Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca2-13-00627/USCOURTS-ca2-13-00627-0/pdf.json

Nature of Suit Code: 430
Nature of Suit: Banks and Banking
Cause of Action: 

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13‐0627‐cv

Fjarde AP‐Fonden v. Morgan Stanley

1 UNITED STATES COURT OF APPEALS

2 FOR THE SECOND CIRCUIT

3

4 August Term 2013

5

6

7 Argued: December 10, 2013

8 Decided: January 12, 2015

9

10 No. 13‐0627‐cv

11

12 _____________________________________

13

14 JOEL STRATTE‐MCCLURE ,

15 Plaintiff,

16

17 FJARDE AP‐FONDEN ,

18 Plaintiff‐Appellant,

19

20 PLAINTIFF STATEBOSTON RETIREMENT SYSTEM,

21 STATE‐BOSTON RETIREMENT SYSTEM,

22 Movant‐Appellant,

23

24 ‐v‐

25

26 MORGAN STANLEY, a Delaware Corporation, JOHN J. MACK,

27 ZOE CRUZ, DAVID SIDWELL, THOMAS COLM KELLEHER, THOMAS V. DAULA,

28 Defendants‐Appellees,

29

30 GARY G. LYNCH,

31 Defendant.

32 _____________________________________

33

1

Case 13-627, Document 113, 01/12/2015, 1412823, Page1 of 32
1 Before: CABRANES, WESLEY, and LIVINGSTON

2

3 Appeal from April 4, 2011 and January 18, 2013 orders of the United States

4 District Court for the Southern District of New York (Batts, J.), granting the

5 Defendants’ motions to dismiss.  Forthe reasons statedhere andin a summary order

6 issued simultaneously with this opinion, we AFFIRM the order granting the

7 Defendants’ motion to dismiss.

8

9 AFFIRMED.

10

11

12 David Kessler (Andrew L. Zivitz, Kimberly A.

13 Justice, Richard A. Russo, Jr., Joshua A. Materese,

14 on the brief) Kessler Topaz Meltzer & Check, LLP,

15 Radnor, PA, for Plaintiff‐Appellant Fjarde AP‐Fonden

16 and for the Class.

17

18 JAVIER BLEICHMAR (Jonathan M. Plasse, Joseph A.

19 Fonti, Wilson M. Meeks, on the brief), Labaton

20 Sucharow LLP, New York, NY, forMovant‐Appellant

21 State‐Boston Retirement System and for the Class.

22

23 ROBERT F. WISE, JR. (Charles S. Duggan, Andrew

24 Ditchfield, on the brief),DavisPolk&WardwellLLP,

25 New York, NY, for Defendants‐Appellees.

26

27

28 DEBRA ANN LIVINGSTON, Circuit Judge:

29 Lead Plaintiffs State‐Boston Retirement System and Fjarde AP‐Fonden

30 brought this putative securities fraud class action on behalf of themselves and other

31 similarly situated investors (“Plaintiffs”) pursuant to Sections 10(b) and 20(a), 15

2

Case 13-627, Document 113, 01/12/2015, 1412823, Page2 of 32
1 U.S.C. §§ 78j(b) and 78t(a), of the Securities Exchange Act of 1934.   They allege that

2 Morgan Stanley and six of its officers and former officers — John J. Mack, Zoe Cruz,

3 David Sidwell, Thomas Colm Kelleher, and Thomas Daula (collectively, “Morgan

4 Stanley” or “Defendants”) — made material misstatements and omissions between

5 June 20, 2007 and November 19, 2007 (the “class period”) in an effort to conceal

6 Morgan Stanley’s exposure to and losses from the subprime mortgage market.  As

7 a result, Plaintiffs claim, they suffered substantial financial loss when Morgan

8 Stanley’s stock prices dropped following public disclosure of the truth about

9 Morgan Stanley’s positions and losses.

10 The United States District Court forthe Southern District of New York (Batts,

11 J.) dismissed all claims on the pleadings for failure to state a claim, and we affirm.

12 For the reasons stated in this opinion, we conclude that the district court properly

13 dismissed Plaintiffs’ claim that Defendants’ omission of information purportedly

14 required to be disclosed under Item 303 of Regulation S‐K, 17 C.F.R.

15 § 229.303(a)(3)(ii) (“Item 303ʺ), violated Section 10(b).   We also affirm its order

16 dismissing Plaintiffs’ other claims in a summary order issued simultaneously with

17 this decision.

3

Case 13-627, Document 113, 01/12/2015, 1412823, Page3 of 32
BACKGROUND1 1

2 This case arises out of a massive proprietary trade executed by Morgan

3 Stanley’s Proprietary Trading Group in December 2006.  The trade consisted of two

4 components: a $2 billion short position (“Short Position”) and a $13.5 billion long

5 position (“Long Position”).  In the Short Position, Morgan Stanley purchased credit

6 default swaps (“CDSs”) on collateralized debt obligations (“CDOs”) backed by

7 “mezzanine tranches” of subprime residential mortgage‐backed securities

(“RMBSs”).2 8   These CDSs operated like insurance policies — Morgan Stanley paid

9 annual premiums for the assurance that, if the housing market worsened and the

10 mezzanineRMBS tranches backing its CDOsdefaultedordeclinedin value, it would

1 The facts presented here are drawn from the allegations in Plaintiffs’ second

amended complaint, which we accept as true for the purposes of reviewing the motion

to dismiss.  See Anschutz Corp. v. Merrill Lynch & Co., 690 F.3d 98, 107 (2d Cir. 2012).

Although we decide only one issue in this opinion, we describe the Plaintiffs’

allegations in greater detail to provide context.

