Chapter 14 - § 14.11 • THE CONCEPT OF MATERIALITY
| Jurisdiction | Colorado |
§ 14.11.1—General
Materiality is difficult to define, and is "one of the most unpredictable and elusive concepts of the federal securities laws."153 Nevertheless, the concept of "materiality" flows throughout the disclosure requirements of the federal securities laws. 1933 Act § 12(a)(2) imposes liability on any person who:
offers or sells a security . . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading . . . . [Emphasis added.]
Rule 10b-5 provides similarly, assessing liability against any person who makes "any untrue statement of a material fact or . . . omits to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, . . . in connection with the purchase or sale of any security." [Emphasis added.] Regulations S-K, S-B, and S-X, and other disclosure requirements are intended to ensure that all material facts are accurately and completely disclosed in registration statements and 1934 Act reports. A failure to accurately and complete disclose material facts will result in the risk of liability to all participants in the disclosure process.
The Colorado Court of Appeals approved a trial court's jury instruction that "[a] misrepresented or omitted 'fact' is considered 'material' if there is a substantial likelihood that a reasonable investor would consider the matter important in making an investment decision. Whether or not a misrepresented or omitted fact is important turns on whether a reasonable investor would regard it as significantly altering the total mix of information made available."154 Thus, materiality is quite an important concept in understanding the securities laws, but unfortunately it is a factual question that must be judged based on all of the surrounding facts and circumstances — leading to a holding such as "I know it when I see it."
The role of the materiality requirement is not to "attribute to investors a child-like simplicity, an inability to grasp the probabilistic significance of negotiations," Flamm v. Ederstadt, [814 F.2d 1169, 1175 (7th Cir. 1987)], but to filter out essentially useless information that a reasonable investor would not consider significant, even as part of a larger "mix" of factors to consider in making his investment decision.155
It is important to realize that disclosure obligations are moving targets. The requirements change with the circumstances, and the SEC's regulations only provide a guide, not the definitive requirement. The SEC has paid significantly more attention to the disclosure of environmental matters since the early 1990s, even though the specific requirement in Regulation S-K is nominal.156 As noted by Commissioner Roberts in a speech before the Dallas Bar Association in June 1992:
Environmental regulation imposes costs that may need to be disclosed to investors under federal securities laws. Compliance costs associated with regulations restricting development and limiting harmful emissions can have a material effect on a company's operating expenses. Environmental laws can also impose large liabilities, particularly with respect to past generators of waste materials.157
The SEC has commented that disclosure of environmental liabilities must be made by companies considered to be "foreign private issuers" as well as registered U.S. companies.158
In a criminal trial for insider trading, the U.S. District Court for the District of Colorado gave the following instruction to the jury to define "materiality":
If you should decide that a particular statement or a particular omission was false or misleading at the time that it was made, then you must determine if the fact stated or omitted was a "material" fact or a "material" omission under the evidence received in this case. In order for you to find a "material" fact or a "material" omission, the government must prove beyond a reasonable doubt that the fact misstated or the fact omitted was of such importance that it could reasonably be expected to cause or to induce a person to act or to cause or to induce a person not to act with respect to the securities transaction at issue. Information may be material even if it relates not to past events but to forecasts and forward-looking statements, so long as a reasonable investor would consider it important in deciding to act or not to act with respect to the securities transaction at issue. The securities fraud statute under which the charges are brought is concerned only with such "material" misstatements or such "material" omissions and does not cover minor, or meaningless, or unimportant ones.159
A 2007 article in the ABA's The Business Lawyer extensively discusses numerous aspects of materiality, recognizing that "[m]ateriality represents the dividing line between information reasonably likely to influence investment decisions and everything else."160 The article also recognizes that "[t]he concept of materiality is inherently situational. It takes on definition from the context. Therefore there is no formulation that will eliminate the facts-and-circumstances quality of materiality analyses."161 In a case brought against a company by a shareholder who sold his shares, the Sixth Circuit determined that preliminary acquisition discussions were, by their nature, immaterial.162 The court said, "[n]ot every business negotiation gives rise to a legal obligation."163
§ 14.11.2—The Balancing Test For Materiality; Basic Inc. v. Levinson
The cases, including TSC Industries, Inc. v. Northway, have held that a fact is "material" if there is a substantial likelihood that a reasonable investor would (not might) consider it important in reaching an investment decision (whether to buy, sell, or hold, or how to vote).164 In the context of a Rule 10b-5 action, the U.S. District Court for the Eastern District of Pennsylvania has said the test as to the materiality of undisclosed or misrepresented facts is an objective one, turning on "'whether a reasonable man would attach importance [to them] in determining his choice of action in the transaction.'"165 "Material facts include those that 'affect the probable future of the company and [that] may affect the desire of investors to buy, sell, or hold the company's securities.'"166
In Basic Inc. v. Levinson, Basic publicly denied that it was involved in merger negotiations at a time when there was heavy trading in its stock. Basic was, in fact, engaged in preliminary negotiations for a merger at the time. The lower courts found that, given the stage of the negotiations, the denial was wrong but immaterial. In reversing the lower courts, the Supreme Court held that when judging the materiality of an uncertain event, the venerable SEC v. Texas Gulf Sulphur167 formula should be applied. This required balancing:
• The probability that the event will take place, and
• The event's likely magnitude in light of the totality of the company's activity.
The Supreme Court said: "'[Materiality] will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of company activity.'"168
It is important to note that "materiality" as defined in TSC Industries and Basic Inc. (and their progeny) is not outcome-determinative — i.e., "If I had known that fact, I would not have invested."169 The test as to the materiality of undisclosed or misrepresented facts is an objective one, turning on "'whether a reasonable man would attach importance [to them] in determining his choice of action in the transaction.'"170
Whether a statement is material or misleading is not to be judged by hindsight, but rather by placing oneself in the position of the person making the statement, and is a fact-specific inquiry. For example, in Berliner v. Lotus Development Corp.,171 plaintiffs sued Lotus claiming that they bought stock at prices that were artificially high because of statements made by Lotus regarding the anticipated early release of enhancements to its spreadsheet program. The enhancements were released about a year after the initial announcements predicted. The court found that the delays were understandable, that the statements were not materially inaccurate when made, and that allegations in the complaint "disclose[d] no circumstances that might separate fraud from the benefit of hindsight."172 As described in Berliner.
[The] typical "fraud-by-hindsight" suit alleges that information concerning impending misfortune or its root causes was omitted from earlier management publications despite [the] fact that management then knew [the] information. Especially where, as here, a product is understood to be in development, plaintiffs may not assert merely that, because the product did not come out when projected, plans for an earlier release were false.173
In In re 2007 Novastar Financial Inc., Securities Litigation,174 the Eighth Circuit affirmed the district court's dismissal of the complaint without leave to amend, where the complaint failed to specify the allegedly misleading statements. The court went on to say that the complaint discussed the claimed wrongdoing in generalities and attempted to turn poor business decisions into fraud by hindsight.
§ 14.11.3—Staff Accounting Bulletin 99 And Other Accounting Guidance
Staff Accounting Bulletin 99 (Aug. 12, 1999) follows the balancing test for materiality found in Basic Inc.175 During the audit process, auditors review the company's financial statements and journal entries and frequently make adjustments to the company's financial statements. Some adjustments will likely be positive and others negative. Thus, one audit may have several dozen adjustments with...
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