Even the most experienced securities defense attorneys regularly summarize Rule 10b-5(b) as creating a cause of action for “false or misleading statements and omissions of material fact.” Courts –including the Supreme Court – routinely use the same shorthand. When I was a new securities litigation defense attorney, one of the first things that I learned was the importance of adding the rest of the sentence: “false or misleading statements and omissions of material fact necessary to make statements made not misleading.”
One of the most common misconceptions about the federal securities laws is that Rule 10b-5(b) creates a cause of action for omissions as well as for false or misleading statements. But by the express terms of the rule, and Supreme Court precedent, omissions are only actionable if they cause an affirmative statement to be false or misleading because of the information that was omitted. In other words, when a claim is based upon an alleged omission, it is not enough for a plaintiff to demonstrate that something was omitted, or even that the omitted fact was material. Rather, in order to state a cause of action, the omitted information must have made an affirmative statement materially misleading by creating “an impression of a state of affairs that differs in a material way from the one that actually exists.” See Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).
It is understandable that plaintiffs’ attorneys would try to obscure this standard. If all they needed to establish was that material information was omitted, it would be relatively easy to bring a successful claim. No matter how much is disclosed, you can always find something that was omitted, and the squishy standard for materiality leaves plenty of room to make a case that the omission was material. But the key to many successful motions to dismiss is to hold plaintiffs to the text of the rule: whether they are alleging an affirmative lie, or a lie by omission, they must point to a statement that was false or misleading.
In the building frenzy among securities attorneys over the possible consequences of the Supreme Court’s upcoming ruling in Halliburton Co. v. Erica P. John Fund, this key distinction has been widely forgotten. As attorneys contemplate the possible demise of the fraud-on-the-market presumption laid down in Basic v. Levinson, there is wide speculation about how, in the face of such a ruling, securities class actions might continue. (See Doug Greene’s discussion of the possible impact of Halliburton.) One theory that has been repeatedly put forward by defense attorneys and legal commentators is that plaintiffs’ attorneys could cast their claims as alleging only material omissions, rather than false or misleading statements. The theory is that this approach would allow plaintiffs to sidestep the formidable obstacle of proving class-wide reliance in the absence of the fraud-on-the-market presumption, by taking advantage of a Supreme Court ruling that indicated that proof of reliance was not necessary to support a claim based on omissions. See Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972).
Wrote one securities litigation defense firm: if the Halliburton court rejects the fraud-on-the-market presumption, “plaintiffs could turn to the Affiliated Ute presumption, in which a plaintiff can avoid pleading actual reliance in a case framed as a material omission . . .The Affiliated Ute presumption will allow plaintiffs’ lawyers to recast their affirmative misrepresentation claims as pure omission claims, which do not need to rely on the fraud-on-the-market presumption to proceed.. . .Parties will vigorously litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.”
But Affiliated Ute does not offer a quick fix to the potential elimination of Basic’s fraud-on-the-market presumption. Affiliated Ute did not involve public statements or the securities markets, much less a securities class action under Rule 10b-5(b). Rather, it involved face-to-face transactions among a relatively small group of individuals related to the allocation of Native American mineral rights. The Affiliated Ute Court found that the defendants had failed to disclose material information to Native Americans as part of a fraudulent scheme to induce them to sell their mineral rights below market value. The Court found that this created liability under Rule 10b-5(a) and (c), the subsections of the rule that create liability for a fraudulent “device, scheme, or artifice” or “practice or course of business.” In these circumstances, the Court held that causation was established, and the plaintiffs did not need to prove “reliance” on the material omissions.
The Affiliated Ute ruling is thus based on the existence of a material omission as part of a fraudulent scheme. But as the Supreme Court pointed out in Basic, and recently reaffirmed in Matrixx: “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.” Basic, Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988); Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1322 (2011). No matter how material it might be, an omission is not actionable unless there is a duty to disclose. See, e.g., In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993) (“[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.”). There are specific circumstances under which such a duty to disclose might arise – for example, when there is a fiduciary relationship between the parties, if an insider is trading stock, or under Items 303 or 503 of Regulation S-K relating to public offerings.
But Rule 10b-5(b), the traditional territory of securities class actions, imposes no such requirement. For this reason, as several courts have pointed out, the “presumption” of reliance on material omissions that developed from Affiliated Ute does not implicate core securities fraud claims. See, e.g., Regents of the University of California v. Credit Suisse First Boston, 482 F. 3d 372, (5th Cir. 2007) (clarifying that Affiliated Ute does not apply to actions for misrepresentations under Rule 10b-5(b)). Thus, plaintiffs cannot simply recast their securities fraud allegations as “omissions,” as many commentators have suggested, and cause the parties to have to “litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.” Plaintiffs may only state a claim under 10b-5(b) based on an affirmative misstatement – whether that affirmative statement was misleading because of what it said, or because of what it did not say.
Under Affiliated Ute itself, the presumption of reliance on omissions is only invoked under Rule 10b-5 if there is proof of a fraudulent “course of business” or a “device, scheme or artifice that operated as a fraud” – under the Rule’s little-used subsections (a) and (c). Do these subsections – which are not necessarily dependent upon affirmative misstatements – create a route for plaintiffs to find a way around the potential rejection of the fraud-on-the-market presumption? Maybe in some cases, where plaintiffs are able to allege additional facts necessary to show some form of “scheme” liability under these subsections. See Credit Suisse, 482 F.3d at 384 (“Merely pleading that defendants failed to fulfill [a duty to disclose] by means of a scheme or act, rather than by a misleading statement, does not entitled plaintiffs to employ the Affiliated Ute presumption.”). But that potential “solution” raises more questions than it answers, since the law surrounding these subsections is far less developed that the law of Rule 10b-5(b), and incorporates a number of additional complexities.*
One thing is clear. Affiliated Ute does not offer a straightforward solution for plaintiffs’ lawyers if the Halliburton Court takes away the fraud-on-the-market presumption. Whether they phrase their allegations as claims of affirmatively false statements or statements made false by omission, they are still claims based on statements, not omissions, and current law requires that plaintiffs find a way to show class-wide reliance.
* For example, the courts have established that Rule 10b-5 imposes a duty to disclose material nonpublic information on a defendant who sells stock. But this “omission” claim is difficult for plaintiffs’ lawyers to bring, because a plaintiff must be a contemporaneous buyer to have standing – which generally means the plaintiff must have purchased stock in the few days surrounding when the defendant sold. The standing requirement also restricts damages for such a claim to a class of contemporaneous purchasers – a much smaller group than the typical class in a securities class action arising out of a false or misleading statement, which can include purchasers of stock over a period of several years.