2 Briefly, as described by Plaintiffs, a RMBS is created by pooling thousands of

residential mortgages into a trust.  The trust then issues bonds, which investors

purchase.  The mortgages serve as collateral for these bonds, and the interest on the

bonds derives from the cash flow created by mortgage payments.  RMBSs can be

aggregated into CDOs, which are sold in “tranches” based on priority of entitlement to

the cash flow.  Each tranche of a given RMBS is exposed to the same pool of mortgages,

but lower tranches sustain losses before higher tranches in the event that mortgages in

the pool default or do not meet payment deadlines. CDOs are similarly divided into

higher and lower tranches.

4

Case 13-627, Document 113, 01/12/2015, 1412823, Page4 of 32
1 receive payments.  In the Long Position, Morgan Stanley sold CDSs. These CDSs,

2 like those it bought for the Short Position, referenced CDOs backed by mezzanine

3 tranches of subprime RMBSs. But the CDOs referenced by the Long Position were

4 super‐seniortranches of CDOs that were higher‐ratedandlower‐risk than the CDOs

5 referenced by the Short Position. Through the Long Position, Morgan Stanley

6 therefore received premium payments for the guarantee that it would pay the CDS

7 purchasers in the event that these lower‐risk CDO tranches defaulted or declined in

8 value.  Morgan Stanley could use the income from those premiums to finance the

9 Short Position, but would have to make payouts if the CDO tranches referenced by

10 the Long Position suffered defaults — up to a maximum of $13.5 billion in the event

11 of a 100 percent default in these CDOs.  In essence, the company was betting that

12 defaults in the subprime mortgage markets would be significant enough to impair

13 the value of the higher‐risk CDO tranches referenced by the Short Position, but not

14 significant enough to impairthe value ofthe lower‐risk CDO tranches referenced by

15 the Long Position.

16 According to thePlaintiffs, “[b]y mid‐2006,the biggest housing bubble in U.S.

17 history had popped.”  J.A. 465.  Subprime mortgages issued in 2005 and 2006, like

18 those backing Morgan Stanley’s proprietary trade, rapidly began to suffer from

5

Case 13-627, Document 113, 01/12/2015, 1412823, Page5 of 32
1 delinquencies and defaults.  “On February 12, 2007, Morgan [Stanley] economist

2 Richard Berner acknowledged that these ‘[s]oaring defaults signal that the long‐

3 awaited meltdown in subprime mortgage lending is now underway[.]’”  J.A. 469.

4 Although Morgan Stanley’s Proprietary Trading Group had correctly predicted the

5 direction that the subprime housing market would turn, it apparently

6 underestimated the magnitude of the collapse.  The value of Morgan Stanley’s swap

7 positions declined substantially over the course of 2007, and Morgan Stanley

8 ultimately lost billions of dollars on the proprietary trade.

9 Plaintiffs allege that Defendants made numerous material misstatements and

10 omissions from June 20, 2007 through November 19, 2007 to conceal Morgan

11 Stanley’s exposure to and losses from this subprime proprietary trade.  The second

12 amended complaint identifies two categories of misrepresentations and omissions:

13 (1)misrepresentations andomissions regardingMorgan Stanley’s exposure to credit

14 risk relatedto theU.S. subprimemortgagemarket arising fromitsLongPosition (the

15 “exposure claim”), and (2) misrepresentations regarding Morgan Stanley’s losses

16 arising from the Long Position (the “valuation claim”).  Plaintiffs allege that these

17 misstatements and omissions fraudulently inflated Morgan Stanley’s stock price

6

Case 13-627, Document 113, 01/12/2015, 1412823, Page6 of 32
1 during the class period and caused them to suffer financially when the market

2 learned the truth about Morgan Stanley’s exposure and losses.

3 A. Exposure Claim

4 The second amended complaint alleges that Defendants materially

5 misrepresented Morgan Stanley’s exposure to the subprime mortgage market.

6 Plaintiffs rely on four statements from Morgan Stanley officers, and one alleged

7 omission.  First, on a June 20, 2007 call with market analysts about Morgan Stanley’s

8 second quarter earnings, Defendant Sidwell stated that “concerns early in the

9 quarter about whether issues in the sub‐prime market were going to spread

10 dissipated.”  J.A. 498.  Second, on that same call, Sidwell responded to a request to

11 characterize Morgan Stanley’s position in the mortgage market and to explain the

12 decline in the company’s fixed income revenues by stating that Morgan Stanley

13 “really did benefit” from conditions in the subprime market in the first quarter of

14 2007, and “certainly did not lose money in this business” during the second quarter.

15 J.A. 498, 499.  Third,during another earnings call with market analysts on September

16 19, 2007,Defendant Kelleher statedthatMorganStanley “remain[ed] exposedto risk

17 exposures through a number ofinstruments [including] CDOs,” withoutdescribing

18 the extent of that exposure.  J.A. 506‐07.  And fourth, Kelleher stated in an October

7

Case 13-627, Document 113, 01/12/2015, 1412823, Page7 of 32
1 24, 2007 interview with CIBC World Markets analyst Meredith Whitney that he

2 “[did] not see further write‐downs to [Morgan Stanley’s] carrying values over the

3 near term.”  J.A. 516.  Plaintiffs claim that each of these statements was materially

4 false or misleading.  

5 As pertinent here, Plaintiffs also allege that Defendants made material

6 omissions in their 10‐Q filings by failing to disclose the existence of the Long

7 Position, that Morgan Stanley had sustained losses on that position in the second

8 and third quarters of 2007, and that the company was likely to incur additional

9 significant losses on the position in the future.    They argue that Item 303 of

10 Regulation S‐K and related guidance requires companies to disclose on their 10‐Q

11 filings any “known trends, or uncertainties that have had, or might reasonably be

12 expected to have, a[n] . . . unfavorable material effect” on the company’s “revenue,

13 operating income or net income.”  J.A. 465.   Plaintiffs claim that “[b]y July 4[, 2007,]

14 at the latest, Defendants knew that the Long Position was reasonably expected to

15 have an unfavorable material effect on revenue.”  J.A. 482.  It is not disputed that

