(Article from Securities Law Alert, October 2014)
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On October 2, 2014, the Ninth Circuit held that “Item 303 [of Regulation S-K] does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” In re NVIDIA Corp. Sec. Litig., 2014 WL 4922264 (9th Cir. 2014) (O’Connell, J.).
Background
NVIDIA Corporation is a publicly traded company that manufactures semiconductors. In the spring of 2008, NVIDIA disclosed certain product defects. Plaintiffs later brought suit under Section 10(b) and Rule 10b-5 alleging that “NVIDIA should have informed investors about the defects as early as November 2007.” According to plaintiffs, “NVIDIA’s intervening statements regarding its financial condition were misleading to investors.”
On October 12, 2011, the Northern District of California dismissed the complaint without leave to amend for failure to plead scienter. Plaintiffs appealed. Among other arguments, plaintiffs asserted that “the district court [had] erred by failing to consider their allegations of scienter in the context of Item 303 of Regulation S-K.” Item 303 of Regulation S-K sets forth the disclosure requirements for the Management’s Discussion and Analysis (MD&A) section of a public company’s SEC filings. In relevant part, Item 303 states that a public company must “[d]escribe 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.” 17 C.F.R. § 229.303(a)(3)(ii). Plaintiffs contended that a failure to comply with “the disclosure duty under Item 303 of Regulation S-K … is actionable under Section 10(b) and Rule 10b-5.”
Ninth Circuit Finds Item 303’s Disclosure Requirement Much Broader Than the Duty to Disclose Under Section 10(b) and Rule 10b-5
On appeal, the Ninth Circuit explained that it has “never directly decided whether Item 303’s disclosure duty is actionable under Section 10(b) and Rule 10b-5.” Addressing the issue squarely for the first time, the court determined that a failure to comply with the disclosure requirements of Item 303 of Regulation S-K does not give rise to a cause of action under of Section 10(b) and Rule 10b-5.
The Ninth Circuit began its analysis by noting that “neither Section 10(b) nor Rule 10b-5 ‘create[s] an affirmative duty to disclose any and all material information.’” NVIDIA, 2014 WL 4922264 (quoting Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011)). Rather, “[d]isclosure is required under these provisions only when necessary ‘to make … statements made, in the … light of the circumstances under which they were made, not misleading.’” Id. The court emphasized that “‘[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.’” NVIDIA, 2014 WL 4922264 (quoting Basic Inc. v. Levinson, 485 U.S. 224 (1988)).
The Ninth Circuit rejected plaintiffs’ contention that Item 303 of Regulation S-K “creates a ‘duty to disclose’” within the meaning of the Supreme Court’s decision in Basic. In so holding, the Ninth Circuit found persuasive the Third Circuit’s reasoning in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). There, the Third Circuit “explained that Item 303’s disclosure requirement ‘varies considerably from the general test for securities fraud materiality set out by the Supreme Court in Basic.’” NVIDIA, 2014 WL 4922264 (quoting Oran, 226 F.3d 275). The Third Circuit therefore determined that “‘a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.’” Id.
Concurring with the Third Circuit, the Ninth Circuit found that “[m]anagement’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic.” The Basic test for the materiality of forward-looking information balances “the indicated probability that the event will occur” against “the anticipated magnitude of the event in light of the totality of the company activity.” Basic, 485 U.S. 224. In contrast, Item 303 requires disclosure of “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.” 17 C.F.R. § 229.303(a)(3)(ii). Notably, the SEC has explicitly stated that Basic’s “probability/magnitude test for materiality … is inapposite to Item 303 disclosure,” which “specifies its own standard for disclosure — i.e., reasonably likely to have a material effect.” Exchange Act Release No. 34-26831, 54 Fed. Reg. 22427 (May 24, 1989). The Ninth Circuit determined that “[t]he SEC’s effort to distinguish Basic’s materiality test from Item 303’s disclosure requirement provides further support for the position that … what must be disclosed under Item 303 is not necessarily required under the standard in Basic.” NVIDIA, 2014 WL 4922264.
The Ninth Circuit found “unavailing” plaintiffs’ reliance on Litwin v. Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011) and Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012). In both cases, the Second Circuit found that plaintiffs had stated a claim under Sections 11 and 12(a)(2) of the Securities Act of 1933 based on defendants’ alleged failure to comply with Item 303’s disclosure requirements. The Ninth Circuit explained that “Section 10(b) of the Exchange Act … differs significantly from Sections 11 and 12(a) (2) of the Securities Act.” NVIDIA, 2014 WL 4922264. “Liability under Sections 11 and 12(a)(2) of the Securities Act may arise from ‘omitt[ing] to state a material fact required to be stated.’” NVIDIA, 2014 WL 4922264 (citing 15 U.S.C. §§ 77k(a), 77l(b)). While a claim under Section 11 or 12(a)(2) can stem from “an omission in contravention of an affirmative legal disclosure obligation,” the Ninth Circuit emphasized that “[t]here is no such requirement under Section 10(b) or Rule 10b-5.” Moreover, “scienter is not an element of either a Section 11 or Section 12(a)(2) claim” and “[s]uch claims are not subject to the [Private Securities Litigation Reform Act’s] heightened pleading standards unless based on allegations of fraud.”
The Ninth Circuit concluded that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” Rather, “[s]uch a duty to disclose must be separately shown according to the principles set forth by the Supreme Court in
Basic and
Matrixx Initiatives.” In the case before it, the Ninth Circuit found that the complaint did “not plausibly allege that [defendants] intentionally misled investors, or acted with deliberate recklessness, by not disclosing the [product defects] sooner,” and affirmed dismissal of the complaint for failure to allege scienter.
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