130627cv

FjardeAPFondenv.MorganStanley
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UNITEDSTATESCOURTOFAPPEALS
FORTHESECONDCIRCUIT

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AugustTerm2013

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Argued:December10,2013
Decided:January12,2015

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No.130627cv

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_____________________________________

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JOELSTRATTEMCCLURE,
Plaintiff,

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FJARDEAPFONDEN,
PlaintiffAppellant,

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PLAINTIFFSTATEBOSTONRETIREMENTSYSTEM,
STATEBOSTONRETIREMENTSYSTEM,
MovantAppellant,

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MORGANSTANLEY,aDelawareCorporation,JOHNJ.MACK,
ZOECRUZ,DAVIDSIDWELL,THOMASCOLMKELLEHER,THOMASV.DAULA,
DefendantsAppellees,

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GARYG.LYNCH,
Defendant.
_____________________________________

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Before:

CABRANES,WESLEY,andLIVINGSTON

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AppealfromApril4,2011andJanuary18,2013ordersoftheUnitedStates
District Court for the Southern District of New York (Batts, J.), granting the
Defendantsmotionstodismiss.Forthereasonsstatedhereandinasummaryorder
issued simultaneously with this opinion, we AFFIRM the order granting the
Defendantsmotiontodismiss.

AFFIRMED.

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David Kessler (Andrew L. Zivitz, Kimberly A.

Justice,RichardA.Russo,Jr.,JoshuaA.Materese,
onthebrief)KesslerTopazMeltzer&Check,LLP,
Radnor,PA,forPlaintiffAppellantFjardeAPFonden
andfortheClass.

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JAVIER BLEICHMAR (JonathanM.Plasse,JosephA.

Fonti, Wilson M. Meeks, on the brief), Labaton
SucharowLLP,NewYork,NY,forMovantAppellant
StateBostonRetirementSystemandfortheClass.

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

Ditchfield,onthebrief),DavisPolk&WardwellLLP,
NewYork,NY,forDefendantsAppellees.

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DEBRAANNLIVINGSTON,CircuitJudge:

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Lead Plaintiffs StateBoston Retirement System and Fjarde APFonden

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broughtthisputativesecuritiesfraudclassactiononbehalfofthemselvesandother

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similarlysituatedinvestors(Plaintiffs)pursuanttoSections10(b)and20(a),15

U.S.C.78j(b)and78t(a),oftheSecuritiesExchangeActof1934.Theyallegethat

MorganStanleyandsixofitsofficersandformerofficersJohnJ.Mack,ZoeCruz,

DavidSidwell,ThomasColmKelleher,andThomasDaula(collectively,Morgan

StanleyorDefendants)madematerialmisstatementsandomissionsbetween

June20,2007andNovember19,2007(theclassperiod)inanefforttoconceal

MorganStanleysexposuretoandlossesfromthesubprimemortgagemarket.As

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

Stanleys stock prices dropped following public disclosure of the truth about

MorganStanleyspositionsandlosses.

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TheUnitedStatesDistrictCourtfortheSouthernDistrictofNewYork(Batts,

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J.)dismissedallclaimsonthepleadingsforfailuretostateaclaim,andweaffirm.

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Forthereasonsstatedinthisopinion,weconcludethatthedistrictcourtproperly

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dismissedPlaintiffsclaimthatDefendantsomissionofinformationpurportedly

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required to be disclosed under Item 303 of Regulation SK, 17 C.F.R.

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

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dismissingPlaintiffsotherclaimsinasummaryorderissuedsimultaneouslywith

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thisdecision.

BACKGROUND1

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

StanleysProprietaryTradingGroupinDecember2006.Thetradeconsistedoftwo

components:a$2billionshortposition(ShortPosition)anda$13.5billionlong

position(LongPosition).IntheShortPosition,MorganStanleypurchasedcredit

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

mezzanine tranches of subprime residential mortgagebacked securities

(RMBSs).2TheseCDSsoperatedlikeinsurancepoliciesMorganStanleypaid

annualpremiumsfortheassurancethat,ifthehousingmarketworsenedandthe

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mezzanineRMBStranchesbackingitsCDOsdefaultedordeclinedinvalue,itwould

ThefactspresentedherearedrawnfromtheallegationsinPlaintiffssecond
amendedcomplaint,whichweacceptastrueforthepurposesofreviewingthemotion
todismiss.SeeAnschutzCorp.v.MerrillLynch&Co.,690F.3d98,107(2dCir.2012).
Althoughwedecideonlyoneissueinthisopinion,wedescribethePlaintiffs
allegationsingreaterdetailtoprovidecontext.
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Briefly,asdescribedbyPlaintiffs,aRMBSiscreatedbypoolingthousandsof
residentialmortgagesintoatrust.Thetrustthenissuesbonds,whichinvestors
purchase.Themortgagesserveascollateralforthesebonds,andtheinterestonthe
bondsderivesfromthecashflowcreatedbymortgagepayments.RMBSscanbe
aggregatedintoCDOs,whicharesoldintranchesbasedonpriorityofentitlementto
thecashflow.EachtrancheofagivenRMBSisexposedtothesamepoolofmortgages,
butlowertranchessustainlossesbeforehighertranchesintheeventthatmortgagesin
thepooldefaultordonotmeetpaymentdeadlines.CDOsaresimilarlydividedinto
higherandlowertranches.
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receivepayments.IntheLongPosition,MorganStanleysoldCDSs.TheseCDSs,

likethoseitboughtfortheShortPosition,referencedCDOsbackedbymezzanine

tranchesofsubprimeRMBSs.ButtheCDOsreferencedbytheLongPositionwere

superseniortranchesofCDOsthatwerehigherratedandlowerriskthantheCDOs

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

thereforereceivedpremiumpaymentsfortheguaranteethatitwouldpaytheCDS

purchasersintheeventthattheselowerriskCDOtranchesdefaultedordeclinedin

value.MorganStanleycouldusetheincomefromthosepremiumstofinancethe

ShortPosition,butwouldhavetomakepayoutsiftheCDOtranchesreferencedby

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theLongPositionsuffereddefaultsuptoamaximumof$13.5billionintheevent

