Failure To Disclose Known Trends Or Uncertainties In Public Filings May Create Liability Under Section 10(b)

On January 12, 2015, the U.S. Court of Appeals for the Second Circuit held in Stratte-McClure v. Morgan Stanley1 that a failure to make a required disclosure under Item 303 of Regulation S-K in a Quarterly Report on Form 10-Q is an omission that can serve as the basis for a Section 10(b) securities fraud claim if (1) the omission satisfies the materiality requirements outlined in Basic v. Levinson2, and (2) all of the other requirements to sustain an action under Section 10(b) are satisfied.

Background

Morgan Stanley entered into two trading positions regarding the sub-prime mortgage market in December 2006. First, Morgan Stanley sold a $13.5 billion long position in a super-senior tranche of a collateralized debt obligation ("CDO") in the form of a credit default swap ("CDS"). Second, Morgan Stanley purchased a $2 billion short position through another CDS that tracked a lower-rated, higher-risk tranche of another CDO. Stated in a rudimentary manner, CDSs act as a form of insurance with the buyer making "premium" payments to the seller, and the seller responsible for covering losses in the event of default or a decline in value within the contractually agreed tranche. As a result, Morgan Stanley was making premium payments on its short position, which had a higher risk of default than its long position, and was receiving premium payments on its long position with the responsibility to make payments if the specified tranche declined in value or went into default. Morgan Stanley's strategy reveals a belief that the housing market would decline (the purpose of its short position), but that the magnitude of damage would not reach the super-senior tranches (the purpose of its long position). Unfortunately, Morgan Stanley did not correctly predict the magnitude of the collapse and the resulting widespread risk the burst of the housing position posed on its long position.

As a result of the collapse, the financial losses incurred under the long position and the subsequent disclosures in Morgan Stanley's filings, the plaintiffs argued that Morgan Stanley made material omissions in their Quarterly Reports on Form 10-Q by failing to disclose (1) the existence of the long position, (2) that Morgan Stanley had sustained losses on the long position during the company's second and third quarters of 2007, and (3) that the company was likely to incur additional significant losses on the position in the future.

Item 303 of Regulation S-K

Item 303 states...