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Risk of investor claims for non-disclosure

Failure to make certain disclosures required under US securities laws can result in SEC enforcement proceedings. Until recently, however, there was no appellate authority suggesting that one particular provision, Item 303 of SEC Regulation S-K, could give rise to a private right of action by investors for Item 303 violations. This article examines recent rulings, and discusses the potential areas of non-disclosure which could lead to investor action.

What is Item 303?

Item 303 disclosures, otherwise known as Management Discussion & Analysis of Financial Condition and Results of Operation (or MD&A) disclosures, are intended to provide material, historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant’s prospects for the future. Item 303 applies to U.S. registered companies and non-U.S. financial institutions listed on a U.S. exchange.

MD&A disclosures are often quite lengthy and cover a wide range of subject matters relevant to a registrant’s financial condition. They should include disclosures of potential threats to a registrant’s business, operational results, and financial condition.

Looking into the future

Several specific provisions in Item 303 require disclosure of forward-¬≠looking information. MD&A requires discussions of “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.” Further, disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues or income from continuing operations is required. Instructions accompanying Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”

Non-disclosure – regulatory enforcement and, potentially, investor action

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 in 2016, 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 registrant fails to make a disclosure required by Item 303.1 The Second Circuit’s view is that Item 303 creates an actionable duty to disclose. The Second Circuit recently relied on this holding to reverse a district court decision granting a motion to dismiss a civil complaint by an investor alleging that Alibaba’s initial US public offering disclosures failed to disclose discussions Alibaba had with its home-Chinese regulator concerning potential counterfeiting-related fines.2 As a result of the Second Circuit’s decision, the proceedings against Alibaba will continue, and the investor plaintiff will be entitled to discovery concerning Alibaba’s meetings with its regulator and, to the extent not protected by privilege, Alibaba’s internal communications concerning the impact the potential fines might have on its business.

Mixed judicial views

The Second Circuit’s holding conflicts 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.3 Notably, the Third Circuit’s opinion in Oran v Stafford 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 scepticism that there is any basis for a private right of action to enforce Item 303.4 The Supreme Court granted certiorari to resolve the circuit 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.

Predicted areas for further shareholder activism

Shareholder activism is already prevalent in the United States and continues to increase. Activist investors generally attempt to encourage changes in a registrant’s management, policies, practices or social responsibilities (eg, 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. We predict further action in 2018 in the following areas:

Cyber security

The SEC has made clear that enforcing against registrants who fail to take appropriate steps to safeguard information is a priority. 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.”5 Registrants 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 registrant faces as a result of climate change. An Australian-law based shareholder litigation was recently filed in Australia against Commonwealth 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 the disclosures in its annual report.

Technological disruption

Investors may also expect registrants to make disclosures when management sees technological trends that may devalue registrant products or offerings and threaten the registrant’s bottom line.

Underwriting risk

For financial institutions, the possible availability of a private right of action under Item 303 also gives rise to underwriting risk. Recently, a U.S. district judge, following the Second Circuit’s holding in SAIC, denied a motion to dismiss investors’ Item 303 claims filed by underwriters for the initial public offering of a technology company providing cloud-based platforms to the healthcare industry. The technology company allegedly failed to disclose information about its customer base that had a material impact on its tax liabilities. The investor plaintiffs were allowed to proceed with Item 303-based claims against the company, its officers and directors, and its underwriters.6 As in the Alibaba case, as a result of the court’s decision to allow the case against the underwriters to proceed, the underwriters will have to provide discovery concerning their knowledge of the matters the technology company allegedly failed to disclose.

In the United States, 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.


1 See Indiana Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016).
2 Christine Asia Co. v. Ma, --- F. App’x ----. 2017 WL 6003340, at *2 (2d Cir. Dec. 5, 2017).
3 See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1064 (9th Cir. 2014); Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000).
4 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).
5 Stephanie Avakian, Co-Director, Division of Enforcement, “The SEC Enforcement Division’s Initiatives Regarding Retail Investor Protection and Cybersecurity” (Oct. 26, 2017).
6 See generally Yi Xiang v. Inovalon Holdings, Inc., 254 F. Supp. 2d 635 (S.D.N.Y. 2017).

Further information

This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch –, or tel +44 20 3088 3710.


Legal and Regulatory Risk Note
United States