Is Item 303 Liability under the Securities Act Becoming a "Trend"?

By Matthew L. Mustokoff – September 18, 2012

The federal securities laws have been clearly interpreted by the courts to impose a duty to disclose all material non-public information regarding a particular subject once a company elects to speak on that subject. For example, when there is an incomplete or inaccurate disclosure, the affirmative duty to speak completely and accurately arises. What is less clear, however, is the scope of the duty to disclose when the company has been completely silent on the subject.

The U.S. Court of Appeals for the Second Circuit recently issued its second decision in 15 months, recognizing a 1933 Securities Act claim for failing to disclose “known trends or uncertainties” that are reasonably likely to have an effect on sales, revenues, or income, in violation of Item 303 of SEC Regulation S-K. Sometimes referred to as the “sleeping tiger” of securities class-action litigation because it is relatively under-invoked by plaintiffs, Item 303 casts a wide net with respect to the range of so-called “soft” information that must be disclosed by a company’s management. See The 10b-5 Daily, Waking the Tiger (Feb. 18, 2011). As these recent Second Circuit cases illustrate, when invoked as the basis for a ’33 Act claim, Item 303 becomes a formidable hammer because plaintiffs have the additional benefit of not having to prove scienter, reliance, or loss causation—all elements of a section 10(b) fraud claim under the 1934 Exchange Act but not elements of a section 11 or 12 claim under the ’33 Act.

Item 303
Item 303 of Regulation S-K, 17 C.F.R. § 229.303, mandates the disclosure of, inter alia, “any 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,” as well as “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.” 17 C.F.R. §§ 229.303(a)(1) and (a)(3)(ii).

The Second, Sixth, and Ninth Circuits have all held that violations of Item 303’s disclosure provisions are actionable under the ’33 Act. See, e.g., Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1296 (9th Cir. 1998) (“Allegations which sufficiently state a claim under Item 303 also state a claim under section 11 [of the ’33 Act].”); Litwin v. Blackstone Group, L.P.,634 F.3d 706, 716 (2d Cir. 2011); J&R Marketing v. GMC, 549 F.3d 384, 392 (6th Cir. 2008). In addition, the Second Circuit has held that Item 303 equally gives rise to a section 10(b) claim under the ’33 Act. See In re Scholastic Corp. Secs. Litig., 252 F.3d 63, 70, 74 (2d Cir. 2001) (reversing dismissal of section 10(b) claim where the complaint adequately alleged that the defendants failed to disclose a “known trend” under Item 303 on Form 10-Q; “We conclude therefore that the facts alleged are sufficiently detailed to allow the plaintiffs to present proofs that the defendants knew, despite the fact that their business was cyclical, of a material downward secular trend.”). In contrast, the Third Circuit, in an opinion authored by now Supreme Court Justice Samuel Alito, declined to recognize that the affirmative-disclosure obligations of Item 303 give rise to a private cause of action. However, that case involved a ’34 Act section 10(b) claim, not a ’33 Act claim. See Oran v. Stafford, 226 F.3d 275, 287–88 (3d Cir. 2000) (“Neither the language of the regulation nor the SEC’s interpretative releases construing it suggest that it was intended to establish a private cause of action. . . . [A] violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5.”).

Blackstone
Last year, the Second Circuit generated a renewed focus on ’33 Act claims based on Item 303’s disclosure requirements when it revived such a claim in Litwin v. Blackstone Group, L.P.,634 F.3d 706 (2d Cir. 2011). Blackstone, which marked the first major appellate victory for plaintiffs in a securities class action arising from the subprime-mortgage crisis, related to Blackstone’s IPO and the uncertainties surrounding the impact of the crisis on Blackstone’s mortgage and real-estate-related investments.

