In a narrow but potentially significant decision, the Supreme
Court has held that securities-fraud plaintiffs cannot recover
based on a “pure omission” from a company’s public
statements under the most common legal basis for private securities
lawsuits, the SEC’s Rule 10b-5(b). The Court’s unanimous
April 12 decision in Macquarie Infrastructure Corp. v.
Moab Partners L.P. wipes out precedent from the Second
Circuit that potentially made any omission from the
“Management’s Discussion & Analysis” (MD&A)
section of periodic reports filed under the federal securities laws
actionable.
The Court emphasized that misleading half-truths are still
actionable under Rule 10b-5(b); existing law requires public
companies to disclose facts that are necessary to keep their
statements from being materially misleading. But as the case was
presented to the Court, there was no misleading statement in the
company’s 10-Ks or 10-Qs—just the omission from MD&A.
The Court did not rule out other possible theories that could
conceivably make even a pure omission actionable, but the decision
does eliminate the broad theory of failure-to-disclose liability
that had posed a threat to any company that could be sued within
the Second Circuit.
Background
Public companies’ periodic reports and registration
statements must include or incorporate by reference a
“Management’s Discussion & Analysis of Financial
Condition and Results of Operations,” or “MD&A”
section. Item 303 of the SEC’s Regulation S-K contains the
disclosure requirements for MD&A.
MD&A is required to “[d]escribe any known trends or
uncertainties that have had or that are reasonably likely to have a
material favorable or unfavorable impact on net sales or revenues
or income from continuing operations,” among other
disclosures. Item 303(b)(2)(ii). In its most recent amendment to
this requirement, the SEC stated that this discussion and analysis
“is expected to better allow investors to view the [company]
from management’s perspective.” Its standard for
disclosure of known trends and uncertainties—”reasonably
likely to have a material impact”—differs from the
materiality standard generally applicable in private securities
litigation. As amended in 2021, Item 303(a) provides that
“[t]he discussion and analysis must focus specifically on
material events and uncertainties known to management that are
reasonably likely to cause reported financial information not to be
necessarily indicative of future operating results or of future
financial condition.” And that likelihood is based on
“management’s assessment,” rather than what a court
might think. See Management’s Discussion and Analysis, Selected
Financial Data, and Supplementary Financial Information, 86
Fed. Reg. 2080, 2094 (Jan. 11, 2021) (quoting Item 303(a)).
The Macquarie case raised the question whether a public
company could be liable for damages for securities fraud, under
Section 10(b) of the Securities Exchange Act and Rule 10b-5(b)
thereunder, when (the plaintiffs alleged) the company completely
omitted an issue from its MD&A that it should have included.
The company owned storage terminals that stored, among other
things, a type of liquid fuel oil with high sulfur content. The
International Maritime Organization adopted a regulation that
would, when it took effect, cap the sulfur content of fuel oil used
in shipping. About two years later, the company experienced a drop
in its stock price, after it announced that a structural decline in
demand for the higher-sulfur fuel oil had contributed to lower
demand for storage. The plaintiffs alleged that the company should
have discussed the regulation in its MD&A well before that
announcement.
The Second Circuit had decided in 2015 that Item 303 gives rise
to a duty to disclose, and that “a failure to make a required
Item 303 disclosure in a 10-Q filing is indeed an omission that can
serve as the basis for a Section 10(b) securities fraud
claim.” Stratte-McClure v. Morgan Stanley, 776 F.3d
94, 100 (2d Cir. 2015). That created a split between federal courts
of appeals, and relatively soon after the Second Circuit decision,
the Supreme Court agreed to take up the issue in a case called
Leidos, Inc. v. Indiana Public Retirement System. That
case settled after the Supreme Court granted certiorari, however,
and the circuit conflict remained unresolved.
A number of plaintiffs filed suit against Macquarie
Infrastructure Corporation in federal court in New York. The
district court dismissed their suit, but the Second Circuit vacated
the dismissal. Citing Stratte-McClure, the Second Circuit
held that the plaintiffs had identified a “known trend or
uncertainty” that the company should have disclosed in its
MD&A, but did not.
The Supreme Court granted certiorari once again. Significantly,
the company phrased the question it asked the Supreme Court to
decide in a very specific way: whether “a failure to make a
disclosure required under Item 303 can support a private claim
under Section 10(b), even in the absence of an
otherwise-misleading statement.”
Both the plaintiffs and the federal government (which filed a
brief supporting the plaintiffs) argued in the Supreme Court that
an omission from MD&A is actionable because it renders the
remainder of the disclosure misleading. The plaintiffs also argued
that this case did involve specific statements that were
misleading in light of the claimed omission from MD&A.
The Supreme Court’s Decision
In a unanimous opinion authored by Justice Sonia Sotomayor, the
Supreme Court vacated the Second Circuit’s decision and
remanded. It held that a “pure omission” is not
actionable as fraud under the SEC’s Rule 10b-5(b). Rather, a
plaintiff proceeding under that rule must identify “statements
made” by the company that the omission rendered misleading.
