The Second Circuit just split from the Ninth in Stratte-Mcclure v. Stanley, 2015 U.S. App. LEXIS 428 (2d Cir. N.Y. Jan. 12, 2015) regarding whether a company violates Section 10(b) – and is subject to private lawsuits – for failure to disclose required information.  The holding would be well-positioned for a Supreme Court grant except that it was not outcome determinative, functionally insulating the decision from Supreme Court review.  But this is definitely a split to watch in the future.

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Section 10(b) forbids manipulative and deceptive acts taken in connection with a securities transaction.  Rule 10b-5 specifies that such acts include making “any untrue statement of a material fact or [omitting] 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.”

In Basic Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme Court held that silence, absent a duty to disclose, is not deceptive.  So, for example, a company’s mere failure to mention that a product in development suddenly turned out to be a dud would not, standing alone, count as deceptive under this rule.

Clearly, if a company makes a misleading statement, that gives rise to a duty to disclose whatever information is necessary to make it not deceptive, and plaintiffs may bring a claim if the company fails to do so.

The more difficult question is whether a company’s failure to disclose information affirmatively required by the securities laws can be “deceptive” for Section 10(b) purposes – assuming that all other elements of a Section 10(b) violation are met (scienter, materiality, loss causation, etc).

Previously, the Second Circuit strongly suggested that the answer to that question is yes.   In Stratte-McClure, the Second Circuit reaffirmed its earlier precedent, holding that plaintiffs may bring a Section 10(b) claim for a company’s failure to disclose information required under Item 303 of Regulation S-K.

In so doing, the Second Circuit sharply split from the Ninth Circuit’s holding in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. Cal. 2014).  There, the Ninth Circuit held that Section 10(b) violations may not be predicated on mere silence, even if an SEC rule would require speech.

Abstractly speaking, the Second Circuit’s reasoning is correct.  Investors know what the SEC requirements are; they know that companies are required to reveal certain types of information if they have it in their possession.  Silence in that context will be taken as an affirmative representation that such information does not exist – thereby deceiving investors.

Moreover, Section 10(b) claims still require that the plaintiff demonstrate an intent to deceive – so if defendants know that they are deceiving the market by failing to release required information, the equities surely run in favor of allowing plaintiffs to bring a claim.

The problem, however, is that the disclosure requirements of the securities laws are incredibly broad.  Item 303 of Regulation S-K, for example, requires management to disclose known “trends” that may affect liquidity, capital resources, and sales or revenues or income from continuing operations.   Other rules require that management disclose risks to which the business is exposed, and countless other broad-stroke assessments of the state of the company. 

Since, we can reasonably assume, most of the time management will prefer to remain silent when news is bad rather than good, allowing Section 10(b) claims in this context threatens to collapse the distinction between claims for fraud and simply claims for poor management.  Ever since Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977), where the Supreme Court held that Section 10(b) may only be used for deceptive conduct and not mere breaches of fiduciary duty, courts have struggled to distinguish bad management from fraud.  The line they usually draw is whether the plaintiff alleges the existence of an actual false statement.  If claims can be brought based on silence, then, given the breadth of today’s disclosure requirements, that distinction is no longer tenable.

This is a topic that I discuss in my forthcoming piece, Slouching Towards Monell: The Disappearance of Vicarious Liability Under Section 10(b), which will appear in the April 2015 volume of the Washington University Law Review.  Basically, even under the “affirmative statement” standard, many of today’s securities claims are predicated on some kind of illegal or unethical conduct – antitrust violations, foreign bribery, and the like – that the company did not reveal.    Courts have used a variety of techniques – such as, as I discuss in my article, adopting a narrow definition of corporate scienter – to try to separate out claims that look like fraud aimed at investors from claims that appear to simply be challenges to management’s judgment regarding how the business will be run.  If plaintiffs can bring claims based on silence, that just makes it easier for plaintiffs to allege that defendants violated 10(b) by failing to disclose their failures of management, which would undermine the distinction Santa Fe tried to draw.

This kind of dilemma can also be seen in the concept of “puffery” – i.e., the notion that some statements are simply too vague or hyperbolic to be material to investors.   Puffery is frequently deployed by courts to distinguish claims that “feel” like fraud from claims that “feel” like mismanagement. 

There was a fantastic example of this recently in the context of litigation brought against Standard & Poor’s for issuing false ratings of mortgage-backed securities.  When it was first publicly revealed that S&P may have goosed its ratings to win business, its stock price tanked.  S&P investors brought a Section 10(b) claim against the company, alleging that it falsely described its business model by claiming to be “independent” of the companies it rated.  The Second Circuit affirmed the district court’s dismissal the case, holding that S&P’s claims to independence were mere “puffery” on which no reasonable investor would rely.  See Boca Raton Firefighters & Police Pension Fund v. Bahash, 506 Fed. Appx. 32 (2d Cir. 2012).

Later, DoJ brought a claim against S&P, alleging that S&P had deceived banks that purchased MBS in reliance on S&P's ratings.  DoJ, like the plaintiffs in Boca Raton, claimed that banks had relied on S&P’s claims to independence.  This time, however, the court refused to hold that S&P’s statements were puffery.  See United States v. McGraw-Hill Cos., 2013 U.S. Dist. LEXIS 99961 (C.D. Cal. July 16, 2013)

The difference, I think, has nothing to do with whether “independence” is or is not an inherently vague term – the issue is that the first case felt to the court like the investors were really suing about the fact that S&P made bad business decisions.  The second case, however, felt more like a classic fraud aimed at investors. 

Anyway, all of this is a long way of saying that these are the dilemmas posed by the issue whether silence = deception in the context of a failure to comply with affirmative disclosure obligations.  

That said, the plaintiffs in Stratte-McClure are still out of luck – because even though the Second Circuit agreed that Section 10(b) covers failures to disclose, it also held that the plaintiffs in that case failed to allege that the defendants had acted with scienter, and affirmed the dismissal of their claims.  That part of the opinion takes it out of the running for a Supreme Court grant, because it means that the Circuit's holding with respect to failures to disclose ultimately did not dictate the outcome of the case.  For that reason, the Supreme Court won't be interested.

Nonetheless, this is a split to watch.