Securities Regulation Daily Lack of true contestability dooms interlocutory appeal on Item 303
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Friday, February 22, 2019

Lack of true contestability dooms interlocutory appeal on Item 303

By Rodney F. Tonkovic, J.D.

A court concluded that the Seventh Circuit would be likely to agree with the Second Circuit's stance that Item 303 violations may support a duty to disclose under the Exchange Act.

A district court denied a motion for interlocutory appeal after finding that the questions raised were not contestable. The court acknowledged that there is a circuit split on the issue of whether a violation of Item 303 of Regulation S-K can be used to show a violation of the antifraud provisions of the Exchange Act, but found one side of the argument to be overwhelmingly persuasive and thus not particularly contestable. There was similarly no significant conflict on the issue of the use of factual allegations from another case's complaint (Shah v. Zimmer Biomet Holdings, Inc. , February 20, 2019, Simon, P.).

Hiding a "time bomb." The complaint alleged securities fraud by Zimmer Biomet Holdings, Inc. (ZBH), a medical device manufacturer. According to the plaintiff, the defendants issued financial guidance that would be impossible to meet because of known issues at a manufacturing facility. The plaintiff claimed that ZBH sat on a "ticking time bomb," allowing the private equity defendants to make a profitable exit before the bad news was inevitably discovered by the FDA and investing public.

In late 2018, the court allowed fraud claims under the Exchange Act to proceed. In particular, the court found that the plaintiff sufficiently alleged that ZBH violated duty under Item 303 of Regulation S-K to disclose reasonably expected risks. Here, ZBH had telegraphed growth and success to the markets while knowing that it would have trouble meeting product demand due to significant quality issues at a manufacturing plant.

Interlocutory appeal. After ZBH's motion to dismiss was denied, an "avalanche of filings," as the court put it, followed. In short, ZBH asked for an interlocutory appeal on two issues: the extent to which a plaintiff may base Section 10(b) fraud claims on Item 303; and the extent to which a plaintiff may rely on factual allegations taken from another lawsuit to support scienter. The company also sought a discovery stay while the matter is pending before the Seventh Circuit.

At the outset, the court noted that the bar to obtain an interlocutory appeal is set very high and requires a showing of "exceptional circumstances." In the Seventh Circuit, a court will look to four factors: the issue must be (1) a question of law; (2) the question must be "controlling"; (3) the question must be "contestable"; and (4) its resolution must promise to speed up the litigation. The court ultimately denied the motion, finding that ZBH failed to meet all the requirements for an interlocutory appeal.

Item 303. The court first addressed the duty to disclose under Item 303 for the purposes of a Section 10(b) claim. A circuit split exists on the matter with, broadly, and as discussed in this case, the Second Circuit holding that Item 303 could form the basis of a duty to disclose, so long as the information in question was also or otherwise material, and the Ninth Circuit taking the opposite stance, that Item 303 violations are never actionable under Rule 10b-5.

Unfortunately for ZBH, it never squarely raised the issue of an Item 303 violation resulting in a per se violation of Section 10(b) in its initial motion to dismiss. Instead, ZBH made the distinctly different argument that the plaintiffs had failed to sufficiently plead a violation of Item 303 in the first place. But, instead of deeming the issue waived, the court addressed the issue on the merits due to its importance.

There was no dispute that the Item 303 issue is a question of law, the court said, but whether that issue is "contestable" is much closer. The court concluded that the approach taken by the Second Circuit in Stratte-McClure is sound and the one likely to be taken by the Seventh Circuit when it addresses this question; the court noted that the Seventh Circuit has signaled some support for the use of Item 303 as the basis of a duty to disclose. The court also saw considerable support for the Second Circuit's approach in Supreme Court precedent. In sum, the court saw the Second Circuit's approach as far more persuasive than the Ninth's, meaning that the issue was not particularly contestable.

Even if the issue were contestable, the court went on, ZBH still failed to show how resolution of the issue would advance the litigation. If the Seventh Circuit agreed with the Ninth, the court supposed, some of the plaintiff's claims would be disposed of, but numerous others would survive. According to the court, ZBH's inability to articulate how discovery and the scope of the case would be meaningfully narrowed by a successful appeal was fatal to ZBH’s bid for an interlocutory appeal.

Allegations from other suits. The court then turned to the second issue: whether plaintiffs may rely on allegations in an unadjudicated third-party complaint. The court again found that a lack of contestability doomed the interlocutory appeal. According to the court, the few conflicting opinions cited by ZBH failed to create the necessary "substantial ground for difference of opinion." In addition, there were numerous other allegations of scienter in addition to those at issue.

The case is No. 3:16-cv-815.

Attorneys: Ira M. Press (Kirby McInerney LLP) for Rajesh M. Shah. Elizabeth M. Gary (Morgan, Lewis & Bockius LLP) and Paul A. Wolfla (Faegre Baker Daniels LLP) for Zimmer Biomet Holdings, Inc.

Companies: Zimmer Biomet Holdings, Inc.

MainStory: TopStory FraudManipulation PublicCompanyReportingDisclosure IndianaNews

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