I was traveling when the decision came down, but I’d be remiss if I didn’t put in a word for the Supreme Court’s unanimous opinion in Macquarie Infrastructure Corp. v. MOAB Partners, L.P.
This decision pared back a theory of liability in my old area of practice, federal securities litigation under Section 10(b) of the Securities Exchange Act of 1934 and its implementing rule, Rule 10b-5. The bulk of such suits are class actions brought after a big drop in a stock’s price, on behalf of buyers of the stock who claim that they were misled by what the company told the markets. As I’ve explained before, this is mostly a judicially-invented area of law made up between the mid-1940s and the mid-1970s, which has made it challenging for the courts in a more rigorous age to make rules that are tethered to written law rather than adding to the body of judge-created law:
Investor class actions have long been one of the mainstays of the federal bar. For years, they were easily the largest category of class actions in federal court, although that distinction has been eroded since the 2005 expansion of federal jurisdiction over national class actions. Yet the main statute — Section 10(b) of the Securities Exchange Act of 1934 — does not say anything about private damages lawsuits for false or misleading statements to the stock market, let alone whether or how investors are supposed to show that they relied on those statements when they bought a stock. Section 10(b) was written as a criminal and regulatory statute, not a source of civil lawsuits. Rule 10b-5, the SEC rule that implements it, was drafted in an afternoon in 1942 without a moment’s discussion of private-damages lawsuits.
For decades, the courts have just been making up as they go along. Then–Justice Rehnquist in 1975 described Section 10(b) cases as “a judicial oak which has grown from little more than a legislative acorn.” But stare decisis in reading statutes is strong, and because Congress for half a century has gradually written rules about how to decide Section 10(b) lawsuits, the courts have treated that as congressional consent to let judge-made rules fill the gaps. Legitimacy-minded conservative judges have come up with a variety of next-best-thing limiting principles, such as looking at what similar statutes say, to keep this from becoming an exercise in pure judicial creative writing.
The statute itself makes it “unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . [,] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.” It’s long been understood that a “manipulative or deceptive device” includes a false statement, and also includes market manipulation. Over the years, following in the track of the traditional common law of fraud, the courts have held that it also includes omissions of the truth — if the defendant owed the plaintiff a fiduciary or other duty of disclosure. But fiduciary duties of that sort are typically not owed by corporations to the general mass of people who buy their stock, so while those duties play an important role in criminal cases, plaintiffs’ lawyers looking to make a Section 10(b) class action out of a failure to inform the market have had to get creative.
The famous story about Rule 10b-5, recounted by former SEC staff attorney Milton Freeman in 1967, shows how carefully the agency drafted its language:
I was sitting in my office in the S.E.C. building in Philadelphia and I received a call from…the Director of the Trading and Exchange Division. He said, “I have just been on the telephone with [the S.E.C. Regional Administrator in Boston]…and he has told me about the president of some company in Boston who is going around buying up the stock of his company from his own shareholders at $4.00 a share, and he has been telling them that the company is doing very badly, whereas, in fact, the earnings are going to be quadrupled and will be $2.00 a share for this coming year. Is there anything we can do about it?” So he came upstairs and I called in my secretary and I looked at Section 10(b) and I looked at Section 17 [of the Securities Act of 1933], and I put them together, and the only discussion we had there was where “in connection with the purchase or sale” should be, and we decided it should be at the end. We called the Commission and we got on the calendar, and I don’t remember whether we got there that morning or after lunch. We passed a piece of paper around to all the commissioners. All the commissioners read the rule and they tossed it on the table, indicating approval. Nobody said anything except [one commissioner]…”Well,” he said, “we are against fraud, aren’t we?” That is how it happened.
Section 17(a) of the Securities Act of 1933, which unlike Section 10(b) applies to fraudulent sales but not fraudulent purchases (hence the SEC’s need to pass a new rule that afternoon in 1942) provides:
It shall be unlawful for any person in the offer or sale of any securities…directly or indirectly— (1) to employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Cribbing more from this language than from the actual statute it was implementing, the SEC wrote Rule 10b-5:
It shall be unlawful for any person, directly or indirectly…(a) To employ any device, scheme, or artifice to defraud, (b) 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 (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
The Court as far back as Ernst & Ernst v. Hochfelder (1976) ruled that the SEC exceeded its statutory authority in writing Rule 10b-5 this way, because subparts (b) and (c) are modeled on Sections 17(a)(2) and 17(a)(3), which don’t require proof of fraudulent intent, but the language of Section 10(b) itself does, and so a Rule 10b-5 violation always requires proof of fraudulent intent. (I’ve written repeatedly, including in connection with the federal and state indictments of Donald Trump, on the common law elements of fraud and how courts traditionally rule that criminal and civil fraud statutes are strongly presumed to incorporate those elements unless the language plainly departs from them).
