Unveiling Management's Crystal Ball

Author:Eric R. Harper
Unveiling Management’s Crystal Ball
Have you ever wanted to look into a crystal ball and predict the future?
Although not always accurate, most companies have the ability to look
into their “crystal ball” and make predictions for the future of the business.
Companies may disclose this forward-looking information to shareholders
or potential investors, but may also choose not to unveil the crystal ball,
considering that the predictions could have a negative impact on their
current stock prices. If a company’s investors suspect a company’s
statements were materially false or misleading, the investors may bring a
securities fraud class action lawsuit, claiming the company omitted certain
material forward-looking information that likely would have had a
negative impact on revenues and profits.1
Item 303 under the Securities Act of 1933, as amended (“Securities
Act”), the Securities Exchange Act of 1934, as amended (“Exchange
Act”), and the Energy Policy and Conservation Act of 1975, as amended
(collectively “Item 303”) requires that reporting companies disclose
information about the companies’ plans and outlooks for the future of their
businesses.2 The Second and Ninth Circuitsthe two United States circuit
courts hearing the most securities fraud caseshave interpreted the
jurisprudence differently and thus are divided on the legal consequences of
management’s failure to provide adequate forward-looking information.3
The two interpretations come from a Third Circuit opinion about whether a
material omission of Item 303 forward-looking information could be the
foundation of a Rule 10b-5 securities fraud claim.4 The Third Circuit
reasoned that a violation of Item 303’s reporting requirements5the most
Copyright 2017, by ERIC R. HARPER.
1. See Item 303, 17 C.F.R. § 229.303 (2016).
2. See id.
3. John Stigi & Madalyn Macarr, Second Circuit Notes Split with Ninth Circuit
Over Whether Failure to Make Adequate Disclosures Under Item 303 of Regulation
S-K May Serve as Basis for Section 10(b) Claim, SHEPPARDMULLIN: CORP. & SEC.
L. BLOG (Jan. 26, 2015), http://www.corporatesecuritieslawblog.com/2015/01
claim/ [https://perma.cc/K88R-DGPK].
4. Compare In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 105455 (9th
Cir. 2014), cert. denied, 135 S. Ct. 234 9 (2015), with Stratte-McClure v. Morgan
Stanley, 776 F.3d 94, 10304 (2d Cir. 2015).
5. For a detailed explanation of Item 303’s reporting requirements see infra
Part I.E.
significant public disclosures focusing on current operations and
management’s plans for the future6—“does not automatically give rise to a
material omission under Rule 10b-5” and result in related liability,7 but the
circuits have not universally accepted this reasoning.8
Some circuits, such as the Ninth Circuit, assert that Item 303 does not
create a duty to disclose for purposes of Section 10(b) under the Exchange
Act (“Section 10(b)”) and SEC Rule 10b-5 promulgated under Section
10(b) (“Rule 10b-5”).9 However, other circuits, such as the Second Circuit,
hold that a Section 10(b) claim arises when a company fails to make
required Item 303 disclosures and the “materiality” requirements as set
forth by the United States Supreme Court in Basic v. Levinson are
satisfied.10 While the United States Supreme Court had an opportunity to
resolve this conflict in 2015, it refused to grant a writ of certiorari on this
To eliminate cross-circuit disparity and provide clarity regarding
whether omitted Item 303 information is subject to a claim under Section
10(b) and Rule 10b-5, the United States Supreme Court should review the
Ninth and Second Circuits’ conflicting analyses when given the
opportunity. Further, the Supreme Court should adopt the Second Circuit’s
conclusion and hold that failure to make a mandatory Item 303 disclosure
is a material omission that can serve as the foundation for a securities fraud
claim under Section 10(b) or Rule 10b-5, because Item 303 creates a duty
to disclose material information.12 This unifying effort helps achieve the
REGULATION § 9.4[7][C], at 30 (4th ed. 2002).
7. Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000). See also 17 C.F.R. §
8. Compare NVIDIA Corp. Sec. Litig., 768 F.3d at 1056 (“[I]tem 303 does
not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.”), with
Stratte-McClure, 776 F.3d at 100 (“[A] failure to make a required Item 303
disclosure . . . is indeed an omission that can serve as the basis for a Section 10(b)
securities fraud claim.”).
9. See, e.g., NVIDIA Corp. Sec. Litig., 768 F.3d at 1056.
10. See, e.g., Stratte-McClure, 776 F.3d at 100 (citing Basic Inc. v. Levinson,
485 U.S. 224 (1988)).
11. See Petition for Writ of Certiorari at i, Cohen v. NVIDIA Corp., 135 S.
Ct. 2349 (2015) (No. 14-975) (declining to resolve “[w]hether Item 303 of
Regulation S-K forms the basis for a duty to disclose otherwise material
information for purposes of an omission actionable under § 10(b) of the Securities
Exchange Act of 1934 and Rule 10b-5 as the Second Circuit recently held in direct
conflict with the Ninth Circuit’s holding in this case”).
12. See Stratte-McClure, 776 F.3d at 101.
2017] COMMENT 881
purpose of the Exchange Act.13 Additionally, the circuits’ agreement on
the application of Item 303 in a 10b-5 class action lawsuit provides clear
guidance to the investors and helps to promote integrity in the capital
This Comment proceeds in five parts. Part I provides background
information concerning the Exchange Act and Rule 10b-5, including the
Court’s interpretation of materiality in Basic Inc. v. Levinson,15 and Item
303.16 Part II explains the evolution of the approach adopted by the
Securities and Exchange Commission (“SEC”) regarding the disclosure of
forward-looking information.17 This Part focuses primarily on the SEC’s
1989 interpretative release, which illustrated the SEC’s modern approach
to Item 303 disclosures, demonstrating that the modern approach should
not be used as a rationale for preventing private securities fraud causes of
action.18 Part III describes the differences between a private cause of action
for securities fraud under Rule 10b-5 and the cease-and-desist powers of
the SEC, including the benefits of both, demonstrating that the SEC’s
powers are an ineffective deterrent to securities fraud.19 Part IV describes
the various approaches courts have taken to Item 303, focusing on three
recent holdings from the Second, Third, and Ninth Circuits.20 Finally, Part
V proposes that the Supreme Court adopt the findings in Stratte-McClure
v. Morgan Stanley21making a party liable for federal securities fraud
13. The United States Supreme Court has repeatedly stated that the purpose
of the Exchange Act is to implement a “philosophy of full disclosure.” Basic Inc.
v. Levinson, 485 U.S. 224, 230 (1988) (quoting San ta Fe Indus., Inc. v. Green,
430 U.S. 462, 47778 (1977)).
14. See Joan MacLeod Heminway, Materia lity Guida nce in the Context of
Insider Trading: A Call for Action, 52 AM. U. L. REV. 1131, 1169 (2003) (“Section
10(b) and Rule 10b-5 were designed to protect investors and promote the integrity
of our securities markets by preventing fraud, manipulation, and decep tion in
connection with the purchase or sale of a security.”).
15. The United States Supreme Court also analyzed the reliance factor of a
10b-5 class action lawsuit, proclaiming a presumption of reliance, but only the
materiality analysis is relevant to this Comment. See Basic, 485 U.S. 224.
16. See infra Part I.AE.
17. See infra Part II.AB.
18. See infra Part II.AB.
19. See infra Part III.AB.
20. See infra Part IV.AC.
21. The Seco nd Circuit interpreted Item 303 as creating a disclosure duty.
Stratte-McClure, 776 F.3 d 94, 101 (2d Cir. 2015). Accordingly, if a class of
investors satisfies the Basic materiality standard, as well as the additional 10b-5
elements, then the class could recover damages for fraudulent material omissions
by a company. See id. at 100.

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