Second Circuit Allows S-K Item 303 Claim Against Chip Maker to Proceed

By N. Peter Rasmussen, J.D.

In a second look at a case arising from allegedly undisclosed defects in semiconductor chips, the 2nd Circuit allowed claims of Securities Act 11, 12(a)(2) and 15 violations to move forward. The court found that the allegations stated a claim for failure to comply with the disclosure requirements of Regulation S-K Item 303. Under this provision, registrants must discuss in the MD&A section “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.”

The issuer, Ikanos Communications Inc., manufactured programmable semiconductors for sale to equipment manufacturers for telecommunications carriers. Ikanos learned in January 2006 that there were quality issues with some of its chips that caused the networks operated by end users to fail. The company conducted a secondary stock offering in March 2006. The registration statement and prospectus did not specifically disclose the defect issue. Rather, the documents stated in general terms that its “highly complex products…frequently contain defects and bugs.” Ikanos eventually had to pay to replace at its expense all of the units sold to two of its largest customers.

The appellate court emphasized that when “viewed in the context of Item 303's disclosure obligations, the defect rate, in a vacuum, is not what is at issue. Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.” Two allegations in the complaint were crucial to the court’s decision. The first was that Ikanos was receiving regular and increasing numbers of complaints from two customers that represented more than 70 percent of the company’s revenues. The second was that Ikanos knew when it was receiving the complaints that it would be unable to determine which chip sets contained defective chips, and that all of the chip sets sold to these major customers would have to be replaced.

The court concluded that the “reasonable and plausible inferences from these allegations are not simply that Ikanos quite possibly would have to replace and write off a large volume of chip sets, but also that it had jeopardized its relationship with clients who at that time accounted for the vast majority of its revenues.” The court stated that “Item 303’s disclosure obligations, like materiality under the federal securities laws’ anti-fraud provisions, do not turn on restrictive mechanical or quantitative inquiries." In light of the allegations concerning known defects in sales to major customers, the court found that the generic discussion of bugs and defects was inadequate.

Panther Partners Inc. v. Ikanos Communications Inc.

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