Among regulators and prosecutors, the standard view of securities law is that it’s about fairness and justice. Securities regulation is part of the effort to ensure the public’s confidence in getting a fair shake at tapping the dynamism of the markets. And if those markets aren’t judged by investors to be principled, then the supply of capital to an important engine of economic growth would shrink. To that end, many laws regulating securities are based on Justice Brandeis’s famous observation that sunlight is the best disinfectant.[1]

Since Congress delegated to the SEC the broad authority to tame the lions of Wall Street, the agency has had wide discretion to develop rules governing corporate disclosures.[2] Yet the notion that drafting ongoing disclosures for investors somehow allows the investing public to make good decisions holds water only if the market-making news is released before insiders can trade on it. Corporate officers who have access to key information are at a distinct advantage. It’s easy to imagine why.

If an insider knows that his company just agreed to a friendly merger with a rival in a blockbuster deal, he could buy short-dated call options written on the target company’s stock—before the deal has even been announced.[3] When the offer is made public, the value of the underlying shares would jump, and the insider’s options on the target company would finish deep in-the-money. And it’s not limited to the trading of derivatives like above, either. Trading any public securities on confidential information can be a very profitable strategy. This kind of wild-west market environment is obviously unfair to investors who aren’t privy to corporate secrets, and so that’s where many believe insider trading law comes in.

Insider trading is well-publicized but much misunderstood. People tend to read fairness into insider trading law, but the crime of insider trading is actually rooted in theft. Most insider trading cases are brought under section 10(b) of the Securities Exchange Act of 1934[4] and its counterpart, Rule 10b-5.[5] Yet neither the statute nor the later-adopted Rule[6] make any explicit reference to insider trading. Indeed they are broad antifraud provisions that make unlawful any willful violation of their standards against deceptive or manipulative conduct. Insider trading jurisprudence is not statutorily defined; it is, rather, the culmination of many years of judge- and agency-made law.

Before the Supreme Court’s 1980 decision in Chiarella v. United States,[7] the SEC had long interpreted section 10(b) and Rule 10b-5 as requiring anyone who wanted to trade on private corporate information to publicly reveal it first. This “parity of information” theory of insider trading was a broad weapon for prosecutors to make their cases. Then, in a decision that would eventually come back to bite it years later, the Chiarella Court remarked—and in dicta, no less—that “when an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”[8]

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When read literally, the language of the Chiarella opinion crafts a firm legal contour that sharply limits Rule 10b-5 liability for nondisclosure. In short, no duty to disclose, no section 10(b) liability for staying quiet. Following that logic, simply knowing what others don’t know is not enough to give rise to a general duty to speak—except when prior statements to the market become false or misleading due to some new revelation.[9] The ex ante thinking is that demanding a parity of information between all market participants would reduce the incentive to conduct due diligence.[10] In a world where everyone has access to the latest scoops, how many professionals would put forth the painstaking effort to find undervalued public stocks? Probably none, if everyone reaps the benefits. Equal access to so-called material nonpublic information is not, as such, actually good for facilitating the efficient allocation of capital.

But that necessarily prompts yet another question: What does it mean for market information to be “material?”

The answer to that is hard to come by. There’s no bright-line way to see if something is legally “material.” However, as a start, the materiality standard prescribed by the Supreme Court in Basic v. Levinson looks to whether there’s a substantial likelihood that a reasonable investor would view the particular fact as significantly altering the total mix of available information.[11] Translation: Materiality is whatever the jury says it is. As if that isn’t enough, large public companies have to struggle with the complexities of complying with the dizzying reporting requirements thrown at them by regulators, one of which is known as Management’s Discussion and Analysis (MD&A).

The launching point for preparing MD&A is Item 303 of Regulation S-K.[12] Item 303 requires a company to discuss any “known trends and uncertainties” that are expected to have an unfavorable effect on its future financial results.[13] Deciding what trends and uncertainties to disclose in MD&A depends on a two-step “reasonably likely” test. That test requires disclosure if the event is reasonably likely to happen and be material. Materiality in MD&A, thus, is a standard made murky by subjective criteria. And all of this, of course, leads to a further question: If a company fails to disclose known trends and uncertainties in shareholder reports, can it be sued under section 10(b) by investors on that basis?

