The kids are back in school and the Supreme Court is back in session. When Justice Ginsburg described the fall term as momentous, she was most likely referring to the blockbuster cases that will shape American life from the ballot box to the bake shop. The Court will hear argument on political gerrymandering, workers’ rights, digital privacy, and whether a cakemaker can legally refuse to serve gay couples in the name of religious freedom.
While they may not steal headlines, the Court’s docket also includes three significant securities matters: Leidos, Digital Realty, and Cyan. These cases are noteworthy because they address frequently litigated issues including the scope of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act), whistleblower protection, and the Securities Litigation Uniform Standards Act (SLUSA). The outcome of these cases should resolve splits of authority and provide clarity for investors on topics that often cause confusion and inconsistent rulings.
Silence is Not Golden in Leidos, Inc. v. Indiana Public Retirement System
On November 6th, the Court will hear arguments in Leidos, Inc. v. Indiana Public Retirement System, which presents the issue of whether an alleged failure to make a disclosure of a known trend or uncertainty required by a Securities and Exchange Commission (SEC) regulation is an actionable omission under federal securities laws.
The SEC regulation at play, Item 303 of Reg. S-K, states that, in periodic reports to the SEC, companies are required to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a materially favorable or unfavorable impact on net sales or revenues or income from continuing operations.” The SEC states that a disclosure is necessary under Item 303 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 “uncertainty” in the Leidos matter arises from a half billion-dollar fraud. Leidos, Inc. formerly known as SAIC, Inc., is a government contractor that provides technology services. In 2010, federal and New York investigators discovered a billing kickback scheme involving an IT contract in which SAIC was providing services to New York City. The investigation determined that the scheme resulted in the project’s budget blowing up from $73 million in 2000 to around $620 million by 2011. In 2012, SAIC entered into a deferred prosecution agreement with federal and state authorities that required it to pay more than $500 million in restitution and penalties, and SAIC admitted to defrauding the city.
In 2012, a securities class action was filed against SAIC in the Southern District of New York. Investors alleged they were deceived by SAIC’s March 2011 annual report on SEC Form 10-K because when the company made that filing, it had known for months about the kickback-and-overbilling scheme in its New York City contract. Indeed, by that time, the project was already the subject of multiple law-enforcement investigations, and SAIC had already lost business opportunities as a result of the investigations. Despite this, SAIC’s March 2011 annual report contained no disclosures regarding the New York City project. The report was certified and signed by SAIC’s chief executive officer and chief financial officer attesting that the report “fully complie[d]” with federal securities laws. Investors alleged that the report did not comply with those requirements because Item 303 required SAIC to disclose known material “uncertainties” likely to affect its business prospects. Even though the report gave every indication that it contained all of the information required to be disclosed, SAIC did not reveal that by March 2011, the problems with the New York City project had and would continue to have a negative impact on its business.
The district court dismissed the case finding, among other things, that the investor’s claims based on the allegation that the company’s SEC filings omitted disclosures required by Item 303 were insufficiently pled. Following the investor’s appeal, the Second Circuit vacated the portion of the district court’s decision regarding Item 303, finding that “Item 303 imposes an affirmative duty to disclose that can serve as the basis for a securities fraud claim under Section 10(b).” The Court went on to state that “failure to comply with Item 303 … can give rise to liability under Rule 10b-5 so long as the omission is material … and the other elements of Rule 10b-5 have been established.” In other words, omitting an item required to be disclosed in an SEC filing can render that statement misleading.
Item 303 creates an actionable duty of disclosure in the Second Circuit, but the Ninth and Third Circuits disagree. SAIC, now known as Leidos, sought review from the Supreme Court to resolve this “deep split of authority.” Leidos argues that the Second Circuit dramatically expanded the scope of liability for omissions, and that Section 10(b) and Rule 10b-5 do not establish an affirmative duty to disclose, but instead only require the disclosure of information necessary to ensure that statements are not false and misleading.
If Item 303 does in fact create an actionable duty of disclosure, based on the facts of the case, it is hard to imagine how omitting a potential settlement and multiple law-enforcement investigations could be seen as anything other than false and misleading. Nonetheless, if the Court determines that Item 303 does not create an actionable duty, investors will find themselves with one less legal protection.
The Ins and Outs of Whistleblower Protection in Digital Realty Trust, Inc. v. Somers
Digital Realty Trust, Inc. v. Somers addresses whether the anti-retaliation provision for whistleblowers in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 protects whistleblowers making reports to the SEC, or whether it also protects whistleblowers who report internally within their companies.