As you may notice, Rule 10b-5(b)’s language only makes it unlawful either “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.” Both of these involve actually saying something. For a while, there was a vogue in the plaintiffs’ bar trying to plug the gap by bringing omission cases under Rules 10b-5(a) and (c), trying to exploit the seeming vagueness of terms such as “device, scheme, or artifice to defraud” and “act, practice, or course of business which operates or would operate as a fraud or deceit.” (I wrote about this in 2006 in the Delaware Journal of Corporate Law, and co-wrote a number of amicus briefs to the Supreme Court on the issue for securities industry groups). The Court shut down that end-run in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., (2008), holding that a non-speaking party couldn’t be sued under Section 10(b) for “scheming” to have another party make a statement, and drove the point home in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), concluding that to “make” a statement under Rule 10b-5(b), it was necessary to be the party that actually published the statement.
Macquarie dealt with another end-run theory: that in the absence of a fiduciary duty of disclosure, companies could be sued for what they didn’t say on the theory that they violated a regulatory duty of disclosure to be found elsewhere in the vast volume of SEC rules. The most fertile field for these suits is Item 303 of Regulation S-K, which governs the “MD&A” section of a company’s quarterly and annual reports (MD&A being short for “Management’s Discussion and Analysis of Financial Conditions and Results of Operation”). Item 303 requires companies to “describe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” As you might expect, this is an open-ended rule, more a principle than a specific regulation; it’s easy in retrospect to second-guess what the company might have considered a “known…uncertaint[y].”
There’s been an open Circuit split for at least a decade on whether a failure to comply with disclosure regulations could provide a basis for a Section 10(b) suit in the absence of any specific statement that was made misleading as a result of the omission. The Third Circuit said no as far back as Oran v. Stafford (2000) — an opinion written by then-judge Samuel Alito. The Second and Ninth Circuits went the other way, although the Second Circuit fretted about the problem in inherent in the whole MD&A disclosure, which is that it pressures companies to reveal proprietary information that could be useful to its competitors, which is not in the interests of the company’s shareholders.
To the extent that there’s a respectable argument in favor of treating a Rule 303 violation as a breach of Section 10(b) and Rule 10b-5, it’s that an annual or quarterly report includes many statements, and “the circumstances under which they were made” includes the regulatory requirements for what goes into them, so investors might reasonably be misled by a report that leaves out those required disclosures. But that’s an especially flimsy basis when applying that theory to such a generalized requirement that plainly requires a lot of judgment calls. Perhaps more to the point, as the Macquarie opinion noted, Section 10(b) was enacted just a year after Congress wrote a statute governing lawsuits against initial offerers of stock, and that statute used similar language but explicitly included liability for failure to make disclosures required by regulations:
Statutory context confirms what the text plainly provides. Congress imposed liability for pure omissions in §11(a) of the Securities Act of 1933. Section 11(a) prohibits any registration statement that “contain[s] an untrue statement of a material fact or omit[s] to state a material fact required to be stated therein or necessary to make the statements therein not misleading.”…By its terms, in addition to proscribing lies and half-truths, this section also creates liability for failure to speak on a subject at all….There is no similar language in §10(b) or Rule 10b-5(b)…Neither Congress in §10(b) nor the SEC in Rule 10b-5(b) mirrored §11(a) to create liability for pure omissions. That omission (unlike a pure omission) is telling….
[Plaintiff] and the United States suggest that a plaintiff does not need to plead any statements rendered misleading by a pure omission because reasonable investors know that Item 303 requires an MD&A to disclose all known trends and uncertainties. That argument fails, however, because it reads the words “statements made” out of Rule 10b-5(b) and shifts the focus of that Rule and §10(b) from fraud to disclosure.
As for investor expectations, as Justice Sonia Sotomayor’s opinion noted, “take the simplest example. If a company fails entirely to file an MD&A, then the omission of particular information required in the MD&A has no special significance because no information was disclosed.” This was a clearer and more tightly-reasoned opinion than we’ve come to expect from Sotomayor, and all nine justices joined it without further comment. They got this one right.