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ofa100percentdefaultintheseCDOs.Inessence,thecompanywasbettingthat

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defaultsinthesubprimemortgagemarketswouldbesignificantenoughtoimpair

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thevalueofthehigherriskCDOtranchesreferencedbytheShortPosition,butnot

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significantenoughtoimpairthevalueofthelowerriskCDOtranchesreferencedby

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theLongPosition.

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AccordingtothePlaintiffs,[b]ymid2006,thebiggesthousingbubbleinU.S.

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historyhadpopped.J.A.465.Subprimemortgagesissuedin2005and2006,like

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those backing Morgan Stanleys proprietary trade, rapidly began to suffer from
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delinquenciesanddefaults.OnFebruary12,2007,Morgan[Stanley]economist

RichardBerneracknowledgedthatthese[s]oaringdefaultssignalthatthelong

awaitedmeltdowninsubprimemortgagelendingisnowunderway[.]J.A.469.

AlthoughMorganStanleysProprietaryTradingGrouphadcorrectlypredictedthe

direction that the subprime housing market would turn, it apparently

underestimatedthemagnitudeofthecollapse.ThevalueofMorganStanleysswap

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

ultimatelylostbillionsofdollarsontheproprietarytrade.

PlaintiffsallegethatDefendantsmadenumerousmaterialmisstatementsand

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

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Stanleysexposuretoandlossesfromthissubprimeproprietarytrade.Thesecond

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amendedcomplaintidentifiestwocategoriesofmisrepresentationsandomissions:

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(1)misrepresentationsandomissionsregardingMorganStanleysexposuretocredit

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riskrelatedtotheU.S.subprimemortgagemarketarisingfromitsLongPosition(the

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exposureclaim),and(2)misrepresentationsregardingMorganStanleyslosses

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arisingfromtheLongPosition(thevaluationclaim).Plaintiffsallegethatthese

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misstatementsandomissionsfraudulentlyinflatedMorganStanleysstockprice

during the class period and caused them to suffer financially when the market

learnedthetruthaboutMorganStanleysexposureandlosses.

A.ExposureClaim

The second amended complaint alleges that Defendants materially

misrepresented Morgan Stanleys exposure to the subprime mortgage market.

PlaintiffsrelyonfourstatementsfromMorganStanleyofficers,andonealleged

omission.First,onaJune20,2007callwithmarketanalystsaboutMorganStanleys

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

quarter about whether issues in the subprime market were going to spread

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dissipated.J.A.498.Second,onthatsamecall,Sidwellrespondedtoarequestto

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characterizeMorganStanleyspositioninthemortgagemarketandtoexplainthe

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declineinthecompanysfixedincomerevenuesbystatingthatMorganStanley

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reallydidbenefitfromconditionsinthesubprimemarketinthefirstquarterof

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2007,andcertainlydidnotlosemoneyinthisbusinessduringthesecondquarter.

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J.A.498,499.Third,duringanotherearningscallwithmarketanalystsonSeptember

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19,2007,DefendantKelleherstatedthatMorganStanleyremain[ed]exposedtorisk

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exposuresthroughanumberofinstruments[including]CDOs,withoutdescribing

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theextentofthatexposure.J.A.50607.Andfourth,KelleherstatedinanOctober
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24, 2007 interview with CIBC World Markets analyst Meredith Whitney that he

[did]notseefurtherwritedownsto[MorganStanleys]carryingvaluesoverthe

nearterm.J.A.516.Plaintiffsclaimthateachofthesestatementswasmaterially

falseormisleading.

As pertinent here, Plaintiffs also allege that Defendants made material

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

Position,thatMorganStanleyhadsustainedlossesonthatpositioninthesecond

andthirdquartersof2007,andthatthecompanywas likelytoincuradditional

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

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RegulationSKandrelatedguidancerequirescompaniestodiscloseontheir10Q

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filingsanyknowntrends,oruncertaintiesthathavehad,ormightreasonablybe

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expectedtohave,a[n]...unfavorablematerialeffectonthecompanysrevenue,

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operatingincomeornetincome.J.A.465.Plaintiffsclaimthat[b]yJuly4[,2007,]

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atthelatest,DefendantsknewthattheLongPositionwasreasonablyexpectedto

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haveanunfavorablematerialeffectonrevenue.J.A.482.Itisnotdisputedthat

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MorganStanleydidnotmakethisItem303disclosureonits10Qfilingsin2007.

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B.ValuationClaim

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

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

sufficientlywritedownthevalueofitsLongPosition.AccordingtoPlaintiffs,the

LongPositionsvaluewasinherentlylinkedtoanindexofRMBSsknownasthe

ABX.BBB.061Index(theABXIndex).Thus,whentheABXIndexdeclinedby32.8

percentinthethirdquarterof2007,MorganStanleyshouldhavemarkeddownthe

valueoftheLongPositionbythatsamepercentageanddisclosedthelossinits

quarterlystatement.Insteadoftakingthat$4.4billionmarkdown,however,Morgan

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Stanleyrecognizedonlya$1.9billionlossontheLongPositionaftervaluingitusing

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internalmodelsthatdidnotexclusivelyrelyontheABXIndex.Plaintiffsallegethat

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MorganStanleylaterwrotedownthevalueoftheLongPositionbyapercentage

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greaterthanthatdictatedbytheABXIndexinordertomakeupforthemisstatement

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inthethirdquarter.

