Second Circuit Warns That Omission In Public Filings May Constitute Actionable Securities Fraud

While recent news has been about decisions which potentially limit liability in insider trading cases, little attention has been paid to one which potentially expands the reach of the securities fraud statutes.  In Stratte-McClure v Morgan Stanley, the Court of Appeals for the Second Circuit recently held that mere silence in a required public filing can be the basis for liability under the securities laws.

The Case Against Morgan Stanley

Plaintiffs, investors in Morgan Stanley, alleged they suffered substantial financial losses after a drop in Morgan Stanley’s stock price.  Plaintiffs alleged that the drop was the result of material misstatements and omissions made by Morgan Stanley and several of its current and former officers in late 2007 in an alleged effort by Morgan Stanley to conceal losses resulting from investments in the subprime mortgage market.  The subject of the alleged omissions was a proprietary trade Morgan Stanley had executed, consisting of a $2 billion short position to purchase credit default swaps and a $13.5 billion long position to sell them.  Because the credit default swaps in the long position were rated significantly higher than those in the short position, Morgan Stanley’s investment thesis was that its short position credit default swaps would default but that those in the long position would not.  Ultimately, Morgan Stanley suffered billions of dollars of losses as the value of its proprietary trade began to decline in 2007. 

The Second Circuit’s ruling focused on Item 303 of Regulation S-K, which requires a company to disclose “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” Plaintiffs contended that Morgan Stanley—by failing to disclose the existence of its long position credit default swaps, the nature and extent of the losses it already had sustained and its anticipated future losses—artificially inflated its stock price.

The Second Circuit’s Decision

Since the Supreme Court’s 1988 decision in Basic Inc. v. Levinson, companies have operated with the understanding that silence, absent a duty to disclose, is not considered “misleading” under U.S. securities laws.  The Second Circuit, however, concluded “as a matter of first impression … 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.”  Companies have a duty to disclose material facts in such filings, since “[d]ue to the obligatory nature of these regulations, a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties’ … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.”  The Court noted that while Morgan Stanley did not need to disclose exhaustive and complete details of its long position, it needed to disclose that “it faced deteriorating real estate, credit, and subprime mortgage markets, that it had significant exposure to those markets, and that if the trends came to fruition, the company faced trading losses that could materially affect its financial condition.”

Noting that Item 303 raises a duty to disclose, the Second Circuit also held that an omission would expose a company to liability only if it (i) were material and (ii) fulfilled the other requirements of Section 10(b) of the Securities Exchange Act of 1934.  An Item 303 omission still might not be actionable, therefore if the event is not likely to occur and/or the consequences of its occurrence would be mild or would not have a material impact on the company’s bottom line.

In addition, the Court made clear that the intent of the defendants remains a required element as in any Rule 10b-5 action.  The Court ultimately held that the claim against Morgan Stanley failed because the allegations against it did not give rise to a strong inference of scienter (that Morgan Stanley acted with the required state of mind). The scienter component of a securities fraud claim requires allegations (i) showing that the defendants had both motive and opportunity to commit the fraud, and (ii) constituting strong circumstantial evidence of conscious misbehavior or recklessness.  Plaintiffs needed to allege that Morgan Stanley was at least consciously reckless with respect to whether its 10-Q would mislead investors.  Since plaintiffs were unable to allege the requisite state of mind approximating actual intent, as opposed to merely a heightened form of negligence, the claims against Morgan Stanley were dismissed.

Impact

Although the plaintiffs’ allegations were found to be legally insufficient in Stratte-McClure, people required to make filings with the SEC are now on notice that material omissions in those filings can lead to potential liability under Section 10(b) of the Exchange Act.  Remaining silent about negative information no longer affords a safe harbor.