CLS Blue Sky Blog

Will the Supreme Court Expand Silence as a Basis for Securities Fraud?

The Supreme Court has long held that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.”[1]  And such a duty to disclose only arises where necessary to make a statement already made not misleading, thus allowing companies to “control what they have to disclose … by controlling what they say to the market.”[2]  On March 27, 2017, in Leidos, Inc. v. Indiana Public Retirement System, the court granted certiorari to determine whether, in the absence of any need to correct a prior statement, there exists a separate disclosure duty under Item 303 of SEC Regulation S-K that is actionable under Section 10(b) of the Securities Exchange Act and Rule 10b-5.[3]  In Leidos, the U.S. Court of Appeals for the Second Circuit held, contrary to two other circuits, that Item 303, which pertains to disclosure of so-called “soft” information like trends or uncertainties, does create such a disclosure duty.[4]

Such an affirmative disclosure duty under Item 303 would broadly subject issuers to possible Rule 10b-5 liability for omissions relating to, among other things, “any known trends or uncertainties that … the registrant reasonably expects will have a material … impact on net sales or revenues or income from continuing operations.”[5]  Interpreting Item 303, the SEC has stressed its breadth by noting that its disclosure provisions “are intentionally flexible and general,” as “no two registrants are identical.”[6]  Consequently, the Supreme Court’s determination in Leidos will likely have a substantial impact on issuers’ disclosure determinations in their periodic reports, and on Rule 10b-5 claims they will face for omission of such soft information.

Second Circuit’s Take on Item 303 Omissions Liability

The Leidos case involved a securities class action claim that Leidos, Inc. (then known as SAIC[7]), an intelligence and logistics provider primarily serving government agencies, failed to disclose that it had potential exposure as a result of a fraudulent kickback scheme affecting the company’s large technology contract with the New York City government.  Plaintiffs charged, among other things, that SAIC should have disclosed this possibly substantial exposure in its March 2011 Form 10-K as a “known trend or uncertainty” that it then “reasonably expected” would have a material impact on its financial condition under Item 303.

The Second Circuit  in Leidos agreed with plaintiffs that Rule 10b-5 omissions liability can exist for a violation of Item 303.  In so doing, the court simply relied without substantive discussion or analysis on its decision several months earlier in Stratte-McClure v. Morgan Stanley[8] for its holdings that (i) Item 303 imposes “an affirmative duty to disclose that can serve as the basis for a securities fraud claim under Section 10(b),” and (ii) “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.”[9]  Thus, the earlier Stratte-McClure decision provides the Second Circuit’s analysis that the Supreme Court has committed to consider in granting certiorari in Leidos.[10]

Stratte-McClure involved a “massive” proprietary trade consisting of short and long positions in credit default swaps referencing different tranches of collateralized debt obligations that were backed by residential mortgage-backed securities – effectively a bet on the severity of defaults in the subprime mortgage markets.  Plaintiffs alleged that, for a period of several months, defendants concealed their firm’s exposure to and losses from this very large subprime proprietary trade.[11]

The Stratte-McClure decision began its analysis of Item 303 omissions liability by acknowledging the fundamental principle that silence alone, absent a duty to disclose, is not actionable under Rule 10b-5.[12]  But the court then noted that Item 303 explicitly “imposes disclosure requirements on companies filing SEC-mandated reports.”  The court then reasoned that an omission in the face of Item 303’s “affirmative duty to disclose” in periodic reports “can serve as the basis for a securities fraud claim under Section 10(b).”  The court found support for its analysis in cases holding that Item 303 omissions from registration statements or prospectuses can be actionable under Securities Act Sections 11 and 12(a)(2).[13]

Finally, the court commented that it “stands to reason” that Item 303 omissions can support fraud claims because “omitting an item required to be disclosed” in a mandatory periodic report “can render that financial statement misleading.”  The court further reasoned that “the obligatory nature of these regulations” would cause a reasonable investor to “interpret the absence of an Item 303 disclosure to imply the nonexistence” of the known trends or uncertainties referenced in Item 303.[14]

Second Circuit Going It Alone

The Second Circuit’s holding in Leidos and Stratte-McClure that an Item 303 omission can support 10b-5 liability is in direct conflict with the views of other circuits that have considered the question.  The Ninth Circuit held the opposite in In re NVIDIA Corp. Securities Litigation,[15] which in turn relied on then-Judge Samuel Alito’s decision for the Third Circuit in Oran v. Stafford.[16]  Judge Alito’s views in Oran are thus the starting point for the competing analysis.

