April 3, 2017
Supreme Court grants certiorari in Second Circuit
case testing the role of MD&A disclosures in
Rule 10b-5 cases
By Karl D. Belgum, Richard A. McGuirk and George J. Skelly
On March 27, 2017, the Supreme Court agreed to review a Second Circuit decision, which allows a
securities plaintiff to meet the “duty to disclose” element of a Rule 10b-5 omissions case by alleging
that the withheld facts were required to be disclosed under Regulation S-K, Item 303. Leidos, Inc. v.
Indiana Public Retirement System, 2016 WL 7011426 (U.S. March 27, 2017) (No. 16-581). Item 303
requires annual reports on Form 10-K and certain other securities filings to contain a management
discussion and analysis (MD&A) section, and specifies the subjects required to be discussed in it,
including “known trends or uncertainties.” The Court is now poised to resolve a split in the circuits
as to the role that such Item 303 disclosures play in Rule 10b-5 litigation.
The Court’s opinion will draw significant interest from public issuers, who frequently face the
difficult question of when and how to disclose contingent, but potentially material, events, a
problem that can arise in a wide variety of circumstances such as ongoing government
investigations, whistleblower claims or problems with a major product. The need to address the
risk of Rule 10b-5 liability, while at the same time managing the underlying problem, is a common
reason clients seek legal advice from their Nixon Peabody counsel.
Section 11 of the Securities Act of 1933 provides a private right of action for investors who
purchase securities pursuant to a registration statement that “omit[s] to state a material fact
required to be stated therein.” (Emphasis added.) Thus, SEC regulations regarding what is required in
a registration statement also shape the scope of civil liability for non-disclosure.
Liability under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 has evolved
along a different path; mere non-disclosure of a fact is not actionable absent some affirmative “duty
to speak.” Defense lawyers – at least in some jurisdictions – may argue that the duty to speak under
Rule 10b-5 has been held to arise in only two specific circumstances: (1) where an insider has
material non-public information, he/she is barred from trading in the issuer’s securities unless the
facts are disclosed, and (2) where a duty to disclose arises when necessary to “tell the whole
truth”—i.e., where the omission of a fact would render other statements made on the same subject
matter misleading. See, e.g., Dirks v. SEC, 463 U.S. 646, 654 (1983); Chiarella v. United States, 445 U.S.
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222, 230 (1980). In the Leidos case, those two different approaches to omission liability have now
become blurred, leading to the Court’s recent grant of certiorari.
The defendant in Leidos (then called SAIC) was a large publicly traded systems integration
company. Plaintiff alleged that at the time Leidos issued its 2011 annual report on Form 10-K, it
was aware that it was under investigation for a kickback scheme, which was likely to result in a
material liability for the company. News reports had already disclosed criminal charges against
certain persons involved in the scheme (but not SAIC itself). Nevertheless, SAIC’s annual report
was silent on the subject. Five months later, SAIC disclosed that its financial results would be
materially impacted by the scandal, and that it faced a “probable” large restitution obligation. A
complaint under Rule 10b-5 promptly followed.
The district court dismissed the complaint, but the Second Circuit reversed, holding that plaintiff
had adequately pled an actionable omission under Rule 10b-5 by alleging that the annual report
failed to disclose the threatened kickback liability as a “known trend or uncertainty” in the MD&A
section of the annual report. The fact that the annual report said nothing at all about the subject
was no defense. The “duty to speak” element for omission liability under Rule10b-5 was satisfied by
the SEC regulations concerning MD&A disclosure.
In its petition for certiorari, Leidos portrayed the Second Circuit opinion as a dramatic departure
from the existing limited “duty to speak” principles under Rule 10b-5. From the defense
perspective, the opinion potentially sweeps into Rule 10b-5 all of the subjects required to be
addressed in Item 303. According to defendants, this erodes the principle articulated in Matrix
Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011), that issuers can limit their duty to discuss sensitive
topics by saying nothing about them at all. Even worse, the MD&A subjects are inherently “soft”
and subjective. For example, Item 303 mandates disclosure of “known trends or uncertainties that
have had or that the registrant reasonably expects will have a material favorable or unfavorable
impact.” (17 C.F.R. § 229.303(3)(ii).) The specter of a duty by issuers to make predictions about the
future under Regulation S-K combined with Rule 10b-5 liability if they guess wrong is a daunting
prospect for company management. Moreover, defendant argued, the standards for materiality
under Item 303 are broader and less certain than the well-established test for materiality in Rule
10b-5 litigation under Basic v. Levinson, 485 U.S. 224 (1988).
In opposing the certiorari petition, plaintiff pointed out that a number of prior cases have stated
that the duty to disclose arises in three circumstances, not two, one of which is when disclosure is
required by a statute or regulation. However, they also reassured the Court that allowing a duty to
disclose to be premised on Item 303 will not unduly expand Rule 10b-5. For example, in another
recent Second Circuit case, Stratte-McClure v. Stanley, 776 F.3d 102, 103 (2d Cir. 2015), the court
held that a violation of the Item 303 disclosure obligation does not by itself establish an actionable
omission under Rule 10b-5; all the elements of Rule 10b-5 liability still need to be met, including
materiality under the standard in Basic and, of course, scienter.
Defendants counter that even though some prior cases have referred to a duty to disclose based on
the mandate of a statute or regulation, few if any cases have found liability solely on that basis, and
that Item 303 is the worst possible candidate to support such a duty. The SEC itself has stated that
“[t]he probability/magnitude test for materiality approved by the Supreme Court in Basic . . . is
inapposite to Item 303 disclosure.” Exchange Act Release No. 34-26831, 54 Fed. Reg. at 22430 n. 27,
cited in Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000).
The Court’s decision to grant review was clearly prompted by a split in the circuits on this issue.
The Ninth Circuit held in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046, 1056 (9th Cir.
2014), that “[I]tem 303 does not create a duty to disclose for purposes of Section 10(b) and Rule
10b-5.” See also Oran v. Stafford, supra.
The securities defense bar values black and white tests for liability because they can potentially
serve as the basis for a motion to dismiss or for summary judgment. The doctrine that there is no
general duty to speak under Rule 10b-5 has, in many courts, served as such a test. The focus of the
battle before the Supreme Court will be whether the defense bar can convince the justices to
preserve or even enhance the “duty to speak” as a useable bright line test, or whether the duty to
speak barrier will be eroded by the soft and subjective disclosure requirements of Regulation S-K.
For more information on the content of this alert, please contact your Nixon Peabody attorney or:
— Karl D. Belgum at [email protected] or (415) 984-8409
— Richard A. McGuirk at [email protected] or (585) 263-1644
— George J. Skelly at [email protected] or (617) 345-1220
— Christopher M. Mason at [email protected] or (212) 940-3017
— Carolyn G. Nussbaum at [email protected] or (585) 263-1558