16 Morgan Stanley did not make this Item 303 disclosure on its 10‐Q filings in 2007.

17

18

8

Case 13-627, Document 113, 01/12/2015, 1412823, Page8 of 32
1 B. Valuation Claim

2 In a separate claim, the second amended complaint alleges that Morgan

3 Stanley overstated its earnings in the third quarter of 2007 because it did not

4 sufficiently write down the value of its Long Position.  According to Plaintiffs, the

5 Long Position’s value was “inherently linked” to an index of RMBSs known as the

6 ABX.BBB.06‐1 Index (the “ABXIndex”).  Thus, when theABXIndexdeclinedby 32.8

7 percent in the third quarter of 2007, Morgan Stanley should have marked down the

8 value of the Long Position by that same percentage and disclosed the loss in its

9 quarterly statement.  Insteadoftaking that $4.4 billionmarkdown,however,Morgan

10 Stanley recognized only a $1.9 billion loss on the Long Position after valuing it using

11 internal models that did not exclusively rely on the ABX Index.  Plaintiffs allege that

12 Morgan Stanley later wrote down the value of the Long Position by a percentage

13 greaterthan that dictated by the ABX Index in orderto make up forthe misstatement

14 in the third quarter.  

15 C. Procedural History

16 Plaintiffs brought suit in the United States District Court for the Central

17 District of California, filing an initial complaint in early 2008 and then an amended

18 complaint on November 24, 2008.  The case was then transferred to theUnited States

9

Case 13-627, Document 113, 01/12/2015, 1412823, Page9 of 32
1 District Court for the Southern District of New York (Batts, J.), where Defendants

2 moved to dismiss all claims pursuant to Rules 9(b) and 12(b)(6) of the Federal Rules

3 of Civil Procedure and Section 78u‐4(b) of the Private Securities Litigation Reform

4 Act.  Stratte‐McClure v. Morgan Stanley, 784 F. Supp. 2d 373, 376 (S.D.N.Y. 2011).  The

5 district court granted the motion to dismiss on April 4, 2011.  Id. at 391.  On the

6 exposure claim, the district courtruled that the amended complaint did not specify

7 why Defendants’ statements about risk and its trading positions were false or

8 misleading and decided that Defendants had no obligation to disclose the Long

9 Position.   See id. at 385‐86. On the valuation claim, the district court ruled that

10 Plaintiffs failed to plead loss causation.  Seeid. at 390‐91.  The court granted Plaintiffs

11 leave to amend their pleadings with regard to the exposure claim and loss causation

12 on the valuation claim, but otherwise dismissed Plaintiffs’ claims with prejudice.

13 See id. at 391.

14 On June 9, 2011, Plaintiffs filed a second amended complaint and Defendants

15 moved to dismiss soon thereafter.  Once again, the district court dismissed all of the

16 claims.    Stratte‐McClure v. Morgan Stanley, No. 09‐Civ.‐2017, 2013 WL 297954

17 (S.D.N.Y. Jan. 18, 2013).    The district court found no reason to alter its earlier

18 decision that Plaintiffs failed to plead loss causation for the valuation claim.  See id.

10

Case 13-627, Document 113, 01/12/2015, 1412823, Page10 of 32
1 at*12‐*13.  With regard to the affirmative statements considered in connection with

2 the exposure claim, the district courtfound no reason to alterits earlier decision that

3 Plaintiffs did not sufficiently plead falsity. See id. at *4‐*5.  But this time, the court

4 ruled that Morgan Stanley did have a duty under Item 303 to disclose the Long

5 Position in its 2007 Form 10‐Q filings.  See id. at *7.  The district court justified the

6 change in its stance by relying on this Court’s intervening decisions in Panther

7 Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012), and Litwin v.

8 Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011), which held that Item 303 may

9 provide a basis for disclosure obligations under Sections 11 and 12(a)(2) of the

10 Securities Act of 1933.    2013 WL 297954, at *5.    The district court nevertheless

11 dismissed the exposure claim after deciding that the second amended complaint

12 failed to plead “a strong inference of scienter” with respect to Defendants’ failure to

13 disclose the Long Position.   Id. at *9.    Plaintiffs now appeal both district court

14 decisions.

15 DISCUSSION

16 We review de novo the district court’s judgment granting Defendants’ motion

17 to dismiss.  Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 65 (2d Cir.

18 2012).  “To survive a motion to dismiss, a complaint must contain sufficient factual

11

Case 13-627, Document 113, 01/12/2015, 1412823, Page11 of 32
1 matter, accepted as true, to state a claim for relief that is plausible on its face.”

2 Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (internal quotation marks omitted).  In

3 making this determination, we consider “any written instrument attached to [the

4 complaint] as an exhibit or any statements or documents incorporated in it by

5 reference, as well as public disclosure documents required by law to be, and that

6 have been, filed with the SEC, and documents that the plaintiffs either possessed or

7 knew about and upon which they relied in bringing the suit.”  Rothman v. Gregor, 220

8 F.3d 81, 88 (2d Cir. 2000) (citations omitted).

9 Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful to “use

10 or employ, in connection with the purchase or sale of any security . . . any

11 manipulative or deceptive device or contrivance in contravention of [the] rules and

12 regulations” that the SEC prescribes. 15 U.S.C. § 78j.  In turn, Rule 10b‐5, which

13 implements Section 10(b), provides:

14 It shall be unlawful for any person, directly or indirectly . . . :

15

16 (a) To employ any device, scheme, or artifice to defraud,

17

18 (b) To make any untrue statement of a material fact or to omit to

19 state a material fact necessary in order to make the statements

20 made, in the light of the circumstances under which they were

21 made, not misleading, or

22

12

Case 13-627, Document 113, 01/12/2015, 1412823, Page12 of 32
1 (c) To engage in any act, practice, or course of business which

2 operates or would operate as a fraud or deceit upon any person,

3

4 in connection with the purchase or sale of any security.  