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C.ProceduralHistory

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

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DistrictofCalifornia,filinganinitialcomplaintinearly2008andthenanamended

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complaintonNovember24,2008.ThecasewasthentransferredtotheUnitedStates
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DistrictCourtfortheSouthernDistrictofNewYork(Batts,J.),whereDefendants

movedtodismissallclaimspursuanttoRules9(b)and12(b)(6)oftheFederalRules

ofCivilProcedureandSection78u4(b)ofthePrivateSecuritiesLitigationReform

Act.StratteMcClurev.MorganStanley,784F.Supp.2d373,376(S.D.N.Y.2011).The

districtcourtgrantedthemotiontodismissonApril4,2011.Id.at391.Onthe

exposureclaim,thedistrictcourtruledthattheamendedcomplaintdidnotspecify

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

misleadinganddecidedthatDefendantshadnoobligationtodisclosetheLong

Position. See id. at 38586. On the valuation claim, the district court ruled that

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Plaintiffsfailedtopleadlosscausation.Seeid.at39091.ThecourtgrantedPlaintiffs

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leavetoamendtheirpleadingswithregardtotheexposureclaimandlosscausation

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onthevaluationclaim,butotherwisedismissedPlaintiffsclaimswithprejudice.

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Seeid.at391.

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OnJune9,2011,PlaintiffsfiledasecondamendedcomplaintandDefendants

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movedtodismisssoonthereafter.Onceagain,thedistrictcourtdismissedallofthe

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claims. StratteMcClure v. Morgan Stanley, No. 09Civ.2017, 2013 WL 297954

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

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decisionthatPlaintiffsfailedtopleadlosscausationforthevaluationclaim.Seeid.
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at*12*13.Withregardtotheaffirmativestatementsconsideredinconnectionwith

theexposureclaim,thedistrictcourtfoundnoreasontoalteritsearlierdecisionthat

Plaintiffsdidnotsufficientlypleadfalsity.Seeid.at*4*5.Butthistime,thecourt

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

Positioninits2007Form10Qfilings.Seeid.at*7.Thedistrictcourtjustifiedthe

change in its stance by relying on this Courts intervening decisions in Panther

PartnersInc.v.IkanosCommunications,Inc.,681F.3d114(2dCir.2012),andLitwinv.

BlackstoneGroup,L.P.,634F.3d706(2dCir.2011),whichheldthatItem303may

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

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

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dismissedtheexposureclaimafterdecidingthatthesecondamendedcomplaint

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failedtopleadastronginferenceofscienterwithrespecttoDefendantsfailureto

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

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decisions.

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DISCUSSION

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WereviewdenovothedistrictcourtsjudgmentgrantingDefendantsmotion

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todismiss.AbsoluteActivistValueMasterFundLtd.v.Ficeto,677F.3d60,65(2dCir.

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2012).Tosurviveamotiontodismiss,acomplaintmustcontainsufficientfactual
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matter, accepted as true, to state a claim for relief that is plausible on its face.

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

makingthisdetermination,weconsideranywritteninstrumentattachedto[the

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

reference,aswellaspublicdisclosuredocumentsrequiredbylawtobe,andthat

havebeen,filedwiththeSEC,anddocumentsthattheplaintiffseitherpossessedor

knewaboutanduponwhichtheyreliedinbringingthesuit.Rothmanv.Gregor,220

F.3d81,88(2dCir.2000)(citationsomitted).

Section10(b)oftheSecuritiesExchangeActof1934makesitunlawfultouse

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

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manipulativeordeceptivedeviceorcontrivanceincontraventionof[the]rulesand

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regulationsthattheSECprescribes.15U.S.C.78j.Inturn,Rule10b5,which

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implementsSection10(b),provides:

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Itshallbeunlawfulforanyperson,directlyorindirectly...:

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(a)Toemployanydevice,scheme,orartificetodefraud,

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(b)Tomakeanyuntruestatementofamaterialfactortoomitto
stateamaterialfactnecessaryinordertomakethestatements
made,inthelightofthecircumstancesunderwhichtheywere
made,notmisleading,or

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(c)Toengageinanyact,practice,orcourseofbusinesswhich
operatesorwouldoperateasafraudordeceituponanyperson,

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inconnectionwiththepurchaseorsaleofanysecurity.

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17C.F.R.240.10b5.Tostateaclaimforsecuritiesfraudundertheseprovisionsa

plaintiffmustallegethateachdefendant(1)mademisstatementsoromissionsof

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

securities,(4)uponwhichtheplaintiffrelied,and(5)thattheplaintiffsreliancewas

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theproximatecauseofitsinjury.ATSICommcns,Inc.v.ShaarFund,Ltd.,493F.3d

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87,105(2dCir.2007).

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This opinion addresses the district courts decision that Morgan Stanleys

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failuretodisclosetheLongPositioninitsJulyandOctober10Qfilings,inalleged

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disregardofItem303ofRegulationSK,constitutedanactionableomissionunder

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Section10(b)andRule10b5.3Weconclude,asamatteroffirstimpressioninthis

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Court,thatafailuretomakearequiredItem303disclosureina10Qfilingisindeed

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anomissionthatcanserveasthebasisforaSection10(b)securitiesfraudclaim.

