[This story previously appeared in Securities Regulation Daily.]
By Matthew Garza, J.D.
The management's discussion and analysis (MD&A) requirement of Regulation S-K Item 303 creates an affirmative duty to disclose that can serve as the basis for an Exchange Act 10(b) fraud claim, the Second Circuit held Monday in a matter of first impression. The ruling came in a suit filed by pension fund investors against Morgan Stanley stemming from crisis-era trading in residential mortgage-backed securities (RMBS). The court nonetheless found that fraud allegations against the bank fell short because scienter and loss causation pleadings were lacking. (Stratte-McClure v. Morgan Stanley, January 12, 2015, Livingston, D.).
Background. A trade structured in a way that is familiar to those that followed the implosion of the residential mortgage-backed securities (RMBS) market was behind the suit. In December 2006, Morgan Stanley’s Proprietary Trading Group sold CDOs to take a $13.5 million long position in a portfolio of subprime RMBS, while simultaneously purchasing credit default swaps to establish a $2 billion short position. The long position was in the lower risk RMBS, for which the bank received premium payments that it used to fund the short position. Morgan Stanley lost billions on the trade when the housing market began a precipitous decline in mid-2006. The complaint filed by the pension funds alleged that Morgan committed fraud by misrepresenting its exposure to credit risks related to the long position, and misrepresenting the bank’s consequently inflated stock price.
Officer statements. Six of Morgan Stanley’s officers were accused of making misrepresentations or omissions to conceal the bank’s exposure to the subprime mortgage market. One said on a June 20, 2007, analyst call that “concerns earlier in the quarter about whether issues in the sub-prime market were going to spread dissipated,” and that in fact the bank benefited from market conditions. Another officer in September stated that the bank “remained exposed” to the subprime market, but did not specify the extent of the exposure. A month later, investors complained, the same officer said in an interview that he did not anticipate further write-downs related to the trade.
Disclosures. The investors also alleged that the bank’s 10-Q filings were deficient because Item 303 of Regulation S-K requires companies to disclose on their 10-Q filings known trends, or uncertainties that have had, or might reasonably be expected to have a negative material effect on the company’s revenue. In another claim, the pension funds alleged that Morgan Stanley overstated its third quarter 2007 income by failing to sufficiently write down the value of the long position. The investors pointed out that the ABX Index, which tracks RMBS, declined 32.8 percent in the third quarter of 2007. A loss calculated with that indicator would have amounted to a $4.4 billion loss, investors claimed, but the bank wrote down only $1.9 billion after relying on internal models. The bank later increased the amount of the write down. The Southern District of New York dismissed the plaintiffs complaint on April 4, 2011, finding that it did not specify why the bank’s statements about the risk to its trading positions were false or misleading, that the bank had no obligation of disclose the long position, and that the funds failed to plead loss causation.
Known trends. Obligatory Item 303 disclosures “give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant’s financial condition and results of operations,” the court said, quoting Exchange Act Release No. 6835. A reasonable investor would interpret the absence of a disclosure to imply the nonexistence of such “known trends.” It follows, said the court, that Item 303 imposes the type of duty to speak that can give rise to liability under 10(b). However, all the other requirements attendant in a 10(b) action still apply, the court pointed out, including materiality under Basic, Inc. v. Levinson.
Circuit Split. The court noted that the decision is contrary to the conclusion reached in the Ninth Circuit in In re NVIDIA Corp. Securities Litigation, which relied on a Third Circuit opinion written by then-Judge Alito that concluded that Item 303’s disclosure duty is not actionable under 10(b) and 10b-5. The Second Circuit took a narrower view on Oran, saying that “Contrary to the Ninth Circuit’s implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b‐5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b‐5 omission.”
The court went on to hold that investors did sufficiently allege that Morgan Stanley breached its duty under Reg S-K Item 303 to disclose the fact that the bank faced a deteriorating subprime mortgage market that was likely to materially affect its financial condition, but dismissed the case for failure to plead a strong inference of scienter.
Tandem order. A summary order issued in tandem with the opinion decided that Morgan’s affirmative statements about its exposure to the mortgage securities market during the relevant time period were not misleading, but the “most cogent inference” from the allegations was that the bank delayed releasing information on its Form 10‐Qs in the second and third quarters of 2007 in a manner that was “at worst negligent” as to the effect the delay would have on investors. The order affirmed the dismissal of the valuation claim for failure to plead loss causation.
The case is No. 13-0627-cv.