In Novel Ruling, Second Circuit Says Investors May Sue Over Regulation S-K Duty to Disclose

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By Yin Wilczek

Jan. 16 — In a ruling of first impression, the Second Circuit Jan. 12 held that the failure to disclose “known trends or uncertainties” under Item 303 of Regulation S-K may form the basis of a securities fraud lawsuit.

However, the U.S. Court of Appeals for the Second Circuit also warned that although a company's alleged disregard of Item 303 may be an actionable omission under 1934 Securities Exchange Act Section 10(b) and Rule 10b-5, “such an omission is actionable only if it satisfies the materiality requirements outlined” by the U.S. Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988), and other Section 10(b) requirements.

The court's opinion, written by Judge Debra Ann Livingston, conflicts with the stance taken by the U.S. Court of Appeals for the Ninth Circuit in In re Nvidia Corp. Sec. Litig., 768 F.3d 1046 (2014).

Attorneys also have suggested that although the Second Circuit may have broadened liability under the antifraud rule, it also placed significant challenges for plaintiffs who seek to sue under Item 303. The provision requires companies to disclose “any known trends or uncertainties” that they reasonably expect will have a material adverse impact on corporate revenues or income.

The court issued its ruling in dismissing a lawsuit filed by investors alleging that Morgan Stanley and its officers made material misstatements and omissions to hide the losses from a proprietary trade in December 2006 involving subprime residential mortgage-backed securities.

Alleged Omissions 

The plaintiffs alleged that Morgan Stanley and six of its current and former officer issued material misstatements and omissions between June and November 2007 to hide the firm's exposure to and losses from the subprime mortgage market. The plaintiffs alleged that the firm failed to disclose in its 10-Q filings the losses from its proprietary trade in the second and third quarters of 2007, and that more losses were likely.

Originally filed in the U.S. District Court for the Central District of California, the case was transferred to the U.S. District Court for the Southern District of New York. The district court dismissed the claims, finding that the plaintiffs failed to adequately plead scienter, or culpable intent.

In prior cases, the Second Circuit determined that Item 303 creates a duty to disclose for the purposes of liability under Sections 11 and 12(a)(2) of the 1933 Securities Act. In a similar vein, the court concluded that the failure to issue a disclosure under Item 303 is actionable.

The court added, however, that to be able to sustain a claim, the plaintiff must also satisfy Basic's materiality requirements and the requirements for a Section 10(b) action.

In other words, the plaintiff must first allege that the defendant failed to make a disclosure under Item 303 that it had a duty to disclose, the court explained. The plaintiff must then allege that the omitted information is material under Basic's “probability/magnitude test, because 10b-5 only makes unlawful an omission of ‘material information' that is” necessary to make the filing not misleading.

“Of course, as with any Section 10(b) claim, a plaintiff must also sufficiently plead scienter,” a connection between the omission and the purchase or sale of a security, reliance on the omission and an economic loss caused by the reliance, the court added.

Inadequate Pleading

In this case, the court affirmed that the plaintiffs failed to adequately plead scienter against Morgan Stanley.

Attorneys for Morgan Stanley and the plaintiffs did not immediately respond to requests for comment.

In a client memo, Paul, Weiss, Rifkind, Wharton & Garrison LLP said that the additional requirements imposed by the court for an actionable Item 303 claim—“all of which can be raised by defendants at the motion to dismiss stage—are likely to impose significant limitations on such claims.” In particular, the firm pointed to the court's requirement for a strong inference of scienter.

“Allegations that information was improperly omitted under Item 303 will often turn on finely balanced questions about whether the trends were in fact known and significant and whether the disclosures were sufficient, particularly given the Second Circuit’s confirmation that Item 303’s disclosure obligations are not unlimited,” the memo said. “Even if plaintiffs successfully show that disclosures were inadequate, in many cases—as in Stratte-McClure itself—plaintiffs will face significant difficulties showing that defendants intended to mislead investors by omitting information or were consciously reckless in that respect.”

The class plaintiffs were represented by David Kessler, Kessler Topaz Meltzer & Check LLP, Radnor, Pa. Morgan Stanley and its officers were represented by Robert F. Wise Jr., Davis Polk & Wardwell LLP, New York.

To contact the reporter on this story: Yin Wilczek in Washington at

To contact the editor responsible for this story: Ryan Tuck at

The opinion is available at

The Paul Weiss memo is available at