Oran involved a pharmaceutical company’s alleged failure to disclose health concerns that ultimately led it to withdraw two products from the market.  Judge Alito rejected plaintiffs’ claims that an omission of known trends or uncertainties can give rise to Rule 10b-5 liability.  He started by comparing the materiality standard for 10b-5 liability set out in Basic – a balancing of the probability an event will occur and the event’s anticipated magnitude to the company – with what he found to be a “significantly” different materiality standard for Item 303 disclosure.  Under Item 303 the standard is whether the trend or uncertainty is reasonably likely to occur, and if management cannot make that determination, then disclosure is required, unless management determines it not likely that a material effect on financial condition or results of operations will occur.[17]

In view of these significantly different materiality standards between Rule 10b-5 and Item 303, Judge Alito determined for the Third Circuit that “demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.  Such a duty must be separately shown.”[18]  This led Judge Alito to “hold that a violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5.”  As plaintiffs failed to plead an actionable misrepresentation or omission under Rule 10b-5, the claim would be dismissed because “SK-303 cannot provide a basis for liability.”[19]

NVIDIA involved a claim that a semiconductor company failed to timely disclose certain product defects.  The Ninth Circuit expressly relied on Judge Alito’s reasoning to likewise reach the conclusion that an Item 303 omission will not support a Rule 10b-5 fraud claim.  The Ninth Circuit observed that “[m]anagement’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic” for Rule 10b-5 liability, and that “what must be disclosed under Item 303 is not necessarily required” for Rule 10b-5.[20]  The Ninth Circuit also declined to apply precedent under Securities Act Sections 11 and 12(a)(2), as they impose liability directly for “an omission in contravention of an affirmative legal disclosure obligation,” while Rule 10b-5 does not require disclosure unless omission of the information would cause other disclosed information to be misleading.[21]

The Second Circuit’s ruling also conflicted with views on Item 303 previously expressed by the Sixth and Eleventh Circuits.  See In re Sofamor Danek Group, Inc., 123 F.3d 394, 403 (6th Cir. 1997) (finding “not persuasive” an argument that a “disclosure duty under the Rule 10b-5 claim may stem from Item 303”); Thompson v. RelationServe Media, Inc., 610 F.3d 628, 682 n. 78 (11th Cir. 2010) (finding “generous” an assumption that Item 303 would impose an actionable duty to speak).

Problems Presented for Issuers Under Second Circuit View

Under SEC guidance in its MD&A Release, in evaluating trends or uncertainties under Item 303, issuer management should engage in the following analytical process:  (i) Determine whether the known trend or uncertainty is “likely to come to fruition,” and, if it is “not reasonably likely to occur,” disclosure is excused;  (ii) If this “likelihood” determination cannot be made, then “evaluate objectively the consequences” of the known trend or uncertainty “on the assumption that it will come to fruition,” and disclose unless management determines it is “not reasonably likely” to have a “material effect on the registrant’s financial condition or results of operations.”[22]  In terms of potential Rule 10b-5 liability exposure, this multifaceted judgmental process under Item 303 obviously offers many junctures for management to guess wrong.

As petitioners in Leidos have argued, the Second Circuit’s determination that Item 303 omissions can form the basis for Rule 10b-5 claims would represent a “vast” expansion of the private right of action under the rule, and this flies in the face of the recent movement to limit such claims.[23]  For example, in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., the Supreme Court observed that it can be assumed that in enacting the Private Securities Litigation Reform Act, Congress “accepted the 10(b) private cause of action as then defined but chose to extend it no further.”[24]

