Second Circuit: Failure to Comply With Item 303 of Regulation S-K May Only Be Actionable Under Section 10(b) If the Alleged Omission Was Material Under Basic's Probability/Magnitude Test
Item 303 of Regulation S-K sets forth the disclosure requirements for the Management's Discussion and Analysis (MD&A) section of a public company's Form 10-Qs and other SEC filings. In relevant part, Item 303 states that a public company must "[d]escribe any 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."
On January 12, 2015, the Second Circuit held "as a matter of first impression . . . that a failure to make a required Item 303 disclosure . . . is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim." Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015) (Livingston, J.). The court explained that "Form 10-Qs are mandatory filings that speak . . . to the entire market," and reasoned that "omitting an item required to be disclosed on a 10-Q can render that financial statement misleading."
Significantly, the Second Circuit found that "such an omission is actionable only if it satisfies the materiality requirements outlined in [Basic Inc. v. Levinson, 485 U.S. 224 (1988)], and if all of the other requirements to sustain an action under Section 10(b) are fulfilled." The Second Circuit explained that "[t]he SEC's test for a duty to report under Item 303 . . . involves a two-part . . . inquiry" that is "different" from the test for materiality under Basic. When determining whether Item 303 mandates disclosure of a "known trend," "management must make two assessments." First, management must consider whether the known trend is "likely to come to fruition." Second, in the event that "management cannot make that determination, it must evaluate objectively the consequences of the known trend . . . on the assumption that it will come to fruition." Item 303 then requires disclosure of the trend "unless management determines that a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur." Under the Basic test, on the other hand, "the materiality of an allegedly required forward-looking disclosure is determined by 'a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.'" Stratte-McClure, 776 F.3d 94 (quoting Basic, 485 U.S. at 224) (emphasis added by the Second Circuit). The Second Circuit held that a plaintiff alleging "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 . . . was material underBasic's probability/magnitude test" and if all other requirements for a claim under Section 10(b) and Rule 10b-5 are satisfied.
In so holding, the Second Circuit recognized that its decision was "at odds" with the Ninth Circuit's opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014). The NVIDIA court held that "Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5." The Second Circuit determined that the Ninth Circuit's decision was based on an overbroad reading of the Third Circuit's decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). The Second Circuit found that "Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material [Rule] 10b-5 omission."
Fourth Circuit: Partial Disclosure Can Give Rise to a Duty to Disclose for Section 10(b) Purposes
On March 16, 2015, in a securities fraud action brought against Chelsea Therapeutics International and several of its executives, the Fourth Circuit found "plaintiffs' allegations . . . permit[ted] a strong inference that . . . defendants [had] either knowingly or recklessly misled investors by failing to disclose critical information received from the FDA during the new drug application process, while releasing less damaging information that they knew was incomplete." Zak v. Chelsea Therapeutics Int'l, 780 F.3d 597 (4th Cir. 2015) (Keenan, J.). The court concluded that plaintiffs had adequately pled scienter by alleging a "conflict[ ]" between the "material, non-public information known to [ ] defendants about the status of" the company's application for FDA approval and "defendants' public statements on those subjects."
The Fourth Circuit "emphasize[d] that [its] conclusion [did] not stand for the proposition that a strong inference of scienter can arise merely based on a defendant's failure to disclose information." The court recognized that "Chelsea and its corporate officers may have lacked an independent, affirmative duty to disclose" adverse information received from the FDA in connection with the company's application for FDA approval. However, the Fourth Circuit stated that "defendants' failure" to disclose "must be viewed under Section 10(b) and Rule 10b-5(b) in the context of the statements that they affirmatively elected to make" regarding the likelihood of FDA approval. The Fourth Circuit noted that under Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), "companies can control what they have to disclose under [Section 10(b) and Rule 10b-5(b)] by controlling what they say to the market" (quotingMatrixx, 131 S. Ct. 1309).
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