By Rodney F. Tonkovic, J.D.
The Washington Legal Foundation has filed an amicus brief with the U.S. Supreme Court supporting the petitioner in Leidos, Inc. v. Indiana Public Retirement System. In Leidos, a Second Circuit panel held that the failure to make a required disclosure under Item 303 of Regulation S-K is an omission that can serve as the basis for a securities fraud claim under Section 10(b). The brief argues that the Second Circuit's ruling would dramatically expand securities fraud liability.
Item 303. In the Second Circuit, the failure to make a required Item 303 disclosure is an omission that can serve as the basis for a securities fraud claim under Section 10(b). In Leidos, the court held specifically that the plain language of Item 303 requires actual knowledge of the relevant trend or uncertainty in order to be liable for failing to disclose it.
The Leidos petition argues that the Second Circuit’s holding entrenches a deep circuit split, particularly between the Second and Ninth Circuits, which see more securities cases than the rest combined. According to the Second Circuit, the petition explains, a duty to disclose under Section 10(b) can derive from statutes or regulations obliging a party to speak, including Item 303, even if those omissions do not make any affirmative statements misleading. This holding is in direct conflict with Third and Ninth Circuit decisions holding that Item 303 does not create such an independent duty to disclose. Moreover, the petition argues, the decision is an "unprecedented expansion" of liability under Section 10(b) that, left undisturbed, could expose issuers to massive liability and would lead to an increase in fraud claims.
WLF urges reversal. The WLF argues that the Second Circuit's interpretation is flawed and at odds with the plain meaning of Rule 10b-5(b), the common law of fraud by omission, and Supreme Court precedent. Failing to comply with Item 303 should not be an independent basis for liability under the antifraud provisions and to rule otherwise would greatly expand the implied private right of action well beyond anything contemplated by Congress or the courts, the brief says.
The WLF first argues that the Second Circuit has misapplied Rule 10b-5(b) and the common law principle of half-truth on which the rule is based (i.e., a statement that is literally true but still misleading by omission). Simply put, the brief says an affirmative statement is a misleading half-truth, and thus potentially actionable, or it is not and is thus not actionable. Accordingly, Rule 10b-5 cannot support a finding that the failure to make disclosures of uncertainties and trends under Item 303 creates a duty to disclose where there is no specific, identified statement alleged to be misleading as a result of an omission. The Court has made clear in Matrixx and other cases that there is no affirmative duty to disclose any and all material information.
Even if viewed as a pure omission claim, the brief continues, the Supreme Court has only recognized an actionable fraudulent omission where there is: (1) a fiduciary relationship; and (2) a transaction to which the defendant was a party and in which he participated for personal gain. Neither condition is satisfied by the mere omission of information that is the subject of Item 303. The Second Circuit, the WLF argues, has imposed fraud liability for an issuer's omission in its financial results where there was no transaction with the investors and no actionable fiduciary relationship. This is an unwarranted expansion of the Court's Section 10(b) jurisprudence, the brief maintains.
Concluding by turning to the public policy implications of the Leidos holding, the WLF says adopting the Second Circuit’s holding would undermine the purpose and benefits of Item 303. The brief points out that the SEC discourages unnecessary and duplicative disclosure in favor of information that promotes the understanding of a company's financial condition. The specter of fraud claims for inadequate Item 303 disclosures would "trigger a deluge of disclosures." There is also the potential for a flood of shareholder litigation that will burden the courts and drive up costs for companies.