Petitioners have further argued that such an expansion of the private right of action to cover Item 303 omissions would present particular difficulties, because Item 303 deals with disclosure of difficult-to-evaluate “soft” information that is “easily susceptible to manipulation by plaintiff’s attorneys.”  Such information is “so malleable that it will take only the slightest bit of creativity to identify a ‘trend’ or ‘uncertainty’ that a company should have disclosed.”  They note that SEC guidance “vest[s] management with the authority and responsibility to determine what, if anything, must be disclosed under Item 303,” and that, under the Second Circuit’s holding, Item 303 “will be used as a powerful (and frequently employed) vehicle to assert hindsight Section 10(b) claims, which the PSLRA was intended to weed out.”[25]

Finally, petitioners predict that if the Second Circuit’s ruling stands, companies will rush to protect themselves from Rule 10b-5 liability “by inundating investors with a flood of non-material information.”  They say that this will “severely undercut Item 303’s intent to promote meaningful disclosure to investors” and “defeat the very purpose of disclosure regulations.”[26]


The circuit split on such a potentially important question for securities liability makes the certiorari grant here completely understandable, especially since the first of the circuit decisions in question was written by a judge now sitting on the Supreme Court.  Given the trend to limit private rights of action, it seems likely that the court will reject the Second Circuit’s dramatic expansion of omission liability.  But there is enough at play here for the Supreme Court’s decision to provide a vehicle to elucidate core disclosure duties in ways that could shape securities law duties and claims for decades to come.


[1] Basic, Inc. v. Levinson, 485 U.S. 224, 239 n. 17 (1988).

[2] Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 45 (2011).  Additionally, in the area of insider trading enforcement, the so-called “disclose or abstain” rule requires corporate insiders to disclose material nonpublic information before trading in their issuer’s securities.  Chiarella v. U.S., 445 U.S. 222, 226-27 (1980).

[3] No. 16-581 (March 27, 2017).

[4] Indiana Public Retirement System v. SAIC, Inc. (n/k/a Leidos, Inc.), 818 F.3d 85 (2d Cir. 2016).

[5] 17 C.F.R. §229.303(a)(3)(ii).

[6] “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Release Nos. 33-6835, 34-26831, IC-16961, 43 SEC Docket 1330, 1989 WL 1092885 at *17 (May 18, 1989) (the “SEC MD&A Release”).

[7] In September 2013, SAIC changed its name to Leidos and spun off a separate public company under the SAIC name.  Leidos continued as a public company, and the spun-off company presently doing business as SAIC is not a party to the litigation.  Petition for Certiorari, 2016 WL 6472615 (Oct. 31, 2016).

[8] 776 F.3d 94, 101 (2d Cir. 2015).

[9] 818 F.3d at 94 and fn. 7, quoting Stratte-McClure, 776 F.3d at 101, 103-04.

[10] The Leidos panel separately held, however, that Item 303’s “plain language” shows that proof an Item 303 violation requires a showing of “actual knowledge of the relevant trend or uncertainty,” not mere negligence or even recklessness.  818 F.3d at 95.

[11] 776 F.3d at 97-98.

[12] Id. at 100-101.

[13] Id. at 101-102, citing, inter alia, Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2d Cir. 2012).

[14] Id. at 102.

[15] 768 F.3d 1046 (9th Cir. 2014).

[16] 226 F.3d 275 (3d Cir. 2000).

[17] Id. at 287-88.

[18] Id. at 288, quoting Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598, 608 (N.D. Cal. 1991).

[19] Id.

[20] 768 F.3d at 1054-55.

[21] Id. at 1055-56.

[22] SEC MD&A Release, 1989 WL 1092885 at *6.

[23] Petition for certiorari, 2016 WL 6472615 at *23-24.

[24] 552 U.S. 148, 166 (2008).

[25] Petition for certiorari, 2016 WL 6472615 at *25, 27.

[26] Id. at *29-30.  Amici have similarly commented that the “breadth and amorphousness” of Item 303 often make it almost impossible to determine when disclosure is needed, and that the Second Circuit’s approach frustrates the SEC’s goal to give “wide latitude … in deciding whether forward-looking information is sufficiently certain” to support disclosure.  Brief of Securities Industry and Financial Markets Association and the Chamber of Commerce as Amici Curiae, 2016 WL 7011426 at *2-3 (Nov. 30, 2016).

This post comes to us from Stephen J. Crimmins and James K. Goldfarb, partners in the New York law firm of Murphy & McGonigle, a securities boutique established in 2010.

Exit mobile version