Securities fraud class action litigation—where investors sue after a company announces bad news and its stock price drops—is commonplace these days, but these suits rest on a shaky historical basis.

The US Supreme Court, relying on the history of the securities laws, could reject an expansion of securities fraud claims in a case to be argued later this term, Macquarie Infrastructure Corp. v. Moab Partners, LP.  

Right to Sue

Some historical context is helpful to understand the stakes in the high court case. In 1933, Congress enacted the Securities Act. It requires most securities to be registered and prohibits selling securities via false or misleading documents.

In 1934, Congress enacted the Securities Exchange Act, which created the Securities and Exchange Commission. Section 10(b) prohibits securities fraud—“any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors.” 

In 1942, acting under Section 10(b), the SEC adopted Rule 10b-5, which prohibits making false or misleading statements and schemes to defraud. Almost all securities fraud cases are brought under Rule 10b-5 and since 1998 securities class actions can be brought only under federal law, not state law.

Section 10(b) and Rule 10b-5, however, do not mention any explicit right for an investor to sue for securities fraud. This gap—so to speak—was filled by a 1971 Supreme Court decision. It adopted rulings that implied a right to sue for a violation of Section 10(b) and Rule 10b-5 even though neither contains explicit language to that effect.

Since then, for the most part, Congress has left it to the courts to debate the scope of the implied right of action. The Supreme Court has returned to the debate in Macquarie.

New Cases

Macquarie centers on a different SEC regulation: Item 303 of Regulation S-K. It requires companies to disclose “known trends or uncertainties” that had or are reasonably likely to have a material impact on financial performance. 

When a company announces bad news, investors sometimes contend that it reflected a trend the company knew much earlier and had to disclose under Item 303. They claim the company committed securities fraud by failing to disclose that trend under Item 303.

Courts have divided on allowing this type of claim. Item 303 is different from Section 10(b) and Rule 10b-5. They prohibit companies from lying and from omitting material facts that undermine their statements to investors. But they don’t require companies to provide information to investors—even if information is important (material).

The defendants in Macquarie also claim it is a bad idea to allow securities fraud lawsuits based on Item 303. They say it is difficult to decide whether there has been a “trend” and if so whether it will continue and have an impact on performance. Allowing lawsuits based on Item 303 makes it too easy to sue companies that simply fail to predict the future, and encourages companies to disclose too much information lest they be accused of missing a “known trend.”

The Supreme Court could resolve this disagreement in Macquarie. In addition to policy considerations, there is a historical argument that supports the defendants. It is that Item 303 is not a securities fraud regulation at all.

An amicus brief supporting the defendants partly makes this point. It states that Rule 10b–5 was adopted under the Exchange Act and Item 303 was adopted under the Securities Act.

Actually, Item 303 also was adopted under parts of the Exchange Act. The key point, though, is that the SEC did not adopt Item 303 under the part of the Exchange Act that prohibits fraud—Section 10(b).

This was not an accident. The SEC issued an explanatory release when it adopted Item 303 that refers to Section 10(b) in an unrelated context. Yet the SEC did not cite Section 10(b) as authority for adopting Item 303 even as it cited six other sections of the Exchange Act. The same was true when the SEC amended Item 303.

As a result, the court decisions that implied an anti-fraud right of action under Rule 10b-5 as adopted under the anti-fraud Section 10(b) statute don’t apply to Item 303: Item 303 isn’t an anti-fraud regulation and Item 303 wasn’t adopted under Section 10(b).

No Statutory Private Right of Action

There are potential counter-arguments. For example, Section 10(b) applies to regulations the SEC “may prescribe as necessary or appropriate in the public interest.” A regulation such as Item 303 can be in the public interest even if it isn’t an anti-fraud regulation.

However, this doesn’t change the fact that the SEC itself didn’t consider Item 303 to be an anti-fraud regulation when it adopted and amended it. It also doesn’t address the other statutes under which Item 303 was adopted. This is important due to other parts of securities litigation history. 

At the time the Supreme Court recognized the Section 10(b) and Rule 10b-5 right of action, courts implied a right of action from a statute or SEC rule if allowing private lawsuits would help enforce the statute.

Starting around 1975, the Supreme Court changed its approach. It now focuses on the text of the statute at issue. For example, in 1979, the Supreme Court refused to imply a right to sue under Section 17(a) of the Exchange Act. The “language of the statute itself” didn’t “purport to create a private cause of action in favor of anyone.” In contrast, Congress had expressly created private rights of action in three other parts of the Exchange Act.

To our knowledge, no court has held that the statutes under which Item 303 was adopted allow a private right of action for securities fraud. Without this type of legal foundation, Item 303 shouldn’t be allowed to support a securities fraud claim.

The case is Macquarie Infrastructure Corp. v. Moab Partners LP, U.S., No. 22-1165.