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In Stratte-McClure v. Morgan Stanley et al, the Second Circuit held that MD&A rules set forth in Item 303 of Regulation S-K can give rise to a Rule 10b-5 claim. In so doing, the Second Circuit split with the Ninth Circuit which drew the opposite conclusion.

Key to the understanding of the Second Circuit decision is recognition that the materiality standards in Item 303 are different from the materiality standards in Rule 10b-5.  Item 303 requires a two part assessment set forth in the rule once a trend becomes known.  On the other hand, materiality for Rule 10b-5 is based on the Supreme Court’s decision in Basic Inc. v. Levinson.

The Second Circuit held that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b‐5 if the allegedly omitted information satisfies Basic’s test for materiality. That is, a plaintiff must first allege that the defendant failed to comply with Item 303 in a 10-Q or other filing. Such a showing establishes that the defendant had a duty to disclose. A plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test, because 10b‐5 only makes unlawful an omission of “material information” that is “necessary to make . . . statements made,” . . . “not misleading.”

The Second Circuit explained the reasons why it differed from the Ninth Circuit:

  • The Ninth Circuit misinterpreted a precedent case.  The case did not foreclose a Rule 10b-5 claim based on Item 303 but only held because the materiality standards for Rule 10b‐5 and Item 303 differ significantly,” a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b‐5.
  • The Ninth Circuit also misconstrued another precedent opinion regarding the relationship between Rule 10b-5 and Section 12(a)(2) of the Securities Act.  The Second Circuit noted that Rule 10b-5 and Section 12(a)(2) are textually identical.

The facts of the case involved long and short positions in differing types of credit default swaps.  The defendants argued that they satisfied their obligations under Item 303 by disclosing the deterioration of the real estate, credit, and subprime mortgage markets, and its potential to negatively affect Morgan Stanley. The Second Circuit stated Morgan Stanley’s disclosures about market trends were generic, spread out over several different filings, and often unconnected to the company’s financial position. The Court found such “generic cautionary language” does not satisfy Item 303. The SEC has emphasized that Item 303 “requires not only a ‘discussion’ but also an ‘analysis’ of known material trends,” and that disclosure is “necessary to an understanding of a company’s performance, and the extent to which reported financial information is indicative of future results.”

The Second Circuit also noted the SEC has never gone so far as to require a company to announce its internal business strategies or to identify the particulars of its trading positions. This is in line with the Court’s reluctance to interpret the securities laws in a manner that requires companies to give competitors notice of proprietary strategies and information.

Ultimately the Second Circuit decided the District Court properly dismissed the claims as the plaintiffs did not adequately allege scienter.


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