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Why Item 303 Just Doesn’t Matter In Securities Litigation
Law360, New York (October 13, 2015, 12:49 PM ET) -Does Item 303 of Regulation S-K matter in private securities litigation? In
Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2nd Cir. 2015), the Second
Circuit held that Item 303 imposes a duty to disclose for purposes of Section
10(b), meaning that the omission of information required by Item 303 can
provide the basis for a Section 10(b) claim. This ruling is at odds with the
Ninth Circuit’s opinion in In re Nvidia Corp. Securities Litigation, 768 F.3d
1046 (9th Cir. 2014), in which the court held that Item 303 does not establish
such a duty. The U.S. Supreme Court declined a cert petition in Nvidia.
I am glad the Supreme Court didn’t take the case, because while this issue
seems important, it really isn’t — as a practical matter, a claim under Item
303 doesn’t add much, if anything, to a plain vanilla claim alleging that a
statement was misleading for omitting the same information.
Douglas W. Greene
Evolution of the Legal Issue
U.S. Securities and Exchange Commission forms, under both the Securities Act and the Exchange Act,
require the disclosure of various items described in SEC Regulation S-K. Some of the most important
disclosures are found in S-K Item 303(a), which includes “management’s discussion and analysis”
(MD&A) of the company’s “financial condition, changes in financial condition and results of operations.”
And Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or
uncertainties that have had or that the [company] reasonably expects will have a material ...
unfavorable impact on net sales or revenues or income from continuing operations.” This is a high
hurdle for a plaintiff to clear: a company must actually know: (1) the facts underlying the trend or
uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have
a negative and material impact.
The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of
1934 and Section 11 of the Securities Act of 1933, prohibit a false statement or omission of a fact that
causes a statement to be misleading. In addition, the text of Section 11 allows a claim to be based on the
issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. §
77k(a) (emphasis added). One such requirement is Item 303. Panther Partners Inc. v. Ikanos
Communications Inc., 681 F.3d 114, 120 (2nd Cir. 2012). Based on this statutory language — which is
unique to Section 11 — Section 11 claims thus appropriately can include claims based on Item 303.
Panther Partners is the decision that has fueled plaintiffs counsel’s use of Item 303. In Panther Partners,
the Second Circuit held that Item 303 required the issuer, Ikanos Communications, to disclose
information about a high product defect rate, and that the omission of this information from a
registration statement gave rise to a cause of action under Section 11. There are two important facets of
the decision that have largely been forgotten. First, the court emphasized Section 11’s language, which
isn’t present in the statute or decisions under Section 10(b), that an issuer must disclose “a material fact
required to be stated” in a registration statement. Second, the court was troubled by the fact that the
company’s risk factor about product defects suggested there were no defects when, in fact, there were:
In light of these allegations, the Registration Statement’s generic cautionary language that “[h]ighly
complex products such as those that [Ikanos] offer[s] frequently contain defects and bugs” was
incomplete and, consequently, did not fulfill Ikanos’s duty to inform the investing public of the
particular, factually-based uncertainties of which it was aware in the weeks leading up to the Secondary
Offering.
Id.at 122.
I could make a strong argument that the driver of the court’s decision was a false or misleading risk
factor, and Item 303 was just the way the court articulated its conclusion. As I’ve written, courts are
often troubled by boilerplate risk factors, especially those that cast as hypothetical risks that have
materialized.
In Nvidia, plaintiffs alleged that several of Nvidia’s SEC filings contained materially false and misleading
statements because they omitted information relating to a defect in Nvidia’s graphics processing unit
(GPU) chips. Plaintiffs also argued that certain omissions in filing statements were actionable under
Section 10(b) because the chip defects constituted a “known trend” under Item 303 — but did not
present this theory in the complaint itself.
The district court found that plaintiffs had pled “at least one” material misrepresentation — a risk factor
saying that defects “might occur,” which falsely suggested that Nvidia was not already aware of the
same defect in other products. The district court did not inquire into whether any of the other specific
statements were also materially misleading. Nonetheless, the district court dismissed the complaint on
the ground that plaintiffs had failed to plead scienter. The district court opinion only mentioned Item
303 briefly, as it was not (yet) a centerpiece of the plaintiffs’ theory.
