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By Linda L. Griggs, John J. Huber, and Christian J. Mixter
Ms. Griggs is a Consultant, and Mr. Mixter is a partner, with Morgan, Lewis & Bockius LLP in Washington, D.C. Mr. Huber is an Affiliate with FTI Consulting in Washington, D.C. The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc., Morgan Lewis or their other professionals.
The Supreme Court is poised to decide whether sub-item (a)(3)(ii) of Item 303 of Regulation S-K, Management’s Discussion and Analysis of Financial Condition and Results of Operations, 17 C.F.R. §229.303 (“MD&A” or “Item 303”), creates a duty to disclose that is actionable by private plaintiffs under Rule 10b-5, 17 CFR §240.10b-5, adopted pursuant to Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 USC §78j(b). If the Court concludes that Item 303 creates such a duty, the Court will likely also address other conditions to Rule 10b-5 liability, such as materiality and scienter. The vehicle for that decision will be the Supreme Court’s review of Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016). (Because of a corporate name change, we refer to both the defendant company and the Second Circuit’s decision as “ Leidos.”) In Leidos, the Second Circuit broke with the Third and Ninth Circuits and held that a public company that omits a disclosure required by Item 303 violates a duty to disclose under Rule 10b-5. In resolving this conflict between the circuits with respect to Item 303(a)(3)(ii), the Court’s decision will also likely affect whether Rule 10b-5 would apply to a violation of every other sub-item of Item 303 as well as every one of the disclosure requirements adopted by the Securities and Exchange Commission (the “SEC” or the “Commission”) under Sections 13(a) and 15(d) and perhaps Section 14(a) of the Exchange Act, which would usher in a new era of litigation under Rule 10b-5.
This Article considers the issues before the Supreme Court from three perspectives. In Part I, we discuss the history and purpose of Item 303, as well as the SEC’s enforcement of the disclosure requirements contained in that Item. In Parts II and III, which will be published in the next edition, we summarize the circuit split, make some observations about the legal implications of the Second Circuit’s decision, and discuss the likely negative effects that would flow from a Supreme Court affirmance of that decision.
Item 303 is part of Regulation S-K, which is the central repository of disclosure for periodic reports under the Exchange Act and registration statements under the Securities Act of 1933 (the “Securities Act”). Adopted in 1980, Item 303 represented an effort by the SEC to respond to criticisms by investors about the prior disclosure requirements that were contained in the agency’s Guide No. 1 (Summary of Operations) and Guide No. 22 (Summary of Earnings). The two Guides were part of the Guides for Preparation and Filing of Registration Statements under the Securities Act. Guidelines for Registration and Reporting, Securities Act Rel. No. 5520 (August 14, 1974) [39 FR 31894] (the “1974 Release”). (In this article, SEC releases that are available as of September 1, 2017 on the SEC’s Website, www.sec.gov, are cited only to their release numbers and dates; older releases are cited to other sources such as the Federal Register.)
Originally adopted in 1968 and reflecting the policies and practices of the SEC’s Division of Corporation Finance (the “Division”), Guide 22 applied to registration statements and focused on a summary of earnings. Guides for Preparation and Filing of Registration Statements, Securities Act Rel. No. 4936 (December 9, 1968) [33 FR 18617]. Guide 1 applied to Exchange Act filings and dealt with a company’s operations. 1974 Release. When it adopted Guide 1 in 1974, the SEC changed the titles of both Guides; Guide 22 became “Management’s Discussion and Analysis of the Summary of Earnings” and Guide 1 became “Management’s Discussion and Analysis of the Summary of Operations.” Id., 39 FR at 31895. See also Concept Release on Management’s Discussion and Analysis of Financial Condition and Operations, Securities Act Rel. No. 33-6711 (April 24, 1987) [52 FR 13715] (the “1987 Release”).
As the SEC has put it, “Prior to 1980, Commission rules required registrants to provide a summary of earnings, including a discussion of unusual conditions that affected the appropriateness of the earnings presentations. The rules also required registrants to discuss items of revenue or expense that changed more than ten percent from the prior period or changed more than two percent of the average net income or loss for the most recent three years presented.” Business and Financial Disclosure Required by Regulation S-K, Securities Act Rel. No. 10064 (April 13, 2016) (the “Concept Release”) at 100-101. “However, disclosure also was required if an item did not meet the applicable percentage test but was necessary to an understanding of the summary. Conversely, where a registrant believed that a particular item was unnecessary to an understanding of the summary, the Division considered petitions for exemptions where the percentage test was met.” 1987 Release, 52 FR at 13716.