To address that, it’s helpful to remember that section 10(b) governs fraud that results from deception by misstatement or omission of material facts. Recall also that without a duty to disclose, mere silence is not deceptive. So the answer, essentially, turns on both whether Item 303 imposes a duty to speak, and whether the breach of such a duty can be the subject of a section 10(b) lawsuit. And that’s exactly what has split the circuit courts.

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In one case involving a chip manufacturer that hid a rising pattern of defects, the Second Circuit emphatically held that Item 303 created an affirmative duty of disclosure.[14] Then when the court decided another Item 303 case, Stratte-Mcclure v. Stanley, it determined as a matter of first impression that a breach of the duty imposed by Item 303 is enough to let investors sue under section 10(b).[15] In so doing, the Second Circuit admitted it was splitting from the Ninth Circuit on whether a failure to disclose Item 303 information was enough to make a colorable claim for securities fraud under section 10(b).[16]

Just months later, another Item 303 case came to the Second Circuit on appeal. In Leidos, Inc. v. Indiana Public Retirement System,[17] the court deferred to its previous reasoning in Stratte-Mcclure, thereby reaffirming its conclusion that an Item 303 violation alone could support a private section 10(b) lawsuit. The decision seemingly deepened the circuit split over the Item 303 issue. With most securities lawsuits being filed in the Second and Ninth Circuits, Leidos’s holding set the stage for Supreme Court intervention.

Leidos is an odd duck that the Court added to its docket—not only because it’s a case involving securities fraud which, while hardly common, is becoming more routine—but it’s strange, too, because the Court had refused to take up the same issue in a 2014 case.[18] And for some, Leidos also presents many problems unlikely to be settled by the Court. Writing in the Harvard Business Law Review, Aaron Benjamin, an attorney at Wilson Sonsini Goodrich & Rosati, argues that there’s no express private right to sue for securities fraud under Item 303 itself.

… Item 303 provides no private right of action. A private plaintiff can bring an Item 303 action only if there is a separate violation of a securities law for which there is a private right of action.[19]

Perhaps. But on a practical level, it’s hard to picture a scenario where something is so serious that it belongs in MD&A but is a matter that the company hasn’t ever talked about before. The same is largely true of many other line-item disclosures as well. As the existing disclosure scheme becomes trickier and more extensive, the periodic statements and reports that together make up a company’s disclosures to date, in a way, becomes a house of cards. So if a company withheld Item 303 information, it probably made some material misstatement elsewhere that could be challenged in court. Item 303 is not a hard-edged provision in securities litigation.

Benjamin’s article then goes on to sketch out the details of why the omission of Item 303 information isn’t a “surrogate for section 10(b) liability”:

Item 303 sets a lower threshold for materiality than section 10(b). Under section 10(b), the alleged omission must be material under a heightened “substantial likelihood” standard followed by the Supreme Court in Basic v. Levinson. In contrast, Item 303 materiality is defined by a lower (and different) “reasonably likely” standard set by the SEC. An omission sufficiently material under the lower standard of Item 303 is not necessarily material under the higher standard of section 10(b).[20]

In other words, the materiality standard of “reasonably likely,” which applies to Item 303, is less stringent than the “substantial likelihood” language set forth in Basic that applies to section 10(b).

A basic insight about what makes societies society is that humans are social creatures who at some point learned how to think verbally. The very fabric of human culture is woven with the weft of language. But such a heavy reliance on language is itself a problem. Expressions in natural languages are ambiguous and, though there is some debate about the pace, living languages are in a constant state of flux. Legal disputes often turn on pure semantics. But there is something more going on here, and Benjamin fails to address it.

Even if investors could lodge a fraud claim for simple nondisclosure, it’s not entirely clear that a company’s outright breach of a duty required of it by the SEC amounts to fraud under federal securities law. Since the late ‘70s, the Court has interpreted section 10(b) and Rule 10b-5 narrowly so as to not reach a finding of fraud when there is no pointed evidence of manipulative or deceptive conduct.[21] Securities fraud, simply put, is not bad corporate governance.

When it comes to something as unreliable and futile as looking forward to an uncertain future, it’s easy to envision managers regarding an event as too improbable to disclose, or as seemingly harmless. And it’s not a leap to assume that publicly-traded companies don’t want to deliver bad news prematurely, prompting selloffs by scaring the open market. The great difficulty for judges is that with the sweeping disclosure rules imposed on today’s big corporations, the line between misjudgment and fraud is a fine one. A lawsuit asserting section 10(b) liability based on a company’s silence can look a lot like a proxy for a claim that a company had been poorly run. And the realpolitik of opening the floodgates for such bad-management claims is that these suits encourage rent-seeking and do little to promote good corporate governance.