Before the Ninth Circuit, the plaintiffs argued that the district court should have considered scienter in
the context of Item 303, focusing on whether the defendants had acted with scienter in violating that
rule. The Ninth Circuit rejected this line of argument on the ground that Item 303 does not establish an
independent duty of disclosure for the purposes of Section 10(b). The Ninth Circuit did not consider
whether plaintiffs had successfully pled a material misrepresentation (as the district court had found),
focusing instead on scienter, and affirming the district court’s judgment on this ground.
Shortly thereafter, the Second Circuit, in Stratte-McClure, held that Item 303 does establish an
independent duty of disclosure for purposes of Section 10(b). The court began with the cardinal rule
that silence, absent a duty to disclose, is not actionable, and such a duty is created when a company
omits facts that make a statement misleading. 768 F.3d at 101-02. The court then grappled with
whether omission of facts required to be disclosed under Item 303 creates a duty of disclosure for
purposes of Section 10(b). In analyzing this issue, the court relied on the Panther Partners holding,
though the court compared Section 10(b)’s requirements to Section 12(a)(2) of the 1933 Act, which does
not contain Section 11’s unique statutory language, i.e., Section 11 makes actionable not just a false or
misleading statement, but also a failure to disclose “a material fact required to be stated” in a
registration statement.
The court’s comparison of Section 10(b) to Section 12(a)(2) instead of to Section 11 resulted in a large
legal leap. The court in Panther Partners stated that “[o]ne of the potential bases for liability under §§
11 and 12(a)(2) is an omission in contravention of an affirmative legal disclosure obligation” (i.e. making
actionable the omission of “a material fact required to be stated” in a registration statement). 681 F.3d
at 120. But, in fact, only Section 11, and not Section 12(a)(2), contains that provision. Instead, Section
12(a)(2), like Section 10(b), imposes liability for a false or misleading statement, and doesn’t contain the
alternative basis of liability for a failure to disclose “a material fact required to be stated ....” As a result,
Stratte-McClure doesn’t fairly portray the rationale for the holding in Panther Partners.
Nevertheless, the court in Stratte-McClure supplied a separate basis, grounded in Section 10(b)’s
requirement of a false or misleading statement, for concluding that Item 303 supplies a duty to disclose
that can be actionable under Section 10(b):
Due to the obligatory nature of [Item 303], a reasonable investor would interpret the absence of an Item
303 disclosure to imply the nonexistence of “known trends or uncertainties ... that the registrant
reasonably expects will have a material … unfavorable impact on … revenues or income from continuing
operations.” … It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases,
give rise to liability under Section 10(b).
776 F.3d at 102 (citations omitted).
In other words, a company that fails to disclose information required to be disclosed by Item 303 has
misled investors by creating an impression of a state of affairs (that there are no materially negative
trends or uncertainties) that differs from the one that actually exists (that there are such trends or
uncertainties). Thus, what the court implicitly held is that an Item 303 omission makes the whole set of
the company’s affirmative statements misleading.
Item 303’s Lack of Practical Impact
The Item 303 issue is certainly interesting. My colleagues and I have had lively discussions about the
questions it raises. But we keep concluding that it doesn’t really add anything.
We first reached this conclusion in a roundabout way in a case a few years ago. There were two
offerings at issue, and just after Panther Partners, plaintiffs counsel featured the Item 303 allegations.
We drafted a detailed motion to dismiss section on the Item 303 issue. As we evaluated our arguments
in light of the page limit, we kept shortening the Item 303 argument. In the end, we decided that the
Item 303 claim was redundant: the court wasn’t going to deny the motion to dismiss under Item 303
without also finding that the plaintiffs had sufficiently pleaded a false statement and scienter, because
the plaintiffs challenged many statements and pleaded scienter using the same allegations that formed
the basis of the Item 303 claim. So in the filed version of the motion, the argument became a fraction of
the size of the original one. And in the reply brief, the Item 303 argument was in a short footnote.
Since then, the plaintiffs bar’s focus on the issue, and various court decisions, and even a cert petition,
have kept me rethinking the importance of Item 303 to securities claims. But I haven’t changed my view
that Item 303 is redundant: very rarely, if ever, would there be an omitted fact that gives rise to an Item
303 claim without also rendering false or misleading one or more challenged statements; and the
knowledge required under Item 303 is at least as great as is necessary to establish scienter. Even under
Section 11, where the unique statutory language allows for a claim, Item 303’s multiple knowledge
requirements, if appropriately applied, make the claim difficult to plead and prove.