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

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requirementsoutlinedinBasicInc.v.Levinson,485U.S.224(1988),andifallofthe

Asalreadynoted,Plaintiffsremainingclaimsareaddressedinthesummary
orderfiledsimultaneouslywiththisopinion.
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otherrequirementstosustainanactionunderSection10(b)arefulfilled.Here,the

districtcourtproperlydismissedPlaintiffsexposureclaimpredicatedonMorgan

StanleysfailuretodiscloseunderItem303becausethesecondamendedcomplaint

didnotsufficientlypleadscienter.

I.

TheSupremeCourthasinstructedthat[s]ilence,absentadutytodisclose,

isnotmisleadingunderRule10b5.Basic,485U.S.at239n.17;seealsoChiarellav.

UnitedStates,445U.S.222,230(1980).Asaresult,wehaveconsistentlyheldthatan

omissionisactionableunderthesecuritieslawsonlywhenthecorporationissubject

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toadutytodisclosetheomittedfacts.InreTimeWarnerInc.Sec.Litig.,9F.3d259,

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267(2dCir.1993);seeGlazerv.FormicaCorp.,964F.2d149,157(2dCir.1992).Such

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

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information,astatuteorregulationrequiringdisclosure,oracorporatestatement

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thatwouldotherwisebeinaccurate,incomplete,ormisleading.Glazer,964F.2d

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at157(quotingBackmanv.PolaroidCorp.,910F.2d10,12(1stCir.1990)(enbanc));

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accordOranv.Stafford,226F.3d275,28586(3dCir.2000).

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AsPlaintiffscorrectlyargue,Item303ofRegulationSKimposesdisclosure

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requirementsoncompaniesfilingSECmandatedreports,includingquarterlyForm
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10Qreports.SeeLouisLoss&JoelSeligman,FundamentalsofSecuritiesRegulation

512&n.14(5thed.2004).Thoserequirementsincludetheobligationto[d]escribe

anyknowntrendsoruncertainties...thattheregistrantreasonablyexpectswill

haveamaterial...unfavorableimpacton...revenuesorincomefromcontinuing

operations.17C.F.R.229.303(a)(3)(ii).TheSEChasprovidedguidanceonItem

303,clarifyingthatdisclosureisnecessarywhereatrend,demand,commitment,

eventoruncertaintyisbothpresentlyknowntomanagementandreasonablylikely

to have material effects on the registrants financial conditions or results of

operations.ManagementsDiscussionandAnalysisofFinancialConditionand

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ResultsofOperations,ExchangeActReleaseNo.6835,43S.E.C.Docket1330,1989

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WL1092885,at*4(May18,1989)[hereinafterExchangeActReleaseNo.6835].

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Item303saffirmativedutytodiscloseinForm10Qscanserveasthebasisfor

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asecuritiesfraudclaimunderSection10(b).Wehavealreadyheldthatfailingto

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complywithItem303byomittingknowntrendsoruncertaintiesfromaregistration

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statementorprospectusisactionableunderSections11and12(a)(2)oftheSecurities

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Actof1933.4SeePantherPartners,681F.3dat120;Litwin,634F.3dat716;accordJ&R

Wehavealsoheldthatdefendantsfailuretomakerequireddisclosuresunder
Item303contributedtoanadequatelypledsecuritiesfraudclaimunderSection10(b)in
InreScholasticCorp.SecuritiesLitigation,252F.3d63,7074(2dCir.2001).Whilethat
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Mktg. v. Gen. Motors Corp., 549 F.3d 384, 392 (6th Cir. 2008); Silverstrand Invs. v.

AMAGPharm.,Inc.,707F.3d95,10203,107(1stCir.2013).LikeSection12(a)(2),

Rule10b5requiresdisclosureofmaterialfact[s]necessaryinordertomake...

statementsmade...notmisleading.ThisCourtandoursistercircuitshavelong

recognizedthatadutytodiscloseunderSection10(b)canderivefromstatutesor

regulationsthatobligateapartytospeak.See,e.g.,Glazer,964F.2dat149;Backman,

910F.2dat20;Oran,226F.3dat28586;Gallagherv.AbbottLabs.,269F.3d806,808

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

casealsoinvolvedaffirmativelymisleadingstatements,weciteddefendantsalleged
failuretodisclosetrendsinitsForm10Q,despiteadutyunderItem303todisclose
thosetrends,asevidencethatplaintiffsadequatelyallegedaSection10(b)violation,
implyingthatItem303saffirmativedutytodiscloseinForm10Qscanserveasthe
basisforasecuritiesfraudclaimunderSection10(b).Seeid.Nevertheless,perhaps
becauseInreScholasticdidnotsquarelyaddresswhetherItem303cangiverisetoa
dutytodiscloseunder10b5,districtcourtsinthisCircuithavecontinuedtoexpress
confusionontheissue.See,e.g.,Abuhamdanv.Blyth,Inc.,9F.Supp.3d175,206n.25(D.
Conn.2014)([I]tisfarfromcertainthattherequirementthattherebeadutytodisclose
underRule10b5maybesatisfiedbyimportingthedisclosuredutiesfromSK303....
(internalquotationmarksomitted));InreNevsunRes.Ltd.,No.12cv1845,2013WL
6017402,at*11n.4(S.D.N.Y.Sept.27,2013)(PlaintiffscannotbasetheirSection10(b)
claimonatheorythatDefendantsviolatedItem303.);cf.InreCorning,Inc.Sec.Litig.,
349F.Supp.2d698,716(S.D.N.Y.2004)([T]heSecondCircuit...reversedadistrict
courtsdismissalofaRule10b5claimthatwasbasedonadefendantsfailuretomake
disclosuresallegedlyrequiredunderSK303.Itwouldappearthatthe[District]Court
mustconsiderItem303inconnectionwithplaintiffsclaimunderRule10b5.(citingIn
reScholastic,252F.3dat74)).
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requiredtobedisclosedona10Qcanrenderthatfinancialstatementmisleading.

