Second Circuit: Failure to Disclose "Known Uncertainties" States Securities Claim

Second Circuit: Failure to Disclose "Known Uncertainties" States Securities Claim

In a May 25, 2012 decision in a long-running case that, among other things, could have important implications for the lawsuits recently filed against Facebook, the Second Circuit reversed the lower court's dismissal of the securities suit involving Ikanos Communications, holding that the plaintiff's proposed amended complaint "plausibly alleged that the [undisclosed] defects constituted a known trend or uncertainty that the Company reasonably expected would have a material unfavorable impact on revenues." A copy of the Second Circuit's May 25 opinion can be found here.


As discussed at greater length here, the Ikanos lawsuit relates to problems the company was having with defects concerning certain of the company's semiconductor chips at or about the time the company completed a $120 million secondary offering in March 2006. The plaintiffs allege that the company first learned there were quality issues with the chips in January 2006. They allege that the issues became more pronounced in the weeks leading up to the offering, as the company received more complaints. The complaint alleges that the company's board discussed the problems.

The plaintiffs allege that the company's offering documents did not disclose the magnitude of the defects issue. Ultimately, the company determined that the particular chips had an "extremely high" failure rate, and the company agreed to replace all of the units it had sold. The company later reported a net loss, and its share price declined. After the company's CEO resigned, plaintiffs filed suit.

The district court dismissed the plaintiff's initial complaint for failure to state a claim, concluding that the "no plausibly pleaded fact suggests that Ikanos knew of should have known of the scope of the magnitude of the defect problem at the time of the Secondary Offering." The plaintiff moved for reconsideration, offering a proposed amended complaint, which included the specific allegation that the defect problem was becoming more pronounced in the weeks leading up to the offering. The district court denied the motion for reconsideration, reiterating the view that no plausibly pleaded fact suggested that the company knew of should have known of the magnitude of the defect problem at the time of the offering.

The plaintiffs appealed. In a September 2009 Summary Order, the Second Circuit vacated the district court's judgment denying the motion for reconsideration, noting that "it seems to us plausible that [the plaintiff] could allege additional facts that Ikanos knew the defect rate was above average." The Second Circuit urged on remand for the district court to "consider all possible amendments."

On remand, the district court again denied the plaintiffs leave to replead, finding that the plaintiff's proposed amended complaint failed to allege that the company knew that prior to the offering that the defect rate was above average. The plaintiffs again appealed.

The May 25 Opinion

In a May 25, 2012 opinion written by Judge Barrington Parker, Jr.  for a three-judge panel, the Second Circuit reversed the district court and remanded the case back to the district court.

The Second Circuit said that in focusing on whether or not the defect rate was known to be above average prior to the offering, the district court had focused on the wrong issue. Rather, the district court should have "addressed the question of whether, in failing to disclose the scope of the defect issue with which Ikanos was then grappling, defendants concealed a 'known trend or uncertainty that {Ikanos] reasonably expected would have a material unfavorable impact on revenues or income" as was required by Item 303 under Regulation S-K.

The Second Circuit said:

We believe that, viewed in the context of Item 303's disclosure obligations, the defect rate, in a vacuum, is not what is at issue. Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.

Citing its own February 2010 opinion in Litwin v. The Blackstone Group, the Second Circuit held that the plaintiff's proposed amended complaint "plausibly alleges that the defect issue, and its potential impact on Ikanos's business, constituted a known trend or uncertainty that Ikanos reasonably expected would have a material unfavorable impact on revenues or income from continuing operations." The plausible inferences were not simply that it might have to replace a large number of chipsets; rather it was that  there were a number of "known uncertainties" that could materially impact revenues. The Court said that it had "little difficulty concluding" that the plaintiff had "adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303."


This decision obviously represents a significant victory for the plaintiff in the case, as the plaintiff has after a series of long procedural battles secured the right to go forward with their case. The decision also represents a demonstration of the usefulness to securities plaintiff of pleading in reliance on Item 303 that a company failed to disclose a known risk, trend or uncertainty. As Lyle Roberts observed on his blog The 10b-5 Daily at the time when the Second Circuit issued its opinion in Litwin v. The Blackstone Group, on which the Second Circuit relied in the Ikanos decision, pleading in reliance on Item 303 may represent an attractive opportunity for plaintiffs.

The Ikanos decision illustrates the attributes that make Item 303 attractive to plaintiffs. The Second Circuit was not as concerned whether or not the plaintiff's allegations were factually specific (as would relate, for example to the known defect rate). Rather the court was more concerned that the plaintiffs had alleged that there were "known uncertainties" that could materially impact revenues.

The defendants' argument in this case that there were no allegations that the defect rate was "above average," and therefore there was no need for further disclosure of the defect reports, has echoes of the argument that the U.S. Supreme Court rejected in the Matrixx Initiatives case (about which refer here) . The defendants had argued in that case that adverse product reports must be "statistically significant" in order for a manufacturer to have an obligation to disclose the reports to investors. In both the Supreme Court's Matrixx Initiatives decision and the Second Circuit's ruling in Ikanos, the courts rejected the argument that there is a mathematically identifiable threshold that determines whether or not disclosure of adverse information is required.