The Nvidia case provides a good illustration. Recall that the plaintiffs alleged that Nvidia made false
statements related to a defect in its GPU chips, and argued that the chip defects constituted a known
trend under Item 303. The complaint challenged many statements, and the district court concluded that
“at least one” was misleading as a result of the defects:
“Our core businesses are continuing to grow as the GPU becomes increasingly central to today’s
computing experience in both the consumer and professional market segments.”
“Fiscal 2008 was another outstanding and record year for us. Strong demand for GPUs in all
market segments drove our growth. Relative to Q4 one year ago, our discrete GPU business
grew 80%.”
“As we have in the past, we intend to use this [R&D] strategy to achieve new levels of graphics,
networking and communications features and performance and ultra-low power designs,
enabling our customers to achieve superior performance in their products.”
“[W]e believe that close relationships with OEMs, ODMs and major system builders will allow us
to better anticipate and address customer needs with future generations of our products.”
“The growth of GPUs continues to outpace the PC market. We shipped 42 percent more GPUs
this quarter compared to the same period a year ago, resulting in our best first quarter ever. …
We expect this positive feedback loop to continue to drive our growth.”
“In the past, we have discovered defects and incompatibilities with customers’ hardware in
some of our products. Similar issues in the future may result in delays or loss of revenue to
correct any defects or incompatibilities.”
“If our products contain significant defects our financial results could be negatively impacted,
our reputation could be damaged and we could lose market share.”
In a statement disclosing the defects: “We are evaluating the potential scope of this situation, including
the nature and cause of the alleged defect and the merits of the customer’s claim, and to what extent
the alleged defect might occur with other of our products.”
This list of challenged statements illustrates that companies affirmatively say many things on the subject
matter of an omission sufficient to yield an Item 303 claim. Indeed, it’s hard to imagine a case in which
an issue is so major as to require Item 303 disclosure but isn’t something about which the company has
spoken.
And given that is the case, and Item 303’s disclosure requirements are infused with knowledge
requirements, it also would be an anomalous case in which there is an Item 303 violation but not
scienter. For example, if a company violates Item 303 by not disclosing that its biggest customer is
switching suppliers next quarter, and proceeds to say things about its business and financial outlook as it
of course would, it has made misleading statements with intent to defraud. The Item 303 claim adds
nothing. Stratte-McClure, on its face, is an anomalous case. After concluding that Morgan Stanley had a
duty to disclose certain facts about subprime lending that were likely to cause material trading losses,
the court concluded that the failure to disclose those facts wasn’t done with scienter. The analysis is
fact-specific and technical. Suffice it to say that I could easily rewrite the opinion, using the court’s own
scienter analysis, to conclude that no disclosure was required under Item 303 in the first place — it’s
really a matter of six of one, half a dozen of another.
Why, then, have plaintiffs counsel pushed Item 303 claims so hard? I believe it’s mostly to combat the
cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of
facts every time they speak, and it’s relatively easy for a plaintiff to identify omitted facts — but it’s
analytically difficult work, and often unsuccessful, to challenge affirmative statements.
Another important reason is defendants’ attack on the fraud-on-the-market presumption of reliance
over the past several years — first to the legitimacy of Basic v. Levinson, which gave rise to securities
class actions, and now to its viability in specific cases under the price-impact rule of Halliburton II. Claims
of pure omission under Item 303 arguably would fall under the Affiliated Ute presumption of reliance,
rather than under Basic, which would make class certification easier and more certain. But the court’s
reasoning in Stratte-McClure that an Item 303 violation makes what the company said misleading would
make the claim a statement-based claim that would be evaluated under Basic, not Affiliated Ute.
Whatever the reason, I hope parties and courts don’t waste time litigating over Item 303 further. It just
doesn’t matter.
—By Douglas W. Greene, Lane Powell PC
Doug Greene is a shareholder in Lane Powell’s Seattle office. He is also chairman of the firm’s director
and officer liability and securities litigation practice groups.
This article first appeared on Lane Powell's blog, D&O Discourse.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its
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