Likeregistrationstatementsandprospectuses,Form10Qsaremandatoryfilings

thatspeak...totheentiremarket.Shawv.DigitalEquip.Corp.,82F.3d1194,1222

(1stCir.1996)(abrogatedbystatuteonothergrounds).Asrequiredelementsof

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

registrant through the eyes of management by providing a historical and

prospectiveanalysisoftheregistrantsfinancialconditionandresultsofoperations.

ExchangeActReleaseNo.6835,1989WL1092885,at*17.Duetotheobligatory

natureoftheseregulations,areasonableinvestorwouldinterprettheabsenceofan

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Item303disclosuretoimplythenonexistenceofknowntrendsoruncertainties.

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..thattheregistrantreasonablyexpectswillhaveamaterial...unfavorableimpact

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on...revenuesorincomefromcontinuingoperations.17C.F.R.229.303(a)(3)(ii);

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seealsoDonaldC.Langevoort&G.MituGulati,TheMuddledDutytoDiscloseUnder

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Rule10b5,57Vand.L.Rev.1639,1680(2004).ItfollowsthatItem303imposesthe

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

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Section10(b).5

BecauseSection10(b)prohibitsmanipulativeordeceptivedevice[s]...in
contraventionof[theSECs]rulesandregulations,15U.S.C.78j,allowinga10b5
causeofactiontoarisefromafailuretodiscloseunderItem303doesnotexceedwhat
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ThefailuretomakearequireddisclosureunderItem303,however,isnotby

itselfsufficienttostateaclaimforsecuritiesfraudunderSection10(b).Significantly,

Rule10b5makesonlymaterialomissionsactionable.17C.F.R.240.10b5(b).

InBasicInc.v.Levinson,theSupremeCourtconcludedthat,insecuritiesfraudcases

underSection10(b)andRule10b5,thematerialityofanallegedlyrequiredforward

lookingdisclosureisdeterminedbyabalancingofboththeindicatedprobabilitythat

theeventwilloccurandtheanticipatedmagnitudeoftheeventinlightofthetotality

ofthecompanyactivity.485U.S.at238(quotingSECv.TexasGulfSulfurCo.,401

F.2d833,849(2dCir.1968)(enbanc))(emphasisadded).TheSECstestforaduty

Congressauthorize[d]whenitfirstenactedthe[SecuritiesExchangeAct].Janus
CapitalGrp.,Inc.v.FirstDerivativeTraders,131S.Ct.2296,2302(2011)(internalquotation
marksomitted);seealsoCent.BankofDenver,N.A.v.FirstInterstateBankofDenver,N.A.,
511U.S.164,173(1994)([A]privateplaintiffmaynotbringa10b5suitagainsta
defendantforactsnotprohibitedbythetextof10(b).).OurconclusionthatItem303
mayprovidethebasisfora10b5violationissupportedbyanSECCeaseandDesist
Order,inwhichtheCommissionheldthatacompanyviolatedSection10(b)andRule
10b5byfailingtoincludeinForm10Qsinformationitwasobligatedtodiscloseunder
Item303.InreValleySys.,Inc.,FileNo.38811,1995WL547801,at*4(S.E.C.Sept.14,
1995).OurdecisionisalsoconsistentwithanopinionintheFirstCircuit.SeeShaw,82
F.3dat1222&n.37([I]nthecontextofapublicoffering,plaintiffswho(throughthe
market)relyuponthecompletenessofaregistrationstatementorprospectusmaysue
underSection10(b)andRule10b5fornondisclosuresofmaterialfactsomittedfrom
thosedocumentsinviolationoftheapplicableSECrulesandregulations.).
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toreportunderItem303,ontheotherhand,involvesatwopart(anddifferent)

inquiry.Onceatrendbecomesknown,managementmustmaketwoassessments:

(1)Istheknowntrend...likelytocometofruition?Ifmanagement
determines that it is not reasonably likely to occur, no disclosure is
required.

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(2)Ifmanagementcannotmakethatdetermination,itmustevaluate
objectivelytheconsequencesoftheknowntrend...ontheassumption
that it will come to fruition. Disclosure is then required unless
management determines that a material effect on the registrants
financialconditionorresultsofoperationsisnotreasonablylikelyto
occur.

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ExchangeActReleaseNo.6835,1989WL1092885,at*6.AccordingtotheSEC,this

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disclosurestandardisuniquetoItem303,and[t]heprobability/magnitudetestfor

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materialityapprovedbytheSupremeCourtin[Basic]isinapposite.Id.at*6n.27;

17

seealsoOran,226F.3dat288(notingthatItem303sdisclosureobligationsextend

18

considerablybeyondthoserequiredbyRule10b5).

19

SincetheSupremeCourtsinterpretationofmaterialinRule10b5dictates

20

whetheraprivateplaintiffhasproperlystatedaclaim,weconcludethataviolation

21

ofItem303sdisclosurerequirementscanonlysustainaclaimunderSection10(b)

22

and Rule 10b5 if the allegedly omitted information satisfies Basics test for

23

materiality.Thatis,aplaintiffmustfirstallegethatthedefendantfailedtocomply

19

with Item 303 in a 10Q or other filing. Such a showing establishes that the

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

informationwasmaterialunderBasicsprobability/magnitudetest,because10b5

onlymakesunlawfulanomissionofmaterialinformationthatisnecessaryto

make...statementsmade,inthiscasetheForm10Qs,notmisleading.Matrixx

Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 132122 (2011) (quoting 17 C.F.R.