One very recent and high profile case in which this line of cases could prove to be helpful is the securities litigation filed last week in connection with the Facebook IPO. In the complaints filed so far, the plaintiffs' main allegation is that Facebook failed to disclose in its IPO offering documents that it was experiencing a reduction in revenue growth due to an increase of users of its Facebook app or website through mobile devices rather than traditional PCs. The plaintiffs further allege that this information was selectively disclosed to key institutional investors but not to the investing public.

The Facebook  plaintiffs (or at least those that are proceeding in the S.D.N.Y., which is within the Second Circuit) will allege that this revenue downturn was material and should have been disclosed; they will argue further in reliance on Ikanos and Litwin that the question is not whether the extent of the revenue downturn was precisely known and undisclosed; the question rather should be whether the revenue downturn represented a known trend or uncertainty that could material impact the company's results.

Of course, it remains to be seen whether and to what extent this line of cases will prove to make a difference in the Facebook case itself. But the cases could be valuable for plaintiffs in general in securities  cases where the plaintiff allege that the defendant company failed to disclosure a known risk, trend or uncertainty. It seems likely that these cases will encourage plaintiffs to rely on Item 303 in pleading their claims.

Victor Li's May 25, 2012 Am Law Litigation Daily article about the Ikanos decision can be found here. Special thanks to a loyal reader for sending me a copy of the Second Circuit's opinion.

Judge Kaplan Approves $90 Million Lehman Brothers D&O Settlement: As I discussed in a prior post (here, scroll down), Southern District of New York Judge Lewis Kaplan had stirred some attention through his initial refusal to approve a proposed $90 million settlement of the Lehman Brothers securities class action suit - a settlement to be funded entirely with D&O insurance, without the individual defendants making a cash contribution - and directing the parties to provide to him the information an independent expert had reviewed in concluding that the individual defendants did not have aggregate liquid net worth in excess of $100 million.

Lead plaintiffs' counsel had offered the expert's report in support of their contention that the plaintiff' class would not be better off if the lead plaintiff continued to pursue the individual defendants rather than just accepting the remaining $90 million D&O insurance in settlement of the case. Judge Kaplan felt that in order to determine the appropriateness of the settlement, he needed to review in camera the financial information on which the expert relied.

In a May 24, 2012 opinion, written following his review of the financial information, Judge Kaplan approved the proposed $90 million settlement. With respect to financial information he reviewed, Judge Kaplan said:

The Court has reviewed the essential documents filed in camera in order to make a practical judgment about whether it is reasonable to compromise this case, rather than pursuing it, in light of both the likelihood of ultimate success and the likelihood in the event of success of collecting the eventual judgment give the resources of those defendants as to who information is reasonably available. While some may be concerned at the lack of any contribution by the former director and officer defendants to the settlement, Lead Counsel's judgment that the $90 million bird in the hand is worth at least as much as in the bush, discounted for the risk of an unsuccessful outcome of the case, is reasonable.

Susan Beck's May 25, 2012 Am Law Litigation Daily article about Judge Kaplan's order can be found here.

The Latest FDIC Failed Bank Lawsuit: In what is the first failed bank lawsuit the FDIC has filed in several weeks, on May 24, 2012, the FDIC as receiver of the failed Innovative Bank of Oakland, California filed a complaint in the Northern District of California against 14 of the bank's former directors and officers. A copy of the FDIC's complaint can be found here.

Innovative Bank failed on April 16, 2010. In its lawsuit, the FDIC seeks to recover "not less than $7.1 million" the FDIC alleges the bank lost in connection with lending activities on eleven commercial loans and forty-three Small Business Administration loans. The complaint asserts claims for negligence, gross negligence and breach of fiduciary duty against the individual defendants, and also asserts fraud against one officer defendant, as discussed below.

The complaint alleges that the defendants "in violation of repeated and serious regulatory warnings, were grossly negligent and in breach of their fiduciary duties by failing to supervise the lending function at the Bank," and were negligent, grossly negligent and in breach of fiduciary duties by "repeatedly permitting unsound underwriting practices and violations of written loan policies."

The complaint also alleges claims of $3.3 million against one officer defendant for his "perpetration of a fraudulent scheme within the Bank's SBA program for his own financial gain." Two other defendants, the Bank's CEO and Chief Lending Officer, are separately charged with negligence and gross negligence for hiring the lending officer who is accused of fraud and for retaining him as an officer "despite serious red flags and concerns being raised about the performance of his duties."

This latest lawsuit is the 30th the FDIC has filed so far as part of the current wave of bank failures, but the first that the FDIC has filed since April 20, 2012. Earlier this year there had been a flurry of FDIC litigation filings but for the last several weeks there had been something of a lull. The FDIC has continued to increase its web site listing of the number of authorized suits (about which refer here), by implication increasing further the backlog of cases yet to be filed. In any event with this new lawsuit, the FDIC has now filed 12 lawsuits this year. The latest lawsuit is the sixth that the agency has filed in connection with failed banks located in California. 

Special thanks to a loyal reader for providing a copy of the FDIC's latest complaint. subscribers can access the Lexis enhanced version of the Panther, 2012 U.S. App. LEXIS 10726 (2d Cir. May 25, 2012), decision with summary, headnotes, and Shepard's.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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