Chapter 3

• Jurisdiction: United States

Chapter 3 Materiality

Why Do We Care About "Materiality"?

As noted, securities markets are basically markets based on information but there can be a problem: too little or too much information can distort a market. To rectify that problem, the securities laws have developed the concept of "materiality." This concept is important in two different contexts. First, it used to define information that issuers or filers must publicly disclose and file with the SEC. Second, it acts as a definition of the types of misstatements or omissions that would constitute violations of the securities laws. Unfortunately, like the word "security" that we discussed in the preceding chapter, there is no definite or universal definition of the word "materiality."

What Is "Materiality"?

There is no definition of the word "materiality" in either the 1933 or the 1934 Act although, as we will see, the SEC has attempted various definitions in its rules. The prevailing definition comes from the Supreme Court case TSC Industries, Inc. v. Northway Inc., 426 U.S. 438 (1976): "An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. . . . Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." This test was similar but not exactly the same as the test articulated by the Seventh Circuit below. The Supreme Court substituted the word "would" for the word "might" in the Seventh Circuit test.

Some observers believe that the Northway test had two parts, the "substantial likelihood" part and the "total mix" part. However, recall that according to Justice Thurgood Marshall, the "real nature of the question being asked is this: is there a substantial likelihood that the omitted information would have assumed actual significance in the deliberations of the reasonable investor?" Moreover, a close reading of the text makes it rather clear that the "total mix" part is merely one way of proving the "substantial likelihood" part. This is how the SEC reads the test, at least in some of its interpretations.

A few years after Northway, in Basic v. Levinson, 485 U.S. 224 (1988), the Supreme Court again endorsed the Northway test, making it clear that there was no "bright-line test" for materiality and that at least with respect to future events, "[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 the company activity." This became known as the "probability and magnitude" test of materiality.¹

And in Matrixx Initiatives Inc. v. Siracusano, 563 U.S. 27 (2011), the Supreme Court slightly modified the Northway test by changing the phrase "a substantial likelihood" to the phrase "it is substantially likely that . . ."

The Northway test raises more questions than it answers. For example, who is a "reasonable investor"? Does it have to be a person who buys and sells securities? Does the investor have to understand how securities markets operate and have a more than basic understanding of financial documents? What is a "substantial likelihood" or "substantially likely"? Does there have to be a more than fifty-fifty chance that the event will occur or that the reasonable investor would consider it important? How could a "substantial likelihood" be proved? What does "significantly altered" mean?

Because Northway remains the current test for "materiality," let's take a closer look at the case. National Industries merged with TSC and did not disclose in the proxy statement that National had already taken control of TSC. Northway brought claims under 1934 Act Rule 14a-3 alleging that the corporate defendants failed to mention in their proxies that a change in control had already taken place when certain interests in TSC were transferred to National. It also alleged under Rule 14a-9 that the proxy statement failed to include material information concerning (1) the degree of National's influence over the management of TSC, including the favorability of the terms of National's acquisition proposal to the TSC shareholders, and (2) the fact that its investment banker had submitted an opinion letter to the effect that the merger would be less profitable to the TSC shareholders than earlier predicted. The plaintiff moved for summary judgment, and the defendant National cross-moved for summary judgment. The district court denied both motions. The U.S. Court of Appeals for the Seventh Circuit affirmed the district court except that it found that the failure to include the investment banker's adverse opinion letter violated Rule 14a-9 as a matter of law and that the motion for summary judgment should have been granted on that claim.

What gave rise to the Supreme Court's review of the case was the Seventh Circuit's articulation of the proper test for materiality, that it should include "all facts which a reasonable stockholder might consider important . . . in the process of determining how to vote" (emphasis added). The question was whether "might" was the right test. It was not; the Supreme Court's new articulation did not include that word. The Supreme Court held that National's failure to include the banker's letter was not materially misleading as a matter of law, and therefore that Northway was not entitled to a decision of partial summary judgment on that claim.

Basic seemed to hold that materiality was a question of fact but some lower courts treat materiality determinations as questions of law. For example, Longman v. Food Lion Inc., 197 F.3d 675 (4th Cir. 1999), held that a company's omissions with respect to its labor and sanitary problems were well known to the market and therefore not material as a matter of law. The better view, according to most courts, is that materiality is a mixed question of law and fact. In Chadbourne & Parke LLP v. Troice, 571 U.S. 321 (2104), the Supreme Court held—in substance but not words—that the question was a mixed question of law and fact; the issue was whether the representation that the covered securities would be backed by uncovered securities was in fact not true, and whether in law the securities were "covered securities" under the Securities Litigation Uniform Standards Act. The test adopted by the Supreme Court was only a slight variation from the Northway test, that materiality is "something that makes a significant difference in a decision to buy or sell a security." Query: Is "significant difference" essentially the same as "substantial likelihood"?

In some cases, the difference between "material" and "immaterial" can be quite subjective. For example, in In re MCI WorldCom Securities Litigation, 93 F. Supp. 2d 276 (E.D.N.Y. 2000), the court held that a statement denying the existence of actual pending merger negotiations was material because the truth "might have given a reasonable investor pause." But in Philips v. LCI International, Inc., 190 F.3d 609 (4th Cir. 1999), the court held that the statement "We're not a company for sale" in the middle of merger negotiations was not material. Perhaps for this reason, few materiality determinations are made on a summary judgment motion.

A few additional points concerning materiality and class actions:

• In Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), the Supreme Court decided that to certify a class, the court need not decide whether the statement at issue was material, since that is a merits issue. But after Halliburton v. Erica P. John Fund, 573 U.S. 258 (2014) (Halliburton II), a defendant can defeat class certification by showing that the statement at issue did not have a price impact and therefore is not "material." This is discussed further in Chapter 10.
• Does a material misrepresentation always result in a price distortion or impact? Could the "price impact" be merely maintaining the stock price at a certain level? That question was posed to the Supreme Court in the Goldman Sachs case but the court declined to decide it. We will discuss that case at length in Chapter 10.
• In Matrixx Initiatives Inc., 563 U.S. 27 (2011), the court held that the fact that adverse reaction reports to the use of a nasal spray were not rendered immaterial even though there were not enough of them to be statistically significant.

Who Is a "Reasonable Investor"?

The courts do not provide a clear, simple answer to this question. This is the result of a disagreement with respect to who is the object of the securities law's disclosure regime: is it a sophisticated analyst or an unsophisticated investor? Many of the SEC's required disclosure forms are clearly not intended for the unsophisticated investor but for a professional analyst (see Wielgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989)). Others must be written in "plain English," obviously for the benefit of the less than fully sophisticated investor (see Securities Act Rule 421 (the "plain English" rule); Pinter v. Dahl, 486 U.S. 622 (1988)). In In re Merck & Co. Inc. Securities Litigation, 432 F.3d 261 (3d Cir. 2005), the court held that "reasonable investors are the market." Does that make sense? Is the "reasonable investor" similar to the "reasonable person" of tort law? Could a jury be expected to decide who a "reasonable investor" is without substantial additional jury instructions? Who decides? Although, as noted, materiality is a mixed question of law and fact, it is most often decided by the court, not a jury.

Perhaps the best definition of "reasonable investor" came from the...