240.10b5(b))(internalquotationmarksomitted).Ofcourse,aswithanySection

10(b)claim,aplaintiffmustalsosufficientlypleadscienter,aconnectionbetween

the...omissionandthepurchaseorsaleofasecurity,relianceontheomission,

10

andaneconomiclosscausedbythatreliance.Levittv.J.P.MorganSec.,Inc.,710F.3d

11

454,465(2dCir.2013).

12

WenotethatourconclusionisatoddswiththeNinthCircuitsrecentopinion

13

inInreNVIDIACorp.SecuritiesLitigation,768F.3d1046(9thCir.2014).Thatcase

14

heldthatItem303sdisclosuredutyisnotactionableunderSection10(b)andRule

15

10b5,relyingonaThirdCircuitopinionbythenJudgeAlito,Oranv.Stafford,226

16

F.3dat275.ButOransimplydeterminedthat,[b]ecausethematerialitystandards

17

forRule10b5and[Item303]differsignificantly,aviolationofItem303doesnot

18

automaticallygiverisetoamaterialomissionunderRule10b5.Id.at288(emphasis
20

added).Havingalreadydecidedthattheomissionsinthatcasewerenotmaterial

underBasic,theThirdCircuitconcludedthatItem303couldnotprovideabasisfor

liability. Id. Contrary to the Ninth Circuits implication that Oran compels a

conclusionthatItem303violationsareneveractionableunder10b5,Oranactually

suggested,withoutdeciding,thatincertaininstancesaviolationofItem303could

giverisetoamaterial10b5omission.Ataminimum,Oranisconsistentwithour

decisionthatfailuretocomplywithItem303inaForm10Qcangiverisetoliability

under Rule 10b5 so long as the omission is material under Basic, and the other

elementsofRule10b5havebeenestablished.

10

TheNinthCircuitsopinioninNVIDIAalsomisconstruestherelationship

11

betweenRule10b5andSection12(a)(2)oftheSecuritiesAct.InLitwinandPanther

12

Partners,weestablishedthatItem303createsadutytodiscloseforthepurposesof

13

liabilityunderSection12(a)(2).Litwin,634F.3dat716;PantherPartners,681F.3dat

14

120.TheNinthCircuithadalsoadoptedthatposition.SeeSteckmanv.HartBrewing,

15

Inc.,143F.3d1293,1296(9thCir.1998).InNVIDIA,apaneloftheNinthCircuit

16

found these decisions irrelevant to its interpretation of Rule 10b5. But Section

17

12(a)(2)sprohibitiononomissionsistextuallyidenticaltothatofRule10b5:both

18

makeunlawfulomissionofmaterialfact[s].. .necessaryinordertomake...
21

statements, in light of the circumstances under which they were made, not

misleading.15U.S.C.77l;seealso17C.F.R.240.10b5.SECregulations,likeItem

303,dictatethecontentsofmandatorydisclosuresbetheyForm10Qsinthecase

ofRule10b5orprospectusesinthecaseofSection12(a)(2)andarethereforean

essentialpartofthecircumstancesunderwhichsuchdisclosuresaremade.Litwin

andPantherPartnersrecognizedthatissuingfinancialstatementsthatomitelements

requiredbyItem303canmisleadinvestors.Thosedecisionsprovidefirmfooting

forourdecisioninthiscase.

II.

10

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

11

adequatelyallegedthatDefendantsbreachedtheirItem303dutytodisclosethat

12

MorganStanleyfacedadeterioratingsubprimemortgagemarketthat,inlightofthe

13

companysexposuretothemarket,waslikelytocausetradinglossesthatwould

14

materiallyaffectthecompanysfinancialcondition.Weassume,arguendo,thatthis

15

omission was material under Basic. We nonetheless affirm the district courts

16

dismissaloftheclaim,concludingthatPlaintiffsfailedadequatelytopleadscienter.

17

Plaintiffshaveplausiblyallegedthat,bythesecondandthirdquartersof2007,there

18

wasasignificantdownwardtrendinthesubprimeresidentialmortgagemarketthat
22

couldnegativelyaffectMorganStanleysoverallfinancialposition.Tobeginwith,

Plaintiffsallegethatmarketwatchers,includingMorganStanleyanalysts,reported

adownwardtrendintherealestateandsubprimemortgagemarketsasearlyas

2006.ByFebruary27,2007,aMorganStanleyeconomisthadwrittenthat[s]oaring

defaultssignalthatthelongawaitedmeltdowninsubprimemortgagelendingis

nowunderway,andthecompanysownCDOanalystsreportedsignificantrisks

toCDOsbackedbyassetbackedsecurities,includingRMBSs.J.A.469.Thattrend

continuedintothesummer,whenMorganStanleyanalystsallegedlyreportedthat

[r]atingsdowngradesin[assetbacked]CDOtranchesareinevitableandmaterial,

10

thatthoseCDOswereexpectedtoremainunderseverepressure,andthatlong

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

exposuretoasharpdownturninthesubprimemarketthroughitsLongPosition.

15

Atthebeginningoftheclassperiod,DefendantshadalreadywrittendowntheLong

16

Positionby$300millionasaresultoftheweakeningmarket.Whilethatwritedown

17

didnotexceedgainsfromtheShortPosition,itdidcatchtheDefendantsattention,

18

andMorganStanleyorderedstresstestsontheLongPositionandtheninitiateda
23

task force to find strategies to sell off its assets that were placed at risk by the

collapseofthesubprimemarket.Atthemotiontodismissstage,theseallegations

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

trend[]...that[was]reasonablyexpectedtohavematerialeffectsonthecompanys

financialposition.ExchangeActReleaseNo.6835,1989WL1092885at*4(emphasis

omitted)(describingreductionintheregistrantsproductprices;erosioninthe

registrantsmarketshare;changesininsurancecoverage;orthelikelynonrenewal

ofamaterialcontractasexamplesofcurrentlyknowntrends).

