Tuesday, September 12, 2023

Item 303 duty to disclose can give rise to 10(b) fraud liability

By Anne Sherry, J.D.

A failure to disclose information under Item 303 can serve as the basis for liability under Section 10(b) and Rule 10b-5 if the omission is material and the other necessary fraud elements are satisfied, the district court in Chicago held. While the court granted the defendants’ motion to dismiss in part, several of the plaintiffs’ claims that a physical therapy company misled about therapist attrition survived the court’s preliminary analysis (Phoenix Insurance Co., Ltd. v. ATI Physical Therapy, Inc., September 6, 2023, Chang, E.).

The defendant physical-therapy company, ATI, had issues retaining physical therapists. This problem snowballed when the remaining physical therapists became overworked due to the attrition. The concern did not surface publicly until after ATI completed a SPAC merger with fellow defendant Fortress Value Acquisition Corp. II. Investors sued, taking issue with some affirmative pre-merger statements about the high retention and low turnover of physical therapists, as well as ATI’s alleged omission to disclose the known trend of materially greater-than-average attrition rates.

Misrepresentations. The court ultimately found that many of the alleged misrepresentations, and the omission, were actionable. Although the court agreed with the defendants that some of the challenged statements were adjective-laden puffery, the statements that ATI had “very high retention” and “low turnover” of employees and physical therapists were concrete statements targeting a specific aspect of ATI’s operations. Certain other statements, while forward-looking, were not accompanied by meaningful cautionary language because the language warned only of the potential for attrition and turnover, when in fact these conditions had already materialized.

Omission. As for the omission, the Seventh Circuit has not yet decided whether a Section 10(b) or 14(a) claim can be premised on a violation of Item 303. In the Second Circuit, “positive law” (statutes or regulations, like Item 303) can give rise to an affirmative duty to disclose under Exchange Act Section 10(b) or 14(a). The Ninth Circuit, though, held otherwise, reasoning that Item 303’s disclosure requirement varies from the Basic test for materiality.

In the Illinois district court’s view, the Ninth Circuit conflated the distinct concepts of duty to disclose and materiality. The district court thus adopted the reasoning of the Second Circuit that failure to comply with Item 303 can give rise to Section 10(b) fraud liability if the omission is material under Basic and the other elements of the securities fraud claim are established. “That reasoning, which recognizes the difference between the legal concepts of duty to disclose and materiality, makes sense,” the Illinois court wrote. “It also likely—though not definitely—squares with an earlier case that the Ninth and Second Circuits both cite.”

For the same reasons, the court also held that Item 303 can sustain a claim under Section 14(a). As with a Section 10(b) claim predicated on an Item 303 violation, it is also necessary to satisfy the materiality requirement, but not scienter. Accordingly, the alleged omission under Item 303 of the supposedly known trend that ATI “was suffering attrition rates among its clinical staff that were materially greater than the industry average” was actionable.

Scienter. Furthermore, the court found that the collective scienter allegations raised a strong inference as to the CEO and CFO defendants, but not a third. Although the plaintiffs’ motive allegations did not support a strong inference of scienter as to any defendant, confidential witness statements strongly suggested that the CEO and CFO knew about the attrition problems leading into the merger. “Given the allegations, it seems unlikely that the then CEO and CFO (top executives) of ATI would not have known about a significant, worsening problem—ultimately disclosed to the market—of such importance to the company’s core service of providing therapy: a lack of enough physical therapists.” The fact that the CEO was terminated close to when the attrition problems were disclosed, without advance warning or even an interim replacement lined up, also had some probative value as to the claims against the CEO.

Remaining claims. Because certain of the 10(b) and 10b-5 claims survived, and there is no scienter requirement for a Section 14(a) claim, the court also held that these proxy-related claims survived. And to the extent the complaint pleaded primary violations against certain defendants, the Section 20(a) control-person claims also survived as to those defendants.

The case is No. 21-cv-04349.