5

6 17 C.F.R. § 240.10b‐5.  To state a claim for securities fraud under these provisions a

7 plaintiff must allege that each defendant “(1) made misstatements or omissions of

8 material fact, (2) with scienter, (3) in connection with the purchase or sale of

9 securities, (4) upon which the plaintiffrelied, and (5) that the plaintiff’s reliance was

10 the proximate cause of its injury.”  ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d

11 87, 105 (2d Cir. 2007).

12 This opinion addresses the district court’s decision that Morgan Stanley’s

13 failure to disclose the Long Position in its July and October 10‐Q filings, in alleged

14 disregard of Item 303 of Regulation S‐K, constituted an actionable omission under

Section 10(b) and Rule 10b‐5.3 15   We conclude, as a matter of first impression in this

16 Court, that a failure to make a required Item 303 disclosure in a 10‐Q filing is indeed

17 an omission that can serve as the basis for a Section 10(b) securities fraud claim.

18 However, such an omission is actionable only if it satisfies the materiality

19 requirements outlined in Basic Inc. v. Levinson, 485 U.S. 224 (1988), and if all of the

3 As already noted, Plaintiffs’ remaining claims are addressed in the summary

order filed simultaneously with this opinion.

13

Case 13-627, Document 113, 01/12/2015, 1412823, Page13 of 32
1 other requirements to sustain an action under Section 10(b) are fulfilled.  Here, the

2 district court properly dismissed Plaintiffs’ exposure claim predicated on Morgan

3 Stanley’s failure to disclose underItem 303 because the second amended complaint

4 did not sufficiently plead scienter.

5 I.

6 The Supreme Court has instructed that “[s]ilence, absent a duty to disclose,

7 is not misleading under Rule 10b‐5.”  Basic, 485 U.S. at 239 n.17; see also Chiarella v.

8 United States, 445 U.S. 222, 230 (1980).  As a result, we have consistently held that “an

9 omission is actionableunderthe securities laws only when the corporation is subject

10 to a duty to disclose the omitted facts.”  In re Time Warner Inc. Sec. Litig., 9 F.3d 259,

11 267 (2d Cir. 1993); see Glazer v. Formica Corp., 964 F.2d 149, 157 (2d Cir. 1992).  Such

12 a duty may arise when there is “a corporate insider trad[ing] on confidential

13 information,” a “statute orregulation requiringdisclosure,” or a corporate statement

14 that would otherwise be “inaccurate, incomplete, or misleading.”  Glazer, 964 F.2d

15 at 157 (quoting Backman v. Polaroid Corp., 910 F.2d 10, 12 (1st Cir. 1990) (en banc));

16 accord Oran v. Stafford, 226 F.3d 275, 285‐86 (3d Cir. 2000).

17 As Plaintiffs correctly argue, Item 303 of Regulation S‐K imposes disclosure

18 requirements on companies filing SEC‐mandatedreports, including quarterly Form

14

Case 13-627, Document 113, 01/12/2015, 1412823, Page14 of 32
1 10‐Q reports.  See Louis Loss & Joel Seligman, Fundamentals of Securities Regulation

2 512 & n.14 (5th ed. 2004).  Those requirements include the obligation to “[d]escribe

3 any known trends or uncertainties . . . that the registrant reasonably expects will

4 have a material . . . unfavorable impact on . . . revenues or income from continuing

5 operations.”  17 C.F.R. § 229.303(a)(3)(ii).  The SEC has provided guidance on Item

6 303, clarifying that disclosure is necessary “where a trend, demand, commitment,

7 event or uncertainty is both presently known to management and  reasonably likely

8 to have material effects on the registrant’s financial conditions or results of

9 operations.”  Management’s Discussion and Analysis of Financial Condition and

10 Results of Operations, Exchange Act Release No. 6835, 43 S.E.C. Docket 1330, 1989

11 WL 1092885, at *4 (May 18, 1989) [hereinafter Exchange Act Release No. 6835].

12 Item 303’s affirmative duty to disclose in Form 10‐Qs can serve as the basis for

13 a securities fraud claim under Section 10(b).  We have already held that failing to

14 comply with Item 303 by omitting known trends or uncertainties from a registration

15 statement or prospectus is actionable under Sections 11 and 12(a)(2) ofthe Securities

Act of 1933.4 16   See Panther Partners, 681 F.3d at 120; Litwin, 634 F.3d at 716; accord J&R

4 We have also held that defendants’ failure to make required disclosures under

Item 303 contributed to an adequately pled securities fraud claim under Section 10(b) in

In re Scholastic Corp. Securities Litigation, 252 F.3d 63, 70‐74 (2d Cir. 2001).  While that

15

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1 Mktg. v. Gen. Motors Corp., 549 F.3d 384, 392 (6th Cir. 2008); Silverstrand Invs. v.

2 AMAG Pharm., Inc., 707 F.3d 95, 102‐03, 107 (1st Cir. 2013).  Like Section 12(a)(2),

3 Rule 10b‐5 requires disclosure of “material fact[s] necessary in order to make . . .

4 statements made . . . not misleading.”   This Court and our sister circuits have long

5 recognized that a duty to disclose under Section 10(b) can derive from statutes or

6 regulations that obligate a party to speak.  See, e.g., Glazer, 964 F.2d at 149; Backman,

7 910 F.2d at 20; Oran, 226 F.3d at 285‐86; Gallagher v. Abbott Labs., 269 F.3d 806, 808

8 (7th Cir. 2001).    And this conclusion stands to reason — for omitting an item

case also involved affirmatively misleading statements, we cited defendants’ alleged

failure to disclose trends in its Form 10‐Q, despite a duty under Item 303 to disclose

those trends, as evidence that plaintiffs adequately alleged a Section 10(b) violation,

implying that Item 303’s affirmative duty to disclose in Form 10‐Qs can serve as the

basis for a securities fraud claim under Section 10(b).  See id.  Nevertheless, perhaps

because In re Scholastic did not squarely address whether Item 303 can give rise to a

duty to disclose under 10b‐5, district courts in this Circuit have continued to express

confusion on the issue.  See, e.g., Abuhamdan v. Blyth, Inc., 9 F. Supp. 3d 175, 206 n.25 (D.

