In Stratte-McClure v. Morgan Stanley, No. 13-0627-cv, 2015 WL 136213 (2d Cir. Jan. 12, 2015), the United States Court of Appeals for the Second Circuit affirmed the dismissal of securities fraud claims against Morgan Stanley arising out of its exposure to and losses from a proprietary subprime mortgage trade in 2007.  In reaching its decision, the Second Circuit held that a failure to make a disclosure required by Item 303 of Regulation S-K, 17 C.F.R. § 229.303(a)(3)(ii), may serve as a basis for a securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities & Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder.  The Second Circuit recognized that its holding regarding Item 303 of Regulation S-K was directly “at odds” with the 2014 decision of the United States Court of Appeals for the Ninth Circuit in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014). Morgan Stanley establishes a circuit split between the Second and Ninth Circuits on the issue of whether failure to make adequate disclosures under Item 303 may serve as the basis for Section 10(b) claims, potentially warranting review by the United States Supreme Court.

In Morgan Stanley, plaintiffs brought a putative securities fraud class action alleging that Morgan Stanley and six of its officers and former officers made material misstatements and omissions in an effort to conceal Morgan Stanley’s exposure to and losses from a proprietary subprime mortgage trade.  Plaintiffs alleged that Morgan Stanley’s failure to disclose that subprime mortgage trade (and the risk of loss attendant thereto) in its Form 10-Q and Form 10-K filings was a violation of a disclosure requirement in Item 303, and as such, constituted an actionable omission under Section 10(b) and Rule 10b-5.  Item 303 of Regulation S-K requires companies to disclose on their quarterly filings any “known trends, or uncertainties that have had, or might reasonably be expected to have, a material favorable or unfavorable material impact” on the company’s revenue, operating income or net income.  Plaintiffs claimed that Morgan Stanley’s alleged misstatements and omissions caused them to suffer financial loss when Morgan Stanley’s stock prices dropped following public disclosure of the truth about its positions and losses.

Defendants moved to dismiss all claims.  The United States District Court for the Southern District of New York held that the alleged omission was actionable because Morgan Stanley had a duty under Item 303 to disclose the risks from the trade in its 2007 Form 10-Q filings.  The district court nevertheless dismissed plaintiffs’ claims for failure to plead facts giving rise to a strong inference of scienter with respect to Defendants’ purported failure to disclose.  Plaintiffs appealed.

The Second Circuit affirmed the dismissal of plaintiffs’ claims for failure to plead a strong inference of scienter.  The Court, however, also agreed with the district court that Morgan Stanley’s alleged failure to make a required Item 303 disclosure was an omission that, if “material” to investors as defined by Basic, Inc. v. Levinson, 485 U.S. 224 (1988), could serve as a basis for a Section 10(b) securities fraud claim.  The Court reasoned that, due to the obligatory nature of Item 303, “Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).”

The Second Circuit recognized that its decision conflicted with the Ninth Circuit’s 2014 decision inNVIDIA.  In that case, investors alleged that statements made in NVIDIA’s SEC filings were materially false and misleading because NVIDIA failed to timely disclose reported defects in its products, allegedly as required by Item 303.  The NVIDIA court held that Item 303 creates no duty to disclose for purposes of Section 10(b) and Rule 10b-5, and thus that a violation of Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b-5.  The NVIDIA Court reasoned that because the materiality standards for Rule 10b-5 and Item 303 differed significantly, a violation of Item 303 did not give rise to an inference that the registrant violated Rule 10b-5.

Both the Second and Ninth Circuits cited the Third Circuit’s decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), but came to opposite interpretations of Oran’s holding.  The Court in Oran held that violations of Item 303’s disclosure obligations did not provide the basis for Rule 10b-5 liability in that case because the omissions were not material under Basic.  The NVIDIA court relied on Oran’s suggestion that “violations of Item 303 do not automatically give rise to a material omission under Rule 10b-5” in concluding that violations of Item 303 “do not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.”  In contrast, the Morgan Stanley court interpreted this language in Oran as suggesting that in certain instances, a violation of Item 303 could give rise to an actionable Section 10(b) and Rule 10b-5 omission.

Morgan Stanley and NVIDIA represent a clear circuit split on this issue of law.  Given this split, especially between the two circuits with the most securities fraud cases, the issue of whether omitted Item 303 information can be the subject of a Section 10(b) and Rule 10b-5 claim will need to be resolved by the Supreme Court.