Securities Regulation Daily Does Item 303 create an independent duty to disclose under Section 10(b)?
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Wednesday, November 2, 2016

Does Item 303 create an independent duty to disclose under Section 10(b)?

By Rodney F. Tonkovic, J.D.

A petition for certiorari has been filed asking whether Item 303 of Regulation S-K creates an actionable duty to disclose under the antifraud provisions of the Exchange Act. The petitioners argue that in so holding, the Second Circuit is in direct conflict with decisions of the Third and Ninth circuits holding that Item 303 creates no independent duty to disclose (Leidos, Inc. v. Indiana Public Retirement System, October 31, 2016).

CityTime. In 2000, the petitioner, known at the time as SAIC, Inc., became the prime government contractor on a project with New York City to develop and implement CityTime, an automated timekeeping program for employees of various city agencies. While the project was underway, two SAIC employees formulated a scheme under which a subcontractor paid the employees kickbacks for each hour it billed to the project, resulting in overcharges. The employees went to great lengths to keep the scheme a secret, including threatening other employees, and SAIC and its management was unaware of the improper activity until the scheme was uncovered by government investigators in December 2010. SAIC eventually entered into a deferred prosecution agreement in which it agreed to pay over $500 million in fines and forfeitures and accepted responsibility for the employees' conduct.

In 2012, investors filed this lawsuit alleging that SAIC's statements, including SEC filings, contained false statements and omissions about potential liability related to CityTime. The district court dismissed the complaint for failure to state a claim.

Actual knowledge. On appeal, the Second Circuit for the first time specifically held that the plain language of Item 303 requires actual knowledge of the relevant trend or uncertainty. It is not enough, the court said, that a registrant should have known of the existing trend, event, or uncertainty. The court went on to find that the complaint supported a strong inference that SAIC actually knew about the CityTime fraud, and that it could be implicated in the fraud, before filing its Form 10-K. Moreover, Exposure of the fraud also jeopardized SAIC's existing or future relationships with other governmental entities that accounted for a significant amount of its revenue. Under these circumstances, the court said, SAIC was required under Item 303 to disclose the expectation of a material impact to its future revenues.

Circuit Split. The petition argues that the Second Circuit's holding entrenches a deep circuit split. According to the Second Circuit, the petition explains, a duty to disclose under Section 10(b) can derive from statutes or regulations obliging a party to speak, including Item 303, even if those omissions do not make any affirmative statements misleading. This holding is in direct conflict with Third and Ninth circuit decisions holding that Item 303 does not create an independent duty to disclose for purposes of Section 10(b). The Second Circuit's position is also at odds with views expressed within the Sixth and Eleventh circuits, the petition adds, and this inconsistency is already fueling forum shopping in Section 10(b) litigation.

The petition also urges the court to take the opportunity to clarify the scope of the duty to disclose under Section 10(b). The Court has stated that Section 10(b) and rule 10b-5 do not create an affirmative duty to disclose any and all material information, the petition notes. Since 1934, the Court has recognized only two situations giving rise to an affirmative duty to disclose: in the context of insider trading and when necessary to make earlier statements not misleading. The Second Circuit's holding, the petition contends, undermines and conflicts with the Court's decisions cautioning against judicial expansion of Section 10(b) liability. Left undisturbed, the petition concludes, the Second Circuit's holding could expose issuers to massive liability for omitting information that might later be found to be a trend or uncertainty under Item 303.

The petition is No. 16-581.

Attorneys: Andrew S. Tulumello (Gibson Dunn & Crutcher LLP) for Leidos, Inc. f/k/a SAIC, Inc. Douglas S. Wilens (Robbins Geller Rudman & Dowd LLP) for Indiana Public Retirement System, Indiana State Teachers' Retirement Fund and Indiana Public Employees' Retirement Fund.

Companies: Leidos, Inc. f/k/a SAIC, Inc; Indiana Public Retirement System; Indiana State Teachers' Retirement Fund; Indiana Public Employees' Retirement Fund

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