Conn. 2014) (“[I]t is far from certain that the requirement that there be a duty to disclose

under Rule 10b‐5 may be satisfied by importing the disclosure duties from S‐K 303. . . .”

(internal quotation marks omitted)); In re Nevsun Res. Ltd., No. 12‐cv‐1845, 2013 WL

6017402, at *11 n.4 (S.D.N.Y. Sept. 27, 2013) (“Plaintiffs cannot base their Section 10(b)

claim on a theory that Defendants violated Item 303.”); cf. In re Corning, Inc. Sec. Litig.,

349 F. Supp. 2d 698, 716 (S.D.N.Y. 2004) (“[T]he Second Circuit . . . reversed a district

court’s dismissal of a Rule 10b‐5 claim that was based on a defendant’s failure to make

disclosures allegedly required under SK‐303.  It would appear that the [District] Court

must consider Item 303 in connection with plaintiffs’ claim under Rule 10b‐5.” (citing In

re Scholastic, 252 F.3d at 74)).

 

16

Case 13-627, Document 113, 01/12/2015, 1412823, Page16 of 32
1 required to be disclosed on a 10‐Q can render that financial statement misleading.

2 Like registration statements and prospectuses, Form 10‐Qs are mandatory filings

3 that “speak . . . to the entire market.”  Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1222

4 (1st Cir. 1996) (abrogated by statute on other grounds).  As required elements of

5 those filings, Item 303 disclosures “give investors an opportunity to look at the

6 registrant through the eyes of management by providing a historical and

7 prospective analysis ofthe registrant’s financial conditionandresults of operations.”

8 Exchange Act Release No. 6835, 1989 WL 1092885, at *17.  Due to the obligatory

9 nature of these regulations, a reasonable investor would interpret the absence of an

10 Item 303 disclosure to imply the nonexistence of “known trends or uncertainties  .

11 . . that the registrantreasonably expects will have a material . . . unfavorable impact

12 on . . .revenues orincome from continuing operations.”  17 C.F.R. § 229.303(a)(3)(ii);

13 see also Donald C. Langevoort & G. Mitu Gulati, The Muddled Duty to Disclose Under

14 Rule 10b‐5, 57 Vand. L. Rev. 1639, 1680 (2004).  It follows that Item 303 imposes the

15 type of duty to speak that can, in appropriate cases, give rise to liability under

Section 10(b).5 16

5 Because Section 10(b) prohibits “manipulative or deceptive device[s] . . . in

contravention of [the SEC’s] rules and regulations,” 15 U.S.C. § 78j, allowing a 10b‐5

cause of action to arise from a failure to disclose under Item 303 does not exceed what

17

Case 13-627, Document 113, 01/12/2015, 1412823, Page17 of 32
1 The failure to make a required disclosure under Item 303, however, is not by

2 itself sufficientto state a claim for securities fraud under Section 10(b).  Significantly,

3 Rule 10b‐5 makes only “material” omissions actionable.  17 C.F.R. § 240.10b‐5(b).

4 In Basic Inc. v. Levinson, the Supreme Court concluded that, in securities fraud cases

5 under Section 10(b) andRule 10b‐5,themateriality of an allegedly requiredforward‐

6 looking disclosure is determined by “a balancing of both the indicated probability that

7 the event will occur and the anticipated magnitude of the event in light of the totality

8 of the company activity.”  485 U.S. at 238 (quoting SEC v. Texas Gulf Sulfur Co., 401

9 F.2d 833, 849 (2d Cir. 1968) (en banc)) (emphasis added).  The SEC’s test for a duty

Congress “authorize[d] when it first enacted the [Securities Exchange Act].”  Janus

Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2302 (2011) (internal quotation

marks omitted); see also Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,

511 U.S. 164, 173 (1994) (“[A] private plaintiff may not bring a 10b‐5 suit against a

defendant for acts not prohibited by the text of § 10(b).”).  Our conclusion that Item 303

may provide the basis for a 10b‐5 violation is supported by an SEC Cease and Desist

Order, in which the Commission held that a company violated Section 10(b) and Rule

10b‐5 by failing to include in Form 10‐Qs information it was obligated to disclose under

Item 303.  In re Valley Sys., Inc., File No. 3‐8811, 1995 WL 547801, at *4 (S.E.C. Sept. 14,

1995).  Our decision is also consistent with an opinion in the First Circuit.  See Shaw, 82

F.3d at 1222 & n.37 (“[I]n the context of a public offering, plaintiffs who (through the

market) rely upon the completeness of a registration statement or prospectus may sue

under Section 10(b) and Rule 10b–5 for nondisclosures of material facts omitted from

those documents in violation of the applicable SEC rules and regulations.”).

18

Case 13-627, Document 113, 01/12/2015, 1412823, Page18 of 32
1 to report under Item 303, on the other hand, involves a two‐part (and different)

2 inquiry.  Once a trend becomes known, management must make two assessments:

3 (1) Is the known trend . . . likely to come to fruition?  If management

4 determines that it is not reasonably likely to occur, no disclosure is

5 required.

6

7 (2) If management cannot make that determination, it must evaluate

8 objectively the consequences of the known trend . . . on the assumption

9 that it will come to fruition.    Disclosure is then required unless

10 management determines that a material effect on the registrant’s

11 financial condition or results of operations is not reasonably likely to

12 occur.

13

14 Exchange Act Release No. 6835, 1989 WL 1092885, at *6.  According to the SEC, this

15 disclosure standard is unique to Item 303, and “[t]he probability/magnitude test for

16 materiality approved by the Supreme Court in [Basic] is inapposite.”  Id. at *6 n.27;

17 see also Oran, 226 F.3d at 288 (noting that Item 303’s disclosure obligations “extend

18 considerably beyond those required by Rule 10b‐5”).

