In Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. Jan. 12, 2015), the Second Circuit Court of Appeals held that the omission of information required to be disclosed under Item 303 of Regulation S‐K (“Item 303ʺ) can serve as the basis for a securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934. The decision is at odds with the Ninth Circuit Court of Appeals, which reached the opposite conclusion.
The Legal Background
Item 303 of Regulation S‐K imposes disclosure requirements on companies filing reports mandated by the Securities and Exchange Commission (“SEC”), including quarterly Form 10‐Q reports. Those requirements include the obligation to “[d]escribe any known trends or uncertainties . . . that the registrant reasonably expects will have a material . . . unfavorable impact on . . . revenues or income from continuing operations.” Pursuant to SEC guidance on Item 303, disclosure is necessary “where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”
The Facts of the Case
Plaintiffs filed a securities fraud class action pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The suit alleged that Morgan Stanley and six of its officers and former officers made material misstatements and omissions in an effort to conceal Morgan Stanley’s exposure to and losses from the subprime mortgage market, which resulted in significant investment losses once the positions and losses were disclosed. The plaintiffs specifically maintained that the defendants’ omission of information that purportedly must be disclosed under Item 303 violated Section 10(b). The United States District Court for the Southern District of New York dismissed the suit for failure to state a claim.
The Second Circuit’s Decision
The Second Circuit concluded that the “affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b).”
The court, however, held that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b‐5 if the allegedly omitted information satisfies the test for materiality set forth in Basic Inc. v. Levinson, 485 U.S. 224 (1988). Accordingly, a plaintiff must first allege that the defendant failed to comply with Item 303 in a 10‐Q or other filing, which establishes that the defendant had a duty to disclose. As further detailed in the opinion, 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,’ in this case the Form 10‐Qs, ‘not misleading.’” In addition, the plaintiff must sufficiently plead the other elements of a Section 10(b) claim.
The Second Circuit acknowledged that its conclusion conflicts with the Ninth Circuit’s recent opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), which held that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b‐5. According to the Second Circuit, the Ninth Circuit misinterpreted a Third Circuit opinion by then‐Judge Alito, Oran v. Stafford, 226 F.3d 275, 284 (3d Cir. 2000). As explained by the Second Circuit:
Contrary to the Ninth Circuit’s implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b‐5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b‐5 omission. At a minimum, Oran is consistent with our decision that failure to comply with Item 303 in a Form 10‐Q can give rise to liability under Rule 10b‐5 so long as the omission is material under Basic, and the other elements of Rule 10b‐5 have been established.
In Stratte-McClure, the Second Circuit concluded that the plaintiffs sufficiently 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.” The court nonetheless affirmed the dismissal of the Section 10(b) claim because it found the plaintiffs failed adequately to plead scienter.
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