Supreme Court Grants Review in Securities Case About Duty to Disclose

April 3, 2017

On March 27, 2017, the Supreme Court of the United States granted a petition for a writ of certiorari filed by Gibson Dunn on behalf of its client Leidos, Inc.  In Leidos, Inc. v. Indiana Public Retirement System, No. 16-581, the Supreme Court will resolve an existing split among the Second, Third, and Ninth Circuits on an important question of federal securities law:  whether omitting information required to be disclosed under Item 303 of SEC Regulation S-K, which governs the contents of the Management’s Discussion & Analysis section of a company’s quarterly and annual reports, gives rise to a private claim for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b–5.  Stated differently:  Can the SEC’s disclosure regulations create private liability for securities fraud under Section 10(b) and Rule 10b–5?

I.     Summary

 The case concerns Leidos’ alleged failure to disclose in its 2010 annual report on Form 10-K (the "2010 Form 10-K") information related to a contract Leidos had with the City of New York.  At the time the 2010 Form 10-K was filed, there was an ongoing criminal investigation into contract irregularities; several individuals associated with the project had been indicted, although none were Leidos employees.  The 2010 Form 10-K made no mention of the contract or the investigation; at that time, no reimbursement demand had been made upon Leidos, nor had the government informed Leidos that it might seek to hold Leidos accountable for the City’s losses.  Leidos later entered into a deferred prosecution agreement with federal prosecutors.  In a follow-on securities class action, plaintiffs alleged that the 2010 Form 10-K omitted information required to be disclosed under Item 303 of Regulation S-K.  Among other things, Item 303 requires companies to "[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."  17 C.F.R. § 229.303(a)(3)(ii).  The plaintiffs alleged that Leidos should have disclosed the government investigation and its potential exposure to civil and criminal penalties.  The district court dismissed the complaint and plaintiffs appealed.      

II.     The Circuit Split

The Second Circuit agreed with plaintiffs that the complaint’s Item 303 allegations were sufficient to state a claim under Section 10(b).  The Court applied its earlier decision in Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 101 (2d Cir. 2015), which held that "Item 303’s affirmative duty to disclose . . . can serve as the basis for a securities fraud claim under Section 10(b)."  The court held that plaintiffs’ amended complaint pleaded facts sufficient to allege that Leidos "actually knew . . . that it could be implicated in the fraud and required to repay the City the revenue generated by the . . . contract," a "trend" or "uncertainty" subject to Item 303 disclosure.  Ind. Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85, 95 (2d Cir. 2016).[1]  The court therefore reversed in part and remanded to allow for the filing of the amended complaint.    

In reaching its conclusion in Stratte-McClure, the Second Circuit openly acknowledged that its holding conflicted with the Ninth Circuit’s decision in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046, 1056 (9th Cir. 2014), which expressly rejected the notion that "Item 303 . . . create[s] a duty to disclose for purposes of Section 10(b) and Rule 10b–5."  The Ninth Circuit’s NVIDIA decision rested largely on the court’s interpretation of Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000), a Third Circuit case authored by then-Judge Alito, which rejected an attempt to plead a Section 10(b) claim premised on an alleged violation of Item 303.  The Ninth Circuit was persuaded by then-Judge Alito’s reasoning that Item 303’s disclosure standards "differ[ed] significantly" from what the Supreme Court has said is required for disclosure under Section 10(b).  NVIDIA, 768 F.3d  at 1055.        

III.     Implications                         

1.  Resolution of Confusion in the Lower Courts and Elimination of Forum Shopping. 

The Supreme Court will have the opportunity to put an end to confusion in the lower courts, and clarify when you can and cannot stay silent.  The Supreme Court has recognized Section 10(b) omissions liability only in two circumstances: (1) where confidential information is used in a violation of a relationship of trust and confidence, such as a fiduciary relationship, see, e.g., Chiarella v. United States, 445 U.S. 222, 230 (1980); and (2) when disclosure is necessary to render previous statements not misleading, see, e.g., Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011).  The Court has emphasized that Section 10(b) does not create "an affirmative duty to disclose any and all material information," id. at 44, and therefore "companies can control what they have to disclose . . . by controlling what they say to the market," id. at 45.  The Second Circuit’s recent rulings–holding that Section 10(b) claims can be based merely on omissions under Item 303–flatly contradict the Supreme Court’s Section 10(b) guidance. 