The plaintiffs appealed a decision of the district court dismissing claims against Blackstone for its alleged violations of sections 11 and 12(a)(2) of the ’33 Act. The plaintiffs alleged that Item 303 of Regulation S-K required Blackstone to disclose that worsening market conditions were reasonably likely to impact its revenues in light of the composition of its investments, including (i) an 88 percent stake in FGIC Corp., a monoline financial guarantor that wrote insurance on collateralized debt obligations (CDOs) based on the values of subprime mortgage pools, (ii) a $3.1 billion investment in Freescale Semiconductor, which lost an exclusive agreement to manufacture wireless 3G chipsets for its largest customer, Motorola, shortly before the Blackstone IPO, and (iii) certain real-estate investments that constituted 22.6 percent of Blackstone’s assets under management. U.S. District Judge Harold Baer Jr. held that the omission of the potential revenue decline was not actionable because it was not material, and thus, its disclosure was not required by Item 303.

The Second Circuit disagreed and reversed, holding that, because the plaintiffs alleged that the known trend existed at the time of the IPO, and the trend “was reasonably likely to have a material impact on Blackstone’s financial condition,” they had adequately pled a violation of Item 303 and, in turn, a violation of section 11 of the ’33 Act. As the Blackstone court stated, a plaintiff satisfies the materiality requirement of Regulation S-K by merely alleging that a defendant “reasonably expects the impact [of the undisclosed trend] to be material.”

With respect to Blackstone’s FGIC and Freescale investments, the court clarified that

the focus of plaintiffs’ claims is the required disclosures under Item 303—plaintiffs are not seeking the disclosure of the mere fact of Blackstone’s investment in FGIC, of the downward trend in the real estate market, or of Freescale’s loss of its exclusive contract with Motorola. Rather, plaintiffs claim that Blackstone was required to disclose the manner in which those then-known trends, events, or uncertainties might reasonably be expected to materially impact Blackstone's future revenues.

634 F.3d at 718.

The Second Circuit found that, because Blackstone’s omission of these adverse trends “‘mask[ed] a change in earnings’”—one of the factors for materiality enunciated by the SEC in Staff Accounting Bulletin No. 99, 64 Fed. Reg. 45,150 (1999) (SAB No. 99)—Item 303 was triggered because “[s]uch a possibility is precisely what the required disclosures under Item 303 aim to avoid.” (Blackstone ultimately had to write down $122 million of its $331 investment in FGIC.) The court concluded that these disclosure violations by the company “masked a reasonably likely change in earnings, as well as a trend, event or uncertainty that was likely to cause such a change.” With respect to Blackstone’s real-estate investments, the Second Circuit found that they were equally material and thus triggered a disclosure obligation under Item 303:

A reasonable Blackstone investor may well have wanted to know of any potentially adverse trends concerning a segment that constituted nearly a quarter of Blackstone’s total assets under management. Second, the alleged misstatements and omissions regarding real estate were qualitatively material because they masked a potential change in earnings or other trends.

Id. at 721.

In emphasizing that such trends and uncertainties constituted “information [Blackstone] had a duty to report,” the Second Circuit explained that the district court had erred in dismissing the plaintiffs’ claim on the ground that the complaint did not identify specific real-estate investments at risk. Rather, the court stated that the pleading burden under Federal Rule of Civil Procedure 8 was “minimal,” and that the plaintiffs had satisfied this burden by pleading that Blackstone “failed to disclose the manner in which [its] unidentified, particular investments might be materially affected by the then-existing downward trend in housing prices, the increasing default rates for subprime mortgage loans, and the pending problems for complex mortgage securities.”

Panther Partners
A year later, the Second Circuit relied on Blackstone to revive a ’33 Act claim based on the “known uncertainties” prong of Item 303 in Panther Partners v. Ikanos Communications, Inc., ___ F.3d ___, 2012 WL 1889622 (2d Cir. May 25, 2012). The Panther Partners case arose out of the rising rate of defects in Ikanos’s semiconductor chips, of which the plaintiffs alleged, management and the board of directors were aware in the days leading up to the company’s $120 million secondary offering in 2006.