19 Since the Supreme Court’s interpretation of “material” in Rule 10b‐5 dictates

20 whether a private plaintiff has properly stated a claim, we conclude that a violation

21 of Item 303’s disclosure requirements can only sustain a claim under Section 10(b)

22 and Rule 10b‐5 if the allegedly omitted information satisfies Basic’s test for

23 materiality.  That is, a plaintiff must first allege that the defendant failed to comply

19

Case 13-627, Document 113, 01/12/2015, 1412823, Page19 of 32
1 with Item 303 in a 10‐Q or other filing.    Such a showing establishes that the

2 defendant had a duty to disclose.  A plaintiff must then allege that the omitted

3 information was material under Basic’s probability/magnitude test, because 10b‐5

4 only makes unlawful an omission of “material information” that is “necessary to

5 make . . . statements made,” in this case the Form 10‐Qs, “not misleading.”  Matrixx

6 Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1321‐22 (2011) (quoting 17 C.F.R.

7 § 240.10b‐5(b)) (internal quotation marks omitted).  Of course, as with any Section

8 10(b) claim, a plaintiff must also sufficiently plead scienter, a “connection between

9 the . . . omission and the purchase or sale of a security,” reliance on the omission,

10 and an economic loss caused by thatreliance.  Levitt v. J.P. Morgan Sec., Inc., 710 F.3d

11 454, 465 (2d Cir. 2013).

12 We note that our conclusion is at odds with the Ninth Circuit’s recent opinion

13 in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014).  That case

14 held that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule

15 10b‐5, relying on a Third Circuit opinion by then‐Judge Alito, Oran v. Stafford, 226

16 F.3d at 275.  But Oran simply determined that, “[b]ecause the materiality standards

17 for Rule 10b‐5 and [Item 303] differ significantly,” a violation of Item 303 “does not

18 automatically give rise to a material omission under Rule 10b‐5.”  Id. at 288 (emphasis

20

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1 added).  Having already decided that the omissions in that case were not material

2 under Basic, the Third Circuit concluded thatItem 303 could not “provide a basis for

3 liability.” Id.    Contrary to the Ninth Circuit’s implication that Oran compels a

4 conclusion that Item 303 violations are never actionable under 10b‐5, Oran actually

5 suggested, without deciding, that in certain instances a violation of Item 303 could

6 give rise to a material 10b‐5 omission.  At a minimum, Oran is consistent with our

7 decision that failure to comply with Item 303 in a Form 10‐Q can give rise to liability

8 under Rule 10b‐5 so long as the omission is material under Basic, and the other

9 elements of Rule 10b‐5 have been established.

10 The Ninth Circuit’s opinion in NVIDIA also misconstrues the relationship

11 between Rule 10b‐5 and Section 12(a)(2) of the Securities Act.  In Litwin and Panther

12 Partners, we established that Item 303 creates a duty to disclose for the purposes of

13 liability under Section 12(a)(2).  Litwin, 634 F.3d at 716; Panther Partners, 681 F.3d at

14 120.  The Ninth Circuit had also adopted that position.  See Steckman v. Hart Brewing,

15 Inc., 143 F.3d 1293, 1296 (9th Cir. 1998).  In NVIDIA, a panel of the Ninth Circuit

16 found these decisions irrelevant to its interpretation of Rule 10b‐5.  But Section

17 12(a)(2)’s prohibition on omissions is textually identical to that of Rule 10b‐5: both

18 make unlawful omission of “material fact[s] . . . necessary in order to make . . .

21

Case 13-627, Document 113, 01/12/2015, 1412823, Page21 of 32
1 statements, in light of the circumstances under which they were made, not

2 misleading.”  15 U.S.C. § 77l;see also 17 C.F.R. § 240.10b‐5.  SEC regulations, like Item

3 303, dictate the contents of mandatory disclosures — be they Form 10‐Qs in the case

4 of Rule 10b‐5 or prospectuses in the case of Section 12(a)(2) — and are therefore an

5 essential part of the circumstances under which such disclosures are made.  Litwin

6 and Panther Partnersrecognized thatissuing financial statements that omit elements

7 required by Item 303 can mislead investors.  Those decisions provide firm footing

8 for our decision in this case.

9 II.

10 Applying the standards set forth above, we conclude that Plaintiffs have

11 adequately alleged that Defendants breached their Item 303 duty to disclose that

12 Morgan Stanley faced a deteriorating subprime mortgage marketthat, in light ofthe

13 company’s exposure to the market, was likely to cause trading losses that would

14 materially affect the company’s financial condition.  We assume, arguendo, that this

15 omission was material under Basic.    We nonetheless affirm the district court’s

16 dismissal of the claim, concluding that Plaintiffs failed adequately to plead scienter.

17 Plaintiffs have plausibly alleged that, by the second and third quarters of 2007, there

18 was a significantdownwardtrendin the subprime residential mortgage marketthat

22

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1 could negatively affect Morgan Stanley’s overall financial position.  To begin with,

2 Plaintiffs allege that market watchers, including Morgan Stanley analysts,reported

3 a downward trend in the real estate and subprime mortgage markets as early as

4 2006.  By February 27, 2007, a Morgan Stanley economist had written that “[s]oaring

5 defaults signal that the long‐awaited meltdown in subprime mortgage lending is

6 now underway,” and the company’s own CDO analysts reported significant risks

7 to CDOs backed by asset backed securities, including RMBSs. J.A. 469. That trend

8 continued into the summer, when Morgan Stanley analysts allegedly reported that

9 “[r]atings downgrades in [asset backed] CDO tranches are inevitable and material,”

10 that those CDOs were expected to “remain under severe pressure,” and that long‐

11 term value assessment metrics would continue to decline.    J.A. 473 (emphasis

12 omitted).  

13 Plaintiffs have also plausibly alleged that Morgan Stanley had significant

14 exposure to a sharp downturn in the subprime market through its Long Position.

