circuit became the first—and still the only—federal appellate court to conclude that "Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b)," creating the circuit split that the Supreme Court has now agreed to resolve.

Stratte-McClure concerned securities fraud claims against Morgan Stanley based on an alleged failure to disclose the company's exposure to subprime mortgages. While holding that Item 303 could support a Rule 10b-5 claim, the court stressed that "failure to make a required disclosure under Item 303, however, is not by itself sufficient to state a claim for securities fraud under Section 10(b)."

First, recognizing the differing materiality standards under Rule 10b-5 and Item 303, the court held that "a violation of Item 303's disclosure requirements can only sustain a [Section 10(b)] claim" if "the allegedly omitted information satisfies Basic's test for materiality."

Second, the court stressed that, "as with any Section 10(b) claim, a plaintiff must also sufficiently plead scienter." Id. Thus, under the heightened standard for pleading scienter under Rule 10b-5, a securities fraud claim based on an alleged violation of Item 303 would require allegation of "facts…approximat[ing] actual intent to mislead investors by failing to make Item 303 disclosures." Ultimately, the Second Circuit affirmed dismissal of the Item 3030 claim because the plaintiff failed to plead scienter under this stringent standard.

Thus, on its face, Stratte-McClure's expansion of potential liability appeared narrow: Plaintiffs asserting claims based on Item 303 violations would bear a heavy burden to plead facts establishing a violation of Item 303 and pleading that the omitted information was material under Basic and pleading facts that "'approximat[e] actual intent' to mislead investors by failing to make Item 303 disclosures."

But subsequent decisions have not consistently applied these limitations. The Second Circuit's post-Stratte-McClure decisions illustrate the potential expansion of liability resulting from recognition of claims based on Item 303 if Rule 10b-5's materiality and scienter requirements are not stringently enforced.

In Indiana Public Retirement System v. SAIC, Inc. (2017), the Second Circuit considered claims based on the defendant corporation's alleged failure to disclose that some of its employees had engaged in billing fraud in connection with a government contract. The district court had dismissed the claims, consistent with the long-standing rule that "companies do not have a duty to disclose uncharged, unadjudicated wrongdoing" under Rule 10b-5. The Second Circuit reversed, finding that the uncharged misconduct should have been disclosed as a "known uncertainty" under Item 303.

The defendants argued that, even if the complaint had pleaded an Item 303 violation, the omitted information was immaterial under Basic because it concerned (i) an isolated instance of misconduct by a small number of employees, (ii) potential loss of a single contract out of more than 10,000 ongoing government contracts, and (iii) the implicated conduct affected a small fraction of the company's revenue below the SEC's quantitative standard for materiality.

The Second Circuit rejected this argument, concluding that materiality could not be determined on a motion to dismiss by "consider[ing] quantitative factors only in the narrowest light." Thus, the court functionally discarded Stratte-McClure's requirement that any Item 303 claim plead facts establishing that the omitted information was material under the standard the Supreme Court articulated in Basic.

In Macquarie Infrastructure—the decision the Supreme Court will review—the court functionally abandoned the requirement that an Item 303 claim independently plead facts establishing a strong inference of scienter. The defendant in that case (Macquarie Infrastructure) owned various infrastructure-related business, including IMTT, which owned tanks for storage of "No. 6 oil," a high-sulfur oil principally used as fuel for large shipping vessels.

In 2016, the International Maritime Organization proposed regulations, known as IMO 2020, that would ban the use of high-sulfur oils in international shipping beginning in 2020. Market participants knew No. 6 oil storage represented a significant portion of IMTT's business and debated the regulation's likely effect on the No. 6 oil market: Some predicted that IMO 2020 would be revised before going into effect; some that technological advances could allow continued use of No. 6 oil; and some predicted that IMO 2020 would eliminate demand for No. 6 oil altogether. During the alleged class period, Macquarie Infrastructure did not publicly discuss IMTT's No. 6 oil storage business or IMO 2020's potential effect on that business.

