Unveiling Management's Crystal Ball

• Author: Eric R. Harper
• Pages: 879-912

Unveiling Management’s Crystal Ball INTRODUCTION 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 Circuits—the two United States circuit courts hearing the most securities fraud cases—have 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 requirements 5 —the 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 /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-a-section-10b-claim/ [https://perma.cc/K88R-DGPK]. 4. Compare In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1054–55 (9th Cir. 2014), cert. denied, 135 S. Ct. 2349 (2015), with Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 103–04 (2d Cir. 2015). 5. For a detailed explanation of Item 303’s reporting requirements see infra Part I.E. 880 LOUISIANA LAW REVIEW [Vol. 77 significant public disclosures focusing on current operations and management’s plans for the future 6 —“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 issue. 11 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 6. 2 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES 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. § 229.303. 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 markets. 14 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 Stanley 21 —making 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 Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477–78 (1977)). 14. See Joan MacLeod Heminway, Materiality Guidance 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 deception 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.A–E. 17. See infra Part II.A–B. 18. See infra Part II.A–B. 19. See infra Part III.A–B. 20. See infra Part IV.A–C. 21. The Second Circuit interpreted Item 303 as creating a disclosure duty. Stratte-McClure, 776 F.3d 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. 882 LOUISIANA LAW REVIEW [Vol. 77 under Section 10(b) and Rule 10b-5 due to a material omission of Item 303 forward-looking information. 22 I. PEEKING INTO MANAGEMENT’S CRYSTAL BALL Rooted in the Exchange Act, 23 and, more specifically, promulgated by the SEC under Section 10(b), 24 Rule 10b-5 25 is designed to protect private investors and deter issuers of securities from engaging in fraudulent conduct. 26 Until 1980, when Regulation S-K was enacted, there were no means to satisfy the Exchange Act’s disclosure requirements in an integrated manner. 27 Regulation S-K is a securities regulatory scheme that was designed to satisfy the filing requirements under the Securities Act 28 and the Exchange Act. 29 Particularly, Item 303 mandates that a company must file certain information with the SEC, including known trends and uncertainties relating to liquidity, capital resources, and results of operations. 30 Although the United States Supreme Court has proclaimed a basic rule for materiality, 31 the lower courts are split as to its application to a securities fraud lawsuit relating to a material omission of forward-looking information. 32 22. See infra Part V. 23. Securities Exchange Act of 1934, 15 U.S.C. §§ 78a–78nn (2012). 24. Id. § 78j. 25. 17 C.F.R § 240.10b-5 (2016). 26. See Sargent v. Genesco, Inc., 492 F.2d 750, 760 (5th Cir. 1974) (“The basic intent of . . . [R]ule 10b-5 . . . is to protect investors and instill confidence in the securities markets by penalizing unfair dealings.”). 27. See Amendments to Annual Report Form, Related Forms, Rules, Regulations, and Guides; Integration of Securities Acts Disclosure Systems, Exchange Act Release No. 33–6231, 45 Fed. Reg. 63,630 (Sept. 2, 1980)...