15 Atthe beginning ofthe class period, Defendants had already written down the Long

16 Position by $300 million as a result ofthe weakening market. While that write‐down

17 did not exceed gains from the Short Position, it did catch the Defendants’ attention,

18 and Morgan Stanley ordered stress tests on the Long Position and then initiated a

23

Case 13-627, Document 113, 01/12/2015, 1412823, Page23 of 32
1 task force to find strategies to sell off its assets that were placed at risk by the

2 collapse of the subprime market.  At the motion to dismiss stage, these allegations

3 are sufficient to support a claim that Morgan Stanley was faced with a “known

4 trend[]. . .that[was]reasonably expectedto have material effects” on the company’s

5 financial position.  Exchange ActRelease No. 6835, 1989WL 1092885 at*4 (emphasis

6 omitted) (describing “reduction in the registrant’s product prices; erosion in the

7 registrant’s market share; changes in insurance coverage; or the likely non‐renewal

8 of a material contract” as examples of “currently known trends”).

9 Defendants argue that they satisfied their obligations under Item 303 by

10 disclosing the deterioration of the real estate, credit, and subprime mortgage

11 markets, anditspotentialnegatively to affectMorgan Stanley.  ButMorgan Stanley’s

12 disclosures about market trends were generic, spread out over several different

13 filings, and often unconnected to the company’s financial position.  Such “generic

14 cautionary language” does not satisfy Item 303.  See Panther Partners, 681 F.3d at 122.

15 The SEC has emphasized that Item 303 “requires not only a ‘discussion’ but also an

16 ‘analysis’ of known material trends,” and that disclosure is “necessary to an

17 understanding of a company’s performance, and the extent to which reported

18 financial information is indicative of future results.”    Commission Guidance

24

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1 Regarding Management’s Discussion and Analysis of Financial Condition and

2 Results of Operations, Release Nos. 33‐8350, 34‐48960, 68 Fed. Reg. 75056, 75061

3 (Dec. 29, 2003)[hereinafterRelease No. 34‐48960].  Plaintiffshave adequately alleged

4 thatMorgan Stanley’spatchwork commentary on the relevantmarkettrendsdidnot

5 live up to that obligation.

6 Thatis notto say, however,thatMorgan Stanley’sdisclosure obligations were

7 as extensive as thedistrict courtdecided.  As we have emphasized,Item 303 requires

8 disclosure of a known trend and the “manner in which” it “might reasonably be

9 expected to materially impact” a company’s overall financial position.  Litwin, 634

F.3d at 718‐19.6 10   The SEC has cautioned that this obligation requires “quantitative

11 information” only when it is “reasonably available and will provide material

12 information for investors.”   Release No. 34‐48960, 68 Fed. Reg. at 75062, 75065.

13 Contrary to the district court’s view, the Commission has never gone so far as to

14 require a company to announce its internal business strategies or to identify the

6 The SEC distinguishes required disclosures about “currently known trends . . .

that are reasonably expected to have material effects” and optional “forward‐looking

disclosure[s]” that “involve[] anticipating a future trend . . . or anticipating a less

predictable impact of a known event, trend or uncertainty.”  Exchange Act Release No.

33‐6835, 1989 WL 1092885, at *4.  “Any forward‐looking information supplied is

expressly covered by the safe harbor rule for projections.”  17 C.F.R. § 229.303(a),

Instruction 7.

25

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1 particulars of its trading positions such as the Long Position.  This is in line with this

2 Court’s reluctance to interpret the securities laws in a manner that requires

3 companies to give competitors notice of proprietary strategies and information.  See

4 San Leandro Emergency Med. Grp. Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801,

5 809 (2d Cir. 1996).  Therefore, instead of being required to disclose the details of the

6 Long Position, underItem 303, Morgan Stanley needed to disclose only that it faced

7 deteriorating real estate, credit, and subprime mortgage markets, that it had

8 significant exposure to those markets, and that if the trends came to fruition, the

company faced trading losses that could materially affect its financial condition.7 9

10 ThePlaintiffs, moreover, while adequately alleging thatDefendants breached

11 theirItem 303 duty to disclose, did not adequately plead a claim under Section 10(b).

12 For Defendants’ breach of their Item 303 duty to be actionable under Section 10(b),

13 Plaintiffs were required adequately to plead each element of a 10b‐5 securities fraud

14 claim.  The second amended complaint does not accomplish that goal.  We assume,

15 without deciding,thatMorgan Stanley’s failure to disclose pursuantto Item 303 met

16 the materiality threshold established by Basic.    The Plaintiffs’ exposure claim

7 As discussed supra, however, Morgan Stanley was required to connect the

trends to its financial position and to offer more than “generic cautionary language.”

Panther Partners, 681 F.3d at 122.

26

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1 nonetheless fails because the second amended complaint does not give rise to a

2 strong inference of scienter.

3 The Private Securities Litigation Reform Act, 15 U.S.C. § 78u‐4(b), subjects

4 Section 10(b) claims to heightened pleading standards.    To adequately plead

5 scienter, the statute requires that plaintiffs allege facts giving rise to a “strong

6 inference that the defendant acted with the required state of mind.”   Id. § 78u‐

7 4(b)(2)(A).  This requirement can be satisfied by “alleging facts (1) showing that the

8 defendants had both motive and opportunity to committhe fraud or(2) constituting

9 strong circumstantial evidence of conscious misbehavior or recklessness.”  ATSI

10 Commc’ns, 493 F.3d at 99.  Here, Plaintiffs rely solely on the Defendants’ alleged

11 conscious misbehavior or recklessness and therefore must show “conscious

12 recklessness — i.e., a state of mind approximating actual intent, and not merely a

13 heightened form of negligence.”  S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d

14 98, 109 (2d Cir. 2009) (quoting Novak v. Kasaks, 216 F.3d 300, 312 (2d Cir. 2000))

15 (emphasis omitted).  We considerthe complaintin its entirety and“take into account

16 plausible opposing inferences.”  Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S.

17 308, 323 (2007).    The inference of scienter “must be . . . cogent and at least as

18 compelling as any opposing inference one could draw from the facts alleged.”  Id.