So pick a harsh face shown here, as it were. Would you rather allow the plaintiffs’ bar to extract rents from a company for being sloppy? Or would you rather let companies keep bad news under wraps at the expense of investors?

 

Endnotes

[1] Louis D. Brandeis, What Publicity Can Do, Harper’s Wkly., Dec. 20, 1913, reprinted in Louis D. Brandeis, Other People’s Money And How The Bankers Use It 92, 92 (1932) (“Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”).

[2] Securities Act of 1933, § 19(a). 15 U.S.C. § 77s(a) (1933).

[3] In what follows, whenever reference is made to “company” or “corporation,” it means the publicly-traded securities issuers under the jurisdiction of the SEC.

[4] “It shall be unlawful for any person directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange … (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Securities Exchange Act of 1934, § 10 (b), 48 Stat. 891, 15 U.S.C. § 78j (1958).

[5] Rule 10b-5, pursuant to § 10 (b) of the Exchange Act, makes it “unlawful … (1) To employ any device, scheme, or artifice to defraud, (2) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” 17 C.F.R. § 240.10b-5 (1949).

[6] Rule 10b-5 was promulgated by the SEC because § 10(b) wasn’t self-executing. “Section 10(b) of the Securities Exchange Act does not by its terms make unlawful any conduct or activity but confers rulemaking power upon the SEC to condemn deceptive practices in th sale or purchase of securities.” See Birnbaum v. Newport Steel Corp., 193 F.2d 461, 463 (2d Cir. 1952).

[7] Chiarella v. United States, 445 U.S. 222 (1980).

[8] See Chiarella, 445 U.S. 222, 230 (1980). See also Basic v. Levinson, 485 U.S. at 239, n. 17 (“Silence, absent a duty to disclose, is not misleading under Rule 10b-5.”).

[9] See Ross v. A.H. Robins Co., 65 F. Supp. 904 (S.D.N.Y. 1979); Naye v. Boyd, CCH 92, 980 (W.D. Wash. Oct. 20, 1986); Sharp v. Coopers & Lybrand, CCH 96, 952 (E.D. Pa. 1979); SEC v. Shattuck Denn Mining Corp., 297 F. Supp. 470 (S.D.N.Y. 1968); Fischer v. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967).

[10] See Bench Memorandum, Chiarella, to Justice Lewis F. Powell, Jr. 2 (Sept. 28, 1979).

[11] See Basic, 485 U.S. at 232–33 (citing TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).

[12] Regulation S-K is the core “repository” for the SEC’s disclosure system. See generally, 17 C.F.R. § 229.

[13] See 17 C.F.R. § 229.303.

[14] See Panther Partners Inc. v. Ikanos Commc’ns,. Inc., 681 F.3d 114, 119 (2d Cir. 2012).

[15] See Stratte-McClure v. Morgan Stanley, 776 F.3d 94 at 100.

[16] Compare In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1056 (9th Cir. 2014) (“[I]tem 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.”), cert. denied, 135 S. Ct. 2349 (2015), with Stratte-McClure, 776 F.3d at 100 (“[A] failure to make a required Item 303 disclosure … is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim.”).

[17] Prior to a corporate name change, Leidos was known as Science Applications International Corporation (SAIC). Both the defendant company and Second Circuit’s decision will be referred to as “Leidos” throughout. See Ind. Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85, 94 (2d Cir. 2016), cert. granted,  Leidos, Inc. v. Ind. Pub. Sys., 2017 WL 1114966 (U.S. Mar. 27, 2017) (No. 16-581) [hereinafter Leidos].

[18] See In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014), cert. denied, 135 S. Ct. 2349 (2015).

[19] See Aaron J. Benjamin, Stuck with Steckman: Why Item 303 Cannot Be a Surrogate for Section 11, 7 Harv. Bus. L. Rev. Online 49, n. 97 (2017), http://www.hblr.org/2017/05/stuck-with-steckman-why-item-303-cannot-be-a-surrogate-for-section-11/.

[20] Id.

[21] See Santa Fe Indus., Inc. v. Green, 430 U.S. 462 (1977) (holding that a breach of fiduciary duty, without manipulation or deception, cannot be the basis for a claim under Rule 10b-5).