The U.S. Supreme Court recently accepted an appeal to resolve a circuit split over whether companies have an actionable duty to disclose known trends or uncertainties that could affect their business. The case–Leidos, Inc. v. Indiana Public Retirement System, No. 16-581 (U.S.)–may significantly impact the ability of investors to hold companies liable for omitting information from their financial reporting.
The dispute centers around a U.S. Securities and Exchange Commission (SEC) regulation–Item 303 of Regulation S-K–which requires public companies 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 the company. Such disclosures are included in the “management’s discussion and analysis” section of a company’s quarterly and annual filings. According to the SEC, an Item 303 disclosure is required where a trend or uncertainty “is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operations.”
The Supreme Court is now poised to determine whether a failure to comply with Item 303 is an actionable omission under the anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5–tools often employed by investors in private securities litigation. While the Second Circuit sided with investors, the Third and Ninth Circuits have rejected the argument that a violation of Item 303 is automatic grounds for Section 10(b) liability.
This debate stems from an appellate opinion issued by now-Supreme Court Justice Samuel Alito. Back when Justice Alito was sitting on the Third Circuit Court of Appeals, he authored Oran v. Stafford, finding that the materiality analysis under Item 303 differed significantly from the analysis under Section 10(b). Bolstering his argument, he pointed to an SEC interpretive release stating that “[t]he probability/magnitude test for materiality approved by the Supreme Court in Basic, Inc. v. Levinson, 108 S. Ct. 978 (1988) is inapposite to Item 303 disclosure.” The Oran court therefore held that because the materiality standards differed, a violation of Item 303 would “not automatically give rise to a material omission under Rule 10b-5.” In 2014, in In re NVIDIA Corp. Sec. Litig., the Ninth Circuit agreed with then-Judge Alito’s Oran reasoning.
But the Second Circuit took a contrary position. In Indiana Pub. Ret. Sys. v. SAIC, Inc., the Second Circuit expressly broke with the Third and Ninth Circuits by emphasizing that “failure to comply with Item 303 . . . can give rise to liability under Rule 10b-5 so long as the omission is material under Basic . . .” The Second Circuit re-affirmed its prior decision in Stratte-McClure v. Stanley that a disclosure required by Item 303, and thus material under the SEC’s standard for Item 303 disclosures, could form the basis for an actionable duty to disclose, as long as it also met the Supreme Court’s standard for materiality set out in Basic, Inc. v. Levinson. The Third and Ninth Circuits would not allow investors to sue over omissions if the duty to disclose arose from Item 303.
The SAIC dispute involved investors accusing Leidos, formerly known as SAIC, of failing to disclose possible liability to one of its clients, New York City, for a kickback and overbilling scheme related to a contract with the city to revamp its payroll systems. That scheme eventually led to a $500 million settlement with New York City and alleged investor losses when the scheme came to light the year after Leidos allegedly failed to disclose it. The district court dismissed the shareholder action, but the Second Circuit vacated the decision and remanded. SAIC filed a petition for writ of certiorari.
In March 2017, the Supreme Court granted certiorari in the case–now captioned as Leidos, Inc. v. Indiana Public Retirement System. The justices will hear oral arguments during the term that starts in October 2017, and Justice Alito will have another chance to weigh in on this issue. (As the parties are not the same, while the circumstance is one that occurs somewhat infrequently, it does not raise any conflict concerns.)
While a reversal of the Second Circuit’s decision would be a setback for investors, all hope is not lost. Even if a violation of Item 303 does not give rise automatically to a Section 10(b) claim, it is likely that in most scenarios the facts will support alternative ways to plead the same violations. For instance, if an omitted fact about a known trend or uncertainty is material and renders a statement false or misleading, then that could still be actionable–it is just not automatically actionable by virtue of being a violation of Item 303. As always, investors–and their counsel–must maintain their vigilance. For now, the ball is in Justice Alito’s court.