27

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1 at 324;see Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d

2 190, 195 (2d Cir. 2008).

3 Thedistrict court correctly ruled thatthe secondamendedcomplaintdoes not

4 include sufficient facts to give rise to a strong inference of scienter as to the matter

5 omitted from the 10‐Q filings.  To meet that requirement, Plaintiffs must allege that

6 Defendants were at least consciously reckless regarding whether their failure to

7 provide adequate Item 303 disclosures during the second and third quarters of 2007

8 would mislead investors about material facts.   See ECA & Local 134 IBEW Joint

9 Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 202 (2d Cir. 2009)

10 (concluding that, to adequately plead scienter, plaintiffs must plead facts showing

11 that defendants knew an omission was material).  Here, Plaintiffs make allegations

12 aboutdevelopments inthe subprimemarket, internal concernabout capital calls and

13 write‐downs on the Long Position, and the creation of a task force to investigate

14 selling off some of Morgan Stanley’s subprime positions.  But these facts do not

15 “approximat[e] actual intent” to mislead investors by failing to make Item 303

16 disclosures.  South Cherry St., 573 F.3d at 109 (emphasis omitted).  Specifically, while

17 the complaint makes out that Morgan Stanley was in the process of assessing the

18 risk to its proprietary trade during the second and third quarters of 2007, it is silent

28

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1 about when employees realized thatthe more pessimistic assessments ofthe market

2 were likely to come to fruition and that they would be unable to reduce the Long

3 Position.    To the contrary, the complaint shows that Cruz ordered Daula and

4 another Morgan Stanley employee, Neal Shear, to cut the Long Position regardless

5 of the likelihood that the pessimistic assumptions of the stress test would come to

6 pass.  See J.A. 477 (“I don’t care what your view of probability [sic] is.  Cut the

7 position.”).  The meetings aboutthe proprietary trade show similar caution:Morgan

8 Stanley’s task force discussed strategies to reduce the Long Position while also

9 developing a better sense of the “range” of losses the company could face.  J.A. 485.

10 Given the rigidity of Form 10‐Q filing deadlines, we find no basis to infer anything

11 more than “a heightened form of negligence” (if that) about whether Morgan

12 Stanley’s 10‐Qs would mislead investors about these internal deliberations,

13 especially after taking into account that Morgan Stanley was also profiting from the

14 declining market through its Short Position.  See South Cherry St., 573 F.3d at 109;see

15 also Kalnit v. Eichler, 264 F.3d 131, 144 (2d Cir. 2001) (holding that where a complaint

16 “does not present facts indicating a clear duty to disclose” it does not establish

17 “strong evidence of conscious misbehavior or recklessness”).

29

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1 Moreover, as we decide in the summary order issued in tandem with this

2 opinion,MorganStanley’s affirmative statements aboutits exposure to themortgage

3 securities market during the relevant time period were not misleading.  Cf. Matrixx,

4 131 S. Ct. at 1324 (finding it “most significant[]” for scienter that the defendant

5 “issued a press release” that affirmatively misrepresented facts).  And the company

6 did fully report its exposure to mortgage securities backed by subprime loans in

7 November 2007 — less than a month after its third quarter filing and a month in

8 advance of the next quarterly report.  See Rombach v. Chang, 355 F.3d 164, 176 (2d Cir.

9 2004) (noting that disclosure of facts prior to a filing deadline “weaken[s]” the

10 inference thatdefendants actedrecklessly);Novak, 216 F.3dat 308‐09 (explaining that

11 scienter should not be found where defendants merely “should have anticipated

12 future events and made certain disclosures earlier than they actually did”).  The

13 “most cogent inference” from these allegations, in tandem with assertions about

14 Morgan Stanley’s internal deliberations, “is that [the company] delayed releasing

15 information” on its Form 10‐Qs in the secondand third quarters of 2007 “to carefully

16 review” all of the relevant evidence and was at worst negligent as to the effect of the

17 delay on investors.    Matrixx, 131 S. Ct. at 1324 n.15 (internal quotation marks

18 omitted).  Because “a reasonableperson” wouldnotdeem the inference thatMorgan

30

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1 Stanley was consciously reckless about whetherits mandated filings would mislead

2 investors “at least as compelling” as this opposing inference, we conclude that the

3 Plaintiffs have not adequately pled scienter.  Tellabs, 551 U.S. at 324.

4 CONCLUSION

5 To summarize:

6 (1) We conclude that, as a matter of first impression in this Court, a

7 failure to make a required disclosure underItem 303 ofRegulation S‐K,

8 17 C.F.R. § 229.303(a)(3)(ii), in a 10‐Q filing is an omission that can

9 serve as the basis for a Section 10(b) securities fraud claim, if the

10 omission satisfies the materiality requirements outlined in Basic v.

11 Levinson, 485 U.S. at 224, and if all of the other requirements to sustain

12 an action under Section 10(b) are fulfilled.

13

14 (2) Plaintiffs have adequately alleged that Defendants breached their

15 Item 303 duty to disclose that Morgan Stanley faced a deteriorating

16 subprime mortgage market that, in light of the company’s exposure to

17 the market, was likely to cause trading losses that would materially

18 affect the company’s financial condition.

19

20 (3) We assume without deciding that this omission met the materiality

21 threshold established by Basic.  However, we do not agree with the

22 district court regarding the extent of Morgan Stanley’s disclosure

23 obligations.  Specifically, the Commission has never gone so far as to

24 require a company to announce its internal business strategies or to

25 identify the particulars of its trading positions.

26

27 (4) The district court properly dismissed Plaintiffs’ claim that

28 Defendants’ omissions violated Section 10(b) and Rule 10b‐5, because

29 the second amended complaint does not give rise to a strong inference

30 of scienter.

31

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1 For the foregoing reasons, and for the reasons stated in the summary order issued

2 simultaneously with this opinion, the judgment of the district court is hereby

3 AFFIRMED.

32

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