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,anditspotentialnegativelytoaffectMorganStanley.ButMorganStanleys

12

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

13

filings,andoftenunconnectedtothecompanysfinancialposition.Suchgeneric

14

cautionarylanguagedoesnotsatisfyItem303.SeePantherPartners,681F.3dat122.

15

TheSEChasemphasizedthatItem303requiresnotonlyadiscussionbutalsoan

16

analysis of known material trends, and that disclosure is necessary to an

17

understanding of a companys performance, and the extent to which reported

18

financial information is indicative of future results. Commission Guidance

24

Regarding Managements Discussion and Analysis of Financial Condition and

ResultsofOperations,ReleaseNos.338350,3448960,68Fed.Reg.75056,75061

(Dec.29,2003)[hereinafterReleaseNo.3448960].Plaintiffshaveadequatelyalleged

thatMorganStanleyspatchworkcommentaryontherelevantmarkettrendsdidnot

liveuptothatobligation.

Thatisnottosay,however,thatMorganStanleysdisclosureobligationswere

asextensiveasthedistrictcourtdecided.Aswehaveemphasized,Item303requires

disclosureofaknowntrendandthemannerinwhichitmightreasonablybe

expectedtomateriallyimpactacompanysoverallfinancialposition.Litwin,634

10

F.3dat71819.6TheSEChascautionedthatthisobligationrequiresquantitative

11

information only when it is reasonably available and will provide material

12

information for investors. Release No. 3448960, 68 Fed. Reg. at 75062, 75065.

13

Contrarytothedistrictcourtsview,theCommissionhasnevergonesofarasto

14

requireacompanytoannounceitsinternalbusinessstrategiesortoidentifythe

TheSECdistinguishesrequireddisclosuresaboutcurrentlyknowntrends...
thatarereasonablyexpectedtohavematerialeffectsandoptionalforwardlooking
disclosure[s]thatinvolve[]anticipatingafuturetrend...oranticipatingaless
predictableimpactofaknownevent,trendoruncertainty.ExchangeActReleaseNo.
336835,1989WL1092885,at*4.Anyforwardlookinginformationsuppliedis
expresslycoveredbythesafeharborruleforprojections.17C.F.R.229.303(a),
Instruction7.
25

particularsofitstradingpositionssuchastheLongPosition.Thisisinlinewiththis

Courts reluctance to interpret the securities laws in a manner that requires

companiestogivecompetitorsnoticeofproprietarystrategiesandinformation.See

SanLeandroEmergencyMed.Grp.ProfitSharingPlanv.PhilipMorrisCos.,75F.3d801,

809(2dCir.1996).Therefore,insteadofbeingrequiredtodisclosethedetailsofthe

LongPosition,underItem303,MorganStanleyneededtodiscloseonlythatitfaced

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

significantexposuretothosemarkets,andthatifthetrendscametofruition,the

companyfacedtradinglossesthatcouldmateriallyaffectitsfinancialcondition.7

10

ThePlaintiffs,moreover,whileadequatelyallegingthatDefendantsbreached

11

theirItem303dutytodisclose,didnotadequatelypleadaclaimunderSection10(b).

12

ForDefendantsbreachoftheirItem303dutytobeactionableunderSection10(b),

13

Plaintiffswererequiredadequatelytopleadeachelementofa10b5securitiesfraud

14

claim.Thesecondamendedcomplaintdoesnotaccomplishthatgoal.Weassume,

15

withoutdeciding,thatMorganStanleysfailuretodisclosepursuanttoItem303met

16

the materiality threshold established by Basic. The Plaintiffs exposure claim

Asdiscussedsupra,however,MorganStanleywasrequiredtoconnectthe
trendstoitsfinancialpositionandtooffermorethangenericcautionarylanguage.
PantherPartners,681F.3dat122.
26

nonethelessfailsbecausethesecondamendedcomplaintdoesnotgiverisetoa

stronginferenceofscienter.

ThePrivateSecuritiesLitigationReformAct,15U.S.C.78u4(b),subjects

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

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

inference that the defendant acted with the required state of mind. Id. 78u

4(b)(2)(A).Thisrequirementcanbesatisfiedbyallegingfacts(1)showingthatthe

defendantshadbothmotiveandopportunitytocommitthefraudor(2)constituting

strongcircumstantialevidenceofconsciousmisbehaviororrecklessness.ATSI

10

Commcns,493F.3dat99.Here,PlaintiffsrelysolelyontheDefendantsalleged

11

conscious misbehavior or recklessness and therefore must show conscious

12

recklessnessi.e.,astateofmindapproximatingactualintent,andnotmerelya

13

heightenedformofnegligence.S.CherrySt.,LLCv.HennesseeGrp.LLC,573F.3d

14

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

15

(emphasisomitted).Weconsiderthecomplaintinitsentiretyandtakeintoaccount

16

plausibleopposinginferences.Tellabs,Inc.v.MakorIssues&Rights,Ltd.,551U.S.

17

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

18

compellingasanyopposinginferenceonecoulddrawfromthefactsalleged.Id.
27

at324;seeTeamstersLocal445FreightDiv.PensionFundv.DynexCapitalInc.,531F.3d

190,195(2dCir.2008).

