For Now, No Clarity On Item 303 Disclosure Liability: What’s Next?
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Item 303 of SEC Regulation S-K requires registrants to disclose “any known trends . . . events or uncertainties . . . that will result in . . . the registrant’s liquidity increasing or decreasing in any material way[.]” The purpose of Item 303 is to require disclosure of company management’s discussion and analysis of information that may be important to an investor’s understanding of the company’s earnings, current financial position and outlook for the future. These disclosures are often quite lengthy and cover a wide range of subject matters relevant to a company’s financial condition, and should include disclosures of potential threats to a company’s business, operational results, and financial condition.
Failure to make the disclosures required by Item 303 can result in SEC enforcement proceedings. Until recently, however, there was no appellate authority suggesting that Item 303 could give rise to a private right of action by investors for Item 303 violations.
The landscape changed last year, when the U.S. Court of Appeals for the Second Circuit held that investors have a private right of action under Section 10(b) of the Exchange Act and SEC Rule 10b-5 when a company fails to make a disclosure required by Item 303. See Indiana Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016). In other words, in the Second Circuit’s view, Item 303 creates an actionable duty to disclose.
The Second Circuit’s holding is in direct conflict with holdings from the Third and Ninth Circuits, which have rejected the argument that Item 303 imposes a duty to disclose that can give rise to a private right of action for securities fraud. See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1064 (9th Cir. 2014); Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). Notably, the Third Circuit’s opinion in Oran was authored by now-Justice Samuel Alito when he was a court of appeals judge. Judges in the Sixth and Eleventh Circuits, while not reaching the ultimate question, have also expressed skepticism that there is any basis for a private right of action to enforce Item 303. See Thompson v. RelationServe Media, Inc., 610 F.3d 628, 682 n.78 (11th Cir. 2010) (Tjoflat, J., concurring in part and dissenting in part); In re Sofamor Danek Grp., Inc., 123 F.3d 394, 403 (6th Cir. 1997).
The Supreme Court granted certiorari to resolve the split created by the Second Circuit, and scheduled argument in the case for November 6, 2017. The argument, however, was cancelled, and the case is being held in abeyance while the parties seek court approval of a settlement. Assuming the settlement is approved, it will result in a continuing circuit split that may only deepen as new cases are filed in circuits that have not yet taken a position on this issue. Certainly, investors will continue to file Item 303 litigation in the Second Circuit.
Shareholder activism is already prevalent in the United States and continues to increase. Activist investors generally attempt to encourage changes in a company’s management, policies, practices or social responsibilities (e.g., climate change initiatives). Failure to make required disclosures around trends that may materially impact a registrant could lead to exposure to activist shareholder litigation on a number of fronts, including:
- Cyber security: The SEC has made clear that enforcing against registrants who fail to take appropriate steps to safeguard information is a priority. (See a recent speech on the subject by the Co-Director of the SEC’s Division of Enforcement here.) In particular, SEC enforcers have “reminded registrants that material information regarding cyber risk may be required in connection with disclosures mandated by the Commission’s rules regarding Management Discussion and Analysis, as well as other items, such as Risk Factor Disclosures.” Companies who fail to disclose cyber security-related risks may face shareholder-initiated securities fraud litigation for their silence if and when such risks materialize.
- Climate change: Investors, and particularly activist shareholders, will expect disclosures relating to the reputational and financial risks a company faces as a result of climate change. An Australian-law based shareholder litigation was recently filed in Australia against a bank for failure to make climate change-related disclosures stemming from the bank’s plan to provide funding to a coal mine project. The shareholders dropped the suit after the bank made changes to its annual report. (See reporting on the matter here.)
- Technological disruption: Investors may also expect companies to make disclosures when management sees technological trends that may devalue company products and threaten the company’s bottom line.
Until the Supreme Court once again has the opportunity to address the division among the federal appellate courts on this issue, registrants will face Item 303 failure to disclose litigation by investors in the Second Circuit and any other circuit that follows the Second Circuit’s lead. Given the slow pace of U.S. securities litigation, it may be many years before a new case presenting this issue makes its way to Supreme Court.
This blog post was written with assistance from Justin Ormand, an associate in Allen & Overy's New York litigation group.