Morgan Stanley entered into two trading positions regarding the sub-prime mortgage market in December 2006. First, Morgan Stanley sold a $13.5 billion long position in a super-senior tranche of a collateralized debt obligation (“CDO”) in the form of a credit default swap (“CDS”). Second, Morgan Stanley purchased a $2 billion short position through another CDS that tracked a lower-rated, higher-risk tranche of another CDO. Stated in a rudimentary manner, CDSs act as a form of insurance with the buyer making “premium” payments to the seller, and the seller responsible for covering losses in the event of default or a decline in value within the contractually agreed tranche. As a result, Morgan Stanley was making premium payments on its short position, which had a higher risk of default than its long position, and was receiving premium payments on its long position with the responsibility to make payments if the specified tranche declined in value or went into default. Morgan Stanley’s strategy reveals a belief that the housing market would decline (the purpose of its short position), but that the magnitude of damage would not reach the super-senior tranches (the purpose of its long position). Unfortunately, Morgan Stanley did not correctly predict the magnitude of the collapse and the resulting widespread risk the burst of the housing position posed on its long position.
As a result of the collapse, the financial losses incurred under the long position and the subsequent disclosures in Morgan Stanley’s filings, the plaintiffs argued that Morgan Stanley made material omissions in their Quarterly Reports on Form 10-Q by failing to disclose (1) the existence of the long position, (2) that Morgan Stanley had sustained losses on the long position during the company’s second and third quarters of 2007, and (3) that the company was likely to incur additional significant losses on the position in the future.
Item 303 states, in pertinent part, that a company is to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact” on the company. Guidance provided by the SEC on Item 303, clarifies that disclosure is necessary where a “trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”3
Before Stratte-McClure, both the Second Circuit and the U.S. Court of Appeals for the Ninth Circuit held that the failure to comply with Item 303 in company registration statements and prospectuses is actionable under Sections 11 and 12(a)(2) of the Securities Act of 1933, as amended.4 However, whether a breach of an Item 303 duty to disclose in the context of a public filing could give rise to liability under Section 10(b) of the Securities Exchange Act of 1934, as amended, had not been addressed until the Ninth Circuit held in In re NVIDA Corp. Securities Litigation that Item 303 does not create a duty to disclose for purposes of Section 10(b).5 As discussed below, the Second Circuit distinguished its holding from the Ninth Circuit’s analysis in NVIDIA.
The Second Circuit held that a “failure to make a required Item 303 disclosure in a 10-Q filing is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim.” Yet, in holding that Section 10(b) may apply to an omission under Item 303, the Second Circuit clarified that such an omission is only actionably if (1) it satisfies the materiality requirements outlined in Basic and (2) all of the other requirements to sustain an action under Section 10(b) are fulfilled as well.
Breach of an Item 303 of Regulation S-K Duty to Disclose
According to the SEC, a company has a duty to report under Item 303 after management engages in a two-part inquiry:
Violation Under Basic
As stated above, despite a breach of an Item 303 duty to disclose, according to the Second Circuit, a plaintiff would only be able to proceed under Section 10(b) if the alleged omitted information satisfies Basic’s test for materiality. To do so, the plaintiff must allege that the defendant failed to comply with Item 303 and then that the omitted information was material under Basic’s probability/magnitude test. The plaintiff must meet the materiality test because Rule 10b-5 only makes an omission of material information unlawful where it is necessary to make statements made “not misleading.”
Violation of Section 10(b)
Simplistically, Rule 10b-5, which implements Section 10(b), states that to bring a claim for securities fraud, a plaintiff must alleged that each defendant (1) made material misstatements or omissions of material fact, (2) with intent or knowledge of wrongdoing, (3) in connection with the purchase or sale of securities, (4) upon which the plaintiff relied, and (5) that the plaintiff’s reliance was the proximate cause of its injury.Second Circuit’s Decision
Morgan Stanley argued that they had satisfied their disclosure obligations under Item 303 by including a discussion on the decline of the real estate, credit and subprime mortgage markets and their potential adverse effects. However, the Second Circuit criticized the disclosures employed by Morgan Stanley for being too generic in nature and dispersed throughout numerous filings. To satisfy their disclosure requirements, the Second Circuit was looking not only for a discussion, but analysis that covered the decline of real estate, credit and subprime mortgage markets and that tied the particular discussion to the potential impact Morgan Stanley’s significant exposure to such markets could have on their financial position.
Despite holding that Morgan Stanley breached its Item 303 duty to disclose, the Second Circuit clarified that it would not expect Morgan Stanley to disclose the details of its long position — only the consequences of having such a position. The Second Circuit believed this couched requirement comported with their reluctance to interpret the securities laws in a manner that requires companies to give competitors notice of proprietary strategies and information.
The Second Circuit was able to distinguish its holding from the Ninth Circuit’s holding in NVIDIA, because the Second Circuit believed precedent was inaccurately relied upon by the Ninth Circuit — that a previous case did not imply that a breach of a company’s Item 303 duty to disclose is never actionable under Section 10(b), but that the case suggested, without deciding, that in certain circumstances, a breach of an Item 303 duty to disclose could give rise to a material 10b-5 omission.
Ultimately, the Second Circuit dismissed the case, holding that (1) the plaintiffs properly alleged a breach of their Item 303 duty to disclose, and (2) that although the Second Circuit, assumed for the sake of argument, that the omission was material under Basic, the plaintiffs failed to sufficiently plead scienter (the intent or knowledge of wrongdoing).
If a company is to omit such material information from its Quarterly Reports on Form 10-Q and Annual Reports on 10-K, the company may face Section 10(b) liability if the plaintiffs can prove that there was (1) a breach of an Item 303 duty to disclose, (2) the omission was material under Basic, and (3) that the remaining requirements of Section 10(b) are satisfied.
As this disclosure has been a point of emphasis by the SEC, companies should be cognizant of the requirements under Item 303 to disclose trends or uncertainties that would have a material effect on the company. Although, in contemplating the disclosure requirements, remember that the Second Circuit’s holding does not require the disclosure of a company’s internal business strategy or trading positions; rather, it is only requesting an analysis of how a trend or uncertainty may have a material effect on the company. Regardless, until the U.S. Supreme Court reconciles any differences between the Second and Ninth Circuit as to whether Section 10(b) liability can attach to a breach of an Item 303 duty to disclose, the result of Stratte-McClure dictates companies continue to give heightened attention going forward to company and industry trends and uncertainties to ensure appropriate disclosure.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss the topic further, please contact your Foley attorney or the following:
Mark T. Plichta
Garrett F. Bishop
1Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. Jan. 12, 2015).
2Basic v. Levinson, 485 U.S. at 224 (1988).
3Management’s Discussion and Analysis of Financial Condition and Results of Operations, Exchange Act Release No. 6835 (May 18, 1989).
4See Panther Partners Inc. v. Ikanos Commc’ns, Inc., 681 F.3d 114 (2d Cir. 2012); Steckman v. Hart Brewing, Inc., 143 F.3d 1293 (9th Cir. 1998).
5In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014).