Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, May 29, 2012

Second Circuit Interprets Disclosure Obligations under Item 303 of Reg S-K

The Second Circuit has issued several opinions interpreting the disclosure obligations created by Item 303 of Regulation S-K, which requires registrants to "describe any known trends or uncertainties ... that the registrant reasonably expects will have a material ... unfavorable impact on ... revenues or income from continuing operations."  Panther Partners Inc. v. Ikanos Communications, Inc. (decided May 25, 2012)(Download PantherPartners.052512[2]) is the latest in this line of cases.  Plaintiff appealed a federal district court order that dismissed its third complaint alleging violations of Securities Act 11, 12(a)(2) and 15 in connection with a March 2006 secondary offering of Ikanos Communications stock.  In contrast to the district court, the appeals courts held that the complaint stated a claim because it plausibly alleged that defects in the company's semiconductor chips constituted a known trend or uncertainty that the company reasonably expected would have a material unfavorable impact on revenues.

As alleged in the complaint, in 2005 Ikanos sold chips to Sumitomo and NEC, its two largest customers and the source of 72% of its 2005 revenues.  They in turn incorporated the chips into products that were sold to NTT and installed in its network.  In early 2006 Ikanos learned that the chips were defective and were causing the network to fail, with the complaints increasing in the weeks preceding the March 2006 offering.  Indeed the board of directors met and discussed the problem, and company representatives regularly traveled to Japan to meet with Sumitomo and NEC to discuss the problem.  Ultimately, the company had to replace at its expense all of the units sold, resulting in substantial losses.  

Plaintiff alleged that the company did not adequately disclose in its Registration Statement the magnitude of the problem and instead provided a generic cautionary warning that "highly complex products ... frequently contain defects and bugs..."  The district court had previously dismissed the complaint twice and denied plaintiff's motion to file another amended complaint because it failed to allege "additional facts that Ikanos knew the defect rate was above average before filing the registration statement."  In vacating the district court's judgment, the appeals court held that it construed the proposed complaint too narrowly:

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.

The appeals court emphasized two allegations in the amended complaint that it considered critical: (1) Sumitomo andNEC accounted for 72% of revenues and (2) Ikanos knew when it was receiving the complaints that it would be unable to determine which chip sets contained defective chips. From these facts, two reasonable and plausible inference could be drawn: Ikanos would have to replace and write off a large volume of chip sets and it had jeopardized its relationship with the two customers that accounted for the vast majority of its revenues.

In light of these allegations, the Registration Statement's generic cautionary language did not fulfill the company's duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks before the offering.  The court had "little difficulty concluding that Panther has adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303."

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