Investors believed that the disclosure that public companies were providing pursuant to Guides 1 and 22 was mechanistic and did not provide meaningful disclosure. Public companies informed the SEC that a flexible disclosure item would permit management to exercise judgment in making disclosure that would result in providing meaningful information to investors and the marketplace. A flexible requirement permitting the exercise of judgment would enable managements to tell their story, instead of providing disclosure that essentially said: “Operating income increased 10% because revenue increased 10%.”
In contrast to prescriptive requirements like Guides 1 and 22, Item 303 provides flexibility. An example is the SEC’s description of the terms “liquidity” and capital resources,” as used in Item 303. While the terms “lack some precision in definition, it is believed that additional specificity would decrease the flexibility needed by management for a meaningful discussion.” Amendments to Annual Report Form, Related Forms, Rules, Regulations, and Guides; Integration of Securities Act Disclosure Systems, Securities Act Rel. No. 6231 (Sept. 2, 1980) [45 FR 63630] (the “1980 Release”) at 63636. Thus, Item 303 can be viewed as one of the SEC’s initial efforts at adopting a principles-based disclosure requirement, which the agency has described as follows: “These rules rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances and determine whether disclosure is necessary. The requirements are often referred to as ‘principles-based’ because they articulate a disclosure objective and look to management to exercise judgment in satisfying that objective.” Concept Release at 34-35 [footnotes omitted].
Item 303’s focus is on the financial statements as a whole, not a summary of earnings or operations. In proposing and adopting Item 303, the SEC concluded that “there is a growing need in today’s environment to analyze enterprise liquidity and capital resources,” as well as inflation and changing prices, topics that were not included in the Guides. 1980 Release, 45 FR at 63636. Within each of liquidity, capital resources and results of operations, Item 303, unlike the Guides, “required disclosure of favorable or unfavorable trends and identification of certain material events or uncertainties.” 1987 Release, 52 FR at 13716. Item 303 was broader in scope than Guides 1 and 22, far more comprehensive than the Guides and intentionally general in nature. The Commission believed that a flexible approach would elicit more meaningful disclosure and avoid boilerplate discussions that a more specific approach could foster. “Further, the Commission reasoned that, because each registrant is unique, no one checklist could be fashioned to cover all registrants comprehensively.” Id. Hence, Item 303 represents a combination of specific requirements and disclosure principles, rather than just a list of specific requirements.
As shown by this administrative history, the SEC made a trade-off in proposing and adopting Item 303. Rather than a prescriptive rule, like Guides 1 and 22, that would have had a high probability of eliciting mechanistic disclosure that was not meaningful to either individual or institutional investors, the SEC adopted a principles-based rule to encourage public companies to tell their story. “In order to allow registrants to discuss their businesses in the manner most appropriate to individual circumstances and to encourage flexibility, the provisions were intentionally general and offered a minimum of specific requirements.” Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Rel. No. 6349, 1981 WL 379268 (Sept. 28, 1981) (the “1981 Release”), at 2. Item 303 does this by: expanding the scope of disclosure beyond operations and earnings to a narrative discussion of the financial statements; requiring an analysis in addition to a discussion; changing from requiring percentage change disclosure to having management disclose known trends or uncertainties; distinguishing between trends that were required to be disclosed and projections, which were not mandated, but encouraged; focusing on items like liquidity and capital resources, which had not received sufficient attention in the past; having the narrative disclosure discuss and analyze changes in Generally Accepted Accounting Principles (“GAAP”) and the effects of such changes on the registrant’s business; providing segment disclosure or “other breakdowns such as subdivisions, if investor understanding would thereby be improved,” 1980 Release, 45 FR at 63637; and allowing management to exercise judgment within the context of specific parameters.
As originally adopted, Item 303(a)(1)-(3) required management to discuss and analyze three core components: liquidity, capital resources and results of operations. In 2003, Item 303 was amended to change the disclosure of inflation and price changes (Item 303(a)(4)), and to require disclosure of off-balance sheet arrangements and contractual obligations (Item 303(a)(5)). Final Rule: Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations, Securities Act Rel. No. 8182, (January 28, 2003).
Neither Item 303 itself as promulgated in 1980 nor either of the amendments to Item 303 was adopted pursuant to the SEC’s authority under Section 10(b) of the Exchange Act. Instead, Item 303 was adopted in 1980 pursuant to the authority in Sections 5, 7, 8, 10 and 19(a) of the Securities Act and Sections 12, 13, 15(d) and 23(a) of the Exchange Act. 1980 Release, 45 FR at 63847. The 2003 amendments to Item 303 were adopted pursuant to the authority in Sections 7, 10, 19, 27A and 28 of the Securities Act, Sections 12, 13, 14, 21E, 23 and 36 of the Exchange Act, and Sections 3(a) and 401(a) of the Sarbanes-Oxley Act of 2002. Securities Act Rel. No. 8182.