Until Paul Somers was fired, he worked for Digital Realty Trust, a real estate investment trust specializing in properties for data centers. He filed a lawsuit under the anti-retaliation provision, arguing that he was terminated based on false allegations of misconduct after he complained to management that a senior vice president had eliminated some internal corporate controls, making his internal complaints protected by the Sarbanes-Oxley Act. The company argued that his claims could not go forward because he had not complained to the SEC, as the Dodd-Frank Act’s definition of a whistleblower provides.
The district court denied the company’s motion to dismiss, and the Ninth Circuit affirmed, finding that Dodd-Frank’s whistleblower anti-retaliation provision “unambiguously and expressly protects” both those who report to the SEC and internal whistleblowers.
The Ninth Circuit is in accord with the SEC. The SEC has taken the position that the anti-retaliation provision protects not only whistleblowers who make their report to the SEC, but also whistleblowers who report internally. Under the doctrine of Chevron deference, courts should defer to regulatory agencies in interpreting ambiguous laws. This topic is of particular interest to Justice Gorsuch, who has been a vocal critic of the theory, as stated in his 2016 Gutierrez-Brizuela v. Lynch decision.
The Court’s decision in Digital Realty Trust could yield unintended results. On the one hand, if the Court rules that internal whistleblowers are entitled to anti-retaliation protections, the group of potential claimants is expanded. However, if the Court finds that internal whistleblowers are not entitled to anti-retaliation protection that may incentivize whistleblowers to go straight to the SEC which could lead to more SEC probes and enforcement actions. The U.S. Chamber of Commerce and the Cato Institute have thrown their support behind Digital Realty. But corporate America should be careful what they wish for, because they may find themselves embroiled in more whistleblower problems, not less.
As for Chevron deference, that issue does not necessarily need to be considered in reaching a decision. Justice Gorsuch may attempt to broaden the scope of the ruling to challenge the doctrine, but it seems unlikely that he will be able to convince a majority of his colleagues on the Court to come around to his way of thinking on the theory.
California Dreamin’ of State Court Jurisdiction in Cyan, Inc. v. Beaver County Employees’ Retirement Fund
We previously summarized, Cyan, Inc. v. Beaver County Employees’ Retirement Fund, in January before the Court agreed to hear the matter. Cyan addresses whether class actions that allege only federal Securities Act of 1933 (Securities Act) claims may be maintained in state court, or whether SLUSA completely eliminated state court jurisdiction. This matter comes to the Supreme Court against a backdrop of an increasing number of Securities Act class actions being filed in California state courts.
Class actions alleging Securities Act claims typically arise from initial public offerings (IPOs), and Cyan is no exception. Following Cyan’s IPO in May 2013, a securities class action was filed in California state court asserting Securities Act claims. Cyan unsuccessfully argued that the state court lacked authority under SLUSA to hear the matter. In denying Cyan’s motion for dismissal, the trial court held that such claims may be brought in either state or federal court, and SLUSA did not change that analysis.
Since our last update, Acting Solicitor General Jeffery Wall submitted in May the government’s somewhat surprising view of the matter, agreeing that SLUSA does not strip state courts of jurisdiction. The government nonetheless encouraged the Court to hear the matter to resolve “this difficult interpretative issue that has generated confusion in lower courts.” Although the issue was not raised in Cyan, the government noted that even if state courts retain jurisdiction, SLUSA still provides defendants a means to transfer many class actions to federal court under a different provision of SLUSA.
While California state court is a safe haven for these actions, that is not the case everywhere. Many courts outside of California hold that SLUSA stripped state courts of jurisdiction over Securities Act class actions. If the Supreme Court affirms or lets stand the lower court’s ruling, investors would retain flexibility in deciding where to bring Securities Act claims based on misrepresentations in offering documents.
But Wait, There’s More
Also of interest are three additional securities matters that the Court may take up this term. Holtz v. JP Morgan Chase & Co. and Goldberg v. Bank of America Corp., involve similar questions of whether state law breach of fiduciary duty claims can be alleged in a SLUSA matter. Lucia v. SEC Litigation asks the question of whether the SEC’s administrative judges function as inferior officers that need to be appointed rather than hired. The Court is expected to decide whether to hear these appeals in the coming months.
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With the optimism of students starting a new school year, we are eager to learn what the Court has in store for investors during this momentous term.
[Update: Since publication, the Leidos parties reached an agreement to settle the litigation. As a result, on October 17, 2017, the U.S. Supreme Court removed the case from its argument calendar and ordered that it will hold the matter in abeyance. Thus, the Leidos issues outlined above will not be reviewed by the Court at this time.]