Circuit Court Decisions Addressing Liability For Omissions Under Section 10(B)

Second Circuit: Failure to Comply With Item 303 of Regulation S-K May Only Be Actionable Under Section 10(b) If the Alleged Omission Was Material Under Basic's Probability/Magnitude Test

Item 303 of Regulation S-K sets forth the disclosure requirements for the Management's Discussion and Analysis (MD&A) section of a public company's Form 10-Qs and other SEC filings. In relevant part, Item 303 states that a public company must "[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."

On January 12, 2015, the Second Circuit held "as a matter of first impression . . . that a failure to make a required Item 303 disclosure . . . is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim." Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015) (Livingston, J.). The court explained that "Form 10-Qs are mandatory filings that speak . . . to the entire market," and reasoned that "omitting an item required to be disclosed on a 10-Q can render that financial statement misleading."

Significantly, the Second Circuit found that "such an omission is actionable only if it satisfies the materiality requirements outlined in [Basic Inc. v. Levinson, 485 U.S. 224 (1988)], and if all of the other requirements to sustain an action under Section 10(b) are fulfilled." The Second Circuit explained that "[t]he SEC's test for a duty to report under Item 303 . . . involves a two-part . . . inquiry" that is "different" from the test for materiality under Basic. When determining whether Item 303 mandates disclosure of a "known trend," "management must make two assessments." First, management must consider whether the known trend is "likely to come to fruition." Second, in the event that "management cannot make that determination, it must evaluate objectively the consequences of the known trend . . . on the assumption that it will come to fruition." Item 303 then requires disclosure of the trend "unless management determines that a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur." Under the Basic test, on the other hand, "the materiality of an allegedly required forward-looking disclosure is determined by 'a balancing of both the indicated probability that the event will occur and the anticipated magnitude...