The meaning and application of MD&A has been shaped by periodic reviews of the SEC’s disclosure policy, by interpretive releases published by the SEC, through comments issued by the Division in its review of filings, by no-action letters issued by the Division, by SEC enforcement cases and by case law. Even though the meaning and application of Item 303 have been dynamic over the past 37 years, the purposes for which it was adopted have not changed. As the Commission has stated,
The MD&A requirements are intended to satisfy three principal objectives:• to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management;• to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and • to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Rel. No. 8350 (the “2003 Release”), at 2.
During the 1980s, public companies attempted to comply with the new Item 303, “especially the more novel disclosure areas,” 1981 Release at 2, while the Division reviewed the disclosure made pursuant to a requirement that was “intentionally general and nonspecific.” Id. at 1. As discussed below, this did not prevent the SEC from enforcing the requirements of Item 303, but it did present a challenge for the Division’s review process. In the early years of Item 303, deferring to management’s judgments in complying with a disclosure item titled “Management’s Discussion and Analysis” often resulted in the Division’s review staff asking questions about the disclosure, rather than requiring amendments to the disclosure that was already made. Registrants also found Item 303’s approach to be challenging, as evidenced by the examples of MD&A disclosure by public companies contained in a number of the more than a dozen interpretive releases that the SEC has published since 1980.
The concept of encouraging public company managements to “tell their story” morphed into giving “the investor the opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company.” 1987 Release at 13717. The 1989 interpretive release repeated the 1987 Release’s description of looking at the company through the eyes of management. Management’s Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures, Securities Act Rel. No. 6835 (May 18, 1989) (the “1989 Release”), at 3. It also was consistent with past releases in recounting how Item 303 was more comprehensive than earlier formulations and intentionally general, and repeated the SEC’s view that a “flexible approach elicits more meaningful disclosure and avoids boilerplate discussions which a more specific approach could foster.” Id. at 2. A principles-based disclosure item that is general and flexible also enables the SEC to respond more quickly to developments in business and the economy that affect public companies generally without having to propose and adopt amendments to Item 303 pursuant to the Administrative Procedure Act.
One of the six matters on which the 1989 Release provided interpretive guidance was “prospective information required in MD&A.” Id. Rather than follow prior releases in encouraging, but not requiring forward looking information in MD&A, the 1989 Release included the following statement:
[S]everal specific provisions in Item 303 require disclosure of forward-looking information. MD&A requires discussions of “known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.” Further, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”Id. at 4 [footnotes omitted].
Thus, the 1989 Release, like the 1987 Release, distinguished between forward-looking information that was optional or voluntary ( i.e., disclosure that “involves anticipating a future trend or event or anticipating a less predictable impact of a known event, trend or uncertainty”), 1989 Release at 4, citing 1987 Release at n.1, and required forward-looking disclosure ( i.e., “currently known trends, events and uncertainties that are reasonably expected to have material effects”). Id. In an apparent effort to minimize any adverse reaction from registrants that had understood prior releases to say that known trends or uncertainties that were occurring at the time of the filing were not forward-looking, the 1989 Release states that the SEC’s safe harbor rules apply to both required and voluntary forward looking disclosure. See 1989 Release n. 22, citing Rule 175 under the Securities Act and Rule 3b-6 under the Exchange Act. (Given the addition of Section 21E to the Exchange Act in 1995, the SEC’s description of such disclosure as “forward-looking” meant that it would also be covered by that safe harbor. See also Safe Harbor for Forward Looking Statements, Securities Act Rel. No. 7101 (October 13, 1994) at 9.) In addition to clarifying the scope of forward-looking information, this section of the 1989 Release discussed how managements should determine whether forward-looking information concerning a trend, demand, commitment, event or uncertainty is required to be disclosed because it is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operation. Management first needs to “determine and carefully review what trends, demands, commitments, events or uncertainties are known to management.” 1989 Release at 5. In conducting this review, management needs to consider each specific category of known data under Item 303. In addition to known events that have occurred or are occurring, disclosure is required with respect to planned material events that are reasonably likely to occur. Id. “Events that have already occurred or are anticipated often give rise to known uncertainties.” Id. at 6. After conducting this review, management is ready to make the determination of whether disclosure is required.
