September 20, 2020

Dismissal of Fraud Case Against Morgan Stanley Is Upheld


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Morgan-StanleyBy Mark Hamblett, New York Law Journal
The dismissal of a securities fraud class action alleging Morgan Stanley concealed its exposure to and losses during the subprime mortgage market meltdown has been upheld by a federal appeals court.
The U.S. Court of Appeals for the Second Circuit made new law as it said a lower court was right to dismiss the case against Morgan Stanley and six of its officers because plaintiffs alleging fraud failed to adequately plead scienter.
The court decided a case of first impression on the disclosure requirements of Item 303 of Regulation S-K, which include the obligation to disclose “any known trends or uncertainties” in Securities and Exchange Commission mandated quarterly Form 10-Q reports that the filer believes will have an “unfavorable impact” on revenues or income.
Judges Jose Cabranes (See Profile), Richard Wesley (See Profile) and Debra Ann Livingston (See Profile) held that the failure to make a required Item 303 disclosure in a 10-Q filing is an omission that can serve as a basis for a securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934.
The plaintiffs in Fjarde AP-Fonden v. Morgan Stanley, 13-0627-cv, alleged Morgan Stanley made misstatements and omissions in filings between June 20, 2007 and Nov. 19, 2007 that concealed their exposure to billions of dollars in losses in the subprime mortgage market.
Morgan Stanley had made huge bets in 2006 that were backed by subprime mortgages—the first was a $2 billion short position and the second was a $13.5 billion long position.
Morgan Stanley lost billions on the long position and lead plaintiffs State-Boston Retirement System and AP-Fonden said they suffered because the value of Morgan Stanley stock was artificially inflated due to the misrepresentations and omissions about both the exposure to credit risk and the amount of losses.
Southern Judge Deborah Batts (See Profile) dismissed the case and the plaintiffs appealed to the Second Circuit in 2013.
Writing for the circuit Monday, Livingston said, “This court and our sister circuits have long recognized that a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak.”
Citing the regulation, 17 C.F.R.§229.303(a)(3)(ii), Livingston said “a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties'” that could effect revenues.
“It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b),” she said.
The judge said the plaintiffs had adequately pleaded Morgan Stanley had an Item 303 duty to disclose it faced a deteriorating subprime mortgage market that could affect its financial condition.
But the planiffs failed to properly allege scienter—a connection between the omission and the purchase or sale of a security, reliance on that omission by the purchaser and a resulting economic loss.
To succeed, Livingston said, they had to allege defendants “were at least consciously reckless regarding whether their failure to provide adequate Item 3003 disclosures during the second and third quarters of 2007 would mislead investors about material facts.”
Instead, Livingston said the complaint itself showed that a top official ordered employees to cut Morgan Stanley’s long position and that an internal task force “discussed strategies to reduce the Long Position while also developing a better sense of the ‘range’ of losses the company could face.”
“Given the rigidity of the Form 10-Q filing deadlines, we find no basis to infer anything more than ‘a heightened form of negligence’ (if that) about whether Morgan Stanley’s 10-Qs would mislead investors about these internal deliberations, especially after taking into account that Morgan Stanley was also ‘profiting’ from the declining market through its short position,” she said.
And, as the court decided in an accompanying summary order also issued Monday, Livingston said, “Morgan Stanley’s affirmative statements about its exposure to the mortgage securities market during the relevant time period were not misleading.”
David Kessler of Kessler Topaz Meltzer & Check is lead counsel for plaintiff Fjarde AP-Fonden and for the class.
Partner Jonathan Plasse of Labaton Sucharow is lead counsel for plaintiff Boston Retirement System and the class.
Robert Wise, senior counsel at Davis Polk & Wardwell, argued for the defendants.
IMAGE: Morgan Stanley headquarters at 1585 Broadway Alan Wu
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