November 18, 2014

Ninth Circuit Court of Appeals Holds MD&A Disclosure Rules Do Not Create a Duty to Disclose Under Rule 10b-5

In upholding the district court’s dismissal of a securities fraud action against NVIDIA Corporation and other defendants, the Court of Appeals in In re:  NVIDIA Corporation Securities Litigation, 768 F.3d 1046 (9th Cir. 2014) held that the duty of disclosure under Item 303 of Regulation S-K is not actionable under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  The decision sensibly avoids turning the MD&A section of periodic reports into a back door for plaintiffs’ firms to bring Rule 10b-5 actions.

Plaintiff shareholders claimed that NVIDIA knew it would be liable for the defective products long before the 2008 disclosure, and should have informed investors several months before it did.  Plaintiffs claimed that NVIDIA’s failure to inform investors, in light of other statements regarding its financial condition in NVIDIA’s SEC filings, constituted a violation of Section 10(b) and Rule 10b-5.  The district court dismissed plaintiffs’ amended complaint, holding it failed to sufficiently plead scienter.  Among their arguments on appeal, plaintiffs claimed that the district court erred in failing to consider their allegations of scienter in the context of Item 303 of Regulation S-K.  Plaintiffs claimed that Item 303 requires disclosure of certain information, and if that information is material, failure to disclose it constitutes a material omission for purposes of Section 10(b) and Rule 10b-5.  Plaintiffs claimed that an analysis should be undertaken to determine whether the defendants acted with scienter in violating Item 303’s disclosure requirements.

In considering plaintiffs’ claims, the appellate court first set forth the following six elements for establishing a violation of either Section 10(b) or Rule 10b-5:  (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.  Pursuant to the Private Securities Litigation Reform Act of 1995 (the PSLRA), a complaint must plead both falsity and scienter with particularity.

In addressing the material misstatement or omission requirement, the appellate court noted that neither Section 10(b) nor Rule 10b-5 creates an affirmative duty to disclose all material information.  The appellate court cited the rule in Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988) that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.” However, the appellate court noted, the Basic court did not explain what would give rise to a duty to disclose.  The appellate court noted that while it was an issue of first impression in the Ninth Circuit, precedent strongly suggested that Item 303 does not create such a duty to disclose.  The appellate court then referenced with approval the reasoning in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), where the court in that case explained that Item 303’s disclosure standard is very different from the materiality test set forth in Basic.

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.” According to SEC interpretive guidance, determining whether disclosure is required under Item 303 entails a two-part test.  If the known trend, demand, commitment, event or uncertainty is not reasonably likely to occur, no disclosure is required.  If management cannot make the determination, an evaluation is required of the consequences if it comes to fruition.  Disclosure is required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.  The In re NVIDIA appellate court contrasted that test with the test regarding the materiality of forward-looking information set forth in Basic, which depends “upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” The appellate court noted that management’s duty to disclose under Item 303 is much broader than the duty to disclose under Basic.  Thus, “because the materiality standards for Rule 10b-5 and Item 303 differ significantly, the demonstration of 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.” In upholding the district court’s failure to consider plaintiffs’ allegations of scienter in the context of Item 303, the appellate court held that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.  Such a duty to disclose must be separately shown according to the principles set forth by the Supreme Court in Basic and Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).”

The plaintiffs in In re NVIDIA tried to use the MD&A disclosure rules as a tool to help them avoid dismissal.  The decision will be welcomed by issuers and securities lawyers responsible for drafting those sections of periodic reports.  Note that the decision does not address other potential duties to disclose.  For example, in reaching its decision, the court distinguished actions brought under Sections 11 and 12(a)(2) of the Securities Act of 1933, where liability arises from “an omission in contravention of an affirmative legal disclosure obligation,” as compared to Section 10(b), where disclosure is not required unless omission of the information “would cause other information that is disclosed to be misleading.”  The decision does not address the potential duty to update statements made in press releases or otherwise outside the context of Item 303.  Issuers and their counsel should therefore continue to be vigilant of their duty to provide materially complete disclosure in their SEC filings and other public disclosure documents.


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