Anne Sherry
If a company violates Securities and Exchange Commission requirements and fails to disclose a trend that will likely impact its financial position, does that leave the company open to a private legal challenge?
The Supreme Court has agreed to hear a case that focuses on that question and the potential impacts are wide-ranging, including added litigation risk.
“If a company or executives like to tell a half-truth, that can be the basis of fraud liability, but the question that’s so pivotal here is if they just stay completely silent about something, whether that can support a class-action suit or a private securities fraud suit,” said Anne Sherry, a content management consultant in the securities group of Wolters Kluwer Legal & Regulatory U.S.
The Supreme Court will hear a case brought by hedge fund Moab Partners against Macquarie Infrastructure Corp., a former publicly traded company that owned and operated a portfolio of infrastructure-related businesses, including one involving the storage of a high-sulfur fuel oil, No. 6 oil. In its class-action lawsuit, Moab alleged that from 2016 to 2018 Macquarie and its management defrauded investors by failing to predict — and disclose — that a proposed cap on sulfur in fuel oil would have a material negative impact on Macquarie’s financial performance, Sherry explained.
Item 303 of the SEC’s Regulation S-K requires companies to make a disclosure “where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”
Private securities plaintiffs have long taken the position that a failure to make a required disclosure under Item 303 is an omission that can give rise to a securities fraud claim under Section 10(b) of the Securities Exchange Act even in the absence of an otherwise misleading statement or an independent duty to disclose the allegedly omitted information, attorneys from Vinson & Elkins said in post on the firm’s website.
Macquarie argued that a Section 10(b) claim cannot rest entirely on a failure to provide a disclosure required under Item 303 and that there needs to be some affirmative statement rendered misleading by the omission, Sherry said. The case does not impact the SEC’s ability to bring an enforcement action against a company for an Item 303 omission.
After a federal District Court in Manhattan in 2021 dismissed the claims against Macquarie, the 2nd Circuit Court of Appeals in New York in 2022 disagreed and concluded that Moab had adequately alleged a “known trend or uncertainty” that gave rise to a duty to disclose under Item 303.
The 2nd Circuit is the only circuit court that has found that omissions of Item 303 disclosures, without any affirmative statement, could serve as the basis for private actions under Section 10(b).
Previously, other circuit courts including the 3rd, 9th and 11th have rejected this position and have all held that only untrue or misleading statements are grounds for Section 10(b) liability and, thus, allegedly omitted disclosures under Item 303 do not give rise to a cause of action under Section 10(b), noted Jay A. Dubow, partner at Troutman Pepper Hamilton Sanders who co-leads the firm’s securities investigations and enforcement practice group.
“The SEC disclosure (rules) have a lot of different requirements and provisions and what all the other circuits are saying is just the fact that you omitted something under one of those requirements doesn’t by itself give rise to a private action for fraud,” Dubow said.
Macquarie held the position that by allowing an Item 303 violation to serve as the premise for a Section 10(b) claim, the 2nd Circuit eliminated the fraudulent intent requirement of Section 10(b), which requires that defendants have acted with scienter— a state of mind embracing intent to deceive, manipulate or defraud, Dubow explained.Now, the Supreme Court will settle matters.
Oral arguments for the case have yet to be scheduled, but sources expect the conservative leaning court to favor the defendants.
“It’s a pretty critical area of securities litigation and the 2nd Circuit is incredibly influential in this area, so if there’s any debate, especially to a conservative court, about expanding liability for corporations, I could see why they would want to weigh in,” Sherry said.
And while the Supreme Court’s conservative majority makes a positive ruling for Macquarie more likely, nothing is certain, Sherry added. “I do think that the court leaning a little conservative gives an edge to the defendants just because the court is going to be wary of expanding liability to this extent,” she said.
The Securities Industry and Financial Markets Association and U.S. Chamber of Commerce in July filed an amicus brief in support of Macquarie and urged the Supreme Court to take up the case.
“The 2nd Circuit’s erroneous rule means that public companies run a risk by omitting a disclosure in any remotely doubtful case — they must over-disclose,” the trade groups said in their brief. “Such over-disclosure is hardly benign. This court, the SEC, and scholars have all warned against bloated disclosures that bury actually useful information in a pile of verbal junk. The 2nd Circuit’s interpretation aggravates this problem, and amici have an interest in restoring the proper boundaries of Rule 10b-5.”
Sherry said the case is crucial because even though this matter only deals with Item 303, the Supreme Court’s decision could set precedent for “any duty to disclose under any statute or regulation, so it is potentially much more far reaching than even just this case.”
Added Dubow, “I think it’s more likely that the Supreme Court is going to reject the 2nd Circuit view but if for some reason the Supreme Court goes the other way and accepts the 2nd Circuit position, I think that opens up companies to a lot more risk of litigation surviving motions to dismiss.”