U.S. District Judge Paul A. Crotty of the Southern District of New York dismissed the action, finding that the allegations did not support an inference that the company was aware of, or should have been aware of, the extent of the chip defects prior to the offering. In particular, the district court found that the pleading “failed to allege ‘additional facts that Ikanos knew the defect rate was above average before filing the registration statement.’”

On appeal, the Second Circuit reversed and remanded. As a threshold matter, the court reiterated the minimal pleading standard for the plaintiffs’ ’33 Act claims, stating that “[n]either scienter, reliance, nor loss causation is an element of § 11 or § 12(a)(2) claims which—unless they are premised on allegations of fraud—need not satisfy the heightened particularity requirements of Rule 9(b) of the Federal Rules of Civil Procedure.” The court then addressed the proper inquiry for a claim premised on a violation of Item 303. Essentially, the court concluded that the relevant inquiry under Item 303, as applied to this case, was not the defendants’ knowledge of the statistical degree of the defect rate, but rather their awareness of the uncertainties surrounding the defect problem’s impact on revenues. As stated by the court:

We believe that, viewed in the context of Item 303’s disclosure obligations, the defect rate, in a vacuum, is not what is at issue. Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.

2012 WL 1889622 at *5.

The Second Circuit concluded that the complaint “plausibly alleges that the defect issue, and its potential impact on Ikanos’s business, constituted a known trend or uncertainty that Ikanos reasonably expected would have a material unfavorable impact on revenues or income from continuing operations.” The court found that two allegations in particular were adequate to sustain the claim: (i) Ikanos had received an increasing number of calls from its two largest customers, Sumitomo Electric and NEC, which accounted for 72 percent of Ikanos’s revenues in the year prior to the offering, informing the company that its chips were resulting in network failures, and (ii) Ikanos’s board of directors had been aware of the increasing number of complaints about the defective chips. As the Second Circuit explained, the complaint “articulates the plausible inference to be drawn from these facts: that Ikanos ‘knew that . . . the chips that it had sold to . . . its largest customers and the largest source of its revenues[ ] were defective, . . . and that it [may] therefore have to accept returns of all of the chips that it had sold to these two important customers.’”

The Second Circuit found that, “[i]n focusing on whether the plaintiff alleged that Ikanos knew the defect rate was ‘above average’ before the offering,” the district court construed the complaint “too narrowly.” Citing the U.S. Supreme Court’s 2011 decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), which rejected a “bright-line” statistical test for materiality, the Second Circuit emphasized that “Item 303’s disclosure obligations, like materiality under the federal securities laws’ anti-fraud provisions, do not turn on restrictive mechanical or quantitative inquiries.” The court reasoned that, regardless of whether the defect rate was “above average” across the board, “the defect rate was, in essence, 100% for all chips sold to clients representing 72% of revenues,” and that such “circumstances were not simply ‘potentially problematic’ for the Company; they were very bad.” Id. at *7 (emphasis added). Accordingly, the court found little difficulty concluding that Panther had adequately alleged that “the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303.”

Conclusion
The Second Circuit’s decisions in Blackstone and Panther Partners signal a notable expansion of liability to private claimants under Item 303 of SEC Regulation S-K, a development that one would expect to influence the disclosure decisions made by SEC registrants, particularly those numerous companies doing business in the Southern District of New York. These recent decisions illuminate how, when pled under the ’33 Act, which requires no showing of scienter, reliance, or loss causation, a claim premised on Item 303’s disclosure requirements can be difficult to challenge at the pleading stage. Whether the courts permit plaintiffs to allege Item 303 violations as grounds for fraud claims under the Exchange Act remains to be seen.

Keywords: securities litigation, Blackstone, Panther Partners, disclosure, 1933 Securities Act

Matthew L. Mustokoff is a partner at Kessler Topaz Meltzer & Check LLP in Radnor, Pennsylvania. He currently serves as cochair of the ABA Section of Litigation's Subcommittee on Securities Class Actions and Derivative Suits.