SCOTUS weighs disclosure standard for material omissions

The US Supreme Court is wrestling with a case that could have major implications for financial service firms on either side of private securities lawsuits.

The central question in Macquarie Infrastructure Corp, et al v Moab Partners, et al is whether evidence of a violation of Item 303 under SEC rule S-K – which requires public companies to disclose “known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact” in their periodic regulatory filings – can support private litigation under the antifraud provisions of the 1934 Securities and Exchange Act. If the justices answer in the affirmative, Macquarie and its allies are worried, it will “open the floodgates to potentially crippling private securities fraud liability,” the company’s lawyers said in their brief.

Moab and its allies argue that an answer in the negative “would create broad immunity any time an issuer fraudulently omits information Congress and the SEC require it to disclose.”

The SEC, through the US Solicitor General’s office, is backing Moab. It has urged the justices to go even further. The commission says it cannot police every single public filing. Plaintiffs’ suits are a useful supplement to the commission’s enforcement authority. A ruling against Moab and its fellow plaintiffs could “allow unscrupulous parties to exploit the very trust that disclosure requirements are designed to foster by engaging in strategic omissions that they expect investors to misconstrue,” government lawyers said in their amicus brief.

The high court held oral arguments in the case on Tuesday.

Divided industry

The case has divided the private funds industry. Moab is an SEC-registered private fund adviser, and some of its fellow plaintiffs include public pension funds. Macquarie is a publicly traded company managed by its largest shareholder, a Sydney-based private infrastructure fund adviser.

In 2018, Moab filed a putative class-action suit against Macquarie, claiming that the company should have disclosed the impact of then-pending international rules limiting high-sulfur fuel oils on Macquarie’s business. Most of Macquarie’s profits had been driven by a subsidiary in the business of storing one of those kinds of fuels, known as “No 6 fuel oil.” In a 2012 earnings call, Macquarie told investors there was a risk that demand for “heavy oil residual product” might fall, but said it had no plans to convert its subsidiaries’ heavy oil tanks. Between 2012-18 – the international regulations curbing high-sulfur fuel oils took effect in 2016 – Macquarie officials didn’t mention the regulations or its No 6 storage but said more than once they weren’t worried about price changes for crude oil or petroleum products.

In February 2018, Macquarie – two years after the anti-sulfur regulations were adopted and Macquarie had separately issued common stock for sale – announced that demand for its No 6 storage business had fallen, that the company had missed its financial projections and that it would cut dividends. Two days later, the company’s stock fell by more than 40 percent.

Moab and its allies claim that Macquarie’s refusal to disclose the potential damage from the anti-sulfur regulations was materially misleading, tantamount to fraud under 10b-5 of the Exchange Act. A judge in the Southern District of New York tossed the suit, claiming that Moab had failed to prove material omissions or scienter. But a unanimous panel of the Second Circuit US Court of Appeals overturned the dismissal, ruling that the court should’ve rationally concluded that Macquarie’s material omissions were evidence for scienter. Macquarie appealed to the Supreme Court.

‘Hard to apply’

The high court’s hard-right majority is generally thought to be hostile to the plaintiffs’ bar – Macquarie lead counsel Linda Coberly, a partner at Winston & Strawn, reminded the justices that they are usually “loath to expand” private rights of action – but Chief Justice John Roberts opened arguments by telling Coberly “the distinction you draw between sort of half-truths and omissions strikes me as one that might be hard to apply in practice.”

Justices Clarence Thomas and Brett Kavanaugh seemed most worried about whether the SEC should be in charge of enforcing Item 303. “If pure omissions are misleading – it seems as though you’re saying the mere fact that it is an omission makes it misleading,” Thomas told Moab lead counsel and Kellogg, Hansen, Todd, Figel & Frederick partner David Frederick, “Is there a limit to that?”

Kavanaugh wanted to know, “Can we just say that an omission alone is not good enough, you have to identify a statement as well, and send it back?” When Frederick responded that such a ruling would not help, Kavanaugh said, “It’ll help us,” drawing laughs.

Both Thomas and Kavanaugh pressed Ephraim McDowell, who argued for the solicitor general’s office, on how the government was arguing that a public statement that omitted a fact (however material) renders the whole disclosure misleading without containing an otherwise false statement.

‘Verbal junk’

Advocates on both sides are watching the case closely. SIFMA, the US Chamber of Commerce and the Business Roundtable, among others, filed an amicus brief supporting Macquarie. The business trio say they’re worried that a ruling for Moab will sow even more confusion among investors.

“The Second Circuit’s erroneous rule means that public companies must overdisclose or incur risk simply by omitting a disclosure in any remotely doubtful case,” the groups said in their brief. “Such overdisclosure is hardly benign. This Court, the SEC and scholars have all warned against bloated disclosures that bury actually useful information in a pile of verbal junk.”

In a separate amicus brief, 10 different pension funds – including New York State Comptroller Thomas DiNapoli in his capacity as trustee to New York’s public pension plan – and three investment advisers said the Second Circuit got things right. “Amici institutional investors, their investment advisers and investment professionals generally rely heavily not only on the accuracy of the information disclosed under this regime, but also on the completeness of those disclosures,” the funds and fund advisers said. “Item 303 disclosures are particularly important. Most information provided under federal securities law is backward-looking. That information is important, but stock valuations are principally based on a prediction of future performance.”

Motions to dismiss

Among those watching the case is Troutman Pepper partner Jay Dubow. He says how a fund manager views the case will depend on their business model. Activist, disruptive fund managers are more likely to support Moab. Portfolio managers are more likely to support Macquarie.

The difficulty is that the Second Circuit seems to have determined that an omission is per se evidence of fraud. That makes it much easier for class-action lawsuits to survive motions to dismiss, which in turns puts enormous pressure on companies to settle such actions.

“The big thing in these securities cases, plaintiffs just want to get past the motion to dismiss,” he says. “These cases almost never go to trial. The cases usually settle, because there’s going to be lots of expensive discovery involved.”

Like SIFMA, Dubow says he worries that a decision for Moab could force companies to make all kinds of useless disclosures. It’s easy to see how knowledge would dissolve in information under such circumstances, Dubow says.

“I think the potential for having companies having to make all kinds of unnecessary, extra disclosures, could really dilute the usefulness of disclosures,” he says. “Now they’re going to put 50 different things, because, who knows, maybe a comet will hit us.”

The Supreme Court’s decision in Macquarie is not likely to land until April.