Without notice or the opportunity for public comment pursuant to the Administrative Procedure Act, the 1989 Release also introduced a two-step test (the “Two Step Test””) for managements to determine whether forward-looking disclosure is required by Item 303:
Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.Id. at 6-7.
The 1989 Release added that “Each final determination resulting from the assessments made by management must be objectively reasonable, viewed as of the time that the determination is made.” Id. at 7.
In presenting the Two Step Test, the 1989 Release stated that Item 303 “specifies its own standard for disclosure – i.e., reasonably likely to have a material effect. This specific standard governs the circumstances in which Item 303 requires disclosure. The probability/magnitude test for materiality approved by the Supreme Court in Basic, Inc. v. Levinson, 108 S. Ct. 978 (1988), is inapposite to Item 303 disclosure.” 1989 Release at n. 27; see also Concept Release at 107. The SEC did not provide a reason for its position, which seems odd given that the probability/magnitude test is particularly appropriate to analyze disclosure of forward-looking information. The Two Step Test has a lower threshold for requiring disclosure of forward-looking information than Basic; the SEC has explained that “reasonably likely,” which is a less than 50% probability, is a lower threshold than “more likely than not,” which is a more than 50% probability.
Indeed, the Two Step Test appears to have set a lower threshold for disclosure than the words of Item 303 itself. For example, Item 303(a)(1) uses the phrase “reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.” And Item 303(a)(3)(ii) uses the phrase “reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” One of these sub-items of Item 303 uses “reasonably likely” like the Two Step Test and the other uses “reasonably expects.” Unlike the Two Step Test, however, the sub-items of Item 303 have materiality as the frame of reference: reasonably expects to be material or reasonable likely to be material, which is a higher standard than how the term “reasonably likely” is used in two of the three instances in the Two Step Test: “reasonably likely to come to fruition” and “not reasonably likely to occur.” The Two Step Test unlinks reasonable likelihood from materiality, which may be a reason why footnote 27 of the 1989 Release states that Basic is inapposite to Item 303. In addition to a lower threshold than Basic for requiring disclosure, the 1989 Release’s statement that “the assessments made by management must be objectively reasonable” implies a lower threshold than scienter, one akin to negligence.
Applying the Two Step Test can lead managements to have to disclose a known trend or uncertainty under the Two Step Test, even though they would not have had to do so pursuant to the words of the applicable sub-item of Item 303. Under Item 303(a)(3)(ii), disclosure is required if the trend or uncertainty is known and management reasonably expects the trend or uncertainty to have a material effect on sales, revenues or income from continuing operations. The analysis that Item 303(a)(3)(ii) requires is similar to the analysis companies make to determine materiality: a probability/magnitude analysis. Simply put, will the trend or uncertainty occur and if it does will it have a material effect? If the answer to both questions is yes, disclosure is required, and if the answer to either of the two questions is no, no disclosure is required. In contrast, the Two Step Test requires a negative analysis which can result in requiring disclosure even when the effect of the known trend or uncertainty may be immaterial. Under Step 1, no disclosure is required if management can determine that a known trend or uncertainty is not reasonably likely to occur. Under Step 2, if management cannot make the determination in Step 1, disclosure is required unless management determines that it is not reasonably likely that the known trend or uncertainty will materially affect the company’s financial condition or results of operations. Step 2 requires a double negative analysis: if management cannot determine that a known trend or uncertainty will not occur, disclosure is required unless management determines that the effect of the known trend or uncertainty will not be material.
The SEC has repeated the Two Step Test in subsequent releases as applying to each sub-item of Item 303 that references trends or uncertainties, not just to Item 303(a)(3)(ii). See 2002 Release at 4; 2003 Release at 9; Concept Release at 106-07. The 1987 Release, however, may be inconsistent with the Two Step Test. In discussing the difference between “required disclosure” and “optional disclosure,” the 1987 Release stated that, in contrast to required disclosure, “optional-forward-looking disclosure involves anticipating a future trend or event or anticipating a less predictable impact of a known event, trend, or uncertainty.” Id. at 13717. Ironically, the Two Step Test as set forth in the 1989 Release, just two years after the 1987 Release, would consider “anticipating a less predictable impact of a known event, trend or uncertainty” as requiring disclosure when it does not meet the double negative of Step 2: management cannot reach a conclusion as to its fruition and cannot determine, if it does occur, that it won’t have a material effect.