Thedistrictcourtcorrectlyruledthatthesecondamendedcomplaintdoesnot

includesufficientfactstogiverisetoastronginferenceofscienterastothematter

omittedfromthe10Qfilings.Tomeetthatrequirement,Plaintiffsmustallegethat

Defendants wereatleastconsciouslyrecklessregardingwhethertheirfailureto

provideadequateItem303disclosuresduringthesecondandthirdquartersof2007

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

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

10

(concludingthat,toadequatelypleadscienter,plaintiffsmustpleadfactsshowing

11

thatdefendantsknewanomissionwasmaterial).Here,Plaintiffsmakeallegations

12

aboutdevelopmentsinthesubprimemarket,internalconcernaboutcapitalcallsand

13

writedownsontheLongPosition,andthecreationofataskforcetoinvestigate

14

sellingoffsomeofMorganStanleyssubprimepositions.Butthesefactsdonot

15

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

16

disclosures.SouthCherrySt.,573F.3dat109(emphasisomitted).Specifically,while

17

thecomplaintmakesoutthatMorganStanleywasintheprocessofassessingthe

18

risktoitsproprietarytradeduringthesecondandthirdquartersof2007,itissilent
28

aboutwhenemployeesrealizedthatthemorepessimisticassessmentsofthemarket

werelikelytocometofruitionandthattheywouldbeunabletoreducetheLong

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

anotherMorganStanleyemployee,NealShear,tocuttheLongPositionregardless

ofthelikelihoodthatthepessimisticassumptionsofthestresstestwouldcometo

pass. See J.A. 477 (I dont care what your view of probability [sic] is. Cut the

position.).Themeetingsabouttheproprietarytradeshowsimilarcaution:Morgan

Stanleys task force discussed strategies to reduce the Long Position while also

developingabettersenseoftherangeoflossesthecompanycouldface.J.A.485.

10

GiventherigidityofForm10Qfilingdeadlines,wefindnobasistoinferanything

11

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

12

Stanleys 10Qs would mislead investors about these internal deliberations,

13

especiallyaftertakingintoaccountthatMorganStanleywasalsoprofitingfromthe

14

decliningmarketthroughitsShortPosition.SeeSouthCherrySt.,573F.3dat109;see

15

alsoKalnitv.Eichler,264F.3d131,144(2dCir.2001)(holdingthatwhereacomplaint

16

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

17

strongevidenceofconsciousmisbehaviororrecklessness).

29

Moreover,aswedecideinthesummaryorderissuedintandemwiththis

opinion,MorganStanleysaffirmativestatementsaboutitsexposuretothemortgage

securitiesmarketduringtherelevanttimeperiodwerenotmisleading.Cf.Matrixx,

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

issuedapressreleasethataffirmativelymisrepresentedfacts).Andthecompany

didfullyreportitsexposuretomortgagesecuritiesbackedbysubprimeloansin

November2007lessthanamonthafteritsthirdquarterfilingandamonthin

advanceofthenextquarterlyreport.SeeRombachv.Chang,355F.3d164,176(2dCir.

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

10

inferencethatdefendantsactedrecklessly);Novak,216F.3dat30809(explainingthat

11

scientershouldnotbefoundwheredefendantsmerelyshouldhaveanticipated

12

futureeventsandmadecertaindisclosuresearlierthantheyactuallydid).The

13

mostcogentinferencefromtheseallegations,intandemwithassertionsabout

14

MorganStanleysinternaldeliberations,isthat[thecompany]delayedreleasing

15

informationonitsForm10Qsinthesecondandthirdquartersof2007tocarefully

16

reviewalloftherelevantevidenceandwasatworstnegligentastotheeffectofthe

17

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

18

omitted).BecauseareasonablepersonwouldnotdeemtheinferencethatMorgan
30

Stanleywasconsciouslyrecklessaboutwhetheritsmandatedfilingswouldmislead

investorsatleastascompellingasthisopposinginference,weconcludethatthe

Plaintiffshavenotadequatelypledscienter.Tellabs,551U.S.at324.
CONCLUSION

4
5

Tosummarize:

(1)Weconcludethat,asamatteroffirstimpressioninthisCourt,a
failuretomakearequireddisclosureunderItem303ofRegulationSK,
17 C.F.R. 229.303(a)(3)(ii), in a 10Q filing is an omission that can
serve as the basis for a Section 10(b) securities fraud claim, if the
omission satisfies the materiality requirements outlined in Basic v.
Levinson,485U.S.at224,andifalloftheotherrequirementstosustain
anactionunderSection10(b)arefulfilled.

7
8
9
10
11
12
13
14
15
16
17
18

(2)PlaintiffshaveadequatelyallegedthatDefendantsbreachedtheir
Item303dutytodisclosethatMorganStanleyfacedadeteriorating
subprimemortgagemarketthat,inlightofthecompanysexposureto
themarket,waslikelytocausetradinglossesthatwouldmaterially
affectthecompanysfinancialcondition.

19
20
21
22
23
24
25

(3)Weassumewithoutdecidingthatthisomissionmetthemateriality
thresholdestablishedbyBasic.However,wedonotagreewiththe
district court regarding the extent of Morgan Stanleys disclosure
obligations.Specifically,theCommissionhasnevergonesofarasto
requireacompanytoannounceitsinternalbusinessstrategiesorto
identifytheparticularsofitstradingpositions.

26
27
28
29
30

(4) The district court properly dismissed Plaintiffs claim that

DefendantsomissionsviolatedSection10(b)andRule10b5,because
thesecondamendedcomplaintdoesnotgiverisetoastronginference
ofscienter.
31

Fortheforegoingreasons,andforthereasonsstatedinthesummaryorderissued

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

AFFIRMED.

32