In February 2018, Macquarie Infrastructure released its financial results and announced that it had missed its projections in part because of the effect of a "structural decline in the 6 oil market" on IMTT's business. Following the announcement, MIC's stock price fell 41 percent, and shareholders sued. The complaint asserted (i) that various statements MIC made during the class period were misleading by omission because they failed to disclose information about the risk that IMO 2020 posed to IMTT's No. 6 oil storage business and (ii) that Macquarie should have disclosed the risk of IMO 2020 under Item 303.

The district court dismissed the complaint. The Second Circuit affirmed in part but reversed the dismissal of claims based on Item 303. The court found that "Plaintiff has satisfied [its] burden by pleading actionable omissions" by alleging the existence of a "'known trend or uncertaint[y]' that gave rise to a duty to disclose under Item 303."

As to scienter, the court found that the complaint had adequately alleged that senior Macquarie executives knew "that it was likely that revenue contributions would be down from IMTT" because of IMO 2020. The court found this sufficient to plead scienter based on Second Circuit precedent finding that "securities fraud claims…suffice[ ] to state a claim based on recklessness when they have specifically alleged defendants' knowledge of facts or access to information contradicting their public statements." This rule makes sense in a misstatement cases: If senior executives of a company are aware of information contradicting their public statements, then they are aware that their public statements may be false. And knowingly making false statements to investors supports an inference of an intent to mislead.

But the mere fact that someone is aware of undisclosed information—without any showing that the information contradicted the company's public statements—does not suggest that he knows the company had a legal duty to disclose the information or that omitting to disclose the information would be misleading. Indeed, knowledge of the omitted information is an element to pleading the underlying Item 303 violation in the first place. Thus, under the Second Circuit's scienter analysis in Macquarie, merely pleading an Item 303 violation would be sufficient to plead scienter.

The Second Circuit's decisions in Rule 10b-5 cases asserting Item 303 violations threaten to extend Rule 10b-5 liability to pure omissions, contrary to the Rule's express language and the Supreme Court's directive in Matrixx.

Virtually anytime a public company's stock price falls following negative news, creative plaintiffs' lawyers could theorize that some relevant information should have been disclosed earlier under Item 303, leading to potential Rule 10b-5 liability even where a company has chosen to remain silent about a topic. And finding scienter based only on executives' knowledge of the undisclosed information—without allegations showing that those executives knew that the omission would mislead—abrogates the heightened standard for pleading fraud under federal securities law.

In addition, the threat of private liability for omissions under Item 303 has the perverse effect of undermining the purpose of Item 303 itself. Rather than focusing on providing investors with management's perspective on the business, companies drafting MD&As will inevitably focus on avoiding potential liability through overinclusive disclosures of every conceivable trend or uncertainty. Lengthy, defensive disclosures do not serve investors' interests. As the Supreme Court has recognized, "an avalanche of trivial information…is hardly conducive to informed decision making." Basic v. Levinson, 485 U.S. at 231.

Conclusion

Permitting private plaintiffs to bring Rule 10b-5 claims based on alleged omissions in violation of Item 303 conflicts with Rule 10b-5's plain language and expands Rule 10b-5's scope beyond its intended target: materially false or misleading statements.

Permitting investor claims based on alleged violations of Item 303 also undermines Item 303's purpose, encouraging heavily lawyered prophylactic securities disclosures rather than providing investors with meaningful insight on management's views about a company's business.

Consistent with Rule 10b-5's plan language and the policies underlying the securities laws, the Supreme Court in Macquarie should confirm that private plaintiffs cannot bring Section 10(b) claims based on alleged violations of Item 303, absent some affirmative statement that is either false or misleading by omission.

James J. Beha II is a partner in the New York office of Baker Botts. He focuses on the defense of public companies, corporate officers and directors, and underwriters in securities litigation in federal and state courts.

From: New York Law Journal