Item 303(a) has four sub-items that use the term “trend,” one of which, Item 303(a)(3)(ii), provides in relevant part: “[D]escribe 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.” Although neither Item 303 nor the SEC’s other rules or regulations define the term “trend,” the Eleventh Circuit has explained that evaluating whether a “trend” exists “require[s] an assessment of whether an observed pattern accurately reflects persistent conditions of the particular registrant’s business environment” and it “may be that a particular pattern is, for example, of such short duration that it will not support any conclusions about the registrant’s business environment.” SeeOxford Asset Mgmt. Ltd. v. Jaharis, 297 F.3d 1182, 1191 (11th Cir. 2002). Webster’s New World Dictionary of the American Language (1955) describes the word “uncertainty” as ranging from a mere lack of absolute sureness to such vagueness as to preclude anything more than guesswork. The word “uncertain” is defined as not surely or certainly known; questionable; problematical; not sure or certain in knowledge; doubtful; vague; not definite or determined; liable to vary or change.
Management’s analysis of a known trend or uncertainty must be done at the time of filing of the periodic report, not later on with the benefit of 20-20 hindsight. Furthermore, Item 303(a)(3)(ii) provides that management must reasonably expect that the known trend or uncertainty will have a material effect on net sales or revenues or income from continuing operations. Thus, under Item 303(a)(3)(ii), management may know a trend is occurring and is reasonably likely to continue into the future, but disclosure is not required unless management reasonably expects the known trend or uncertainty will have a material impact or effect on net sales, revenues or income in the future. In addition, management’s analysis of the known trend or uncertainty needs to consider and may be required to disclose “the underlying reasons or implications, interrelationships between constituent elements or the relative significance of those matters.” 2003 Release at 9.
Although their disclosures may be overseen by the board of directors, advised on by outside counsel, and reviewed by the registrant’s independent public accounting firm, these determinations are made by management. That is why Item 303 is called Management’s Discussion and Analysis. Using the short-hand term “MD&A” can result in losing track of what the SEC intended in 1980, how the SEC has interpreted and administered the item for 37 years and how seeing the business through the eyes of management is inherently subjective and judgmental. Having the registrant’s disclosure controls and procedures (“DC&Ps”) effective at a reasonable assurance level can be of great assistance in compliance, but they do not guarantee getting it right every time. In addition, premature disclosure of something as a known trend or uncertainty that turns out not to be one can be just as harmful to investors as not disclosing a known trend or uncertainty at the right time. With respect to something as complex as disclosing a known trend or uncertainty, it would not be unreasonable for management to believe that disclosure is not required because management cannot conclude that an adverse effect is reasonably possible given the uncertainty of looking into the future, although non-disclosure might not be consistent with the Two Step Test. Premature disclosure that does not turn out to be the case can have adverse effects on the company because, for every buyer in a trading market, there is a seller.
Item 303(b), which pertains to interim periods and quarterly reports on Form 10-Q, requires that “[t]he discussion and analysis shall include a discussion of material changes in those items specifically listed in paragraph (a) of this item.” Thus, if the registrant disclosed a known trend or uncertainty in the MD&A in its most recently filed Form 10-K, which is subject to Item 303(a), Item 303(b) would require the registrant to update that disclosure if there was a material change in the known trend or uncertainty. Instruction 3 to Instructions to Paragraph (b) of Item 303 states in pertinent part: “[t]he discussion and analysis required by this paragraph (b) is required to focus only on material changes.”
Even though the words of Item 303(b) specifically state that it applies only to material changes, the Division in its review process applies the terms of Item 303(a) as if the filing is subject to that sub-item. Whether or not the registrant has disclosed a known trend or uncertainty in the MD&A of its Form 10-K for the preceding fiscal year, the Division’s review staff requires disclosure of known trends or uncertainties in quarterly reports on Form 10-Q in accordance with the requirements of Item 303(a). The rationale for this position is quite simple: if the registrant had not disclosed a known trend or uncertainty in the MD&A of its preceding Form 10-K, having a known trend or uncertainty in a subsequently filed Form 10-Q is a material change from what was disclosed in the preceding Form 10-K.
