Supreme Court Rejects Securities Lawsuit Based On “Pure Omission” From SEC Filings

In a narrow but potentially significant decision, the Supreme Court has held that securities-fraud plaintiffs cannot recover based on a “pure omission” from a company’s public statements under the most common legal basis for private securities lawsuits, the SEC’s Rule 10b-5(b).  The Court’s unanimous April 12 decision in Macquarie Infrastructure Corp. v. Moab Partners L.P. wipes out precedent from the Second Circuit that potentially made any omission from the “Management’s Discussion & Analysis” (MD&A) section of periodic reports filed under the federal securities laws actionable.

The Court emphasized that misleading half-truths are still actionable under Rule 10b-5(b); existing law requires public companies to disclose facts that are necessary to keep their statements from being materially misleading.  But as the case was presented to the Court, there was no misleading statement in the company’s 10-Ks or 10-Qs—just the omission from MD&A.  The Court did not rule out other possible theories that could conceivably make even a pure omission actionable, but the decision does eliminate the broad theory of failure-to-disclose liability that had posed a threat to any company that could be sued within the Second Circuit.

Background

Public companies’ periodic reports and registration statements must include or incorporate by reference a “Management’s Discussion & Analysis of Financial Condition and Results of Operations,” or “MD&A” section.  Item 303 of the SEC’s Regulation S-K contains the disclosure requirements for MD&A.

MD&A is required to “[d]escribe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations,” among other disclosures.  Item 303(b)(2)(ii).  In its most recent amendment to this requirement, the SEC stated that this discussion and analysis “is expected to better allow investors to view the [company] from management’s perspective.” Its standard for disclosure of known trends and uncertainties—“reasonably likely to have a material impact”—differs from the materiality standard generally applicable in private securities litigation.  As amended in 2021, Item 303(a) provides that “[t]he discussion and analysis must focus specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”  And that likelihood is based on “management’s assessment,” rather than what a court might think.  See Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information, 86 Fed. Reg. 2080, 2094 (Jan. 11, 2021) (quoting Item 303(a)).

The Macquarie case raised the question whether a public company could be liable for damages for securities fraud, under Section 10(b) of the Securities Exchange Act and Rule 10b-5(b) thereunder, when (the plaintiffs alleged) the company completely omitted an issue from its MD&A that it should have included.  The company owned storage terminals that stored, among other things, a type of liquid fuel oil with high sulfur content.  The International Maritime Organization adopted a regulation that would, when it took effect, cap the sulfur content of fuel oil used in shipping.  About two years later, the company experienced a drop in its stock price, after it announced that a structural decline in demand for the higher-sulfur fuel oil had contributed to lower demand for storage.  The plaintiffs alleged that the company should have discussed the regulation in its MD&A well before that announcement.

The Second Circuit had decided in 2015 that Item 303 gives rise to a duty to disclose, and 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.”  Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 100 (2d Cir. 2015).  That created a split between federal courts of appeals, and relatively soon after the Second Circuit decision, the Supreme Court agreed to take up the issue in a case called Leidos, Inc. v. Indiana Public Retirement System.  That case settled after the Supreme Court granted certiorari, however, and the circuit conflict remained unresolved.

A number of plaintiffs filed suit against Macquarie Infrastructure Corporation in federal court in New York.  The district court dismissed their suit, but the Second Circuit vacated the dismissal.  Citing Stratte-McClure, the Second Circuit held that the plaintiffs had identified a “known trend or uncertainty” that the company should have disclosed in its MD&A, but did not.

The Supreme Court granted certiorari once again.  Significantly, the company phrased the question it asked the Supreme Court to decide in a very specific way: whether “a failure to make a disclosure required under Item 303 can support a private claim under Section 10(b), even in the absence of an otherwise-misleading statement.”

Both the plaintiffs and the federal government (which filed a brief supporting the plaintiffs) argued in the Supreme Court that an omission from MD&A is actionable because it renders the remainder of the disclosure misleading.  The plaintiffs also argued that this case did involve specific statements that were misleading in light of the claimed omission from MD&A.

The Supreme Court’s Decision

In a unanimous opinion authored by Justice Sonia Sotomayor, the Supreme Court vacated the Second Circuit’s decision and remanded.  It held that a “pure omission” is not actionable as fraud under the SEC’s Rule 10b-5(b).  Rather, a plaintiff proceeding under that rule must identify “statements made” by the company that the omission rendered misleading.  The focus of the rule is fraud, not disclosure.