Resolution of the split also may put an end to forum shopping.  Since Stratte-McClure was decided in January 2015, at least twenty-two cases alleging violations of Section 10(b) premised on alleged violations of Item 303 have been filed in the Second Circuit, compared to only a handful in other circuits.  Since the Exchange Act’s liberal venue provision subjects virtually every publicly traded company to suit in the Second Circuit, a ruling for Leidos could sharply reduce the extent to which issuers are forced to defend meritless Item 303 suits.  See 15 U.S.C. § 78aa(a).

2.  Reduction of Fraud-by-Hindsight Pleading. 

The Supreme Court’s decision in this case could curtail the ability of the plaintiffs’ bar to bring hindsight-based claims in the form of Item 303 violations.  The Private Securities Litigation Reform Act of 1995 ("PSLRA") was intended to weed out meritless fraud-by-hindsight lawsuits, in which plaintiffs’ attorneys manipulate later-revealed facts to support an inference of fraud.  According to SEC guidance, Item 303’s requirements are "intentionally general" and require management to make judgment calls as to (1) whether the known trend, demand, commitment, event or uncertainty is likely to come to fruition; and (2) whether the consequences of such trend, demand, commitment, event, or uncertainty are reasonably likely to have a material effect on the issuer’s financial condition or results of operations.  See Certain Investment Company Disclosures, Securities Act Release No. 6835, Exchange Act Release No. 26831, Investment Company Act Release No. 16961, 43 SEC Docket 1330, 1989 WL 1092885, at *6 (hereinafter "SEC Guidance").  Imposing liability on management for making difficult judgment calls which later turn out to be incorrect will permit plaintiffs to "weaponize" Item 303 and bring meritless suits over "difficult-to-foresee contingencies," which Congress intended to prohibit by enacting the PSLRA.  See SIFMA/USCC Amicus Br. at 9.

3.  Clarification of An Issuer’s Ability to Remain Silent. 

The Supreme Court’s decision will likely provide clarity as to the extent of information required to be disclosed by issuers for purposes of avoiding liability for private claims under Section 10(b).  The Court has previously expressed concern that companies will "bury the[ir] shareholders in an avalanche of trivial information[,] a result that is hardly conducive to informed decisionmaking."  Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).  The significant difference in the materiality standards between Basic and Item 303 further exacerbate this problem.  While Basic requires management to balance the probability that an event will occur with the anticipated magnitude of the event, id. at 238, Item 303 mandates disclosure of any information "reasonably likely to have a material effect," SEC Guidance at *6 n.27.  A decision in favor of Leidos will likely reaffirm that securities issuers need not over-disclose immaterial information merely to guard against later Section 10(b) liability.

* * *

Leidos, Inc. v. Indiana Public Retirement System will resolve an existing circuit split and enable the Supreme Court to clarify or reaffirm its prior statement in Matrixx that companies can control what they have to disclose by controlling what they say to the market.  The case will be set for argument in the fall of 2017 with a decision expected by June 2018.        


   [1]   Leidos was formerly known as SAIC, Inc.  In the time after this litigation was initiated, however, SAIC Inc. changed its name to Leidos, Inc. and spun off a separate, publicly traded company under its former name.   


Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  If you have any questions or would like to discuss these issues further, please feel free to contact the Gibson Dunn lawyer with whom you usually work or the Gibson Dunn lawyers representing Leidos in the Supreme Court:

Andrew S. Tulumello – Washington, D.C. (+1 202-955-8657, atulumello@gibsondunn.com)
Jason J. Mendro – Washington, D.C. (+1 202-887-3726, jmendro@gibsondunn.com)

Please also feel free to contact any of the following practice group leaders:

Appellate and Constitutional Law Group:
Mark A. Perry – Washington, D.C. (+1 202-887-3667, mperry@gibsondunn.com)
James C. Ho – Dallas (+1 214-698-3264, jho@gibsondunn.com)
Caitlin J. Halligan – New York (+1 212-351-4000, challigan@gibsondunn.com)

Securities Litigation Group:
Meryl L. Young – Orange County (+1 949-451-4229, myoung@gibsondunn.com)
Robert F. Serio – New York (+1 212-351-3917, rserio@gibsondunn.com)

Securities Regulation and Corporate Governance Group:
Elizabeth IsingWashington, D.C. (+1 202-955-8287, eising@gibsondunn.com)
James J. Moloney - Orange County, CA (+1 949-451-4343, jmoloney@gibsondunn.com)


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