The SEC can enforce compliance with Item 303(a) under Section 13(a) of the Exchange Act and its associated rules, which do not create an implied private right of action. See, e.g., In re Penn Central Sec. Litig. M.D.L. Docket No. 56, 494 F.2d 528, 540 (3d Cir. 1974); Srebnik v. Dean, 2006 WL 2790408 at *3 (D. Colo. Sept. 26, 2006). Three of those provisions — Section 13(a) itself, 15 U.S.C. § 78m(a) (requiring Exchange Act registrants to file reports as required by SEC rules), Rule 13a-1, 17 C.F.R. § 240.13a-1 (requiring Exchange Act registrants to file annual reports), and Rule 13a-13, 17 C.F.R. § 240.13a-13 (requiring most Exchange Act registrants to file quarterly reports) — require on their face only that information be filed, but it is well settled that implicit in the filing obligation is the requirement that the information be truthful in all material respects. See also Exchange Act § 15(d), 15 U.S.C. § 78o(d) (covering reports by other issuers), Rule 15d-1, 17 C.F.R. § 240.15d-1 (covering annual reports by other issuers), and Rule 15d-13, 17 C.F.R. § 240.15d-13 (covering quarterly reports by other issuers). A fourth related provision, Rule 12b-20, mandates that, “[i]n addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.” 17 C.F.R. § 240.12b-20. Rule 12b-20 can result in requiring more disclosure to be provided than a specific line item would otherwise require. For example, if the line item requires the company to state the color of the sky, and the company discloses that the color of the sky is blue, Rule 12b-20 could require disclosure that, “while the color of the sky is blue, there is a funnel cloud on the horizon that appears to be headed directly at the company’s only manufacturing facility.” Section 13(a) and the attendant rules are particularly attractive enforcement tools for the SEC because the SEC need not show scienter on the part of the issuer to prove a violation. See, e.g., SEC v. McNulty, 137 F.3d 732, 740-741 (2d Cir. 1998); SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1167 (D.C. Cir. 1978).
Section 13(a) requires public companies to file documents that conform to SEC rules, including Item 303, so that an Item 303 failing leads to a violation of Section 13(a). Thus, the SEC does not need Section 10(b) or Rule 10b-5 to enforce Item 303. As we will see from the enforcement cases discussed below, an enforcement action under Section 13(a) permits the SEC to obtain either an injunction or a cease and desist order (depending on its choice of forum) and civil money penalties, and also permits the agency to reach the responsible corporate officers as aiders and abettors or causes of an Item 303 violation. With only occasional exceptions, e.g., In the Matter of Valley Systems, Inc., Exchange Act Rel. No. 36227, 1995 WL 547801 (Sept. 14, 1995) (describing an Item 303 failure of cash flow disclosure in the section of the settled order that discusses Section 10(b) and Rule 10b-5) and In the Matter of Sulcus Computer Corp., Exchange Act Rel. No. 37160 (May 2, 1996) (discussing an MD&A failure in the section of the settled order that discusses Sections 17(a)(2) and (3) of the Securities Act), the SEC’s settled orders in Item 303 enforcement cases have been brought under Section 13(a) and the attendant rules, rather than the antifraud provisions. Even the Commission views settled orders as having “limited precedential value.” SeeSIG Specialists, Inc., 58 S.E.C. 519, 537 n.36; (2005); Carl L. Shipley, 45 S.E.C. 589, 591-92 n.6, 1974 WL 161761 (1974); In the Matter of BDO China Dahua CPA Co., Ltd., Init. Dec. Rel. No. 553 at 95 (Jan. 22, 2014), finality order, Exchange Act Rel. No. 74552 (March 20, 2015).
In general, both the volume and the specific content of the SEC’s cases charging failures to disclose under Item 303(a) have been consistent with the use of prosecutorial discretion by the agency to pursue cases that serve the goals of the SEC’s integrated disclosure program, and not to bring cases reflexively. Many of those cases — especially the “pure” Item 303 cases in which Item 303 is the only or the lead violation rather than an additional charge in a matter that also alleges other issues such as GAAP violations — plainly have been brought by the SEC as “teachable moments” for registrants.
The first enforcement case under Item 303(a) was SEC v. The E.F. Hutton Group Inc., Lit. Rel. No. 10915, 1985 WL 548287 (October 29, 1985), in which the agency announced the filing of an injunctive action that defendant The E.F. Hutton Group Inc. (“Hutton”) immediately settled. The case centered on Hutton’s failure to disclose (1) its increased use of its “cash concentration” system, which encouraged overdrafting and “chaining” (a form of check-kiting) that significantly reduced Hutton’s need to borrow and, consequently, its interest expense in 1981, and (2) its decreased use of that system in 1982, which resulted in increases in bank borrowings and commercial paper issuances and, consequently, greater interest expense in 1982. According to the Commission, the MD&A portions of Hutton’s “1981 and 1982 Forms 10-K, which discuss the changes in net interest income from 1980 to 1981 and from 1981 to 1982, fail to identify the overdrafting practices, fail to state that the overdrafting practices constituted a material element of these changes and fail to discuss the risks and uncertainties associated with those practices, all in violation of the reporting provisions of the Exchange Act” contained in Section 13(a), Rule 13a-1, and Rule 12b-20. In addition, the Commission included a charge that Hutton violated Rule 13(b)(2)(B) for having had insufficient internal controls in that it lacked any procedures to detect or prevent abuse of the “cash concentration” system.
