Extracted from Law360
On Jan. 16, the U.S. Supreme Court heard oral argument in Macquarie Infrastructure Corp. v. Moab Partners LP, a case that could significantly alter private securities litigation liability.
There is currently a circuit split regarding public companies' liability for disclosures required by Item 303 of Regulation S-K. The appeal here comes after the U.S. Court of Appeals for the Second Circuit held that the petitioners' failure to disclose the potential impact of industry regulations on its business, as required by Item 303, could support a private claim under Section 10(b) of the Securities Exchange Act.
What Is Item 303?
Item 303 is intended to enhance a stockholder's understanding of a public company's financial condition, cash flows and operations from management's perspective.[1]
Item 303 requires issuers to "describe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations" in the Management's Discussion and Analysis, or MD&A, section of Forms 10-K and 10-Q.[2]
The requirements are intentionally general, even vague, reflecting the U.S. Securities and Exchange Commission's view that the flexibility afforded by Item 303 leads to more meaningful disclosures and avoids boilerplate.[3] Item 303 contemplates that SEC staff will enforce disclosure violations under this provision.
In contrast, Section 10(b) of the Securities Exchange Act, and the related Rule 10b-5, which contain the main anti-fraud provision of the federal securities laws, carry an implied private right of action for statements by issuers that are misleading, or omissions that render statements by issuers misleading.[4] Importantly, Section 10(b) does not create liability for pure omissions.
The respondents in Macquarie argue that cases addressing the omission of material information that Item 303 requires to be disclosed can be brought by investors under Rule 10b-5.[5]
The petitioners respond that Section 10(b) and Rule 10b-5 impose liability for misrepresentations and half-truths, but do not impose liability for pure omissions where the speaker did not address a subject, even where Item 303 required disclosure of the underlying information.[6]
The petitioners further argue that enforcement of Item 303 properly belongs with the SEC, and that allowing the plaintiffs bar to enforce a disclosure requirement through the anti-fraud provision of the Exchange Act stretches an implied right of action too broadly.[7]
The private right of action for Section 10(b) and Rule 10b-5 is in place to monitor the truthfulness of fact in reporting a company's financial condition and business results. Disclosures made under Item 303 fall into an area that courts have called "softer information," and are intended to give investors a view of the company's future that provides further context for understanding the company's financial reporting.
Disclosures made under Item 303 necessarily require management to share opinions about the future — making it particularly problematic for private plaintiffs to substitute their own predictions and opinions for management's judgment with the benefit of hindsight.
The Oral Argument
At oral argument, the justices focused on the distinction between an omission and a half-truth, with all nine justices weighing in to ask questions of counsel arguing the case.
The counsel for the petitioner asked the court for "respect of the text" and argued that for an omission to be actionable under Rule 10b-5, a plaintiff must identify the specific statement or statements that are made misleading by the omission.
Based on Second Circuit precedent, counsel for the respondent and the solicitor general, who was present as an amicus curiae, responded that the omission of information required to be disclosed by Item 303 rendered the entire MD&A section of a filing, which itself is a statement, misleading.
According to counsel for the petitioner, the failure to mention a specific trend in the Item 303 disclosures should be considered a pure omission for purposes of Rule 10b-5 liability, while the counsel for the respondent argued that the failure to mention a trend rendered the Item 303 disclosures to be a series of half-truths.
In response, counsel for the respondent distinguished between pure omissions in press releases or other voluntary disclosures and required disclosures, arguing that because the SEC requires companies to provide a complete description of trends or uncertainties expected to affect the business, the only pure omission possible would be to fail to include any Item 303 disclosures in a filing.
Justice Ketanji Brown Jackson focused on the distinction between Rule 10b-5 and Section 11, noting in several questions that Section 11 specifies that omissions are actionable, but that Rule 10b-5 does not.
In response to a question of whether the petitioners are seeking immunity for statements made in Item 303 disclosures, Justice Brett Kavanaugh raised the issue that the SEC has and will continue to have the ability to bring enforcement actions for Item 303 disclosure violations.
At the end of argument, the counsel for the solicitor general stated in response to a question from Justice Kavanaugh that the purpose of a private right of action is for the private plaintiffs bar to supplement the SEC's enforcement capabilities, because the SEC cannot review and penalize all disclosure violations.
What's at Stake
The questions asked indicated that the court seems focused on answering the narrow question presented, rather than affirmatively ruling on whether a private right of action exists for Item 303 disclosure violations.
The instant question is whether a failure to make a disclosure required under Item 303 can support a private claim under Rule 10b-5, even in the absence of an otherwise misleading statement. The court could hold that while statements made in Item 303 disclosures could result in liability under Rule 10b-5 if the other elements of that claim are satisfied, plaintiffs may not privately pursue an Item 303 disclosure violation on its own merits.
In response to the extensive discussion of whether the entire MD&A section could be considered a misleading statement if a trend is omitted, the court could also provide guidance on what a "statement" is for purposes of a Rule 10b-5 suit. Since the court only sporadically weighs in on securities issues, whatever guidance the opinion ultimately contains will have a great impact on securities litigation for years to come.
A decision allowing private enforcement by the plaintiffs bar of Item 303 could heighten the stakes of drafting management disclosures in Item 303, and could decrease the efficacy of such disclosures. To determine what must be disclosed under Item 303, management must identify a trend or uncertainty, predict how likely the trend or uncertainty is to materialize, and predict whether the trend or uncertainty will have a material effect on the company's position — all of which require management to make a judgment call.
The prospect of the plaintiffs bar reviewing management disclosures with the benefit of hindsight may push management to overdisclose the possible impact of any known trend or uncertainty, leading to overly inclusive or duplicative disclosures. Such a result would not achieve the SEC's stated objective in Item 303 of enhancing investors' understanding.
A ruling allowing enforcement of Item 303 requirements through a Rule 10b-5 suit could also increase the risk of facing a Rule 10b-5 class action lawsuit.
Under current securities laws, public companies have a duty to be truthful when making affirmative statements and to reveal material information necessary to avoid a half-truth being misleading. Introducing the possibility of additional liability under Rule 10b-5 for silence in management's analysis could further encourage issuers to overdisclose with boilerplate risk disclosures, in a prophylactic effort to avoid additional private securities litigation.
The difficulty of proving that an omission was made with the necessary scienter would still be a hurdle for plaintiffs to overcome at the motion to dismiss stage.
Regardless of the result, the Supreme Court's decision in resolving this circuit split will be of great interest to both public companies and securities litigators. The decision is expected to be released in June.
[1] 17 CFR § 229.303(a).
[2] 17 C.F.R. § 229.303(b)(2)(ii) (2021). Prior to a November 2020 amendment to Item 303, the regulation required management to "describe any known trends or uncertainties that have had or the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations." 17 C.F.R. § 229.303(a)(3)(ii)(2018).
[3] Management's Discussion & Analysis of Financial Condition & Results of Operations, Exchange Act Release No. 26831 ("1989 Guidance"), 54 Fed. Reg. 22,427, 22,427 (May 24, 1989).
[4] No. 22-165, Pet'rs' Br. 7, Nov. 13, 2023.
[5] No. 22-165, Resp't. Br. 38, Dec. 13, 2023.
[6] Supra n. 3 at 16.
[7] Id. at 17.