Sabrina M. Hendershot

A new question has arisen in the realm of securities litigation: does an alleged failure to make disclosure under Item 303 of Regulation S-K in a filing with the Securities Exchange Commission (“SEC”) give rise to a securities fraud class action under Section 10(b) of the Securities Exchange Act of 1934?  The Ninth Circuit, in its October 2014 decision in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014), held that it does not, while in January 2015, the Second Circuit, in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015), held that it could.

Item 303 of Reg. S-K, 17 C.F.R. § 229.303 requires securities issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity.  The SEC requires that this information also be disclosed in Form 10-Q and 10-K filings.  Additionally, Section 10(b) of the Exchange Act prohibits “any manipulative or deceptive device or contrivance in contravention of such rules and regulations” prescribed by the U.S. Securities and Exchange Commission. Furthermore, rule 10b–5(b) prohibits anyone from “mak[ing] any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances . . . not misleading.”

The divide on this issue dates back to a Third Circuit opinion issued by then-Judge, now Justice, Samuel Alito.  In Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), the Third Circuit dismissed securities fraud allegations against a pharmaceutical company that did not disclose studies lamenting the adverse side effects of its diet pill product.  The court held that “materiality” for the purposes of SEC disclosure regulations was different from that for shareholder fraud claims under Rule 10b–5 and held that the studies were immaterial because they only represented a speculative risk of exposure.

The shareholders in In re NVIDIA Corp. sued the corporation after it failed to disclose liability for certain manufacturing defects in its products.  The plaintiffs alleged that the company knew about the defects long before it ultimately made its disclosure and that absent a disclosure about the product defects, NVIDIA’s statements regarding its financial condition were misleading and consequently in violation of Section 10(b) of the Exchange Act and corresponding SEC Rule 10b–5.  The Ninth Circuit rejected the plaintiffs’ argument, holding that “neither Section 10(b) nor Rule 10b–5 creates an affirmative duty to disclose any and all material information.” It also noted that the materiality standards of Item 303 and Rule 10b–5 “differ considerably” meaning that these disclosure duties are independent and a violation of Item 303 “does not automatically give rise to a material omission under 10b–5.” Instead a plaintiff must independently allege a violation under that rule. This decision makes sense because with the benefit of hindsight, it is much too easy for dissident shareholders to allege that a “known trend” was material, and that the corporation’s failure to disclose was fraudulent.  Although class actions are an important component of corporate accountability, adding an additional litigation remedy to the already exhaustive list of competing interests for corporations to consider would simply become unduly burdensome.

Conversely, the Second Circuit held that failure to make a disclosure under Item 303 in a 10–Q filing could potentially serve as a basis for a 10(b) securities fraud claim.  In Stratte-McClure, shareholders of Morgan Stanley sued the company alleging that six of its officers made misleading statements to conceal the company’s exposure to and losses from the subprime mortgage market, which ultimately resulted in substantial losses.  It is encouraging to note, however, that even though the court adopted a more liberal view of what constitutes fraud, it set the standards to win such a case fairly high. The Second Circuit dismissed this case, finding that the shareholders failed to show the bank’s fraudulent intent.

The shareholders in In re NVIDIA Corp., filed a petition for review by the United States Supreme Court on February 12, 2015, citing the Second Circuit’s reasoning in Stratte-McClure.  As it stands, Delaware corporations should carefully consider whether to provide more detail in their periodic reporting documents regarding known trends that may have the potential to materially impact the company’s financial state. Although it is unknown what result will ensue at the Supreme Court, detailed disclosure will ensure compliance with SEC rules —and avoid litigation.

Sabrina Hendershot is a second-year student at Widener University School of Law and the incoming External Managing Editor of Volume 41 of the Delaware Journal of Corporate Law.  Sabrina also serves as a Judicial Intern to the Honorable Abigail LeGrow in the Delaware Court of Chancery.

Suggested Citation: Sabrina M. Hendershot, Material or Not: Can Failure to Disclose Under S-K Item 303 Give Rise to a Fraud Class Action?, Del. J. Corp. L (April 29, 2015),