The 1990s saw six more settlements of “pure” Item 303(a) cases, all brought (like Hutton) under Section 13(a) of the Exchange Act: In the Matter of Caterpillar Inc., Exchange Act Rel. No. 30532, 1992 WL 71907 (March 31, 1992); In the Matter of Shared Medical Systems Corp., Exchange Act Rel. No. 33632, 1994 WL 49960 (February 17, 1994); In the Matter of Salant Corp. and Martin F. Tynan, Exchange Act Rel. No. 34046, 1994 WL 183411 (May 12, 1994); In the Matter of America West Airlines, Inc., Exchange Act Rel. No. 34047, 1994 WL 183412 (May 12, 1994); In the Matter of Kemper Corp. and William R. Buecking, Exchange Act Rel. No. 35814, 1995 WL 358038 (June 6, 1995); and In the Matter of Sony Corporation and Sumio Sano, Exchange Act Rel. No. 40305 (August 5, 1998). In Caterpillar, the Commission made the point that if a trend or uncertainty is sufficiently important to bring to the attention of a public company’s board of directors, the company must be prepared to discuss it in its MD&A. Sony is noteworthy because it extended Item 303(a) enforcement to a foreign private issuer. In addition in Sony, as in Salant and Kemper, the SEC sued individual corporate officers, and not just the registrant, for Item 303 shortcomings.
The 1990s also contained a “pure” Item 303(a) enforcement case that the SEC litigated. On January 11, 1994, the Commission commenced an administrative proceeding against Bank of Boston that was tried to an SEC administrative law judge. See In the Matter of Bank of Boston Corp., Initial Dec. Rel. No. 81 (December 22, 1995), finality order, Exchange Act Rel. No. 36887 (February 26, 1996). At issue in the case was the Bank’s disclosure, in a single quarterly report, surrounding its provision for credit losses. The SEC did not attack the provision directly, by claiming that the number in the Bank’s quarterly filing was misstated under GAAP; instead, the proof at the Bank of Boston hearing focused on the deterioration of the underlying loan portfolio and management’s failure to share that information with the investing public. The administrative law judge relied heavily on the Two Step Test in the 1989 Release and on what she concluded management “should have known” -- which is the language of negligence liability. See KPMG, LLP v. SEC, 289 F.3d 109, 120 (D.C. Cir. 2002). The following passages make that clear:
Issuance of a cease and desist order is appropriate because BOB, acting through Mr. Stepanian [BOB’s Chairman and CEO], violated the Exchange Act and rules thereunder because it knew or should have known when it filed its Form 10-Q on August 10, 1989, that its financials without explanation were misleading, and that known trends and uncertainties in its real estate portfolio would reasonably be expected to have a material unfavorable impact on BOB’s financial condition. Disclosure in the MD&A section of the Form 10-Q is required in situations such as this because BOB knew, or should have known, that (1) without explanation its financials were misleading, and (2) BOB’s financial statements and accompanying footnotes were insufficient, without a narrative explanation, for an investor to judge the quality of earnings and the likelihood that reported financial information is not indicative of material changes in future operating results. No one who read BOB’s second quarter financials in its Form 10-Q would have anticipated what management knew was highly likely to happen, and did happen, to BOB’s earnings in the third quarter 1989. The 1989 Interpretative Release requires that management assess whether a known trend, demand, commitment, event or uncertainty is reasonably likely to occur. If it cannot make this determination, it must evaluate the consequences of the known trend, demand, commitment, event or uncertainty on the assumption that it will occur and make disclosure unless it determines that a material effect on its financial operations or results is not reasonably likely. Applying that standard to this situation, BOB was required to disclose additional information because (1) its real estate portfolio had deteriorated significantly in value in 1988 and the first six months of 1989, and the evidence was that the deterioration was reasonably likely to continue, and (2) even if BOB could not make this determination, but assumed that the deterioration would continue, the record indicates that it was reasonable to expect that the impact on earnings would be material.Initial Decision Rel. No. 81 at 10-11 [citations and footnotes omitted].