The focus of the rule is fraud, not disclosure.
As the Court explained, “A pure omission occurs when a
speaker says nothing, in circumstances that do not give any
particular meaning to that silence.” By contrast, a half-truth
occurs when a speaker says something, but “state[s] the truth
only so far as it goes, while omitting critical qualifying
information.” Omissions that cause the speaker to state a
misleading half-truth are not “pure omissions.”
Rule 10b-5(b) prohibits half-truths but not pure omissions, the
Court held. The text of the rule prohibits omitting information
from a public disclosure that is “necessary in order to make
the statements made … not misleading.” Liability under that
provision turns on there being “statements made” that
were misleading. While other provisions of the securities
laws prohibit pure omissions (the Court specifically cited Section
11 of the Securities Act of 1933, which governs registration
statements), neither Rule 10b-5(b) nor the underlying statute,
Section 10(b), contains such an express prohibition.
The Court stated that just because a particular disclosure is
legally required does not mean that failure to make it
necessarily makes the company’s disclosures as a whole
misleading. For example, the plaintiffs and the government had
argued that because Item 303 requires disclosure of
“any” known trends or uncertainties, the reader
expects the company’s MD&A to be complete and any
omission makes the remainder of the MD&A misleading. The Court
rejected that argument, because it would negate the
“statements made” language in the statutory text. At
least under Rule 10b-5(b), pure omissions are not actionable as
fraud.
The Court noted, however, that “private parties remain free
to bring claims based on Item 303 violations that create misleading
half-truths,” meaning actual “statements made” that
become misleading because of an omission. The plaintiffs disputed
that the case against Macquarie involved only pure omissions. But
as the Court pointed out, the question it had agreed to decide
presumed that the Second Circuit allowed for liability “even
in the absence of an otherwise-misleading statement.” The
Court did not allow the plaintiffs to fight the premise of the
question at this stage.
What the Supreme Court Left Open
The government had heavily emphasized other provisions of Rule
10b-5, i.e., subsections (a) and (c). These separate
subsections prohibit “any device, scheme, or artifice to
defraud,” and “any act, practice, or course of business
which operates or would operate as a fraud.” The government
argued that these terms are very broad and that a pure omission
could result in liability under these subsections of Rule 10b-5. In
a footnote, the Supreme Court declined to consider that argument,
as it had not been litigated in the lower courts. Plaintiffs forced
to litigate a pure-omission theory might seize upon the Supreme
Court’s footnote to salvage this theory, but as yet there is no
appellate authority validating it. And liability under subsections
(a) and (c) may be more difficult for plaintiffs to establish: both
require proof of a scheme to engage in “fraud” or
“deceit,” whereas subsection (b) is more commonly
litigated because it requires only a public statement that is
“untrue” or “misleading.”
The Court also made clear that it was not opining on other
issues not presented to it, such as “what constitutes
‘statements made'” and “when a statement is
misleading as a half-truth.” Companies defending against
private securities litigation will want to resist attempts to
negate the Supreme Court’s holding by redefining the word
“statements” to include implications, readers’
perceptions, or other ways to look beyond what the company actually
says in a disclosure.
Finally, the Court cautioned that the SEC itself has ways of
requiring companies to comply with the disclosure requirements of
Item 303, which are not subject to the same limits as a private
securities-fraud action. These range from comments on a
company’s periodic report to enforcement actions in
administrative or judicial proceedings.
The Decision’s Impact
Allegations about omissions from MD&A disclosure under Item
303 have become common in securities complaints in recent years. So
have allegations about omissions from the “Risk Factors”
disclosure under Item 105 of Regulation S-K. The Supreme
Court’s decision should halt that trend. Going forward, a
securities-fraud plaintiff making claims based on an alleged
omission in a Section 10(b) case will have to identify
“statements made” by the company that the omission made
misleading—something that fits what the Court described as a
“misleading half-truth.” Furthermore, the decision is not
limited to MD&A disclosure required by Item 303—it
applies at least to all cases brought under Rule 10b-5(b).
The Supreme Court’s unanimous reminder that Section 10(b) and
Rule 10b-5 target fraud, not disclosure, will also be helpful to
defendants accused of making other highly technical errors in their
disclosures.
That does not mean that private plaintiffs can never litigate
omissions, or even MD&A omissions, however. Registration
statements (which also contain or incorporate MD&A) are
governed by a different statute, Section 11 of the 1933 Act. And as
the Supreme Court noted, liability under that provision can be
based on a pure omission—of “a material fact” that
is either “required to be stated therein”
or “necessary to make the statements therein not
misleading.” “[I]n addition to proscribing lies and
half-truths,” the Court said, Section 11 “also creates
liability for failure to speak on a subject at all.”
The Supreme Court’s decision also wipes out a pro-plaintiff
Second Circuit precedent and thus eliminates one reason for
plaintiffs to choose venues within the Second Circuit. But it is
unlikely that this will have any more than a marginal impact on the
busy securities dockets of the federal courts in that circuit.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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