Item 303 of Regulation S-K requires issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity. Plaintiffs often contend that if the disclosure required under Item 303 involves material information, then a company’s failure to disclose that information constitutes a material omission for purposes of securities fraud liability. In October, the Ninth Circuit rejected that position, holding that the disclosure duty created by Item 303 cannot form the basis for an actionable securities fraud claim. This week, the Second Circuit disagreed.
In Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. Jan. 12, 2015), the Second Circuit addressed claims that Morgan Stanley, in 2007, failed to disclose a negative trend in a large credit default swap position. Noting that its position is “at odds with the Ninth Circuit,” the court held that Item 303’s “affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b).” The court described it as a two-part test: (1) the “plaintiff must first allege that the defendant failed to comply with Item 303,” thereby “establish[ing] that the defendant had a duty to disclose;” and (2) the “plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test.” In addition, of course, the plaintiff must sufficiently plead the other elements of a Section 10(b) claim.
As to Morgan Stanley and its credit default swap position, the court concluded the plaintiffs had adequately alleged both that “Defendants breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market” and that the omission was material. However, the court found that the complaint was “silent about when employees realized that the more pessimistic assessments of the market were likely to come to fruition and they would be unable to reduce [the credit default swap position].” As a result, the complaint did not create a strong inference of scienter as to the Item 303-based claims.
Holding: Dismissal affirmed.