The evidence is overwhelming that before August 10, 1989, Mr. Stepanian and others in top management positions at BOB, whose knowledge is imputed to BOB, knew or should have known that the future risk of loss in BOB’s commercial real estate portfolio was considerably higher than was reflected from the financials for the second quarter, and that its loan loss reserve would not be sufficient to cover those losses. These persons knew, or should have known, in early August 1989 that BOB most likely would have to increase its Provision Expense substantially to add funds to its reserve and that the impact on its income statement would be material.I find that on August 10, 1989, Mr. Stepanian and BOB knew or should have known with a reasonable degree of certainty, from information supplied by four independent sources – BOB’s internal reports, information from OCC and other regulators, the highly leveraged transactions in its portfolio, and New England real estate values which had declined and continued to decline substantially – that its commercial loan portfolio had deteriorated significantly in value, that deterioration was continuing, that BOB’s loan loss reserve was inadequate, and that adding to it would have a material impact on earnings. I find further that BOB was required to disclose this information in the MD&A section of its Form 10-Q for the second quarter of 1989, and it did not do so.Id. at 15-16 [footnote omitted]. The result was a cease and desist order against further violations of Section 13(a), Rule 13a-13, and Rule 12b-20, which Bank of Boston permitted to become final by not petitioning for Commission review of the ALJ’s initial decision.
In SEC v. BankAtlantic Bancorp, Inc. and Alan Levan, Lit. Rel. No. 22229 (Jan. 18, 2012), in which Mr. Huber appeared as an expert witness for the defense, the SEC made Item 303(a)(3)(ii) allegations concerning a failure to disclose known trends relating to BankAtlantic’s loan portfolio, but confined its arguments at trial to the actual words of Item 303(a)(3)(ii) and did not rely on the Two Step Test. The case ended in a defense verdict. SEC v. BankAtlantic Bancorp, Inc., No-12-cv-60082 (S.D. Fla. Dec. 15, 2014) ECF No. 415.
In the past two decades, “pure” Item 303(a) enforcement cases, in which the only violation or the main violation charged by the SEC is failure to disclose a “known trend or uncertainty,” have become extremely rare. It has been far more common for the SEC to add an Item 303(a) charge in a case that mainly is about other violations. See, e.g., SEC v. RPM International Inc. and Edward W. Moore, Lit. Rel. No. 23639 (September 9, 2016) (partially settled, partially-litigated case regarding failure to disclose a material loss contingency relating to, or record an accrual for, a government investigation); SEC v. Jill D. Cook and Mark C. Pierce, Lit. Rel. No. 23367 (September 28, 2015) (litigated case involving misstated loan loss provision and allowances); SEC v. Edward J. Woodard, Jr., Cynthia A. Sabol, CPA, and Stephen G. Fields, Lit. Rel. No. 22587 (January 9, 2013) (litigated case regarding material understatements of allowance for loan and lease losses and underreporting of non-performing loans); In the Matter of Southpeak Interactive Corporation and Patrice K. Strachan, Exchange Act Rel. No. 64320 (April 21, 2011) (undisclosed related party transactions and false statements to auditors); In the Matter of Electronic Data Systems Corporation, Exchange Act Rel. No. 56519 (September 25, 2007) (failure to adequately disclose impact of derivatives contracts in Item 303(b), along with violations of Regulation FD); In the Matter of Comerica, Inc., Exchange Act Rel. No. 52041 (July 15, 2005) (case focused on failure to record appropriate loan loss reserves); In the Matter of Global Crossing Ltd., Thomas J. Casey, Dan J. Cohrs, and Joseph P. Perrone, Exchange Act Rel. No. 51517 (April 11, 2005) (insufficient disclosure of reciprocal transactions); In the Matter of Sunbeam Corporation, Exchange Act Rel. No. 44305 (May 15, 2001) (revenue recognition fraud in violation of Exchange Act Section 10(b) and Rule 10b-5); and In the Matter of Larry L. Skaff and John F. Liechty, Exchange Act Rel. No. 41313 (April 20, 1999) (numerous GAAP violations). Earlier cases taking this same approach include In the Matter of National Partnership Investments Corp., Exchange Act Rel. No. 38773 (June 25, 1997) (violations of Section 10(b) and Rule 10b-9 in connection with a part-or-none offering, along with various GAAP violations).
Two notable exceptions to the general rarity of “pure” Item 303 cases in the past two decades are:
To be sure, in some of its releases and also in the context of litigation, the SEC has from time to time asserted the view that Item 303 violations supply a duty to disclose under Section 10(b) and Rule 10b-5. BankAtlantic, cited above, was a litigated matter in which the SEC made that assertion, albeit unsuccessfully on the facts of that case. In the main, however, the SEC’s enforcement history under Item 303 has made effective use of the SEC’s powers under Section 13(a) of the Exchange Act to send messages to registrants and, where needed, to obtain significant sanctions.
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