Pomerantz LLP

The Supreme Court To Review Duty To Disclose

Attorney: Brenda Szydlo
Pomerantz Monitor May/June 2017

The Supreme Court recently granted certiorari in Leidos, Inc. v. Indiana Public Retirement System, taking up the question whether the Second Circuit erred in holding that Item 303 of SEC Regulation S-K, which imposes specific disclosure requirements on public companies, creates a duty to disclose that is actionable under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The high court’s decision will resolve a split between the Second and Ninth Circuits, and could expand the playing field to other circuits by giving investors a powerful tool – the ability to use an SEC disclosure regulation as the basis for a securities fraud claim.

The Second Circuit’s decision in Leidos revived a Section 10(b) suit by investors against a government contractor that failed to disclose in its March 2011 Form 10-K a kickback scheme’s impact as a known trend or uncertainty reasonably expected to have a material impact on the corporation’s financial condition in violation of Item 303. The court stated that in Stratte-McClure v. Morgan Stanley, “we held that Item 303 imposes an ‘affirmative duty to disclose . . . [that] can serve as the basis for a securities fraud claim under Section 10(b)[,]’” and now “hold that Item 303  requires the registrant to disclose only those trends, events, or uncertainties that it actually knows of when it files the relevant report with the SEC.” The court concluded that the proposed amended complaint supported a strong inference that Leidos actually knew about the fraud before filing the 10-K, and that it could be implicated and required to repay the revenue it generated to the City of New York.

The Second Circuit’s holding in Leidos is in direct conflict with the Ninth Circuit’s decision in In re NVIDIA Corp. Sec. Litig. In finding that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b- 5[,]” the Ninth Circuit relied on the Third Circuit’s opinion in Oran v. Stafford, written by then-Judge Samuel Alito. In Oran, Justice Alito wrote that “a violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5” and further held that the duty did not arise under the specific facts of the case. (Emphasis added).

The Supreme Court’s decision in Leidos could be potentially explosive. In Matrixx Initiatives, Inc. v. Siracusano, the Supreme Court held that Section 10(b) and Rule 10b-5 do not create an affirmative duty for public companies to disclose material information, except in cases where an omission renders an affirmative statement misleading. As the Supreme Court stated in Basic v. Levinson, “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.” But the Supreme Court’s decision in Leidos could significantly alter the securities fraud landscape, in that public companies could be subjected to securities fraud liability for failing to comply with Item 303’s duty to disclose information about a subject it had been completely silent about.

Regulation S-K, and Item 303 in particular, set forth comprehensive reporting requirements for various SEC filings. If failure to disclose information required by Item 303 can serve as the basis for fraud, and the same is true for other regulations requiring disclosure of specific information, we could be on the verge of a new era in securities fraud litigation.

Private litigants should have the right to assert securities fraud claims against public companies that hide material information in violation of SEC disclosure regulations. There is no question that the failure to disclose immaterial information cannot support liability, even if Item 303 requires that it be disclosed. However, others will contend that the litigation floodgates will be opened if the high court sides with the Second Circuit and expands silence as a basis for securities fraud claims. Given the importance of the outcome, Leidos warrants careful observation.