As the Court explained, “A pure omission occurs when a speaker says nothing, in circumstances that do not give any particular meaning to that silence.”  By contrast, a half-truth occurs when a speaker says something, but “state[s] the truth only so far as it goes, while omitting critical qualifying information.”  Omissions that cause the speaker to state a misleading half-truth are not “pure omissions.”

Rule 10b-5(b) prohibits half-truths but not pure omissions, the Court held.  The text of the rule prohibits omitting information from a public disclosure that is “necessary in order to make the statements made … not misleading.”  Liability under that provision turns on there being “statements made” that were misleading.  While other provisions of the securities laws prohibit pure omissions (the Court specifically cited Section 11 of the Securities Act of 1933, which governs registration statements), neither Rule 10b-5(b) nor the underlying statute, Section 10(b), contains such an express prohibition.

The Court stated that just because a particular disclosure is legally required does not mean that failure to make it necessarily makes the company’s disclosures as a whole misleading.  For example, the plaintiffs and the government had argued that because Item 303 requires disclosure of “any” known trends or uncertainties, the reader expects the company’s MD&A to be complete and any omission makes the remainder of the MD&A misleading.  The Court rejected that argument, because it would negate the “statements made” language in the statutory text.  At least under Rule 10b-5(b), pure omissions are not actionable as fraud.

The Court noted, however, that “private parties remain free to bring claims based on Item 303 violations that create misleading half-truths,” meaning actual “statements made” that become misleading because of an omission.  The plaintiffs disputed that the case against Macquarie involved only pure omissions.  But as the Court pointed out, the question it had agreed to decide presumed that the Second Circuit allowed for liability “even in the absence of an otherwise-misleading statement.”  The Court did not allow the plaintiffs to fight the premise of the question at this stage.

What the Supreme Court Left Open

The government had heavily emphasized other provisions of Rule 10b-5, i.e., subsections (a) and (c).  These separate subsections prohibit “any device, scheme, or artifice to defraud,” and “any act, practice, or course of business which operates or would operate as a fraud.”  The government argued that these terms are very broad and that a pure omission could result in liability under these subsections of Rule 10b-5.  In a footnote, the Supreme Court declined to consider that argument, as it had not been litigated in the lower courts.  Plaintiffs forced to litigate a pure-omission theory might seize upon the Supreme Court’s footnote to salvage this theory, but as yet there is no appellate authority validating it.  And liability under subsections (a) and (c) may be more difficult for plaintiffs to establish:  both require proof of a scheme to engage in “fraud” or “deceit,” whereas subsection (b) is more commonly litigated because it requires only a public statement that is “untrue” or “misleading.”

The Court also made clear that it was not opining on other issues not presented to it, such as “what constitutes ‘statements made’” and “when a statement is misleading as a half-truth.”  Companies defending against private securities litigation will want to resist attempts to negate the Supreme Court’s holding by redefining the word “statements” to include implications, readers’ perceptions, or other ways to look beyond what the company actually says in a disclosure.

Finally, the Court cautioned that the SEC itself has ways of requiring companies to comply with the disclosure requirements of Item 303, which are not subject to the same limits as a private securities-fraud action.  These range from comments on a company’s periodic report to enforcement actions in administrative or judicial proceedings.

The Decision’s Impact

Allegations about omissions from MD&A disclosure under Item 303 have become common in securities complaints in recent years.  So have allegations about omissions from the “Risk Factors” disclosure under Item 105 of Regulation S-K.  The Supreme Court’s decision should halt that trend.  Going forward, a securities-fraud plaintiff making claims based on an alleged omission in a Section 10(b) case will have to identify “statements made” by the company that the omission made misleading—something that fits what the Court described as a “misleading half-truth.”  Furthermore, the decision is not limited to MD&A disclosure required by Item 303—it applies at least to all cases brought under Rule 10b-5(b).  The Supreme Court’s unanimous reminder that Section 10(b) and Rule 10b-5 target fraud, not disclosure, will also be helpful to defendants accused of making other highly technical errors in their disclosures.

That does not mean that private plaintiffs can never litigate omissions, or even MD&A omissions, however.  Registration statements (which also contain or incorporate MD&A) are governed by a different statute, Section 11 of the 1933 Act.  And as the Supreme Court noted, liability under that provision can be based on a pure omission—of “a material fact” that is either “required to be stated therein” or “necessary to make the statements therein not misleading.”  “[I]n addition to proscribing lies and half-truths,” the Court said, Section 11 “also creates liability for failure to speak on a subject at all.”

The Supreme Court’s decision also wipes out a pro-plaintiff Second Circuit precedent and thus eliminates one reason for plaintiffs to choose venues within the Second Circuit.  But it is unlikely that this will have any more than a marginal impact on the busy securities dockets of the federal courts in that circuit.

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